Note 3 Purchase of Applied Optics Products Line

On November 3, 2014, Optex Systems, Inc. entered into a Purchase Agreement with L-3 Communications, Inc. (“L-3”) pursuant to which Optex purchased from L-3 the assets comprising L-3’s Applied Optics Products Line (“Purchased Assets”). Applied Optics (“AOC”) is primarily engaged in the production, marketing and sales of precision optical assemblies utilizing thin film coating capabilities for optical systems and components primarily used for military purposes. The Purchased Assets consist of personal property, inventory, books and records, contracts, prepaid expenses and deposits, intellectual property, and governmental contracts and licenses utilized in the business comprised of the Purchased Assets.

The purchase price for the acquisition was $1,013.1 thousand, which was paid in full at closing, plus the assumption of certain liabilities associated with the Purchased Assets in the approximate amount of $270.7. The source of funds for the acquisition consisted of Optex working capital of $213.1 thousand and an advance of $800 thousand from accredited investors which was subsequently consummated on November 17, 2014 through the private placement of convertible notes issued by Optex Systems Holdings in a transaction exempt from registration under Section 4(2) of the Securities Act. See Note 7 “Issuance of Convertible Notes”.

The asset acquisition met the definition of a business for business combinations under ASC 805-10-20. The following table reconciles the fair value of the acquired assets and assumed liabilities to the total purchase price of the Applied Optics Product Line Acquisition (in thousands):

The aggregate purchase consideration has been allocated to the assets and liabilities acquired, including identifiable intangible assets, based on their respective estimated fair values. The total assets acquired exceeded the total consideration paid, thus there is no goodwill associated with the asset purchase and the acquisition has been determined as a bargain purchase which requires immediate recognition of a gain on the purchased assets. The gain is reflected in earnings in Other Income on the Consolidated Statement of Operations as “Gain on Purchased Asset”.

The intangible assets include finite-life intangibles associated with undelivered customer backlog as of the acquisition date and was valued using the income approach methodology that includes the discounted cash flow method as well as other generally accepted valuation methodologies, which requires significant judgment by management.  The cash flow projections took into effect the expected net sales from the customer backlog as of November 3, 2014 and the corresponding expenses against those sales in the respective periods. The shipments against the customer backlog are anticipated to be delivered completed between January and June of 2015, and as such, the intangible amortization against those shipments will be completed by the end of the third fiscal quarter (June) of 2015.

The respective estimated fair values for property plant & equipment, and fixed assets were determined by an independent third-party appraisal firm. The appraisal methods employed by the firm in arriving at the final values on all of the equipment included a combination of the “Cost Approach” the “Market Data Approach” as well as “Income Approach” on specific high historical cost assets as presented by the seller. Certain assets which had very specific military manufacturing applications were operating at less than optimal capacity due to significantly reduced government spending from historical levels related to those processes. The excess or “idle” capacity on these unique assets was considered in the appraiser’s valuation, and the appraised values adjusted downward accordingly, in consideration of the reduced revenue and corresponding limited cash flow that could reasonably be generated from these assets under the current market conditions.

Separate from the appraisal analysis, Optex completed a physical inventory of all raw material, work in process and finished goods inventories in their various stages of production as of the acquisition date, and conducted a thorough revaluation and review of the counted inventory carrying values giving downward consideration to any excess, obsolete, or other product inventories which were valued in excess of the expected net realizable values given the depressed market conditions. Based on the supplemental inventory review, combined with the income approach used on the excess and idle capacity assets applied by the appraiser, the company was satisfied that the third party appraisal fairly valued those assets. The total fair value appraisal for the purchased assets, before intangible assets and assumed liabilities approximated 73% of the net carrying values of those same assets on the sellers closing balance sheet as of November 3, 2014.

Optex Systems Holdings believes that it was able to acquire the Applied Optics Product Line for less than the fair value of its assets because of (i) its unique position as a market leader in the industry segment that directly utilizes the manufactured components specific to the Applied Optics Product Line, (ii) a previous customer/supplier relationship with the acquisition target, (iii) L-3’s intent to exit the optical coating operations, and (iv) L-3’s desire to provide for continued employment of the Applied Optics workforce. The Applied Optics Product Line had a recent history of losses, and the seller approached Optex Systems in an effort to sell the product line and exit the optical coating manufacturing business that no longer fit its strategy. With the seller's intent to exit the business segment and Optex’s position as a market leader within the same industry segment utilizing the product line capability, Optex was able to agree on a favorable purchase price with L-3 Communications.

The recorded gain is provisional and subject to possible changes in the next quarter. There were no contingent liabilities or consideration included as a part of the purchase transaction, and we anticipate any subsequent changes will be limited to differences in actual accounts payable invoices received subsequent to November 3, 2014 compared to estimates of those accrued operating liabilities as of the closing date. The Company continues to evaluate the purchase price allocation, including the opening fair value of inventory, property, plant & equipment, intangible assets, and accrued liabilities, which may require the Company to adjust the recorded gain.

As a result of the asset purchase, the company has incurred additional acquisition-related costs of approximately $40.2 thousand for legal, accounting and valuation consulting fees which have been expensed to general administrative costs.

The following table represents the unaudited pro forma condensed balance sheet as if the acquisition of the Applied Optics Product Line had occurred as of the beginning of the fiscal year starting on September 29, 2014:

Optex Systems Holdings, Inc.

Balance Sheet Adjusted for Applied Optics Product Line Acquisition

Notes related to pro forma balance sheet adjustments:

The pro forma financial information is presented for information purposes only. Such information is based on the historical results of each company and does not reflect the actual results that would have been reported had the acquisition been completed when assumed, nor is it indicative of the future results of operations for the combined entity. The unaudited pro forma information provided herein does not reflect any operating efficiencies and/or cost savings that the Company may achieve with respect to the combined entities.

The following represents condensed pro forma revenue and earnings information for the three months ended December 28, 2014 and December 29, 2013 as if the acquisition of the Applied Optics Product Line had occurred on the first day of each of the fiscal years.

The unaudited, pro forma information depicted above reflects the impact of the acquisition of the Applied Optics Product Line to the revenue and operating income of the consolidated entity as of the three months ending December 28, 2014 and December 29, 2013, respectively, as if the acquisition had begun at the beginning of each of the fiscal years. The condensed statements of revenue and earnings exclude the impact of L-3’s corporate allocation costs to the Applied Optics Product Line for the period of September 29 through November 2, 2014, as well as the three months ending December 29, 2013.  There is no expected tax effect of the pro forma adjustments for the period affected in fiscal year 2015 due to the net loss and accumulated retained deficit of Optex Systems Holdings, Inc.

The unaudited pro forma financial information should be read in conjunction with Optex Systems Holding Inc.’s annual report, 10K, filed with the U.S. Securities Exchange Commission for the year ended September 28, 2014 as well as the 8-K filing dated November 7, 2014 and subsequent 8-K/A filed on January 20, 2015.