Innovative Aerosystems, Inc. (ISSC) Q4 2012 Earnings Report, Transcript and Summary

Good morning, and welcome to the Innovative Solutions & Support Fourth Quarter and Full Year 2012 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mr. Geoffrey Hedrick, Chairman and Chief Executive Officer. Mr. Hedrick, you may begin.

Good morning. This is Geoff Hedrick, Chairman and CEO of Innovative Solutions & Support. I'd like to welcome you this morning to our conference call to discuss fourth quarter and full year 2012 results and our current business conditions and outlook. Joining me today in our Exton headquarters are Shahram Askarpour, our President; and Ron Albrecht, our CFO. Before I begin, I would like Ron to read our Safe Harbor statement. Ron?

Thank you, Geoff, and good morning, everyone. I would like to remind our listeners that certain matters discussed in the conference call today, including operational and financial results for future periods, are forward-looking statements that are subject to the risks and uncertainties that could cause actual results to differ materially, either better or worse than those discussed, including other risks and uncertainties reflected in our top company’s 10-K, which is on file with the SEC. I will now turn the call back to Geoff.

Thanks, Ron. Last night, we announced that we ended the year on a positive note with a 7% fourth quarter revenues growth compared to fiscal 2011, and net income of $2.8 million or $0.17 a share, of which $2.4 million of that net income and $0.15 a share are a result of a release of income tax reserves that Ron Albrecht will detail later. As a result, the company was profitable for the fourth consecutive year and generated cash, both in the quarter and in the year. Based on the progress in both our production and development programs, we are cautiously optimistic that we can achieve the planned 20% annual growth target for fiscal 2013. While defense budgets remain under pressure, our products offer an outstanding performance to cost value proposition and we believe will lead to increased military orders in 2013. On the commercial air transport market side, our development program for the NNSA or National Nuclear Security Administration's Boeing 737-400, we received the STC for the Cockpit/IP Flat Panel Display System, and we're nearing completion of flight testing of the flight management system phase, opening a potential market of 1,000 aircraft. Although the business in general aviation market remains relatively weak, we plan to begin production on an initial 50 set order from Eclipse Aviation for their production phase in 2013, and we continue development of the utility management system for another OEM customer. We remain optimistic because several of our sole-source customer-funded engineering modification and development programs and our IR&D programs are nearing completion, and we anticipate production orders from these projects. In fiscal 2012, new orders of $28.2 million exceeded revenues of $24.6 million, and the potential value of various Engineering Modification Development programs and IR&D programs is over $100 million and will be included in the backlog as we receive production releases. Because we expect production of many of these programs to commence or increase in fiscal 2014, we will be investing heavily over the next 12 months to meet that expected demand. Consequently, our spending on engineering, both customer funded and IR&D, could exceed our historical average of 20% of revenues. Despite this investment, the company anticipates that it will increase its operating income and continue to generate cash from operations. Now let me turn it -- let me turn the call over to Ron Albrecht for more detailed discussion of our financial performance. Ron?

Thank you, Geoff, and thank you all for joining us this morning. For the fourth quarter, the company reported revenue of $6.9 million, up 7% from revenue of $6.5 million in the fourth quarter of 2011. The company reported fourth quarter 2012 net income of $2.8 million or $0.17 a share compared to $12,000 or $0.00 per share in the same quarter a year ago. For the fourth quarter, the company generated positive operating cash flow of $1.3 million, up from $0.4 million in the fourth quarter of fiscal 2011. Of the reported net income and earnings per share, $2.4 million and $0.15, respectively, resulted from the reversal of income tax valuation allowance, which we recorded in prior years to offset deferred asset -- tax assets related to book-to-tax temporary differences and for unused research and development credits. The company established the valuation allowances in 2008 following several years of losses, at which time the realization of certain deferred tax assets is considered unlikely in accordance with the requirements of ASC Topic 740 Income Taxes. Over the past several years, the company has been profitable. And in accordance with the requirements of ASC Topic 740, the company has concluded that based upon an analysis of past results and future projections, the valuation allowances for certain deferred tax assets should be reversed. From a product standpoint, flat panel display revenues in the quarter were approximately $6 million. Air Data product shipments in the quarter were about $900,000 or approximately 13% of total shipments, as the declining combat operations may be leading to increased maintenance on existing aircraft. Gross profit in the fourth quarter was $2.7 million or 39% of revenues. This result was somewhat lower than the 43% for the year because of a higher proportion of Engineering Modification and Development programs in the quarter. Total operating expenses in the quarter were $2.3 million, consistent with this year's quarterly pace and down nearly $800,000 from $3.1 million last year. Compared to a year ago, most of the increase -- decrease, sorry, resulted from a reduction in internally-funded research and development, which totaled $561,000 for the quarter compared to $1.2 million in the fourth quarter a year ago. The company's total engineering spend in the quarter remained high with the majority of the spend reported as cost of sales against Engineering Modification and Development revenues. Selling, general and administrative spend in the quarter was $1.7 million, down 6% from the third quarter and 8% from the same quarter a year ago, attributable primarily to tighter expense control. We reported fourth quarter operating income of approximately $373,000 compared to $95,000 in the same quarter last year. For the full year, revenues for the fiscal year ended September 30, 2012, were $24.6 million compared to $25.7 million for the 12 months ended September 30, 2011. Net income was $3 million or $0.18 per share for fiscal 2012 compared to $700,000 or $0.04 a share for the 12 months ended September 30, 2011. Our reported net income and earnings per share, $2.4 million and $0.15, respectively, resulted from the reversal of the income tax valuation allowances that I discussed in conjunction with the fourth quarter result. Excluding the income -- excuse me, excluding the income of this onetime tax adjustment, the company had net income of $500,000 or $0.03 a share. Cash flow from operating activities was $1.4 million for the 12 months ended September 30, 2012 compared to $2.3 million for the prior year. During fiscal 2012, the company used $798,000 of cash to repurchase 211,722 shares of its stock, an average cost of $3.77 per share. Gross margins were 42.8%, down from fiscal 2011 primarily due to the investment in customer-funded Engineering Modification and Development programs. Operating expenses reduced by over $3 million because engineering costs were charged to Engineering Modification and Development programs, and selling, general and administrative expenses were controlled. The company reported its fourth consecutive profitable year before taking into account the onetime adjustments and net income of the reduction for the income tax valuation allowance. Our balance sheet remains strong with $43 million in cash and no debt. I will conclude with our outlook for fiscal year 2013. For the full year, we expect sales to increase compared to 2012. We expect pretax income to increase also, but not as much as sales on a percentage basis because of the continued high engineering cost of sales and higher IR&D. We anticipate generating operating cash flow for the year. Now I'll turn the call over to Shahram for some comments on current market conditions and our business development efforts. Shahram?

Thank you, Ron. The company's growth strategy is focused on leveraging our proprietary technology to broaden our platforms in the military, commercial air transport and general aviation industries. Our products are in demand because they are both cost effective and versatile. We design our products to meet the stringent industry requirements and to accommodate foreseeable future regulatory and operator requirements. This quarter, we announced 2 new additions to our product portfolio, an integrated standby instrument and the NextGen Cockpit/IP II flight deck for business and general aviation aircraft. These 2 new products, together with the full Engineering Modification and Development programs currently underway, have broadened the company's product offerings and increased its market opportunities. As Geoff mentioned, we anticipate that several of our development programs will lead to production revenues over the next 12 months. In October, Eclipse Aerospace placed a production order for an initial 50 ship sets of a 300-ship set forecast for the IS&S advanced avionics suite for the new Eclipse 550 aircraft. IS&S is the supplier of the integrated cockpit management system for the new Eclipse Jet. The Avio IFMS avionics suite is one of the most advanced cockpits available on any aircraft. The 11 microprocessors in the IS&S system control all major aircraft systems from takeoff to all phases of flights and landing. It provides performance found only in aircraft costing 10 times as much. Last quarter, we received an STC for the primary and standby flight displays on our system integration and cockpit avionics upgrade of the National Nuclear Security Administration Boeing 737-400. Presently, we are flight testing the flight management system in the second phase of the contract. The completion of this program this year will open a new market of RNP capable air transport flight management systems for IS&S. The Engineering Modification and Development phase of the Boeing aerial refueling operator control and display unit is progressing and our development efforts are largely complete. Following Boeing's overall aircraft development and testing program, we anticipate the production of 179 ship sets for the United States Air Force's KC-46A tankers. We are making progress on our contract for an advanced OEM electronic monitoring and control system. Our engineering team is completing the design of the hardware and software leading to critical design review. We have delivered engineering prototypes to our customer for the system integration lapse evaluation. With respect to new product introductions, we have developed an Integrated Multifunction Standby Unit for a variety of fixed-wing aircraft and helicopters. The IMSU measures, processes and displays altitude, attitude, heading, airspeed, slip/skid and navigation display information independent of other aircraft instruments. The IMSU includes data state-of-the-art sensors and utilizes the company's RVSM compliance air data and flat panel display technologies. By combining advanced display technology with a versatile interface capability, we have developed a product that is suitable for both retrofit and OEM applications. We announced recently our NextGen Cockpit/IP II flight deck for business and general aviation aircraft. The Cockpit/IP II is an advanced next-generation product, which includes a number of innovations in aircraft system design. The increased performance and functionality, and lowered direct operating costs provide our customers with a value proposition. The system includes dual flight management functionality, electronic charts, satellite weather, synthetic vision, integrated terrain awareness and enhanced vision. The Cockpit/IP II has a 60% larger display area and more display pixels than the systems offered in the latest generation aircraft, and is fully compliant with NextGen requirements for RNP and ADS-B. Both of these new products open growth opportunities because they are suitable for a variety of airframes across all 3 of our end markets. At the end of the fourth quarter, we had a backlog of $19.7 million. This backlog excludes the Eclipse production contract, production phase of the new OEM advanced electronic monitoring and control system beyond the first year and the production phase of the Boeing KC-46A tanker contracts. As Geoff mentioned earlier, new orders in fiscal 2012 exceeded revenues. However, backlog is down from a year ago because we reduced the American backlog in accordance with their revised requirements. Innovative Solutions & Support has served many of the most respected names in the aerospace industry. We provide value to our customers by offering them technologically advanced products at a cost-effective price and technical support. This is our tradition, and this is reflected in our name. Consequently, we are cautiously optimistic that the wide number of programs on which we are engaged, either in backlog or in development and maturing, will result in fiscal year 2013 revenues that are in line with our 20% growth objective. I would now like to turn the call back to Geoff.

Thanks, Shahram. Before we open the call to questions, I'd like to provide a few closing thoughts and our targets for the balance of the fiscal 2013. Over the next 18 to 24 months, we expect a number of our development programs to begin to generate additional production revenue. The initial production order with Eclipse begins the transition of our engineering investments over the last -- over the last 2 years and the profitable production revenues. As other programs mature, we are targeting to achieve growing revenues and profit. In the shorter term, we are cautiously optimistic that in fiscal 2013 we will achieve the 2,000 -- the 20% growth target for 2013 with continued profitability and cash generation as long as the company -- economy remains relatively stable. We expect revenues in the first quarter to be up compared to a year ago, and we expect full year revenues and income before taxes to increase compared to fiscal 2012. Operator, would you please open the call for questions.

[Operator Instructions] Our first question comes from Tim Fronda of Sidoti & Company.

With respect to the Eclipse 550 order, what is the time period for you in supplying the avionics suite and where do you go from here after this initial order?

We have an order without -- we have a release for 50 ship sets and an order for 300, which is we start production next year, middle of next year. They will deliver their first aircraft, and we will be on the airplane as anticipated as the airplane continues in production. Does that answer your question?

Yes. And you gave a good description of the new products, the NextGen Cockpit flight deck and the Integrated Multifunction Standby Unit. Can you give a little more description on the market opportunity they provide and the growth potential for these products?

Well, on that integrated standby unit, every aircraft that is being built today and small and large general aviation, military and commercial use an integrated -- some sort of integrated standby backup for the display system in the aircraft. We manufacture this integrated standby that essentially combines all the functions in the aircraft cockpit into a fully independent system that will supply all the needed guidance to the cockpit if the primary system should fail. The opportunity is every new airplane, that's a potential market, every new airplane that we can get the order is being built today and retrofit of virtually every airplane that's out there. So it's a very large market. There are several competitors in the market and we've come out with an excellent price performance ratio and a unit with several additional features that our competitors do not have. As far as the new Flat Panel Display System, the new Flat Panel Display System is a large, very high-resolution display system offering high-definition quality. A cockpit with 3 displays will have over 6 million pixels, which is more than the 787 has. It is a remarkable achievement, and it integrates systems like Flight Management Systems and comprehensive engine display systems. So we believe that this is unlike anything that's available in the market today on any aircraft and will be priced very competitively as well.

Great. And do you expect the -- your outlook for next year to change at all once the fiscal cliff finally gets resolved? I mean, do you think that will lead to more certainty with respect to FAA funding and will generate more business for you on that end?

I mean, it is one man's opinion. I mean, first of all, I don't know what -- I can't imagine that they can change FAA funding a whole lot because our economy absolutely depends on a viable commercial air transport system. So there's very little you can do with that. The fiscal cliff, one way or the other, I don't think has any impact. You could actually make a case for, if we were -- if we didn't resolve the fiscal cliff, that it would put more pressure on buying our equipment because our equipment traditionally is less expensive and provides far more functionality and performance per dollar than our competitors. So it actually gives us, and at a time -- as I've mentioned many times before, at a time of retrenchment, we actually have a stronger market.

Okay. My final question, you ended the year with a lot of cash and no debt. You have the repurchase program in place. What other plans do you have for the cash at this time?

We are looking obviously in light of changing tax laws and a bunch of other things, how we can best utilize that cash. And before the end of the year, we will be -- if we come to a unique conclusion, we will be announcing it. Is that vague enough?

Our next question comes from David Campbell of Thompson, Davis & Company.

It's not my fault, David. The tax guys made us do it.

Well, that's the way it goes. It's the fiscal cliff. You're supposed to pay out all your cash now this year. One of my companies has decided today that they were going to pay their 2013 and 2014 dividends in December right this month. So they'll have no dividends next year, no dividends the following year. They're going to pay it all in December, so there you go. That's -- maybe that's a precedent for you guys, but that's what happens when you fool around with the tax laws. Anyway...

We believe we're going to generate cash, and that's an important thing. We've made a point out of generating cash. As you can see, even over the last 4 years, through very, very difficult times, we've maintained marginal profitability albeit but always generating not insignificant amounts of cash. How we deploy that, and how it's -- what's in best interest of our stockholders is under obvious review at this point. So but the good news is that the business, forgetting the cash and availability of the cash, the business will generate and is looking strong in a way that we clearly haven't been able to address in -- certainly in the last 4 years.

All right. Now the backlog of the $19.7 million, I heard you say or somebody say that does not include any of the Eclipse business. Is that correct?

It doesn't include -- and the only thing that appears in our backlogs are fully-released business that says that you will deliver on a given schedule. It's traditional in all OEM programs, Boeing included, where you may get an order for 500 airplanes but they're only building 50 a year, so they will release 50 aircraft. And you -- and essentially, we would only show that kind of business as a 50-piece order not as 500 pieces. The business we're talking about is the orders that we may have that do not have releases against them yet.

But, David, the $19.7 million does not include the 50 ship sets from Eclipse.

It does not, right?

Because that order was placed in October.

So there's additional...

That's right, that was in October, yes. So the current backlog exceeds $19.7 million?

Well, yes, I mean...

It does.

We're not speaking to that, obviously.

Right. Now also excluded any American business, any American Airlines retrofit business?

I'm sorry, David, what was your question?

The $19.7 million excludes any American business?

It excludes certain reductions that American has given us based on their current fleet requirements.

Right. But there is some business in there?

Yes, and we expect to achieve that business. In our minds, the achievement of that business is -- of that backlog is not a question.

So the 20% revenue target in fiscal 2013 includes some American business but less than you'd hope for?

I think -- yes, that's correct. It includes American business. I think, it includes what we would have expected.

Have they taken any business in this quarter? Have they taken any deliveries this quarter?

Yes, they will.

Okay. Now the IMSU Air Data equipment, I assume that's Air Data equipment not flat panels. That's...

That's in Air Data, flat panels as well as added tube reference and headings.

It's both, okay.

It's a complete system and a small -- a roughly 4-inch by 3-inch size package.

And I assume that mostly that is in the potential military business.

No, as I explained, every airplane, every airplane that's being built virtually in the world is going to be using some sort of standby like that. Military, commercial, general aviation, recreational.

So some -- if you do any of that business, some of it will be in Air Data -- some will be in Air Data and some will be in flat panel revenues?

I don't know how we're going to define it. We're not certainly not going to split it up. If we sell one of these, we will probably define it as a flat panel revenue even though it has all kinds of functionalities in it. We're not going to divide it up on our revenue reporting.

Right, right. But none of it's a deal -- you don't have any contracts at this point?

We do.

You do have contracts?

Yes.

And it's in -- was it in the $19.7 million backlog?

No.

Okay, okay. So the June 30 backlog had more American business in it than the September 30 backlog? Is that right?

Excuse me. Give me a second on that one, David. I haven't thought about things quite that way. What was your question again?

The June 30 backlog had more American business in it than the September 30 backlog?

June 30 had more -- it had, I think, about the same. We've known about the American situation for quite some time and adjusted the backlog some time ago.

They declared bankruptcy a year ago so...

I got the impression that the reason for the decrease in backlog was that American would have been -- American had been taken out of it or reduced and...

It had been. But that's the -- you're looking at the -- we're looking at the backlog over a period of a year, from beginning to the end of year. And so if you look at it in that context, the sales or the increases in the -- or the additions to the backlog exceeded our sales for the year, but we made during the course of the year an adjustment for the American.

So that was an annual calculation, yes, a year ago calculation. Right, right. And the Eclipse Aero -- we've already done that one -- or the Next-Generation Cockpit, this is really what you've been working with the 737s, that's correct, right?

No. This is a new development for -- that will be targeted initially at a military application and then general aviation application and ultimately, air transport. But it's a very revolutionary displays and operation system. It's a fully integrated. It's a development that becomes off of our work on Eclipse and some military programs.

So nothing to do with the nuclear science delivery and its contract?

No, nothing to do with that.

But that's an existing contract that's well underway, and we've already installed and delivered other equipment.

Okay, okay. Now -- so the way you described the profit outlook for 2013 is potentially revenue growth of 20%, that's despite not getting as much American revenue as you might have hoped for.

Well, $10 million dollars worth of revenue.

But that's -- David, you need to understand, that's not getting as much American revenue as we have thought we're going to get a year ago. This was what we've been thinking over the last year.

Yes, if you look, we survived 2 bankruptcies and come out remarkably well. We -- think about it. We've had 2 huge, major customers, major customers representing upwards to 40% of our revenue go bankrupt. We survived those bankruptcies and we generated cash, and we've remained profitable, and we're growing. So I mean, it's kind of an amazing survival story.

Right. Well, just working on the numbers for a sec. So say, you get 20% revenue growth in fiscal '13, that's roughly $5 million of revenue growth. What you're saying in that paragraph is that the percentage increase will be -- and profits will be less than that.

No, we don't say that. It could be more than that.

But that's what I'm trying to get at. So you're not necessarily referring to the percentage growth, but you're referring to the fact that $5 million in revenue growth may be less than $5 million in profit growth. Is that what you're saying?

What we're saying, we have a double whammy here. We have a situation where we have $0.15 a share, a very special impact to our profitability. That's not traditional operating profit. As we've explained, that's profit from the reversal of reserves against certain tax benefits.

I'm just looking at a pretax basis, the pretax basis.

What we're saying, David, and maybe it wasn't said terribly well. What we're saying is we expect the profits to grow at a -- if you simply take the margins that we typically get on our revenues, you can't simply apply that margin to the sales increase and come up with a new profit before tax because we're spending significantly more money this coming year on engineering.

I understand that. You will have lower margins.

We would expect to make more money than we make -- operating pretax money than we made this year if you want to know an answer, that's as simple. We will grow the bottom line pretax in 2013.

Yes, I know that but 10% -- 10% growth on...

And it may be equal to 20% or greater than 20%, could be either one. We're not clear because we have huge investments, huge opportunities that we can invest money into, and we think that's what our stockholders want us to do is invest in those opportunities will ultimately give us a lot more revenue. So that means that we will grow our profitability, I would expect, by at least what we will grow the top line. And again that's pretax, so it excludes the $0.15 a share.

Yes, we probably could have explained it a little better, David.

I's complex.

Geoff's got it right, but I'll just repeat myself. If sales go up, whatever, and you simply apply a gross margin percentage to that and say that's going to drop to the pretax income line, you're probably going to have the wrong answer.

You can't do that. You can't do that because your gross margins is not going to be...

We can't do it because we're going to invest more in engineering. Look, the object is, we want to grow the business. We're especially focused at the top line. So we're trying to grow the revenue. So we're investing, look it, over 20% of revenues, we're investing in product development and it's starting to pay off in a real way. That's 3 times what our competitors are doing. Now is the time to invest. Now is the time to go and grow the business. And we think the opportunity is there to do it, and that's what we'll do. So we're committed to make a profit, however, marginal, and we are committed to generate cash if at all possible. So we're going to try to do both of those things and invest basically everything else into new product development. That's sort of the summary.

Okay. But what is this Atlanta field office have to do with all of that?

Atlanta field office -- the Atlanta field office has 2 things. We have a major customer, a military customer in Warner Robins, Georgia, which is the home of the C-130 and several other large Air Force programs. So they serve that whole southeastern portion of the United States, including Pensacola, Florida, and by the way, also serve Memphis, Tennessee because Memphis is a hell of a lot closer to Atlanta and there are day flights over there. So we have a big customer in Tulsa, Oklahoma and in Memphis, Tennessee and other opportunities in that area. And we have a field engineer resident in that location as well as a sales guy.

But you've got that business already without having an Atlanta office.

I don't have business in Warner Robins and I need a field engineering guy to support the Federal Express. I took him out of Memphis where he was resident and put him in Atlanta so we can service more than one customer, or I can leave him in Memphis and not serve any other customer. Tell American not to go pound sand [ph] , we don't want to do that. So this gives them an opportunity to fly in Tulsa easily, fly and talk to Memphis easily and most importantly support Warner Robins on a very viable C-130 program.

Yes, okay. So you think you'll be profitable in the first quarter?

Yes.

Because that's a tough quarter, as you know.

It is a tough quarter, and we try to stay either profitable or if we're not profitable, be it by a very small amount, but that's one of the criteria in running the business. It's good discipline, don't lose money. So that's just a basic discipline that we have within the company. If you start accommodating big losses, you got to change the name of your company to .com or something.

Okay. We don't want to do that. We don't want to do that.

It's just short a practical business 101.

[Operator Instructions] If there are no more questions, this concludes the conference for today. Thank you for attending today's presentation. You may now disconnect your lines.