Optex Systems Holdings, Inc. — Form 10-Q Summary
Reporting period: Three months ended December 28, 2014, compared with the three months ended December 29, 2013. The filing was dated February 11, 2015. Optex manufactures optical sighting systems, periscopes, rifle and surveillance sights, and related assemblies primarily for U.S. and foreign defense applications. The company had approximately 80 full-time equivalent employees.
Financial Performance and Position
| Metric | Q1 FY2015 | Q1 FY2014 | Change |
|---|---|---|---|
| Revenue | $2.098 million | $3.354 million | Down $1.256 million, or 37.4% |
| Cost of sales | $1.719 million | $2.736 million | Down $1.017 million |
| Gross margin | $379 thousand | $618 thousand | Down $239 thousand |
| General and administrative expense | $687 thousand | $629 thousand | Up $58 thousand |
| Operating loss | $308 thousand | $11 thousand | Loss increased $297 thousand |
| Net loss applicable to common shareholders | $2.830 million | $13 thousand | Loss increased $2.817 million |
| Basic and diluted loss per share | $0.0166 | $0.0001 | Greater loss per share |
The reported gross margin was approximately 18.1% of revenue based on the financial statements; the MD&A states 19.1%, creating a filing inconsistency. Management attributed the lower gross profit primarily to reduced revenue, partially offset by a more favorable product mix.
- Cash flow: Operating activities provided $269 thousand, compared with $1.120 million in the prior-year quarter.
- Investing activities: Used $2.081 million, including $2.088 million of property and equipment purchases associated primarily with the Applied Optics acquisition.
- Financing activities: Provided $1.486 million, primarily from convertible notes, net of $74 thousand of issuance costs.
- Cash: $1.359 million at December 28, 2014, compared with $1.685 million at September 28, 2014.
- Working capital: Current assets were $9.346 million and current liabilities were $1.975 million. Inventory increased to $7.084 million from $5.910 million, primarily from the acquisition and delayed shipments.
- Debt and derivative liabilities: Convertible notes had $1.560 million of principal, but were reported net of discount at $33 thousand. The embedded conversion feature was recorded as a $6.127 million long-term derivative liability. The Avidbank revolving credit facility had no outstanding balance and provided access to up to $1.0 million, subject to eligibility and covenants.
- Equity: Stockholders’ equity declined to $3.136 million from $5.898 million, primarily because of the current-period net loss and derivative accounting effects. Common shares outstanding totaled 170,913,943.
Material Changes Versus the Prior Comparable Period
- Revenue declined 37.4%, driven principally by a 66.6% decline in periscope revenue as several prior orders were completed and U.S. defense spending remained weak.
- Sighting systems revenue increased 12.8% to $706 thousand, supported by deliveries under the M36 DDAN program.
- Applied Optical Coatings contributed $342 thousand of revenue after the November 3, 2014 acquisition, but shipments were delayed pending contract novation and government acceptance.
- General and administrative expense increased 16.6%, primarily due to the Applied Optics acquisition.
- Interest expense increased to $5.479 million, largely because the convertible notes’ conversion feature was initially valued as a substantial debt discount and derivative liability. A $847 thousand derivative fair-value gain was also recorded.
- The company recognized a $2.110 million bargain-purchase gain from acquiring Applied Optics assets for less than their estimated fair value. The gain remained provisional and could be adjusted in subsequent periods.
- Backlog was $11.2 million at December 28, 2014, up from $10.4 million at December 29, 2013. Applied Optical Coatings represented $3.4 million of backlog.
Acquisition, Outlook, Risks, and Unusual Items
On November 3, 2014, Optex acquired the Applied Optics Products Line from L-3 Communications for $1.013 million in cash and assumed approximately $271 thousand of liabilities. Acquired assets included equipment, inventory, contracts, intellectual property, and approximately $342 thousand of customer-backlog intangible assets. The company assumed an additional facility lease with approximately $30 thousand of monthly rent, partially offset by sublease receipts.
Management expects the Applied Optics line to contribute up to $6.5 million of revenue by fiscal year-end, subject to contract novations and customer acceptance. Management also reported $2.1 million of additional orders during the first six weeks of the second fiscal quarter. Sighting systems revenue was expected to increase during the year, while periscope revenue could remain at approximately 50% to 60% of prior-year levels.
Management expects continued net losses for at least the next year and stated that profitability depends on generating sufficient revenue to support the company’s cost structure. The company does not expect alternative business to fully offset reduced U.S. government spending during the current fiscal year or the following twelve months. Management plans to manage operations in line with available working capital but warned that certain assets may not be recoverable if its business plan is unsuccessful.
- The $1.55 million convertible notes bear 12% annual interest, mature in two years, are convertible at $0.0025 per share, include full-ratchet anti-dilution protection, and require or contemplated a 1-for-350 reverse stock split. Noteholders waived the filing and reverse-split deadlines described in the agreements.
- The registration rights agreement could require liquidated damages if specified obligations are not met.
- The Applied Optics acquisition added lease obligations and operating costs, while delayed contract novation increased inventory and working-capital requirements.
- An equitable-adjustment claim related to a previously completed Howitzer program remained under appeal before the Armed Services Board of Contract Appeals. The company could not predict the outcome, although any recovery would benefit working capital and no future margin impact was expected from an unsuccessful claim.
- Approximately $342 thousand of acquired customer-backlog intangibles was scheduled for amortization at roughly $57 thousand per month from January through June 2015.
- The filing reported no material pending or threatened litigation and no material changes to previously disclosed risk factors. Management concluded that disclosure controls were effective.
Investor Verification Priorities
- Verify the gross-margin percentage discrepancy between the financial statements and MD&A.
- Assess the economic impact, dilution potential, conversion terms, anti-dilution provisions, and derivative valuation of the convertible notes.
- Monitor cash usage, inventory levels, working-capital availability, and compliance with the Avidbank credit facility.
- Confirm Applied Optics contract novations, government acceptance, shipment timing, backlog conversion, and actual revenue contribution.
- Evaluate whether management’s revenue expectations and expected $6.5 million Applied Optics contribution are achievable given the company’s defense-spending and backlog risks.
- Review subsequent purchase-price-allocation adjustments to the provisional $2.110 million bargain-purchase gain.
- Track the Howitzer equitable-adjustment appeal and any effect on liquidity or working capital.