Optex Systems Holdings Inc - Quarter Report: 2016 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended June 26, 2016

For the transition period from ______to______.

OPTEX SYSTEMS HOLDINGS, INC.

(Exact Name of Registrant as Specified in Charter)

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

Check whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, 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 x  No ¨

Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act.

Yes ¨ No x

State the number of shares outstanding of each of the issuer’s classes of common equity, as of June 26, 2016: 1,621,145 shares of common stock.

State the issuer’s public float as of June 26, 2016; $508,459. 

OPTEX SYSTEMS HOLDINGS, INC.

FORM 10-Q

For the period ended June 26, 2016

INDEX

Part 1. Financial Information

Item 1. Consolidated Financial Statements

OPTEX SYSTEMS HOLDINGS, INC.

UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF JUNE 26, 2016

Optex Systems Holdings, Inc.

Condensed Consolidated Balance Sheets

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

Optex Systems Holdings, Inc.

Condensed Consolidated Statements of Operations

(Unaudited)

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

Optex Systems Holdings, Inc.
Condensed Consolidated Statements of Cash Flows

(Unaudited)

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

Note 1 - Organization and Operations

Optex Systems Holdings’ operations are based in Dallas and Richardson, Texas in two leased facilities comprising approximately 93,733 square feet. As of June 26, 2016, Optex Systems Holdings operated with 89 full-time equivalent employees.

Optex Systems Holdings manufactures optical sighting systems and assemblies, primarily for Department of Defense and foreign military applications. 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. Optex Systems Holdings is an ISO 9001:2008 certified company. On November 3, 2014, Optex Systems, Inc. purchased the assets comprising the Applied Optics Products Line of L-3 Communications, Inc., a thin film coating manufacturer for lenses used primarily in the defense industry.

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, we have 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.

On October 7, 2015, we effected a 1:1000 reverse split of our issued and outstanding shares of common stock and all share numbers in these consolidated financial statements have been adjusted to give effect to this reverse split.

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.

The condensed consolidated financial statements of Optex Systems Holdings included herein have been prepared by Optex Systems Holdings, without audit, pursuant to the rules and regulations of the SEC. Certain information and footnote disclosures normally included in financial statements prepared in conjunction with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although Optex Systems Holdings believes that the disclosures are adequate to make the information presented not misleading.

These condensed consolidated financial statements should be read in conjunction with the annual audited consolidated financial statements and the notes thereto included in the Optex Systems Holdings’ Form 10-K for the year ended September 27, 2015 and other reports filed with the SEC.

The accompanying unaudited interim consolidated financial statements reflect all adjustments of a normal and recurring nature which are, in the opinion of management, necessary to present fairly the financial position, results of operations and cash flows of Optex Systems Holdings for the interim periods presented. The results of operations for these periods are not necessarily comparable to, or indicative of, results of any other interim period or for the fiscal year taken as a whole. Certain information that is not required for interim financial reporting purposes has been omitted.

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. Management estimates include bad debt allowances, depreciable asset lives, accrued warranties, valuations of derivatives, stock compensation expenses, inventory valuation reserves, as well as estimated contract costs at completion used to derive cost of sales. Actual results could differ from the estimates.

Inventory: Inventory is recorded at the lower of cost or market value, and adjusted, as necessary, 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. There were no unliquidated progress payments as of June 26, 2016 and September 27, 2015. As of June 26, 2016 and September 27, 2015, inventory included:

Net inventory increased by $797 thousand during the nine months ending June 26, 2016 in support of revenues anticipated during the fourth quarter of the current fiscal year.

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.

Optex Systems Holdings may at times have contracts that allow for invoicing based on achievement of milestone events. In such cases, Optex Systems Inc. recognizes revenue based on the milestone method in accordance with FASB ASC 605-28, as applicable. On October 24, 2011, Optex Systems, Inc. was awarded an $8.0 million contract with General Dynamics Land Systems - Canada that provided for milestone invoices up to a total of $3.9 million. The terms of the contract extend through 2017 during which time we are required to purchase the necessary materials to fulfill the delivery of products required by the contract. Currently, there are no additional contracts providing for milestone payments. In accordance with FASB 605-28, Optex Systems, Inc. recognizes milestone payments as revenue upon completion of a substantive milestone as commensurate with the following guidelines: our performance to achieve the milestone, the milestone relates solely to past performance and is reasonable relative to all of the deliverables and payment terms within the arrangement. Milestones are not considered as substantive if any portion of the associated milestone consideration relates to the remaining deliverables in the unit of accounting. Non-substantive milestone payments are reported as a liability on the balance sheet as Short Term and Long Term Customer Advance Deposits.

Pursuant to the contract, all substantive milestones events were completed as of September 30, 2012 and as such, there was zero revenue recognized for milestones in the three and nine months ending June 26, 2016 and June 28, 2015 and no unpaid/invoiced customer deposits related to the completed milestone events, respectively. 

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 June 26, 2016, Optex Systems, Inc. had a balance of $0.6 million in short term customer advance deposits for deliveries to occur within the next twelve months on non-substantive milestone billings.

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 consolidated 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.

The Company’s 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.

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 in assessing 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. See Note 4 below regarding segment reporting for the company.

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, refundable tax credits, prepaid expenses, accounts payable, accrued expenses, notes payable to related parties and convertible debt-related securities. Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of the financial statement presentation date. The carrying value of the balance sheet financial instruments included in Optex Systems Holdings’ consolidated financial statements approximated their fair values.

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.

Optex Systems Holdings has preferred stock, 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 is perpetual, with no stated maturity date, and the conversions may occur any time from inception, the dividend is recognized immediately when a beneficial conversion exists at issuance. During the three and nine months ending June 28, 2015 Optex Systems Holdings recognized dividends of zero and $6.4 million, respectively, on series A and series B preferred stock related to the beneficial conversion feature of arising from a common stock conversion rate of $2.50 versus a current market price of $10.00 per common share. There was zero dividends recognized during the three and nine months ending June 26, 2016, as the conversion price was above the market.

Intangible Assets:  Optex Systems Holdings has acquisition-related intangible assets which include the fair market value of customer order backlog as of the acquisition date. We determine the fair value of intangible assets using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies, which requires some judgment by management.  Amortization of acquisition-related intangible assets is expensed to total operating expenses as cost of sales and general and administrative expenses on a straight-line basis over their estimated useful lives, unless such lives are deemed indefinite. Amortizable intangible assets are tested for impairment based on undiscounted cash flows and, if impaired, written down to fair value based on either discounted cash flows or appraised values. The residual values and useful lives are reviewed at each balance sheet date and adjusted, if appropriate. Optex Systems Holdings identified intangible assets of $342 thousand from the acquisition of the Applied Optics Center from L3 on November 3, 2014 which consisted primarily of customer backlog, with an initial useful life of less than one year. As of June 26, 2016 and September 27, 2015 the unamortized balance of the intangible assets was zero. See Note 5 “Intangible Assets”.

Intangible assets with indefinite lives are tested annually for impairment, during the fiscal fourth quarter and between annual periods, if impairment indicators exist, and are written down to fair value as required.

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 consolidated 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 the Company will not realize tax assets through future operations.

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, convertible debt, stock options and warrants. In computing the dilutive effect of convertible preferred stock or debt, the numerator is adjusted to add back any convertible preferred dividends and interest on convertible debt, 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, convertible debt, stock options and warrants that are anti-dilutive are excluded from the calculation of diluted earnings per common share.

For the three and nine months ended June 26, 2016, respectively, 546 shares of Series A preferred stock, 969 shares of Series B preferred stock, 52,850 stock options and zero warrants were excluded from the earnings per share calculation as anti-dilutive. For the three and nine months ended June 28, 2015, respectively, 1,001 shares of Series A preferred stock, 994 shares of Series B preferred stock, 62,858 stock options and 1,000 warrants were excluded from the earnings per share calculation as anti-dilutive.

Note 3 Purchase of Applied Optics Products Line

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

The purchase price for the acquisition was $1,013.1 thousand, which was paid in full at closing, plus the assumption of certain liabilities associated with the Purchased Assets in the approximate amount of $270.7 thousand. The source of funds for the acquisition consisted of Optex working capital of $213.1 thousand and an advance of $800 thousand from accredited investors which was subsequently consummated on November 17, 2014 through the private placement of convertible notes issued by Optex Systems Holdings in a transaction exempt from registration under Section 4(2) of the Securities Act. See Note 8 “Issuance of Convertible Notes”.

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

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

The intangible assets include finite-life intangibles associated with undelivered customer backlog as of the acquisition date and was valued using the income approach methodology that includes the discounted cash flow method as well as other generally accepted valuation methodologies, which requires significant judgment by management.  The cash flow projections took into effect the expected net sales from the customer backlog as of November 3, 2014 and the corresponding expenses against those sales in the respective periods. The shipments against the customer backlog were delivered between January and June of 2015, and as such, the intangible amortization against those shipments was complete by June 28, 2015. As of September 27, 2015 the balance in unamortized intangible assets was zero.

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

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

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

As a result of the asset purchase, the Company incurred additional acquisition-related costs of approximately $40.2 thousand during the nine months ending June 28, 2015 for legal, accounting and valuation consulting fees which were expensed to general administrative costs.

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.

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. Applied Optics Center was acquired as a unit, and the management in place just prior to the time of the acquisition was retained.

The Applied Optics Center segment also serves as the key supplier of laser coated filters used in the production of periscope assemblies for 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.

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 each of the segment’s 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; and

(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 and foreign military 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.

Optex Systems – Richardson revenues predominately support prime and subcontracted military customers both domestically and abroad. The Optex Systems segment serves domestic military customers, 69% and foreign military customers, 31%. The Optex Systems segment revenue for nine months ending June 26, 2016 was derived from external customers consisting of General Dynamics, 26%, the U.S. government, 57%, International Parts Supply Co (IPS), 8%, and other external customers, 9%.

Optex Systems is located in Richardson, Texas, with leased premises consisting of approximately 49,100 square feet.  As of June 26, 2016, the Richardson facility operated with 52 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 3). 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 Corporation and others. AOC also creates a new sector of opportunity for commercial products. Globally, 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, externally, and as an internal supplier for Optex Systems – Dallas. Applied Optics Center sales to commercial customers represent 32% and military sales to prime and subcontracted customers represent 46% of the total segment revenue. Intersegment sales to Optex Systems – Richardson, comprised 22% of the total segments revenue and was primarily in support of military contracts. The Applied Optics Center external customer revenue for the nine months ending June 26, 2016 was derived from Nightforce Optics, Inc., 38%, L3 Communications, 15%, Exelis, Inc., 22%, the U.S. government, 20%, and other external customers, 5%.

The Applied Optics Center (AOC), is located in Dallas, Texas with leased premises consisting of approximately 56,633 square feet of space, of which 12,000 square feet is currently subleased to L3 Mobile Vision. As of June 26, 2016, AOC operated with 37 full time equivalent employees in a single shift operation.

The financial tables below present the information for each of the reportable segments profit or loss as well as segment assets for the three months ending June 26, 2016 and the three months ending June 28, 2015. Optex Systems Holdings does not allocate interest expense, income taxes or unusual items to segments.

The financial tables below present the information for each of the reportable segments profit or loss as well as segment assets for the nine months ending June 26, 2016 and the nine months ending June 28, 2015. Optex Systems Holdings does not allocate interest expense, income taxes or unusual items to segments.

(1) The Applied Optics Center was acquired on November 3, 2014.

Note 5 – Intangible Assets

On November 3, 2014, Optex Systems, Inc. purchased the assets comprising L-3 Communications’ Applied Optics Products Line (“Purchased Assets”) in exchange for $1,013.1 thousand and the assumption of approximately $270.7 thousand of liabilities (see Note 3 “Purchase of Applied Optics Product Line”). Optex Systems, Inc. has allocated the consideration for the acquisition of the purchased assets among tangible and intangible assets acquired and liabilities assumed based upon their fair values as of the acquisition date. Assets that met the criteria for recognition as intangible assets apart from goodwill were also valued at their fair values.

The purchase price was assigned to the acquired interest in the assets and liabilities of Optex Systems Holdings as of November 3, 2014 as follows:

The fair values of the intangible assets as of the asset transfer date consisted primarily of $342.2 thousand of undelivered customer order backlog with contracted delivery dates that is essentially fulfilled as of quarter ended June 28, 2015. The amortization of identifiable intangible assets associated with the acquisition was amortized on a straight line basis over the six month period beginning on December 29, 2014 at a rate of $57.0 thousand per month pursuant to the expected order deliveries. The intangible amortization is allocable to operating expenses as manufacturing cost of sales and general and administrative expenses at a rate of $145.5 thousand and $25.5 thousand per quarter, respectively, through quarter ending June 28, 2015. The identifiable intangible assets are amortized over 15 years for income tax purposes. There were no unamortized intangible assets or amortization expenses incurred in the three and nine months ending June 26, 2016. During the three and nine months ending June 28, 2015, $145.5 thousand and $291.1 thousand had been amortized to cost of sales, respectively, and $25.5 thousand and $51.1 thousand had been amortized to general and administrative expenses, respectively. As of the periods ending June 26, 2016 and September 27, 2015, the total unamortized balance of intangible assets was zero.

Note 6 - Commitments and Contingencies

Investor Relations - IRTH Communications

On April 6, 2016 Optex Systems Holdings Inc. executed an investor relations services agreement with IRTH Communications. The material terms of the agreement are as follows:

On April 29, 2016, Optex Systems Holdings, Inc. issued 40,000 common “restricted” shares at a market price of $2.35 per share ($94,000) in support of the IRTH Communications agreement.

Rental Payments under Non-cancellable 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. As of June 26, 2016 the unamortized deferred rent was $108 thousand as compared to $106 thousand as of September 27, 2015. Deferred rent expense is amortized monthly over the life of the lease.

The leased facility under the Applied Optics Center at 9839 and 9827 Chartwell Drive, Dallas, Texas, consists of 56,633 square feet of space at the premises. The term of the lease expires September 30, 2016. We are currently in negotiations with the property manager to renew the lease with a reduced floor space for an additional five years by September 30, 2016.

Approximately 12,000 square feet covered under the current Applied Optics Center lease, is subleased under a separate Memorandum of Understanding dated October 27, 2014, to L-3 Communications Mobile Vision Inc. The sublease term is for November 2014 through September 2016. The sublease is treated as a reduction in the company facilities rental and CAM expenses in the statement of operations. L-3 has notified Optex that it will not be renewing the sublease at the end of the current term. We are negotiating with the property manager to exclude a substantial portion of the floor space currently associated with the L-3 Mobile Vision Inc. address from the Optex lease renewal.

As of June 26, 2016, the remaining minimum lease and estimated adjusted common area maintenance (CAM) payments under the non-cancelable office and facility space leases are as follows:

Non-cancellable Operating Leases Minimum Payments

Total facilities rental and CAM expense for both facility lease agreements as of the three and nine months ended June 26, 2016 was $169 and $473 thousand. Total expense under facility lease agreements as of the three and nine months ended June 28, 2015 was $181 and $435 thousand.

Note 7 – Prepaid Royalties

Prepaid royalties represent payments made for the purchase of non-transferable, non-exclusive patent rights associated with a patent license. The patent license allows for development of current and future products in our digital line of periscopes. We completed our first international shipment utilizing this technology in 2014 and are currently in production to support a U.S. Government Foreign Military Sale contract awarded in January 2016. We estimate the commercial life of the patent at seven years. As of June 26, 2016, the balance of the patent license is $98 thousand net of accumulated amortization. The royalty expenses for the associated patent license are amortized on a straight line basis starting in fiscal year 2013. The amortized royalty expense for the three and nine months ending June 26, 2016 and June 28, 2015 was $8 thousand and $22 thousand each year, respectively.

Note 8 - 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.  Currently, Sileas is the majority owner of Optex Systems Holdings.

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 new majority owner of Optex Systems, Inc. (Delaware), executed and delivered to Longview, a Secured Promissory Note in an original principal amount of $13,524,405 and bearing simple interest at the rate of 4% per annum.

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

Simultaneously therewith, Sileas entered into a Blocker Agreement with us pursuant to which the Series A preferred stock shall not be convertible by Sileas into our common stock, and we shall not effect any conversion of the Series A Stock or otherwise issue any shares of our common stock pursuant hereto, to the extent (but only to the extent) that after giving effect to such conversion or other share issuance hereunder Sileas (together with its affiliates) would beneficially own in excess of 9.99% our common stock. Sileas also agreed to not vote any of its shares of Series A preferred stock in excess of 9.99% of our common stock. This Blocker Agreement has been waived by us until further notice.

Conversion of Sileas Owned Series A Preferred Shares to Common Stock

On March 27, 2016, Sileas exercised a conversion of 455.52 shares of Optex Systems, Inc. Preferred Series A shares at a total stated value of $3.1 million into 1,250,000 shares of common stock. The conversion rate to common stock was $2.50 per share. There was no impact to the balance sheet net equity as a result of this transaction.

Credit Facility — Avidbank (formerly known as Peninsula Bank Business Funding)

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:

As of June 26, 2016 and September 27, 2015, the outstanding principal and accrued interest balance on the line of credit was $730 thousand and $817 thousand, respectively.  For the three and nine months ended June 26, 2016 and June 28, 2015, the total interest expense against the outstanding line of credit balance was $12 and $28 thousand and $10 and $20 thousand, respectively.

Issuance of Convertible Notes

On November 17, 2014, Optex Systems Holdings entered into a Subscription Agreement (the “Agreement”) to sell up to $2.1 million principal amount of convertible promissory notes (“Notes”) to several accredited investors (the “Investors”) in a private placement pursuant to which the Investors purchased a series of Notes with an aggregate principal amount of $1,550 thousand. An additional convertible promissory note for $10 thousand was issued to the placement agency in consideration for placement services on the transaction.

Optex Systems, Inc. incurred $74 thousand in debt issuance costs, for investment banking, legal and placements fee services, inclusive of the $10 thousand supplemental convertible note issued for placement fees. These costs are reflected in the June 28, 2015 cash flow statement as debt issuance costs and were amortized to interest expense across the term of the notes based on the effective interest method. For the three and nine months ending June 26, 2016 the total interest expense related to the debt was zero. For the three and nine months ending June 28, 2015 the total interest expense related to the debt was $3 and $146 thousand, respectively. As of June 26, 2016 and September 27, 2015 the unamortized debt issuance costs were zero.

On June 28, 2015, the holders of the Company’s $1,560,000 principal amount of convertible promissory notes, issued on or about November 17, 2014, converted the entire principal amount thereof and all accrued and unpaid interest thereon, into 1,000 shares of the Company’s Series B Preferred Stock.

Note 9-Stock Based Compensation

Stock Options issued to Employees, Officers and Directors

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 June 26, 2016, Optex Systems Holdings has granted stock options to officers and employees as follows:

The following table summarizes the status of Optex Systems Holdings’ aggregate stock options granted under the incentive stock option plan:

As of June 26, 2016, the intrinsic value of the outstanding options was zero. There were zero options granted in the three and nine months ended June 26, 2016 and June 28, 2015, respectively.

The following table summarizes the status of Optex Systems Holdings’ aggregate non-vested shares granted under the 2009 Stock Option Plan: 

Restricted Stock Units issued to Officers and Employees

On June 14, 2016, the Compensation Committee (“Committee”) of the Board of Directors of Optex Systems Holdings, Inc. approved the Company’s 2016 Restricted Stock Unit Plan (the “Plan”). The Plan provides for the issuance of stock units (“RSU”) for up to 1,000,000 shares of the Company’s common stock to Optex Systems Holdings officers and employees. Each RSU constitutes a right to receive one share of the Company’s 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 the Company’s 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 the Company 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 the Company 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, the Company’s 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, the Company issued 150,000 RSUs to its Chief Executive Officer, Danny Schoening, and 50,000 RSUs to its 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. The total market value of the restricted stock units based on the shares price of $1.85 as of June 15, 2016 is $372 thousand. The cost of the shares is amortized on a straight line basis across the vesting periods.

Consulting and Vendor Equity Issues

On April 29, 2016, Optex Systems Holdings, Inc. issued 40,000 common “restricted” shares at a market price of $2.35 per share ($94,000) in support of the IRTH Communications agreement (See note 6). The cost of the shares is amortized on a straight line basis through April 2017. There were no other equity instruments issued to consultants and vendors during the three or nine months ended June 26, 2016 and June 28, 2015.

Warrant Agreements

Optex Systems Holdings calculates the fair value of warrants issued with debt or preferred stock using the Black-Scholes-Merton valuation method. The total proceeds received in the sale of debt or preferred stock and related warrants are allocated among these financial instruments based on their relative fair values. The discount arising from assigning a portion of the total proceeds to the warrants issued is recognized as interest expense for debt from the date of issuance to the earlier of the maturity date of the debt or the conversion dates using the effective yield method.

As of June 26, 2016, Optex Systems Holdings had the zero outstanding warrants outstanding. As of March 3, 2016 1,000 warrants issued to Avidbank on March 4, 2010 expired unexercised.

Stock Based Compensation Expense

Equity compensation is amortized based on a straight line basis across the vesting or service period as applicable. The recorded compensation costs for options and shares granted and restricted stock units awarded as well as the unrecognized compensation costs are summarized in the table below:

(1) The three months ending June 26, 2016 includes a cumulative correction for over amortization stock options during the six months ending March 27, 2016.

Note 10 Stockholders’ Equity

Common stock

On August 31, 2015, the Optex Systems board of directors approved a reverse stock split of our common stock, in a ratio to be determined by the board of directors, of not less than 1-for-400 nor more than 1-for-1000. On October 6, 2015, 20 calendar days had passed since the mailing to our shareholders of the Definitive Schedule 14C filed on September 11, 2015 regarding the approval by the board of the reverse stock split. On October 7, 2015, we effected a 1-for-1000 reverse split of our common stock. Pursuant to the reverse split, all shareholders of less than 100,000 pre-split common shares, were issued a round lot quantity of 100 common shares post-split. The total share round up quantity related to the reverse split resulted in an additional issue of 139,953 common shares post-split. All share and related option information has been retroactively adjusted to reflect the decrease in shares resulting from this action. Additional funds were reclassified from the common stock to additional paid in capital to reflect the change in total par value represented by the lower common shares after the reverse split. The par value of the common stock outstanding shall remain at $0.001 per share subsequent to the reverse split action.

As of September 28, 2014, Optex Systems had 170,914 common shares outstanding. Pursuant to an October 7, 2015 reverse split, there was an additional 139,953 shares issued to preserve round lots of 100 shares for all lot holders holding less than 100,000 pre-split, or 100 post-split shares common shares. An adjustment to common stock par value and additional paid in capital was recorded to reflect the change in values as a result of the reverse split.

On May 27, 2015 a private investor converted $10 thousand, or 6 shares of the Series B preferred stock at a stated value of $1,629 per share, for 4,000 shares of common stock. The outstanding common shares as of September 27, 2015 were 314,867.

On October 23, 2015 a private investor converted $40 thousand, or 25 shares of the Series B preferred stock at a stated value of $1,629 per share, for 16,031 shares of common stock. On December 8, 2015 Optex Systems issued an additional 247 common shares to certain beneficial holders to correct Depository Trust and Clearing Corporation (DTC) rounding errors occurring from the October 7, 2015 reverse split. On March 27, 2016, Sileas Corporation converted $3,125 thousand or 455.52 shares of the Series A preferred stock at a stated value of $6,860 per share, for 1,250,000 shares of common stock. On April 29, 2016, Optex Systems Holdings, Inc. issued 40,000 common “restricted” shares at a market price of $2.35 per share ($94,000) in support of the IRTH Communications agreement (See note 6). The outstanding common shares as of June 26, 2016 is 1,621,145.

The table below reflects the retroactive changes to common shares and equity accounts as a result of the 1000:1 reverse split and subsequent share issues as of June 26, 2016.

There were no other issuances of common or preferred stock during the three or nine months ended June 26, 2016 or June 28, 2015.

On December 15, 2015, our board of directors and the shareholders holding a majority of our issued and outstanding Common Stock approved an amendment to our Certificate of Incorporation, as amended, to effect a reverse stock split which combines the outstanding shares of our common stock into a lesser number of outstanding shares. Our board of directors will have the sole discretion to effect the amendment and reverse stock split at any time prior to June 30, 2016, and to fix the specific ratio for the combination, provided that the ratio would be not less than 1-for-2 and not more than 1-for-3. We did not effect this reverse split within the time period allotted.

Series A preferred stock

Optex Systems Holdings has filed a Certificate of Designation with the Secretary of State of the State of Delaware authorizing a series of preferred stock, under its articles of incorporation, known as “Series A preferred stock”. The Certificate of Designation currently sets forth the following terms for the Series A preferred stock: (i) number of authorized shares: 1,027; (ii) per share stated value: $6,860; (iii) liquidation preference per share: stated value; (iv) conversion price: $0.15 per share as adjusted from time to time; and (v) voting rights: votes along with the common stock on an as converted basis with one vote per share (vi) par value $0.001 per share. The conversion price was subsequently reset to $2.50 per share as discussed below.

The Series A preferred stock entitles the holders to receive cumulative dividends at the rate of 6% per annum, payable in cash at the discretion of Board of Directors. Each share of preferred stock is immediately convertible into common shares at the option of the holder which entitles the holder to receive the equivalent number of common shares equal to the stated value of the preferred shares divided by the conversion price, which was initially set at $0.15 per share. The dividends were subsequently waived and the price per share was reset to $0.01 on February 21, 2012 as discussed below. On November 17, 2014 an exercise price per share ratchet was triggered by the issuance of convertible notes with a lower conversion price and the exercise price was reset to $0.0025 per common share Effective as of October 7, 2015, the conversion price has been reset to $2.50 per share pursuant to the 1000:1 reverse stock split on common shares.

Holders of preferred shares receive preferential rights in the event of liquidation. Additionally, the preferred stock shareholders are entitled to vote together with the common stock on an “as-converted” basis.

As of April 1, 2012, the preferred shareholders agreed to waive the past dividends in arrears through June 29, 2014 of $884 thousand in exchange for an increase in the stated value to $6,860. On February 21, 2012, in connection with the purchase of the 5,000 shares of common stock of Optex Systems Holdings by Alpha Capital, the preferred shareholders executed an irrevocable waiver for any and all previously accrued and outstanding dividends and the right to receive any future dividends on the Series A Preferred Stock. The per share conversion price of the Optex Systems Holdings’ Series A Preferred Stock was automatically reset to $0.01 per share in accordance with the reset provision as set forth in paragraph 4(d)(ii) of the Series Designation for the Optex Systems Holdings’ Series A Preferred Stock. The total amount of dividends waived as a result of the February 21, 2012 waiver is $213 thousand. As a result of the executed waiver dated February 21, 2012, there were no dividends in arrears on preferred shares and no future dividends will accrue on the preferred shares.

On March 19, 2013, Alpha Capital Anstalt converted 7.29 shares of Series A preferred stock at a stated value of $6,860 into 5,000 shares of its Common Stock for a total converted value of $50,000. On February 11, 2014 and March 24, 2014, Alpha Capital Anstalt converted 7.29 shares of Series A preferred stock at a stated value of $6,860 into 5,000 shares of its Common Stock for a converted value of $50,000 each transaction, respectively. On March 27, 2016, Sileas Corp. converted $3,125 thousand or 455.52 shares of our Series A preferred stock into 1,250,000 shares of our common stock. As a result of the conversions, Optex Systems Holdings had 546 of preferred shares outstanding as of June 26, 2016 and 1,001 of preferred shares outstanding as of September 27, 2015 respectively.

As of April 3, 2015, a majority in interest of the holders of the Series A preferred stock have waived the right to convert its Series A preferred stock into Company common shares until such a time as a reverse stock split of the Company’s stock is effected in sufficient ratio to accommodate full conversion of both Series A and Series B preferred stock from authorized and unissued shares. On October 7, 2015, we effected a 1-for-1000 reverse split of our common stock.

On June 5, 2015, Sileas entered into a Blocker Agreement with us pursuant to which the Series A preferred stock shall not be convertible by Sileas into our common stock, and we shall not effect any conversion of the Series A Stock or otherwise issue any shares of our common stock pursuant hereto, to the extent (but only to the extent) that after giving effect to such conversion or other share issuance hereunder Sileas (together with its affiliates) would beneficially own in excess of 9.99% our common stock. Sileas also agreed to not vote any of its shares of Series A preferred stock in excess of 9.99% of our common stock. This has been waived by us until further notice.

For the three months ending June 26, 2016 and June 28, 2015, there were no preferred dividends booked or preferred dividends payable in arrears. As of March 29, 2015, based on the price reset to $2.50 per common share, there were 75.5 shares of preferred stock with a beneficial conversion feature, “in the money”, which were subject to immediate conversion at the discretion of the holder. In the nine months ending June 28, 2015, Optex Systems Holdings recognized a $1.5 million adjustment to retained earnings for dividends for the intrinsic value of the beneficial conversion feature for the 75.5 preferred shares issued and convertible as of March 29, 2015. During the nine months ending June 26, 2016 there were no dividends booked to retained earnings related to the beneficial conversion feature on Series A preferred shares. Based on the market price of the common stock of $1.90 as of June 26, 2016, these preferred shares are not subject to the beneficial conversion feature as the conversion price of $2.50 per share is above the market. As these Series A preferred shares are subject to the potential for further adjustments to the conversion ratio based on future occurrences, any new conversion price reset may trigger recognition of an additional beneficial conversion feature on occurrence.

Series B Preferred Stock

On March 26, 2015, Optex Systems Holdings filed a Certificate of Designation with the Secretary of State of the State of Delaware authorizing a series of preferred stock, under its articles of incorporation, known as “Series B preferred stock”. The Certificate of Designation currently sets forth the following terms for the Series B preferred stock: (i) number of authorized shares: 1,010; (ii) per share stated value: $1,629 (iii) liquidation preference per share, other than Series A preferred stock: stated value; (iv) conversion price: $0.0025 per share as adjusted from time to time; (v) voting rights: votes along with the common stock on an as converted basis with one vote per share; and (vi) par value of $0.001 per share. Effective as of October 7, 2015, the conversion price has been reset to $2.50 per share pursuant to the 1000:1 reverse stock split on common shares.

On March 28, 2015, the holders of the Company’s $1,560,000 principal amount of convertible promissory notes, issued on or about November 17, 2014, converted the entire principal amount thereof and all accrued and unpaid interest thereon, into 1,000 shares of the Company’s Series B Preferred Stock. Each share of preferred stock is immediately convertible into common shares at the option of the holder which entitles the holder to receive the equivalent number of common shares equal to the stated value of the preferred shares divided by the conversion price, which is initially set at $0.0025 per share and was reset to $2.50 per share pursuant to the October 7, 2015 1000:1 reverse stock split.

Upon the March 28, 2015 issuance, the market value of the common stock was $10.00 ($0.01 pre-split). As the conversion rate of $2.50 ($0.0025 pre-split) was below the market price, the issued preferred series B stock contained a beneficial conversion feature. As the series B preferred stock is immediately convertible with no stated maturity date, Optex Systems Holdings recognized a retained earnings and additional paid in capital adjustment for the intrinsic value, “in the money portion”, of the conversion options. During the three and nine months ending June 28, 2015 Optex Systems Holdings recognized a retained earnings dividends and additional paid in capital adjustment of zero and $4.9 million, respectively, which represented the intrinsic value of the options at the March 28, 2015 commitment date. There were no retained earnings dividends booked during the three and nine months ending June 26, 2016 for the beneficial conversion feature on the Series B preferred stock. As these shares are subject to the potential for further adjustments to the conversion ratio based on future occurrences, any new conversion price reset may trigger recognition of an additional beneficial conversion feature on occurrence.

On May 27, 2015 a private investor converted $10,000, or 6 shares of the Series B preferred stock at a stated value of $1,629 per share, for 4,000 shares of common stock. On October 23, 2015 a private investor converted $40,000, or 25 shares of the Series B preferred stock at a stated value of $1,629 per share, for 16,031 shares of common stock. As of June 26, 2016 and September 27, 2015, there were 969 and 994 shares of Series B preferred shares outstanding, respectively. 

Note 11 Subsequent Events

On June 30, 2016 a private investor converted $273,226, or 167.7 shares of the Series B preferred stock at a stated value of $1,629 per share, for 109,291 shares of common stock.

On July 20, 2016 Optex Systems Inc. was awarded a 5-year Indefinite Delivery, Indefinite Quantity (IDIQ) contract with a total potential order value up to $6.0 million to supply its laser protected periscopes to the Defense Logistics Agency over the next 5 years.

On August 2, 2016 Optex Systems Holdings filed an amended registration statement on Form S-1/A for a primary offering in August 2016 and are seeking to consummate an underwritten offering of up to $5,000,000 in gross proceeds from the sale of common stock with a potential additional $750,000 if the entire overallotment is exercised in the offering. 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis or Plan of Operations

This MD&A is intended to supplement and complement our audited consolidated financial statements and notes thereto for the fiscal year ended September 27, 2015 and our reviewed but unaudited consolidated financial statements and footnotes thereto for the quarter ended June 26, 2016, prepared in accordance with U.S. generally accepted accounting principles (GAAP). You are encouraged to review our consolidated financial statements in conjunction with your review 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 non-GAAP measures are used in this MD&A, they are clearly identified as non-GAAP measures and reconciled to the most closely corresponding GAAP measure.

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).

A majority 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.

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.

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 company as defined by Federal Acquisition Regulation clause 52.249-8. In addition, the Government may require us 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 we have specifically produced or acquired for the terminated portion of this contract. The Government shall pay contract price for completed supplies delivered and accepted, and we 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.

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 Optex Systems Holdings 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. As of June 26, 2016, there were no outstanding requests for equitable adjustments on our contracts.

In some cases, we may receive an “undefinitized” (i.e., price, specifications and terms are not agreed upon before performance commenced) contract award for contracts that exceed the $750,000, which is the federal government Truth in Negotiations Act “TINA” threshold.  These contracts are considered firm contracts at an undefinitized, but not to exceed specified limits threshold.  Cost Accounting Standards Board covered contracts are subject to the Truth in Negotiations Act disclosure requirements and downward only price negotiation.  As of June 26, 2016, none of our outstanding backlog fell under this criterion.

Results of Operations

Backlog as of June 26, 2016, was $15.0 million as compared to a backlog of $11.9 million as of June 28, 2015, representing an increase of $3.1 million or 26.1%.  The following table depicts the current expected delivery by period of all contracts awarded as of June 26, 2016:

During the nine months ending June 26, 2016, Optex Systems Holdings received $15.0 million in new orders consisting of $6.7 million in periscopes, $5.8 million attributable to the Applied Optics Center, $0.6 million in sighting systems, and $1.9 million in other orders.

As of June 26, 2016, backlog for our periscope line has increased by $1.2 million or 32.4% in the last twelve months since June 28, 2015. 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.  Our acquisition of the Applied Optics Center in November 2014, combined with our expanded footprint into foreign vehicle platforms has positioned Optex Systems Inc. to effectively compete for domestic and foreign defense market share as the best value supplier for laser protected periscopes.

Sighting Systems backlog decreased by ($1.4) million or (27.5%) in the last twelve months as we continue to deliver against our existing M36 DDAN contract. We anticipate the possibility of new sighting systems orders for DDANs as well as similar sighting systems for delivery beyond 2016.

Applied Optics Center backlog increased $1.9 million, or 67.9% in the last twelve months since June 28, 2015 primarily due to increases in commercial products for our Nightforce optical assembly products. In May, 2015, the Applied Optics Center entered into a supply agreement with Nightforce Optics, Inc. for supply by us to Nightforce of certain critical optical assemblies through our Applied Optics Center division. The production rate and delivery schedule shall be agreed upon by the parties and are subject to aggregate annual minimum order values of $3.0 million in calendar year 2015 and $3.9 million in calendar 2016. Our backlog for the Nightforce optical assemblies is $3.4 million as of June 26, 2016, as compared to $1.5 million for the period ended June 28, 2015. We are anticipating additional orders against this product line in the next three months.

Our backlog increased by $1.4 million or 466.7% on other products in the last twelve months due to new orders booked for collimator assemblies in support of the U.S government and General Dynamics, and cable assemblies for the U.S. Government.

Three Months Ended June 26, 2016 Compared to the Three Months Ended June 28, 2015

Revenues. In the three months ended June 26, 2016, revenues increased by $3.0 million or 130.4% from the respective prior period in 2015 as set forth in the table below:

Revenues increased by $2.1 million or 300.0% on our periscope line during the three months ended June 26, 2016 as compared to the three months ended June 28, 2015 due to increased customer demand for the U.S. government as well as foreign military sales during the year. Based on our current backlog schedule, we expect periscope shipments to decline during the next quarter but continue to exceed prior year levels.

Sighting systems revenues for the three months ending June 26, 2016 increased by $0.3 million or 150.0% from revenues in the prior year period due to material delays in the video controller equipment required to complete M36 DDAN units. Shipments are expected to continue at the same pace in the last quarter of the fiscal year as the customer has requested a delay in shipments pending an updated delivery schedule. We expect deliveries against the DDAN units to increase during the first half of fiscal year 2017.

Applied Optics Center revenue increased by $0.8 million or 66.7% during the three months ended June 26, 2016 as compared to the three months ended June 28, 2015. The U.S. military shipments increased by $0.7 million due to shipments against the new ACOG laser filter contract during the current quarter and an increase of $0.1 million on our commercial Nightforce optical assemblies. We expect Applied Optics Center revenue to continue at a higher rate into the fourth quarter of fiscal 2016 as we continue shipments against the ACOG laser filter and Nightforce optical assembly orders.

Revenue on other product lines decreased by ($0.2) million or (100.0%) compared to revenues in the prior year period due to the completion of previous orders for spare parts and muzzle reference systems.

Cost of Goods Sold. During the three months ended June 26, 2016 and June 28, 2015, we recorded cost of goods sold of $4.3 million and $2.6 million, respectively. The gross margin during the three months ended June 26, 2016 was $1.1 million or 20.8% of revenues as compared to a gross margin of ($0.2) million or (12.6%) for the three months ended June 28, 2015. The increased cost of sales of $1.7 million is primarily due to the $3.0 million increase in revenue offset with the reduction in intangible amortization related to the Applied Optics Center acquisition in the prior year. The increase in gross margin of $1.3 million for the current year period as compared to the prior year period, is primarily due to higher revenue combined with improved labor efficiencies, updated pricing on new orders, and increased plant utilization in the current year quarter versus the prior year quarter.

G&A Expenses. During the three months ended June 26, 2016, we recorded operating expenses of $0.8 million as opposed to $0.7 million, during the three months ended June 28, 2015. The increase of $0.1 million in the current quarter as compared to the prior year period is primarily due to the write off of costs in the current period which were attributable to the suspended capital raise during the first half of the fiscal year 2016.

Operating Loss. During the three months ended June 26, 2016, we recorded an operating profit of $0.2 million, as compared to an operating loss of ($1.0) million during the three months ended June 28, 2015. The $1.2 million increase in operating profit in the current year period over the prior year period is primarily due to increased revenue of $3.0 million and the resulting gross margin increase of $1.3 million which was offset by slightly higher general and administrative costs of ($0.1) million.

Net Income applicable to common shareholders. During the three months ended June 26, 2016, we recorded a net income applicable to common shareholders of $0.2 million as compared to net a loss applicable to common shareholders of ($1.0) million during the three months ended June 28, 2015. The increased income of $1.2 million is attributable to the increases in revenue, gross margin and operating profit noted above.

Nine months Ended June 26, 2016 Compared to the Nine Months Ended June 28, 2015

Revenues. In the nine months ended June 26, 2016, revenues increased by $4.0 million or 51.3% from the respective prior period in 2015 as set forth in the table below:

Revenues increased by $2.9 million or 111.5% on our periscope line during the nine months ended June 26, 2016 as compared to the nine months ended June 28, 2015. During the period, we experienced increased revenue across all periscope types due to increased orders booked in support of foreign and domestic orders received during fiscal year 2015 and 2016. Based on our current backlog schedule, we expect periscope shipments to decline during the next quarter but continue to exceed prior year levels over the next six months.

Sighting systems revenues for the nine months ending June 26, 2016 decreased by ($0.1) million or (6.3%) from revenues in the prior year period due to software issues causing a delay in the video controller equipment required to complete M36 DDAN units. Shipments are expected to continue at the same pace in the last quarter of the fiscal year as the customer has requested a delay in shipments pending an updated delivery schedule. We expect deliveries against the DDAN units to increase during the first half of fiscal year 2017.

Applied Optics Center revenue increased $1.3 million or 43.3% during the nine months ended June 26, 2016 as compared to the nine months ended June 28, 2015. Revenues increased due to a ramp up of deliveries on our commercial Nightforce optical assemblies of $1.0 million and deliveries against the ACOG U.S. military laser interface filters order of $0.7 million, which was offset by a decline of ($0.4) million in other laser filters to another military subcontractor. We expect Applied Optics Center revenue to continue at a higher rate into the fourth quarter of fiscal 2016 as we continue shipments against the ACOG laser filter and Nightforce optical assembly orders.

Revenue on other product lines decreased by ($0.1) million or (16.7%) compared to revenues in the prior year period due to the completion of previous orders for spare parts and muzzle reference systems in the prior year.

Cost of Goods Sold. During the nine months ended June 26, 2016 and June 28, 2015, we recorded cost of goods sold of $9.7 million and $7.7 million, respectively. The gross margin during the nine months ended June 26, 2016 was $2.1 million or 17.8% of revenues as compared to a gross margin of $0.1 million or 1.3% for the nine months ended June 28, 2015. The increase in cost of sales of $2.0 million is primarily due to the $4.0 million increase in revenue during the same period. The increase in gross margin for the current year period, as compared to the prior year period, is primarily due to higher revenue combined with improved labor efficiencies, updated pricing on new orders, increased plant utilization and reduced amortization of intangibles.

G&A Expenses. During the nine months ended June 26, 2016, we recorded operating expenses of $2.4 million as opposed to $2.2 million, during the nine months ended June 28, 2015. The increased general and administrative expenses in the current year period over the prior year period is primarily due to the write off of costs in the current period which were attributable to the suspended capital raise during the first half of the fiscal year 2016.

Operating Loss. During the nine months ended June 26, 2016, we recorded an operating loss of ($0.3) million, as compared to an operating loss of ($2.1) million during the nine months ended June 28, 2015. The $1.8 million decreased operating loss in the current year period over the prior year period is primarily due to increased gross margin of $2.0 million on higher revenue partially offset by higher general and administrative costs of ($0.2) million.

Net Loss applicable to common shareholders. During the nine months ended June 26, 2016, we recorded a net loss applicable to common shareholders of ($0.4) million as compared to net loss applicable to common shareholders of ($6.6) million during the nine months ended June 28, 2015. The decreased loss of $6.2 million is primarily attributable to a decrease in the current year operation loss of $1.8 million offset by decreases in the current year other income and expense from the prior year period for non-recurring items recognized as a gain on asset purchase of the Applied Optics Center of ($2.1) million, a decrease of $6.4 million for premiums on preferred stock and a reduction in interest expense of $0.1 million from the prior year period.

Liquidity and Capital Resources

As of June 26, 2016, Optex Systems Holdings had working capital of $6.0 million, as compared to $6.1 million as of September 27, 2015. During the nine months ended June 26, 2016, the Company experienced a net loss of ($0.4) million and an increase of 51.3%, or $4.0 million in revenues to $11.8 million in the current year period as compared to $7.8 million in the prior year period ending June 28, 2015. Backlog as of June 26, 2016 has increased by $3.1 million or 26.1% to $15.0 million as compared to backlog of $11.9 million as of June 28, 2015.

We have historically funded our working capital through operations, convertible notes, preferred stock offerings and bank debt.  We also filed a registration statement on Form S-1 for a primary offering late in July 2016 and are seeking to consummate an underwritten offering. Our ability to generate positive cash flows depends on a variety of factors, including the continued development and successful marketing of our products. At June 26, 2016, we had approximately $0.6 million in cash and an outstanding payable balance of $0.7 million against our working line of credit.  The line of credit allows for borrowing up to a maximum of $2 million, which fluctuates based on our open accounts receivable balance. As of June 26, 2016 our outstanding accounts receivable was $1.8 million. We expect to increase revenues and profitability during the last quarter of the fiscal year and over the next twelve months.  Successful transition to attaining profitable operations is dependent upon achieving a level of revenue adequate to support our cost structure.  Our current backlog supports increased revenues in the fourth quarter of fiscal year 2016 over the first three quarter levels. Management intends to manage operations commensurate with its level of working capital during the next twelve months; however, uneven revenue levels driven by changes in customer delivery demands, first article inspection requirements or other program delays could create a working capital shortfall.  In the event we do not successfully implement its ultimate business plan, certain assets may not be recoverable.

Cash Flows for the Period from September 27, 2015 through June 26, 2016

Cash and Cash Equivalents: As of June 26, 2016, we had cash and cash equivalents of $0.6 million which representing a decrease of ($0.1) million during the nine months ended June 26, 2016.

Net Cash Provided by Operating Activities. Net cash used by operating activities during the nine months from September 27, 2015 to June 26, 2016 totaled zero as compared to ($0.8) million used in the nine months ended June 28, 2015. The primary uses of cash during the period is increased inventory ($0.8) million offset by collections against accounts receivable of $1.0 million and other working capital changes of ($0.2) million. Inventory increases are primarily in support of higher planned revenue during the next six months.

Net Cash Provided by Investing Activities. In the nine months ended June 26, 2016, cash provided by investing activities was $0 as compared to ($2.1) million used in the nine months ended June 28, 2015 related to the Applied Optics Center acquisition in November 2014.

Net Cash Used in Financing Activities. Net cash used in financing activities was ($0.1) million during the nine months ended June 26, 2016 due to payments against the credit facility. Net cash provided by financing activities of $2.0 million during the nine months ending June 28, 2015 consist of proceeds of convertible notes and borrowing against the credit facility. As of June 26, 2016, the outstanding line of credit balance was $0.7 million as compared to $0.8 million as of September 27, 2015.

Critical Policies and Accounting Pronouncements

Our significant accounting policies are fundamental to understanding our results of operations and financial condition. Some accounting policies require that we use estimates and assumptions that may affect the value of our assets or liabilities and financial results. These policies are described in “Critical Policies and Accounting Pronouncements” and Note 2 (Accounting Policies) to consolidated financial statements in our Annual Report on Form 10-K for the year ended September 27, 2015.

Cautionary Factors That May Affect Future Results

This Quarterly Report on Form 10-Q 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.

Optex Systems Holdings does not assume the obligation to update any forward-looking statement. You should carefully evaluate such statements in light of factors described in this Form 10-Q. In various filings 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. 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by our Quarterly Report on Form 10-Q for the quarter ended June 26, 2016, management performed, with the participation of our Principal Executive Officer and Principal Financial Officer, an evaluation of the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the report we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s forms, and that such information is accumulated and communicated to our management including our Principal Executive Officer and our Principal Financial Officer, to allow timely decisions regarding required disclosures. Based upon the evaluation described above, our Principal Executive Officer and our Principal Financial Officer concluded that, as of June 26, 2016, our disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

During the quarter ended June 26, 2016, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

We are not aware of any material litigation pending or threatened against us.

Item 1A. Risk Factors

There have been no material changes in risk factors since the risk factors set forth in the Form 10-K filed for the year ended September 27, 2015.

Item 4. Mine Safety Disclosures

Not applicable.

Item 6. Exhibits

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.