UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON, D.C. 20549

 

FORM 10-K

 

  ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended October 1, 2017

 

☐ TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ___ until ___

 

Commission File Number 000-54114

 

OPTEX SYSTEMS HOLDINGS, INC. 

(Exact name of registrant as specified in its charter)

 

Delaware 33-143215
(State or other jurisdiction of (I.R.S. Employer
incorporation organization) Identification No.)
   
1420 Presidential Drive  
Richardson, TX 75081-2439
(Address of principal executive offices) (Zip Code)
   

Registrant’s telephone number, including area code (972) 764-5700

 

Securities Registered under Section 12(b) of the Act 

None

 

Securities Registered under Section 12(g) of the Act 

Common Stock, par value $.001 per share

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☒

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒

 

Indicate by check mark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒  No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒  No ☐

  

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ☐   Accelerated filer ☐
Non-accelerated filer ☐   Smaller reporting company ☒

 

Indicate by check mark whether the registrant is an emerging growth company as defined in Rule 405 of the Securities Act of 1933 (§230.405 of this chapter) or Rule 12b-2 of the Securities Exchange Act of 1934 (§240.12b-2 of this chapter).

 

Emerging growth company
   
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to section 13(a) of the Exchange Act.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

 

The aggregate market value of the 4,535,870 shares of voting stock held by non-affiliates of the registrant based on the closing price on the OTC Markets on March 31, 2017 was $3,220,468.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

 

    Shares Outstanding
Title of Class   December 19, 2017
Common Stock   8,590,101

 

DOCUMENTS INCORPORATED BY REFERENCE

 

None.

 

 

 

 

TABLE OF CONTENTS 

     
PART I  
     
Item 1. Description of Business 3
     
Item 1A. Risk Factors 22
     
Item 2. Properties 31
     
Item 3. Legal Proceedings 31
     
Item 4. Mine Safety Disclosures 31
     
PART II  
     
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Securities 32
     
Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations 33
     
Item 8. Financial Statements and Supplementary Data 47
     
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 78
     
Item 9A. Controls and Procedures 79
     
PART III  
     
Item 10. Directors, Executive Officers and Corporate Governance 80
     
Item 11. Executive Compensation 83
     
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 89
     
Item 13. Certain Relationships and Related Transactions, and Director Independence 91
     
Item 14. Principal Accounting Fees and Services 94
     
PART IV    
     
Item 15. Exhibits 95

 

2 

 

 

Cautionary Note Regarding Forward-Looking Information

 

This Report on Form 10-K, in particular Part II Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements represent our expectations, beliefs, intentions or strategies concerning future events, including, but not limited to, any statements regarding our assumptions about financial performance; the continuation of historical trends; the sufficiency of our cash balances for future liquidity and capital resource needs; the expected impact of changes in accounting policies on our results of operations, financial condition or cash flows; anticipated problems and our plans for future operations; and the economy in general or the future of the defense industry, all of which were subject to various risks and uncertainties.

 

When used in this Report on Form 10- K and other reports, statements, and information we have filed with the Securities and Exchange Commission (“Commission” or “SEC”), in our press releases, presentations to securities analysts or investors, in oral statements made by or with the approval of an executive officer, the words or phrases “believes,” “may,” “will,” “expects,” “should,” “continue,” “anticipates,” “intends,” “will likely result,” “estimates,” “projects” or similar expressions and variations thereof are intended to identify such forward-looking statements. However, any statements contained in this Report on Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements. We caution that these statements by their nature involve risks and uncertainties, certain of which are beyond our control, and actual results may differ materially depending on a variety of important factors.

 

We do not assume the obligation to update any forward-looking statement. You should carefully evaluate such statements in light of factors described in this annual report. In this Form 10-K, Optex Systems Holdings, Inc. (“Optex Systems Holdings”) has identified important factors that could cause actual results to differ from expected or historic results. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider any such list to be a complete list of all potential risks or uncertainties. 

 

PART I

 

Item 1  Description of Business

  

Background

 

Prior History — Sustut Exploration, Inc.

 

Sustut Exploration, Inc. was a Delaware corporation formed on April 11, 2006 to search for available mining properties in North Central British Columbia. It entered into an option agreement in 2006 to purchase a mineral claim, and the option expired in May 2008 without any payment being made. Thus, as of May 2008, Sustut had no operating business.

 

As a result of the reorganization on March 30, 2009, which is described below, Optex Systems Holdings changed its name from Sustut Exploration Inc. to Optex Systems Holdings, Inc.

 

Reorganization

 

On March 30, 2009, a reorganization occurred whereby the then existing shareholders of Optex Systems, Inc., a private Delaware corporation (“Optex Systems, Inc. (Delaware)”), exchanged their shares of Optex Systems, Inc. (Delaware) common stock with the shares of common stock of us as follows (all on a pre-split basis due to the historical context): (i) the outstanding 85,000,000 shares of Optex Systems, Inc. (Delaware) common stock were exchanged for 113,333,282 shares of our common stock, (ii) the outstanding 1,027 shares of Optex Systems, Inc. (Delaware) Series A preferred stock were exchanged for 1,027 shares of Series A preferred stock and (iii) the 8,131,667 shares of Optex Systems, Inc. (Delaware) common stock purchased in the private placement were exchanged for 8,131,667 (presplit) shares of us common stock. Optex Systems, Inc. (Delaware) has remained our wholly-owned subsidiary.

 

3 

 

 

Current Line of Business

 

We manufacture optical sighting systems and assemblies, primarily for Department of Defense applications. Our products are installed on various types of U.S. military land vehicles, such as the Abrams and Bradley fighting vehicles, light armored and armored security vehicles and have been selected for installation on the Stryker family of vehicles. We also manufacture and deliver numerous periscope configurations, rifle and surveillance sights and night vision optical assemblies. Our products consist primarily of build-to-customer print products that are delivered both directly to the armed services and to other defense prime contractors. Less than 1% of today’s revenue is related to the resale of products substantially manufactured by others. In this case, the product would likely be a simple replacement part of a larger system previously produced by us.

 

We continue to field new product opportunities from both domestic and international customers. Given continuing unrest in multiple global hot spots, the need for precision optics continues to increase. Most of these requirements are for observation and situational awareness applications; however, we continue to see requests for higher magnification and custom reticles in various product modifications. The basic need to protect the soldier while providing information about the mission environment continues to be the primary driver for these requirements.

 

We do not believe that the change in government administration will cause a major change in the direction of funding or product need for the U.S. military. Maintenance will still be required, and the opportunities for us to upgrade existing systems with higher performing systems will continue to present themselves. Spending levels may change, but given the mix between foreign spending, domestic/prime demand, and the more recent commercial opportunities, we do not expect any negative trends arising from political domestic changes into fiscal 2017.

 

Recent Events

 

Sileas Corp.

 

On June 9, 2017, Sileas Corp. (“Sileas”), a related party to us, entered into a transaction with The Longview Fund, L.P.(“Longview”) to settle its February 20, 2009 note with Longview in the original principal amount of $13,524,405 (the “Note”). The parties agreed to a conversion by Longview of $3,358,538 of the amount due under the Note into 2,798,782 shares of Company common stock owned by Sileas and previously pledged to Longview as security with respect to the Note. Simultaneously therewith, Sileas made a $250,000 cash payment to Longview, and Longview agreed to cancel the remaining debt of $10,571,791 due under the Note. The remaining amount due under the Note is $64,000 which shall be paid in cash by Sileas to Longview on a quarterly basis, upon the payment of quarterly dividends by us, over the next four calendar quarters commencing on or about June 30, 2017. In order to effect the above, Longview also released the pledge on all of our shares owned by Sileas and previously pledged to Longview.

 

Simultaneously with the above, Sileas sold 800,000 shares of our common stock to Danny Schoening and Karen Hawkins at a price equal to $314,000  (which is a discounted amount based upon recognition of years of administrative support by Mr. Schoening and Ms. Hawkins for the Company) as follows: (i) Danny Schoening: 640,000 Shares for $200,000 plus a $50,825 promissory note; and (ii) Karen Hawkins: 160,000 Shares for $50,000 plus a $12,706 promissory note. Each promissory note has a one year term, with interest at 1.18% per annum and shall be payable in four equal quarterly installments of $12,800 for Danny Schoening and $3,200 for Karen Hawkins, each installment payable within five business days after the payment of cash dividends by us to each of them. As a result, Sileas no longer owns any shares of our common stock.

 

After giving effect to the above transactions, the beneficial ownership of our equity securities by held by each of the Longview Fund, Danny Schoening and Karen Hawkins as of December 18, 2017 is follows:

 

The Longview Fund 2,800,132 shares or 31.1%

 

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Danny Schoening 744,287 shares or 8.3%

 

Karen Hawkins shares 192,563 or 2.1%

 

Changes to the Board of Directors

 

Effective as of May 31, 2017, Charles Trego resigned as a director of us and from all appointments to Committees of our Board of Directors. On May 26, 2016, Kerry Craven resigned as one of our directors.

 

Effective as of June 9, 2017, Peter Benz resigned as Chairman of the Board and a Director of us. Effective as of that same date, our Board of Directors appointed Danny Schoening, its CEO and a director, as the Chairman of the Board of Directors and appointed Karen Hawkins, its CFO, and Bill Bates, the General Manager of its Applied Optics Center division, as directors. Stanley Hirschman retired as our President as of July 20, 2017.

 

Dividend

 

On July 12, 2017, we paid our holders (as of July 5, 2017) of common stock, Series C preferred stock and warrants (with the Series C preferred stock and warrants on an as converted/exercised basis) a dividend of $.02 per share. On October 19, 2017, we paid our shareholders of record, as October 12, 2017, a cash dividend at the rate of $0.02 per share for each share of our common stock, warrants and Series C preferred stock (on an as exerciseable/convertible basis for the warrants and Series C preferred stock).

 

Compensation Changes

 

On January 21, 2016, our Board of Directors Compensation Committee held a meeting and approved the following compensation changes:

 

  A base salary increase of 10% for Danny Schoening, CEO, and Karen Hawkins, CFO.
     
  A bonus payment of $7.5 thousand awarded to Karen Hawkins for 2015 performance.
     
  A $10 thousand monthly director fee for Peter Benz, Chairman, effective for calendar 2016.

 

On November 4, 2016, our Board of Directors Compensation Committee held a meeting and approved the following compensation changes:

 

  A bonus payment of $48.9 thousand awarded to Danny Schoening for 2016 performance.
     
  A bonus payment of $35.7 thousand awarded to Karen Hawkins for 2016 performance.

  

 On March 31, 2017, our Board of Directors Compensation Committee held a meeting and approved the following compensation changes:

 

  A base salary increase of 4% for Danny Schoening, CEO, and Karen Hawkins, CFO.

 

 On June 9, 2017, through Unanimous Written Consent, our Board of Directors approved the following compensation changes:

 

  Danny Schoening’s employment agreement shall be amended to increase his annual bonus from a maximum of 30% to 60% of his base salary.
     
  A $10 thousand monthly board advisory fee for Peter Benz (former board Chairman), through December 2017.

 

5 

 

 

On June 14, 2017, through Unanimous Written Consent, our Board of Directors approved the following compensation changes for independent board members:

 

  Increased the monthly fee paid to the remaining independent directors from $1,000 to $1,500 per month, effective immediately.

 

Credit Facility — Avidbank

 

On April 20, 2016, we amended our revolving credit facility with Avidbank. The new renewable revolving maturity date is January 22, 2018. The facility provides up to $2 million in financing against eligible receivables and is subject to meeting certain covenants including an asset coverage ratio test for up to twenty months. The material terms of the amended revolving credit facility are as follows:

 

  The interest rate for all advances shall be the then in effect prime rate plus 2.5% and is subject to a minimum interest payment requirement per six month period of $10,000.
     
  Interest shall be paid monthly in arrears.
     
  A facility fee of (0.5%) of the revolving line ($10,000) was due (and paid) on May 22, 2016 and each anniversary thereof for so long as the revolving credit facility is in effect.
     
  The loan period is from April 20 through January 22, 2018 at which time any outstanding advances, and accrued and unpaid interest thereon, will be due and payable.
     
  Our obligations to Avidbank are secured by a first lien on all of its assets (including intellectual property assets should it have any in the future) in favor of Avidbank.
     
  The facility contains customary events of default. Upon the occurrence of an event of default that remains uncured after any applicable cure period, Avidbank’s commitment to make further advances may terminate, and Avidbank would also be entitled to pursue other remedies against us and the pledged collateral.
     
  Pursuant to a guaranty executed by Optex Systems Holdings in favor of Avidbank, Optex Systems Holdings has guaranteed all obligations of Optex Systems, Inc. to Avidbank.

 

On October 17, 2016, we further amended our revolving credit facility with Avidbank to increase the facility to $2.2 million and to allow for a $250 thousand letter of credit sublimit with an annual fee of 1.5% of the face amount of the letter of credit. On October 17, 2016, we secured a $250 thousand irrevocable letter of credit from Avidbank with Cabot Industrial Value Fund II Operating Partnership, L.P. as the beneficiary. The letter of credit was issued as a condition of our facility lease, executed on October 21, 2016t for the Applied Optics Center facility in Dallas, Texas.

 

2016 Restricted Stock Unit Plan

 

On June 14, 2016, our Compensation Committee approved our 2016 Restricted Stock Unit Plan. This plan provides for issuance of stock units (“RSUs”) for up to 1,000,000 shares of our common stock. Each RSU constitutes a right to receive one share of our common stock, subject to vesting, which unless otherwise stated in an RSU agreement, shall vest in equal amounts on the first, second and third anniversary of the grant date. Shares of our common stock underlying the number of vested RSUs will be delivered as soon as practicable after vesting. During the period between grant and vesting, the RSUs may not be transferred, and the grantee has no rights as a shareholder until vesting has occurred. If the grantee’s employment is terminated for any reason (other than following a change in control of us or a termination of an officer other than for cause), then any unvested RSUs under the award will automatically terminate and be forfeited. If an officer grantee’s employment is terminated by us without cause or by the grantee for good reason, then, provided that the RSUs have not been previously forfeited, the remaining unvested portion of the RSUs will immediately vest as of the officer grantee’s termination date. In the event of a change in control, our obligations regarding outstanding RSUs shall, on such terms as may be approved by the Committee prior to such event, immediately vest, be assumed by the surviving or continuing company or cancelled in exchange for property (including cash).

 

6 

 

 

On June 15, 2016, we issued 150,000 RSUs to our Chief Executive Officer, Danny Schoening, and 50,000 RSUs to our Chief Financial Officer, Karen Hawkins. The RSUs issued to Mr. Schoening and Ms. Hawkins vest as follows: 34% on January 1, 2017, 33% on January 1, 2018 and 33% on January 1, 2019.

 

On June 14, 2017, we issued 50,000 RSUs to Bill Bates, General Manager of the Applied Optics Center and a newly appointed board member. The RSUs will vest over three years as follows: 34% on January 1, 2018, 33% on January 1, 2019 and 33% on January 1, 2020.

 

Public Offering

 

On August 26, 2016, we consummated a public offering of 2,291,000 Class A units consisting of common stock and warrants and 400 Class B units consisting of shares of Series C convertible stock and warrants for a total gross purchase price of $4,750,280.

 

New Product Development

 

On November 10, 2015, we entered into a retail sales relationship with Cabela’s Inc., to distribute our Red Tail Digital Spotting Scope, patented on July 11, 2017, as well as our new Stabilized Monocular. We are presently in negotiations to make these devices available via General Services Administration schedules for government personnel.

 

Products

 

Our products are installed on various types of U.S. military land vehicles, such as the Abrams and Bradley, and Stryker families of fighting vehicles, as well as light armored and armored security vehicles. We also manufacture and deliver numerous periscope configurations, rifle and surveillance sights and night vision optical assemblies. We deliver our products both directly to the federal government and to prime contractors.

 

We deliver high volume products, under multi-year contracts, to large defense contractors and government customers. Increased emphasis in the past two years has been on new opportunities to promote and deliver our products in foreign military sales, where U.S.-manufactured, combat and wheeled vehicles, are supplied (and upgraded) in cooperation with the U.S. Department of Defense. We have a reputation for quality and credibility with our customers as a strategic supplier. We also anticipate the opportunity to integrate some of our night vision and optical sights products into commercial applications.

 

Specific product categories include:

 

  Electronic sighting systems
     
  Mechanical sighting systems
     
  Laser protected plastic and glass periscopes
     
  Non-laser protected plastic and glass periscopes
     
  Howitzer sighting systems
     
  M36 Thermal Day/Night Periscopes
     
  M17 Day/Thermal Periscopes
     
  Ship binoculars
     
  Replacement optics (e.g. filters, mirrors)
     

  Optical assemblies and laser filters
     

7 

 

Product Line   Product Category
Periscopes   Laser & Non Laser Protected Plastic & Glass Periscopes, Electronic M17 Day/Thermal Periscopes, Vision Blocks
     
Sighting Systems   Back Up Sights, Digital Day and Night Sighting Systems (DDAN), M36 Thermal Periscope, Unity Mirrors
     
Howitzers   M137 Telescope, M187 Mount, M119 Aiming Device
     
Other   Muzzle Reference Systems (MRS), Binoculars, Collimators, Optical Lenses & Elements, Windows
     
Applied Optics Center   ACOG Laser filter, Laser Filter Interface, Optical Assemblies

 

Location and Facility

 

We are headquartered in Richardson, TX and lease approximately 93,967 combined square feet of facilities including Richardson, Texas and Dallas, Texas. As of December 5, 2017, we had 98 full time equivalent employees. We operate with a single shift, and capacity could be expanded by adding a second shift. Our proprietary processes and methodologies provide barriers to entry for other competing suppliers. In many cases, we are the sole source provider or one of only two providers of a product. We have capabilities which include machining, bonding, painting, tracking, engraving and assembly and can perform both optical and environmental testing in-house. We renewed the lease on our 49,100 square foot, Richardson, Texas facility, effective as of December 10, 2013, with a lease expiration of March 31, 2021. As of December 5, 2017, the Richardson facility operates with 61 full time equivalent employees in a single shift operation.

 

In November 2014, we also acquired a business unit from L-3 Communications, Inc., which is described herein below under “Recent Events — Acquisition”. The acquisition, Applied Optics Center, is located in Dallas, Texas with leased premises consisting of approximately 44,867 square feet of space. As of December 5, 2017, the Applied Optics Center operates with 37 full time equivalent employees in a single shift operation.

 

Contracts

 

Many of our contracts allow for government contract financing in the form of contract progress payments pursuant to Federal Acquisition Regulation 52.232-16, “Progress Payments”.  As a small business, and subject to certain limitations, this clause provides for government payment of up to 90% of incurred program costs prior to product delivery.  To the extent our contracts allow for progress payments, we intend to utilize this benefit, thereby minimizing the working capital impact on us for materials and labor required to complete the contracts.

 

Our contracts allow for Federal Acquisition Regulation 52.243-1 which entitles the contractor to an “equitable adjustment” to the contract if the contract changes result in a change in contract costs or time of performance.  In essence, an equitable price adjustment request is a request for a contract price modification (generally an increase) that allows for the contractor to be “made whole” for additional costs incurred which were necessitated by some modification of the contract effort.  This modification may come from an overt change in U.S. Government requirements or scope, or it may come from a change in the conditions surrounding the contract (e.g., differing site conditions or late delivery of U.S. Government-furnished property) which result in statement of work additions, deletions, part substitutions, schedule or other changes to the contract which impact the contractor’s overall cost to complete. 

 

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Each contract with our customers has specific quantities of material that need to be purchased, assembled, and then shipped. Prior to bidding a contract, we contact potential sources of material and receive qualified quotations for each material. In some cases, the entire volume is given to a single supplier and in other cases, the volume might be split between several suppliers. If a contract has a single source supplier and that supplier fails to meet their obligations (e.g., quality, delivery), then we would attempt to find an acceptable alternate supplier, and if successful, we would then renegotiate contractual deliverables (e.g., specifications, delivery, price). As of December 5, 2017, approximately 22% of our material requirements are single-sourced across 9 suppliers representing approximately 17% of our active supplier orders. Single-sourced component requirements span across all of our major product lines. Of these single sourced components, we have material contracts (purchase orders) with firm pricing and delivery schedules in place with each of the suppliers to supply the parts necessary to satisfy our current contractual needs.

 

We are subject to, and must comply with, various governmental regulations that impact, among other things, our revenue, operating costs, profit margins and the internal organization and operation of our business. The material regulations affecting our U.S. government business are summarized in the table below.

 

Regulation   Summary
Federal Acquisition Regulation   The principal set of rules in the Federal Acquisition Regulation System. This system consists of sets of regulations issued by agencies of the federal government of the United States to govern what is called the “acquisition process,” which is the process through which the government acquires goods and services. That process consists of three phases: (1) need recognition and acquisition planning, (2) contract formation, and (3) contract administration. This system regulates the activities of government personnel in carrying out that process. It does not regulate the purchasing activities of private sector firms, except to the extent that those activities involve government solicitations and contracts by reference.
     
International Traffic in Arms Regulations   United States government regulations that control the export and import of defense-related articles and services on the United States Munitions List. These regulations implement the provisions of the Arms Export Control Act.
     
Truth in Negotiations Act   A public law enacted for the purpose of providing for full and fair disclosure by contractors in the conduct of negotiations with the government. The most significant provision included is the requirement that contractors submit certified cost and pricing data for negotiated procurements above a defined threshold of $750,000. It requires contractors to provide the government with an extremely broad range of cost or pricing information relevant to the expected costs of contract performance, and it requires contractors and subcontractors to submit cost or pricing data to the government and to certify that, to the best of their knowledge and belief, the data are current, accurate, and complete.

 

We are responsible for full compliance with the Federal Acquisition Regulation. Upon award, the contract may identify certain regulations that we need to meet. For example, a contract may allow progress billing pursuant to specific Federal Acquisition Regulation clauses incorporated into the contract. Other contracts may call for specific first article acceptance and testing requirements. The Federal Acquisition Regulation will identify the specific regulations that we must follow based on the type of contract awarded. The Federal Acquisition Regulation also contains guidelines and regulations for managing a contract after award, including conditions under which contracts may be terminated, in whole or in part, at the government’s convenience or for default. These regulations also subject us to financial audits and other reviews by the government of our costs, performance, accounting and general business practices relating to our government contracts, which may result in adjustment of our contract-related costs and fees and, among other things and impose accounting rules that define allowable and unallowable costs governing our right to reimbursement under certain contracts.

 

First Article Testing and Acceptance requirements consist of specific steps. For example, the first article testing associated with Howitzer-type product is comprehensive and time consuming. The dimensions and material specifications of each piece of the assembly must be verified, and each product has in excess of 100 piece parts. Once the individual piece parts are verified to be compliant to the specification, the assembly processes are documented and verified. A sample of the production (typically three units) is verified to meet final performance specifications. Once the units meet the final performance specification, they are then subjected to accelerated life testing, a series of tests which simulate the lifetime use of the product in the field. This consists of exposing the units to thermal extremes, humidity, mechanical shock, vibration, and other physical exposure tests. Once completed, the units undergo a final verification process to ensure that no damage has occurred as a result of the testing and that they continue to meet the performance specification. All of the information and data is recorded into a final first article inspection and test report and submitted to the customer along with the test units for final approval. First Article Acceptance and Testing is generally required on new contracts/product awards but may also be required on existing products or contracts where there has been a significant gap in production, or where the product has undergone significant manufacturing process, material, tooling, equipment or product configuration changes.

 

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We are also subject to laws, regulations and executive orders restricting the use and dissemination of information deemed classified for national security purposes and the exportation of certain products and technical data as covered by the International Traffic in Arms Regulation. In order to import or export items listed on the U.S. Munitions List, we are required to be registered with the Directorate of Defense Trade Controls office. The registration is valid for one year, and the registration fees are established based on the number of license applications submitted the previous year. We currently have an approved and current registration on file with the Directorate of Defense Trade Controls office. Once the registration is approved, each import/export license must be filed separately. License approval requires the company to provide proof of need, such as a valid contract or purchase order requirement for the specific product or technical data requested on the license and requires a detailed listing of the items requested for export/import, the end-user, the end-user statement, the value of the items, consignees/freight forwarders and a copy of a valid contract or purchase order from the end-user. The approval process for the license can vary from several weeks to six months or more. The licenses we currently use are the DSP-5 (permanent export), DSP-6 (license revisions) and DSP-73 (temporary export).

 

The aforementioned licenses are valid for 48 months from date that each such license is issued as set forth on the table below (updated as of December 5, 2017).

 

DSP - 5 licenses   Issue Date 

Expiration Date 

(48 months of issue) 

   Value ($) 
050490628   1/3/2014   1/2/2018    45,928 
050490371   1/14/2014   1/13/2018    14,290 
050497324   2/1/2014   1/31/2018    15,384 
050497307   2/12/2014   2/11/2018    11,881 
050497162   2/20/2014   2/19/2018    2,122 
050501481   2/26/2014   2/25/2018    255,700 
050504795   3/27/2014   3/26/2018    26,794 
050511388   4/21/2014   4/20/2018    30,086 
050510061   5/19/2014   5/18/2018    10,564 
050521562   6/27/2014   6/26/2018    3,108 
050521680   7/7/2014   7/6/2018    10,572 
050521706   7/15/2014   7/14/2018    7,441 
050521673   7/15/2014   7/14/2018    1,236 
050521555   7/17/2014   7/16/2018    18,970 
050530555   9/22/2014   9/21/2018    4,930 
050537697   11/4/2014   11/3/2018    6,028 
050539610   11/14/2014   11/13/2018    7,746 
050486913   11/20/2014   11/19/2018    79,882 
050490381   12/11/2014   12/10/2018    36,250 
050546222   1/9/2015   1/8/2019    2,950 
050549789   2/18/2015   2/17/2019    53,720 
050549846   2/23/2015   2/22/2019    165,372 
050549534   2/25/2015   2/24/2019    88,555 
050549933   2/27/2015   2/26/2019    34,888 
050549843   3/23/2015   3/22/2019    1,213 

 

10 

 

 

DSP - 5 licenses   Issue Date 

Expiration Date

(48 months of issue)

   Value ($) 
050553879   3/23/2015   3/22/2019    4,066 
050553874   3/27/2015   3/26/2019    3,472 
050553876   3/27/2015   3/26/2019    1,021 
050560846   5/21/2015   5/20/2019    6,418 
050560953   5/29/2015   5/28/2019    1,792 
050561878   6/5/2015   6/4/2019    75,047 
050562319   6/12/2015   6/11/2019    2,815 
050560740   6/30/2015   6/29/2019    3,308 
050565738   7/9/2015   7/8/2019    1,543 
050566061   7/22/2015   7/21/2019    27,401 
050561747   7/27/2015   7/26/2019    250 
050565746   7/30/2015   7/29/2019    1,543 
050568890   8/7/2015   8/6/2019    4,204 
050570373   8/21/2015   8/20/2019    4,297 
050571083   9/8/2015   9/7/2019    92,042 
050574185   9/25/2015   9/24/2019    413,263 
050581564   12/11/2015   12/10/2019    2 
050581341   12/17/2015   12/16/2019    30,541 
050582302   12/17/2015   12/16/2019    402 
050581218   12/18/2015   12/17/2019    4,298 
050573342   10/7/2015   10/6/2019    203,832 
050581341   12/17/2015   12/16/2019    30,541 
050573343   10/7/2015   10/6/2019    8,446 
050582108   1/20/2016   1/19/2020    1,075 
050586060   2/24/2016   2/23/2020    931 
050598474   6/10/2016   6/9/2020    35,713 
050596660   6/23/2016   6/22/2020    631 
050598467   6/23/2016   6/22/2020    4,519 
050601710   7/12/2016   7/11/2020    6,757 
050596660   6/20/2016   6/19/2020    631 
050607056   10/5/2016   10/4/2020    10,001 
050587550   3/1/2016   2/29/2020    1 
050602855   7/27/2016   7/26/2020    75,552 
050603610   8/9/2016   8/8/2020    6,094 
050596718   6/28/2016   6/27/2020    917 
050612378   11/28/2016   11/27/2020    292,670 
050612416   11/28/2016   11/27/2020    151,761 
050612399   11/28/2016   11/27/2020    46,301 
050612547   11/28/2016   11/27/2020    6,976 
050612382   11/28/2016   11/27/2020    83,902 
050612402   11/28/2016   11/27/2020    45,801 
050615460   12/15/2016   12/14/2020    1,018,908 
050615456   1/11/2017   1/10/2021    463,140 
050615457   1/11/2017   1/10/2021    61,472 
050624356   3/22/2017   3/21/2021    1,033,093 
050629385   6/12/2017   6/11/2021    9,240 
050635531   7/12/2017   7/11/2021    24,449 
050643341   10/4/2017   10/3/2021    94,609 

 

11 

 

 

DSP - 6 Licenses   Issue Date   Expiration Date
(48 months of issue)
  Total Contract 
Value ($)
 
060046631   10/22/2015   10/6/2019   $  
060046632   10/21/2015   10/6/2019      

 

DSP -73 Licenses   Issue Date   Expiration Date
(48 months of issue)
  Total Contract 
Value ($)
 
730053549   7/29/2015   7/28/2019   $ 30,000  

  

BIS - 711 Licenses    Issue Date 

Expiration Date

(48 months of issue) 

   Total Contract
Value ($)
 
D1083980    2/28/2017   2/27/2021   $4,744 
D1083993    2/28/2017   2/27/2021   $2,875 
D1083955    3/2/2017   3/1/2021   $1,176 
D1085182    3/20/2017   3/19/2021   $46,032 
D1085299    3/20/2017   3/19/2021   $45,800 
D1085522    3/20/2017   3/19/2021   $2,966 
D1085153    3/20/2017   3/19/2021   $1,614,572 

 

Licenses are subject to termination if a licensee is found to be in violation of the Arms Export Control Act or the International Traffic in Arms Regulations requirements. If a licensee is found to be in violation, in addition to a termination of its licenses, it can be subject to fines and penalties by the government.

 

Our contracts may also be governed by the Truth in Negotiation Act requirements where certain of our contracts or proposals exceed the $750,000 threshold and/or are deemed as sole source, or non-competitive awards, covered under this act. For these contracts, we must provide a vast array of cost and pricing data in addition to certification that our pricing data and disclosure materials are current, accurate and complete upon conclusion of the negotiation. Due to the additional disclosure and certification requirements, if a post contract award audit were to uncover that the pricing data provided was in any way not current, accurate or complete as of the certification date, we could be subjected to a defective pricing claim adjustment with accrued interest. Currently, we do not have any pending defective pricing claim adjustments. Additionally, as a result of this requirement, contract price negotiations may span from two to six months and can result in undefinitized or not to exceed ceiling priced contracts subject to future downward negotiations and price adjustments. Currently, we do not have any undefinitized contracts subject to further price negotiation.

 

Our failure to comply with applicable regulations, rules and approvals or misconduct by any of our employees could result in the imposition of fines and penalties, the loss of security clearances, the loss of our U.S. government contracts or our suspension or debarment from contracting with the U.S. government generally, any of which could have a material adverse effect our business, financial condition, results of operations and cash flows. We are currently in compliance with all applicable regulations and do not have any pending claims as a result of noncompliance.

 

12 

 

 

The terms of our material contracts are as follows (updated as of October 30, 2017):

 

Customer   Customer
PO/Contract
  Contract
Type(1)
  Total
Award
Value(2)
(millions)
    Remaining
Value(3)
(millions)
    Delivery
Period
                         
GDLS – Canada(4)
Sighting Systems
  Subcontract
PO 35334144
  FFPQ   $ 8.7     $ 1.2     Mid 2012 – May 2018
                             
GDLS – Canada(5)
Sighting Systems
  Subcontract
PO 35419634
  FFPQ   $ 1.0     $ 0.5     June 2017- Mar 2018
                             

General Dynamics(6) 

Periscopes

 

  Subcontract
PO 40242047
  FFPQ   $ 1.3     $ 0.3     Aug 2016 – Apr 2018
                             

GDLS - Canada (7) 

Periscopes

 

  Subcontract
PO 35506523
  FFPQ   $ 1.5     $ 1.5     Dec 2017 – May 2020
                             

Harris Corp (8) 

Laser Filters

 

  Subcontract
PO 35506523
  FFPQ   $ 1.7     $ 0.5     June 2017 – Jan 2018
                             

DLA Land at Aberdeen(9) 

Laser Filter Assemblies

 

 

Prime 

SPRBL1-17-D-0008

 

  IDIQ   $ 1.6     $ 1.6     Jan 2018- Aug 2018
                             
GDLS – Canada(10)
Sighting Systems
  Subcontract
PO 35515590
  FFPQ   $ 1.4     $ 1.4     Oct 2017- Sept 2020
                             

DLA Land and Maritime (11)

Periscopes 

  Prime
SPE7LX17D0053
  IDIQ   $ 1.5     $ 1.5     Oct 2017- Sept 2020
(1) FFPQ – Firm fixed price and quantity, IDIQ – Indefinite delivery indefinite quantity, PP – Progress Billable. . Payment terms on shipments are net 30 or net-45 days.
(2) “Total Award Value” as included in the table represents the total value of all delivery orders against the prime contract that have already been awarded to us. The total award value represents already awarded delivery order contracts. Based on our historical experience with these contracts and other similar contracts, the amount awarded has directly correlated to the amount received.
(3) The “Remaining Value” depicts the open undelivered values remaining to be delivered against the contract awards as of October 30, 2017. Only these undelivered values of the contracts may be subject to the contract termination clause. It has been our experience that these clauses are rarely invoked.
(4) Contract was awarded on October 24, 2011 but effective November 4, 2011 as the date on which approved for disclosure by contractor. Total award value includes all statement of work change orders through June 26, 2016.
(5) Contract award quantity added on December 3, 2013 as a follow on quantity to the original PO 35334144.
(6) Contract quantity awarded on January 24, 2016.
(7) Contract quantity awarded on December 14, 2016 for laser protected periscopes installed on Light Armored Vehicles in the Middle East.
(8) Contract quantity awarded on March 30, 2017.
(9) Five year IDIQ contract for Light Interference Filter Assemblies awarded on July 3, 2017.  The contract calls for five one-year ordering periods running consecutively commencing on July 5, 2017.  On July 12, 2017 the first task delivery order DO-0001 was awarded for $1.6 million.  The Company expects to generate between $8.4 and $12.4 million in revenue over the next five year period from this contract.
(10) Contract awarded on September 11, 2017 to provide LAV 6.0 optimized weapon system support for Optex’s Commander Sighting System. The in-service support will continue over the next three years for their existing fleet of Light Armored Vehicles.

 

13 

 

 

(11) Three year IDIQ contract for periscopes awarded on September 18, 2017.  The contract includes three base years and two option years. The based contract expires September 11, 2020.  As of October 30, three task delivery orders have been awarded against the IDIQ for a total value of $1.5 million.  The company expects to generate between $1.5 and $2.4 million in revenue over the next five year period from this contract.

 

Market Opportunity — U.S. Military

 

During the twelve months ending October 1, 2017, approximately 68% of our business was in support of U.S. military products. The chart below was derived from public government spending sources and depicts total U.S. military spending from 2007 through 2016 and estimated spending through 2022. The purpose of including this chart is to provide the reader with historical trend data and projected U.S. military defense and procurement spending over time. Military spending peaked at $678.1 billion in 2011. As of fiscal year 2017 the total projected military spending is projected to decline by 15.5% to $573.0 billion from the peak 2011 level. However, the military spending in the chart below depicts increased spending through 2022 of 11.8% with the largest increase of 8.5% occurring in the next fiscal year (2018). The projected increase of military procurement in fiscal 2018 represents an 8.1% increase over fiscal year 2017 levels. On November 16, 2017, the National Defense Authorization Act (NDAA) for fiscal year 2018 was sent to President Trump to sign into law after passing both the House of Representatives and the Senate. The NDAA authorizes total spending of $700 billion which includes the authorization of $65.8 billion in additional funding for the Overseas Contingency Operation (OCO) account.

 

(BAR CHART)

Source: Government Publishing Office, U.S. Budget Historical Tables, FY 2018, Table 3.2 Outlays by function and subfunction, 1962-2022. 

 

14 

 

 

The table below depicts the U.S. Department of Defense budget request for fiscal year 2018 for major ground system programs. The total fiscal year 2018 budget request for major ground system programs is increased by 11.2% over the fiscal year 2017 levels and 16.7% over the fiscal year 2016 levels. Although it is difficult to directly tie the budget request to specific components provided by Optex Systems, we provide periscopes, collimator assemblies, vision blocks and laser interface filters to the U.S. armed forces on almost all of the ground system platforms categorized below.

 

              FY 2018 
Major Weapon System Summary          Base   OCO   Total 
($ in Millions)  FY 2016   FY 2017   Budget   Budget   Request 
Ground Systems - Joint Service                        
JLTV  Joint Light Tactical Vehicle  $366.2   $775.8   $1,141.6   $1.1   $1,142.7 
Ground Systems - USA                        
AMPV  Armored Multi-Purpose Vehicle   213.0    184.2    393.5    253.9    647.4 
FHTV  Family Of Heavy Tactical Vehicles   30.8    57.1    92.1    25.9    118.0 
M-I  Abrams Tank Modification/Upgrades   504.7    898.7    632.4    581.5    1,213.9 
PIM  Paladin Integrated Management   410.3    636.0    652.5    125.7    778.2 
FMTV  Family of Medium Tactical Vehicles   334.0    352.8    84.7        84.7 
Stryker  Stryker   1,191.0    735.4    178.2        178.2 
Ground Systems - USMC                        
ACV  Amphibious Combat Vehicle   197.0    158.7    340.5        340.5 
Total Ground Systems $2,880.8   $3,022.9   $2,373.9   $987.0   $3,360.9 

  

Source: Office of the Under Secretary of Defense (Comptroller)/Chief Financial Officer, “Program Acquisition Cost by Weapon System, United States Department of Defense, Fiscal Year 2018 Budget Request”, May 2017

  

The U.S. government spending reductions in the last seven years have had a significant impact on our product lines as our products directly support various types of U.S. military land vehicle procurements. As a result of lower U.S. government spending from the peak 2011 levels, the Company has continued to explore other opportunities for manufacturing outside of our traditional product lines for products which could be manufactured using our existing lines in order to fully utilize our existing capacity.

 

We are cautiously optimistic that the new government administrations proposed boost in military spending will have a favorable impact in the direction of funding or product need for the U.S. military. We anticipate that absent any significant changes from the current defense spending levels, maintenance will still be required, and the opportunities for us to upgrade existing systems with higher performing systems will continue to present themselves. Spending levels may change, but given the mix between foreign spending, domestic/prime demand, and the more recent commercial opportunities, we do not expect any negative trends arising from political domestic changes over the next twelve months.

 

The following factors are important to the U.S. military:

 

  Product reliability — failure can cost lives
     
  Speed to delivery and adherence to delivery schedule
     
  System life cycle extension
     
  Low cost/best value
     
  Visual aids for successful execution of mission objectives
     
  Mission critical products specifically related to soldier safety.

 

15 

 

 

We focus on delivering products that satisfy these factors and believes it is well positioned to continue to service U.S. and foreign military needs. 

 

Market Opportunity — Foreign Military 

 

Despite the downturn in U.S. military spending, foreign military funding for products built in the United States for selected foreign militaries has held to peak funding levels. Thus, we have increased efforts to promote our proven military products, as well as newly improved product solutions directly to foreign military representatives. In 2014, we completed the first shipments of M17 Day/Thermal Periscope (NSN 6650-01-619-6545) to a country in South America. During fiscal year 2016, Optex Systems completed its first order of its patented M17 Day / Thermal Periscope for $0.6 million to Brazil. These direct sales transactions allow us to directly serve South American customers and affect influence into their future procurements. Additionally, shipment of the new M17 Day/Thermal Periscope validates our efforts to upgrade existing platforms with new technology. The M17 Day/Thermal Periscope is a cost effective upgrade to existing systems in that it provides both day and thermal views specifically designed for driving armored vehicles. It can be installed in vehicles which were originally designed without this technology and may be used as a backup to existing systems. We anticipate our efforts in South America will culminate in new orders for this technology in the near term. We will continue to pursue international opportunities through direct sales (e.g., General Dynamics Land Systems — Canada), International Parts Supply and through other existing customers (e.g., General Dynamics Land Systems — Israeli Namer Project).

 

We are also exploring possibilities to adapt some of our products for commercial use in those markets that demonstrate potential for solid revenue growth, both domestically and internationally. 

 

Market Opportunity — Commercial

 

Our products are currently sold to military and related government markets. We believe there may be opportunities to commercialize various products we presently manufacture to address other markets. Our initial focus will be directed in four product areas.

 

  Big Eye Binoculars — While the military application we produce is based on mature military designs, we own all castings, tooling and glass technology. These large fixed mount binoculars could be sold to cruise ships, personal yachts and cities/municipalities. The binoculars are also applicable to fixed, land based outposts for private commercial security as well as border patrols and regional law enforcement.

 

  Night Vision Sight — We have manufactured the optical system for the NL-61 Night Vision Sight for the Ministry of Defense of Israel. This technology could be implemented for commercial applications.

 

  Infrared Imaging Equipment — We manufacture and assemble infrared imaging equipment and components for Raytheon’s Thermal Imaging M36 Mount product and has recently added a low-cost, uncooled, thin film, thermal imager through its partnership with selective suppliers. This combined equipment and technology has potential applications with the border patrol, police and governmental or commercial security agencies.

 

  Thin Film Coatings — The acquisition of the Applied Optics Center (AOC) also creates a new sector of opportunity for commercial products for us. Globally, commercial optical products use thin film coatings to create product differentiation. These coatings can be used for redirecting light (mirrors), blocking light (laser protection), absorbing select light (desired wavelengths), and many other combinations. They are used in telescopes, rifle scopes, binoculars, microscopes, range finders, protective eyewear, photography, etc. Given this broad potential, the commercial applications are a key opportunity going forward.

 

  Optical Assemblies – Through the Applied Optics Center, we are utilizing our experience in military sighting systems to pursue commercial opportunities associated with products that incorporate multi-lens optical cell assemblies, bonded optical elements and mechanical assemblies.  There are a wide variety of products in the medical, machine vision, automotive and outdoor recreation fields that can benefit from our capabilities.  Support to domestic customers for these type products has driven significant increases in overall sales during the last two years.

 

16 

 

 

Customer Base

  

We serve customers in four primary categories: as prime defense contractor (Defense Logistics Agency (DLA) Land and Maritime, DLA Warren, DLA Aviation, U.S. Army, Navy and Marine Corps), as defense subcontractor (General Dynamics, L-3 Communications, Harris Corporations, BAE, and NorcaTec), as a military supplier to foreign governments (Israel, Australia, South America and NAMSA) and also as a commercial optical assembly supplier (Nightforce Optics, Cabela’s). During the twelve months ended October 1, 2017, we derived approximately 86% of our gross business revenue from four major customers: U.S. government agencies (38%), Nightforce Optics, Inc. (22%), General Dynamics (19%), Harris Corporation (7%). We have approximately 100 discrete contracts for items that are utilized in vehicles, product lines and spare parts. Due to the high percentage of prime and subcontracted U.S. defense revenues, large customer size and the fact that there are multiple contracts with each entity, which are not interdependent, we are of the opinion that this provides us with a fairly well diversified revenue pool.

  

Marketing Plan

 

(FLOW CHART) 

 

Potential Entrants — Low Risk to us. In order to enter this market, potential competitors must overcome several barriers to entry. The first hurdle is that an entrant would need to prove to the government agency in question the existence of a government approved accounting system for larger contracts. Second, the entrant would need to develop the processes required to produce the product. Third, the entrant would then need to produce the product and then submit successful test requirements (many of which require lengthy government consultation for completion). Finally, in many cases, the customer has an immediate need and therefore cannot wait for this qualification cycle and therefore must issue the contracts to existing suppliers. 

 

Historically, we competed with two other companies in different spaces. First, we previously competed with Miller-Holzwarth in the plastic periscope business. In July 2012, Miller-Holzwarth, Inc. ceased operations apparently as a result of an inability to meet its financial obligations combined with a decline in defense market conditions. Second, we currently compete with Seiler Instruments for fire control products. These contracts are higher value products, but lower quantities. Given the expense of development and qualification testing, the barrier to entry is high for new competitors. During the last four years, overall plastic periscope demand quantities have declined, while competition on the lower level periscope products has significantly increased as new contractors aggressively compete for market share amongst the existing customer base and quantities.

 

17 

 

 

Buyers — Medium Risk to us. In most cases the buyers (usually government agencies or defense contractors) have two fairly strong suppliers. It is in their best interest to keep at least two, and therefore, in some cases, the contracts are split between suppliers. In the case of larger contracts, the customer can request an open book policy on costs and expects a reasonable margin to have been applied. 

 

Substitutes — Low Risk to us. We have both new vehicle contracts and replacement part contracts for the exact same product. The U.S. government has declared that the Abrams/Bradley base vehicles will be the ground vehicle of choice through 2040.

 

The Bradley vehicle has been in service for 28 years, the Abrams for 27 years. In February 2008, the U.S. Army signed a multiyear third party contract for the delivery of improved Abrams and Bradleys. The contract is for up to 435 tanks and 540 Bradley vehicles. These are the only production tanks currently in production by the government. This, in conjunction with the 30-year life span, supports their continued use through 2040. The Abrams is the principal battle tank of the United States Army and Marine Corps, and the armies of Egypt, Kuwait, Saudi Arabia, and since 2007, Australia. The new contract terms allow efficiencies within the supply chain and a very long return on investment on new vehicle proposals. 

 

Suppliers — Low to Medium Risk to Optex Systems Holdings. The suppliers of standard processes (e.g., casting, machining and plating) need to be very competitive to gain and/or maintain contracts. Those suppliers of products that use top secret clearance processes are slightly better off; however, there continues to be multiple avenues of supply and therefore only moderate power. 

 

Consistent with our marketing plan and business model, the AOC acquisition strengthened our overall position by decreasing the bargaining power of their suppliers through the backwards integration of a key supplier and created additional barriers of entry of potential competitors. Overall, the customer base and the competition have seen the acquisition as creating a stronger company.

 

The second model is a two by two matrix for products and customers.

 

             Existing Customers             New Customers
         
New Products       Chile      M17 Day/Thermal
    USACC Binoculars   Brazil     M17 Day/Thermal
    GDLS DDAN   Israel      M17 Day/Thermal
    Commercial Optical Lens  

 

        Commercial: Optical Lens, Spotting Scopes, Monocular Lens
         
Existing Products   USACC Periscopes, Back Up Sights,   Marines   Sighting Systems
    Binoculars, Vision Blocks,    
    ACOG Filter Units   Commercial:  Optical Lens, Spotting
    GDLS Periscopes, Collimators   Scopes, Monocular Lens
    BAE Periscopes    
    L3- Laser Interface Filters    
    DLAOptical Elements    

 

This product/customer matrix sets forth our four basic approaches: 

 

  1) Sell existing products to existing customers.

 

18 

 

 

  2) Sell existing products to new customers.

 

  3) Develop new products to meet the needs of our existing customers.

 

  4) Develop new products to meet the needs of new customers.

 

The product categories described in the above matrix are associated with the product lines set forth below: 

 

Product Line   Product Category
Periscopes   Laser & Non Laser Protected Plastic & Glass Periscopes, Electronic M17 Day/Thermal Periscopes, Vision Blocks
     
Sighting Systems   Back Up Sights, Digital Day and Night Sighting Systems (DDAN) and Optimized Weapon System Support (OWSS), M36 Thermal Periscope, Unity Mirrors
     
Howitzers   M137 Telescope, M187 Mount, M119 Aiming Device
     
Other   Muzzle Reference Systems (MRS), Binoculars, Collimators, Optical Lenses & Elements, Windows
     
Applied Optics Center   ACOG Laser filter, Laser Filter Interface, Optical Assemblies

 

Operations Plan

 

Our operations plan can be broken down into three distinct areas: material management, manufacturing space planning and efficiencies associated with economies of scale.

 

Materials Management

 

The largest portion of our costs is materials. We have completed the following activities in order to demonstrate continuous improvement: 

 

  - Successful completion of annual surveillance audit for ISO 9001:2008 certificate, with no major nonconformance issues

  

  - Weekly cycle counts on inventory items

  

  - Weekly material review board meeting on non-moving piece parts

  

  - Kanban kitting on products with consistent ship weekly ship quantities

  

  - Daily cross functional floor meetings focused on delivery, yields and labor savings

  

  - Redesigned floor layout using tenant improvement funds

  

  - Daily review of yields and product velocity

  

  - Bill of material reviews prior to work order release

  

Future continuous improvement opportunities include installation and training of shop floor control module within the ERP system and organizational efficiencies of common procurement techniques among buyers.

 

19 

 

 

Manufacturing Space Planning 

 

We currently lease 93,967 square feet of manufacturing space (see “Location and Facility”), including the additional leased space in conjunction with our recent acquisition as described under “Recent Events”. Our current facilities are sufficient to meet our immediate production needs without excess capacity. As our processes are primarily labor driven, we are able to easily adapt to changes in customer demand by adjusting headcounts, overtime schedules and shifts in line with production needs. In the event additional floor space is required to accommodate new contracts, Optex has the option to lease adjacent floor space at the current negotiated lease cost per square foot. Consistent with the space planning, we will drive economies of scale to reduce support costs on a percentage of sales basis. These cost reductions can then be either passed through directly to the bottom line or used for business investment.

 

Our manufacturing process is driven by the use of six sigma techniques and process standardization. Initial activities in this area have been the successful six sigma projects in several production areas which have led to improved output and customer approval on the aesthetics of the work environment. In addition, we use many tools including 5S programs, six sigma processes, and define, measure, analyze, improve, control (DMAIC) problem solving techniques to identify bottlenecks within the process flow, reduce cost and improve product yields. Successful results can then be replicated across the production floor and drive operational improvements.

 

Economies of Scale

 

Plant efficiencies fluctuate as a function of program longevity, complexity and overall production volume. Our internal processes are primarily direct labor intensive and can be more easily adapted to meet fluctuations in customer demand; however, our material purchases, subcontracted operations and manufacturing support costs are extremely sensitive to changes in volume. As our volume increases, our support labor, material and scrap costs decline as a percentage of revenue as we are able to obtain better material pricing, and scrap, start up and support labor (fixed) costs and they are spread across a higher volume base. On the contrary, as production volumes decline, our labor and material costs per unit of production generally increase. Additional factors that contribute to economies of scale relate to the longevity of the program. Long running, less complex programs (e.g., periscopes) do not experience as significant of an impact on labor costs as production volumes change, as the associated workforce is generally less skilled and can be ramped quickly as headcounts shift. Our more complex thin laser filter coatings, Howitzer and thermal day/night programs are more significantly impacted by volume changes as they require a more highly-skilled workforce and ramp time is longer as the training is more complex. We continually monitor customer demand over a rolling twelve-month window and in order to anticipate any changes in necessary manpower and material which allows us to capitalize on any benefits associated with increased volume and minimize any negative impact associated with potential declines in product quantities. 

 

Intellectual Property

 

We utilize several highly specialized and unique processes in the manufacture of our products. While we believe that these trade secrets have value, it is probable that our future success will depend primarily on the innovation, technical expertise, manufacturing and marketing abilities of our personnel. We cannot assure you that we will be able to maintain the confidentiality of our trade secrets or that our non-disclosure agreements will provide meaningful protection of our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or other disclosure. The confidentiality agreements that are designed to protect our trade secrets could be breached, and we might not have adequate remedies for the breach. Additionally, our trade secrets and proprietary know-how might otherwise become known or be independently discovered by others. We possess two utility patents.

 

Our competitors, many of which have substantially greater resources, may have applied for or obtained, or may in the future apply for and obtain, patents that will prevent, limit or interfere with our ability to make and sell some of our products. Although we believe that our products do not infringe on the patents or other proprietary rights of third parties, we cannot assure you that third parties will not assert infringement claims against us or that such claims will not be successful.

 

On July 11, 2017, we were issued U.S. Patent No. D791,852 S, for our Red Tail Digital Spotting Scope. We have a retail sales relationship with Cabela’s Inc., to distribute these scopes. They are currently the only digital spotting scope offered by Cabela’s. Our Red Tail Digital Spotting Scopes also received a favorable review from Trigger Magazine in 2017. 

 

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In May 2015, we announced the issuance to us of U.S. Patent No. 13,792,297 titled “ICWS Periscope”. This invention improves previously accepted levels of periscope performance that, in turn, improve soldier’s safety.

 

In December 2013, Optex Systems, Inc. was issued U.S. Patent No. 23,357,802 titled “Multiple Spectral Single Image Sighting System Using Single Objective Lens Set.” The technology platform, designed for our DDAN program, is applicable to all ground combat vehicles used by the US and foreign militaries. This invention presents a single image to both day and night sensors using precision optics, which in turn allows the user to individually observe day, night, or day and night simultaneously. In addition, it has proven to be especially useful in light transition points experienced at dusk and dawn. We are in production and currently delivering sighting systems with this advanced technology, a significant upgrade in the goal of supporting our customers as they modernize the worldwide inventory of aging armored vehicles. This technology is applicable to many sighting systems, and it has already been designed for implementation on the Light Armored Vehicles, the Armored Security Vehicle, the Amphibious Assault Vehicle, and the M60 Main Battle Tank. Digital Day and Night technology has advanced the capabilities of these installed weapon systems and is the first in a series of patents we have applied for to protect our Intellectual Property portfolio in support of the warfighters who use these systems.

 

In May 2012, we purchased a perpetual, non-exclusive license, with a single up front license fee of $200,000 to use Patent 7,880,792 “Optical and Infrared Periscope with Display Monitor” owned by Synergy International Optronics, LLC. We believe the purchase of the license agreement may allow us to extend and expand our market potential for the M113APC vehicle type which has the highest number of commonly used armored vehicles in the world. The current estimated active M113 APC worldwide inventory is over 80,000 units. This licensing of this patent allows us to develop additional products for this vehicle type, including the M17 Day/Thermal and M17 Day/Night periscopes. We are actively marketing the new periscopes internationally and completed our first international shipment utilizing this technology in March 2014. We continue to prototype these products and demonstrate them to potential customers. 

 

Competition

 

The markets for our products are competitive. We compete primarily on the basis of our ability to design and engineer products to meet performance specifications set by our customers. Our customers include military and government end users as well as prime contractors that purchase component parts or subassemblies, which they incorporate into their end products. Product pricing, quality, customer support, experience, reputation and financial stability are also important competitive factors.

 

There are a limited number of competitors in each of the markets for the various types of products that we design, manufacture and sell. At this time, we consider our primary competitors for the Optex, Richardson site to be Kent Periscopes and Synergy International Optronics, LLC. The Applied Optics Center thin film and laser coatings products compete primarily with Materion-Barr, Artemis and Alluxa.

 

Our competitors are often well entrenched, particularly in the defense markets. Some of these competitors have substantially greater resources than we do. While we believe that the quality of our technologies and product offerings provides us with a competitive advantage over certain manufacturers, some of our competitors have significantly more financial and other resources than we do to spend on the research and development of their technologies and for funding the construction and operation of commercial scale plants. 

 

We expect our competitors to continue to improve the design and performance of their products. We cannot assure investors that our competitors will not develop enhancements to, or future generations of, competitive products that will offer superior price or performance features, or that new technology or processes will not emerge that render our products less competitive or obsolete. Increased competitive pressure could lead to lower prices for our products, thereby adversely affecting our business, financial condition and results of operations. Also, competitive pressures may force us to implement new technologies at a substantial cost, and we may not be able to successfully develop or expend the financial resources necessary to acquire new technology. We cannot assure you that we will be able to compete successfully in the future.

 

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Employees

 

We had 100 full time equivalent employees as of October 1, 2017 which includes small temporary work forces to handle peak loads as needed. To the best of our knowledge, we are compliant with local prevailing wage, contractor licensing and insurance regulations, and has good relations with its employees, who are not currently unionized.

 

Leases

 

We are headquartered in Richardson, TX and lease 93,967 combined square feet of facilities including Richardson, Texas and Dallas, Texas. We operate with a single shift, and capacity could be expanded by adding a second shift. Our proprietary processes and methodologies provide barriers to entry for other competing suppliers. In many cases, we are the sole source provider or one of only two providers of a product. We have capabilities which include machining, bonding, painting, tracking, engraving and assembly and can perform both optical and environmental testing in-house.

 

We renewed the lease on our 49,100 square foot, Richardson, Texas facility, effective as of December 10, 2013, with a lease expiration of March 31, 2021. As of October 1, 2017, the Richardson facility operates with approximately 62 full time equivalent employees in a single shift operation.

 

Our Applied Optics Center, is located in Dallas, Texas with leased premises consisting of approximately 44,867 square feet of space. We executed a new lease for the Applied Optics Center location, effective as of October 1, 2016, which was countersigned by the landlord on October 21, 2016. The term of the lease expires October 31, 2021. There are two renewal options available to the tenant, and each renewal term is five years in duration. As of October 1, 2017, Applied Optics Center operates with approximately 38 full time equivalent employees in a single shift operation.

 

Item 1A  Risk Factors

 

Investing in our common stock involves a high degree of risk. Prospective investors should carefully consider the risks described below, together with all of the other information included or referred to in this annual report, before purchasing shares of our common stock. There are numerous and varied risks, known and unknown, that may prevent us from achieving our goals. The risks described below are not the only risks we will face. If any of these risks actually occurs, our business, financial condition or results of operations may be materially adversely affected. In such case, the trading price of our common stock could decline and investors in our common stock could lose all or part of their investment. The risks and uncertainties described below are not exclusive and are intended to reflect the material risks that are specific to us, material risks related to our industry and material risks related to companies that undertake a public offering or seek to maintain a class of securities that is registered or traded on any exchange or over-the-counter market.

 

Investing in our common stock involves a high degree of risk. Prospective investors should carefully consider the risks described below, together with all of the other information included or referred to in this annual report, before purchasing shares of our common stock. There are numerous and varied risks, known and unknown, that may prevent us from achieving our goals. The risks described below are not the only risks we will face. If any of these risks actually occurs, our business, financial condition or results of operations may be materially adversely affected. In such case, the trading price of our common stock could decline and investors in our common stock could lose all or part of their investment. The risks and uncertainties described below are not exclusive and are intended to reflect the material risks that are specific to us, material risks related to our industry and material risks related to companies that undertake a public offering or seek to maintain a class of securities that is registered or traded on any exchange or over-the-counter market. 

 

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Risks Related to our Business

 

We expect that we may need to raise additional capital in the future beyond any cash flow from our existing business; additional funds may not be available on terms that are acceptable to us, or at all.

 

We anticipate we may have to raise additional capital in the future to service our debt and to finance our future working capital needs. We cannot assure you that any additional capital will be available on a timely basis, on acceptable terms, or at all. Future equity or debt financings may be difficult to obtain. If we are not able to obtain additional capital as may be required, our business, financial condition and results of operations could be materially and adversely affected.

 

We anticipate that our capital requirements will depend on many factors, including:

 

  our ability to fulfill backlog;

 

  our ability to procure additional production contracts;

 

  our ability to control costs;

 

  the timing of payments and reimbursements from government and other contracts, including but not limited to changes in federal government military spending and the federal government procurement process;

 

  increased sales and marketing expenses;

 

  technological advancements and competitors’ response to our products;

  

  capital improvements to new and existing facilities;

  

  our relationships with customers and suppliers; and

 

  general economic conditions including the effects of future economic slowdowns, acts of war or terrorism and the current international conflicts.

  

Even if available, financings may involve significant costs and expenses, such as legal and accounting fees, diversion of management’s time and efforts, and substantial transaction costs. If adequate funds are not available on acceptable terms, or at all, we may be unable to finance our operations, develop or enhance our products, expand our sales and marketing programs, take advantage of future opportunities or respond to competitive pressures.

 

Current economic conditions may adversely affect our ability to continue operations.

 

Current economic conditions may continue to cause a decline in business and consumer spending and capital market performance, which could adversely affect our business and financial performance. Our ability to raise funds, upon which we are fully dependent to continue to conduct and expand our operations, may be adversely affected by current and future economic conditions, such as a reduction in the availability of credit, financial market volatility and economic recession.

 

Our ability to fulfill our backlog may have an effect on our long term ability to procure contracts and fulfill current contracts. 

 

Our ability to fulfill our backlog may be limited by our ability to devote sufficient financial and human capital resources and limited by available material supplies. If we do not fulfill our backlog in a timely manner, we may experience delays in product delivery which would postpone receipt of revenue from those delayed deliveries. Additionally, if we are consistently unable to fulfill our backlog, this may be a disincentive to customers to award large contracts to us in the future until they are comfortable that we can effectively manage our backlog.

 

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Our historical operations depend on government contracts and subcontracts. We face risks related to contracting with the federal government, including federal budget issues and fixed price contracts. 

 

Future general political and economic conditions, which cannot be accurately predicted, may directly and indirectly affect the quantity and allocation of expenditures by federal agencies. Even the timing of incremental funding commitments to existing, but partially funded, contracts can be affected by these factors. Therefore, cutbacks or re-allocations in the federal budget could have a material adverse impact on our results of operations. Given the continued adverse economic conditions, the federal government has slowed its pace with regard to the release of orders for the U.S. military. Since we depend on orders for equipment for the U.S. military for a significant portion of our revenues, this slower release of orders will continue to have a material adverse impact on our results of operations. Obtaining government contracts may also involve long purchase and payment cycles, competitive bidding, qualification requirements, delays or changes in funding, budgetary constraints, political agendas, extensive specification development, price negotiations and milestone requirements. In addition, our government contracts are primarily fixed price contracts, which may prevent us from recovering costs incurred in excess of budgeted costs. Fixed price contracts require us to estimate the total project cost based on preliminary projections of the project’s requirements. The financial viability of any given project depends in large part on our ability to estimate such costs accurately and complete the project on a timely basis. Some of those contracts are for products that are new to our business and are thus subject to unanticipated impacts to manufacturing costs. Given the current economic conditions, it is also possible that even if our estimates are reasonable at the time made, that prices of materials are subject to unanticipated adverse fluctuation. In the event our actual costs exceed fixed contractual costs of our product contracts, we will not be able to recover the excess costs which could have a material adverse effect on our business and results of operations. We examine these contracts on a regular basis and accrue for anticipated losses on these contracts, if necessary. As of October 1, 2017, there was zero in accrued loss provisions for loss contracts or cost overruns. 

 

Approximately 68% of our contracts contain termination clauses for convenience. In the event these clauses should be invoked by our customer, future revenues against these contracts could be affected, however these clauses allow for a full recovery of any incurred contract costs plus a reasonable fee up through and as a result of the contract termination. We are currently unaware of any pending terminations on our existing contracts.

 

In some cases, contract awards may be issued that are subject to renegotiation at a date (up to 180 days) subsequent to the initial award date. Generally, these subsequent negotiations have had an immaterial impact (zero to 5%) on the contract price of the affected contracts. Currently, none of our awarded contracts are subject to renegotiation. 

 

We have sought to mitigate the adverse impact from the slower pace of U.S. military orders on our results of operations by seeking to obtain foreign military orders as well as new commercial business. We do not expect these markets to completely mitigate the negative impact of lower U.S. defense spending.

 

There is further uncertainty which arises from the sequestration in early 2013 which may continue to affect business opportunities at the federal government level.

 

Military spending has been negatively impacted by the Budget Control Act of 2011, which was passed in August 2011. The Budget Control Act mandated a $917.0 billion reduction in discretionary spending over the next decade, and $1.2 trillion in automatic spending cuts over a nine-year period to be split between defense and non-defense programs beginning in January 2013. 

 

On November 2, 2015 Congress passed the Bipartisan Budget Act of 2015 which sets federal spending through the 2016 and 2017 fiscal years, and eases strict caps on spending set forth in the 2011 sequestration. The plan lifted caps on the appropriated spending each year by $50 billion in 2016 and $30 billion in 2017, evenly divided between defense and domestic programs with an additional $16 billion added each year in the form of inflated war spending, evenly split between the Defense and State departments.

 

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On November 16, 2017, the National Defense Authorization Act (NDAA) for fiscal year 2018 was sent to President Trump to sign into law after passing both the House of Representatives and the Senate. The 2018 NDAA authorizes total spending of $700 billion which includes a base spending authorization of $634 billion plus the authorization of $65.8 billion in additional funding for the Overseas Contingency Operation (OCO) account. The bill authorizes a major hike in military spending over the 2017 NDAA authorization of $619 billion and sets defense spending well above the $549 billion base authorization cap under the 2011 Budget Control Act. There currently is no clear plan from Congress on how to provide additional money above the sequestration limit and changes in the sequestration law will require bipartisan support to reach a senate vote threshold of 60 to avoid a filibuster. Although it is difficult to directly tie the budget request to specific components provided by Optex Systems, we provide periscopes, collimator assemblies, vision blocks and laser interface filters to the U.S. armed forces on almost all of the ground system platforms categorized in the Department of Defense budget request for 2018.

 

If we fail to scale our operations appropriately in response to growth and changes in demand, we may be unable to meet competitive challenges or exploit potential market opportunities, and our business could be materially and adversely affected. 

 

Our past growth has placed, and any future growth in our historical business is expected to continue to place, a significant strain on our management personnel, infrastructure and resources. To implement our current business and product plans, we will need to continue to expand, train, manage and motivate our workforce, and expand our operational and financial systems and our manufacturing and service capabilities. All of these endeavors will require substantial management effort and additional capital. If we are unable to effectively manage our expanding operations, we may be unable to scale our business quickly enough to meet competitive challenges or exploit potential market opportunities, and our current or future business could be materially and adversely affected. 

 

We do not have employment agreements with our key personnel, other than our Chief Executive and Financial Officers, and our management has very minimal unencumbered equity ownership in us. If we are not able to retain our key personnel or attract additional key personnel as required, we may not be able to implement our business plan and our results of operations could be materially and adversely affected.

 

We depend to a large extent on the abilities and continued participation of our executive officers and other key employees. The loss of any key employee could have a material adverse effect on our business. We currently have only two employment agreements, with our Chief Executive Officer which renews on an annual basis and currently expires on December 1, 2018, and our Chief Financial Officer which expires on January 31, 2018, with renewable terms each 18 months thereafter. We do not presently maintain “key man” insurance on any other key employees. Our management also has minimal unencumbered ownership interest in us, thus limiting their direct stake in our outcome. We believe that as our activities increase and change in character, additional, experienced personnel will be required to implement our business plan. Competition for such personnel is intense, and we cannot assure you that they will be available when required, or that we will have the ability to attract and retain them. In addition, due to our small size, we do not presently have depth of staffing in our executive, operational and financial management areas in order to have an effective succession plan should the need arise. Thus, in the event of the loss of one or more of our management employees, our results of operations could be vulnerable to challenges associated with recruiting additional key personnel, if such recruiting efforts are not successful in a timely manner. 

 

Certain of our products are dependent on specialized sources of supply that are potentially subject to disruption which could have a material, adverse impact on our business.

 

We have selectively single-sourced some of our material components in order to mitigate excess procurement costs associated with significant tooling and startup costs. Furthermore, because of the nature of government contracts, we are often required to purchase selected items from U.S. government approved suppliers, which may further limit our ability to utilize multiple supply sources for these key components.

 

To the extent any of these single sourced or government approved suppliers may have disruptions in deliveries due to production, quality, or other issues, we may also experience related production delays or unfavorable cost increases associated with retooling and qualifying alternate suppliers. The impact of delays resulting from disruptions in supply for these items could negatively impact our revenue, our reputation with our customers, and our results of operations. In addition, significant price increases from single-source suppliers could have a negative impact on our profitability to the extent that we are unable to recover these cost increases on our fixed price contracts. 

 

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Each contract has a specific quantity of material which needs to be purchased, assembled, and shipped. Prior to bidding a contract, we contact potential sources of material and receive qualified quotations for this material. In some cases, the entire volume is given to a single supplier and in other cases; the volume might be split between several suppliers. If a contract has a single source supplier and that supplier fails to meet their obligations (e.g., quality, delivery), then we would find an alternate supplier and bring this information back to the final customer. Contractual deliverables would then be re-negotiated (e.g., specifications, delivery, price. As of December 5, 2017, approximately 22% of our material requirements are single-sourced across 9 suppliers representing approximately 17% of our active supplier orders.  Single-sourced component requirements span across all of our major product lines. The vast majority of these single-sourced components could be provided by another supplier with minimal interruption in schedule (supply delay of 3 months or less) or minimally increased costs. We do not believe these single sourced materials to pose any significant risk to us as other suppliers are capable of satisfying the purchase requirements in a reasonable time period with minimal increases in cost. Of these single sourced components, we have contracts (purchase orders) with firm pricing and delivery schedules in place with each of the suppliers to supply parts in satisfaction of our current contractual needs. 

 

We consider only those specialized single source suppliers where a disruption in the supply chain would result in a period of three months or longer for us to identify and qualify a suitable replacement to present a material financial or schedule risk. In the table below, we identify only those specialized single source suppliers and the product lines supported by those materials utilized by us as of December 5, 2017. 

 

Product 
Line
  Supplier   Supply Item   Risk   Purchase Orders
                 
Sighting Systems M36 DDAN   Libra Industries   Digital camera system   Alternative source would take in excess of six months to qualify   This supplier is the designated replacement for Raytheon for the video system boards.  One P.O. is currently in place to drive the transfer from Raytheon.
                 
Periscopes   Newport Corp.   Metal mirrors for Driver periscopes   Alternative source would take in excess of six months to qualify   Current firm fixed price & quantity purchase orders are in place with the supplier to meet all contractual requirements. Supplier is on schedule
                 
Periscopes   Optical Security Inc.   Vision blocks for armored vehicles   Alternative source would take in excess of six months to qualify   Current firm fixed price & quantity purchase orders are in place with the supplier to meet all contractual requirements. Supplier is on schedule.
                 
Periscopes   Brown Die Casting   Die-cast housings   Consolidated all die cast tooling at this supplier.  Would take approximately six months to move tooling and re-qualify.  

 Current firm fixed price & quantity purchase orders are in place with the supplier to meet all contractual requirements. Supplier is on schedule. 

                 
Periscopes   Harbor Castings   Steel castings   Alternative source would take six months to qualify   Current firm fixed price & quantity purchase orders are in place with the supplier to meet all contractual requirements.
                 
Periscopes   Lanzen   MIL Spec welded housings for vision blocks   Would take approximately 4-6 months to re-qualify a new supplier   Current firm fixed price & quantity purchase orders are in place with the supplier to meet all contractual requirements. Supplier is on schedule.

   

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Product
Line
  Supplier   Supply Item   Risk   Purchase Orders
                 

Other Big Eye

 

  Corbett-Steeves Pattern Works   Sand castings for big eye binocular parts   Would take approximately 4-6 months to re-qualify a new supplier   Current firm fixed price & quantity purchase orders are in place with the supplier to meet all contractual requirements.
                 

Applied Optics Center 

Coated Filters

 

  Carter Glass Blowing   Quartz Blocks   Alternative source would take in excess of six months to develop and qualify   Current firm fixed price and quantity purchase orders are in place with the supplier to meet all contractual requirements.  Supplier is on schedule.
                 

Applied Optics Center 

M22/M24 Binocular

 

  FujiFilm North America   Spare Components   Only approved source due to proprietary rights.  Alternate source cannot be developed.   Current firm fixed price and quantity purchase orders are in place with the supplier to meet all contractual requirements.  Supplier is on schedule.

 

The defense technology supply industry is subject to technological change and if we are not able to keep up with our competitors and/or they develop advanced technology as response to our products, we may be at a competitive disadvantage.

 

The market for our products is generally characterized by technological developments, evolving industry standards, changes in customer requirements, frequent new product introductions and enhancements, short product life cycles and severe price competition. Our competitors could also develop new, more advanced technologies in reaction to our products. Currently accepted industry standards may change. Our success depends substantially on our ability, on a cost-effective and timely basis, to continue to enhance our existing products and to develop and introduce new products that take advantage of technological advances and adhere to evolving industry standards. An unexpected change in one or more of the technologies related to our products, in market demand for products based on a particular technology or of accepted industry standards could materially and adversely affect our business. We may or may not be able to develop new products in a timely and satisfactory manner to address new industry standards and technological changes, or to respond to new product announcements by others. In addition, new products may or may not achieve market acceptance. 

 

Unexpected warranty and product liability claims could adversely affect our business and results of operations.

 

The possibility of future product failures could cause us to incur substantial expense to repair or replace defective products. We warrant the quality of our products to meet customer requirements and be free of defects for twelve months subsequent to delivery. We establish reserves for warranty claims based on our historical rate of returned shipments against these contracts. There can be no assurance that this reserve will be sufficient if we were to experience an unexpectedly high incidence of problems with our products. Significant increases in the incidence of such claims may adversely affect our sales and our reputation with consumers. Costs associated with warranty and product liability claims could materially affect our financial condition and results of operations.

 

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We derive almost all of our revenue from four customers and the loss of any of these customers could have a material adverse effect on our revenues.

 

For the year ended October 1, 2017, we derived approximately 86% of our gross operating revenue from four customers: 38% from the U.S. Government (primarily Defense Logistics Agencies (DLA) and USACC-Warren), 22% from Nightforce Optics Inc., 19% from General Dynamics Land Systems Divisions, and 7% from Harris Corporation. Procuring new customers and contracts may partially mitigate this risk. In particular, a decision by General Dynamics Land System Divisions, USACC-Warren, DLA or Nightforce Optics Inc. to cease issuing contracts to us could have a significant material impact on our business and results of operations given that they represent over 79% of our gross business revenue. There can be no assurance that we could replace these customers on a timely basis or at all.

 

We have approximately 60 discrete contracts with General Dynamics Land System Division and the U.S. Government (primarily USACC-Warren and DLA), and other prime contractors. If they choose to terminate these contracts, we are entitled to fully recover all contractual costs and reasonable profits incurred up to or as a result of the terminated contract. 

 

We only possess four patents and rely primarily on trade secrets to protect our intellectual property.

 

We utilize several highly specialized and unique processes in the manufacture of our products, for which we rely solely on trade secrets to protect our innovations. We cannot assure you that we will be able to maintain the confidentiality of our trade secrets or that our non-disclosure agreements will provide meaningful protection of our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or other disclosure. The non-disclosure agreements that are designed to protect our trade secrets could be breached, and we might not have adequate remedies for the breach.

  

It is also possible that our trade secrets will otherwise become known or independently developed by our competitors, many of which have substantially greater resources than us, and these competitors may have applied for or obtained, or may in the future apply for or obtain, patents that will prevent, limit or interfere with our ability to make and sell some of our products. Although based upon our general knowledge (and we have not conducted patent searches), we believe that our products do not infringe on the patents or other proprietary rights of third parties; however, we cannot assure you that third parties will not assert infringement claims against us or that such claims will not be successful. 

 

In the future, we may look to acquire other businesses in our industry and the acquisitions will require us to use substantial resources.

  

In the future, we may decide to pursue acquisitions of other businesses in our industry. In order to successfully acquire other businesses, we would be forced to spend significant resources for both acquisition and transactional costs, which could divert substantial resources in terms of both financial and personnel capital from our current operations. Additionally, we might assume liabilities of the acquired business, and the repayment of those liabilities could have a material adverse impact on our cash flow. Furthermore, when a new business is integrated into our ongoing business, it is possible that there would be a period of integration and adjustment required which could divert resources from ongoing business operations.

 

The Financial Industry Regulatory Authority, or FINRA, has adopted sales practice requirements which may also limit a shareholder’s ability to buy and sell our stock.

 

FINRA has adopted rules that require that in recommending an investment to a customer, a broker-dealer must have reasonable grounds for believing that the investment is suitable for that customer. Prior to recommending speculative low priced securities to their non-institutional customers, broker-dealers must make reasonable efforts to obtain information about the customer’s financial status, tax status, investment objectives and other information. Under interpretations of these rules, FINRA believes that there is a high probability that speculative low priced securities will not be suitable for at least some customers. FINRA requirements make it more difficult for broker-dealers to recommend that their customers buy our common stock, which may limit your ability to buy and sell our stock and have an adverse effect on the market for our shares.

 

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The elimination of monetary liability against our directors, officers and employees under Delaware law and the existence of indemnification rights to our directors, officers and employees may result in substantial expenditures by us and may discourage lawsuits against our directors, officers and employees.

 

We provide indemnification to our directors and officers to the extent provided by Delaware law. The foregoing indemnification obligation could result in our incurring substantial expenditures to cover the cost of settlement or damage awards against directors and officers, which we may be unable to recoup. These provisions and resultant costs may also discourage us from bringing a lawsuit against directors and officers for breaches of their fiduciary duties and may similarly discourage the filing of derivative litigation by our stockholders against our directors and officers even though such actions, if successful, might otherwise benefit us and our stockholders.

 

Risks Related to Our Stock

 

We have issued a large number of shares of preferred stock, warrants and options, which if converted or exercised would substantially increase the number of common shares outstanding.


On December 19, 2017, we had 8,590,101 shares of common stock outstanding, and (a) we have vested options outstanding to purchase common stock that, if fully exercised, would generate proceeds of $600,100 and result in the issuance of an additional 60,010 shares of common stock, and (b) we have 78 shares of Series C preferred stock that, if fully converted into 4,167 common shares per preferred share, would result in the issuance of an additional 325,000 shares of common stock and (c) we have 4,125,200 warrants outstanding at an exercise price of $1.50 per share and (d) we have 182,000 granted unvested restricted stock units outstanding. Future sales of our common stock, warrants, options and Series C preferred stock may also adversely affect our stock price and our ability to raise funds in new offerings. 

 

As a key component of our growth strategy we have provided and intend to continue offering compensation packages to our management and employees that emphasize equity-based compensation and would thus cause further dilution.

 

The warrants and our Series C preferred stock are unlisted securities and there is no public market for them. 

 

There is no established public trading market for the warrants or the Series C preferred stock, and we do not expect a market to develop. In addition, the warrants and Series C preferred stock are not listed, and we do not intend to apply for listing of the warrants or the Series C preferred stock on any securities exchange or trading system. Without an active market, the liquidity of the warrants and the Series C preferred stock is limited, and investors may be unable to liquidate their investments in the warrants and Series C preferred stock.

 

Our stock price is speculative and there is a risk of litigation.

 

The trading price of our common stock has in the past and may in the future be subject to wide fluctuations in response to factors such as the following: 

 

  revenue or results of operations in any quarter failing to meet the expectations, published or otherwise, of the investment community;

  

  speculation in the press or investment community;

 

  wide fluctuations in stock prices, particularly with respect to the stock prices for other defense industry companies;

 

  announcements of technological innovations by us or our competitors;

 

  new products or the acquisition of significant customers by us or our competitors;

 

  changes in investors’ beliefs as to the appropriate price-earnings ratios for us and our competitors;

 

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  changes in management;

 

  sales of common stock by directors and executive officers;

 

  rumors or dissemination of false or misleading information, particularly through Internet chat rooms, instant messaging, and other rapid-dissemination methods;

 

  conditions and trends in the defense industry generally;

 

  the announcement of acquisitions or other significant transactions by us or our competitors;

 

  adoption of new accounting standards affecting our industry;

 

  general market conditions;

 

  domestic or international terrorism and other factors; and

 

  the other factors described in this section.

 

Fluctuations in the price of our common stock may expose us to the risk of securities class action lawsuits. Although no such lawsuits are currently pending against us and we are not aware that any such lawsuit is threatened to be filed in the future, there is no assurance that we will not be sued based on fluctuations in the price of our common stock. Defending against such suits could result in substantial cost and divert management’s attention and resources. In addition, any settlement or adverse determination of such lawsuits could subject us to significant liability.

 

Future sales of our common stock could depress our stock price. 

 

Sales of a large number of shares of our common stock, or the availability of a large number for sale, could materially adversely affect the per share market price of our common stock and could impair our ability to raise funds in addition offering of our debt or equity securities. In the event that we propose to register shares of common stock under the Securities Act for our own account, certain shareholders are entitled to include their shares in the registration, subject to limitations described in the agreements granting these rights.

 

Cautionary Note Regarding Forward-Looking Information

 

This prospectus, in particular the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing herein, contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended (“Exchange Act”). These forward-looking statements represent our expectations, beliefs, intentions or strategies concerning future events, including, but not limited to, any statements regarding our assumptions about financial performance; the continuation of historical trends; the sufficiency of our cash balances for future liquidity and capital resource needs; the expected impact of changes in accounting policies on our results of operations, financial condition or cash flows; anticipated problems and our plans for future operations; and the economy in general or the future of the electrical storage device industry, all of which are subject to various risks and uncertainties. 

 

When used in this prospectus as well as in reports, statements, and information we have filed with the Securities and Exchange Commission, in our press releases, presentations to securities analysts or investors, in oral statements made by or with the approval of an executive officer, the words or phrases “believes,” “may,” “will,” “expects,” “should,” “continue,” “anticipates,” “intends,” “will likely result,” “estimates,” “projects” or similar expressions and variations thereof are intended to identify such forward-looking statements. However, any statements contained in this prospectus that are not statements of historical fact may be deemed to be forward-looking statements. We caution that these statements by their nature involve risks and uncertainties, certain of which are beyond our control, and actual results may differ materially depending on a variety of important factors.

 

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Item 2  Properties 

 

We are headquartered in Richardson, TX and lease 93,967 combined square feet of facilities including Richardson, Texas and Dallas, Texas. As of December 5, 2017, we had 98 full time equivalent employees. We operate with a single shift, and capacity could be expanded by adding a second shift. Our proprietary processes and methodologies provide barriers to entry for other competing suppliers. In many cases, we are the sole source provider or one of only two providers of a product. We have capabilities which include machining, bonding, painting, tracking, engraving and assembly and can perform both optical and environmental testing in-house.

 

We renewed the lease on our 49,100 square foot, Richardson, Texas facility, effective as of December 10, 2013 with a lease expiration of March 31, 2021. As of December 5, 2017, the Richardson facility operates with 61 full time equivalent employees in a single shift operation.

 

In November 2014, we also acquired a new business unit from L-3 Communications, Inc., which is described herein below under “Recent Events — Acquisition”. The acquisition, the Applied Optics Center, is located in Dallas, Texas with leased premises consisting of approximately 44,867 square feet of space. We executed a new lease for the Applied Optics Center location, effective as of October 1, 2016, which was countersigned by the landlord on October 21, 2016. The term of the lease expires October 31, 2021. There are two renewal options available to the tenant, and each renewal term is five years in duration. As of December 5, 2017, Applied Optics Center operates with approximately 37 full time equivalent employees in a single shift operation.

 

Item 3  Legal Proceedings

 

From time to time, we are involved in lawsuits, claims, investigations and proceedings, including pending opposition proceedings involving patents that arise in the ordinary course of business. There are no matters pending that we expect to have a material adverse impact on our business, results of operations, financial condition or cash flows.

 

Item 4  Mine Safety Disclosures

 

None.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.  

 

Market information

 

Our common stock is currently quoted on the OTCQB Marketplace under the symbol “OPXS”. Trading in our common stock has historically lacked consistent volume, and the market price has been volatile.

 

The following table shows the range of high and low bid prices for our common stock as reported by the OTCQB Marketplace. The quotations reflect inter-dealer prices, without retail markup, markdown or commission and may not represent actual transactions.

 

Period  High   Low 
First Quarter 2015  $10.00   $10.00 
Second Quarter 2015  $10.00   $8.00 
Third Quarter 2015  $7.00   $5.00 
Fourth Quarter 2015  $8.00   $8.00 
First Quarter 2016  $7.30   $2.60 
Second Quarter 2016  $3.50   $2.00 
Third Quarter 2016  $2.60   $1.75 
Four Quarter 2016  $2.75   $0.68 
First Quarter 2017  $1.02   $0.59 
Second Quarter 2017  $0.79   $0.59 
Third Quarter 2017  $1.05   $0.66 
           
Fourth Quarter 2017  $1.30   $0.90 

  

On December 15, 2017, the closing price for our common stock as reported on the OTCQB was $1.07 per share.

 

Securities outstanding and holders of record

 

On December 19, 2017, there were approximately 80 shareholders of record for our common stock and 8,590,101 shares of our common stock issued and outstanding.

 

Dividends

 

On June 26, 2017, the board of directors approved a resolution authorizing a $0.02 per share (and per warrant) dividend payment on July 12, 2017, for common and preferred C shareholders and warrant holders of record as of July 5, 2017 and for three subsequent quarterly record dates thereafter. Quarterly dividends of $261 thousand were paid out to share and warrant holders on July 12, 2017. Optex recorded an additional $261 thousand in dividends payable as of October 1, 2017 for the fourth quarter declared dividends which were paid on October 19, 2017. The Company will review its working capital needs after the next two quarters dividend payments prior to determining any future dividends or amounts to be paid to our shareholders beyond April 2018.

 

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Information respecting equity compensation plans

 

Summary Equity Compensation Plan Information

 

Optex Systems Holdings adopted its 2009 Stock Option Plan on March 26, 2009.  On December 9, 2011, the Board of Directors of Optex Systems Holdings, Inc. authorized an amendment to its Stock Option Plan to increase the number of issuable shares from 6,000 to 50,000 and authorized the grant of 10,000 options to two board members and a total of 36,070 to Optex Systems Holdings employees including 20,000 options to executive officers. On December 19, 2013, the Board of Directors of Optex Systems Holdings, Inc. authorized an amendment to its Stock Option Plan to increase the number of issuable shares from 50,000 to 75,000 and authorized the grant of 20,000 options to three board members and a grant of 5,000 to an Optex Systems Holdings officer. The options granted in 2011 and 2013 were at exercise prices of $10.00 per share with each grant to vest 25% per year over four years for each year with which the grantee is still employed by or serving as a director of Optex Systems Holdings, Inc. (with all unvested options automatically expiring on the date of termination of employment by or service as a director of Optex Systems Holdings, Inc.) and all unvested options immediately vesting upon a change of control due to a merger or acquisition of the Company. As of December 18, 2017, 71,070 options had been granted, 6,060 of these options had forfeited due to terminations or expiration, and 65,010 had vested of which 5,000 options were exercised. The outstanding vested and unvested options are 60,010 and zero, respectively. 

 

2016 Restricted Stock Unit Plan

 

On June 14, 2016, our Compensation Committee approved our 2016 Restricted Stock Unit Plan. This plan provides for issuance of stock units (“RSUs”) for up to 1,000,000 shares of our common stock. Each RSU constitutes a right to receive one share of our common stock, subject to vesting, which unless otherwise stated in an RSU agreement, shall vest in equal amounts on the first, second and third anniversary of the grant date. Shares of our common stock underlying the number of vested RSUs will be delivered as soon as practicable after vesting. During the period between grant and vesting, the RSUs may not be transferred, and the grantee has no rights as a shareholder until vesting has occurred. If the grantee’s employment is terminated for any reason (other than following a change in control of us or a termination of an officer other than for cause), then any unvested RSUs under the award will automatically terminate and be forfeited. If an officer grantee’s employment is terminated by us without cause or by the grantee for good reason, then, provided that the RSUs have not been previously forfeited, the remaining unvested portion of the RSUs will immediately vest as of the officer grantee’s termination date. In the event of a change in control, our obligations regarding outstanding RSUs shall, on such terms as may be approved by the Committee prior to such event, immediately vest, be assumed by the surviving or continuing company or cancelled in exchange for property (including cash).

 

On June 15, 2016, we issued 150,000 RSUs to our Chief Executive Officer, Danny Schoening, and 50,000 RSUs to our Chief Financial Officer, Karen Hawkins. The RSUs issued to Mr. Schoening and Ms. Hawkins vest as follows: 34% on January 1, 2017, 33% on January 1, 2018 and 33% on January 1, 2019.

 

On January 5, 2017, Optex Systems Holdings issued 45,799 common shares related to the vesting of the 68,000 restricted stock units on January 1, 2017. The shares issued were net of 22,201 common shares withheld for employee federal income tax requirements.

 

On June 15, 2017, the Company issued 50,000 RSUs to its Applied Optics Center General Manager and new board member, Bill Bates. Pursuant to the RSU agreements the RSUs issued to Mr. Bates will vest as follows: 34% on January 1, 2018, 33% on January 1, 2019 and 33% on January 1, 2020. The total market value of the restricted stock units based on the shares price of $0.95 as of June 15, 2016 is $47.5 thousand. The cost of the shares is amortized on a straight line basis across the vesting periods.

 

As of December 18, 2017 there are 182,000 outstanding unvested restricted stock units remaining to vest of which 83,000 will vest on January 1, 2018.

 

Item 7  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion should be read in conjunction with the consolidated financial statements and the related notes that are set forth in our financial statements elsewhere in this annual report.

 

This management’s discussion and analysis reflects information known to management as of our fiscal year end, October 1, 2017, and the date of filing. This MD&A is intended to supplement and complement our audited financial statements and notes thereto for the year ended October 1, 2017, prepared in accordance with U.S. generally accepted accounting principles (GAAP). You are encouraged to read our financial statements in conjunction with your reading of this MD&A. The financial information in this MD&A has been prepared in accordance with GAAP, unless otherwise indicated. In addition, we use non-GAAP financial measures as supplemental indicators of our operating performance and financial position. We use these non-GAAP financial measures internally for comparing actual results from one period to another, as well as for planning purposes. We will also report non-GAAP financial results as supplemental information, as we believe their use provides more insight into our performance. When a non-GAAP measure is used in this MD&A, it is clearly identified as a non-GAAP measures and reconciled to the most closely corresponding GAAP measure.

 

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The following discussion highlights the principal factors that have affected our financial condition and results of operations as well as our liquidity and capital resources for the periods described.  This discussion contains forward-looking statements. Please see “Special cautionary statement concerning forward-looking statements” and “Risk factors” for a discussion of the uncertainties, risks and assumptions associated with these forward-looking statements. The operating results for the periods presented were not significantly affected by inflation.   

 

Background 


On March 30, 2009, a reorganization was consummated pursuant to which the then existing shareholders of Optex Systems, Inc. (Delaware) exchanged their shares of common stock for shares of common stock of Optex Systems Holdings as follows: (i) the outstanding 85,000,000 shares of Optex Systems, Inc. (Delaware) common stock were exchanged by Optex Systems Holdings for 113,333,282 shares of Optex Systems Holdings common stock, (ii) the outstanding 1,027 shares of Optex Systems, Inc. (Delaware) Series A preferred stock were exchanged by Optex Systems Holdings for 1,027 shares of Optex Systems Holdings Series A preferred stock, and (iii) the 8,131,667 shares of Optex Systems, Inc. (Delaware) common stock purchased in the private placement were exchanged by Optex Systems Holdings for 8,131,667 shares of Optex Systems Holdings common stock. Optex Systems, Inc. (Delaware) has remained a wholly-owned subsidiary of Optex Systems Holdings. The common shares above are presented at their pre reverse split share quantities to preserve historical information. Optex Systems Holdings effected a 1000:1 reverse stock split on October 7, 2015. As a result of the reorganization, Optex Systems Holdings changed its name from Sustut Exploration Inc. to Optex Systems Holdings, Inc., and its year end from December 31 to a fiscal year ending on the Sunday nearest September 30.

 

Optex Systems, Inc. (Delaware) manufactures optical sighting systems and assemblies, primarily for Department of Defense applications. Its products are installed on various types of U.S. military land vehicles, such as the Abrams and Bradley fighting vehicles, light armored and armored security vehicles and have been selected for installation on the Stryker family of vehicles. Optex Systems, Inc. (Delaware) also manufactures and delivers numerous periscope configurations, rifle and surveillance sights and night vision optical assemblies. Optex Systems, Inc. (Delaware) products consist primarily of build-to-customer print products that are delivered both directly to the armed services and to other defense prime contractors. Less than 1% of today’s revenue is related to the resale of products substantially manufactured by others. In this case, the product would likely be a simple replacement part of a larger system previously produced by Optex Systems, Inc. (Delaware).

 

We are both a prime and sub-prime contractor to the Department of Defense. Sub-prime contracts are typically issued through major defense contractors such as General Dynamics Land Systems, Raytheon Corp., BAE, NorcaTec and others. We are also a military supplier to foreign governments such as Israel, Australia and NAMSA and South American countries and as a subcontractor for several large U.S. defense companies serving foreign governments.

By way of background, the Federal Acquisition Regulation is the principal set of regulations that govern the acquisition process of government agencies and contracts with the U.S. government. In general, parts of the Federal Acquisition Regulation are incorporated into government solicitations and contracts by reference as terms and conditions effecting contract awards and pricing solicitations.

 

Many of our contracts are prime or subcontracted directly with the Federal government and, as such, are subject to Federal Acquisition Regulation Subpart 49.5, “Contract Termination Clauses” and more specifically Federal Acquisition Regulation clauses 52.249-2 “Termination for Convenience of the Government Fixed-Price)”, and 49.504 “Termination of fixed-price contracts for default”. These clauses are standard clauses on our prime military contracts and generally apply to us as subcontractors. It has been our experience that the termination for convenience is rarely invoked, except where it is mutually beneficial for both parties. We are currently not aware of any pending terminations for convenience or for default on our existing contracts.

 

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In the event a termination for convenience were to occur, Federal Acquisition Regulation clause 52.249-2 provides for full recovery of all contractual costs and profits reasonably occurred up to and as a result of the terminated contract. In the event a termination for default were to occur, we could be liable for any excess cost incurred by the government to acquire supplies from another supplier similar to those terminated from us. We would not be liable for any excess costs if the failure to perform the contract arises from causes beyond the control and without the fault or negligence of the Ccompany as defined by Federal Acquisition Regulation clause 52.249-8.

 

In addition, some of our contracts allow for government contract financing in the form of contract progress payments pursuant to Federal Acquisition Regulation 52.232-16, “Progress Payments”. As a small business, and subject to certain limitations, this clause provides for government payment of up to 90% of incurred program costs prior to product delivery. To the extent our contracts allow for progress payments, we intend to utilize this benefit, thereby minimizing the working capital impact on Optex Systems Holdings for materials and labor required to complete the contracts.

 

Recent Orders

 

In October 2016, we received a $0.8 million order from L-3 Communications for night vision goggle laser interference filter assemblies deliverable through March 2017.
   
In October 2016, we were awarded a $1.3 million portion of a commercial multi-year strategic supplier agreement with a domestic manufacturer of premium optical devices to supply its optical assemblies. The units will be delivered in fiscal year 2017.
   
In November 2016, we were awarded a $1.5 million contract for laser protected periscopes from Defense Logistics Agency (DLA). The award is the first delivery order against a 5-year Indefinite Delivery, Indefinite Quantity (IDIQ) contract with DLA totaling $5.99 million. Deliveries for the first order against this contract began in January 2017 and will continue through August 2017.
   
In December 2016, we were awarded a $1.5 million purchase order from one of the world’s largest defense companies for laser protected periscopes installed into Light Armored Vehicles in the Middle East. The periscopes will be delivered over three years, with the first delivery beginning in December 2017.
   
In February 2017, we were awarded a $1.3 million award with a domestic manufacturer of premium optical devices for deliveries in fiscal year 2017.
   
In March 2017, we received a purchase order from a domestic defense contractor in the amount of $1.7 million to supply Laser Interference Filter (LIF) Assemblies supporting the U.S. Government spares for fielded night vision goggles. Deliveries will begin in June 2017 and continue through January 2018.
   
On July 3, 2017, we were awarded a five year Indefinite-Delivery Indefinite-Quantity contract through DLA Land at Aberdeen for provision of night vision assemblies for the U.S. military. The Laser Interference Filter Assemblies will be manufactured at the Applied Optics Center (AOC) Division of Optex Systems, Inc. in Dallas, Texas. The contract calls for five one-year ordering periods running consecutively commencing on July 5, 2017 at pricing set forth in the addenda to the contract. The contract calls for first article testing and has a guaranteed minimum of $50,000. Given prior contracts awarded to the Company through DLA, the Company expects to generate between $8.4 and $12.4 million in revenue over the next five year period from this contract.

   

On September 11, 2017 we were awarded a $1.35 million contract by defense industry leader General Dynamics Land Systems-Canada, to provide LAV 6.0 optimized weapon system support for Optex’s Commander Sighting System. This in-service support will continue over the next three years for their existing fleet of Light Armored Vehicles.

 

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On September 18, 2017 was awarded a five year Indefinite-Delivery Indefinite-Quantity (IDIQ) contract through Defense Logistics Association (DLA) in support of the Abrams Main Battle Tank platform. The contract is expected to generate between $1.5M and $2.4 million in revenue over the next five year period for Optex Systems. As of October 30, three task delivery orders have been awarded against the IDIQ for a total value of $1.5 million.

 

New Product Development

 

We continue to field new product opportunities from both domestic and international customers. Given continuing unrest in multiple global hot spots, the need for precision optics continues to increase. Most of these requirements are for observation and situational awareness applications; however, we continue to see requests for higher magnification and custom reticles in various product modifications. The basic need to protect the soldier while providing information about the mission environment continues to be the primary driver for these requirements.

 

We are cautiously optimistic that the new government administrations proposed boost in military spending will have a favorable impact in the direction of funding or product need for the U.S. military. We anticipate that absent any significant changes from the current defense spending levels, maintenance will still be required, and the opportunities for us to upgrade existing systems with higher performing systems will continue to present themselves. Spending levels may change, but given the mix between foreign spending, domestic/prime demand, and the more recent commercial opportunities, we do not expect any negative trends arising from political domestic changes over the next twelve months.

 

In July 2017, Optex Systems was awarded a design patent on our “Red Tail” digital spotting scope. This device is targeted towards long range observation and image recording used by military, border patrol, and select consumer/commercial applications. The device is designed to deliver high definition images with military grade resolution, but at commercial “off the shelf” pricing. Using high grade optics to deliver a 45X magnified image onto a 5 megapixel CMOS sensor, the Red Tail device then transmits this image via Wi-Fi to the user’s smartphone or tablet. Digital still images or videos can then be captured and/or emailed using a custom Red Tail app available for either iOS or Android devices.

 

Recent Events

 

Stock Repurchase

 

On April 27, 2017, the Board of Directors of Optex Systems Holdings approved a purchase of 700,000 shares of its common stock in a private transaction from The Longview Fund, L.P. The transaction was priced at the closing sale price on April 28, 2017 of $0.74 per share for a total transaction amount of $518,000. Upon repurchase on May 1, 2017, the shares were cancelled thereby reducing the total shares outstanding of its common stock.

 

Sileas Corp.

 

On June 9, 2017, Sileas Corp. (“Sileas”), a related party to us, entered into a transaction with The Longview Fund, L.P.(“Longview”) to settle its February 20, 2009 note with Longview in the original principal amount of $13,524,405 (the “Note”). The parties agreed to a conversion by Longview of $3,358,538 of the amount due under the Note into 2,798,782 shares of Company common stock owned by Sileas and previously pledged to Longview as security with respect to the Note. Simultaneously therewith, Sileas made a $250,000 cash payment to Longview, and Longview agreed to cancel the remaining debt of $10,571,791 due under the Note. The remaining amount due under the Note is $64,000 which shall be paid in cash by Sileas to Longview on a quarterly basis, upon the payment of quarterly dividends by us, over the next four calendar quarters commencing on or about June 30, 2017. In order to effect the above, Longview also released the pledge on all of our shares owned by Sileas and previously pledged to Longview.

 

Simultaneously with the above, Sileas sold 800,000 shares of our common stock to Danny Schoening and Karen Hawkins at a price equal to $314,000 (which is a discounted amount based upon recognition of years of administrative support by Mr. Schoening and Ms. Hawkins for the Company) as follows: (i) Danny Schoening: 640,000 Shares for $200,000 plus a $50,825 promissory note; and (ii) Karen Hawkins: 160,000 Shares for $50,000 plus a $12,706 promissory note. Each promissory note has a one year term, with interest at 1.18% per annum and shall be payable in four equal quarterly installments of $12,800 for Danny Schoening and $3,200 for Karen Hawkins, each installment payable within five business days after the payment of cash dividends by us to each of them. As a result, Sileas no longer owns any shares of our common stock.  

 

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Changes to the Board of Directors

 

Effective as of May 31, 2017, Charles Trego resigned as a director of us and from all appointments to Committees of our Board of Directors.

 

Effective as of June 9, 2017, Peter Benz resigned as Chairman of the Board and a Director of us. Effective as of that same date, our Board of Directors appointed Danny Schoening, its CEO and a director, as the Chairman of the Board of Directors and appointed Karen Hawkins, its CFO, and Bill Bates, the General Manager of its Applied Optics Center division, as directors. The board further resolved that Owen Naccarato would replace Charles Trego as the new Audit Committee chair.

 

Executive and Board Compensation

 

On June 9, 2017, through Unanimous Written Consent, the Board of Directors amended Danny Schoening’s employment agreement to increase his annual bonus from a maximum of 30% to 60% of his base salary and entered into a consulting agreement with Peter Benz to provide advisory services at the rate of $10,000 per month through December 2017.

 

On June 14, 2017, through Unanimous Written Consent, the Board of Directors increased the monthly fee paid to the remaining independent directors from $1,000 to $1,500 per month, effective immediately, and granted Bill Bates, the Applied Optics Center General Manager and new board member 50,000 Restricted Stock Units (RSU’s). Pursuant to the RSU agreements the RSUs issued to Mr. Bates will vest as follows: 34% on January 1, 2018, 33% on January 1, 2019 and 33% on January 1, 2020. The total market value of the restricted stock units based on the shares price of $0.95 as of June 15, 2016 is $47.5 thousand.

 

Dividends

 

On June 26, 2017, the board of directors approved a resolution authorizing a $0.02 per share (and per warrant) dividend payment on July 12, 2017, for common and preferred C shareholders and warrant holders of record as of July 5, 2017 and for three subsequent quarterly record dates thereafter. On October 19, 2017, we paid a second $0.02 per share dividend to holders of record as of October 12, 2017.

 

Results of Operations

 

Segment Information

 

We have presented the operating results by segment to provide investors with an additional tool to evaluate our operating results and to have a better understanding of the overall performance of each business segment and its ability to perform in subsequent periods. Management of Optex Systems Holdings uses the selected financial measures by segment internally to evaluate its ongoing segment operations and to allocate resources within the organization accordingly. Segments are determined based on differences in products, location, internal reporting and how operational decisions are made. Management has determined that the Optex Systems, Richardson plant, and the Applied Optics Center, Dallas plant, which was acquired on November 3, 2014, are separately managed, organized, and internally reported as separate business segments. The table below provides a summary of selective statement of operations data by operating segment for the years ended October 1, 2017 and October 2, 2016 reconciled to the Audited Consolidated Results of Operations as presented in Item 8,“Financial Statements and Supplementary Data”. 

 

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Results of Operations Selected Financial Info by Segment

(Thousands)

         
                                 
   Twelve months ending 
     
   October 1, 2017   October 2, 2016 
   Optex
Richardson
   Applied Optics Center
Dallas
   Other
 (non allocated costs and eliminations)
   Consolidated   Optex
Richardson
  

Applied

Optics Center
Dallas

   Other
 (non allocated costs and eliminations)
   Consolidated 
                                 
Revenue from External Customers  $11,256   $7,291   $   $18,547   $11,052   $6,227   $   $17,279 
Intersegment Revenues       1,694    (1,694)           1,892    (1,892)    
Total Segment Revenue   11,256    8,985    (1,694)   18,547    11,052    8,119    (1,892)   17,279 
                                         
Total Cost of Sales   9,099    7,728    (1,694)   15,133    8,891    7,229    (1,892)   14,228 
                                         
Gross Margin   2,157    1,257        3,414    2,161    890        3,051 
Gross Margin %   19.2%   14.0%   0.0%   18.4%   19.6%   11.0%   0.0%   17.7%
                                         
General and Administrative Expense (1)   2,595    435    180    3,210    2,604    507    851    3,962 
Segment Allocated G&A Expense   (776)   776            (728)   728         
Net General & Administrative Expense   1,819    1,211    180    3,210    1,876    1,235    851    3,962 
                                         
Operating Income (Loss)   338    46    (180)   204    285    (345)   (851)   (911)
Operating (Loss) %   3.0%   0.5%   10.6%   1.1%   2.6%   (4.2%)   0.0%   (5.3%)
                                         
(Loss) Gain on Change in Fair Value of Warrants           (489)   (489)           739    739 
Interest Expense           (19)   (19)           (36)   (36)
                                         
Net Income (Loss) before taxes  $338   $46   $(688)  $(304)  $285   $(345)  $(148)  $(208)
Net Income (Loss) %   3.0%   0.5%       (1.6%)   2.6%   (4.2%)       (1.2%)

 

                                     
(1) General and administrative expenses for the twelve months ending October 2, 2016 of  $140 thousand associated with amortized stock compensation attributeable to executive/director restricted stock units has been restated from Optex Richardson to Other (non allocated costs and eliminations). Operating income (loss) for Optex Richardson and Other (non allocated costs and eliminations) as been restated to reflect the change. Other (non allocated costs and eliminations) includes $711 thousand in expenses attributable to warrants issued in the August 2016 public offering.

 

Our total external sales revenues increased by $1.2 million, or 6.9%, in 2017 over the 2016 revenue levels. The Optex Systems Richardson segment realized a $0.1 million, or 0.9%, increase in external revenue and the Applied Optics Center segment realized an increase of $1.1 million, or 17.7%, in external revenue over the prior year period. Intersegment revenues decreased by ($0.2) million during the 2017 year, from $1.9 million to $1.7 million. Intersegment revenues relate primarily to coated filters provided by the Applied Optics Center to Optex Systems in support of the Optex Systems periscope line.

 

Gross margin increased $0.4 million and the gross margin percentage increased by 1% point from 17.7% in 2016 to 18.4% in 2017. The gross margin and the gross margin percentages increased significantly in 2017 for the Applied Optics Center segments over 2016. The Applied Optics Center gross margin increased by $0.4 million and the gross margin percent increased by 3.1% points from 11.0% in 2016 to 14.1% in 2017 over the 2016 gross margin. U.S. government military spending has a significant impact on our product lines as our products directly support various types of U.S. military land vehicle procurements. During 2017, the Optex Systems gross margin percentage declined slightly to 19.2% in 2017 as compared to a gross margin percentage of 19.6% in 2016 primarily driven by changes in product mix between the years.

 

During the year ending 2017, the Applied Optics Center absorbed ($0.8) million of fixed general and administrative costs incurred by Optex Systems for support services, as compared to ($0.7) million in the prior year period. These expenses cover accounting, executive, human resources, information technology, board fees and other corporate expenses paid by Optex Systems and shared across both operating segments.

 

Operating income increased significantly, by $1.1 million, in 2017, to $0.2 million, as compared to the prior year operating loss of ($0.9) million. The Applied Optics Center operating profit increased by $0.4 million, from a prior year operating loss of ($0.3) million to a 2017 operation income of $0.1 million. Optex Systems operating profit increased slightly, $0.04 million, in 2017 as compared to 2016 on higher revenue. The Other (non allocated costs and eliminations) operating loss in 2016 included ($0.7) million in non-recurring warrant expenses associated with the public offering in August 2016.

 

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The net loss before taxes increased from the prior year by ($0.1) million, from a prior year net loss before taxes of ($0.2) million to a current year net loss before taxes of ($0.3) million. The increase in net loss year over year is primarily due increased operating profit of $1.1 million, offset by non cash related changes to the fair value of warrants of ($1.2) million from a gain of $0.7 million 2016 to a loss of ($0.5) million 2017.  

 

Backlog

 

Backlog as of October 1, 2017 was $15.7 million as compared to a backlog of $12.0 million as of October 2, 2016, representing an increase of 30.8%.  The following table depicts the current expected delivery by quarter of all contracts awarded as of October 1, 2017.

 

       (Millions) 
Product Line  Q1
 2018
   Q2
 2018
   Q3
 2018
   Q4
 2018
   2018
Delivery
   2019+
Delivery
   Total Backlog
10/1/2017
   Total Backlog
10/2/2016
   Variance   % Chg 
Periscopes   2.0    1.2    0.5        3.7    1.2    4.9    3.4    1.5    44.1%
Sighting Systems   0.5    1.0    0.8    0.1    2.4    1.7    4.1    3.2    0.9    28.1%
Other   0.2    0.3    0.1        0.6        0.6    2.3    (1.7)   (73.9%)
Optex Systems - Richardson   2.7    2.5    1.4    0.1    6.7    2.9    9.6    8.9    0.7    7.9%
Applied Optics Center - Dallas   1.8    1.8    1.5    0.9    6.0    0.1    6.1    3.1    3.0    96.8%
Total Backlog   4.5    4.3    2.9    1.0    12.7    3.0    15.7    12.0    3.7    30.8%

 

During 2017, Optex Systems Holdings received new orders totaling $22.3 million, a 26.7% increase, as compared to new orders of $17.6 million during the prior year. The 2017 orders consist of $8.6 million in support of our periscope product line, $10.3 million attributable to the Applied Optics Center and $2.1 million attributable to sighting systems and support, and $1.3 million in other products. Approximately 39.1% or $8.7 million of the orders received in fiscal year 2017 were delivered within the year, with $10.6 million deliverable in 2018 and the remaining $3.0 million balance to be delivered in fiscal year 2019 and beyond. As of October 1, 2017 our shippable backlog for fiscal year 2018 is $15.7 million. As of December 5, 2017, Optex Systems Holdings, Inc. has received additional new orders of $2.5 million, which includes $1.3 million in periscopes, $0.7 million in sighting systems, $0.3 million in Optex other and $0.2 million of Applied Optics Center products for deliveries in fiscal year 2018. We expect our orders during fiscal year 2018 to meet or exceed the fiscal year 2017 orders, with a substantial portion, approximately 35-40%, to be deliverable within the fiscal year 2018 period.

 

Military spending has been negatively impacted by the Budget Control Act of 2011, which was passed in August 2011. The Budget Control Act mandated a $917.0 billion reduction in discretionary spending over the next decade, and $1.2 trillion in automatic spending cuts over a nine-year period to be split between defense and non-defense programs beginning in January 2013. The sequestration caps were eased during the 2016 and 2017 fiscal years as Congress passed the Bipartisan Budget Act of 2015.

 

We believe that the defense industry effects of the sequestration from 2011 have reached a plateau and we will begin to see small but steady increases in defense military procurement orders in the coming years. On November 16, 2017, the National Defense Authorization Act (NDAA) for fiscal year 2018 was sent to President Trump to sign into law after passing both the House of Representatives and the Senate. The 2018 NDAA authorizes total spending of $700 billion which includes a base spending authorization of $634 billion plus the authorization of $65.8 billion in additional funding for the Overseas Contingency Operation (OCO) account. The bill authorizes a major hike in military spending over the 2017 NDAA authorization of $619 billion and sets defense spending well above the $549 billion base authorization cap under the 2011 Budget Control Act. There currently is no clear plan from Congress on how to provide additional money above the sequestration limit and changes in the sequestration law will require bipartisan support to reach a senate vote threshold of 60 to avoid a filibuster. Although it is difficult to directly tie the budget request to specific components provided by Optex Systems, we provide periscopes, collimator assemblies, vision blocks and laser interface filters to the U.S. armed forces on almost all of the ground system platforms categorized in the Department of Defense budget request for 2018.

 

The U.S. military supply industry has become highly competitive as suppliers fight for increased market share to offset the impacts of the reduced government spending. We compete with other suppliers on the basis of quality, delivery, price, and overall customer service, among other things. Our competitors include a number of suppliers, some of which have established strong relationships with the defense contracting agencies. Competition can lead to price reductions, reduced margins and an inability to gain or hold market share. We are aggressively pursuing additional periscope market share in both foreign and domestic defense contractor markets in order to mitigate the effect the reduced U.S. military orders has on our operations.

 

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Optex Systems - Richardson:

 

Backlog for our periscope product line has increased 44.1% or $1.5 million to $4.9 million, from our ending 2016 fiscal year level of $3.4 million. We attribute the increased backlog in 2017 to delayed timing of U.S. government contract awards during the fourth quarter of 2016 combined with increased orders in the current fiscal year. Our total periscope contract awards for fiscal 2017 totaled $8.6 million as compared to $7.8 million in the fiscal year 2016. Optex Systems, Inc. has experienced an increase in US government demand for laser protected periscopes in support of ongoing maintenance of US combat vehicles in addition to increased orders for foreign markets in support of Saudi Arabia’s Light Armored Vehicle, Morocco’s conversion of M1A1 vehicles to the situational awareness configuration and US Department of State Foreign Military Sales (FMS) in support of the M113 Periscope Upgrade program for Brazil. During fiscal year 2017 we received a large award consisting of a $1.5 million contract for laser protected periscopes from Defense Logistics Agency (DLA). The award is the first delivery order against a 5-year Indefinite Delivery, Indefinite Quantity (IDIQ) contract with DLA totaling $5.99 million. In addition, Optex was awarded a $1.5 million purchase order from one of the world’s largest defense companies for laser protected periscopes. These periscopes are installed into Light Armored Vehicles in the Middle East and will be delivered over the next three years beginning in December 2017. During the last quarter of fiscal year 2017 Optex was awarded an additional 5-year Indefinite Delivery, Indefinite Quantity (IDIQ) contract with DLA in support of the Abrams Main Battle Tank platform. The total contract is expected to generate between $1.5 million and $2.4 million in revenue over the next five year period for Optex Systems. On September 29, 2017 we received our first task order delivery award of $0.5 million, with an additional $1.0 million awarded in two separate task orders on October 23, 2017 subsequent to the fiscal 2017 year end.

 

Sighting Systems backlog increased by $0.9 million or 28.1% in the last twelve months. In September 2017, we received a substantial contract award of from General Dynamics Land Systems- Canada of $1.35 million to provide LAV 6.0 optimized weapon system support for Optex’s Commander Sighting System. This in-service support will continue over the next three years for their existing fleet of Light Armored Vehicles. We continued to deliver against our existing M36 DDAN sighting systems contract. We anticipate the possibility of new sighting systems orders for DDANs as well as similar sighting systems for delivery beyond 2018. Our current sighting system backlog deliveries have been scheduled through the third quarter of fiscal 2018.

 

Our backlog in other product groups decreased by ($1.7) million or 73.9% from $2.3 million in 2016 to $0.6 million in 2017. The decrease is driven by lower orders for collimator assemblies and cable periscope assemblies. In 2016 we books two large orders which were shipped during 2017. We continue to bid on new orders within these product groups and anticipate new orders on these products throughout 2018.

 

Applied Optics Center – Dallas

 

The Applied Optics Center backlog increased by $3.0 million, or 98.6%, for the year ending 2017 from $3.0 million in 2016 to $6.1 million in 2017. Significant new orders booked during the year consisted of a $0.8 million order from L-3 Communications, a $1.7 million order from a domestic defense contractor to supply night vision goggle laser interference filter assemblies and commercial purchase orders totaling $4.9 million against a multi-year strategic supplier agreement for optical assemblies and $1.6 million in task orders for night vision assemblies for the U.S. military against a five year Indefinite-Delivery Indefinite-Quantity contract through DLA Land at Aberdeen The total expected value of the IDIQ contract is between $8.4 and $12.4 million in revenue over the next five year period.

 

The Applied Optics Center also serves as a primary filter supplier to the Optex Systems – Richardson plant. During the fiscal year 2017, the Applied Optex Center received intracompany orders for laser coated filters in support of Optex periscopes of $1.7 million, as compared to $1.9 million in the prior year.

 

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We are cautiously optimistic that recent proposed boosts in military spending by the government administration will have a favorable impact in the direction of funding or product need for the U.S. military. Optex Systems Holdings continues to pursue new international and commercial opportunities in addition to maintaining its current footprint with U.S. military vehicle manufactures, with existing as well as new product lines. We continue exploring new market opportunities for our M17 day/thermal periscopes and digital optics for commercial applications. We are also reviewing potential products, outside our traditional product lines, which could be manufactured using our current production facilities in order to capitalize on our existing capacity. Further, we continue to look for strategic businesses to acquire that will strengthen our existing product line, expand our operations, and enter new markets.

 

Twelve month period ended October 1, 2017 compared to the twelve month period ended October 2, 2016

 

Revenues:

 

The table below details the revenue changes by segment and product line for the year ended October 1, 2017 as compared to the year ended October 2, 2016.

 

   Twelve months ended     
   (Millions)     
         
Product Line   October 1, 2017    October 2, 2016    Variance    % Chg 
Periscopes  $7.1   $8.1   $(1.0)   (12.3)
Sighting Systems   1.1    1.8    (0.7)   (38.9)
Other   3.0    1.2    1.8    150.0 
Optical Systems – Richardson   11.2    11.1    0.1    0.9 
Applied Optics Center – Dallas   7.3    6.2    1.1    17.7 
Total Revenue  $18.5   $17.3   $1.2    6.9 

 

Our total revenues increased by $1.2 million, or 6.9%, in 2017 over the 2016 revenue levels. The Optex Systems Richardson segment realized a $0.1 million, or 0.9%, increase in revenue and the Applied Optics Center segment realized an increase of $1.1 million, or 17.7%, in revenue over the prior year period. Approximately 39.1% of our total revenue recognized during the fiscal year was from new orders booked during the twelve months ending October 1, 2017.

 

Revenues decreased by ($1.0) million or (12.3%) on our periscope line during the twelve months ended October 1, 2017 as compared to the twelve months ended October 2, 2016. Revenue decreased during the current year from the prior year primarily due to lower revenue on glass periscopes of ($0.5) million for the US government and lower revenue of ($0.5) million on foreign M17 day thermal periscopes for contracts which were completed in 2016. Based on our strong ending September backlog of $4.9 million and new orders of $1.3 million received in the first quarter of fiscal 2018, we expect our 2018 periscope revenues to meet or exceed the 2017 levels with a strong first quarter backlog schedule.

 

Revenues on sighting systems declined by ($0.7) million, or (38.9%) from the prior year period . Deliveries on our backlog for DDAN sighting systems which were previously pending qualification testing, receipt of long lead materials and export licensing were delayed throughout the first half of 2017. We resumed production on these units in June and are anticipated higher production levels through the third quarter of 2018.

 

Revenue on other product lines increased by $1.8 million, or 150%, compared to revenues in the prior year as we completed first article testing and shipped $1.6 million in collimator assembly units against orders received from two U.S. military customers in 2016. In addition, we increased shipments by an additional $0.3 million in cable periscope assemblies against an U.S military order booked in 2016, the increases were offset by lower revenue of ($0.1) million on other smaller orders. We continue to bid on smaller miscellaneous spare orders on an ongoing basis.

 

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The Applied Optics Center external revenue increased by $1.1 million, or 17.7%, during the 2017 fiscal year as compared to the prior year period due to increased deliveries on commercial optical assemblies of $1.4 million and increased revenue in laser coated filters $0.6 million and other AOC products of $0.4 million which was offset by reductions in ACOG 36MM filters of ($1.3) for a contract shipped complete in fiscal year 2016. As are entering fiscal 2018 with a very strong backlog of $6.1 million, a 96.8% increase over the prior year ending backlog, we expect the Applied Optics Center revenue to remain strong through the second quarter with additional orders anticipated for delivery the second half of the year.

 

Gross Margin. The gross margin during the period ending October 1, 2017 was 18.4% of revenue as compared to a gross margin of 17.7% of revenue for the period ending October 2, 2016. Cost of sales increased by $0.9 million to $15.1 million for the fiscal year ending 2017 compared to $14.2 million for the fiscal year ending 2016. The increased cost of sales was primarily driven by higher revenues. The gross margin increased by $0.3 million to $3.4 million in 2017 as compared to $3.1 million in 2016. We attribute the improvement in gross margin to higher revenue combined with cost efficiency improvements at the Applied Optics Center combined with changes in product mix between the respective years.

 

G&A Expenses.  During the fiscal year ended October 1, 2017, we recorded operating expenses of $3.2 million as opposed to $4.0 million during the period ending October 2, 2016, a decrease of ($0.8) million or (17.5%).  The decrease in general and administrative expenses in the year ending 2017 as compared to the year ending 2016 is primarily attributable to ($0.9) million non-recurring expenses incurred in 2016 attributable to the August 2016 public offering offset by increased spending of $0.1 million in 2017 for the executive and management incentive plans.

 

Operating Income (Loss). During the period ending October 1, 2017, we recorded operating income of $0.2 million as compared to an operating loss of ($0.9) million during the period ending October 2, 2016. The $1.1 million increase in operating income in the current year over the prior year is primarily due to the increased gross margin of $0.3 million on higher revenue and reduced general and administrative costs of $0.8 million in 2017 as compared to 2016.

 

Net loss applicable to common shareholders. During the year ended October 1, 2017, we recorded a net loss applicable to common shareholders of ($0.3) million as compared to net loss applicable to common shareholders of ($1.4) million during the year ended October 2, 2016. The decreased loss of $1.1 million is primarily attributable to a decrease in operating losses of $1.1 million. In addition during 2016 we realized a ($0.7) million gain the the change in fair value of warrants, as compared to a loss on the change in fair value of warrants of ($0.5) million in 2017 which was offset by $1.2 million in premiums on preferred stock for the beneficial conversion features recognized on Series A and Series B preferred incurred during 2016. The Series A and Series B preferred shares were converted or redeemed in full during 2016, thus there is no remaining premiums related to a beneficial conversion feature on those shares.

 

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Liquidity and Capital Resources

 

As of October 1, 2017, Optex Systems Holdings had working capital of $8.0 million, as compared to $8.6 million as of October 2, 2016. During the year ended October 1, 2017, the Company experienced a net loss of ($0.3) million as compared to a net loss of $(1.4) million, and an increase in revenues of $1.2 million, or 6.9%, up to $18.5 million, from $17.3 million, as compared to the prior year ended October 2, 2016.  New orders increased 26.7% to $22.3 million, as compared to new orders of $17.6 million during the prior year. Backlog has increased by $3.7 million, or 30.8% to 15.7 million over the prior year backlog of 12.0 million. Approximately 39.1% of annual revenue is derived from new orders booked during the fiscal year.

 

U.S. military spending has been significantly reduced from the 2011 peak spending levels as a result of a decrease in military operations in Iraq and Afghanistan and due to Congressional sequestration cuts to defense spending created by the Budget Control Act of 2011, which began in fiscal year 2013. As a result of lower U.S. government defense spending, the Company has continued to explore other opportunities for manufacturing outside of our traditional product lines for products which could be manufactured using our existing lines in order to fully utilize our existing capacity. On November 16, 2017, the National Defense Authorization Act (NDAA) for fiscal year 2018 was sent to President Trump to sign into law after passing both the House of Representatives and the Senate. The 2018 NDAA authorizes total spending of $700 billion which includes a base spending authorization of $634 billion plus the authorization of $65.8 billion in additional funding for the Overseas Contingency Operation (OCO) account. The bill authorizes a major hike in military spending over the 2017 NDAA authorization amount of $619 billion and sets defense spending well above the $549 billion base authorization cap under the 2011 Budget Control Act. Currently, there is no clear plan from Congress on how to provide the additional money above the sequestration limit as changes in the sequestration law will require bipartisan support to reach a vote threshold of 60 senators to avoid a filibuster. We are cautiously optimistic that the defense industry effects of the sequestration from 2011 have reached a plateau and we will begin to see small but steady increases in defense military procurement orders in fiscal year 2018 and upcoming fiscal years. Further, we continue to look for additional strategic businesses to acquire that will strengthen our existing product line, expand our operations, and enter new markets.

 

The Company has historically funded its operations through operations, convertible notes, common and preferred stock offerings and bank debt.  The Company’s ability to generate positive cash flows depends on a variety of factors, including the continued development and successful marketing of the Company’s products. At October 1, 2017, the Company had approximately $1.7 million in cash and an outstanding payable balance of $0.3 million against our working line of credit.  The line of credit allows for borrowing up to a maximum of $2.2 million, which fluctuates based on our open accounts receivable balance. As of October 1, 2017, our outstanding accounts receivable was $3.1 million. We expect the accounts to be collected during the first quarter of fiscal 2017. The Company expects to incur net income and positive cash flow from operating activities throughout 2018 on higher projected revenue growth combined with increased gross margin related to existing and planned productivity and cost efficiency improvements. Although our 2017 year end net loss was ($0.3) million; it marked a significant improvement of $1.1 million from the prior year net loss of ($1.4) million. Our net income during the final quarter of 2017 was $0.5 million, a significant increase in profitability, offsetting much the ($0.8) million in losses incurred during the first three quarters of the fiscal year. Successful transition to attaining and maintaining profitable operations is dependent upon maintaining a level of revenue adequate to support the Company’s cost structure.  We are entering 2018 with a strong $15.7 million backlog, 30.8% higher than the prior year end with increased orders booked during 2017 fiscal year. Management intends to manage operations commensurate with its level of working capital and facilities line of credit during the next twelve months; however, uneven revenue levels driven by changes in customer delivery demands, first article inspection requirements or other program delays combined with increasing inventory and production costs required to support the increases in backlog could create a working capital shortfall.  In the event the Company does not successfully implement its ultimate business plan, certain assets may not be recoverable. 

 

On August 26, 2016, we consummated a public offering of 2,291,000 Class A units consisting of common stock and warrants and 400 Class B units consisting of shares of Series C convertible stock and warrants for a total gross purchase price of $4.8 million. The net proceeds of the offering were $4.2 million after underwriter expenses. We used $0.3 million of the proceeds for offering expenses paid by Optex Systems Holdings and $1.7 million of the proceeds for the redemption of Series A and Series B preferred shares which were a condition of the offering. The remaining $2.2 million of funds will be used to fund working capital needs to support revenue growth and acquisitions.

 

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On April 27, 2017, the Board of Directors of Optex Systems Holdings approved a purchase of 700,000 shares of its common stock in a private transaction from The Longview Fund, L.P. The transaction was priced at the closing sale price on April 28, 2017 of $0.74 per share for a total transaction amount of $518,000. Upon repurchase on May 1, 2017, the shares were cancelled thereby reducing the total shares outstanding of its common stock.

 

On June 26, 2017, the board of directors approved a resolution authorizing a $0.02 per share (and per warrant) dividend payment on July 12, 2017, for common and preferred C shareholders and warrant holders of record as of July 5, 2017 and for three subsequent quarterly record dates thereafter. Quarterly dividends of $261 thousand were paid out to share and warrant holders on July 12, 2017. Optex recorded an additional $261 thousand in dividends payable as of October 1, 2017 for the fourth quarter declared dividends which were in paid on October 19, 2017, in the first quarter of 2018. The Company expects to pay additional dividends totaling $522 thousand through April 2018, $261 thousand per quarter, covering the first two quarters of 2018 ending in March. The Company will review its working capital needs after the second fiscal quarter prior to determining any future dividends or amounts to be paid to our shareholders beyond April 2018.

 

Period from October 2, 2016 through October 1, 2017

 

Cash and Cash Equivalents.  As of October 1, 2017, we had cash and cash equivalents of $1.7 million as compared to $2.6 million as of October 2, 2016, a decrease in cash and cash equivalents of ($0.9) million.

 

Net Cash (Used by) Provided by Operating Activities.  Net cash provided by operating activities during the period beginning October 2, 2016 and ending October 1, 2017 was zero. The primary use of cash provided by operations was driven by increased inventory of ($1.4) million in support of higher revenue levels projected for 2018, increased accounts receivable of ($1.2) million due to substantially higher shipments during the fourth quarter which will be paid during the first quarter of 2018 and an operating loss of ($0.3) million. These were offset by increased accounts payable and accrued expenses of $1.3 related to inventory purchases and increased operating costs driven by production increases, increased customer deposits on new orders of $0.4, non-cash expenses included in net loss of $1.1 million and other working capital changes of $0.1 million

 

Net Cash (Used) by Investing Activities.  In the twelve months ended October 1, 2017, cash used by investing activities was ($0.1) million for new asset purchases used in support of production.

 

Net Cash (Used) by Financing Activities. Net cash used in financing activities was ($0.8) million during the twelve months ended October 1, 2017 due to the repurchase of outstanding common stock of ($0.5) million in May 2017 and dividend payments in July 2017 of ($0.3) million. As of October 1, 2017, the outstanding line of credit balance was $0.3 million

 

Critical Accounting Policies

 

Revenue Recognition: Optex Systems Holdings recognizes revenue based on the modified percentage of completion method utilizing the units-of-delivery method, in accordance with FASB ASC 605-35:

 

The units-of-delivery method recognizes as revenue the contract price of units of a basic production product delivered during a period and as the cost of earned revenue the costs allocable to the delivered units. Costs allocable to undelivered units are reported in the balance sheet as inventory or work in progress. The method is used in circumstances in which an entity produces units of a basic product under production-type contracts in a continuous or sequential production process to buyers’ specifications.

 

Optex Systems Holdings contracts are fixed price production type contracts whereby a defined order quantity is delivered to the customer during a continuous or sequential production process tailored to the buyer’s specifications (build to print).  Optex Systems Holdings’ deliveries against these contracts generally occur in monthly increments across fixed delivery periods spanning from 3 to 36 months. 

  

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Estimated Costs at Completion and Accrued Loss on Contracts:  Optex Systems Holdings reviews and reports on the performance of its long term contracts and production orders against the respective resource plans for such contracts/orders. These reviews are summarized in the form of estimates at completion. Estimates at completion include Optex Systems Holdings’ incurred costs to date against the contract/order plus management’s current estimates of remaining amounts for direct labor, material, other direct costs and subcontract support and indirect overhead costs based on the completion status and future contractual requirements for each order. 

 

If an estimate at completion indicates a potential overrun against budgeted resources for a fixed price contract/order, management first attempts to implement lower cost solutions that will profitably meet the requirements of the fixed price contract. If such solutions do not appear practicable, management makes a determination whether to seek renegotiation of contract or order requirements from the customer. If neither cost reduction nor renegotiation appears probable, an accrual for the contract loss/overrun is recorded against earnings and the loss is recognized in the first period the loss is identified based on the most recent estimates at completion of the particular contract or product order. As of October 1, 2017 there was $0 in contract loss reserves. As of October 2, 2016 the contract loss reserves were $0 thousand.

 

Stock-Based Compensation: FASB ASC 718 establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, but primarily focuses on transactions whereby an entity obtains employee services for share-based payments. FASB ASC 718 requires that the compensation cost relating to share-based payment transactions be recognized in the financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments.

 

Optex Systems Holdings’ accounting policy for equity instruments issued to consultants and vendors in exchange for goods and services follows the provisions of FASB ASC 505-50. The measurement date for the fair value of the equity instruments issued is determined at the earlier of (i) the date at which a commitment for performance by the consultant or vendor is reached or (ii) the date at which the consultant or vendor’s performance is complete. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement. Stock-based compensation related to non-employees is accounted for based on the fair value of the related stock or options or the fair value of the services, whichever is more readily determinable in accordance with FASB ASC 718.

 

Beneficial Conversion Features of Convertible Securities: Conversion options that are not bifurcated as a derivative pursuant to ASC 815 and not accounted for as a separate equity component under the cash conversion guidance are evaluated to determine whether they are beneficial to the investor at inception (a beneficial conversion feature) or may become beneficial in the future due to potential adjustments. The beneficial conversion feature guidance in ASC 470-20 applies to convertible stock as well as convertible debt which are outside the scope of ASC 815. A beneficial conversion feature is defined as a nondetachable conversion feature that is in the money at the commitment date. In addition, our preferred stock issues contain conversion terms that may change upon the occurrence of a future event, such as antidilution adjustment provisions. The beneficial conversion feature guidance requires recognition of the conversion option’s in-the-money portion, the intrinsic value of the option, in equity, with an offsetting reduction to the carrying amount of the instrument. The resulting discount is amortized as a dividend over either the life of the instrument, if a stated maturity date exists, or to the earliest conversion date, if there is no stated maturity date. If the earliest conversion date is immediately upon issuance, the dividend must be recognized at inception. When there is a subsequent change to the conversion ratio based on a future occurrence, the new conversion price may trigger the recognition of an additional beneficial conversion feature on occurrence. 

 

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During the twelve months ending October 2, 2016, Optex Systems Holdings had preferred stock outstanding, convertible into common shares, containing beneficial conversion features at inception as well as potential beneficial conversion features that could be triggered by future adjustments to the conversion price. Because our preferred stock was perpetual, with no stated maturity date, and the conversions could occur any time from inception, the dividend is recognized immediately when a beneficial conversion exists at issuance. The August 26, 2016 public offering triggered a reset of the preferred stock conversion rate from $2.50 per common share to $1.20 per common share on our Series A and Series B preferred shares and resulted in a $0.8 million beneficial conversion feature. The public offering also included a beneficial conversion feature of $0.4 million at the August 26, 2016 commitment date of the 400 shares of Series C preferred stock issued in the offering, based on the effective conversion price of the shares, net of the allocated warrant proceeds. During the twelve months ending October 2, 2016, Optex Systems Holdings recognized a total preferred stock dividend of $1.2 million as a result of the beneficial conversion features triggered on the existing and new issues of preferred shares. There were no preferred shares outstanding during the twelve months ending October 1, 2017 subject to subsequent beneficial conversion features, thus there was zero preferred stock dividends recognized during the period.

 

Income Tax/Deferred Tax: FASB ASC 740 requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on differing treatment of items for financial reporting and income tax reporting purposes. The deferred tax balances are adjusted to reflect tax rates by tax jurisdiction, based on currently enacted tax laws, which will be in effect in the years in which the temporary differences are expected to reverse. Under FASB ASC 740, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that Optex Systems Holdings will not realize tax assets through future operations. When assessing the recoverability of deferred tax assets, management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies. Based on those estimates, management has determined that the deferred tax assets may not be realized and has established a valuation allowance against the deferred tax asset balance. As of October 1, 2017 Optex Systems Inc. has a deferred tax asset valuation allowance of ($4.6) million against deferred tax assets of $4.6 million.

 

Recent Accounting Pronouncements

 

Recent Accounting Pronouncements are detailed under Note 3 of Item 8 “Financial Statements and Supplementary Data” of this report.  

 

Cautionary Factors That May Affect Future Results

 

This Report on Form 10-K and other written reports and oral statements made from time to time by Optex Systems Holdings may contain so-called “forward-looking statements,” all of which are subject to risks and uncertainties. You can identify these forward-looking statements by their use of words such as “expects,” “plans,” “will,” “estimates,” “forecasts,” “projects” and other words of similar meaning. You can identify them by the fact that they do not relate strictly to historical or current facts. These statements are likely to address Optex Systems Holdings’ growth strategy, financial results and product and development programs. You must carefully consider any such statement and should understand that many factors could cause actual results to differ from Optex Systems Holdings’ forward-looking statements. These factors include inaccurate assumptions and a broad variety of other risks and uncertainties, including some that are known and some that are not. No forward-looking statement can be guaranteed and actual future results may vary materially.

 

We do not assume the obligation to update any forward-looking statement. You should carefully evaluate such statements in light of factors described in this annual report. In this annual report Optex Systems Holdings has identified important factors that could cause actual results to differ from expected or historic results. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider any such list to be a complete list of all potential risks or uncertainties.  

 

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Item 8  Financial Statements and Supplementary Data

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and 

Stockholders of Optex Systems Holdings, Inc.

 

We have audited the accompanying consolidated balance sheet of Optex Systems Holdings, Inc. (the Company) as of October 1, 2017, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Optex Systems Holdings, Inc. as of October 1, 2017, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

 

/s/Whitley Penn LLP

 

December 20, 2017

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and

Stockholders of Optex Systems Holdings, Inc.

 

Richardson, Texas

 

We have audited the accompanying consolidated balance sheets of Optex Systems Holdings, Inc. (the Company) as of October 2, 2016, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Optex Systems Holdings, Inc. as of October 2, 2016, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

  

/s/PMB Helin Donovan, LLP  
   
PMB Helin Donovan, LLP  
   

December 22, 2016 (February 21, 2017 as to Note 13)

 

Austin, Texas

 

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Optex Systems Holdings, Inc.

Consolidated Balance Sheets

 

   (Thousands, except share and per share data)
    
   October 1, 2017    October 2, 2016  
       
ASSETS          
           
Cash and Cash Equivalents  $1,682   $2,568 
Accounts Receivable, Net   3,125    2,095 
Net Inventory   7,614    6,214 
Prepaid Expenses   63    120 
Current Assets   12,484    10,997 
           
Property and Equipment, Net   1,460    1,651 
           
Other Assets          
Prepaid Royalties - Long Term   60    90 
Security Deposits   23    23 
Other Assets   83    113 
           
Total Assets  $14,027   $12,761 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY          
           
Current Liabilities          
Accounts Payable  $1,362   $706 
Dividends Payable   261     
Accrued Expenses   1,450    810 
Accrued Warranties   174    28 
Customer Advance Deposits   927    559 
Credit Facility   300    300 
Current Liabilities   4,474    2,403 
           
Warrant Liability   3,607    3,118 
Total Liabilities   8,081    5,521 
           
Stockholders’ Equity          
Preferred Stock Series C ($0.001 par 400 authorized, 174 and 360 issued and outstanding, respectively)        
Common Stock – ($0.001 par, 2,000,000,000 authorized,  8,190,101 and 8,266,601 shares issued and outstanding, respectively)   8    8 
Additional Paid-in-capital   26,411    26,879 
Accumulated Deficit   (20,473)   (19,647)
Stockholders’ Equity   5,946    7,240 
           
Total Liabilities and Stockholders’ Equity  $14,027   $12,761 

 

The accompanying notes are an integral part of these financial statements

 

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Optex Systems Holdings, Inc.

Consolidated Statements of Operations

 

   (Thousands, except share and per share data)
   Twelve months ended
    
   October 1, 2017    October 2, 2016  
       
Revenue  $18,547   $17,279 
           
Cost of Sales   15,133    14,228 
Gross Margin   3,414    3,051 
           
General and Administrative Expense   3,210    3,962 
Operating Income (Loss)   204    (911)
           
(Loss) Gain on Change in Fair Value of Warrants   (489)   739 
Interest Expense   (19)   (36)
Other Expense   (508)   703 
           
Loss Before Taxes   (304)   (208)
           
Current Income Taxes (Benefit)        
Deferred Income Taxes (Benefit)        
Net Loss After Taxes   (304)   (208)
           
Preferred stock dividend/premium       (1,203)
           
Net (loss) applicable to common shareholders  $(304)  $(1,411)
           
Basic and diluted (loss) per share  $(0.04)  $(0.91)
           
Weighted Average Common Shares Outstanding - basic and fully diluted   7,995,092    1,546,774 

  

The accompanying notes are an integral part of these financial statements. 

 

50 

 

 

Optex Systems Holdings, Inc. 

Consolidated Statements of Cash Flows

 

   (Thousands)
   Twelve months ended
   October 1, 2017    October 2, 2016  
       
Cash flows from operating activities:          
Net loss  $(304)  $(208)
           
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:          
Depreciation and amortization   337    345 
Loss (gain) on change in fair value of warrants   489    (739)
Noncash interest expense       (17)
Stock compensation expense   220    192 
(Use of) provision for inventory valuation   (34)   60 
(Gain) loss on sale of fixed assets   (38)   5 
(Increase) decrease  in accounts receivable   (1,185)   771 
Increase in inventory (net of progress billed)   (1,366)   (562)
Decrease in prepaid expenses   57    51 
Increase in accounts payable and accrued expenses   1,296    130 
Increase in accrued warranty costs   146     
Decrease in prepaid royalties - long term   30    30 
Increase (decrease) in customer advance deposits   368    (597)
Total adjustments   320    (331)
Net cash provided by (used in) operating activities   16    (539)
           
Cash flows (to) from investing activities          
Purchases of property and equipment   (149)   (34)
Proceeds from sale of fixed assets   41    4 
Net cash used in investing activities   (108)   (30)
           
Cash flows from (to) financing activities          
 Dividends paid   (261)    
 Net proceeds from sale of common stock       4,750 
 Redemption of preferred stock       (1,751)
 Deferred public offering costs       (45)
 Cash paid for taxes withheld on net settled restricted stock unit share issue   (15)    
 Proceeds (to) credit facility (net)       (500)
 Proceeds (to) stock repurchase   (518)    
Net cash (used in) provided by financing activities   (794)   2,454 
Net (decrease) increase in cash and cash equivalents   (886)   1,885 
Cash and cash equivalents at beginning of period   2,568    683 
Cash and cash equivalents at end of period  $1,682   $2,568 
           
Supplemental cash flow information:          
Exchange of common stock for non-trade accounts receivable  $155   $ 
Exchange of preferred stock for common stock   930    6,939 
Beneficial conversion features on preferred stock       1,203 
Fair value of warrants issued for underwriter expenses in public offering       156 
Dividends declared and unpaid   261     
Cash paid for interest   19    53 

 

The accompanying notes are an integral part of these financial statements 

 

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Optex Systems Holdings, Inc.
Consolidated Statement of Stockholders’ Equity

 

(Thousands, except share data)

 

   Common
Shares
Outstanding
   Series A
Preferred
Shares
   Series B
Preferred
Shares
   Series C
Preferred
Shares
   Common
Stock
    Additional
Paid in
Capital
   Retained
Earnings
   Total
Stockholders
Equity
 
                                 
Balance at September 27, 2015   314,867    1,001    994       $    $26,394   $(18,236)  $8,158 
                                          
Stock Compensation Expense                        192        192 
                                          
Issue of Shares - DTC/CEDE fractional roundup correction for reverse split 12/8/15   247                              
                                          
Conversion of Preferred Series B (10/23/15)   16,031        (25)                     
                                          
Conversion of Preferred Series A (3/27/16)   1,250,000    (456)           2     (2)        
                                          
Conversion of Preferred Series B (7/6/16)   109,291        (167)                     
                                          
Conversion of Preferred Series A (8/10/16)   25,000    (9)                         
                                          
Issue of Common Shares for Investor Relations (IRTH)   40,000                              
                                          
Issuance of Common Stock 8/26/2016   2,291,900            400    2     4,748        4,750 
                                          
Fees on Share Offering paid by Optex                        (45)       (45)
                                          
Redemption of Series A & Series B Preferred Shares 8/26/2016       (66)   (796)            (1,751)       (1,751)
                                          
Conversion of Series A & Series B Preferred Shares 8/26/2016   2,698,431    (470)   (6)       3     (3)        
                                          
Fair Value of Warrants Issued in Offering 8/26/2016                        (3,856)       (3,856)
                                          
Conversions of Series C Preferred Shares   166,667            (40)                 
                                          
Ratchet on Preferred Series A 3/27/16 Conversion (10/18/16)   1,354,167                1     (1)        
                                          
Beneficial Conversion Feature on Preferred Stock -Dividend/Premium                        1,203    (1,203)    
                                          
Net (loss)                            (208)   (208)
                                          
Balance at October 2, 2016   8,266,601            360   $8    $26,879   $(19,647)  $7,240 
                                          
Stock Compensation Expense                        220        220 
                                          
Shares issued in settlement of 68,000 vested restricted stock units on 1/4/17, net of tax withheld shares of 22,201   45,799                     (15)       (15)
                                          
Return and cancellation of Sileas held Common Shares in exchange for Accounts Recievables due from Sileas   (197,299)                    (155)       (155)
                                          
Conversions of Series C Preferred Shares   775,000            (186)   1     (1)        
                                          
Stock Buyback and Cancellation   (700,000)               (1)    (517)       (518)
                                          
Declared Dividends                            (522)   (522)
                                          
Net (loss)                            (304)   (304)
                                          
Balance at October 1, 2017   8,190,101            174   $8    $26,411   $(20,473)  $5,946 

 

The accompanying notes are an integral part of these financial statements

 

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Note 1 — Organization and Operations

 

On March 30, 2009, Optex Systems Holdings, Inc. (formerly known as Sustut Exploration, Inc.), a Delaware corporation (“Optex Systems Holdings”), along with Optex Systems, Inc., a privately held Delaware corporation (“Optex Systems, Inc.“), which is a wholly-owned subsidiary of Optex Systems Holdings, entered into a reorganization agreement, pursuant to which Optex Systems, Inc. was acquired by Optex Systems Holdings in a share exchange transaction. Optex Systems Holdings became the surviving corporation. At the closing, there was a name change from Sustut Exploration, Inc. to Optex Systems Holdings, Inc., and its year end changed from December 31 to a fiscal year ending on the Sunday nearest September 30.

 

On October 14, 2008, certain senior secured creditors of Irvine Sensors Corporation, Longview Fund, L.P. (Longview) and Alpha Capital Anstalt formed Optex Systems, Inc., which acquired all of the assets and assumed certain liabilities of Optex Systems, Inc., a Texas corporation (“Optex Systems, Inc. (Texas)”), and a wholly-owned subsidiary of Irvine Sensors Corporation, in a transaction that was consummated via purchase at a public auction. Following this asset purchase, Optex Systems, Inc. (Texas) remained a wholly-owned subsidiary of Irvine Sensors Corporation.

 

On February 20, 2009, Sileas Corporation (Sileas), a newly-formed Delaware corporation, owned by present members of Optex Systems Holdings’ management, purchased 100% of Longview’s equity and debt interest in Optex Systems, Inc. (Longview’s interest in Optex Systems, Inc. then representing 90% of the issued and outstanding common equity interests in Optex Systems, Inc.), in a private transaction.

 

Optex Systems, Inc. operated as a privately-held Delaware corporation until March 30, 2009, when, as a result of a reverse merger transaction consummated pursuant to a reorganization agreement dated March 30, 2009, it became a wholly-owned subsidiary of Optex Systems Holdings. Sileas was the majority owner (parent) of Optex Systems Holdings, until June 9, 2017. On June 9, 2017, Sileas entered into a transaction with Longview to settle its original February 20, 2009 Note with Longview in exchange for 2,798,782 common shares of Optex Systems Holdings common stock owned by Sileas, a $250,000 cash payment and a Note to Longview of $64,000 which shall be paid in cash by Sileas to Longview on a quarterly basis. See Note 9. As a result of the transaction, Longview owns 34.2% of the issued and outstanding equity interests in Optex Systems The financial statements of Optex Systems Holdings represent subsidiary statements and do not include the accounts of its majority owner.

 

Optex Systems Holdings’ operations are based in Dallas and Richardson, Texas in leased facilities comprising 93,967 square feet. As of October 1, 2017, Optex Systems Holdings operated with 100 full-time equivalent employees.

 

Optex Systems Holdings manufactures optical sighting systems and assemblies, for the U.S. Department of Defense, foreign military applications and commercial markets. Its products are installed on a variety of U.S. military land vehicles, such as the Abrams and Bradley fighting vehicles, light armored and advanced security vehicles, and have been selected for installation on the Stryker family of vehicles. Optex Systems Holdings also manufactures and delivers numerous periscope configurations, rifle and surveillance sights and night vision optical assemblies. Optex Systems Holdings’ products consist primarily of build to customer print products that are delivered both directly to the military and to other defense prime contractors or commercial customers.

 

In February 2009, Optex Systems Holdings’ ISO certification status was upgraded from 9001:2000 to 9001:2008, bringing Optex Systems Holdings into compliance with the new ISO standards rewritten to align with ISO 14001.

 

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 Center (AOC) Products Line (“Purchased Assets”), which is engaged in the production and marketing and sales of precision optical assemblies utilizing thin film coating capabilities for optical systems and components primarily used for military purposes.

 

U.S. military spending has been significantly reduced as a result of the Congressional sequestration cuts to defense spending, which began in fiscal year 2013. As a result of lower U.S. government spending, the Company has continued to explore other opportunities for manufacturing outside of our traditional product lines for products which could be manufactured using our existing lines in order to fully utilize our existing capacity. Further, we continue to look for additional strategic businesses to acquire that will strengthen our existing product line, expand our operations, and enter new markets. 

 

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We are cautiously optimistic that the new government administrations proposed boost in military spending will have a favorable impact in the direction of funding or product need for the U.S. military. We anticipate that absent any significant changes from the current defense spending levels, maintenance will still be required, and the opportunities for us to upgrade existing systems with higher performing systems will continue to present themselves. Spending levels may change, but given the mix between foreign spending, domestic/prime demand, and the more recent commercial opportunities, we do not expect any negative trends arising from political domestic changes over the next twelve months.

 

Note 2 — Accounting Policies

 

Basis of Presentation

 

Principles of Consolidation:  The consolidated financial statements include the accounts of Optex Systems Holdings and its wholly-owned subsidiary, Optex Systems, Inc.  All significant inter-company balances and transactions have been eliminated in consolidation.

 

Use of Estimates:  The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statement and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from the estimates.

 

Segment Reporting: FASB ASC 280 requires that a public business enterprise report financial and descriptive information about its reportable operating segments. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assess performance. Generally, financial information is required to be reported on the basis that it is used internally for evaluating segment performance and deciding how to allocate resources to segments. Segments are determined based on differences in products, internal reporting and how operational decisions are made. Management has determined that the Optex Systems, Richardson plant, and the Applied Optics Center, Dallas plant, which was acquired on November 3, 2014, are separately managed, organized, and internally reported as separate business segments. The FASB ASC 280 requires that a public business enterprise report a measure of segment profit or loss, certain specific revenue and expense items, and segment assets. It requires reconciliations of total segment revenues, total segment profit or loss, total segment assets, and other amounts disclosed for segments to corresponding amounts in the enterprise’s general-purpose financial statements.

  

Fiscal Year:  Optex System Holdings’ fiscal year ends on the Sunday nearest September 30.  Fiscal year 2016 ended on October 1, 2017 and included 53 weeks.  Fiscal year 2016 ended on October 2, 2016 and included 53 weeks.

 

Fair Value of Financial Instruments:  FASB ASC 825-10 requires disclosure of fair value information about certain financial instruments, including, but not limited to, cash and cash equivalents, accounts receivable, prepaid expenses, accounts payable, accrued expenses credit facilitied and warrant liabilities. Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of fiscal years ended October 1, 2017 and October 2, 2016. The carrying value of the balance sheet financial instruments included in Optex Systems Holdings’ consolidated financial statements approximated their fair values.

  

The carrying value of the balance sheet cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, and credit facilities are carried at, or approximate, fair value as of the reporting date because of their short-term nature. Fair values for the Company’s warrant liabilities and derivatives are estimated by utilizing valuation models that consider current and expected stock prices, volatility, dividends, market interest rates, forward yield curves and discount rates.  Such amounts and the recognition of such amounts are subject to significant estimates that may change in the future.

 

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The accounting guidance FASB ASC 820-10, “Fair Value Measurements and Disclosures” establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value and requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

 

Level 1: Quoted market prices in active markets for identical assets or liabilities.

Level 2: Observable market-based inputs or unobservable inputs that are corroborated by market data.

Level 3: Unobservable inputs reflecting the reporting entity’s own assumptions.

 

The accounting guidance establishes a hierarchy which requires an entity to maximize the use of quoted market prices and minimize the use of unobservable inputs. An asset or liability’s level is based on the lowest level of input that is significant to the fair value measurement. Fair value estimates are reviewed at the origination date and again at the each applicable measurement date and interim or annual financial reporting dates, as applicable for the financial instrument, and are based upon certain market assumptions and pertinent information available to management at those times.

 

The methods, significant inputs and assumptions utilized in estimating the fair value of the warrant liabilities are discussed further in Note 13 “Warrant Liabilities”. Each of the measurements is considered a Level 3 measurement as a result of at least one unobservable input.

 

Cash and Cash Equivalents:  For financial statement presentation purposes, Optex Systems Holdings considers those short-term, highly liquid investments with original maturities of three months or less to be cash or cash equivalents. Optex Systems Holdings has $1,682 thousand in cash on deposit with our bank. Only a portion of the cash, currently $250 thousand, would be covered by federal deposit insurance and the uninsured balances are substantially greater than the insured amounts. We are exploring options to invest a portion of the excess cash into short term treasuries covered by federal deposit insurance in the near term.

 

Concentration of Credit Risk: Optex Systems Holdings’ revenues and accounts receivables for fiscal year ended October 1, 2017 are derived from sales to U.S. government agencies (38%), General Dynamics (19%), Nightforce Optics, Inc. (22%) and all other contractors (21%).  Optex Systems Holdings does not believe that this concentration results in undue credit risk because of the financial strength of the obligees. 

 

Accounts Receivable: Optex Systems Holdings records its accounts receivable at the original sales invoice amount less liquidations for previously collected advance/progress bills and an allowance for doubtful accounts. An account receivable is considered to be past due if any portion of the receivable balance is outstanding beyond its scheduled due date. On a quarterly basis, Optex Systems Holdings evaluates its accounts receivable and establishes an allowance for doubtful accounts, based on its history of past write-offs and collections, and current credit conditions. No interest is accrued on past due accounts receivable. As of October 1, 2017 and October 2, 2016, Optex Systems Holdings had an allowance for doubtful accounts of $2 thousand and $42 thousand, for non U.S. government account balances greater than 120 days. As the customer base is primarily U.S. government and government prime contractors, Optex Systems Holdings allowance for doubtful accounts is minimal.  Optex Systems Holdings charges uncollectible accounts to bad debt expense in the period as they are first deemed uncollectible.  In the fiscal year 2017 we recognized income of ($12) thousand related to bad debt expense deemed as uncollectible in 2016 which was subsequently paid in 2017. In the fiscal year 2016 there was $36 thousand in bad debt expenses associated with uncollectable accounts.

 

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Inventory: Inventory is recorded at the lower of cost or market, and adjusted as appropriate for decreases in valuation and obsolescence. Adjustments to the valuation and obsolescence reserves are made after analyzing market conditions, current and projected sales activity, inventory costs and inventory balances to determine appropriate reserve levels. Cost is determined using the first-in first-out method. Under arrangements by which progress payments are received against certain contracts, the customer retains a security interest in the undelivered inventory identified with these contracts.  Payments received for such undelivered inventory are classified as unliquidated progress payments and deducted from the gross inventory balance.  As of October 1, 2017 and October 2, 2016 inventory included:

 

   (Thousands)
   As of
October 1, 2017
  As of
October 2, 2016
 
Raw Materials  $5,931   $4,655 
Work in Process   2,859    2,830 
Finished Goods   441    380 
Gross Inventory   9,231    7,865 
Less:  Inventory Reserves   (1,617)   (1,651)
Net Inventory  $7,614   $6,214 

   

Warranty Costs: Some of Optex Systems Holdings’ customers require that the Company warrant the quality of its products to meet customer requirements and be free of defects for up to twelve months subsequent to delivery.   Future warranty costs are based on the estimated cost of replacement for expected returns based upon our most recent experience rate of defects as a percentage of warranty covered sales. Throughout the year, warranty costs are expensed as incurred, and as of each year end, Optex Systems Holdings reviews the prior 12 month warranty experience rate and may adjust the warranty accrual as required to cover any additional anticipated warranty costs related to prior shipments. As of October 1, 2017 and October 2, 2016, the existing warranty reserve balances of $174 thousand and $28 thousand, respectively, were reviewed and determined to be adequate to satisfy any future warranty claims that may have existed as of the end of each fiscal year for shipments occurring in the prior 12 months. The increase in warranty reserves of $146 thousand during the twelve months ending October 1, 2017 from the prior year balance represents additional expenses recognized during 2017 related to quality issues encountered on our Applied Optics Center optical assemblies during the year for returned products requiring repairs or replacements. We believe we have made sufficient improvements to the production process to reduce the return rate on any future shipments but we will continue to review and monitor the reserve balances related to this product line against any existing warranty backlog and current trend data until the current warranty backlog is depleted.

 

Property and Equipment:  Property and equipment are recorded at cost. Depreciation is computed using the straight line method over the estimated useful lives of the assets, ranging from three to seven years. Expenditures for renewals and betterments are capitalized.  Expenditures for minor items, repairs and maintenance are charged to operations as incurred. Gain or loss upon sale or retirement due to obsolescence is reflected in the operating results in the period the event takes place.

 

Revenue Recognition: Optex Systems Holdings recognizes revenue based on the modified percentage of completion method utilizing the units-of-delivery method, in accordance with FASB ASC 605-35: 

 

The units-of-delivery method recognizes as revenue the contract price of units of a basic production product delivered during a period and as the cost of earned revenue the costs allocable to the delivered units. Costs allocable to undelivered units are reported in the balance sheet as inventory or work in progress. The method is used in circumstances in which an entity produces units of a basic product under production-type contracts in a continuous or sequential production process to buyers’ specifications. 

 

Optex Systems Holdings contracts are fixed price production type contracts whereby a defined order quantity is delivered to the customer during a continuous or sequential production process tailored to the buyer’s specifications (build to print).  Optex Systems Holdings’ deliveries against these contracts generally occur in monthly increments across fixed delivery periods spanning from 3 to 36 months.

 

Customer Advance Deposits: Customer advance deposits represent amounts collected from customers in advance of shipment or revenue recognition which relate to undelivered product due to non-substantive milestone payments or other cash in advance payment terms. As of October 1, 2017, Optex Systems, Inc. had a balance of $927 thousand in customer advance deposits related to multiple contracts for our sighting system product line. The products associated with the sighting systems customer deposits generally have a high material content with long lead items which require purchase well in advance of final product delivery. We expect the deliveries against these contracts extend into the fourth quarter of fiscal year 2018. Of the total collected customer advance deposits, $927 thousand relate to short term customer advance deposits for deliveries to occur within the next twelve months.

 

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Estimated Costs at Completion and Accrued Loss on Contracts:  Optex Systems Holdings reviews and reports on the performance of its contracts and production orders against the respective resource plans for such contracts/orders. These reviews are summarized in the form of estimates at completion. Estimates at completion include Optex Systems Holdings’ incurred costs to date against the contract/order plus management’s current estimates of remaining amounts for direct labor, material, other direct costs and subcontract support and indirect overhead costs based on the completion status and future contractual requirements for each order.

  

If an estimate at completion indicates a potential overrun against budgeted resources for a fixed price contract/order, management first attempts to implement lower cost solutions that will profitably meet the requirements of the fixed price contract. If such solutions do not appear practicable, management makes a determination whether to seek renegotiation of contract or order requirements from the customer. If neither cost reduction nor renegotiation appears probable, an accrual for the contract loss/overrun is recorded against earnings and the loss is recognized in the first period the loss is identified based on the most recent estimates at completion of the particular contract or product order. As of October 1, 2017 and October 2, 2016 the contract loss reserves were $0 thousand.

 

Government Contracts:  Many of Optex Systems Holdings’ contracts are prime or subcontracted directly with the Federal government and as such, are subject to Federal Acquisition Regulation (Federal Acquisition Regulation) Subpart 49.5, “Contract Termination Clauses” and more specifically Federal Acquisition Regulation clauses 52.249-2 “Termination for Convenience of the Government (Fixed-Price)”, and 49.504 “Termination of fixed-price contracts for default”.  These clauses are standard clauses on prime military contracts and are generally, “flowed down” to Optex Systems Holdings as subcontractors on other military business.  It has been Optex Systems Holdings’ experience that the termination for convenience is rarely invoked, except where it has been mutually beneficial for both parties.  Optex Systems Holdings is not currently aware of any pending terminations for convenience or default on its existing contracts. 

 

In the event a termination for convenience were to occur, these Federal Acquisition Regulation  clause 52.249-2 provides for full recovery of all contractual costs and profits reasonably incurred up to and as a result of the terminated contract.  In the event a termination for default were to occur, Optex Systems Holdings could be liable for any excess cost incurred by the government to acquire supplies from another supplier similar to those terminated from Optex Systems Holdings.  Optex Systems Holdings would not be liable for any excess costs if the failure to perform the contract arises from causes beyond its control and without its fault or negligence as defined by Federal Acquisition Regulation clause 52.249-8.  In addition, the government may require Optex Systems Holdings to transfer title and deliver to the government any completed supplies, partially completed supplies and materials, parts, tools, dies, jigs, fixtures, plans, drawings, information, and contract rights that Optex Systems Holdings has specifically produced or acquired for the terminated portion of this contract.  The government shall pay contract price for completed supplies delivered and accepted, and Optex Systems Holdings and the government would negotiate an agreed upon amount of payment for manufacturing materials delivered and accepted and for the protection and preservation of the property. Failure to agree on an amount for manufacturing materials is subject to the Federal Acquisition Regulation Disputes clause 52.233-1.

 

In some cases, Optex Systems Holdings may receive orders subject to subsequent price negotiation on contracts exceeding the federal government simplified acquisition threshold of $750,000.  These “undefinitized” contracts are considered firm contracts but as Cost Accounting Standards Board covered contracts, they are subject to the Truth in Negotiations Act disclosure requirements and downward only price negotiation.  As of October 1, 2017 and October 2, 2016, Optex Systems had no booked orders that fell under this criterion.

 

Impairment or Disposal of Long-Lived Assets: Optex Systems Holdings follows the provisions of FASB ASC 360-10, “Accounting for the Impairment or Disposal of Long-lived Assets”.  This standard requires, among other things, that long-lived assets be reviewed for potential impairment whenever events or circumstances indicate that the carrying amounts may not be recoverable. The assessment of possible impairment is based on the ability to recover the carrying value of the asset from the expected future pre-tax cash flows (undiscounted and without interest charges) of the related operations. If these cash flows are less than the carrying value of such assets, an impairment loss is recognized for the difference between estimated fair value and carrying value. The measurement of impairment requires management to estimate future cash flows and the fair value of long-lived assets. No impairment of long-lived assets was recorded for the periods presented.

 

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Stock-Based Compensation: FASB ASC 718 establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, but primarily focuses on transactions whereby an entity obtains employee services for share-based payments. FASB ASC 718 requires that the compensation cost relating to share-based payment transactions be recognized in the financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments.

 

Optex Systems Holdings’ accounting policy for equity instruments issued to consultants and vendors in exchange for goods and services follows the provisions of FASB ASC 505-50. The measurement date for the fair value of the equity instruments issued is determined at the earlier of (i) the date at which a commitment for performance by the consultant or vendor is reached or (ii) the date at which the consultant or vendor’s performance is complete. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement. Stock-based compensation related to non-employees is accounted for based on the fair value of the related stock or options or the fair value of the services, whichever is more readily determinable in accordance with FASB ASC 718. 

 

Beneficial Conversion Features of Convertible Securities: Conversion options that are not bifurcated as a derivative pursuant to ASC 815 and not accounted for as a separate equity component under the cash conversion guidance are evaluated to determine whether they are beneficial to the investor at inception (a beneficial conversion feature) or may become beneficial in the future due to potential adjustments. The beneficial conversion feature guidance in ASC 470-20 applies to convertible stock as well as convertible debt which are outside the scope of ASC 815. A beneficial conversion feature is defined as a nondetachable conversion feature that is in the money at the commitment date. In addition, our preferred stock issues contain conversion terms that may change upon the occurrence of a future event, such as antidilution adjustment provisions. The beneficial conversion feature guidance requires recognition of the conversion option’s in-the-money portion, the intrinsic value of the option, in equity, with an offsetting reduction to the carrying amount of the instrument. The resulting discount is amortized as a dividend over either the life of the instrument, if a stated maturity date exists, or to the earliest conversion date, if there is no stated maturity date. If the earliest conversion date is immediately upon issuance, the dividend must be recognized at inception. When there is a subsequent change to the conversion ratio based on a future occurrence, the new conversion price may trigger the recognition of an additional beneficial conversion feature on occurrence.

  

During the twelve months ending October 2, 2016, Optex Systems Holdings had preferred stock outstanding, convertible into common shares, containing beneficial conversion features at inception as well as potential beneficial conversion features that could be triggered by future adjustments to the conversion price. Because our preferred stock was perpetual, with no stated maturity date, and the conversions could occur any time from inception, the dividend is recognized immediately when a beneficial conversion exists at issuance. The August 26, 2016 public offering triggered a reset of the preferred stock conversion rate from $2.50 per common share to $1.20 per common share on our Series A and Series B preferred shares and resulted in a $0.8 million beneficial conversion feature. The public offering also included a beneficial conversion feature of $0.4 million at the August 26, 2016 commitment date of the 400 shares of Series C preferred stock issued in the offering, based on the effective conversion price of the shares, net of the allocated warrant proceeds. During the twelve months ending October 2, 2016, Optex Systems Holdings recognized a total preferred stock dividend of $1.2 million as a result of the beneficial conversion features triggered on the existing and new issues of preferred shares. There were no preferred shares outstanding during the twelve months ending October 1, 2017 subject to subsequent beneficial conversion features, thus there was zero preferred stock dividends recognized during the period.

 

Income Tax/Deferred Tax: FASB ASC 740 requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on differing treatment of items for financial reporting and income tax reporting purposes. The deferred tax balances are adjusted to reflect tax rates by tax jurisdiction, based on currently enacted tax laws, which will be in effect in the years in which the temporary differences are expected to reverse. Under FASB ASC 740, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that Optex Systems Holdings will not realize tax assets through future operations. When assessing the recoverability of deferred tax assets, management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies and results of recent operations. Based on those estimates, management has determined that the deferred tax assets may not be realized and has established a valuation allowance against the deferred tax asset balance. We record uncertain tax positions in accordance with ASC 740 on the basis of a two-step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority.

  

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As of October 1, 2017 Optex Systems Inc. has a deferred tax asset valuation allowance of ($4.6) million against deferred tax assets of $4.6 million due to historical losses resulting in a Net Operating Loss Carryforward for each of the fiscal years 2010 through 2016. We intend to continue maintaining a full valuation allowance on our deferred tax assets until there is sufficient evidence to support the reversal of all or some portion of these allowances. However, given our improved earnings performance during the final quarter of fiscal year ending October 1, 2017, and anticipated future earnings, we believe that there is a reasonable possibility that within the next 12 months, sufficient positive evidence may become available to allow us to reach a conclusion that a significant portion of the valuation allowance will no longer be needed. Release of the valuation allowance would result in the recognition of certain deferred tax assets and a decrease to income tax expense for the period the release is recorded. We believe the change in the valuation allowance could approximate $2.0 million, assuming a change in tax rate from 34% to 21%. However, the exact timing and amount of the valuation allowance release are subject to change on the basis of the level of profitability that we are able to actually achieve and the corporate tax rate in effected at that time.

 

Earnings per Share: Basic earnings per share is computed by dividing income available for common shareholders (the numerator) by the weighted average number of common shares outstanding (the denominator) for the period. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. 

  

The potentially dilutive securities that Optex Systems Holdings has outstanding are convertible preferred stock, stock options and warrants. In computing the dilutive effect of convertible preferred stock, the numerator is adjusted to add back any convertible preferred dividends, and the denominator is increased to assume the conversion of the number of additional common shares. Optex Systems Holdings uses the Treasury Stock Method to compute the dilutive effect of stock options and warrants. Convertible preferred stock, stock options and warrants that are anti-dilutive are excluded from the calculation of diluted earnings per common share.

 

For the twelve months ended October 1, 2017, 4,125,200 warrants, 174 Series C preferred stock (convertible into 725,000 common shares) and 56,260 stock options and 182,000 unvested restricted stock units were excluded as anti-dilutive due to the net loss attributable to common shareholders during the years. For the twelve months ended October 2, 2016, 4,125,200 warrants, 360 Series C preferred stock (convertible into 1,500,000 common shares) and 52,840 stock options and 200,000 unvested restricted stock units were excluded as anti-dilutive due to the net loss attributable to common shareholders during the years.

  

Note 3 — Recent Accounting Pronouncements

  

In May 2017, the FASB issued ASU 2017-09, Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting (“ASU 2017-09). ASU 2017-09 provides clarity and reduce both (1) diversity in practice and (2) cost and complexity when applying the guidance in Topic 718, Compensation—Stock Compensation, to a change to the terms or conditions of a share-based payment award. The amendments in this update provide guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. The amendments in this update are effective for all entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted. As such, Optex Systems Holdings is required to adopt these provisions as of the fiscal year beginning on October 1, 2018. The amendments in this update should be applied prospectively to an award modified on or after the adoption date. We are currently assessing the potential impact of ASU 2017-09 on our consolidated financial statements and results of operations. 

  

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In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). ASU 2016-15 reduces diversity in practice in how certain transactions are classified in the statement of cash flows. The amendments in ASU 2016-15 provide guidance on specific cash flow issues including debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance policies, and distributions received from equity method investees. ASU 2016-15 is effective for annual and interim periods beginning after December 15, 2017. As such, Optex Systems Holdings is required to adopt these provisions as of the fiscal year beginning on October 1, 2018. We are currently assessing the potential impact of ASU 2016-15 on our consolidated financial statements and results of operations.

  

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (“ASU 2016-13”). ASU 2016-13 changes the impairment model for most financial assets and certain other instruments, including trade and other receivables, held-to-maturity debt securities and loans, and requires entities to use a new forward-looking expected loss model that will result in the earlier recognition of allowance for losses. This update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for a fiscal year beginning after December 15, 2018, including interim periods within that fiscal year. Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. As such, Optex Systems Holdings is required to adopt these provisions as of the fiscal year beginning on September 30, 2019. We are currently assessing the potential impact of ASU 2016-13 on our consolidated financial statements and results of operations.

  

In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-09 amending several aspects of share-based payment accounting. This guidance requires all excess tax benefits and tax deficiencies to be recorded in the income statement when the awards vest or are settled, with prospective application required. The guidance also changes the classification of such tax benefits or tax deficiencies on the statement of cash flows from a financing activity to an operating activity, with retrospective or prospective application allowed. Additionally, the guidance requires the classification of employee taxes paid when an employer withholds shares for tax-withholding purposes as a financing activity on the statement of cash flows, with retrospective application required. This ASU is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2016. As such, Optex Systems Holdings adopted these provisions as of the fiscal year beginning October 2, 2017. There was no material effect of the new provisions on our consolidated financial statements and related disclosures.

  

In February 2016, FASB issued ASU 2016-02—Leases (Topic 842). The update is intended to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The amendments in this update are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application of the amendments in this update is permitted. As such, Optex Systems Holdings is required to adopt these provisions as of the fiscal year beginning on September 30, 2019. Optex Systems Holdings is currently evaluating the impact of FASB ASU 2016-02 and expects the adoption thereof will have a material effect on Optex Systems Holdings’ presentation of balance sheet assets and liabilities based on the present value of future lease payments, but does not expect a material effect on the presentation of expenses and cash flows

  

In July 2015, FASB issued ASU 2015-11—Inventory (Topic 330): “Simplifying the Measurement of Inventory”.  The update is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. As such, Optex Systems Holdings is required to adopt these provisions as of the fiscal year beginning on October 2, 2017. The amendments in this Update should be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. The update is part of FASB’s Simplification Initiative, the objective of which is to identify, evaluate, and improve areas of generally accepted accounting principles (GAAP) for which cost and complexity can be reduced. Pursuant to the update, an entity should measure inventory at the lower of cost and net realizable value. The amendments in the update more closely align the measurement of inventory in GAAP with the measurement of inventory in International Financial Reporting Standards (IFRS). Optex Systems Holdings is currently evaluating the impact of FASB ASU 2015-11 but does not expect the adoption thereof to have a material effect on Optex Systems Holdings’ financial statements.

  

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In August 2014, FASB issued ASU 2014-15—Presentation of Financial Statements—Going Concern (ASC Subtopic 205-40): “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern”. The update requires management to assess a company’s ability to continue as a going concern and to provide related footnote disclosures in certain circumstances. All entities are required to apply the new requirements in annual periods ending after December 15, 2016, and interim periods thereafter. As such, Optex Systems Holdings adopted these provisions for the annual period ending October 1, 2017. There was no material effect on Optex Systems Holdings’ financial statements of as a result of adoption of FASB ASU 2014-15.

  

In May 2014, FASB issued ASU 2014-09—Revenue from Contracts with Customers (Topic 606): “Section A—Summary and Amendments That Create Revenue from Contracts with Customers, (Topic 606) and Other Assets and Deferred Costs—Contracts with Customers (Subtopic 340-40), Section B—Conforming Amendments to Other Topics and Subtopics in the Codification and Status Tables, Section C—Background Information and Basis for Conclusions”. The guidance in this update affects any entity that enters into contracts with customers to transfer goods or services and supersedes the revenue recognition requirements in Topic 605, Revenue Recognition. FASB deferred the effective date of ASU 2014-09 in August 2015, with ASU 2015-14—“Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date” The amendments in this update defer the effective date of ASU 2014-09 for all entities by one year. Public business entities should apply the guidance in ASU 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net) (“ASU 2016-08”). ASU 2016-08 does not change the core principle of Topic 606 but clarifies the implementation guidance on principal versus agent considerations. ASU 2016-08 is effective for the annual and interim periods beginning after December 15, 2017. As such, Optex Systems Holdings is required to adopt these provisions as of the fiscal year beginning on October 1, 2018. Optex Systems Holdings is currently evaluating the impact of FASB ASU 2014-09 and subsequent amendments but does not expect the adoption thereof to have a material effect on Optex Systems Holdings’ financial statements.

  

Note 4 Segment Reporting

  

Optex Systems Holdings, Inc. has two reportable segments which include Optex Systems (OPX)-Richardson, and Applied Optics Center (AOC) – Dallas. The accounting policies for each segment are the same as those described in the summary of significant accounting policies. Optex Systems Holdings, Inc. evaluates performance based on profit and loss from operations before income taxes excluding nonrecurring gains and losses.

  

The Optex Systems Holdings reportable segments are strategic businesses offering similar products to similar markets and customers; however the companies are operated and managed separately due to differences in manufacturing technology, equipment, geographic location, and specific product mix. The Applied Optics Center was acquired as a unit, and the management at the time of the acquisition was retained.

  

The Applied Optics Center segment also serves as the key supplier of the laser coated filters used in the production of periscope assemblies at the Optex Systems Richardson segment. Intersegment sales and transfers are accounted for at annually agreed to pricing rates based on estimated segment product cost, which includes segment direct manufacturing and general and administrative costs, but exclude profits that would apply to third party external customers.

   

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Optex Systems – Dallas, serves as the home office for both segments and shared general and administrative costs attributable to both segments are allocated directly to the segments based on the government costs accounting standard, CAS 403 – “Allocation of Home Office Expenses to Segments”. The purpose of CAS 403 is to provide criteria for allocating home office expenses to the segments of an organization based on the beneficial or causal relationships between the expenses and the receiving segments. Based on CAS 403, Optex Systems Holdings allocates home office expenses based on a three factor formula which is the average of the following three percentages for the each segments fiscal year:

 

(1) The percentage of segment payroll dollars to total payroll dollars of all segments;

(2) The percentage of the segment’s operating revenue to the total operating revenue of all segments

(3) The percentage of the average net book value of the sum of the segment’s tangible capital assets plus inventories to the total average net book value of such assets of all segments. 

 

Optex Systems (OPX) – Richardson, Texas 

Optex Systems, Inc. manufactures optical sighting systems and assemblies, primarily for Department of Defense applications. Its products are installed on various types of U.S. military land vehicles, such as the Abrams and Bradley fighting vehicles, light armored and armored security vehicles and have been selected for installation on the Stryker family of vehicles. Optex Systems, Inc. also manufactures and delivers numerous periscope configurations, rifle and surveillance sights and night vision optical assemblies. We have capabilities which include machining, bonding, painting engraving and assembly and can perform both optical and environmental testing in-house.  Optex Systems, Inc. products consist primarily of build-to-customer print products that are delivered both directly to the armed services and to other defense prime contractors. Optex Systems in Richardson is both a prime and sub-prime contractor to the Department of Defense.  Sub-prime contracts are typically issued through major defense contractors such as General Dynamics Land Systems, Raytheon Corp., BAE, NorcaTec and others. Optex Systems is also a military supplier to foreign governments such as Israel, Australia and NAMSA and South American countries and as a subcontractor for several large U.S. defense companies serving foreign governments.

 

During the year ended October 1, 2017, approximately 100% of Optex Systems – Richardson revenues were in support of prime and subcontracted military customers. The Optex Systems segment serves domestic military customers, 87%, and foreign military customers, 13%. The Optex Systems segment revenue for the year ending October 1, 2017 was derived from external customers consisting of the U.S. government, 60%, General Dynamics, 29%, and other external customers, 11%.

 

Optex Systems is located in Richardson Texas, with leased premises consisting of approximately 49,100 square feet.  As of October 1, 2017, the Richardson facility operated with 62 full time equivalent employees in a single shift operation. Optex Systems in Richardson serves as the home office for both the Optex Systems (OPX) and Applied Optics Center (AOC) segments.

 

Applied Optics Center (AOC) – Dallas 

On November 3, 2014, Optex Systems, Inc. entered into a Purchase Agreement with L-3 pursuant to which Optex Systems, Inc. purchased from L-3 the assets comprising L-3’s Applied Optics Center Products Line (see note 4). Applied Optics Center is engaged in the production, marketing and sales of precision optical assemblies and components which utilize thin film coating technologies. Most of the AOC products and services are directly related to the deposition of thin-film coatings. AOC is both a prime and sub-prime contractor to the Department of Defense.  Sub-prime contracts are typically issued through major defense contractors such as General Dynamics Land Systems, Raytheon Corp., L-3 Communications, Harris Corp and others. AOC also creates a new sector of opportunity for commercial productsGlobally, commercial optical products use thin film coatings to create product differentiation and performance levels. These coatings can be used for redirecting light (mirrors), blocking light (laser protection), absorbing select light (desired wavelengths), and many other combinations. They are used in telescopes, rifle scopes, binoculars, microscopes, range finders, protective eyewear, photography, etc. The Applied Optics Center is a key supplier to Nightforce Optics, Inc. and provides optical assembly components to their markets of interest in commercial sporting optics and select military optics. Given this broad potential, the commercial applications are a key opportunity going forward. The Applied Optics Center segment also serves as the key supplier of the laser coated filters used in the production of periscope assemblies at the Optex Systems Richardson segment.

 

The Applied Optics Center serves primarily domestic U.S. customers. Approximately 81% of the Applied Optics Center revenue for the year ending October 1, 2017 was derived from external customers consisting of Nightforce Optics, Inc., 56%, Harris Corp., 17%, L3 Communications, 11%, the U.S. government, 5%, and other external customers, 11%. Sales to commercial customers represent 60% and military sales to prime and subcontracted customers represent 40% of the total segment revenue. Intersegment sales to Optex Systems – Richardson during the year ended October 1, 2017, comprised 19% of the total segments revenue and was primarily in support of military contracts.

 

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The Applied Optics Center (AOC), is located in Dallas, Texas with leased premises consisting of approximately 44,867 square feet of space. As of October 1, 2017, AOC operated with 38 full time equivalent employees in a single shift operation. 

 

The financial table below presents the information for each of the reportable segments profit or loss as well as segment assets for each year. Optex Systems Holdings, Inc. does not allocate interest expense, income taxes, stock compensation associated with restricted stock units, or unusual items to segments.

 

   Reportable Segment Financial Information
(thousands)
   Twelve months ending October 1, 2017
    Optex Systems
Richardson
    Applied Optics Center
Dallas
    Other
(non allocated costs and intersegment eliminations)
    Consolidated
Total
 
                     
Revenues from external customers  $11,256   $7,291   $   $18,547 
Intersegment revenues       1,694    (1,694)    
Total Revenue  $11,256   $8,985   $(1,694)  $18,547 
                     
Interest expense  $   $   $19   $19 
                     
Depreciation and Amortization  $56   $281   $   $337 
                     
Income (Loss) before taxes  $338   $46   $(688)  $(304)
                     
Other significant noncash items:                    
Allocated home office expense  $(776)  $776   $   $ 
Loss on change in fair value of warrants  $   $   $489   $489 
Stock compensation expense (1)  $40   $   $180   $220 
Royalty expense amortization  $30   $   $   $30 
                     
Segment Assets  $8,663   $5,364   $   $14,027 
Expenditures for segment assets  $(23)  $(126)  $   $(149)

 

(1) General and administrative expenses for the twelve months ending October 1, 2017 of $180 thousand, associated with amortized stock compensation attributeable to executive/director restricted stock units has been restated from Optex Richardson to Other non allocated costs. Operating income (loss) for Optex Richardson and Other non allocated has been restated to reflect the change.

 

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   Reportable Segment Financial Information
(thousands)
   Twelve months ending October 2, 2016
    Optex Systems
Richardson
    Applied Optics Center
Dallas  
    Other
(non allocated costs and intersegment eliminations)
    Consolidated
Total
 
                     
Revenues from external customers  $11,052   $6,227   $   $17,279 
Intersegment revenues       1,892    (1,892)    
Total Revenue  $11,052   $8,119   $(1,892)  $17,279 
                     
Interest expense  $   $   $36   $36 
                    
Depreciation and Amortization  $73   $272   $   $345 
                     
Income (Loss) before taxes(1)  $285   $(345)  $(148)  $(208)
                     
Other significant noncash items:                    
Allocated home office expense  $(728)  $728   $   $ 
(Gain) on change in fair value of warrants  $   $   $(739)  $(739)
Stock option compensation expense(1)  $52   $   $140   $192 
Royalty expense amortization  $30   $   $   $30 
Use of contract loss reserves  $   $(54)  $   $(54)
Warrants issued for underwriter expenses  $   $   $156   $156 
                     
Segment Assets  $8,861   $3,900   $   $12,761 
Expenditures for segment assets  $(16)  $(18)  $   $(34)

 

(1) General and administrative expenses for the twelve months ending October 2, 2016 of $140 thousand, associated with amortized stock compensation attributeable to executive/director restricted stock units has been restated from Optex Richardson to Other non allocated costs. Operating income (loss) for Optex Richardson and Other non allocated has been restated to reflect the change.

  

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Note 5 — Property and Equipment

 

A summary of property and equipment at October 1, 2017 and October 2, 2016 is as follows:

 

      (Thousands) 
   Estimated Useful Life  Year Ended
October 1, 2017
   Year Ended
October 2, 2016
 
Property and Equipment             
Furniture and Fixtures  3-5yrs  $368   $356 
Machinery and Equipment  5 yrs   3,364    3,233 
Leasehold Improvements  7 yrs   276    276 
Less: Accumulated Depreciation      (2,548)   (2,214)
Net Property & Equipment     $1,460   $1,651 
              
Depreciation Expense     $337   $345 

 

During the twelve months ending October 1, 2017, Optex Systems Holdings’ purchased $12 thousand and $137 thousand in new furniture and fixtures and new machinery and equipment, respectively, and sold machinery and equipment with a net book value of $3 thousand for $41 thousand in proceeds resulting in a gain on asset sales of $38 thousand.

 

Note 6 — Accrued Expenses

 

The components of accrued liabilities for the years ended October 1, 2017 and October 2, 2016 are summarized below:

 

   (Thousands) 
   Year Ended
October 1,
2017
   Year Ended
October 2,
2016
 
         
Deferred Rent Expense  $123   $108 
Accrued Vacation   328    330 
Property Taxes   105    101 
Operating Expenses   778    144 
Payroll & Payroll Related   116    127 
Total Accrued Expenses  $1,450   $810 

 

Note 7 — Commitments and Contingencies

 

Rental Payments under Non-cancelable Operating Leases

 

Optex Systems Holdings leases its office and manufacturing facilities for the Optex Systems, Inc., Richardson address and the Applied Optics Center Dallas address, under non-cancellable operating leases.

 

The leased facility under Optex Systems Inc. at 1420 Presidential Drive, Richardson, Texas consists of 49,100 square feet of space and expires March 31, 2021. Pursuant to the terms of the most recent amendment to the Richardson site facilities lease, there was no base rent payment due from January 1, 2014 through March 31, 2014, with payments beginning April 2014, and annual rental payment inflationary increases between 3.4% and 4.8% occurring each year beginning in 2016.

 

The leased facility under the Applied Optics Center at 9839 and 9827 Chartwell Drive, Dallas, Texas, consists of 44,867 square feet of space at the premises. On November 17, 2016, we received a countersigned new lease for the Applied Optics Center from the landlord, dated October 21, 2016, and which commenced retroactive to October 1, 2016. The new lease term will expire on October 31, 2021, with two renewal options available to the tenant, each with a renewal term duration of five years. The monthly base rent is $19.4 thousand through September 30, 2017 and escalates approximately 3% October 1, each year thereafter through 2021. The lease includes a one month base rent abatement for October 1 through October 31, 2016 for $19.4 thousand. The monthly rent includes approximately $4.9 thousand for additional Common Area Maintenance fees and taxes (CAM), to be adjusted annually based on actual expenses incurred by the landlord. The total monthly rent including CAM is $24.3 thousand beginning November 1, 2016. Our obligations to make payments under the lease are secured by a $250,000 standby letter of credit which we may be reduced to $125,000 on October 31, 2019.

 

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As of October 1, 2017 the unamortized deferred rent was $123 thousand as compared to $108 thousand as of October 2, 2016. Deferred rent expense is amortized monthly over the life of the leases.

 

As of October 1, 2017, the remaining minimum base lease and estimated common area maintenance (CAM) payments under the non-cancelable office and facility space leases are as follows: 

 

Non-cancellable Operating Leases Minimum Payments

 

    (Thousands)  
       
    Optex Systems Richardson     Applied Optics Center Dallas        
Fiscal Year   Lease
Payments
    CAM
Estimate
    Lease
Payments
    CAM
Estimate
    Total
Payments
 
2018   $ 271     $ 108     $ 240     $ 60     $ 679  
2019     281       110       248       61       700  
2020     291       112       255       62       720  
2021     147       57       262       63       529  
2022                 22       5       27  
Total minimum lease payments   $ 990     $ 387     $ 1,027     $ 251     $ 2,655  

 

Total expense under both facility lease agreements as of the twelve months ended October 1, 2017 was $655 thousand. Total expense under both facility lease agreements as of the twelve months ended October 2, 2016 was $627 thousand. 

 

Note 8 — Transactions with a Related Party

 

In the twelve months ending October 2, 2016, Sileas Corporation converted 926 shares of Optex Systems Series A preferred stock at a total stated value of $6.4 million for 5,293,896 common shares.

 

On October 31, 2016, Longview Fund L.P. authorized the return to Optex Systems Holdings’ treasury of 197,299 common shares, held by Sileas Corporation in settlement of $155 thousand of accounts receivable due for expenses paid by Optex Systems Inc. on behalf of the Sileas Corporation. The shares were subsequently cancelled in satisfaction of the outstanding accounts receivable balance as of October 31, 2016. As of October 1, 2017, and October 2, 2016, accounts receivable included $0 and $132 thousand, respectively of non-trade receivables due from Sileas Corporation, a related party, for operating expenses paid by Optex Systems on their behalf.

 

On April 27, 2017, the Board of Directors of Optex Systems Holdings approved a purchase of 700,000 shares of its common stock in a private transaction from The Longview Fund, L.P. The transaction was priced at the closing sale price on April 28, 2017 of $0.74 per share for a total transaction amount of $518,000. Upon repurchase on May 1, 2017, the shares were cancelled thereby reducing the total shares outstanding of its common stock.

 

There were no other transactions with Related Parties during fiscal years 2017 or 2016 except as described below in Note 9 Debt Financing. 

 

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Note 9 — Debt Financing

 

Related Parties

 

Acquisition by Sileas Corporation on February 20, 2009

 

On February 20, 2009, Sileas purchased 100% of the equity and debt interest held by Longview, which represented 90% of the Optex Systems, Inc. (Delaware) outstanding equity on that date. 

 

Sileas Secured Promissory Note Due on May 29, 2021 to Longview Fund, LP

 

As a result of the transaction described above between Sileas and Longview on February 20, 2009, Sileas, the then new majority owner of Optex Systems, Inc. (Delaware), executed and delivered to Longview, a Secured Promissory Note due February 20, 2012 in the original principal amount of $13,524,405. The original Note bears simple interest at the rate of 4% per annum, and the interest rate upon an event of default increases to 10% per annum. The maturity date of the Note was extended on November 22, 2011 and again on November 27, 2013. In exchange for the extensions, Sileas Corp. agreed to pay the Longview Fund an extension fee equal to 2% of the principal amount of this Secured Note as of each amendment date.

 

On June 5, 2015, Sileas Corp. amended its Secured Note, with Longview Fund, L.P., as lender, as follows:

 

  The principal amount was increased to $18,022,329 to reflect the original principal amount plus all accrued and unpaid interest to date, and the Secured Note ceased to bear interest as of that date;
  The maturity date of the note was extended to May 29, 2021; and
  A conversion feature was added to the Secured Note by which the principal amount of the Secured Note can be converted into our Series A preferred stock, which is owned by Sileas, at the stated value of our Series A preferred stock.

 

On August 4, 2016, Longview Fund, L.P. converted $250 thousand of the note principal for 100,000 shares of Optex Systems Holdings common stock pursuant to the note conversion terms. The Sileas note balance to the Longview Fund, LP as of October 2, 2016 is $17.8 million.

 

In the twelve months ending October 2, 2016, Sileas Corporation converted all their Optex Systems Holdings, Inc. Series A preferred stock, 926 shares, at a total stated value of $6.4 million for 5,293,896 common shares. The total common shares held by Sileas as of October 2, 2016 is 5,296,081. These additional shares have been retroactively reflected in the ending common shares outstanding as of October 2, 2016.

 

On May 1, 2017, The Longview Fund, L.P. converted $0.8 million of the Sileas Corp.(a related party) note principal in exchange for 700,000 shares of Optex Systems Holdings common stock. The Sileas Corp. note balance to The Longview Fund, L.P. as of May 1, 2017, after conversion, is $14.2 million.

 

On June 9, 2017, Sileas Corp. (“Sileas”), a related party to the Company, entered into a transaction with The Longview Fund, L.P.(“Longview”) to settle its February 20, 2009 note with Longview in the original principal amount of $13,524,405 (the “Note”). The parties agreed to a conversion by Longview of $3,358,538 of the amount due under the Note into 2,798,782 shares of Company common stock owned by Sileas and previously pledged to Longview as security with respect to the Note. Simultaneously therewith, Sileas made a $250,000 cash payment to Longview, and Longview agreed to satisfy $10,571,791 of the amount due under the Note. The remaining amount due under the Note is $64,000 which shall be paid in cash by Sileas to Longview on a quarterly basis, upon the payment of quarterly dividends by the Company, over the next four calendar quarters commencing on or about June 30, 2017. In order to effect the above, Longview also released the pledge on all Company shares owned by Sileas and previously pledged to Longview. The Sileas Corp. note balance to The Longview Fund, L.P. as of October 1, 2017 is $48 thousand.

 

Simultaneously with the above on June 9, 2017, Sileas sold 800,000 shares of Company common stock to Danny Schoening and Karen Hawkins at a price equal to $314,000 (which is a discounted amount based upon recognition of years of administrative support by Mr. Schoening and Ms. Hawkins for the Company) as follows: (i) Danny Schoening: 640,000 Shares for $200,000 plus a $50,825 promissory note; and (ii) Karen Hawkins: 160,000 Shares for $50,000 plus a $12,706 promissory note. Each promissory note has a one year term, with interest at 1.18% per annum and shall be payable in four equal quarterly installments of $12,800 for Danny Schoening and $3,200 for Karen Hawkins, each installment payable within five business days after the payment of cash dividends by the Company to each of them. As a result, Sileas no longer owns any shares of Company common stock.

 

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Credit Facility — Avidbank

 

On April 20, 2016, the Company amended its revolving credit facility with Avidbank. The new renewable revolving maturity date is January 22, 2018. The facility provides up to $2 million in financing against eligible receivables and is subject to meeting certain covenants including an asset coverage ratio test for up to twenty months. The material terms of the amended revolving credit facility are as follows:

 

  The interest rate for all advances shall be the then in effect prime rate plus 2.5% and is subject to a minimum interest payment requirement per six month period of $10,000.
     
  Interest shall be paid monthly in arrears.
     
  A facility fee of (0.5%) of the revolving line ($10,000) is due on May 22, 2016 and each anniversary thereof for so long as the revolving credit facility is in effect.
     
  The loan period is from April 20 through January 22, 2018 at which time any outstanding advances, and accrued and unpaid interest thereon, will be due and payable.
     
  The obligations of Optex Systems, Inc. to Avidbank are secured by a first lien on all of its assets (including intellectual property assets should it have any in the future) in favor of Avidbank.
     
  The facility contains customary events of default. Upon the occurrence of an event of default that remains uncured after any applicable cure period, Avidbank’s commitment to make further advances may terminate, and Avidbank would also be entitled to pursue other remedies against Optex Systems, Inc. and the pledged collateral.
     
  Pursuant to a guaranty executed by Optex Systems Holdings in favor of Avidbank, Optex Systems Holdings has guaranteed all obligations of Optex Systems, Inc. to Avidbank.
     

The Company amended its revolving credit facility with Avidbank on October 17, 2016 from $2 million to $2.2 million. The interest rate for all advances against the line of credit shall be the then in effect prime rate plus 2.5% and is subject to a minimum interest payment requirement per nine month period of $10,000. The renewable revolving maturity date is January 22, 2018 and is secured by a first lien on all of its assets in favor of Avidbank. In order to meet the security requirement under the lease, we entered into a letter of credit with Avidbank on October 17, 2016 in the amount of $250,000, which expires on October 17, 2017 and is renewable by us for successive one year periods unless the bank notifies us no later than 60 days prior to the end of the initial or any extended term that it shall not renew the letter of credit.

 

As of October 1, 2017 and October 2, 2016, the outstanding principal balance on the line of credit was $300 thousand. For the years ended October 1, 2017 and October 2, 2016, the total interest expense against the outstanding line of credit balance was $20 thousand and $36 thousand.

 

Note 10 — Stock Based Compensation

 

The Optex Systems Holdings 2009 Stock Option Plan provides for the issuance of up to 75,000 shares to Optex Systems Holdings officers, directors, employees and to independent contractors who provide services to Optex Systems Holdings as either incentive or nonstatutory stock options determined at the time of grant. As of October 1, 2017, Optex Systems Holdings has granted stock options to officers and employees as follows (as adjusted for the 1000:1 reverse stock split on common shares effective October 7, 2015):

 

Date of   Options     Exercise     Options Outstanding     Expiration   Vesting
Grant   Granted     Price     As of 10/01/17     Date   Period
12/09/11     46,070     $ 10.00       35,010     12/08/2018   4 years
12/19/13     25,000     $ 10.00       25,000     12/18/2020   4 years
Total     71,070               60,010          

 

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The following table summarizes the status of Optex Systems Holdings’ aggregate stock options granted under the incentive stock option plan (as adjusted for the 1000:1 reverse stock split on common shares effective October 7, 2015):

 

          Weighted              
    Number of      Average     Weighted     Aggregate  
    Remaining     Fair     Average     Value  
Subject to Exercise   Options     Value     Life (Years)     (Thousands)  
Outstanding as of September 27, 2015     62,858     $       2.32     $  
Granted – 2016                              
Forfeited – 2016     (2,518 )                      
Exercised – 2016                            
Outstanding as of October 2, 2016     60,340     $       1.40     $  
Granted – 2017                              
Forfeited – 2017     (330)                        
Exercised – 2017                            
Outstanding as of October 1, 2017