Optex Systems Holdings Inc: Form 10-Q for the period ended Jul 3, 2022

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to supplement and complement our audited condensed consolidated financial statements and notes thereto for the fiscal year ended October 3, 2021 and our unaudited condensed consolidated financial statements and notes thereto for the quarter ended July 3, 2022, 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 a non-GAAP measure is used in this MD&A, it is clearly identified as a non-GAAP measure 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. The operating results for the periods presented were not significantly affected by inflation.

Cautionary Note Regarding Forward-Looking Information

This Quarterly Report on Form 10-Q, in particular the MD&A, contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Any statements contained in this Quarterly Report on Form 10-Q that are not statements of historical fact may be deemed to be forward-looking statements. When used in this Quarterly Report on Form 10-Q and other reports, statements, and information we have filed with the Securities and Exchange Commission (“Commission” or “SEC”), in our press releases, presentations to securities analysts or investors, or in oral statements made by or with the approval of an executive officer, the words or phrases “believes,” “may,” “will,” “expects,” “should,” “continue,” “anticipates,” “intends,” “will likely result,” “estimates,” “projects” or similar expressions and variations thereof are intended to identify such forward-looking statements.

These forward-looking statements represent our expectations, beliefs, intentions or strategies concerning future events, including, but not limited to, any statements regarding growth strategy; product and development programs; financial performance (including revenue and net income); backlog; orders; the impact of the COVID-19 pandemic; the impact of the Russian invasion of Ukraine; supply chain challenges; the continuation of historical trends; the sufficiency of our cash balances for future liquidity and capital resource needs; the expected impact of changes in accounting policies on our results of operations, financial condition or cash flows; anticipated problems and our plans for future operations; and the economy in general or the future of the defense industry.

We caution that these statements by their nature involve risks and uncertainties, certain of which are beyond our control, and actual results may differ materially depending on a variety of important factors. Some of these risks and uncertainties are identified in “Risk Factors” in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K and you are urged to review those sections. 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.

We do not assume the obligation to update any forward-looking statement. You should carefully evaluate such statements in light of factors described in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K.

Background

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).

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, Harris Corp. 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 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”. 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.

We may be at risk as a result of the current COVID-19 pandemic. Risks that could affect our business include the duration and scope of the COVID-19 pandemic and the impact on the demand for our products; actions by governments, businesses and individuals taken in response to the pandemic; the length of time of the pandemic and the possibility of its reoccurrence; the timing required to develop and implement effective treatments; the success of global vaccination efforts; the eventual impact of the pandemic and actions taken in response to the pandemic on global and regional economies; and the pace of recovery when the pandemic subsides.

Beginning in April 2020 through October 3, 2021, we experienced a significant reduction in new orders and ending customer backlog in our Optex Richardson segment, resulting in an overall decrease in backlog of 40% between September 29, 2019 and October 3, 2021. We attribute the lower orders to a combination of factors including a COVID-19 driven slow-down of contract awards for both U.S. military sales and foreign military sales (FMS), combined with significant shifting in defense spending budget allocations in US military sales and FMS away from Army ground system vehicles toward other military agency applications. In addition, the pandemic has caused several program delays throughout the defense supply chain as a result of plant shutdowns, employee illnesses, travel restrictions, remote work arrangements and similar supply chain issues. While the Applied Optics Center segment experienced a significant decline in orders during the second half of fiscal year 2020, the segment saw a sizable increase in new orders during the fiscal year ended October 3, 2021 as a result of increased military spending in Army infantry optical equipment, a larger customer base and higher customer demand for commercial optical assemblies. As of October 3, 2021, the Applied Optics Center segment backlog had increased by 153% as compared to the level on September 29, 2019. As a result of this significant shift in orders and backlog between segments, we anticipate corresponding shifts in revenue during the 2022 fiscal year, with revenue from the Optex Richardson segment decreasing, and revenue from the Applied Optics Center segment increasing.

Recent Events

Product Opportunities

As disclosed in the Company’s annual report on Form 10-K for the year ended October 3, 2021, the Company has been offering mil-spec quality high efficiency anti-reflective coatings for infrared applications. We anticipate continuing revenue growth and new opportunities relating to this offering in the near term.

Strategic Alternatives

As disclosed in the Company’s current report on Form 8-K on September 10, 2021, in September 2021, the Company’s Board of Directors formed a Strategic Alternatives Committee. The Committee’s purpose is to explore and evaluate strategic alternatives for the Company, including a possible strategic investment, merger or sale of the Company. This Committee continues to assess strategic alternatives from time to time.

Recent Stock Repurchases

On September 22, 2021, the Company announced authorization of a $1 million stock repurchase program. The shares authorized to be repurchased under this repurchase program may be purchased from time to time at prevailing market prices, through open market transactions or in negotiated transactions, depending upon market conditions and subject to Rule 10b-18 as promulgated by the SEC. During the nine months ended July 3, 2022, 188,414 common shares were repurchased under the September 2021 repurchase program at an aggregate cost of $366 thousand. As of July 3, 2022, all shares repurchased under the September 2021 stock repurchase program have been cancelled and there were no shares held in Treasury.

K. Hawkins Salary Increase and Employment Agreement

On March 28, 2022, the Board of Directors Compensation Committee approved a salary increase of 4% for Karen Hawkins, CFO to be effective on April 1, 2022. As a result of the increase, the salary has been changed from $205,425 to $213,642.

On July 1, 2022, Ms. Hawkins’ employment agreement was automatically extended in accordance with its terms for an additional eighteen months. The current term of the extended agreement expires on December 31, 2023, subject to further auto-renewal.

Line of Credit Renewal

On April 12, 2022, the Company and its subsidiary, Optex Systems, Inc. (“Optex”, and with the Company, the “Borrowers”), entered into an Amended and Restated Loan Agreement (the “Loan Agreement”) with PNC Bank, National Association, successor to BBVA USA (the “Lender”), pursuant to which the Borrowers’ existing revolving line of credit facility was decreased from $2.25 million to $1.125 million, and the maturity date was extended from April 15, 2022 to April 15, 2023. Obligations outstanding under the credit facility accrue interest at a rate equal to the Lender’s prime rate minus 0.25%.

D. Schoening Employment Agreement

The Company entered into an amended and restated employment agreement with Danny Schoening dated December 1, 2021. The term of the agreement commenced as of December 1, 2021 and the current term ends on November 30, 2022. Mr. Schoening’s base salary is $296,031 per annum. Mr. Schoening will be eligible for a performance bonus based upon a rolling three-year operating plan adopted by the Company’s Board of Directors (the “Board”). The bonus will be based on operating metrics decided annually by our Board and tied to such three-year plan. The target bonus equates to 30% of Mr. Schoening’s base salary. Our Board will have discretion in good faith to alter the performance bonus upward or downward by 20%.

The updated employment agreement also served to amend Mr. Schoening’s RSU Agreement, dated January 2, 2019, by changing the third and final vesting date for the restricted stock units granted under such agreement from January 1, 2022 to the “change of control date,” that being the first of the following to occur with respect to the Company: (i) any “Person,” as that term is defined in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), with certain exclusions, is or becomes the “Beneficial Owner” (as that term is defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company representing fifty percent (50%) or more of the combined voting power of the Company’s then outstanding securities; or (ii) the Company is merged or consolidated with any other corporation or other entity, other than: (A) a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) more than fifty percent (50%) of the combined voting power of the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation; or (B) the Company engages in a merger or consolidation effected to implement a recapitalization of the Company (or similar transaction) in which No “Person” (as defined above) acquires fifty percent (50%) or more of the combined voting power of the Company’s then outstanding securities. The amended RSU Agreement contains certain exceptions to the definition of change of control.

The employment agreement events of termination consist of: (i) death or permanent disability of Mr. Schoening; (ii) termination by the Company for cause (including conviction of a felony, commission of fraudulent acts, willful misconduct by Mr. Schoening, continued failure to perform duties after written notice, violation of securities laws and breach of the employment agreement), (iii) termination by the Company without cause and (iv) termination by Mr. Schoening for good reason (including breach by the Company of its obligations under the agreement, the requirement for Mr. Schoening to move more than 100 miles away for his employment without consent, and merger or consolidation that results in more than 66% of the combined voting power of the Company’s then outstanding securities or those of its successor changing ownership or a sale of all or substantially all of its assets, without the surviving entity assuming the obligations under the agreement). For a termination by the Company for cause or upon death or permanent disability of Mr. Schoening, Mr. Schoening will be paid salary and for a termination due to his death or permanent disability, also any bonus earned through the date of termination. For a termination by the Company without cause or by Mr. Schoening with good reason, Mr. Schoening will also be paid nine months’ base salary in effect and, if such termination occurs prior to a change of control, Mr. Schoening will not forfeit the unvested RSUs until and unless the change of control does not occur by March 13, 2023.

Results of Operations

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 three-and six-month operating results for the periods ended July 3, 2022 and June 27, 2021, in terms of both the GAAP net income measure and the non-GAAP Adjusted EBITDA measure. We believe that including both measures allows the reader better to evaluate our overall performance.

Our net income decreased by ($1.0) million to $0.4 million net income for the three months ended July 3, 2022, as compared to net income of $1.4 million for the prior year period. Our adjusted EBITDA increased by $0.4 million to $0.6 million for the three months ended July 3, 2022, as compared to $0.2 million for the prior year period. The increase in adjusted EBITDA for the most recent three-month period is primarily driven by increased revenue as compared to the prior year period. Operating segment performance is discussed in greater detail throughout the following sections.

Our net income decreased by ($1.6) million to a net income of $0.3 million for the nine months ended July 3, 2022, as compared to a net income of $1.9 million for the prior year period. Our adjusted EBITDA increased by $0.6 million to $0.7 million for the nine months ended July 3, 2022, as compared to $0.1 million for the prior year period. The increase in adjusted EBITDA for the most recent nine-month period is primarily driven by increased revenue as compared to the prior year period. Operating segment performance is discussed in greater detail throughout the following sections.

During the three and nine months ended July 3, 2022, we did not recognize either a gain or a loss on the change in fair value of warrants, as the warrants had expired on August 26, 2021 in accordance with their terms. By comparison, during the three months ended June 27, 2021, we recognized a gain on the change in fair value of warrants of $1.2 million, and during the nine months ended June 27, 2021, we recognized a gain on the change in fair value of warrants of $2.0 million. As this was a non-cash gain driven by then-current fair value of our outstanding warrants and unrelated to our core business operating performance, the change in fair value losses and gains have historically been excluded from our adjusted EBITDA calculations presented above. Further discussion regarding the changes in fair value of the warrants and the related warrant liability can be found in Item 1, “Unaudited Condensed Consolidated Financial Statements, Note 6 - Warrant Liabilities”.

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For the three months ended July 3, 2022, our total revenues increased by $1.7 million, or 39.2%, compared to the prior year period. The increase in revenue was primarily driven by a $2.2 million increase in external revenue at the Applied Optics Center segment, partially offset by a decrease in revenue at the Optex Richardson segment of ($0.5) million, respectively, over the prior year period.

For the nine months ended July 3, 2022, our total revenues increased by $2.5 million, or 19.0%, compared to the prior year period. The increase in revenue was primarily driven by a $4.9 million increase in external revenue at the Applied Optics Center segment, partially offset by a decrease in revenue at the Optex Richardson segment of ($2.4) million, respectively, over the prior year period.

During the year ended October 3, 2021, we realized a significant increase in customer orders and backlog for the Applied Optics Center segment. For the first nine months of fiscal year 2022, new orders on a consolidated basis were 86.7% higher than in the prior year period driven by increases in both operating segments.

Consolidated gross margin for the three months ended July 3, 2022 increased by $0.5 million, or 70.0%, compared to the prior year period. The increase in margin was primarily attributable to increased revenue at the Applied Optics Center segment.

Consolidated gross margin for the nine months ended July 3, 2022 increased by $0.8 million, or 43.3%, compared to the prior year period. The increase in margin was primarily attributable to increased revenue at the Applied Optics Center segment.

Our operating income for the three months ended July 3, 2022 increased by $0.5 million, or 794.7%, compared to the prior year period. The increase in operating income was primarily driven by increases in revenue and gross margin at the Applied Optics Center segment.

Our operating income for the nine months ended July 3, 2022 increased by $0.6 million, or 219.7%, compared to the prior year period operating loss. The increase in operating income was primarily driven by increases in revenue and gross margin at the Applied Optics Center segment.

Backlog

During the nine months ended July 3, 2022, the Company booked $18.3 million in new orders, representing an 86.7% increase over the prior year period. The orders for the most recently completed nine months consist of $9.8 million for our Optex Richardson segment and $8.5 million attributable to the Applied Optics Center segment.

The following table depicts the new customer orders for the nine months ending July 3, 2022 as compared to the prior year period in millions of dollars:

Backlog as of July 3, 2022 was $30.0 million, compared to a backlog of $27.3 million as of October 3, 2021, representing an increase of $2.7 million or 9.9%. The following table depicts the July 3, 2022 backlog as compared to the backlog on October 3, 2021:

Backlog as of July 3, 2022, was $30.0 million as compared to a backlog of $12.9 million as of June 27, 2021, representing an increase of $17.1 million or 132.6%. The following table depicts the current expected delivery by period of all contracts awarded as of July 3, 2022 in millions of dollars, as well as the July 3, 2022 backlog as compared to the backlog on June 27, 2021:

Optex Systems Richardson backlog as of July 3, 2022, was $14.2 million as compared to a backlog of $8.7 million as of June 27, 2021, representing an increase of $5.5 million or 63.2%.

Applied Optics Center backlog as of July 3, 2022, was $15.8 million as compared to a backlog of $4.2 million as of June 27, 2021, representing an increase of $11.6 million or 276.2%.

During the fourth quarter of the fiscal year ended October 3, 2021, we booked significant new orders in both commercial optical assemblies and laser filter units including a significant new defense contract customer.

Please refer to “—Background” 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 aggressively pursue 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, which could be manufactured using our current production facilities in order to capitalize on our existing excess capacity.

Three Months Ended July 3, 2022 Compared to the Three Months Ended June 27, 2021

Revenue. For the three months ended July 3, 2022, revenue increased by $1.7 million or 39.2% compared to the prior year period as set forth in the table below:

Optex Systems Richardson revenue decreased by $0.5 million or 15.1% for the three months ended July 3, 2022 as compared to the prior year period on lower customer demand in sighting systems and other, only partially offset by increased revenue in periscopes as compared to the prior year period.

Applied Optics Center revenue increased by $2.2 million or 169.1% for the three months ended July 3, 2022 as compared to the prior year period. The revenue increase is primarily attributable to increased customer demand across all optical assembly, laser filters and other product groups as compared to the prior year period.

Gross Margin. The gross margin during the three-month period ended July 3, 2022 was 20.6% of revenue as compared to a gross margin of 16.8% of revenue for the prior year period. The gross margin increased by $0.5 million to $1.3 million for the three months ended July 3, 2022 as compared to $0.8 million in the prior year three months. The increase in gross margin is primarily attributable to higher consolidated revenue and changes in mix between products and operating segments. Cost of sales increased to $4.9 million for the current period as compared to the prior year period of $3.7 million. Inflationary pressures on materials and labor have unfavorably impacted gross margins at our Optex Systems Richardson segment during the period, with a more significant impact on our periscope products due to the nature of long running fixed price IDIQ contracts which were booked in prior years. In addition, margins for our Optex System Richardson segment have been adversely impacted by fixed manufacturing overhead costs incurred on a decreased revenue base. The Applied Optics Center segment has seen increases in gross margins on substantially higher revenue despite similar inflationary pressures on material, labor and overhead costs.

G&A Expenses. During the three months ended July 3, 2022 and June 27, 2021, we recorded operating expenses of $0.8 million and $0.7 million, respectively. Operating expenses increased by 10.0% between the respective periods primarily due to increased salary expenses partially offset by lower stock compensation expenses.

Operating Income. During the three months ended July 3, 2022, we recorded operating income of $0.5 million, as compared to operating income of $0.1 million during the three months ended June 27, 2021. The $0.4 million increase in operating income for the current year period from the prior year period is primarily due to increased revenue and gross margin, partially offset by higher general and administrative costs as compared to the prior year quarter.

Other (Expense) Income. During the three months ended July 3, 2022, we did not recognize either a gain or a loss on the change in fair value of warrants, as the warrants had expired on August 26, 2021 in accordance with their terms. By comparison, during the three months ended June 27, 2021, we recognized a gain on the change in fair value of warrants of $1.2 million. Further discussion regarding the changes in fair value of the warrants and the related warrant liability can be found in Item 1, “Condensed Consolidated Financial Statements, Note 6 - Warrant Liabilities”.

Net Income applicable to common shareholders. During the three months ended July 3, 2022, we recorded a net income applicable to common shareholders of $0.4 million as compared to a net income applicable to common shareholders of $0.9 million during the three months ended June 27, 2021. The decrease in net income of $0.5 million is primarily attributable to the expiration of the warrants, which eliminated the impacts of the fair value gain and deemed dividends on net income from the former year period, partially offset by a $0.4 million increase in operating income for the current year period.

Nine months Ended July 3, 2022 Compared to the Nine months Ended June 27, 2021

Revenues. For the nine months ended July 3, 2022, revenues increased by $2.5 million or 19.0% compared to the prior year period as set forth in the table below:

Optex Systems Richardson revenue decreased by $2.4 million or 26.5% for the nine months ended July 3, 2022 as compared to the prior year period on lower customer demand across all product lines. Based on current customer orders, we are anticipating an overall 15% decrease in the Optex Systems Richardson segment revenue during the year ending October 2, 2022, as compared to the year ended October 3, 2021. While we anticipate future awards for Optex System Richardson programs, they will be at reduced levels from 2021 based on the most recent U.S. defense budget for ground systems programs, more specifically reductions in government spending on the Abrams tank platform. Deliveries against our howitzer program have been delayed by our customer pending resolution of issues related to customer furnished materials. Sighting systems and other products are expected to be below our prior year levels for the remainder of the fiscal year as several previous contracts have completed or are nearing completion.

Applied Optics Center revenue increased by $4.9 million or 116.1% for the nine months ended July 3, 2022 as compared to the prior year period. The revenue increase is primarily attributable to increased customer demand across all optical assembly, laser filter and other product lines as compared to the prior year period. Based on current customer orders, we are anticipating an overall 92% increase in the Applied Optics Center segment revenue during the year ending October 2, 2022, as compared to the year ended October 3, 2021. We anticipate additional orders for delivery in 2023.

Gross Margin. The gross margin during the nine-month period ended July 3, 2022 was 17.9% as compared to a gross margin of 14.9% for the prior year period. The gross margin increased by $0.8 million to $2.8 million for the nine months ended July 3, 2022 as compared to $2.0 million for the prior year period. The increase in gross margin is primarily attributable to higher revenue at the Applied Optics Center segment combined with changes in mix between products and operating segments. Cost of sales increased to $12.8 million for the nine months ended July 3, 2022 as compared to the prior year period of $11.2 million on higher period revenue.

G&A Expenses. During the nine months ended July 3, 2022 and June 27, 2021, we recorded operating expenses of $2.5 million and $2.2 million, respectively. Operating expenses increased by 10.5% between the respective periods primarily due to increased salary expenses, office expenses, legal expenses, audit fees and selling expenses, partially offset by lower stock compensation expenses.

Operating Income (Loss). During the nine months ended July 3, 2022, we recorded operating income of $0.3 million, as compared to an operating loss of ($0.3) million during the nine months ended June 27, 2021. The $0.6 million increase in operating income is primarily due to increased revenue and gross margin, partially offset by higher general and administrative costs in the period ended July 3, 2022 as compared to the prior year period.

Other (Expense) Income. During the nine months ended July 3, 2022, we did not recognize either a gain or a loss on the change in fair value of warrants, as the warrants had expired on August 26, 2021 in accordance with their terms. By comparison, during the nine months ended June 27, 2021, we recognized a gain on the change in fair value of warrants of $2.0 million. Further discussion regarding the changes in fair value of the warrants and the related warrant liability can be found in Item 1, “Consolidated Financial Statements, Note 6 - Warrant Liabilities”.

Net Income applicable to common shareholders. During the nine months ended July 3, 2022, we recorded net income applicable to common shareholders of $0.3 million as compared to net income applicable to common shareholders of $1.2 million during the nine months ended June 27, 2021 The decrease in net income of $0.9 million is primarily attributable to the current year period increased operating profit of $0.6 million, and secondarily to the expiration of the warrants, which eliminated the impacts of the fair value gain and deemed dividends on net income from the former year period.

Liquidity and Capital Resources

As of July 3, 2022, the Company had working capital of $13.3 million, as compared to $12.9 million as of October 3, 2021. Some of our contracts 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.

Backlog as of July 3, 2022 has increased by $2.7 million or 9.9% to $30.0 million as compared to backlog of $27.3 million as of October 3, 2021. Backlog has increased 132.6%, or $17.1 million, from $12.9 million as of June 27, 2021.

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 July 3, 2022, the Company had $5.2 million in cash and no outstanding payable balance against its line of credit at that time.

On April 12, 2022, the Company and its subsidiary, Optex Systems, Inc. (“Optex”, and with the Company, the “Borrowers”), entered into an Amended and Restated Loan Agreement (the “Loan Agreement”) with PNC Bank, National Association, successor to BBVA USA (the “Lender”), pursuant to which the Borrowers’ existing revolving line of credit facility was decreased from $2.25 million to $1.125 million, and the maturity date was extended from April 15, 2022 to April 15, 2023. Obligations outstanding under the credit facility will accrue interest at a rate equal to the Lender’s prime rate minus 0.25%.

The Loan Agreement contains customary events of default and negative covenants, including but not limited to those governing indebtedness, liens, fundamental changes, investments, and restricted payments. The Loan Agreement also requires the Borrowers to maintain a fixed charge coverage ratio of at least 1.25:1. 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. If adequate funds are not available on acceptable terms, or at all, we may be unable to finance our operations, develop or enhance our products, expand our sales and marketing programs, take advantage of future opportunities or respond to competitive pressures.

As of July 3, 2022, our outstanding accounts receivable balance was $1.9 million. The Company currently expects to generate net income and positive cash flow from operating activities for fiscal year 2022. Based on firm customer orders, the Company anticipates a consolidated revenue increase of 21-23% for the twelve months ending October 2, 2022 as compared to the twelve months ended October 3, 2021 combined with increased operating profit and net income. To remain profitable, we need to maintain a level of revenue adequate to support the Company’s cost structure. Management intends to manage operations commensurate with its level of working capital and line of credit 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 September 22, 2021, the Company announced authorization of a $1 million stock repurchase program. The shares authorized to be repurchased under this repurchase program may be purchased from time to time at prevailing market prices, through open market transactions or in negotiated transactions, depending upon market conditions and subject to Rule 10b-18 as promulgated by the SEC. During the three and nine months ended July 3, 2022, 72,443 and 188,414 common shares, were repurchased under the September 2021 repurchase program at an aggregate cost of $144 thousand and $366 thousand, respectively. As of July 3, 2022, all of the shares repurchased under the September 2021 stock repurchase program have been canceled and there were zero shares held in Treasury.

On August 26, 2021, 3,936,391 outstanding warrants expired worthless, resulting in the elimination of the balance sheet warrant liability.

As of October 3, 2021, and July 3, 2022, there were no outstanding declared and unpaid dividends.

On January 11, 2021, the Company executed amendments for each of its leased facilities extending the terms for eighty-six (86) months, commencing at the end of the current lease agreements. The Richardson lease amendment commenced on April 1, 2021 for an eighty-six (86) month term ending on May 31, 2028. The Dallas lease amendment commenced on November 1, 2021 for an eighty-six (86) month term ending on December 31, 2028. Each of the leases include two full months of rent abatement at the beginning of the commencement term. The new lease agreements resulted in the balance sheet recognition of a right-of-use asset of $3.7 million and corresponding operating lease liabilities of approximately $3.7 million as of the year ended October 3, 2021.

Cash Flows for the Period from October 3, 2021 through July 3, 2022

Cash and Cash Equivalents: As of July 3, 2022, and October 3, 2021, we had cash and cash equivalents of $5.2 million and $4.8 million, respectively.

Net Cash Provided by Operating Activities. Net cash provided by operating activities during the nine months from October 3, 2021 to July 3, 2022 totaled $1.9 million. The primary sources of cash during the period relate to collections in accounts receivables and customer deposits of $1.6 million, collection of $0.3 million against deferred taxes related to a tax refund on prior year operating losses, net income of $0.3 million and other changes in working capital of $0.7 million, offset by increases in inventory of ($1.0) million.

Net Cash Used in Investing Activities. In the nine months ended July 3, 2022, cash used in investing activities was $0.2 million for purchases of equipment and leasehold improvements.

Net Cash Used in Financing Activities. Net cash used in financing activities was $0.4 million during the nine months ended July 3, 2022 and primarily relates to the repurchases of common stock of as part of our stock repurchase program.

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 “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 October 3, 2021.

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 July 3, 2022, the Company had accrued warranty costs of $196 thousand, as compared to $78 thousand as of October 3, 2021. The primary reason for the $118 thousand increase in reserve balances relates to higher revenue on warrantied product being sold during the nine months ended July 3, 2022, combined with an increase in customer returned backlog pending repair or replacement to our customer as compared to the warranty backlog as of October 3, 2021.

As of July 3, 2022 and October 3, 2021, we had $33 thousand, and $51 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 significant downturn in defense spending on ground system vehicles. Due to inflationary price increases on component parts and higher internal manufacturing costs (as a result of escalating labor costs and higher burden rates on reduced volume), 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 nine months ended July 3, 2022, there was no significant change to the accrued contract losses. There is no way to reasonably estimate future inflationary impacts, or customer awards on the existing loss contracts.

As of July 3, 2022 and October 3, 2021 our deferred tax assets consisted of $1.7 million and $2.1 million, respectively, partially offset by a valuation reserve of $0.8 million against those assets for a net deferred tax asset of $0.9 million as of July 3, 2022 and $1.3 million as of October 3, 2021. During the nine-month period ended July 3, 2022 we collected $0.3 million in tax refunds related to the prior year net operating loss carryback in deferred tax assets. 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.

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 July 3, 2022, 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 July 3, 2022, our disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

During the three months ended July 3, 2022, 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.

Our results of operations could be adversely affected by economic and political conditions globally and the effects of these conditions on our customers’ businesses and levels of business activity.

Economic and political events this year have altered the landscape in which we and other U.S. companies operate in a variety of ways. In response to inflationary pressures, the U.S. Federal Reserve has raised interest rates, resulting in an increase in the cost of borrowing for our customers, our suppliers, and other companies relying on debt financing. World events, such as the Russian invasion of Ukraine and the resulting economic sanctions, have impacted the global economy, including by exacerbating inflationary and other pressures linked to COVID-related supply chain disruptions. Prolonged inflationary conditions, high and/or increased interest rates, and additional sanctions or retaliatory measures related to the Russia-Ukraine crisis, or other situations, could further negatively affect U.S. and international commerce and exacerbate or prolong the period of high energy prices and supply chain constraints. At this time, the extent and duration of these economic and political events and their effects on the economy and the Company are impossible to predict.

There have been no other material changes in risk factors since the risk factors set forth in the Form 10-K filed for the year ended October 3, 2021.