Optex Systems Holdings Inc quarterly report, Q2 FY2015

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

Reporting period: Quarter and six months ended March 29, 2015, compared with the periods ended March 30, 2014. The financial statements are unaudited. Optex manufactures optical sighting systems, periscopes, surveillance and night-vision assemblies, and thin-film optical coatings primarily for U.S. and foreign defense applications. The company had 77 full-time equivalent employees and 170,913,943 common shares outstanding as of May 11, 2015.

Financial performance and position

Metric	Three months ended March 29, 2015	Three months ended March 30, 2014	Six months ended March 29, 2015	Six months ended March 30, 2014
Revenue	$3.403 million	$2.182 million	$5.501 million	$5.536 million
Gross margin	$(27) thousand	$364 thousand	$352 thousand	$981 thousand
Gross margin percentage	(0.8%)	16.7%	6.4%	17.7%
Operating loss	$(837) thousand	$(213) thousand	$(1.144) million	$(224) thousand
Net income (loss) after tax	$3.642 million	$(142) thousand	$813 thousand	$(155) thousand
Net loss applicable to common shareholders	$(2.799) million	$(142) thousand	$(5.628) million	$(155) thousand
Loss per common share	$(0.0164)	$(0.0009)	$(0.0329)	$(0.0010)

Quarterly revenue increased 56.0%, primarily from $1.482 million of Applied Optics Coatings revenue and higher sighting-systems shipments. Periscope revenue declined 31.5%.
Six-month revenue declined 0.6%. Applied Optics contributed $1.824 million and offset a 52.3% decline in periscope revenue and lower revenue from other product lines.
Quarterly gross margin was approximately break-even; six-month gross margin declined to 6.4% from 17.7%. Cost pressure included acquisition-related amortization, contract cost-to-complete revisions, lower labor efficiency and underabsorbed fixed manufacturing costs.
General and administrative expense increased to $810 thousand for the quarter and $1.496 million for the six months, driven primarily by the Applied Optics acquisition.
Reported six-month net income was substantially affected by a $2.110 million bargain-purchase gain from the Applied Optics acquisition. Results attributable to common shareholders remained a loss because of $6.441 million of preferred-stock dividends and beneficial-conversion-feature adjustments.

Cash flow, liquidity and capital structure

Cash decreased to $1.115 million at March 29, 2015 from $1.685 million at September 28, 2014.
Six-month operating cash flow was $(527) thousand, compared with $1.118 million provided in the prior-year period. Accounts receivable increased $1.018 million, primarily from March shipments not yet collected.
Investing cash flow was $(2.079) million, including $2.094 million of property and equipment purchases associated primarily with the Applied Optics acquisition.
Financing cash flow was $2.036 million, including $1.560 million of convertible-note proceeds, $550 thousand of credit-facility borrowings and $74 thousand of debt-issuance fees.
The Avidbank revolving facility permits borrowings of up to $1.0 million, subject to eligible receivables and covenants. The outstanding balance was $550 thousand at March 29, 2015; the facility matures May 21, 2016 and bears interest at the greater of 7.0% or prime plus 2.5%.
The $1.560 million of convertible notes, issued at 12% interest, were converted on March 29, 2015 into 1,000 shares of Series B Preferred Stock, including accrued interest. The conversion price was $0.0025 per common share, subject to adjustment provisions.
Total assets were $11.694 million and total liabilities were $3.262 million at March 29, 2015. Net inventory was $6.300 million, including $1.345 million of reserves, and customer advance deposits totaled approximately $1.472 million.

Material changes versus the prior comparable period

Optex acquired the Applied Optics Products Line from L-3 on November 3, 2014 for $1.013 million in cash and assumed approximately $271 thousand of liabilities. The acquisition added equipment, inventory, customer backlog and an additional facility lease, and generated a provisional $2.110 million bargain-purchase gain.
Applied Optics represented approximately 33% of six-month revenue. Management stated that the product line had experienced startup and contract-novation delays but was producing higher revenue by March.
Backlog was $11.0 million at March 29, 2015, compared with $11.1 million at March 30, 2014. Management stated that backlog increased $2.3 million during the first six months, including $2.1 million acquired with Applied Optics.
Adjusted gross margin, a non-GAAP measure excluding acquisition-related intangible amortization and certain idle-capacity costs, was $446 thousand, or 13.1%, for the quarter and $1.428 million, or 26.0%, for the six months. Prior-year figures were 33.5% and 24.0%, respectively.
Series B preferred stock was authorized and issued in connection with the conversion of the notes. The conversion generated a $4.887 million beneficial-conversion-feature dividend; a further $1.554 million adjustment resulted from the reset of Series A conversion terms.

Outlook, commentary, risks and unusual items

Management expects continued net losses for at least the next year and states that profitability depends on achieving revenue sufficient to support the company’s cost structure.
Management does not expect alternative business to fully offset reduced U.S. government defense spending during the current fiscal year or the following twelve months. Uneven revenue could create a working-capital shortfall, and certain assets may not be recoverable if the business plan is unsuccessful.
Periscope revenue is expected to remain approximately 50% to 60% of prior-year levels over the near term. Sighting-system revenue is expected to exceed the prior year by 35% to 40% by fiscal year-end based on current schedules.
Management expects Applied Optics to generate approximately $1.5 million to $2.5 million per quarter and to supplement revenue by up to $6.0 million by fiscal year-end.
During the first six weeks of the third fiscal quarter, the company reported $1.5 million of new orders, consisting of $1.1 million of periscope orders and $400 thousand of Applied Optics orders. These are management-reported orders, not audited revenue.
Risks include reduced defense spending, customer and government contract delays, concentration in defense customers, fixed-price contract cost overruns, idle capacity, acquisition integration and valuation risk, limited liquidity, and reliance on additional financing or positive operating cash flow.
The company has an outstanding equitable-adjustment claim related to a completed Howitzer program. An Armed Services Board of Contract Appeals judge ruled in Optex’s favor on a procedural issue in November 2014, but the final outcome remains uncertain. Any recovery could improve working capital; no future margin benefit is expected because the losses were previously recognized.
On May 5, 2015, OTC Markets notified the company that its common stock had traded below the $0.01 minimum bid price for more than 30 consecutive days. The company received until November 1, 2015 to regain compliance or risk removal from OTCQB.
The company reported no material pending or threatened litigation, no material changes to previously disclosed risk factors, and effective disclosure controls as of March 29, 2015.

Important facts for investors to verify

Whether Applied Optics achieves management’s projected quarterly revenue and fiscal-year contribution while improving gross margins.
The company’s ability to fund operating losses, working-capital needs and lease obligations with approximately $1.1 million of cash and available credit.
The dilution and voting effects of the Series A and Series B Preferred Stock, including conversion-price resets and the potential additional $19.1 million retained-earnings adjustment associated with certain Series A shares.
The final purchase-price allocation and bargain-purchase gain for the Applied Optics acquisition, which remained provisional at filing.
The timing and collectability of accounts receivable, customer advance deposits and the $11.0 million backlog.
The outcome of the equitable-adjustment appeal and any resulting cash recovery.
Whether the company regains OTCQB minimum-bid-price compliance by November 1, 2015.