Item 7. Management’s Discussion and Analysis
Item
7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The
following discussion should be read in conjunction with the consolidated financial statements and the related notes that are set forth
in our financial statements elsewhere in this Annual Report.
This
management’s discussion and analysis reflects information known to management as of our fiscal year end, October 1, 2023, and the
date of filing. This MD&A is intended to supplement and complement our audited financial statements and notes thereto for the year
ended October 1, 2023, prepared in accordance with U.S. generally accepted accounting principles (GAAP). You are encouraged to read our
financial statements in conjunction with this MD&A. The financial information in this MD&A has been prepared in accordance with
GAAP, unless otherwise indicated. In addition, we use non-GAAP financial measures as supplemental indicators of our operating performance
and financial position. We use these non-GAAP financial measures internally for comparing actual results from one period to another,
as well as for planning purposes. We will also report non-GAAP financial results as supplemental information, as we believe their use
provides more insight into our performance. When a non-GAAP measure is used in this MD&A, it is clearly identified as a non-GAAP
measures and reconciled to the most closely corresponding GAAP measure.
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.
All
references in the following section to 2022 or 2023 with respect to our financial position and results of operations are to our fiscal
years ended October 2, 2022 or October 1, 2023, respectively.
31
Background
Optex
Systems, Inc. manufactures optical sighting systems and assemblies for the U.S. Department of Defense, foreign military applications
and commercial markets. Its products are installed on a variety of U.S. military land vehicles, such as the Abrams and Bradley fighting
vehicles, light armored and advanced security vehicles and 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 our revenue is related to the resale of products substantially manufactured by others.
In this case, the product would likely be a simple replacement part of a larger system previously produced by Optex Systems, Inc. (Delaware).
We
are both a prime and sub-prime contractor to the Department of Defense. Sub-prime contracts are typically issued through major defense
contractors such as General Dynamics Land Systems, Raytheon Corp., BAE, ADS Inc. and others. We are also a military supplier to foreign
governments such as Israel, Australia and NAMSA and South American countries and as a subcontractor for several large U.S. defense companies
serving foreign governments.
By
way of background, the Federal Acquisition Regulation is the principal set of regulations that govern the acquisition process of government
agencies and contracts with the U.S. government. In general, parts of the Federal Acquisition Regulation are incorporated into government
solicitations and contracts by reference as terms and conditions effecting contract awards and pricing solicitations .
Many
of our contracts are prime or subcontracted directly with the Federal government and, as such, are subject to Federal Acquisition Regulation
Subpart 49.5, “Contract Termination Clauses” and more specifically Federal Acquisition Regulation clauses 52.249-2 “Termination
for Convenience of the Government Fixed-Price)”, and 49.504 “Termination of fixed-price contracts for default”. These
clauses are standard clauses on our prime military contracts and generally apply to us as subcontractors. It has been our experience
that the termination for convenience is rarely invoked, except where it is mutually beneficial for both parties. We are currently not
aware of any material pending terminations for convenience or for default on our existing contracts.
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, some of our contracts allow for government contract financing in the form of contract progress payments pursuant to Federal
Acquisition Regulation 52.232-16, “Progress Payments”. Subject to certain limitations, this clause provides for government
payment of up to 90% of incurred program costs prior to product delivery for small businesses like us. 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.
Material
Trends and Recent Developments
Recent
supply chain disruptions have strained our suppliers and extended supplier delivery lead times, affecting their ability to sustain operations.
We anticipate market wide material shortages for paint and resin products as well as critical epoxies and chemicals used in our manufacturing
process. In addition, we are seeing substantial increases in the costs of aluminum, steel and acrylic commodities, which has affected
our net income in the year ended October 1, 2023 and is expected to continue to have a negative effect on the margins expected to be
generated under our long-term fixed contracts over the next three years. See also “ Item 1A. Risk Factors – Risks Related
to Our Business - Certain of our products are dependent on specialized sources of supply potentially subject to disruption which
could have a material, adverse impact on our business.”
We
have experienced significant material shortages during the year ended October 1, 2023 and extending into the first three months of
fiscal year 2024 from several significant suppliers of our periscope covers and housings. These shortages affect several of our
periscope products at the Optex Richardson segment. The delays in key components, combined with labor shortages during the year
ended October 1, 2023, which continue into the first three months of fiscal year 2024, have negatively impacted our production
levels and have pushed the expected delivery dates into the first half of fiscal year 2024. We are aggressively seeking alternative
sources and actively expediting our current suppliers for these components as well as increasing employee recruitment initiatives
and overtime to attempt to mitigate any continuing risks to the periscope line. While we are encouraged by recent improvements in
supplier performance for the Optex Richardson segment periscope line which yielded increased revenue performance during the second
through fourth quarters, our suppliers have yet to ramp up deliveries sufficiently to keep pace with our current customer demands.
As such, we cannot give any assurances that expected customer delivery dates for our periscope products will not experience further
delays.
32
In
March 2023, we moved our line of credit from PNC Bank to Texas Capital Bank and increased our available line of credit to $3.0 million
from the previous $2.0 million line with PNC. The increase in credit limit helps us meet our working capital requirements in light of
the increased backlog and delay of revenues from the fiscal year 2023.
We
refer also to “ Item 1. Business – Market Opportunity: U.S. Military ” for a description of current trends in
U.S. government military spending and its potential impact on Optex, which may be material, including particularly the tables included
in that section and disclosure on the significant reduction in spending for U.S ground system military programs, which has a direct impact
on the Optex Systems Richardson segment revenue, all of which is incorporated herein by reference.
We
refer to “ Item 1. Business – Recent Events ” of this report for recent developments affecting the Company.
Results
of Operations by Segment
We
have presented the operating results by segment to provide investors with an additional tool to evaluate our operating results. Management
of Optex Systems Holdings uses the selected financial measures by segment internally to evaluate its ongoing segment operations and to
allocate resources within the organization accordingly. Segments are determined based on differences in products, location, internal
reporting and how operational decisions are made. Management has determined that the Optex Systems, Richardson plant (to which we refer
below as the Optex Systems segment or Optex Systems), and the Applied Optics Center, Dallas plant, which was acquired on November 3,
2014 (to which we refer below as the Applied Optics Center segment or Applied Optics Center), are separately managed, organized, and
internally reported as separate business segments. The table below provides a summary of selective statement of operations data by operating
segment for the years ended October 1, 2023 and October 2, 2022 reconciled to the Audited Consolidated Results of Operations as presented
in Item 8, “Financial Statements and Supplementary Data”.
Results
of Operations Selective Financial Info
(Thousands)
Twelve months ended
October 1, 2023
October 2, 2022
Optex
Richardson
Applied Optics Center
Dallas
Other
(non-allocated costs and eliminations)
Consolidated
Optex
Richardson
Applied Optics Center
Dallas
Other
(non-allocated costs and eliminations)
Consolidated
Revenue from External Customers
$ 12,120
$ 13,539
$ -
$ 25,659
$ 9,533
$ 12,850
$ -
$ 22,383
Intersegment Revenues
-
893
(893 )
-
-
879
(879 )
-
Total Segment Revenue
12,120
14,432
(893 )
25,659
9,533
13,729
(879 )
22,383
Total Cost of Sales
9,729
10,204
(893 )
19,040
8,441
9,924
(879 )
17,486
Gross Profit
2,391
4,228
-
6,619
1,092
3,805
-
4,897
Gross Margin %
19.7 %
29.3 %
-
25.8 %
11.5 %
27.7 %
-
21.9 %
General and Administrative Expense
3,121
464
247
3,832
2,613
475
162
3,250
Segment Allocated G&A Expense
(1,338 )
1,338
-
-
(1,141 )
1,141
-
-
Net General & Administrative Expense
1,783
1,802
247
3,832
1,472
1,616
162
3,250
Operating Income (Loss)
608
2,426
(247 )
2,787
(380 )
2,189
(162 )
1,647
Operating Income (Loss) %
5.0 %
16.8 %
-
10.9 %
(4.0 )%
15.9 %
-
7.4 %
Interest Expense
-
-
(55 )
(55 )
-
-
-
-
Income (Loss) before taxes
$ 608
2,426
(302 )
2,732
$ (380 )
2,189
(162 )
1,647
Income (loss) before taxes %
5.0 %
16.8 %
-
10.6 %
(4.0 )%
15.9 %
-
7.4 %
33
Our
total external sales revenues increased by $3.3 million in the fiscal year 2023, or 14.6% compared to the 2022 fiscal year. The Optex
Systems segment realized a $2.6 million, or 27.1% increase, and the Applied Optics Center segment realized an increase of $0.7 million,
or 5.4%, in external revenue compared to the prior year period. Intersegment revenues were $0.9 million for 2023 and 2022. Intersegment
revenues relate primarily to coated filters provided by the Applied Optics Center to Optex Systems in support of the Optex Systems periscope
line.
Gross
profit increased $1.7 million and the gross margin percentage increased by 3.9 points from 21.9% in the 2022 fiscal year to 25.8% in
the 2023 fiscal year. Optex Systems gross profit increased by $1.3 million and the gross margin percentage increased to 19.7% as
compared to 11.5% in the prior year period on significantly higher revenue. Applied Optics Center gross profit increased by $0.4
million and the gross margin percentage increased to 29.3% as compared to 27.7% in the prior year period. The increase in consolidated
gross profit is primarily attributable to higher absorption of the fixed overhead cost base associated with higher revenue levels at
both operating segments combined with shifts in revenue mix in the Applied Optics Center.
Consolidated
general and administrative costs increased from $3.2 million for the twelve months ended October 2, 2022 to $3.8 million for the twelve
months ended October 1, 2023. During the years ended 2023 and 2022, Applied Optics Center absorbed $1.3 million and $1.1 million, respectively, of fixed
general and administrative costs incurred by Optex Systems for support services. The increase in allocated general and administrative
expenses during the 2023 year is directly attributable to the increase of $0.6 million in general and administrative spending during
the twelve-month period combined with a shift in revenue volume between segments. These expenses cover accounting, executive, human resources,
information technology, board fees and other corporate expenses paid by Optex Systems and shared across both operating segments.
Consolidated
operating income increased by $1.2 million in the year ended October 1, 2023 to an income of $2.8 million as compared to the prior year
operating income of $1.6 million. The increase in operating income is primarily attributable to operating income of $1.0 million at the
Optex Systems segment and increased operating income of $0.2 million at the Applied Optics Center segment on higher revenue and gross
profit. The increased segment operating income is slightly offset by a decrease in operating income of ($0.1) million in other unallocated
costs for increases in general and administrative and interest costs as compared to the prior year.
Income
before taxes increased $1.1 million, to $2.7 million in the 2023 fiscal year from a prior year income before taxes of $1.6 million. The
increase in income before taxes year over year is primarily due to the increase in revenue and gross profit in both segments.
New
Orders and Backlog
Product
backlog represents the value of unfulfilled customer manufacturing orders yet to be recognized as revenue. While backlog is not a non-GAAP
financial measure, it is also not defined by GAAP. Therefore, our methodology for calculating backlog may not be consistent with methodologies
used by other companies. The booked backlog by period may also not be fully indicative of the predicted revenues for those periods as
many of our orders provide for accelerated delivery without penalty and may additionally provide customers the option to adjust schedules
to meet their most recent projected demand quantities. However, we provide customer order and backlog information as we believe it provides
significant insight into forward demand, with some predictive power to short term future revenues.
During
the twelve months ended October 1, 2023, the Company booked $34.6 million in new orders, representing a 23.6% increase from the prior
year period orders of $28.0 million. The orders for the most recently completed twelve months consist of $23.3 million for our Optex
Richardson segment and $11.3 million attributable to the Applied Optics Center segment.
34
The
following table depicts the new customer orders for the twelve months ending October 1, 2023 as compared to the prior year period in
millions of dollars:
(Millions)
Product Line
Twelve months ended
October 1, 2023
Twelve months ended
October 2, 2022
Variance
% Chg
Periscopes
$ 15.9
$ 9.2
$ 6.7
72.8 %
Sighting Systems
4.0
0.7
3.3
471.4 %
Howitzer
-
-
-
- %
Other
3.4
3.6
(0.2 )
(5.6 )%
Optex Systems – Richardson
23.3
13.5
9.8
72.6 %
Optical Assemblies
1.9
6.7
(4.8 )
(71.6 )%
Laser Filters
7.6
4.7
2.9
61.7 %
Day Windows
0.3
1.9
(1.6 )
(84.2 )%
Other
1.5
1.2
0.3
25.0 %
Applied Optics Center – Dallas
11.3
14.5
(3.2 )
(22.1 )%
Total Customer Orders
$ 34.6
$ 28.0
$ 6.6
23.6 %
The
Company has seen significant increases in orders for many of its defense products during the fiscal year 2023 inclusive of two new customers
for our sighting systems and filter programs. On November 1, 2022, the Company announced it has been awarded a $3.4 million sighting
system order to repair and refurbish night vision equipment for the Government of Israel. The order represents a significant increase
in our Optex Richardson sighting systems business base for a new customer and includes an additional potential award value with a 100%
optional award quantity clause. Deliveries under this contract are expected to begin in the second quarter of fiscal year 2024. Our Optex
Richardson periscope orders have increased $6.7 million, or 72.8% over the prior year, including $9.0 million in task delivery awards
against our long term IDIQ contracts. On June 30, 2023, we booked a $3.0 million delivery order at our Applied Optics segment for the
delivery of laser interface filters against a five-year IDIQ contract. On September 18, 2023, the Company announced it was awarded a
five-year Indefinite Delivery Indefinite Quantity (IDIQ) contract from the U.S. Government, for M22 (7 x 50) Binoculars with an estimated
value of $2.12 million. As of October 1, 2023, the Applied Optics Center had received task orders valuing $0.5 million against this award.
The
Optex Systems Richardson segment currently has six open US Government IDIQ type military contracts for periscopes and two open IDIQ
contracts with another prime contractor for periscopes and unity mirrors with unspent funding which covers base year and option year
requirement periods into 2029. We anticipate additional orders throughout the next five years for these ongoing contracts. In
addition, the Company has three open bid requests for new multi-year IDIQ contracts pending with the U.S. Government for additional
periscopes that are expected to be awarded in the next twelve months.
Backlog
as of October 1, 2023 was $41.8 million as compared to a backlog of $32.9 million as of October 2, 2022, representing an increase of
27.1%. The following table depicts the current expected delivery by quarter of all contracts awarded as of October 1, 2023, as well as
the October 1, 2023 backlog as compared to the backlog on October 2, 2022.
35
(Millions)
Product Line
Q1
2024
Q2
2024
Q3
2024
Q4
2024
2024
Delivery
2025+
Delivery
Total Backlog
10/1/2023
Total Backlog
10/2/2022
Variance
% Chg
Periscopes
$ 2.1
$ 2.5
$ 3.5
$ 3.9
$ 12.1
$ 2.8
$ 14.9
$ 7.6
$ 7.3
96.1 %
Sighting Systems
0.1
0.5
0.4
0.5
1.6
3.1
4.7
1.7
3.0
176.5 %
Howitzer
-
-
-
-
-
2.3
2.3
2.3
-
- %
Other
1.1
1.3
0.7
0.3
3.2
1.4
4.6
3.4
1.2
35.3 %
Optex Systems – Richardson
3.3
4.3
4.6
4.7
16.9
9.6
26.5
15.0
11.5
76.7 %
Optical Assemblies
1.2
1.1
0.2
0.3
2.8
-
2.8
6.8
(4.0 )
(58.8 )
Laser Filters
1.9
2.1
2.3
1.8
8.1
1.8
9.9
8.7
1.2
13.8
Day Windows
0.2
0.3
0.2
0.2
0.9
0.8
1.7
2.0
(0.3 )
(15.0 )
Other
0.2
0.2
0.1
0.3
0.8
0.1
0.9
0.4
0.5
125.0
Applied Optics Center – Dallas
3.5
3.7
2.8
2.6
12.6
2.7
15.3
17.9
(2.6 )
(14.5 )%
Total Backlog
$ 6.8
$ 8.0
$ 7.4
$ 7.3
$ 29.5
$ 12.3
$ 41.8
$ 32.9
$ 8.9
27.1 %
Optex
Systems - Richardson
During
the twelve months ended October 1, 2023, backlog for our Optex Richardson segment increased by 76.7%, or $11.5 million to $26.5 million,
as compared to the prior year ending backlog of $15.0 million.
Backlog
for our periscope product line has increased 96.1% or $7.3 million to $14.9 million, from our 2022 fiscal year end level of $7.6 million,
primarily on new order releases against our long term IDIQ contracts. Our projected periscope revenue over the next twelve months is
currently exceeding our supplier and headcount capacity. We are currently working with our suppliers to ramp up material deliveries in
addition to adding automated buffing equipment and manpower to increase production capacity in line with our increasing customer demands
over the next twelve months.
Sighting
Systems product line backlog increased 176.5%, or $3.0 million, to $4.7 million, from our 2022 fiscal year end level of $1.7 million. The
increased backlog is primarily driven by the $3.4 million order from Israel for the repair and refurbishment of night vision equipment.
Deliveries against the new award are expected to begin in the second fiscal quarter of 2024, pending the approval of export licenses.
The
Howitzer contract awarded in July 2020 continues to experience customer driven delays related to customer furnished materials. This program
is currently on hold pending statement of work changes and materials furnished by the customer.
Our
backlog in other product groups increased by $1.2 million or 35.3% from $3.4 million in 2022 to $4.6 million in 2023 on new orders booked
during the twelve months ended October 1, 2023, primarily for muzzle reference systems and spare components for a major U.S. defense
contractor, combined with $0.3 million in optical wedge assemblies for a commercial customer.
Applied
Optics Center – Dallas
The
Applied Optics Center backlog decreased by $2.6 million, or 14.5%, for the year ended October 1, 2023, from $17.9 million in 2022 to
$15.3 million in 2023.
Backlog
for our optical assemblies decreased by $4.0 million, or 58.8%, as compared to the prior year on lower customer demand from one of our
commercial customers. We anticipate new order bookings during the next six months, although we are projecting an overall revenue reduction
in optical assemblies of approximately 40% over the next twelve months compared to fiscal year 2023.
36
Laser
filter backlog increased by $1.2 million, or 13.8%, during the year due to $3.5 million in new order releases against our U.S.
Government long term laser interface filter contract in addition to several new orders booked from other U.S. defense contractors
for laser interface filters and laser filter units. We are anticipating additional order bookings for delivery in the fourth fiscal
quarter of 2024 and a substantial increase in laser filter revenue of 55-60% over the next twelve months from the 2023
levels.
Day
window backlog decreased by $0.3 million during the period as compared to the prior year as we continue to deliver against the existing
orders from our ending 2022 backlog. We anticipate a slight increase in deliveries for day windows over the next twelve months based
on the customer contract schedules.
Other
Applied Optics backlog increased by $0.5 million, or 125.0% for the year ended October 1, 2023, on new orders booked during the period
for M22 binoculars. On September 18, 2023, the Company announced it was awarded a 5-year IDIQ contract from the U.S. Government, for
M22 (7 x 50) Binoculars with an estimated value of $2.12 million and during the month of September, the Company received $0.5 million
in task award orders against this contract. Deliveries against the contract are expected to begin in the fourth fiscal quarter of 2024.
Please
refer to “ Material Trends and Recent Events ” above or “ Liquidity and Capital Resources ” below for
more information on recent developments and trends with respect to our orders and backlog, which information is incorporated herein by
reference.
The
Company continues to pursue domestic, international and commercial opportunities in addition to maintaining its current footprint with
U.S. vehicle manufactures, with existing as well as new product lines. We are also reviewing potential products outside our traditional
product lines.
Further, we continue to look for strategic businesses to acquire that will strengthen our existing product line, expand our operations,
and enter new markets.
Twelve
months ended October 1, 2023 compared to the twelve months ended October 2, 2022
Revenues
The
table below details the revenue changes by segment and product line for the year ended October 1, 2023 as compared to the year ended
October 2, 2022.
Twelve
months ended
(Millions)
Product Line
October 1, 2023
October 2, 2022
Variance
% Chg
Periscopes
$ 8.6
$ 7.2
$ 1.4
19.4
Sighting Systems
1.0
0.8
0.2
25.0
Howitzers
-
-
-
-
Other
2.5
1.5
1.0
66.7
Optex Systems – Richardson
12.1
9.5
2.6
27.4
Optical Assemblies
5.6
4.9
0.7
14.3
Laser Filters
6.4
5.9
0.5
8.5
Day Windows
0.6
1.0
(0.4 )
(40.0 )
Other
1.0
1.1
(0.1 )
(9.1 )
Applied Optics Center – Dallas
13.6
12.9
0.7
5.4
Total Revenue
$ 25.7
$ 22.4
$ 3.3
14.7
Our
total revenues increased by $3.3 million, or 14.7% in fiscal year 2023 compared to fiscal year 2022. The Optex Systems Richardson segment
realized a $2.6 million, or 27.4%, increase in revenue and the Applied Optics Center segment realized an increase of $0.7 million, or
5.4%, in revenue compared to the prior year.
37
Optex
Systems - Richardson
Revenues
on our periscope line increased $1.4 million during the twelve months ended October 1, 2023 and October 2, 2022 on higher customer demand
and improved supplier deliveries.
Revenues
on sighting systems increased by $0.2 million, or 25.0% from the prior year period due to shipments of $0.4 million in back up sights
during the fourth quarter, offset by lower shipments against our OWSS repair contract.
Optex
Systems-Richardson revenue on other product lines increased by $1.0 million, or 66.7%, compared to revenues in the prior year due to
increased revenues for optical wedge assemblies, day camera assemblies, unity mirrors and assorted spare part assemblies for both commercial
and U.S. defense contractors.
Applied
Optics Center - Dallas
Revenue
on optical assemblies increased by $0.7 million, or 14.3%, during the twelve months ended October 1, 2023 as compared to the prior twelve-month
period on higher demand on several rifle scope assemblies from one of our major commercial customers.
Laser
filter revenue increased by $0.5 million, or 8.5%, during the twelve months ended October 1, 2023 as compared to the prior twelve-month
period on higher demand for laser interface filters and laser filter units from multiple defense contract customers.
Revenues
on our day windows decreased by $0.4 million, or 40.0%, during the twelve months ended October 1, 2023 as compared to October 2, 2022
as we continue to ship against our existing customer contract schedule.
Applied
Optics Center revenue for other product lines decreased by $0.1 million, or 9.1%, during the twelve months ended October 1, 2023 as compared
to the prior twelve-month period on decreased revenue for unity mirrors.
Gross
Margin . The gross margin for the year ended October 1, 2023 was 25.8% of revenue as compared to a gross margin of 21.9% of revenue
for the year ended October 2, 2022. Cost of sales increased by $1.6 million to $19.0 million for 2023 compared to $17.5 million for 2022.
The gross profit increased by $1.7 million to $6.6 million in 2023 as compared to $4.9 million in 2022. The increase is primarily due
to higher revenue and shifts between segments and product lines combined with higher fixed cost absorption at both the Applied Optics
Center and Optex Richardson segments related to increased production volume.
G&A
Expenses . For the years ended October 1, 2023 and October 2, 2022, we recorded operating expenses of $3.83 million and $3.25 million,
respectively. General and administrative cost increases of $0.6 million, or 17.8%, for fiscal year 2023 as compared to the prior year,
are primarily attributable to increases of $0.2 million relating to labor expenses and $0.2 million relating to office, legal, IT and
audit expenses, combined with a $0.1 million increase in stock compensation and a $0.1 million increase in bank fees. During the twelve
months ended October 1, 2023, approximately $0.1 million of the increase in office and legal expense are directly related to our uplisting
to the NASDAQ market in March 2023.
Operating
Income . For the year ended October 1, 2023, we recorded operating income of $2.8 million as compared to operating income of $1.6
million during the year ended October 2, 2022. The $1.2 million increase in operating income is primarily due to higher revenue and gross profit, partially offset by increased general and administrative expenses.
Net
income applicable to common shareholders . During the year ended October 1, 2023, we recorded net income applicable to common shareholders
of $2.3 million as compared to net income applicable to common shareholders of $1.3 million during the year ended October 2, 2022. The
increase of net income of $1.0 million is primarily attributable to the increase in operating profit, offset by increased interest expense
of $0.1 million and increased income tax expense of $0.1 million over the prior year period.
38
Non
GAAP Adjusted EBITDA
We
use adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) as an additional measure for evaluating the performance
of our business as “net income” includes the significant impact of noncash valuation gains and losses on warrant liabilities,
noncash compensation expenses related to equity stock issues, as well as depreciation, amortization, interest expenses and federal income
taxes. We believe that Adjusted EBITDA is a meaningful indicator of our operating performance because it permits period-over-period comparisons
of our ongoing core operations before the excluded items, which we do not consider relevant to our operations. Adjusted EBITDA is a financial
measure not required by, or presented in accordance with, U.S. generally accepted accounting principles (“GAAP”).
Adjusted
EBITDA has limitations and should not be considered in isolation or a substitute for performance measures calculated under GAAP. This
non-GAAP measure excludes certain cash expenses that we are obligated to make. In addition, other companies in our industry may calculate
Adjusted EBITDA differently than we do or may not calculate it at all, which limits the usefulness of Adjusted EBITDA as a comparative
measure.
The
table below summarizes our twelve-month operating results for the periods ended October 1, 2023 and October 2, 2022, in terms of both
the GAAP net income measure and the non-GAAP Adjusted EBITDA measure.
(Thousands)
Twelve months ended
October 1, 2023
October 2, 2022
Net Income — GAAP
$ 2,263
$ 1,283
Add:
Federal Income Tax Expense
469
364
Depreciation
345
307
Stock Compensation
247
162
Interest Expense
55
-
Adjusted EBITDA - Non GAAP
$ 3,379
$ 2,116
Our
Adjusted EBITDA increased by $1.3 million to $3.4 million during the twelve months ended October 1, 2023 as compared to $2.1 million
during the twelve months ended October 2, 2022. The increase in EBITDA is primarily driven by increased revenue and operating profit
during the current year as compared to the prior year twelve-month period. Operating segment performance is discussed in greater detail
throughout the previous sections.
Liquidity
and Capital Resources
As
of October 1, 2023, Optex Systems Holdings had working capital of $13.5 million, as compared to $10.0 million as of October 2, 2022.
During the twelve months ended October 1, 2023, we used operating cash of ($0.3) million, primarily driven by increased inventory,
and spent ($0.4) million on acquisitions of property and equipment. During the twelve months ended October 1, 2023, our net
borrowing against the credit facility was $1.0 million.
Backlog
as of October 1, 2023 was $41.8 million as compared to a backlog of $32.9 million as of October 2, 3022, representing an increase of
27.1%. For further details, see “ Results of Operations – New Orders and Backlog ”
above.
The
Company has historically funded its operations through cash from operations, convertible notes, common and preferred stock offerings
and bank debt. The Company’s ability to generate positive cash flows depends on a variety of factors, including the continued
development and successful marketing of the Company’s products. At October 1, 2023, the Company had approximately $1.2 million
in cash and an outstanding payable balance of $1.0 against its $3.0 million line of credit. As of October 1, 2023, our outstanding
accounts receivable balance was $3.6 million, which has been collected during the first quarter of fiscal 2024. During the first
quarter of 2024, we paid down our credit facility to zero.
We
refer to the disclosure above under “ Material Trends and Recent Developments” with respect to recent supply chain
disruptions and material shortages, which disclosure is incorporated herein by reference.
39
In
the short term, the Company plans to utilize its current cash, available line of credit and operating cash flow to fund inventory purchases
in support of the backlog growth and higher anticipated revenue during the next twelve months. Short term cash in excess of our working
capital needs may be also be used to fund the purchase of product lines and other assets, including property and equipment required to
maintain or meet our growing backlog, in addition to repurchasing common stock against our current stock repurchase plan. Longer term,
excess cash beyond our operating needs may be used to fund new product development, company or product line acquisitions, or additional
stock purchases as attractive opportunities present themselves.
In
some instances, new contract awards may allow for government contract financing in the form of contract progress payments pursuant to
Federal Acquisition Regulation 52.232-16, “Progress Payments.” Subject to certain limitations, this clause provides for government
payment of up to 90% of incurred program costs prior to product delivery for small businesses like us. To the extent any contracts allow
for progress payments and the respective contracts would result in significant preproduction cash requirements for design, process development,
tooling, material or other resources which could exceed our current working capital or line of credit availability, we intend to utilize
this benefit to minimize any potential negative impact on working capital prior to receipt of payment for the associated contract deliveries.
Currently none of our existing contracts allow for progress payments.
We
refer to “ Note 7 – Commitments and Contingencies – Rental Payments under Non-cancellable Operating
Leases ” for a tabular depiction of our remaining minimum lease and estimated CAM payments under such leases as of October
1, 2023, which disclosure is incorporated herein by reference.
The
Company expects to generate net income and positive cash flow from operating activities over the next twelve months. To remain
profitable, we need to maintain a level of revenue adequate to support our cost structure. Management intends to manage operations
commensurate with its level of working capital and line of credit facility during the next twelve months and beyond; however, uneven
revenue levels driven by changes in customer delivery demands, first article inspection requirements or other program delays
associated with the pandemic could create a working capital shortfall. In the event the Company does not successfully implement its
ultimate business plan, certain assets may not be recoverable.
On
March 22, 2023, the Company and its subsidiary, Optex Systems, Inc. (“Optex”, and with the Company, the “Borrowers”),
entered into a Business Loan Agreement (the “Loan Agreement”) with Texas Capital Bank (the “Lender”), pursuant
to which the Lender will make available to the Borrowers a revolving line of credit in the principal amount of $3 million (the “Credit
Facility”). The commitment period for advances under the Credit Facility is twenty-six months expiring on May 22, 2025. We refer
to the expiration of that time period as the “Maturity Date.” Outstanding advances under the Credit Facility will accrue
interest at a rate equal to the secured overnight financing rate (SOFR) plus a specified margin, subject to a specified floor interest
rate. The interest rate is currently at 8.08% per annum. As of October 1, 2023, the interest rate was 8.07% per annum.
The
Loan Agreement contains customary events of default (including a 25% change in ownership) and negative covenants, including but not limited
to those governing indebtedness, liens, fundamental changes (including changes in management), investments, and restricted payments (including
cash dividends). The Loan Agreement also requires the Borrowers to maintain a fixed charge coverage ratio of at least 1.25:1 and a total
leverage ratio of 3.00:1. The Credit Facility is secured by substantially all of the operating assets of the Borrowers as collateral.
The Borrowers’ obligations under the Credit Facility are subject to acceleration upon the occurrence of an event of default as
defined in the Loan Agreement. The Loan Agreement further provides for a $125,000 Letter of Credit sublimit. As of October 1, 2023, there
was $1.0 million borrowed under the Credit Facility which was fully repaid during the first three months of fiscal year 2024. As of October 1,
2023, the Company is in compliance with all covenants under the Credit Facility.
The
Credit Facility replaced the prior $2 million line of credit with PNC Bank, National Association.
On
September 22, 2021 the Company announced authorization for an additional $1 million stock repurchase program. As of July 2, 2023, there
was an authorized balance of $560 thousand remaining to be spent against the repurchase program. During the year ended October 1, 2023,
there were no stock repurchases against the plan.
During
the twelve months ended October 1, 2023 the Company declared and paid no dividends. As of October 1, 2023, there are no outstanding declared
and unpaid dividends.
40
Critical
Accounting Estimates
A
critical accounting estimate is an estimate that:
●
is
made in accordance with generally accepted accounting principles,
●
involves
a significant level of estimation uncertainty, and
●
has
had or is reasonably likely to have a material impact on the company’s financial condition or results of operation.
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 Note 2 “Summary of Significant Accounting Policies” of Item 8 “Financial Statements and Supplementary
Data” of this report.
Our
critical accounting estimates include warranty costs, contract losses and the deferred tax asset valuation. Future warranty costs are
based on the estimated cost of replacement for expected returns based upon our most recent experience rate of defects as a percentage
of warranty covered sales. Our warranty covered sales primarily include the Applied Optics Center optical assemblies. While our warranty
period is 12 months, our reserve balances assume a general 90-day return period for optical assemblies previously delivered plus any
returned backlog in-house that has not yet been repaired or replaced to our customer. If our actual warranty returns should significantly
exceed our historical rates on new customer products, significant production changes, or substantial customer changes to the 90-day turn-around
times on returned goods, the impact could be material to our operating profit. We have not experienced any significant changes to our
warranty trends in the preceding three years and do not anticipate any significant impacts in the near term. We monitor the actual warranty
costs incurred to the expected values on a quarterly basis and adjust our estimates accordingly. As of October 1, 2023, the Company had
accrued warranty costs of $75 thousand, as compared to $169 thousand as of October 2, 2022. The primary reason for the $94 thousand decrease
in reserve balances relates to lower customer returns on warrantied product being sold during the twelve months ended October 1, 2023,
combined with a decrease in customer returned backlog pending repair or replacement to our customer as compared to the warranty backlog
as of October 2, 2022.
As
of October 1, 2023 and October 2, 2022, we had $243 thousand, and $289 thousand, respectively, of contract loss reserves included in
our balance sheet accrued expenses. These loss contracts are related to some of our older legacy periscope IDIQ contracts which were
priced in 2018 through early 2020, prior to Covid-19 and the subsequent decline in revenue at the Optex Systems Richardson segment combined
with significant inflationary pressures on materials and labor in the last two years. Due to inflationary price increases on component
parts and higher internal manufacturing costs (as a result of escalating labor costs and higher burden rates), some of these contracts
are in a loss condition, or at marginal profit rates. These contracts are typically three-year IDIQ contracts with two optional award
years, and as such, we are obligated to accept new task awards against these contracts until the contract expiration. Should contract
costs continue to increase above the negotiated selling price, or in the event the customer should release substantial quantities against
these existing loss contracts, the losses could be material. For contracts currently in a loss status based on the estimated per unit
contract costs, losses are booked immediately on new task order awards. During the twelve months ended October 1, 2023, the accrued contract
losses decreased by $46 thousand on shipments against the active IDIQ contract backlog combined with improvements in manufacturing overhead
rates on higher revenue volume. There is no way to reasonably estimate future inflationary impacts, or customer awards on the existing
loss contracts. We continue to monitor these contracts throughout the year for any significant changes in addition to seeking potential
cost saving strategies to mitigate risk.
As
of October 1, 2023, Optex Systems Inc. had a net carrying value of $0.9 million in deferred tax assets consisting of deferred tax assets
of $1.7 million and valuation reserves of ($0.8) million. As of October 2, 2022, Optex Systems Inc. had a net carrying value of $0.9
million in deferred tax assets consisting of deferred tax assets of $1.8 million and valuation reserves of ($0.9) million. The valuation
allowance covers certain deferred tax assets where we believe we will be unlikely to recover those tax assets through future operations.
The valuation reserve includes assumptions related to future taxable income which would be available to cover net operating loss carryforward
amounts. Because of the uncertainties of future income forecasts combined with the complexity of some of the deferred assets, these forecasts
are subject to change over time. While we believe our current estimate to be reasonable, changing market conditions and profitability,
changes in equity structure and changes in tax regulations may impact our estimated reserves in future periods.
41
Recent
Accounting Pronouncements
Recent
Accounting Pronouncements are detailed under Note 3 of Item 8 “Financial Statements and Supplementary Data” of this report.
Item
7A. Quantitative and Qualitative Disclosures About Market Risk
Not
applicable.