Optex Systems Holdings Inc quarterly report, Q3 FY2015

Optex Systems Holdings, Inc. — Form 10-Q Summary

Reporting period: Fiscal quarter and nine months ended June 28, 2015; comparable periods ended June 29, 2014. Financial statements are unaudited. The company manufactures optical sighting systems, periscopes, surveillance and night-vision assemblies, and thin-film optical coatings primarily for U.S. and foreign defense markets.

Financial performance and condition

Metric	Three months ended June 28, 2015	Three months ended June 29, 2014	Nine months ended June 28, 2015	Nine months ended June 29, 2014
Revenue	$2.312 million	$1.858 million	$7.814 million	$7.394 million
Gross margin	$(0.260) million	$0.243 million	$0.091 million	$1.224 million
Gross margin percentage	(11.2)%	13.1%	1.2%	16.6%
Operating loss	$(1.001) million	$(0.405) million	$(2.146) million	$(0.629) million
Net income (loss) after taxes	$(1.014) million	$(0.399) million	$(0.202) million	$(0.554) million
Net loss applicable to common shareholders	$(1.014) million	$(0.399) million	$(6.643) million	$(0.554) million

Third-quarter revenue increased 24.4%, but gross margin declined to a loss because of supplier delays, lower labor efficiency, increased plant costs, acquisition-related amortization, and underabsorbed fixed manufacturing overhead.
Nine-month revenue increased 5.7%. Applied Optics contributed approximately $3.0 million, offsetting a $2.6 million, or 35.3%, decline in the legacy business.
General and administrative expense increased 13.8% in the quarter and 15.8% year to date, principally from the Applied Optics acquisition.
The nine-month common-shareholder loss includes $6.4 million of preferred-stock beneficial-conversion-feature dividends: approximately $4.9 million related to Series B and $1.5 million related to Series A.
Adjusted gross margin, a non-GAAP measure, was $0.363 million, or 15.7%, in the quarter and $1.761 million, or 22.5%, for the nine months, after adding back acquisition-related amortization and idle/excess-capacity costs.

Cash flow, liquidity and debt

Cash was $0.885 million at June 28, 2015, compared with $1.685 million at September 28, 2014. Working capital declined to $5.4 million from $6.5 million.
Cash used in operating activities was $0.758 million for the nine months, primarily reflecting a $0.867 million increase in inventory and a $0.337 million increase in accounts receivable.
Cash used in investing activities was $2.078 million, including $2.100 million of property and equipment purchases associated with the Applied Optics business.
Cash provided by financing activities was $2.036 million, including $1.560 million of convertible-note proceeds, $0.550 million of credit-facility borrowings, and $0.074 million of debt issuance fees.
The Avidbank revolving credit facility permits borrowings of up to $1.0 million, subject to eligible receivables and covenants. The outstanding balance was $0.550 million at quarter end, with a stated maturity of May 21, 2016.
A related-party secured note held by Sileas Corp. was amended to a principal amount of approximately $18.0 million, ceased accruing interest, and was extended to May 29, 2021. The note is convertible into Series A preferred stock and is subject to a 9.99% ownership blocker.
The company stated that it expects to incur net losses into the first half of fiscal 2016 and warned that uneven revenue could create a working-capital shortfall.

Material changes and operating developments

The November 3, 2014 acquisition of L-3 Communications’ Applied Optics Products Line added equipment, inventory, customer backlog and optical-coating operations. The company recognized a $2.110 million bargain-purchase gain, and the acquired customer-backlog intangible asset was fully amortized by June 28, 2015.
Applied Optics represented approximately 39.8% of year-to-date revenue. Its new optical-assembly product line experienced supplier delays, excess labor costs and margin losses; management expected the supplier issues to be resolved in the following quarter.
Backlog increased to $11.9 million from $9.9 million a year earlier. Expected deliveries were $5.0 million in the remainder of fiscal 2015, $5.7 million in 2016 and $1.2 million in 2017.
Nightforce Optics supply agreement has stated minimum annual order values of $3.0 million for 2015 and $3.9 million for 2016, subject to agreed production rates and delivery schedules.
The company received a $1.3 million base contract for 11,200 ACOG Laser Filter Units, with an option for an additional 11,200 units and total potential value of $2.6 million. The first task order was received after quarter end, with deliveries scheduled for May through August 2016.
Legacy periscope revenue declined 49.0% year to date because of completed prior-year orders and reduced U.S. government spending. Sighting-system revenue increased 39.9%, although software changes delayed some M36 DDAN deliveries.

Outlook, risks and unusual items

Management does not expect alternative business to fully offset reduced traditional government demand during the current fiscal year and expects continued losses into early fiscal 2016.
Key risks include U.S. defense-budget sequestration, dependence on government and defense-prime customers, production and supplier delays, fixed-cost underabsorption, working-capital requirements, and the need to achieve sufficient revenue to support the cost structure.
The company is pursuing foreign military programs, commercial applications, and new products, including the Red Tail digital spotting scope, but the filing does not provide firm revenue guidance for these initiatives.
The company’s equitable-adjustment claim related to a completed Howitzer program remained unresolved. A favorable administrative decision and DCAA audit were reported, but settlement negotiations and the ultimate recovery were uncertain. Any recovery could improve working capital; no future margin impact was expected because prior losses were already recognized.
OTCQB notified the company that its bid price had remained below $0.01 for more than 30 consecutive days. The company received a grace period ending November 1, 2015 to regain compliance.
Stockholders approved a reverse split ranging from 1-for-400 to 1-for-600; the board subsequently confirmed a 1-for-600 ratio, effective on a future date. The filing also states that Series A and Series B preferred-stock conversion features could result in additional retained-earnings charges, including an estimated $10.4 million related to certain Series A shares when conversion becomes available.
The filing contains inconsistent references to the date on which the convertible notes were exchanged for Series B preferred stock, referring both to March 29 and June 28, 2015. This date and related capitalization disclosures should be verified against subsequent filings.

Facts investors should verify

Whether supplier issues and M36 DDAN software delays were resolved and whether Applied Optics reached profitable production levels.
Current cash, borrowing availability, covenant compliance and maturity or refinancing plans for the Avidbank facility.
The status and terms of the $18.0 million related-party secured note and the potential dilution from Series A and Series B preferred stock.
The effective date and final mechanics of the 1-for-600 reverse stock split and the company’s OTCQB compliance status.
Conversion-date inconsistencies for the convertible notes and the resulting preferred-stock and common-share counts.
The outcome of the Howitzer equitable-adjustment claim and any cash recovery.
Whether the Nightforce minimum-order provisions, ACOG contract options and reported backlog convert into timely shipments and cash collections.