Innovative Aerosystems, Inc. (ISSC) Q2 2013 Earnings Report, Transcript and Summary

Good morning, and welcome to the Innovative Solutions & Support Second Quarter 2013 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mr. Geoff Hedrick, Chairman and CEO. Mr. Hedrick, please, you may begin.

Thank you, and good morning. This is Geoff Hedrick, Chairman and CEO of Innovative Solutions & Support. I'd like to welcome you this morning to our conferencing call to discuss our second quarter fiscal 2013 results, current business conditions and our outlook for the balance of the year. 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 message. Ron, please.

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 company's 10-K, which is on file with the SEC. I'll turn the call back to Geoff.

Thanks, Ron. In the second quarter, we reported revenues of $8.2 million, up 21% from a year ago, with a net income of $1.1 million or $0.07 a share, an increase over a year ago earnings of $289,000 or $0.02 a share. This was our fifth consecutive profitable quarter. We booked $69 million in new orders in the quarter, including the recently announced Delta Air Lines contract. Combined with the $16 million in new orders booked for the first quarter, our backlog has grown to over $90 million and the highest level in recent history. This does not -- in fact, it's probably the highest level ever. This does not include $75 million of unreleased OEM commitments. In response to these strong financial results and new orders, we have raised our financial targets, and now expect to grow revenue by 30% this fiscal year and earnings per share in the range of $0.18 to $0.20. In the past, we have provided minimal guidance, but in light of the recent activity, we would like to avoid excessive speculation. Ron will provide some more detail. In the second quarter, we met our strategic objectives, profitably growing the business and winning new contracts that should provide us a very solid financial foundation on which to build over the next several years. Although gross margins continue to reflect the effect of the high volume and lower margin of engineering development, we have controlled expenses and have achieved positive operating leverage, which will support an increase in operating income substantially greater than the rate of growth in revenue. Over the last -- over the first half of this year, we have received more than $85 million in new orders, including the upgrade to Delta's MD 88 and MD 90 fleet. This contract not only adds substantially to our backlog but provides further market validation of our growing portfolio of advanced technology, including in this case, our next-generation Flight Management System. In the Delta contract, we will replace an outdated cockpit technology with completely new avionics that are comparable to the avionics of the latest production aircraft. As a result, the aircraft will be more fuel-efficient, will substantially reduce their carbon footprints on approach and will comply with next-generation regulatory requirements and can accommodate future upgrades among other benefits. Our plans to expand our system integration capability have realized great success in the last year. We have FMS contracts in each of our separate commercial air transport business aviation and military markets. Our proven ability to integrate systems across the flight deck's radios, communications and navigation enhances our ability to sell systems to our end customer while increasing the size of our addressable market. Our Flight Management System is a strong platform from which to extend that capability in accordance with our strategy of adding new functionality to simplify and to improve aircraft operations. We have an excellent value proposition, especially in the context of our market, which increasingly emphasizes price for performance value. Consequently, we intend to continue our high level of engineering investment, both internally funded and customer supported, to capitalize on expanding market opportunities and to sustain our momentum over the longer term. For example, we are progressing through the development of OEM programs for potential orders of $100 million over the life of these programs, those potential revenues are not reflected in our background. Our current priority is to execute on these programs and to realize their potential. We recognize the need to manage the growth in our revenues in the backlog to create value for our shareholders. Further, we are focused on ensuring that we have the resources to achieve our objectives. As new engineering development programs transition into production, some of the longer-running contracts end. So while we were expecting 30% growth this year, our current plans support growth that means our long term -- that meets our long-term objective at attractive but manageable compound annual growth rate of greater than 20%. Now let me turn it over to Ron Albrecht for more detailed discussion of our financial performance.

Thank you, Geoff. For the 3 months ended March 31, 2013, the company reported its fifth consecutive profitable quarter. For the quarter, revenue was $8.2 million, an increase of 21% compared to $6.8 million in the second quarter of fiscal 2012. Net income increased to $1.1 million or $0.07 per share from $289,000 or $0.02 a share last year. Product revenues for the second quarter increased to $6.8 million or 28% from $5.3 million last year, while engineering development revenues were $1.4 million compared to $1.5 million a year ago. Flat Panel Display sales were $5.1 million or approximately 63% of revenue. Air data product sales were $1.7 million. Gross margins in the second quarter were 48.1%, up from 45.9% a year ago. Margin increase was primarily the result of the period's mix of higher-margin product revenues and lower-margin engineering development revenues, which were approximately 17% of revenue for the quarter compared to 22% last year. Based upon anticipated higher level of engineering development revenues in the second half of this year, we expect the gross margin for the year will be similar to that of fiscal 2012. Total operating expenses for the quarter were $2.7 million, the same level as a year ago. Internally funded research and development was approximately $800,000 for the quarter, down somewhat from the year ago. However, total engineering expenditures, including engineering development, were approximately 30% of revenue for the quarter, slightly higher than the 28% last year. Total engineering spend increased 37% compared to the same period in fiscal 2012. Costs associated with engineering development revenues are recorded in cost of goods sold. Selling, general and administrative expense in the quarter was $1.9 million, a slight increase over the $1.8 million in the second quarter of last year. We do not expect any appreciable increase in overhead this year by our increased growth projections. We reported second quarter operating income of approximately $1.2 million, an improvement of over 300% compared to the second quarter of 2012 operating income of $347,000. For the second quarter, we provided $123,000 for income taxes, and we recognized the full benefit of the retroactive reinstatement by Congress of the research and development tax credit for the year January -- for the period January through September 2012. We anticipate a full year effective tax rate of approximately 24%. Net income for the quarter was $1.1 million or $0.07 a share. For the quarter, operating activities consumed cash of approximately $600,000, this related primarily to timing differences between cash expenditures and receipts on engineering development contracts. The company ended the quarter with $16.3 million of cash on hand and no debt. Cash balance is net of the $25 million special dividend paid to shareholders in December 2012. We expect the timing differences on customer-funded engineering programs will result in a net use of cash from operations this year. We believe that we have more than sufficient cash to fund the operations for the foreseeable future. For the 6 months ended March 31, 2013, revenue increased $3.2 million or 28% over the first 6 months of last year. Net income for the 6 months ended March 31, 2013, was $1.4 million or $0.09 a share compared to a net loss of $54,000 for the first half of the last fiscal year. As Geoff mentioned, based upon our first half results and the current backlog, we expect revenue to grow 30% over last year. We expect net income in a range of $0.18 per share to $0.20 per share. Fiscal 2012 earnings of $0.18 per share included a $0.15 per share nonrecurring benefit related to the reversal of a tax valuation reserve, leaving an underlying earnings per share from operation of $0.03. The anticipated earnings increase reflects the operating leverage that accompanies the increase in revenue. Now I will turn the call over to Shahram Askarpour for further comments on market conditions and our business development efforts. Shahram?

Thank you, Ron, and good morning, everyone. The company's growth strategy is focused on leveraging on core technology to develop new products with features and benefits that meet stringent industry requirements and accommodate foreseeable future regulatory and operating requirements and are cost effective and versatile. Our platforms address the military, commercial air transportation and general aviation markets for both original equipment and retrofit applications. Our strategy is succeeding. As our recent quarters illustrate, we are achieving both near-term revenue and earning targets, while investing in product development and organizational infrastructure either to support our growth objectives over the long term. This year, we anticipate 30% growth in revenue. As we announced at the beginning of this month, Delta Air Lines has awarded IS&S a contract in excess of $60 million to retrofit a fleet of 182 MD 88 and MD 90 aircraft and to upgrade several of the flight simulators with the IS&S avionics suite. The IS&S suite includes an advanced Flight Management System, dual Beta 3 air transport GPS receivers, an integrated standby system and a comprehensive suite of primary flight displays. The IS&S avionics suite will enable the Delta aircraft to improve efficiency, reduce negative environmental impacts and comply with the requirements of the Federal Aviation Administration's next-generation air transportation system. Specially trained IS&S installation teams will remove existing equipment, install the new avionics suite and prepare the aircraft for return to service in less than 6 days. Installation of the enhanced flight deck technology is expected to begin in mid-fiscal 2014 and take several years to complete. This retrofit will provide those aircraft the full required navigational performance, required time of arrival and global positioning system capabilities. As a result, these full-deck aircraft will have operational efficiency and performance characteristics comparable to those of the most modern production aircraft. The MD 88/MD 90 contract, coupled with our previously announced C-130 and L-100 contract is an important endorsement of our strategy to build upon our original cost-reductive platform technology and to develop next-generation Flight Management Systems. This is an effort that we have financed through both internal and external funds over the past 7 years. Our first Flight Management System was developed for the Eclipse E500 aircraft. The technology has been enhanced and extended to enable us to win programs in all 3 of our target market segments: the B-737, MD 88 and MD 90 in the air transport market; the C-130 and the L-100 in the military market; and the Eclipse E500 and E550 in the general aviation market. Including the Delta contract, we received $69 million of new orders in the second quarter. Add it to $16 million of first quarter new orders, we have received $85 million in new orders so far this fiscal year. As a result, backlog has increased to over $90 million at the end of the second quarter, its highest level in several years. Development is progressing on several engineering contracts. The anticipated production of which is not included in backlog for most part. New programs are related to new general aviation aircraft, Eclipse and another as of yet undisclosed manufacturer. Upon completion of the development work, we have sole source production contracts with these manufacturers, representing more than $75 million in additional potential equipment revenues over the life of these programs. Eclipse Aerospace released its initial E550 production order in the first quarter, which is in our backlog, but the anticipated future production is not. Today, we are benefiting from 2 very powerful trends. On one hand, upcoming regulatory that require precision navigation are driving demand for cost-effective state-of-the-art navigation systems. On the other hand, the market has become very price sensitive. As a result, our performance for price value proposition is becoming attractive to customers in all 3 of our market segments. As our product development programs complete and the related transition to production begins, we expect margins to improve. In addition, we expect the addressable market to increase as we add new product and functionality through both internal and customer-funded product development. At this juncture, our primary focus is the successful execution of programs in hand, coupled with the required effort to win the additional programs that help sustain our rapid growth. We are continuously evaluating our organization to ensure that we have the appropriate resources to execute our strategy. We feel well prepared to continue to uphold the IS&S reputation for high-quality and state-of-the-art products. I would now like to turn the call back to Geoff.

Thanks, Shahram. On February 13, Innovative Solutions & Support celebrated its 25th anniversary. We are pleased to have served a broad array of aerospace customers with increasingly sophisticated and technically advanced products. From our original standalone CRT and air data instruments, IS&S has evolved into a full-fledged cockpit and avionics integrator of flight management systems, GPS, global positioning systems, synthetic vision and other advanced systems. We are in an important growth -- I'm sorry, at an important point in our growth and we remain committed to the strategies that have led to our success: state-of-the-art products; high-performance to cost proposition and high investment in research and development; low-cost production techniques; the hiring and nurture of talented employees; and Innovative Solutions & Support. We are developing a strong and growing backlog that we hope will result in a more predictable revenue and profit growth in the future. Present $90 million-plus backlog will deliver over several years, and coupled with normal new orders, should provide a sustainable, a growing revenue stream during that period. Today, I am pleased and excited about the prospects of the company because the market has become receptive to the value proposition that our new NextGen products offer. Consequently, we have raised our revenue growth and profit expectations for fiscal '13. During the first fiscal quarter, we paid a special dividend of $25 million to our shareholders. We believe these actions convey our commitment to creating value for our shareholders. Operator, would you please open the call for questions?

[Operator Instructions] And our first question will come from David Campbell of Thompson, Davis & Co. David P. Campbell - Thompson, Davis & Company: I guess I have sort of a general question. Aviation's Week & Space Technology published this week several reports about NextGen aircraft and cockpit update -- upgrades and had managed to exclude any talk of IS&S, which has the only contract I know about with a commercial airline for retrofitting to NextGen avionics. So -- and then they also suggested that the other airlines won't do this because they're not sure what the FAA requirements will be. Is it possible that Delta will find that your equipment doesn't meet these requirements and therefore not go ahead with it? What is going on with the -- in the 7,000 aircraft supposedly need this equipment?

I think, first of all, the answer to -- we believe that Delta will find that they don't need it, the answer is no. They've spent a great deal of time analyzing their requirements over the last 3 years. We've been talking to them for 3 years. They absolutely know what they need. This modification transforms the aircraft in many respects, but most importantly, allows it to fly and execute required navigational performance approaches, which allow them to significantly increase operations out of high-density airports. And they believe that this program will pay for itself in a matter of a few years. So that's number one. Do I believe that other airlines need that? Well, Europe is requiring -- required navigational performance and they require -- and they're going to require ADS-B in the United States. So all of these things are coming. I think the reason that a lot of people aren't doing much is that as you all know, the economy has been more than uncertain for the last several years. And they are -- the airlines are, for the first time, starting to make a little bit of money, and they're going to be very cautious with their moves. Delta did a lot of long-term research over a significant period of time on how they were going to satisfy the market, and we're prepared to move and move relatively quickly. As far as -- not being mentioned in Aviation Week, that may have something to do that we don't advertise a lot in that. But I can only tell you that we've been trying to focus on the people that pay us for the equipment. And I'm sure you'll find that there's been a significant number of articles being written on the program. And probably significantly, the fact that we are going to do the actual installation in record time and in a fraction of the time that our competitors take to install the same equipment. David P. Campbell - Thompson, Davis & Company: Well, one of these articles also said that this company is providing funding NEXA, whatever it is, NEXA, something or other. And that's the capital part in providing funding, and that they're talking with 3 airlines, including very one large carrier to announce this NextGen installation this year. Is that you? Or you can't -- or don't you want to say or is it not you?

I can't comment on it. David P. Campbell - Thompson, Davis & Company: But do you agree with this 6,000 to 7,000 aircraft market? That's a $3.8 billion market.

Well, it depends how much you charge. I think the basics that we talked about earlier are still valid. First of all, we have a proven solution that we've flown and that is -- offers incredible performance versus price ratios, 2x to 3x better in many cases than our competitor. Clearly, people -- if the market and the market demand is anything like $3 billion to $5 billion, we're going to be very interested in saving whatever percent they can. So we feel reasonably confident, in fact, very confident, that we have a very strong place in the marketplace, and we don't intend to -- we would be more than fortunate to get even a small percentage of that. About 1/3 of it would be $1 billion, so we will be happy. We think it's a big enough market and it's going to have to be served by a number of people. And there's people in the market that can provide solutions, in some cases, that are maybe necessary. Do I think it's -- do I think the total market is there? Yes. And they will probably take 10 years to be fully realized. David P. Campbell - Thompson, Davis & Company: According to this report, it won't take long, that long, because the FAA is going to require this work to be done during -- long before the deadline as aircraft go up for major maintenance. And that seems to me Southwest...

All I know is we're the only people that are retrofitting 184 airplanes. So other than that, I can't comment on what Aviation Week is saying. I really don't know what to say. I can only tell you what I think. And that's our perspective, and frankly, I'm not going to worry about what the periodicals say. I think I'm going to try to focus on executing the programs that we have. We're very fortunate, frankly, to be doing -- working with an airline like Delta. It's an industry standard in every sense of the word, and we're incredibly fortunate to be working on such a significant program with them. So we think it's going to be a real success. And so far, so good. So I don't know it. I'm not good enough to tell you exactly what's going to happen, I really can't comment on Aviation Week's conclusions.

The next question comes from Robert Sussman of Bentley Capital.

So what you've just indicated is that over the next 10 years, you think this is a $3 billion market?

Every time I've seen a projection of how big the market is, I hear it's been wrong. I'll give you an example. The C-130 AMP program was defined as a $7 billion to $10 billion product market. You know the announcements have been made over the last several years where it eroded to a $2 billion market to a $650 million market. And now they try to push it down to a $200 million market, so it's hard for me to tell you. I don't know how big it is. I'll tell you one thing, we're going to have -- our focus is to try to come up with a really cost-effective solution, and I think that's one of the reasons we were selected. If we can keep doing that, you would take the equipment we make for the MD 88, and some portion of that is applicable to the total market. But everybody who has projected the market, I think, tends to overestimate. Because a market that big, people that win it are the people that get very aggressive in their innovation and their technology to come up with cost-effective solutions. The market ends up being probably less than people talk about. Traditionally, if the press writes about it, there's no interest in a $3 billion market, but there's great interest if you can call it a $10 billion market. So other than that, I can't -- I can only tell you that what we've done, and that is probably a reasonable model for air -- other customers or potential customers for us.

Is what you're saying that even aside from the FAA regulations that what Delta's doing would be economically beneficial anyway, whether there were regulations or not from fuel and other savings such that it's a compelling financial decision?

This decision was not based by Delta, my understanding. It was not based on their immediate need to comply with an FAA regulation in any sense. They did it purely on an economic analysis. Two points: this equipment, they expect will save something in the order of 80 million pounds of carbon dioxide a year, so they have some sensitivity to the environment, obviously; secondly, they believe it'll increase their efficiency of their aircraft deployment and thereby save them a hell of a lot of money, both in fuel and utilization of the aircraft. And it was based on those analyses which they expect at least 3 and maybe 5 years working on. So they did it for the economic reasons, and maybe they're -- since responsibility to the environment, but clearly justified on economic terms and totally independent of regulations.

And are the FAA regulations well enough formed that airlines can come to a conclusion as to whether your equipment will meet the requirements or is it just too early now?

Well, I mean, it's our opinion that we'd meet the requirements. We have number -- we have -- we've been flying the Flight Management System for a couple of years now, ran exhaustive tests in commercial air transport simulations and live simulators to prove its performance. Performance has been more than adequate, meets the requirements as we see it. Our GPS receivers, our high-precision GPS receivers work great. So yes, we believe we -- I mean, they can change the regulation, but I can't imagine to keep doing that.

Okay. And my last question is what -- assuming that the market does really open up and become quite large, what is and what kind of capacity can you put together to handle this business? And how labor-intensive is it?

Well, it's not labor-intensive. And let me put it this way, the last time I said no, I didn't understand the question. So we will accommodate, we can and will accommodate any increases that could possibly occur. It is not labor intensive. Historically, our labor content by engineering design is a very small portion of our manufacturing cost. And we do that so that we can -- this company was initially founded to do retrofits. And the retrofit market requires you to adjust your capacity and on very short notice. In the past, we've literally doubled production rates month-over-month and responded to huge demands very, very quickly. And you do that by designing a product that has a relatively low labor content because you can't go out and find 400 people to increase your labor force overnight. So that's why you design the way you do...

Let me ask one question. Is the key to the product hardware or software or both?

We do everything. We even paint in-house. We do -- we have $1 million worth of print circuit board, pick-and-place fabrication equipment, the latest technology in surface mount technology in-house, so that we can depend on the source. We outsource and maintain outsources to support production, but we have full capability in-house to support any prohibitions in the supply chain. And we've always done that because that's the only way you can operate, because we can't afford. When you outsource, you don't get rid of the problem, you just move into someplace else. So you better be prepared to respond to any problem, and that's how the structure of the company is.

[Operator Instructions] I'm showing no more questions. This concludes our conference for today. Thank you for attending today's presentation. You may now disconnect.