Elevator Pitch
Optex Systems has a monopoly in selling laser-protected periscopes to the US military. This market is currently expanding as many of the military vehicles that Optex’s products are on are seeing substantial new orders and/or undergoing upgrades. This has led Optex’s military segment to grow at a 25% CAGR over the last four years, with consistent margin improvement every year. The company’s only competitor went bankrupt in mid-2013 because it was too aggressively competing on price. Optex also recently began selling into commercial applications; this segment is growing at over 50% per year and currently comprises ~25% of total revenues.
For such a rapidly-growing business with many new avenues for growth, shares are relatively cheap. The company just this year inflected on profitability, and trades at 8x annualized 1H 2018 EBIT. Optex has minimal debt and cash at 20% of the market cap and is buying back stock as shown in recent filings. Management owns 10% and has been buying recently. Shares are being artificially deflated right now because a large holder of the stock (Longview Fund) is liquidating its fund and is selling its 15% position in Optex on the open market.
The Business
Optex mainly sells optical sights and periscopes. The business is split into 3 applications: military, foreign, and commercial.
Military (68% FY17 sales)
Optex has a monopoly (100% market share) in the laser-protected periscope market for military applications. This is an ~$10 million/year market. They mainly put their periscopes on armored military vehicles such as tanks and light armored vehicles (LAVs). The market is somewhat recurring because these periscopes need regular maintenance and replacement: because they are on the outside of tanks, they are often shot at and damaged even while the tank remains intact. Optex gets paid both to supply new periscopes to replace damaged ones, and from time to time also to inspect existing parts.
Optex previously had one major competitor in the military segment, Miller-Holzwarth (MHI), who only competed on price and started a massive price war. This competitor then went bankrupt in 2012, leaving Optex to dominate the industry. Optex bought parts of MHI in the bankruptcy auction. The company hasn’t lost a laser-protected periscope contract since then. Since that time, revenues and margins have also improved every year, reflecting Optex’s main military business finally achieving niche-dominating economics. Gross margin has expanded from mid-teens figures in 2013 to ~23% in 2017. This effect is mainly due to previously-depressed margin contracts from price competition with MHI coming off contract, and Optex renegotiating higher margins on the next sets of contracts. Unfortunately, almost all of the contracts from MHI’s time have now already been cycled through and the prices raised, so this source of margin expansion likely will not be as prevalent going forward.
Since MHI went bankrupt, some competitors have also cropped up from time to time, although none of them has managed to gain a foothold in the industry due to both Optex’s existing relationship with the US military, and the technical/development expertise and financing needed to create a sustainable business developing periscopes. The industry is also low-margin, so Optex’s ability to profit on their current level of business is a big competitive advantage.
Growth is strong in this segment at ~20%/year (with large fluctuations), as military contractors like General Dynamics are always developing new generations or iterations of existing tanks. For example, GD is currently upgrading a large amount of their Stryker LAVs to a next generation model. Optex has several products on these vehicles. Similarly, BAE Systems recently received a $347 million contract to upgrade many Bradley tanks, which Optex also has several products on. Last year, GD also received a $2.8 billion contract to upgrade their Abrams tank line, which of course also has several Optex products attached to it. There appears to be a healthy appetite for Optex product-equipped military vehicles going forward for at least the next few years. And this is absent any sort of large-scale boost for increased military spending driven by the Trump administration.
Overall, this is a defensible, relatively recurring niche that Optex controls that will likely sustain for years to come. Recent high double-digits growth and margins seem set to continue well into the future. 20% organic growth and profitable margins are nothing to scoff at.
Commercial (24% FY17 sales)
A key avenue for growth right now for the company is its commercial sales. The majority of commercial sales come from Optex’s exclusive supply agreement with Nightforce Optics, which manufacturers “made-in-USA” rifles that utilize Optex’s periscope technology. Optex is valuable to Nightforce as a partner because it is 100% US-based and therefore supports Nightforce’s “made-in-USA” marketing point. It also controls the US market leaving very few options for Nightforce. Nightforce has been growing rapidly over the last few years (Optex CEO estimates 20-30%/year), and Optex has been riding on the coattails of that growth. The initial supply contract was signed in 2015 for $6 million over a “multi-year period”, but by my calculations they’ve already sold ~$10 million in product to Nightforce in just three years. Nightforce continues to buy product, indicating that a) it continues to value Optex’s products despite fulfilling its exclusive supply contract, and b) it has had more demand for its products than initially anticipated.
Because of all this, Optex’s commercial segment has grown at ~50%/year since the acquisition of Applied Optics in late 2014. Also, Optex plans on rolling out on Amazon soon, where GM is expected to be double current margins (it’s unclear though how much revenue potential there is here).
Foreign (8% FY17 sales)
2017 revenue growth was obfuscated by a large (50% ) decline in foreign revenue. This appears simply due to order timing and not any significant real macro changes. After the first half of 2018, foreign sales are back to their historic ~$2.5 million/year run-rate. Foreign sales are mainly to US-allied nations with US funding, because when the US gives military funding to other nations, they often stipulate that the majority percentage of the money be spent on US goods. So, if these funded allies need to buy periscopes, there’s only one US supplier available.
Reason for Mispricing
Optex originally went public through a forced reverse merger. A large private company, Irvine Sensors, defaulted on a tranche of debt owed to two funds, Longview and Alpha Capital. As collateral, Irvine essentially gave Longview and Alpha the Optex business, with an initial ownership split of 90%-Longview and 10%-Alpha. Longview and Alpha decided to take Optex public because they could only invest in public companies. So that’s why I called it a “forced” reverse merger.
Longview continued to own a large, 30% stake since that time. However, more recently, Longview has had to liquidate their fund, and has thus began selling their stake. They’ve decreased their stake down to 15% over the last few months, the majority of which was on the open market, which is a huge overhang on the stock. For instance, Longview’s selling has represented ~30% of all volume since December 2017 (when they began reporting selling). Also, two funds (Gate City and Echo Lake) disclosed buying over 10% of the company over the last few months, and yet did not move the share price at all, again showing the downwards pressure that Longview’s selling is taking on the stock.
Longview continues to hold ~15% of the shares outstanding, but appears to be intent on selling on the open market. I think that this will continue to be an overhang on the stock, but eventually the true value of the business will be recognized. For now, I think this is an adequate explanation for why the share price is likely currently undervalued.
Risks
Some caveats to the business are their low margins (20% GM, but this is improving every year) and high customer concentration in both the military and Nightforce. Unfortunately, this creates a potentially large tail-risk in the long-term. If a major customer leaves, there is very little to buffer the financial impact. Because of this, the position is a smaller one for me, although I am still quite bullish on the company’s prospects in the immediate term. As a way to mitigate this risk, I will be paying careful attention to the company’s government contracts and partnership agreements to potentially spot any signs of deterioration.
Valuation
Optex just reached breakeven last year and is currently trading at 8x annualized 1H 2018 EBIT and ~10x TTM EBIT. There is a decent amount of earnings leverage to the business, which makes me think earnings could grow significantly in the future. The stock trades at ~1x TBV (absent a $1.6m warrant liability). With that liability it trades for 1.15x. This is good downside protection in my opinion. The majority of assets are inventory (DIO = ~200), because there is a 6-month lead time for government projects. In the worst case of a liquidation, the government is on the hook to refund the majority of Optex’s in-process inventory purchases.
The company has 15% of their market cap in cash and minimal debt (<3% of market cap), and the CEO has mentioned that they are looking at ways to deploy this. They recently bought back 700k shares in two slightly discounted block sales, representing ~8% of the market cap. They are also looking at acquisitions but have not yet settled on a reasonably-priced target.
The CEO and CFO collectively own 10% of shares and are paid a rather-high but reasonable salaries of $250k and $190k, respectively. The CFO recently purchased $10,000 worth of shares. There are 8.6 million shares out, with 4.1 million warrants at $1.50 and a negligible amount of convertible preferred shares. Otherwise the share structure is very clean.
Overall, it appears there is strong downside protection. The stock is trading at TBV and Optex has a relatively stable recurring military business where it has a monopoly. Longview selling on the open market has likely been a big overhang for the past few months, as financials have obviously improved, yet the share price hasn’t moved. I like that I’m buying a company with consistently improving margins that is growing at 20% and likely has a decent runway for future growth at ~8x EBIT and 1x TBV.
