UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q







x
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE
      ACT OF 1934





For
the quarterly period ended January 2, 2011





 ̈
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE
      ACT OF 1934





For
the transition period from ______to______.




OPTEX SYSTEMS HOLDINGS,
INC.


(Exact
Name of Registrant as Specified in Charter)




Delaware
                    
                    000-54144
                    
                    33-143215(State
      or other jurisdiction of
                      incorporation)
                    
                    (Commission
      File Number)
                    
                    (IRS
      Employer Identification
                      No.)




1420
      Presidential Drive, Richardson, TX
                  
                  75081-2439(Address
      of principal executive offices)
                  
                  (Zip
      Code)





Registrant’s
telephone number, including area code: (972) 644-0722




(Former
Name or Former Address if Changed Since Last Report)




Check
whether the issuer (1) has filed all reports required to be filed by Section 13
or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter
period that the issuer was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes  x  No   ̈




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




Large
Accelerated Filer  ̈   
 Accelerated Filer  ̈   
 Non-Accelerated Filer  ̈   
 Smaller Reporting Company x




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such files). Yes   ̈   No 
 ̈




Indicate
by check mark whether the registrant is a shell company as defined in Rule
12b`-2 of the Exchange Act. Yes  ̈  No x




State the
number of shares outstanding of each of the issuer’s classes of common equity,
as of February 16, 2011: 139,444,940 shares of common stock.









OPTEX
SYSTEMS HOLDINGS, INC.


FORM
10-Q


For
the period Ended January 2, 2011




INDEX




PART
      I— FINANCIAL INFORMATIONItem
      1.
                Financial
      Statements
                
                3Item
      2.
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                
                4Item
      4.
                Control
      and Procedures
                
                12PART
      II— OTHER INFORMATIONItem
      1
                Legal
      Proceedings
                
                12Item
      1A
                Risk
      Factors
                
                12Item
      6.
                Exhibits
                
                14SIGNATURE
                
                14




2




Item
1. Financial Information





OPTEX
SYSTEMS HOLDINGS, INC.




UNAUDITED
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




AS OF
JANUARY 2, 2011





BALANCE
      SHEETS AS OF JANUARY 2, 2011 (UNAUDITED) AND OCTOBER 3,
    2010
                  
                  F-1STATEMENTS
      OF OPERATIONS FOR THE THREE MONTHS ENDED JANUARY 2, 2011 AND
      THE THREE MONTHS ENDED DECEMBER 27, 2009 (UNAUDITED)
                  
                  F-3STATEMENTS
      OF CASH FLOWS FOR THE THREE MONTHS ENDED JANUARY 2, 2011
      AND FOR THE THREE MONTHS ENDED DECEMBER 27, 2009
      (UNAUDITED)
                  
                  F-4FINANCIAL
      STATEMENT FOOTNOTES (UNAUDITED)
                  
                  F-6




3




Optex Systems Holdings, Inc.


Condensed
Consolidated Balance Sheets




(Thousands)(Unaudited)January 2, 2011
                                  
                                  
                                  October 3, 2010ASSETSCurrent
      AssetsCash
                                  
                                  $
                                  1,103
                                  
                                  
                                  $
                                  1,030Accounts
      Receivable
                                  
                                  
                                  2,038
                                  
                                  
                                  
                                  2,375Net
      Inventory
                                  
                                  
                                  5,665
                                  
                                  
                                  
                                  5,890Prepaid
      Expenses
                                  
                                  
                                  270
                                  
                                  
                                  
                                  245Total
      Current Assets
                                  
                                  $
                                  9,076
                                  
                                  
                                  $
                                  9,540Property
      and EquipmentProperty
      Plant and Equipment
                                  
                                  $
                                  1,487
                                  
                                  
                                  $
                                  1,457Accumulated
      Depreciation
                                  
                                  
                                  (1,179
                                  )
                                  
                                  
                                  (1,161
                                  )Total
      Property and Equipment
                                  
                                  $
                                  308
                                  
                                  
                                  $
                                  296Other
      AssetsDeferred
      Tax Asset - Long Term
                                  
                                  $
                                  964
                                  
                                  
                                  $
                                  993Security
      Deposits
                                  
                                  
                                  21
                                  
                                  
                                  
                                  21Total
      Other Assets
                                  
                                  $
                                  985
                                  
                                  
                                  $
                                  1,014Total
      Assets
                                  
                                  $
                                  10,369
                                  
                                  
                                  $
                                  10,850





The
accompanying notes are an integral part of these financial
statements




F-1




Optex
Systems Holdings, Inc.


Condensed
Consolidated Balance Sheets – Continued





(Thousands)(Unaudited)January 2, 2011
                                              
                                              
                                              October 3, 2010LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      LiabilitiesAccounts
      Payable
                                              
                                              $
                                              605
                                              
                                              
                                              $
                                              763Accrued
      Expenses
                                              
                                              
                                              820
                                              
                                              
                                              
                                              574Accrued
      Warranties
                                              
                                              
                                              25
                                              
                                              
                                              
                                              25Accrued
      Contract Losses
                                              
                                              
                                              1,102
                                              
                                              
                                              
                                              1,357Credit
      Facility
                                              
                                              $
                                              717
                                              
                                              
                                              $
                                              1,107Total
      Current Liabilities
                                              
                                              $
                                              3,269
                                              
                                              
                                              $
                                              3,826Total
      Liabilities
                                              
                                              $
                                              3,269
                                              
                                              
                                              $
                                              3,826Stockholders'
      EquityOptex
      Systems Holdings, Inc. – (par $0.001, 200,000,000 authorized, 139,444,940
      shares issued and outstanding)
                                              
                                              $
                                              139
                                              
                                              
                                              $
                                              139Optex
      Systems Holdings, Inc.  Preferred Stock (.001 par 5,000
      authorized,  1027 series A preferred issued and
      outstanding)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Additional
      Paid-in-capital
                                              
                                              $
                                              17,289
                                              
                                              
                                              $
                                              17,162Retained
      Earnings (Deficit)
                                              
                                              $
                                              (10,328
                                              )
                                              
                                              $
                                              (10,277
                                              )Total
      Stockholders' Equity
                                              
                                              $
                                              7,100
                                              
                                              
                                              $
                                              7,024Total
      Liabilities and Stockholders' Equity
                                              
                                              $
                                              10,369
                                              
                                              
                                              $
                                              10,850




The
accompanying notes are an integral part of these financial
statements




F-2




Optex
Systems Holdings, Inc.


Condensed
Consolidated Statements of Operations (Unaudited)




(Thousands)Three months endedJanuary 2, 2011
                                              
                                              
                                              Three months endedDecember 27, 2009Revenues
                                              
                                              $
                                              4,984
                                              
                                              
                                              $
                                              5,915Total
      Cost of Sales
                                              
                                              
                                              4,321
                                              
                                              
                                              
                                              5,160Gross
      Margin
                                              
                                              $
                                              663
                                              
                                              
                                              $
                                              755General
      and AdministrativeGeneral
      Expenses
                                              
                                              
                                              560
                                              
                                              
                                              
                                              609Amortization
      of Intangible Assets
                                              
                                              
                                              -
                                              
                                              
                                              
                                              80Total
      General and Administrative
                                              
                                              $
                                              560
                                              
                                              
                                              $
                                              689Operating
      Income (Loss)
                                              
                                              $
                                              103
                                              
                                              
                                              $
                                              66Other
      ExpensesInterest
      (Income) Expense - Net
                                              
                                              
                                              23
                                              
                                              
                                              
                                              3Total
      Other
                                              
                                              $
                                              23
                                              
                                              
                                              $
                                              3Income
      (Loss) Before Taxes
                                              
                                              $
                                              80
                                              
                                              
                                              $
                                              63Deferred
      Income Taxes (Benefit)
                                              
                                              
                                              29
                                              
                                              
                                              
                                              (18
                                              )Net
      Income (Loss) After Taxes
                                              
                                              $
                                              51
                                              
                                              
                                              $
                                              81Less
      preferred stock dividend
                                              
                                              $
                                              (101
                                              )
                                              
                                              $
                                              (95
                                              )Net
      loss applicable to common shareholders
                                              
                                              $
                                              (50
                                              )
                                              
                                              $
                                              (14
                                              )Basic
      and diluted loss per share
                                              
                                              $
                                              (0.00
                                              )
                                              
                                              $
                                              (0.00
                                              )Weighted
      Average Common Shares Outstanding
                                              
                                              
                                              139,444,940
                                              
                                              
                                              
                                              139,444,940




The
accompanying notes are an integral part of these financial
statements




F-3




Optex
Systems Holdings, Inc.


Condensed
Consolidated Statements of Cash Flows (Unaudited)





(Thousands)Three months endedJanuary 2, 2011
                                              
                                              
                                              Three months endedDecember 27, 2009Cash
      flows from operating activities:Net
      income (loss)
                                              
                                              $
                                              51
                                              
                                              
                                              $
                                              81Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
                                              
                                              
                                              18
                                              
                                              
                                              
                                              281Provision
      for allowance for inventory valuation
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (44
                                              )Noncash
      interest expense
                                              
                                              
                                              8
                                              
                                              
                                              
                                              3Stock
      option compensation expense
                                              
                                              
                                              25
                                              
                                              
                                              
                                              23(Increase)
      decrease  in accounts receivable
                                              
                                              
                                              338
                                              
                                              
                                              
                                              (312
                                              )(Increase)
      decrease in inventory (net of progress billed)
                                              
                                              
                                              224
                                              
                                              
                                              
                                              (625
                                              )(Increase)
      decrease in other current assets
                                              
                                              
                                              (33
                                              )
                                              
                                              
                                              39(Increase)
      decrease in deferred tax asset (net of valuation
allowance)
                                              
                                              
                                              29
                                              
                                              
                                              
                                              (18
                                              )Increase
      (decrease) in accounts payable and accrued expenses
                                              
                                              
                                              88
                                              
                                              
                                              
                                              (19
                                              )Increase
      (decrease) in accrued estimated loss on contracts
                                              
                                              
                                              (255
                                              )
                                              
                                              
                                              (120
                                              )Total
      adjustments
                                              
                                              $
                                              442
                                              
                                              
                                              $
                                              (792
                                              )Net
      cash (used)/provided by operating activities
                                              
                                              $
                                              493
                                              
                                              
                                              $
                                              (711
                                              )Cash
      flows from investing activities:Purchased
      of property and equipment
                                              
                                              
                                              (30
                                              )
                                              
                                              
                                              (3
                                              )Net
      cash (used in) provided by investing activities
                                              
                                              $
                                              (30
                                              )
                                              
                                              $
                                              (3
                                              )Cash
      flows from financing activities:Proceeds
      (to) from credit facility (net)
                                              
                                              
                                              (390
                                              )
                                              
                                              
                                              -Proceeds
      from loans payable
                                              
                                              
                                              -
                                              
                                              
                                              
                                              250Net
      cash (used In) provided by financing activities
                                              
                                              $
                                              (390
                                              )
                                              
                                              $
                                              250Net
      increase (decrease) in cash and cash equivalents
                                              
                                              $
                                              73
                                              
                                              
                                              $
                                              (464
                                              )Cash
      and cash equivalents at beginning of period
                                              
                                              
                                              1,030
                                              
                                              
                                              
                                              915Cash
      and cash equivalents at end of period
                                              
                                              $
                                              1,103
                                              
                                              
                                              $
                                              451Supplemental
      cash flow information:Cash
      Paid for Interest
                                              
                                              $
                                              16
                                              
                                              
                                              
                                              -Cash
      Paid for Taxes
                                              
                                              $
                                              -
                                              
                                              
                                              
                                              -




The
accompanying notes are an integral part of these financial
statements




F-4




Note 1 - Organization and
Operations





On March
30, 2009, Optex Systems Holdings, Inc. (formerly known as Sustut Exploration,
Inc.), a Delaware corporation (“Optex Systems Holdings”), along with Optex
Systems, Inc., a privately held Delaware corporation (“Optex Systems, Inc. ”),
which is a wholly-owned subsidiary of Optex Systems Holdings, entered into
a reorganization agreement, pursuant to which Optex Systems, Inc.  was
acquired by Optex Systems Holdings in a share exchange transaction.  Optex
Systems Holdings became the surviving corporation. At the closing, there was a
name change from Sustut Exploration Inc. to Optex Systems Holdings, Inc., and
its year end changed from December 31 to a fiscal year ending on the Sunday
nearest September 30.





On
October 14, 2008, certain senior secured creditors of Irvine Sensors
Corporation, Longview Fund, L.P. and Alpha Capital Anstalt formed Optex Systems,
Inc.  , which acquired all of the assets and assumed certain
liabilities of Optex Systems, Inc., a Texas corporation (“Optex Systems, Inc.
(Texas)”), and a wholly-owned subsidiary of Irvine Sensors Corporation, in a
transaction that was consummated via purchase at a public auction. 
Following this asset purchase, Optex Systems, Inc. (Texas) remained a
wholly-owned subsidiary of Irvine Sensors Corporation.





In
accordance with FASB ASC 805 Optex Systems, Inc.’s purchase of substantially all
of the assets and assumption of certain liabilities represented the acquisition
of a business.  FASB ASC 805 outlines the guidance in determining whether a
“business” has been acquired in a transaction. For a transferred set of
activities and assets to be a business, it must contain all of the inputs and
processes necessary for it to continue to conduct normal operations after the
transferred set of assets is separated from the transferor, which include the
ability to sustain a revenue stream by providing its outputs to customers. Optex
Systems, Inc. obtained the inputs and processes necessary for normal
operations.





On
February 20, 2009, Sileas Corporation, a newly-formed Delaware corporation,
owned by present members of Optex Systems Holdings’ management, purchased 100%
of Longview's equity and debt interest in Optex Systems, Inc. (Longview’s
interest in Optex Systems, Inc. then representing 90% of the issued and
outstanding common equity interests in Optex Systems, Inc.), in a private
transaction .





Optex
Systems, Inc. operated as a privately-held Delaware corporation until March 30,
2009, when, as a result of a reverse merger transaction consummated pursuant to
a reorganization agreement dated March 30, 2009, it became a wholly-owned
subsidiary of Optex Systems Holdings.  Sileas is the majority owner
(parent) of Optex Systems Holdings, owning approximately 73.5% of the issued and
outstanding equity interests in Optex Systems
Holdings.       The financial statements of Optex
Systems Holdings represent subsidiary statements and do not include the accounts
of its majority owner.





Optex
Systems Holdings’ operations are based in Richardson, Texas in a leased facility
comprising 49,100 square feet.  As of January 2, 2011, Optex Systems
Holdings operated with 89 full-time equivalent employees.





Optex
Systems Holdings manufactures optical sighting systems and assemblies, primarily
for Department of Defense applications.  Its products are installed on a
variety of U.S. military land vehicles, such as the Abrams and Bradley fighting
vehicles, light armored and advanced security vehicles, and have been selected
for installation on the Stryker family of vehicles. Optex Systems Holdings also
manufactures and delivers numerous periscope configurations, rifle and
surveillance sights and night vision optical assemblies. Optex Systems Holdings’
products consist primarily of build to customer print products that are
delivered both directly to the military and to other defense prime
contractors.





In
February 2009, Optex Systems Holdings’ ISO certification status was
upgraded from 9001:2000 to 9001:2008, bringing Optex Systems Holdings into
compliance with the new ISO standards rewritten to align with ISO
14001.




F-5




Note
2 - Accounting Policies





Basis
of Presentation





Principles of
Consolidation:The consolidated financial statements include the
accounts of Optex Systems Holdings and its wholly-owned subsidiary, Optex
Systems, Inc.  All significant inter-company balances and transactions
have been eliminated in consolidation.





These
financial statements have been presented as subsidiary-only financial
statements, reflecting the statements of operations and cash flows of the
subsidiary as a stand-alone entity.





The
condensed consolidated financial statements of Optex Systems Holdings included
herein have been prepared by Optex Systems Holdings, without audit, pursuant to
the rules and regulations of the SEC. Certain information and footnote
disclosures normally included in financial statements prepared in conjunction
with generally accepted accounting principles have been condensed or omitted
pursuant to such rules and regulations, although Optex Systems Holdings believes
that the disclosures are adequate to make the information presented not
misleading. These condensed consolidated financial statements should be read in
conjunction with the annual audited financial statements and the notes thereto
included in the Optex Systems Holdings’ Form 10-K and other reports filed
with the SEC.





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





Use
of Estimates:  The preparation of financial statements in
conformity with accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions that affect
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statement and the reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from the estimates.





Inventory:
Inventory is recorded at the lower of cost or market value, and adjusted, as
necessary, for decreases in valuation and obsolescence. Adjustments to the
valuation and obsolescence reserves are made after analyzing market conditions,
current and projected sales activity, inventory costs and inventory balances to
determine appropriate reserve levels. Cost is determined using the first-in
first-out method. Under arrangements by which progress payments are received
against certain contracts, the customer retains a security interest in the
undelivered inventory identified with these contracts.  Payments received
for such undelivered inventory are classified as unliquidated progress payments
and deducted from the gross inventory balance. As of January 2, 2011 and October
3, 2010, inventory included:





F-6




(Thousands)As of
                                    January 2, 2011
                                  
                                  
                                  As of
                                    October 3, 2010(unaudited)Raw
      Materials
                                  
                                  $
                                  3,984
                                  
                                  
                                  $
                                  4,343Work
      in Process
                                  
                                  
                                  2,293
                                  
                                  
                                  
                                  2,824Finished
      Goods
                                  
                                  
                                  138
                                  
                                  
                                  
                                  366Gross
      Inventory
                                  
                                  $
                                  6,415
                                  
                                  
                                  $
                                  7,533Less:Unliquidated
      Progress Payments
                                  
                                  
                                  (324
                                  )
                                  
                                  
                                  (1,217
                                  )Inventory
      Reserves
                                  
                                  
                                  (426
                                  )
                                  
                                  
                                  (426
                                  )Net
      Inventory
                                  
                                  $
                                  5,665
                                  
                                  
                                  $
                                  5,890





Stock-Based
Compensation:In December 2004, FASB issued FASB ASC 718. 
FASB ASC 718 establishes standards for the accounting for transactions in which
an entity exchanges its equity instruments for goods or services, but primarily
focuses on transactions whereby an entity obtains employee services for
share-based payments. FASB ASC 718 requires that the compensation cost
relating to share-based payment transactions be recognized in the financial
statements.  That cost will be measured based on the fair value of the
equity or liability instruments issued. It also addresses transactions in
which an entity incurs liabilities in exchange for goods or services that are
based on the fair value of the entity’s equity instruments or that may be
settled by the issuance of those equity instruments.





The
Company’s accounting policy for equity instruments issued to consultants and
vendors in exchange for goods and services follows the provisions of FASB ASC
505-50.The
measurement date for the fair value of the equity instruments issued is
determined at the earlier of (i) the date at which a commitment for
performance by the consultant or vendor is reached or (ii) the date at
which the consultant or vendor’s performance is complete. In the case of equity
instruments issued to consultants, the fair value of the equity instrument is
recognized over the term of the consulting agreement.  Stock-based
compensation related to non-employees is accounted for based on the fair value
of the related stock or options or the fair value of the services, whichever is
more readily determinable in accordance with FASB ASC 718.





Income
Tax/Deferred Tax:FASB ASC 740 requires recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in the financial statements or tax returns. Under this
method, deferred tax assets and liabilities are determined based on differing
treatment of items for financial reporting and income tax reporting
purposes.  The deferred tax balances are adjusted to reflect tax rates by
tax jurisdiction, based on currently enacted tax laws, which will be in effect
in the years in which the temporary differences are expected to reverse. 
Under FASB ASC 740, the effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date. A valuation allowance is provided for certain deferred tax
assets if it is more likely than not that the Company will not realize tax
assets through future operations.  Optex Systems Holdings has recognized
deferred income tax benefits on net operating loss carry-forwards to the extent
Optex Systems Holdings believes it will be able to utilize them in future tax
filings.  The difference between the income tax expense and pretax
accounting income is primarily attributable to $4 thousand of non deductible
expenses representing permanent timing differences between book income and
taxable income during the three months ending January 2,
2011.   The tax effect of this permanent timing difference is an
increase in income tax expense of $1 thousand for the three months ended January
2, 2011.  There are no permanent timing differences resulting from
goodwill amortization due to the full impairment of goodwill as of the fiscal
year ending October 3, 2010.




Earnings per
Share: Basic earnings per share is computed by dividing income
available for common shareholders (the numerator) by the weighted average number
of common shares outstanding (the denominator) for the period.  Diluted
earnings per share reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock.




The
potentially dilutive securities that Optex Systems Holdings has outstanding are
convertible preferred stock, stock options and warrants. In computing the
dilutive effect of convertible preferred stock, the numerator is adjusted to add
back any convertible preferred dividends, and the denominator is increased to
assume the conversion of the number of additional common shares. Optex Systems
Holdings uses the Treasury Stock Method to compute the dilutive effect of stock
options and warrants. Convertible preferred stocks, stock options and warrants
that are antidilutive are excluded from the calculation of diluted earnings per
common share.




F-7




For the
three months ended January 2, 2011, 1,027 shares of Series A preferred stock,
2,597,649 stock options and 9,948,667 warrants were excluded as antidilutive.
For the three months ended December 27, 2009, there were 2,665,649 stock options
issued and outstanding that were included in the calculation as they were
dilutive.





Reclassification: 
Certain expenses reflected in the financial statements for the three months
ended January 2, 2011 have been reclassified to conform with the current year
presentation.  Prior to the three months ending January 2, 2011,
financial statements had been presented in whole dollars.  Effective
October 4, 2011 as of the beginning of the current fiscal year, all financials
have been converted and presented to the nearest thousand.





Note
4 - Commitments and Contingencies




Leases




Pursuant
to a lease amendment effective January 4, 2010, Optex Systems Holdings leases
its office and manufacturing facilities under a non-cancellable operating lease
expiring July 31, 2015, in addition to maintaining several non-cancellable
operating leases for office and manufacturing equipment.    Total
expense under facility lease agreements as of the three months ended January 2,
2011 was $71 thousand, and total expense for manufacturing and office equipment
was $9 thousand. Total expense under facility lease agreements for the
three months ended December 27, 2009 was $77 thousand.  Total expense for
manufacturing and office equipment for the three months ended December 27, 2009
was $8 thousand.





As of
January 2, 2011, the remaining minimum lease payments under the non-cancelable
operating leases for equipment, office and facility space are as
follows:





OperatingLeases
                            (Thousands)Fiscal
      Year2011
                          
                          $
                          1882012
                          
                          
                          2362013
                          
                          
                          2322014
                          
                          
                          2422015
                          
                          
                          201Total
      minimum lease payments
                          
                          $
                          1,099




Pursuant
to the terms of the amendment to the facilities lease, there was no base rent
payment due from January 1, 2010 through July 31, 2010, and the total value of
this rent abatement wais $134 thousand.  The value of the deferred rent
expense will be amortized monthly at a rate of $2 thousand per month over the
life of the lease.  The total unamortized deferred rent as of January 2,
2011 was $110 thousand.  Commencing on August 1, 2010, the base rent
payment was $19 thousand per month.




F-8




Note
5 - Debt Financing





Short Term Note Payable/Longview
Fund(Related Party)- 
  On October 27, 2009, Optex Systems Holdings borrowed $250 thousand from
the Longview Fund, a related party, pursuant to a promissory note, with an
original maturity date of December 1, 2009, which was extended to July 15, 2010
pursuant to an allonge dated January 5, 2010.  The note carried an interest
rate of 10% per annum, and all accrued and unpaid interest thereon was due upon
maturity.  The note required Optex Systems Holdings to make a prepayment
equal to 50% of the then outstanding principal amount plus accrued and unpaid
interest thereon upon the closing of a credit facility or other equity or debt
financing from which the net proceeds to Optex Systems Holdings were at least
$900 thousand, with any remaining unpaid balance due on July 15, 2010.  In
exchange for the allonge, Optex Systems Holdings granted Longview a warrant to
purchase 100,000 shares of its restricted common stock with an exercise price of
$0.15 per share and with a term of three years.  In conjunction with the
Peninsula Bank financing (below) on March 22, 2010, Optex Systems Holdings paid
to Longview a principal prepayment of $125 thousand and $10 thousand in accrued
interest.  The remaining principal amount of the note of $125 thousand plus
all accrued and unpaid interest thereon was paid in full on June 4,
2010.





Credit
Facility - Peninsula Bank Business Funding





Effective
March 4, 2010, Optex Systems, Inc. entered into a Loan and Security Agreement
(“Agreement”) with Peninsula Bank Business Funding, a division of the Private
Bank of the Peninsula (“Lender”).





The
Agreement provides for a revolving line of credit of up to $2 million, based
upon advances to be made against percentages of eligible receivables as set
forth in the Agreement.  The material terms of the Agreement are as
follows:





·
              The
      interest rate for all advances shall be the greater of 8.5% and the then
      in effect prime rate plus 3.5% and subject to a minimum quarterly interest
      payment of $16 thousand.


·
            Interest shall be paid monthly in
      arrears.


·
            The expiration date of the
      Agreement is March 4, 2011, at which time any outstanding advances, and
      accrued and unpaid interest thereon, will be due and
      payable.


·
            In connection with the entry into
      the Agreement by the Lender, Optex Systems, Inc.   paid the
      Lender a facility fee of $20 thousand and issued a warrant to Lender to
      purchase 1,000,000 shares of its common stock. The warrant bears an
      exercise price of $0.10 per share and expires on March 3,
      2016.


·
            The obligations of Optex Systems,
      Inc.   to the Lender are secured by a first lien on all of
      its assets (including intellectual property assets should it have any in
      the future) in favor of the
Lender.


·
            The Agreement contains
      affirmative and negative covenants that require Optex Systems,
      Inc.   to maintain certain minimum cash and EBITDA levels
      on a quarterly basis and contains other customary covenants.  The
      Agreement also contains customary events of default.  Upon the
      occurrence of an event of default that remains uncured after any
      applicable cure period, the Lender’s commitment to make further advances
      may terminate, and the Lender would also be entitled to pursue other
      remedies against Optex Systems, Inc.   and the pledged
      collateral.


·
            Pursuant to a guaranty executed
      by Optex Systems Holdings in favor of Lender, Optex Systems Holdings has
      guaranteed all obligations of Optex Systems, Inc. to
      Lender.





During
the three months ending January 2, 2011, Optex Systems, Inc. realized EBITDA of
$121 thousand as compared to a loan covenant requirement of $95 thousand,
(pursuant to the revised requirement as set forth in the November 29, 2010
amendment to the applicable loan agreement), and as such did meet the
EBITDA covenant of the Loan and Security Agreement for the first fiscal quarter
of 2011.  As of January 2, 2011, the outstanding balance on the line of
credit is $717 thousand.





Note
6-Stock Based Compensation





Option
Agreements:





On March
26, 2009, the Board of Directors of Optex Systems Holdings adopted the 2009
Stock Option Plan providing for the issuance of up to 6,000,000 shares to Optex
Systems Holdings’ officers, directors, employees and independent contractors who
provide services to Optex Systems Holdings.




F-9





Options
granted under the 2009 Stock Option Plan vest as determined by the Board of
Directors of Optex Systems Holdings or any committee set up to act as a
compensation committee of the Board of Directors and terminate after the
earliest of the following events: (i) expiration of the option as provided in
the option agreement, (ii) 90 days following the date of termination of the
employee, or (iii) ten years from the date of grant (five years from the date of
grant for incentive options granted to an employee who owns more than 10% of the
total combined voting power of all classes of Optex Systems Holdings stock at
the date of grant). In some instances, granted stock options are
immediately exercisable into restricted shares of common stock, which vest in
accordance with the original terms of the related options. Optex Systems
Holdings recognizes compensation expense ratably over the requisite service
period.





The
option price of each share of common stock is determined by the Board of
Directors or compensation committee (when one is established), provided that
with respect to incentive stock options, the option price per share will in all
cases be equal to or greater than 100% of the fair value of a share of common
stock on the date of the grant, except an incentive stock option granted under
the 2009 Stock Option Plan to a shareholder that owns more than 10% of the total
combined voting power of all classes of Optex Systems Holdings’ stock, will have
an exercise price of not less than 110% of the fair value of a share of common
stock on the date of grant. No participant may be granted incentive stock
options, which would result in shares with an aggregate fair value of more than
$100.0 thousand first becoming exercisable in one calendar year.





On March
30, 2009, 1,414,649 stock options with an exercise price of $0.15 per share were
granted to an officer of Optex Systems Holdings.  These options vest as
follows: 34% after the first year, and 33% each after the second and third
years.  These options have a seven year term from the date of
issuance.  On May 14, 2009, 1,267,000 stock options were issued to other
Optex Systems Holdings employees, including options to purchase 250,000 shares
to one executive officer.  These stock options vest 25% per year after
each year of employment and have a seven year term from the date of
issuance.  For shares granted as of May 14, 2009, Optex Systems Holdings
anticipates an annualized employee turnover rate of 3% per year, and as such
anticipates that only 1,174,786 of the 1,267,000 shares will vest by the end of
the end of the contract term.  As of January 2, 2011, 776,731 of the
awarded stock options had vested and 84,000 shares had been forfeited due to
employee turnover.





Optex
Systems Holdings recorded compensation costs for options and shares granted
under the plan amounting to $25 thousand for the three months ended January 2,
2011, as compared to $23 thousand for the three months ended December 27,
2009.  The impact of these expenses is immaterial to the basic and diluted
net loss per share for the three months ended January 2, 2011 and December 27,
2009.  A deduction is not allowed for income tax purposes until
nonqualified options are exercised. The amount of this deduction will be the
difference between the fair value of Optex Systems Holdings’ common stock
and the exercise price at the date of option exercise..  No tax deduction
is allowed for incentive stock options. Accordingly, no deferred tax asset is
recorded for GAAP expense related to these options.





Management
has valued the options at their date of grant utilizing the Black-Scholes-Merton
option pricing model.  The fair value of the underlying shares was
determined based on the closing price of Optex Systems Holdings’
publicly-traded shares on the grant date.  Further, the expected volatility
was calculated using the historical volatility of a diversified index of
companies in the defense, homeland security, and space industry in
accordance with FASB ASC 718-10-S99-1 (Prior authoritative literature: 
Question 6 of SAB Topic 14.D.1).  In making this determination and trying
to find another comparable company, Optex Systems Holdings considered the
industry, stage of life cycle, size and financial leverage of such other
entities.  Based on the development stage of Optex Systems Holdings,
similar companies with sufficient historical data were not available. 
 Optex Systems Holdings utilized the three year volatility of the SPADE
Defense Index, which is a diversified index of 58 companies in the same industry
as Optex Systems Holdings.  The risk-free interest rate is based on the
implied yield available on U.S. Treasury issues with an equivalent term
approximating the expected life of the options depending on the date of the
grant and expected life of the options.  The expected life of options used
was based on the contractual life of the option grant. Optex Systems
Holdings determined the expected dividend rate based on the assumption and
expectation that earnings generated from operations are not expected to be
adequate to allow for the payment of dividends in the near future and the
assumption that the company does not presently have any intention of paying cash
dividends on its common stock





Optex
Systems Holdings has granted stock options to officers and employees as
follows:





Date of
                                        
                                        Shares
                                        
                                        
                                        Exercise
                                        
                                        
                                        Shares Outstanding
                                        
                                        Expiration
                                        
                                        VestingGrant
                                        
                                        Granted
                                        
                                        
                                        Price
                                        
                                        
                                        As of 1/02/11
                                        
                                        Date
                                        
                                        Date03/30/09
                                        
                                        
                                        480,981
                                        
                                        
                                        $
                                        0.15
                                        
                                        
                                        
                                        480,981
                                        
                                        03/29/2016
                                        
                                        03/30/201003/30/09
                                        
                                        
                                        466,834
                                        
                                        
                                        $
                                        0.15
                                        
                                        
                                        
                                        466,834
                                        
                                        03/29/2016
                                        
                                        03/30/201103/30/09
                                        
                                        
                                        466,834
                                        
                                        
                                        $
                                        0.15
                                        
                                        
                                        
                                        466,834
                                        
                                        03/29/2016
                                        
                                        03/30/201205/14/09
                                        
                                        
                                        316,750
                                        
                                        
                                        $
                                        0.15
                                        
                                        
                                        
                                        295,750
                                        
                                        05/13/2016
                                        
                                        05/14/201005/14/09
                                        
                                        
                                        316,750
                                        
                                        
                                        $
                                        0.15
                                        
                                        
                                        
                                        295,750
                                        
                                        05/13/2016
                                        
                                        05/14/201105/14/09
                                        
                                        
                                        316,750
                                        
                                        
                                        $
                                        0.15
                                        
                                        
                                        
                                        295,750
                                        
                                        05/13/2016
                                        
                                        05/14/201205/14/09
                                        
                                        
                                        316,750
                                        
                                        
                                        $
                                        0.15
                                        
                                        
                                        
                                        295,750
                                        
                                        05/13/2016
                                        
                                        05/14/2013Total
                                        
                                        
                                        2,681,649
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        2,597,649





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




Number
                        
                        
                        Weightedof Shares
                        
                        
                        Average
                        
                        
                        WeightedRemaining
                        
                        
                        Intrinsic
                        
                        
                        Average
                        
                        
                        AggregateSubject to Exercise
                        
                        Options
                        
                        
                        Price
                        
                        
                        Life (Years)
                        
                        
                        ValueOutstanding
      as of October 3, 2010
                        
                        
                        2,598,649
                        
                        
                        $
                        -
                        
                        
                        
                        4.13
                        
                        
                        $
                        -Granted
      – 2011
                        
                        
                        -
                        
                        
                        $
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Forfeited
      – 2011
                        
                        
                        (1,000
                        )
                        
                        $
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Exercised
      – 2011
                        
                        
                        -
                        
                        
                        $
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Outstanding
      as of January 2, 2011
                        
                        
                        2,597,649
                        
                        
                        $
                        -
                        
                        
                        
                        3.88
                        
                        
                        $
                        -Exercisable
      as of January 2, 2011
                        
                        
                        776,731
                        
                        
                        $
                        -
                        
                        
                        
                        2.78
                        
                        
                        $
                        -





There
were no new options granted or exercised during the three months ended January
2, 2011.  The total intrinsic value of options forfeited during the
three months ended January 2, 2011 was $0.





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




F-10




Number of
                                              Non-
                                              vested
                                              Shares
                                              Subject to
                                              Options
                                            
                                            
                                            Weighted-
                                              Average
                                              Grant-
                                              Date
                                              Fair ValueNon-vested
      as of October 3, 2010
                                            
                                            
                                            1,821,668
                                            
                                            
                                            $
                                            0.14Non-vested
      granted — three months ended January 2, 2011
                                            
                                            
                                            -
                                            
                                            
                                            $
                                            0.00Vested — 
      three months ended January 2, 2011
                                            
                                            
                                            -
                                            
                                            
                                            $
                                            0.14Forfeited — three
      months ended January 2, 2011
                                            
                                            
                                            (750
                                            )
                                            
                                            $
                                            0.14Non-vested
      as of January 2, 2011
                                            
                                            
                                            1,820,918
                                            
                                            
                                            $
                                            0.14





As of
January 2, 2011, the unrecognized compensation cost related to non-vested share
based compensation arrangements granted under the plan was approximately $202
thousand.  These costs are expected to be recognized on a straight line
basis from March 30, 2009 through May 13, 2013. The total fair value of
options and shares vested during the three months ended January 2, 2011 was
$0.





Warrant
Agreements:





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





As of
January 2, 2011, Optex Systems Holdings had the following warrants
outstanding:





Grant Date
                                  
                                  Warrants
                                    Granted
                                  
                                  
                                  Exercise
                                    Price
                                  
                                  
                                  Outstanding as of
                                    01/02/11
                                  
                                  Expiration
                                    Date
                                  
                                  TermPrivate
      Placement  Stock Holders
                                  
                                  3/30/2009
                                  
                                  
                                  8,131,667
                                  
                                  
                                  $
                                  0.450
                                  
                                  
                                  
                                  8,131,667
                                  
                                  3/29/2014
                                  
                                  5 yearsFinder
      Fee on Private Placement
                                  
                                  3/30/2009
                                  
                                  
                                  717,000
                                  
                                  
                                  $
                                  0.165
                                  
                                  
                                  
                                  717,000
                                  
                                  3/29/2014
                                  
                                  5
      yearsLongview
      Fund Allonge Agreement
                                  
                                  1/5/2010
                                  
                                  
                                  100,000
                                  
                                  
                                  $
                                  0.150
                                  
                                  
                                  
                                  100,000
                                  
                                  1/4/2013
                                  
                                  3
      yearsPeninsula
      Bank Business Funding - Line of Credit
                                  
                                  3/4/2010
                                  
                                  
                                  1,000,000
                                  
                                  
                                  $
                                  0.100
                                  
                                  
                                  
                                  1,000,000
                                  
                                  3/3/2016
                                  
                                  6
      yearsTotal
      Warrants
                                  
                                  
                                  
                                  
                                  9,948,667
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  9,948,667





During
the three months ended January 2, 2011 Optex Systems Holdings recorded a total
of $8 thousand in interest expense related to the outstanding warrants and has
an unamortized interest balance of $5 thousand.  These warrants are not
included in the computation of weighted average of shares as it would be
anti-dilutive.





Note
7–Stockholders Equity




Series
A preferred stock





On March
24, 2009, Optex Systems Holdings filed a Certificate of Designation with the
Secretary of State of the State of Delaware authorizing a series of preferred
stock, under its articles of incorporation, known as “Series A preferred stock”.
This Certificate of Designation was approved by Optex Systems Holdings’ Board of
Directors and Shareholders at a Board Meeting and Shareholders Meeting held on
February 25, 2009. The Certificate of Designation sets forth the following terms
for the Series A preferred stock: (i) number of authorized shares: 1,027; (ii)
per share stated value: $6,000; (iii) liquidation preference per share: stated
value; (iv) conversion price: $0.15 per share as adjusted from time to time; and
(v) voting rights: votes along with the common stock on an as converted basis
with one vote per share.





The
Series A preferred stock entitles the holders to receive cumulative dividends at
the rate of 6% per annum, payable in cash at the discretion of Board of
Directors. Each share of preferred stock is immediately convertible into common
shares at the option of the holder which entitles the holder to receive the
equivalent number of common shares equal to the stated value of the preferred
shares divided by the conversion price, which was initially set at $0.15 per
share.





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





As
of the three months ended January 2, 2011, Optex Systems Holdings recorded $101
thousand of dividends payable on Series A preferred share.





Note
8– Reduction in Force




On April
1, 2010 and June 24, 2010, the Company reduced its workforce by approximately 9
and 15 full-time regular employees, respectively, who were solely or partially
dedicated to our periscope production line and supporting functions.  The
Company also eliminated 2 full-time contract labor employees during April 2010.
These reductions in force were made in anticipation of decreased production
quantities on our periscope lines in the next fiscal quarter and are intended to
reduce the monthly cash burn while maintaining current profit margins on the
remaining periscope business. No further reductions have been
necessary.




Note
9 – Subsequent Events




On
February 15, 2011, Peninsula Bank Business Funding agreed to a third amendment
to its credit facility agreement with us to extend the maturity date to
April 15, 2011.  The maximum amount of the revolving credit line was
reduced to $1 million, section 2.3(a)(ii) was amended so that
the minimum quarterly interest payment is $8.5 thousand, and the minimum
EBITDA requirement was deleted in its entirety.  We are currently
negotiating a full year agreement with Peninsula Bank Business Funding to take
effect at the expiration of the current amendment.




F-11




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





Management’s
Discussion and Analysis or Plan of Operations





This
management's discussion and analysis reflects information known to management as
at January 2, 2011 and through the date of this filing. This MD&A is
intended to supplement and complement our audited financial statements and notes
thereto for the fiscal year ended October 3, 2010 and the quarter ended January
2, 2011, prepared in accordance with U.S. generally accepted accounting
principles (GAAP). You are encouraged to review our financial statements in
conjunction with your review of this MD&A. The financial information in this
MD&A has been prepared in accordance with GAAP, unless otherwise indicated.
In addition, we use non-GAAP financial measures as supplemental indicators of
our operating performance and financial position. We use these non-GAAP
financial measures internally for comparing actual results from one period to
another, as well as for planning purposes. We will also report non-GAAP
financial results as supplemental information, as we believe their use provides
more insight into our performance. When non-GAAP measures are used in this
MD&A, they are clearly identified as 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.  This discussion contains
forward-looking statements. Please see “Special cautionary statement concerning
forward-looking statements” and “Risk factors” for a discussion of the
uncertainties, risks and assumptions associated with these forward-looking
statements. The operating results for the periods presented were not
significantly affected by inflation.





Background





On March
30, 2009, Optex Systems Holdings, Inc. (formerly known as Sustut Exploration,
Inc.), a Delaware corporation (“Optex Systems Holdings”), along with Optex
Systems, Inc., a privately held Delaware corporation (“Optex Systems, Inc.”),
which is a wholly-owned subsidiary of Optex Systems Holdings, entered into
a reorganization agreement, pursuant to which Optex Systems, Inc. was acquired
by Optex Systems Holdings in a share exchange transaction.  Optex Systems
Holdings became the surviving corporation. At the closing, there was a name
change from Sustut Exploration Inc. to Optex Systems Holdings, Inc., and its
year end changed from December 31 to a fiscal year ending on the Sunday
nearest September 30.





On
October 14, 2008, certain senior secured creditors of Irvine Sensors
Corporation, Longview Fund, L.P. and Alpha Capital Anstalt formed Optex Systems,
Inc., which acquired all of the assets and assumed certain liabilities of Optex
Systems, Inc., a Texas corporation (“Optex Systems, Inc. (Texas)”), and a
wholly-owned subsidiary of Irvine Sensors Corporation, in a transaction that was
consummated via purchase at a public auction.  Following this asset
purchase, Optex Systems, Inc. (Texas) remained a wholly-owned subsidiary of
Irvine Sensors Corporation.




4




In
accordance with FASB ASC,805 Optex Systems, Inc.’s purchase of substantially all
of the assets and assumption of certain liabilities represented the acquisition
of a business.  FASB ASC 805 outlines the guidance in determining whether a
“business” has been acquired in a transaction. For a transferred set of
activities and assets to be a business, it must contain all of the inputs and
processes necessary for it to continue to conduct normal operations after the
transferred set of assets is separated from the transferor, which include the
ability to sustain a revenue stream by providing its outputs to customers. Optex
Systems, Inc. obtained the inputs and processes necessary for normal
operations.





On
February 20, 2009, Sileas Corporation, a newly-formed Delaware corporation,
owned by present members of Optex Systems Holdings’ management, purchased 100%
of Longview's equity and debt interest in Optex Systems, Inc. (Longview’s
interest in Optex Systems, Inc. then representing 90% of the issued and
outstanding common equity interests in Optex Systems, Inc.), in a private
transaction .





Optex
Systems, Inc. operated as a privately-held Delaware corporation until March 30,
2009, when, as a result of a reverse merger transaction consummated pursuant to
a reorganization agreement dated March 30, 2009, it became a wholly-owned
subsidiary of Optex Systems Holdings.  Sileas is the majority owner
(parent) of Optex Systems Holdings, owning approximately 73.5% of the issued and
outstanding equity interests in Optex Systems Holdings.   The
financial statements of Optex Systems Holdings represent subsidiary statements
and do not include the accounts of its majority owner.





Optex
Systems Holdings’ operations are based in Richardson, Texas in a leased facility
comprising 49,100 square feet.  As of January 2, 2011, Optex Systems
Holdings operated with 89 full-time equivalent employees.





Optex
Systems Holdings manufactures optical sighting systems and assemblies, primarily
for Department of Defense applications.  Its products are installed on a
variety of U.S. military land vehicles, such as the Abrams and Bradley fighting
vehicles, light armored and advanced security vehicles, and have been selected
for installation on the Stryker family of vehicles. Optex Systems Holdings also
manufactures and delivers numerous periscope configurations, rifle and
surveillance sights and night vision optical assemblies. Optex Systems Holdings’
products consist primarily of build to customer print products that are
delivered both directly to the military and to other defense prime
contractors.





In
February 2009, Optex Systems Holdings’ ISO certification status was
upgraded from 9001:2000 to 9001:2008, bringing Optex Systems Holdings into
compliance with the new ISO standards rewritten to align with ISO
14001.





Many of
our contracts allow for government contract financing in the form of contract
progress payments pursuant to Federal Acquisition Regulation
52.232-16, “Progress Payments”.  As a small business, and subject to
certain limitations, this clause provides for government payment of up to 90% of
incurred program costs prior to product delivery.  To the extent our
contracts allow for progress payments, we intend to utilize this benefit,
thereby minimizing the working capital impact on Optex Systems Holdings for
materials and labor required to complete the contracts.





Results
of Operations




During
the second half of calendar 2010, we experienced reductions in forecasted sales
volume due to changes in incremental funding commitments by federal agencies.
   Approval of the 2011 Congressional budget for the fiscal year
beginning on October 1, 2010 and ending September 30, 2011, has been delayed by
Congress and current U.S. government spending is continuing based on a
congressional stop gap which only provides appropriations at 2010
levels.  There is no indication if and when a 2011 Congressional
Budget will be ratified by Congress. Until the 2011
Congressional budget is approved, Optex and our major customers have been unable
to provide updated volume expectations for the coming year.  The first
presidential draft of the fiscal year 2012 budget is expected in mid February
and should provide more guidance as to the future appropriation levels of Abrams
tanks, Bradley fighting vehicles and Stryker wheeled vehicles, as well as other
significant armored tank programs. We continue to evaluate
the impact of anticipated changes in government defense spending to Optex
Systems Holdings as the information becomes available.  Due to new
periscope orders from non-traditional sources and an aggressive pursuit of
increased market share for all of our existing product lines, we expect to
mitigate some of the current decreased U.S. government requirements with other
new business.  We also continue to explore other opportunities for
manufacturing outside of our traditional product lines for products which could
be manufactured using our existing lines in order to fully utilize our existing
capacity.




5




The table
below summarizes our quarterly and year to date operating results in terms of
both a GAAP net income measure and a non GAAP EBITDA measure. We use EBITDA as
an additional measure for evaluating the performance of our business as “net
income” historically included the significant impact of noncash intangible
amortization on our income performance. Consequently, in order to have a
meaningful measure of our operating performance on a continuing basis, we need
to evaluate an income measure which does not take into account this intangible
amortization. We have summarized the quarterly revenue and margin below along
with a reconciliation of the GAAP net loss to the non GAAP EBITDA calculation
for comparative purposes below. We believe that including both measures allows
the reader to have a “complete picture” of our overall performance.





Three months ending
                        January 2, 2011
                      
                      
                      Three months ending
                        December 27, 2009Net
      Loss Applicable to Common
                        Shareholders
      - GAAP
                      
                      $
                      (0.05
                      )
                      
                      $
                      -Add:Interest
      Expense
                      
                      
                      0.02
                      
                      
                      
                      -Preferred
      Stock Dividend
                      
                      
                      0.10
                      
                      
                      
                      0.10Federal
      Income Taxes (Benefit)
                      
                      
                      0.03
                      
                      
                      
                      -Depreciation
      & Amortization
                      
                      
                      0.02
                      
                      
                      
                      0.30EBITDA
      - Non GAAP
                      
                      $
                      0.12
                      
                      
                      $
                      0.40





Our
EBITDA declined by $0.28 million in the three months ended January 2, 2011 as
compared to the prior year performance for the same period.  The EBITDA
reduction for the period was primarily attributable to the lower sales revenue
of $0.7 million, lower product margins related to the mix of product lines
shipped.  We continue to pursue cost efficiencies in our production
and general and administrative areas.





Product
mix is dictated by customer contracted delivery dates and volume of each product
to be delivered on such delivery dates.  Shifts in gross margin from
quarter to quarter are primarily attributable to the differing product mix
recognized as revenues during each respective period.  In fiscal year 2010,
we completed existing contracts which were awarded in 2003 for legacy loss and
low margin periscope orders.  In the three months ending January 2,
2011, our gross margins on the remaining periscopes business has increased 45%
over the gross margins rates for these products in the same period of the prior
year.  We expect our gross margins on these periscopes types to
continue to improve in as new orders are booked and.additional cost reduction
initiatives are implemented.





We are
currently experiencing losses on all of our U.S government Howitzer programs
awarded from in August 2005 through September 2010 as a result of unanticipated
manufacturing costs due to design and technical data package issues impacting
product manufacturability.  We entered fiscal 2011 with a historically
higher percentage of loss Howitzer contracts, to total shippable backlog and a
reduced visibility into the anticipated orders in other product groups to be
booked in the current year.  Our current backlog on these loss
programs as of January 2, 2011 is $3.8 million with contract loss reserves of
$1.1 million.  We continue to pursue cost reductions in our production
and general and administrative areas to mitigate any further margin impacts and
to improve overall product profitability.  Optex Systems Holdings has
requested an equitable adjustment on one of the howitzer loss programs due to
significant design issues impacting the manufacturability of the
product.  As there is no guarantee that the request will be granted in
part or in full, Optex Systems Holdings recognized the entire estimated loss in
fiscal year 2010.  In the event we are unsuccessful in obtaining an
equitable adjustment, future margins on these revenues are expected to be zero
as these losses have been previously recognized to the extent
identified.


We
are aggressively pursuing additional, potentially higher margin periscope
business,  New orders booked in the three months ending January 2,
2011 are $2.6 million consisting primarily of $2.3 foreign and domestic
periscopes orders from several major defense contractors and foreign Howitzer
units of $0.3 million.  In addition to periscopes, we are currently
pursuing several major proposal efforts in Howitzers and sighting system
programs.





As a
result of the October 14, 2008 acquisition of the assets of Optex Systems, Inc.
(Texas), Optex Systems, Inc.’s amortizable intangible assets increased
significantly in 2009 over prior years. In fiscal year 2010, the amortization
rate of intangible assets was $0.26 million per fiscal quarter.  We
reviewed the fair market value of our goodwill and intangible assets as of
October 3, 2010 and based on significant reductions in anticipated government
military spending, a reduction in customer order trends, and lower contract
backlog, we determined that that goodwill was impaired.  The review
was based on a projected cash flow analysis of our future
operations.  As of the year ended October 3, 2010, after impairment,
the total balance of unamortized intangible assets and goodwill was zero, and as
such there is no intangible asset amortization expense in the three months
ending January 2, 2011.





6




Backlog
as of January 2, 2011 was $16.6 million as compared to a backlog of $28.2
million as of December 27, 2009.  The following table depicts the current
expected delivery by quarter of all contracts awarded as of January 2,
2011.





2011
                      
                      
                      2012
                      
                      
                      2013Program Backlog (millions)
                      
                      Qtr 2
                      
                      
                      Qtr 3
                      
                      
                      Qtr 4
                      
                      
                      Qtr 1
                      
                      
                      Qtr 2
                      
                      
                      Qtr 3
                      
                      
                      Qtr 4
                      
                      
                      Qtr 1
                      
                      
                      Qtr 2
                      
                      
                      Qtr 3
                      
                      
                      TotalHowitzers
                      
                      
                      1.2
                      
                      
                      
                      2.0
                      
                      
                      
                      0.9
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      4.1Periscopes
                      
                      
                      2.5
                      
                      
                      
                      2.4
                      
                      
                      
                      1.4
                      
                      
                      
                      1.5
                      
                      
                      
                      1.3
                      
                      
                      
                      1.0
                      
                      
                      
                      0.7
                      
                      
                      
                      0.4
                      
                      
                      
                      0.3
                      
                      
                      
                      0.1
                      
                      
                      
                      11.6Sighting Systems
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -All
      Other
                      
                      
                      0.4
                      
                      
                      
                      0.1
                      
                      
                      
                      0.1
                      
                      
                      
                      -
                      
                      
                      
                      0.1
                      
                      
                      
                      -
                      
                      
                      
                      0.1
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      0.9Total
                      
                      
                      4.1
                      
                      
                      
                      4.5
                      
                      
                      
                      2.4
                      
                      
                      
                      1.5
                      
                      
                      
                      1.4
                      
                      
                      
                      1.0
                      
                      
                      
                      0.8
                      
                      
                      
                      0.4
                      
                      
                      
                      0.3
                      
                      
                      
                      0.1
                      
                      
                      
                      16.6





Virtually
all of our contracts are prime or subcontracted directly with the federal
government and, as such, are subject to Federal Acquisition Regulation Subpart
49.5, “Contract Termination Clauses” and more specifically Federal Acquisition
Regulation  clauses 52.249-2 “Termination for Convenience of the
Government Fixed-Price)”, and 49.504 “Termination of fixed-price contracts
for default”.  These clauses are standard clauses on our prime military
contracts and generally apply to us as subcontractors.  It has been our
experience that the termination for convenience is rarely invoked, except where
it is mutually beneficial for both parties.  We are currently not aware of
any pending terminations for convenience or for default on our existing
contracts.





By way of
background, Federal Acquisition Regulation is the principal set of regulations
that govern the acquisition process of government agencies and contracts with
the federal government. In general, parts of the Federal Acquisition Regulation
are incorporated into government solicitations and contracts by reference as
terms and conditions affecting contract awards and pricing solicitations.





In the
event a termination for convenience were to occur, Federal Acquisition
Regulation clause 52.249-2 provides for full recovery of all contractual costs
and profits reasonably incurred up to and as a result of the terminated
contract. In the event a termination for default were to occur, we could be
liable for any excess cost incurred by the government to acquire supplies from
another supplier similar to those terminated from us.  We would not be
liable for any excess costs if the failure to perform the contract arises from
causes beyond the control and without the fault or negligence of the company as
defined by Federal Acquisition Regulation clause 52.249-8. In addition, the
federal government may require us to transfer title and deliver to the
federal government any completed supplies, partially completed supplies and
materials, parts, tools, dies, jigs, fixtures, plans, drawings, information, and
contract rights that we have specifically produced or acquired for the
terminated portion of this contract. The federal government shall pay contract
price for completed supplies delivered and accepted, and we would negotiate an
agreed upon amount of payment for manufacturing materials delivered and accepted
and for the protection and preservation of the property. Failure to agree on an
amount for manufacturing materials is subject to the Federal Acquisition
Regulation Disputes clause 52.233-1.


In some
cases, we may receive an “undefinitized” (i.e., price, specifications and terms
are not agreed upon before performance commenced) contract award for contracts
that exceed the $700,000, which is the federal government simplified acquisition
threshold.  These contracts are considered firm contracts at an
undefinitized, but not to exceed specified limits threshold.  Cost
Accounting Standards Board covered contracts are subject to the Truth in
Negotiations Act disclosure requirements and downward only price
negotiation.  As of January 2, 2011, none of our outstanding backlog fell
under this criterion.





Three
Months Ended January 2, 2011  Compared to the Three Months Ended
December 27, 2009


Revenues.  In the three
months ended January 2, 2011, revenues decreased by 15.3% from the respective
prior period in 2009:





Product Line
                  
                  Three months ended
                    1/2/2011
                  
                  
                  Three months ended
                    12/27/2009
                  
                  
                  ChangeHowitzer
      Programs
                  
                  $
                  1.6
                  
                  
                  $
                  1.0
                  
                  
                  $
                  0.6Periscope
      Programs
                  
                  
                  2.9
                  
                  
                  
                  3.1
                  
                  
                  
                  (0.2
                  )Sighting
      Systems
                  
                  
                  -
                  
                  
                  
                  0.5
                  
                  
                  
                  (0.5
                  )All
      Other
                  
                  
                  0.5
                  
                  
                  
                  1.3
                  
                  
                  
                  (0.8
                  )Total
                  
                  $
                  5.0
                  
                  
                  $
                  5.9
                  
                  
                  $
                  (0.9
                  )Percent
      increase (decrease)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (-15.3
                  )%





7




Revenues
decreased by $0.2 million, or 6.5%, on our periscope line during the three
months ended January 2, 2011 as compared to the three months ended December 27,
2009.  Based on our current backlog demand and a recent decline of new
federal government orders deliverable in the remaining quarters of fiscal 2011,
we expect the periscope product line deliveries to decline by 15-20% in the
remaining three quarters of fiscal year 2011 as compared to revenues in the same
period in 2010.  We continue to quote and receive awards for additional
periscopes from multiple customers and are aggressively pursuing increased
market share in the periscope market by drawing business away from our
competitors; however, we cannot yet determine if we will be successful in
gaining sufficient new additional periscope business to offset the downturn
caused by the decline in new federal government orders.  In order to
preserve product margins and mitigate the impact of the reduced periscope
revenues since the first half of fiscal 2010, we implemented a reduction in
force of approximately 24% as of June 24, 2010.





Revenues
from the Howitzer programs increased $0.6 million, or 60.0%, over the same three
months in the prior year.  During the three months ending January 2, 2011,
the contract deliveries increased across all of our Howitzer programs as
compared to contract deliveries in the same quarter for the prior
year.  We do not expect this trend to continue for the balance of
fiscal year 2011 due to a shortage of specialized material required on one of
our Howitzer production lines.  We are currently negotiating a new
contract delivery schedules with our U.S. government customer, which we expect
will shift approximately $1.4 million of current deliverable Howitzer backlog
from quarters two through four of fiscal year 2011 into the first two fiscal
quarters of 2012.  The total impact of the expected contract
modification will result in an overall decline of 33.2% of Howitzer revenue for
fiscal year 2011 over fiscal year 2010 levels.




Sighting
systems revenues decreased $0.5 million, or 100%, over the same three months in
the prior year, due to the completion of U.S. government delivery order on back
up sighting units and General Dynamics commander weapon sighting systems in
fiscal year 2010.  We currently do not have a follow-on delivery order for
additional sighting units; however, the primary contract ordering period for the
U.S. government sighting systems does not expire until December 31, 2012. 
We continue to ship small sighting systems orders pursuant to other contracts to
both federal government and non-U.S. government customers and continue to pursue
business on several substantial programs for commander weapon sighting systems
and M36 thermal sighting units, which if successfully consummated, would yield
deliveries in fiscal year 2011.




8




Decreases
in the other product line of $0.8 million, or 61.6%, for the three months ending
January 2, 2011 are primarily a result of decreased sales of big eye binoculars
, mirror assemblies and TVS4 and PVS Objective assembly sales to multiple
customers for contracts completed fiscal year 2010.





Currently,
we are experiencing losses on our U.S government Howitzer programs as a result
of unanticipated manufacturing costs due to design and technical data package
issues impacting the product manufacturability.  These issues have resulted
in increased labor and material costs due to higher scrap and extensive
engineering costs incurred during the start up phase of the
programs.  As of January 2, 2011, Optex Systems Holdings has reserved
$1.1 million in contract loss reserves on these programs with a remaining
backlog of $3.8 million.  Pending negotiation of contract delivery schedule
changes, we are expecting to ship $2.4 million of the existing loss contract
backlog in fiscal year 2011, with the remaining $1.4 million expected to ship in
the first two quarters of fiscal year 2012  Optex Systems Holdings has
requested an equitable adjustment on one of the howitzer loss programs due to
significant design issues impacting the manufacturability of the
product.  As there is no guarantee that the request will be granted in
part or in full, Optex Systems Holdings recognized the entire estimated loss in
fiscal year 2010.  In the event we are unsuccessful in obtaining an
equitable adjustment, future margins on these revenues are expected to be zero
as these losses have been previously recognized to the extent
identified.





Cost of Goods Sold. During
the three months ended January 2, 2011, we recorded cost of goods sold of $4.3
million as opposed to $5.2 million during the three months ended December 27,
2009, a decrease of $0.9 million or 17.3%. This decrease in cost of goods sold
was primarily associated with decreased revenues from the comparable three month
period in the prior year, in addition to decreased intangible amortization in
the first three months of fiscal 2011 as compared to the first three months of
fiscal 2010 due to the write off of intangible assets associated with the Optex
Systems, Inc. (Texas) acquisition as of the year ending October 3,
2010.  The gross margin during the three months ended January 2, 2011
was $0.7 million or 14.0% of revenues as compared to a gross margin of $0.7
million or 11.9% for the three months ended December 27, 2009.  The
increase in gross margin percentage in the first fiscal quarter of 2011 as
compared to the prior year is primarily due to the decrease in intangible
amortization allocable to cost of goods sold of $0.2 million partially offset by
lower gross margins on contract deliveries due to a shift in product mix towards
Howitzer programs.




G&A Expenses. During the
three months ended January 2, 2011, we recorded operating expenses of $0.6
million as opposed to $0.7 million, during the three months ended December 27,
2009, a decrease of $0.1 million or 14.3%.  Operating expenses decreased
primarily due to the elimination of intangible amortization of $0.1 million
attributable to the write off of intangible assets in the last quarter of fiscal
year 2010,    We expect our operating expenses to continue to
throughout the fiscal year as a result of the elimination of intangible
amortization expense combined with other cost reduction initiatives implemented
in the second half of fiscal year 2010.





Operating Income (Loss).
During the three months ended January 2, 2011, we recorded operating income of
$0.10 million, as compared to an operating income of $0.07 million during the
three months ended December 27, 2009.  Our operating  income has
increased slightly, despite the reduction in revenues primarily due to the
elimination of intangible amortization expense combined with cost reduction
initiatives implemented in 2010 to mitigate anticipated reduced
volume.





Net Income (Loss) applicable to
common shareholders.  During the three months ended January 2, 2011,
we recorded a net loss applicable to common shareholders of $0.05 million, as
compared to $0.01 million for the three months ended December 27, 2010,
representing an increased loss of $0.04 million. In the first three months of
fiscal 2010 we recognized a tax expense of $0.03 million as compared to a $0.02
tax benefit in the same period of fiscal year 2010.  The change in taxes is
primarily due to the effect of temporary and permanent timing differences
related to intangible amortization and changes in reserve
balances.  Interest expense increased by $0.02 million in the current
quarter due to the line of credit instituted in March 2010.


9


Liquidity
and Capital Resources





On March
10, 2010, the Company entered into a revolving credit facility with Peninsula
Bank Business Funding, a division of the Private Bank of the Peninsula, which
provides up to $2.0 million in financing against eligible
receivables.  The revolving credit facility has allowed Optex the
flexibility to more effectively manage the timing of incoming cash from our
accounts receivable against our required cash outlay for operating
activities.  The material terms of the revolving credit facility are as
follows:





·
            The interest rate for all
      advances shall be the greater of 8.5% and the then in effect prime rate
      plus 3.5% and subject to a minimum quarterly interest payment of $16
      thousand.


·
            Interest shall be paid monthly in
      arrears.


·
            The expiration date of the
      facility is March 4, 2011, at which time any outstanding advances, and
      accrued and unpaid interest thereon, will be due and
      payable.


·
            In connection with the entry into
      the facility by Peninsula Bank Business Funding, Optex Systems,
      Inc.   paid Peninsula Bank Business Funding a facility fee
      of $20 thousand and issued a warrant to Peninsula Bank Business Funding to
      purchase 1,000,000 shares of its common stock. The warrant bears an
      exercise price of $0.10 per share and expires on March 3,
      2016.


·
            The obligations of Optex Systems,
      Inc. to Peninsula Bank Business Funding are secured by a first lien on all
      of its assets (including intellectual property assets should it have any
      in the future) in favor of Peninsula Bank Business
      Funding.


·
            The facility contains affirmative
      and negative covenants that require Optex Systems, Inc. to maintain
      certain minimum cash and EBITDA levels on a quarterly basis and contains
      other customary covenants.  The facility also contains customary
      events of default.  Upon the occurrence of an event of default that
      remains uncured after any applicable cure period, Peninsula Bank Business
      Funding’s commitment to make further advances may terminate, and Peninsula
      Bank Business Funding would also be entitled to pursue other remedies
      against Optex Systems, Inc. and the pledged
      collateral.


·
            Pursuant to a guaranty executed
      by Optex Systems Holdings in favor of Peninsula Bank Business Funding,
      Optex Systems Holdings has guaranteed all obligations of Optex Systems,
      Inc. to Peninsula Bank Business
  Funding.





On August
3, 2010, Peninsula Bank Business Funding agreed to amend Sections 6.8(c) and (d)
of the aforesaid agreement to adjust the minimum EBITDA covenant for the fiscal
quarter ending October 2, 2010 to $20 thousand, and for the fiscal quarter
ending January 2, 2011 to $200 thousand.





On
November 23, 2010, Peninsula Bank Business Funding waived the Company’s
requirement to meet the EBITDA requirement set forth in Section 6.8 (c) of the
August 3, 2010 amended Agreement for the fourth quarter ended October 3,
2010.  In addition, on November 29, 2010 Peninsula Bank Business Funding
agreed to a second amendment for Sections 6.8 (d) of the Agreement to adjust the
minimum EBITDA covenant for the fiscal quarter ending January 2, 2011 to
$95 thousand.


.


During
the three months ending January 2, 2011, Optex Systems, Inc. realized EBITDA of
$121 thousand as compared to a loan covenant requirement of $95 thousand,
(pursuant to the revised requirement as set forth in the November 29, 2010
amendment to the applicable loan agreement), and as such did meet the
EBITDA covenant of the Loan and Security Agreement for the first fiscal quarter
of 2011  As of January 2, 2011, the outstanding balance on the line of
credit is $717 thousand and on February 11, 2011, the latest practicable date,
the balance was $436 thousand.




We have
historically met our liquidity requirements from a variety of sources, including
government and customer funding through contract progress bills, short term
loans, notes from related parties, and the sale of equity securities. Based upon
our current working capital position and potential for expanded business
revenues, we believe that our working capital is sufficient to fund our current
operations for at least the next 12 months. However, based on our strategy and
the anticipated growth in our business, we believe that our liquidity needs may
increase in the future. The amount of such increase will depend on many factors,
including the costs associated with the fulfillment of our projects, whether we
upgrade our technology, and the amount of inventory required for our expanding
business. If our liquidity needs do increase, we believe additional capital
resources will be obtained from a variety of sources including, but not limited
to, cash flow from operations and the issuance of our common stock and/or debt,
including receivables funding through a commercial lender.


10


Cash
Flows for the Period from October 4, 2010 through January 2, 2011





Cash and Cash Equivalents. As
of January 2, 2011, we had cash and cash equivalents of $1.1 million. During the
period from October 4, 2010 through January 2, 2011, we increased cash and cash
equivalents by $0.07 million primarily through collections against outstanding
accounts receivable combined with decreases in inventory purchases offset by
reductions in the outstanding balance of our revolving credit
facility.





Net Cash Provided by Operating
Activities. Net cash provided by operating activities during the period
from October 4, 2010 to January 2, 2011 totaled $0.5 million. The primary
sources of cash during this period relate to collections of accounts receivable
of $0.3 million combined with net profit of $0.05 million and increases in
accounts payable and and non cash expenses of $0.15 million.





Net Cash (Used) by Investing
Activities. In the three months ended January 2, 2011, net cash used by
investing activities totaled $0.03 million and consisted of fixed asset
purchases during the period.





Net Cash (Used) by Financing
Activities. Net cash used by financing activities totaled $0.4 million
during the three months ended January 2, 2011 due to the repayment of $0.4
million of the outstanding balance of  the revolving credit facility
we entered into during the second quarter of the fiscal year.





Critical
Policies and Accounting Pronouncements





Our
significant accounting policies are fundamental to understanding our results of
operations and financial condition.  Some accounting policies require that
we use estimates and assumptions that may affect the value of our assets or
liabilities and financial results. These policies are described in “Critical
Policies and Accounting Pronouncements” and Note 2 (Accounting Policies) to
Financial Statements in our Annual Report on Form 10-K for the year ended
October 3, 2010.





Recent
Accounting Pronouncements





None.





Cautionary
Factors That May Affect Future Results





This
Quarterly Report on Form 10-Q and other written reports and oral statements made
from time to time by Optex Systems Holdings may contain so-called
“forward-looking statements,” all of which are subject to risks and
uncertainties. You can identify these forward-looking statements by their use of
words such as “expects,” “plans,” “will,” “estimates,” “forecasts,” “projects”
and other words of similar meaning. You can identify them by the fact that they
do not relate strictly to historical or current facts. These statements are
likely to address Optex Systems Holdings’ growth strategy, financial results and
product and development programs. You must carefully consider any such statement
and should understand that many factors could cause actual results to differ
from Optex Systems Holdings’ forward-looking statements. These factors include
inaccurate assumptions and a broad variety of other risks and uncertainties,
including some that are known and some that are not. No forward-looking
statement can be guaranteed and actual future results may vary
materially.





Optex
Systems Holdings does not assume the obligation to update any forward-looking
statement. You should carefully evaluate such statements in light of factors
described in this Form 10-Q. In various filings Optex Systems Holdings has
identified important factors that could cause actual results to differ from
expected or historic results. You should understand that it is not possible to
predict or identify all such factors. Consequently, you should not consider any
such list to be a complete list of all potential risks or
uncertainties.


11


Item
4. Controls and Procedures





Evaluation
of Disclosure Controls and Procedures





As of the
end of the period covered by our Quarterly Report on Form 10-Q for the quarter
ended January 2, 2011, 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 January 2, 2011, our disclosure controls
and procedures were effective.





Changes
in  Internal Control Over Financial Reporting





During
the quarter ended January 2, 2011, there were no changes in our internal control
over financial reporting that have materially affected, or are reasonably
likely to materially affect, our internal control over financial
reporting.





PART
II - OTHER INFORMATION





Item
1. Legal Proceedings.





We are
not aware of any litigation pending or threatened by or against the
Company.





Item 1A. Risk Factors





RISK
FACTORS




Investing
in our common stock involves a high degree of risk. Prospective investors should
carefully consider the risks described below, together with all of the other
information included or referred to in this Form 10-Q, before purchasing shares
of our common stock. There are numerous and varied risks, known and unknown,
that may prevent us from achieving our goals. The risks described below are not
the only risks we will face. If any of these risks actually occurs, our
business, financial condition or results of operations may be materially
adversely affected. In such case, the trading price of our common stock could
decline and investors in our common stock could lose all or part of their
investment. The risks and uncertainties described below are not exclusive and
are intended to reflect the material risks that are specific to us , material
risks related to our industry and material risks related to companies that
undertake a public offering or seek to maintain a class of securities that is
registered or traded on any exchange or over-the-counter market.





Risks Related to our
Business





Our
historical operations depend on government contracts and subcontracts.  We
face risks related to contracting with the federal government, including federal
budget issues and fixed price contracts.





Future
general political and economic conditions, which cannot be accurately predicted,
may directly and indirectly affect the quantity and allocation of expenditures
by federal agencies. Even the timing of incremental funding commitments to
existing, but partially funded, contracts can be affected by these factors.
Therefore, cutbacks or re-allocations in the federal budget could have a
material adverse impact on our results of operations.   Given the
continued adverse economic conditions, the federal government has slowed its
pace with regard to the release of orders for the U.S. military. Since we depend
on orders for equipment for the U.S. military for a significant portion of our
revenues, this slower  release of orders will continue to have a
material adverse impact on our results of operations.  Obtaining government
contracts may also involve long purchase and payment cycles, competitive
bidding, qualification requirements, delays or changes in funding, budgetary
constraints, political agendas, extensive specification development, price
negotiations and milestone requirements. In addition, our government contracts
are primarily fixed price contracts, which may prevent us from recovering costs
incurred in excess of budgeted costs. Fixed price contracts require us to
estimate the total project cost based on preliminary projections of the
project’s requirements. The financial viability of any given project depends in
large part on our ability to estimate such costs accurately and complete the
project on a timely basis. Some of those contracts are for products that
are new to our business and are thus subject to unanticipated impacts to
manufacturing costs.  Given the current economic conditions, it is also
possible that even if our estimates are reasonable at the time made, that prices
of materials are subject to unanticipated adverse fluctuation.  In the
event our actual costs exceed fixed contractual costs of our product contracts,
we will not be able to recover the excess costs which could have a material
adverse effect on our business and results of operations.  We examine these
contracts on a regular basis and accrue for anticipated losses on these
contracts, if necessary.  As of January 2, 2011, we had approximately $1.1
million of loss provision accrued for these fixed price
contracts.


12


Approximately
95% of our contracts contain contract termination clauses for convenience. 
In the event these clauses should be invoked by our customer, future revenues
against these contracts could be affected, however these clauses allow for a
full recovery of any incurred contract costs plus a reasonable fee up through
and as a result of the contract termination.  We are currently unaware of
any pending terminations on our existing contracts.  In some cases,
contract awards may be issued that are subject to renegotiation at a date (up to
180 days) subsequent to the initial award date.  Generally, these
subsequent negotiations have had an immaterial impact (zero to 5%) on the
contract price of the affected contracts.  Currently, none of our awarded
contracts are subject to renegotiation.





We have
sought to mitigate the adverse impact on our results of operations from U.S.
military orders by seeking to obtain foreign military orders.  We are still
engaged in this process and cannot yet determine if our efforts will result in
securing sufficient additional orders to mitigate the adverse impact on our
results of operations from the slower pace of U.S. military orders.





Conversion
of our Series A preferred stock could cause substantial dilution to our existing
common stock holders, and certain other rights of the preferred stock holders
present other risks to our existing common stock holders.





As of
January 2, 2011, we had 139,444,940 shares of our common stock issued and
outstanding, as well as 1,027 shares of our Series A preferred stock issued and
outstanding.  The Series A preferred stock is convertible into 41,080,000
shares of our common stock, and upon conversion, the Series A preferred stock
would represent 21.7% of our outstanding common stock.  This would greatly
dilute the holdings of our existing common stockholders.  In addition, the
preferred shareholders vote on a one-to-one basis with our common shareholders
on an as converted basis.





Furthermore,
in the event of a liquidation, the holders of our Series A preferred stock would
receive priority liquidation payments before payments to common shareholders
equal to the amount of the stated value of the preferred stock before any
distributions would be made to our common shareholders.  The total stated
value of our preferred stock is $6,162,000, so the preferred shareholders would
be entitled to receive that amount before any distributions could be made to
common shareholders.  The liabilities on our balance sheet exceed the
liquidation value of our assets; therefore, upon a liquidation, there would be
no assets remaining for distribution to common shareholders.





The
preferred shareholders also have the right, by majority vote of the shares of
preferred stock, to generally approve any issuances by us of equity and/or
indebtedness, which is not ordinary course of trade indebtedness. 
Therefore, the preferred shareholders can effectively prevent us from entering
into a transaction which they feel is not in their best interests, even if the
transaction might otherwise be in the best interests of Optex Systems Holdings
and its common shareholders.




13




Item
6. Exhibits





ExhibitNo.
                        
                        Description10.29       Third
      Amendment to Loan and Security Agreement, between Optex and Peninsula Bank
      Business Funding, dated February 15, 201131.1
      and 31.2 Certifications pursuant to Section 302 of Sarbanes Oxley Act of
      200232.1
      and 32.2 Certifications pursuant to Section 906 of Sarbanes Oxley Act of
      2002





SIGNATURES





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





OPTEX
      SYSTEMS HOLDINGS, INC.Date:
      February 16, 2011
                          By:
                          /s/ Stanley A. HirschmanStanley
      A. Hirschman
                            Principal
      Executive
Officer


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OPTEX
      SYSTEMS HOLDINGS, INC.Date:
      February 16, 2011
                      By:
                      /s/ Karen HawkinsKaren
      Hawkins
                        Principal
      Financial Officer and Principal
                        Accounting
      Officer




15