Optex Systems Holdings, Inc. (“Optex Systems”, “OPXS” or the “Company”) manufactures optical sighting systems and assemblies, primarily for Department of Defense applications. Products include periscopes for military land vehicles, surveillance sights, night vision optical assemblies, and rifle scopes for the consumer sector. Optex Systems was founded in Richardson, Texas in 1987.

In 2005, the Company was acquired by Irvine Sensors for $14 million in cash plus a potential $4 million earn-out.

In 2008, Irvine Sensors encountered financial difficulties and was forced to sell Optex Systems to two of Irvine Sensors’ lenders for $15 million.

In 2014, Optex Systems purchased Applied Optics Center from L3 Communications for $1.0 million, expanding the Company’s expertise in optical assemblies and thin-film coatings.

The Company conducts its operations at two locations in the Dallas area and has 90 full-time employees.

The Company’s largest segment and original business line is called Optex Richardson and operates out of a 52,000 square foot facility in Richardson, Texas. The segment manufactures optical sighting systems and assemblies for defense applications. Products include laser-protected periscopes, sighting systems, aiming devices, and big-eye binoculars. The Company’s periscopes and sighting systems are utilized on U.S. military land vehicles including the Abrams Tank and the Bradley Fighting Vehicle. A tank typically has 10 to 15 periscopes costing $750-$1,000 each as well as a sighting system that costs $15,000-$30,000 per vehicle. Many of the Company’s products are equipped with a proprietary technology that prevents laser interference from impacting the functionality of the periscope and injuring the operator.

The Company believes it commands 75% of the U.S. periscope market (estimated at $8-10 million) and 25% of the global market (estimate at $40-50 million). Sales for the segment surpassed $29 million in fiscal 2009 before falling below $9 million in fiscal 2015 as a result of a reduction in military spending related to the sequester. The Company has recently won large contracts for Saudi and Kuwaiti tank programs that have helped grow the backlog from under $9 million in 2014 to over $16 million today. Also of note, Miller-Holzwarth and SSI Technology (two former competitors) recently ceased operations, and we expect the Company to realize higher margins over time given the reduced level of competition.

The Company’s other division is Applied Optics Center. Optex Systems purchased Applied Optics Center from L-3 Communications in November 2014 for $1.0 million (accounted for as a bargain purchase). Applied Optics manufactures laser filters for optics equipment and optical assemblies as well as commercial products including rifle scopes and spotting scopes. The segment has developed a proprietary process for applying a substrate to periscopes and other sighting systems that prevents laser interference.

In addition to products designed for military use, the segment recently began manufacturing consumer rifle scopes for Nightforce Optics. Located in Boise, Idaho, Nightforce Optics is a private company that has developed a strong reputation for high-end scopes with an especially loyal following of military veterans. Nightforce previously had most of their optical systems produced in either Japan or Eastern Europe but discovered that scopes that are entirely made in America command a sizeable price premium and conducting business with a U.S. based company is easier logistically. The Company currently supplies Nightforce with four scope models and hopes to continue to expand the relationship.

When evaluating any potential investment, Gate City Capital Management considers the price we would pay for the entire company. Optex Systems currently has a market capitalization of $9.0 million and an enterprise value of $8.0 million. We expect the Company to generate $20 million of revenue in the current fiscal year and over $1 million of EBITDA. We expect operating results to continue to improve in 2018 given the Company’s growing backlog and the potential for sizeable operating leverage as revenues expand. The Company also has minimal requirements for capital expenditures and a sizeable deferred tax asset that should allow most of the Company’s EBITDA to generate free cash flow.

Optex Systems has expressed confidence in the Company’s recently improved results by repurchasing a large block of stock and also initiating a $0.02/share quarterly dividend (annual yield of approximately 8%). We value Optex Systems using a discounted cash flow analysis to arrive at a target enterprise value of $12 million. We added approximately $1 million of net cash to obtain our target market capitalization of $13 million or $1.45/share. Although the Company’s share price has appreciated considerably from our initial purchase price, we still see substantial upside potential in the years ahead.

This post has been excerpted from a letter of Gate City Capital Management.

Performance for the period from September 2011 through August 2014 has undergone an Examination by Spicer Jeffries LLP. Performance for the period from September 2014 through December 2016 has undergone an Audit by Spicer Jeffries LLP. Performance for 2017 is unaudited. The performance results presented above reflect the reinvestment of interest, dividends and capital gains. The Fund did not charge any fees prior to September 2014.The results shown prior to September 2014 do not reflect the deduction of costs, including management fees, that would have been payable to manage the portfolio and that would have reduced the portfolio’s returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period and investment performance. Specific calculations of net of fees performance can be provided upon request.