Innovative Aerosystems, Inc. (ISSC) Q3 2013 Earnings Report, Transcript and Summary

Good morning, and welcome to the Innovative Solutions & Support Third 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. Geoffrey Hedrick, Chairman and Chief Executive. Please go ahead, sir.

Thank you, and good morning. This is Geoff Hedrick, Chairman and CEO of Innovative Solutions & Support. I would like to welcome you this morning to our conference call to discuss the third 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'd 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 company's 10-K, which is on file with the SEC. I'll turn the call back to Geoff.

Thanks, Ron. In the third quarter, we reported earnings -- revenues of $8.8 million, up 43% from 1 year ago, and net income of $307,000, or $0.02 a share, an increase over 1 year ago of earnings of $260,000, which was also $0.02 a share. The profit for the quarter was impacted by a $0.03-per-share nonrecurring human resources legal matter. In addition, we have increased our level of investment in product development by 70%. We expect this investment in both core technologies and new flight management and NextGen air-traffic-control products to generate excellent returns going forward. We booked $10 million in new orders in Q3 and have booked close to $70 million in orders in the first half of this fiscal year. The release backlog grew to $91 million net of the 43% shipment growth. The backlog does not include an approximate equal amount in long-term potential unreleased sole-source OEM business. Our newest product family is an open-architecture utility management system. This advanced system manages a wide variety of aircraft systems with an array of user-programmable analog and digital interfaces. The initial order for this system is for the revolutionary and recently-announced Pilatus PC-24 twin business jet aircraft. This system saves weight, helping the PC-24 achieve unparalleled operating performance. This UMS adds an additional performance-enhancing feature to our integrated pilots information portal system. Our display system has evolved into an integrated cockpit with dual flight management computer altitude -- Attitude and Heading Reference Systems, RVSM air data systems, auto throttle and open-architecture radios. This unique open architecture allows us to offer the customer a variety of NavCom equipment from several manufacturers. In retrofit application, this flexibility can allow the reuse of existing equipment to lower the cost of the retrofit system. Our systems, like the one for Delta, the recently-awarded by Delta contract, offered -- offers a mature fleet navigation and display technology equivalent to the latest generation of aircraft. These systems are designed to provide full compliance to the next generation regulations well into the next decade. Historically, our products have offered excellent value proposition, and in a market that has become highly price-sensitive, our price-for-performance value proposition has proven to be increasingly appealing. Consequently, we have increased our engineering investment on internally-funded customer-funded -- and customer-funded projects, with the objective of capturing a greater share of an addressable market, which is increasing as our portfolio grows. We are optimistic that the products and solutions which we offer presently and which we are developing for the future will find increasing customer acceptance. In the immediate future, we are making an effort to strengthen our organization to ensure that we have the resources to complete development and fulfill production schedules of the programs in our backlog. The challenges attendant to our rapid growth and an unusual number of low-margin engineering development talents -- contracts constrain profits in the short-term. Our objective is to complete these engineering development programs expeditiously so we can transition into production phases, where we believe the profitability and margin percentages will improve. For the year, we expect the revenues to grow by 30% over fiscal 2012. In the longer-term, we expect the current development program and investments, coupled with higher backlog for our product, will deliver an attractive but manageable compound annual double-digit growth rate. Now let me turn this over to Ron for a more detailed discussion of our financial performance. Ron?

Thank you, Geoff. For the 3 months ended June 30, 2013, the company reported its sixth consecutive profitable quarter. For the quarter, revenue was $8.8 million, an increase of 43% from $6.1 million in the third quarter of 2012. Net income for the quarter was $307,000, up from $260,000 for the same quarter last year. Earnings per share were $0.02 per share in both years. Profit for the quarter is net of a nonrecurring charge for a previously-disclosed human resources legal matter of $640,000 pretax, or $0.03 per share, and reflects also a higher level of revenue from low-margin engineering development contracts. Total product sales for the third quarter were $6.4 million, of which $6 million, or 93%, were flat panel display sales, and of which $400,000, or 7%, were air data product sales. Compared to last year, product sales increased 53%, while engineering development contract revenue of $2.4 million for the quarter increased 22% from 1 year ago. Gross margins in the third quarter were 39.3%, down 3.3 percentage points from 1 year ago, reflecting the increase in engineering development contract revenues that Geoff discussed previously. Although we had a higher proportion of revenue from engineering development contracts in the third quarter of 2012, i.e. 31% of revenues last year compared to 21% of revenues in this quarter, aggregate profitability from the engineering contracts this quarter was lower than the third quarter of last year, because 2012 included the disproportionate impact of a high-margin contract, and 2013 included the impact of revenue adjustments resulting from some projected cost growth in 2 of these programs. We believe that the longer-term profitability of these programs, as they begin production, will more than compensate for the current pressure on margins. Total operating revenues for the quarter were $3.2 million, which included the provision for the nonrecurring legal matter of $640,000. Internally-funded research and development was approximately $559,000 for the quarter, less than the last 2 quarters. However, with the inclusion of the spending in support of the engineering development contracts, total engineering spend was approximately 35% of revenue for the quarter. General and administrative expense in the quarter, excluding the impact of the provision for the nonrecurring legal matter, was $2 million, an increase of $116,000 from the second quarter of last year. Despite the revenue growth this year, we do not expect an appreciable increase in the underlying level of general and administrative expense. We reported third quarter operating income of approximately $286,000, down from the third quarter 2012 operating income of $355,000. For the third quarter, we had a tax benefit of $9,000, which adjusted the year-to-date tax provision to reflect the forecast tax rate for the year. We anticipate a full year effective tax rate in the range of 15% to 16%. For the quarter, we generated cash from operating activities of approximately $670,000, and we ended the quarter with $16.6 million of cash on hand and no debt. Compared to the beginning of the fiscal year, the cash balance was reduced by the $25 million special cash dividend paid to shareholders in December of 2012. While timing differences on cash payments and receipts on customer-funded engineering programs is expected to result in a net use of cash from operations this year, we believe that we have sufficient cash to fund operations for the foreseeable future. For the 9 months ended June 30, 2013, revenue increased 33% to $23.5 million, compared to the first 9 months of last year. Net income for the 9 months ended June 30, 2013, was $1,732,000, or $0.10 a share, compared to net income of $206,000, or $0.01 per share for the first 9 months of last fiscal year. For the first 9 months of the fiscal year, we used cash of $1.6 million to fund operations, primarily because of the previously-mentioned timing differences between cash expenditures and receipts on engineering development contracts. Based on our 2013 results-to-date and current backlog, we expect to grow revenue by approximately 30% over last year. Largely as a result of the aforementioned legal matter, we expect earnings to be somewhat below the range of $0.18 to $0.20 that we have forecasted in our second quarter earnings release and earnings call. Fiscal 2012 earnings of $0.18 per share included $0.15 per share of nonrecurring tax benefit related to the reversal of a tax valuation allowance, leaving an underlying earnings per share from operations for 2012 of $0.03. Now I'll 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 our core technology to develop new products, which provide both cost-effective and versatile solutions to improving aircraft performance. Our products are designed to meet stringent industry requirements and accommodate foreseeable future regulatory and operating requirements in the military, commercial air transportation and general aviation markets. 10 years ago, we certified our first flat-panel Primary Flight Display system. This technology has been fielded on a large number of aircraft in all our market segments. Over the past 10 years, we have made significant investments in product development that has resulted in patented technologies with novel functionality and capability. We now have an array of solutions that address both original equipment and retrofit applications in all of our markets. These solutions include groundbreaking product lines with NextGen capabilities. The company has achieved strong current revenue growth and a significant increase in backlog over the past few quarters. This near-term revenue growth, coupled with the award of several product development contracts, reflect our success in achieving our long-term growth plan of over 20% per year. The product development contracts are based upon our historical price-for-performance value proposition. Our strategy is proving to be successful in a market that has become more price sensitive. Our expanding product portfolio is built upon common components and low labor content to assure highest quality at the lowest cost. Our goal is to capitalize on this strong position in order to sustain top and bottom line growth over the longer term. An example of our growing market share is recently announced development and sole source production contract to provide a Utility Management System, or UMS, for the new Pilatus PC-24 business jet. The IS&S UMS integrates multiple aircraft functions formerly supported by dozens of controllers and monitors. The UMS 24 monitors and controls aircraft sensors and systems. Our open-architecture design allows Pilatus to modify, in-house, the control and monitoring algorithms. The IS&S UMS provides integrated control of systems from within the aircraft avionics suite and facilitates the automation of various normal and emergency functions to reduce crew workload and improve safety conditions. It provides for control and monitoring of aircraft functions such as navigation, auto-flight, landing gear, surface positions, fire protection, ice/rain protection, electrical loads, lighting, environmental conditions, cabin pressurization and oxygen systems. When considered along with the recently-awarded Delta MD 88, MD 90 program, this contract for a signature Pilatus aviation aircraft further validates our strategy of building upon our original cost-effective technology and developing novel products such as Next Generation Flight Management. As Geoff mentioned, the UMS 100 provides us with a complete aircraft avionics suite. Longer-term, this product line has potential applications beyond the Pilatus platform. Including the nearly $10 million of new orders received in the third quarter, backlog has increased to $91 million at the end of the third quarter, up sequentially from the second quarter, and has increased nearly fivefold in this fiscal year. At today's revenue levels, the current backlog represents approximately 3 years of revenue. Backed by our repeat business, it provides the basis for our target long-term annual growth of 20% or more. The product development contracts with Eclipse, Delta, Boeing, iAccess and Pilatus are all progressing. Both Delta and Pilatus are in relatively early stages of development. With respect to the Eclipse program, we are working with our customer and the FAA on the certification of the aircraft. We are in the final qualification phase of our aerial refueling operator control display unit, or AROCDU, for the Boeing KC 468 tanker program, and qualified units are scheduled to deliver to Boeing this quarter. The iAccess Foreign Military C-130 program development is also progressing well, and we anticipate product deliveries for initial aircraft integration this calendar year. When we complete development on these programs, we will have sole-source production with each of these customers. The production phases of the Eclipse, Boeing and Pilatus programs represent potential equipment revenues over the lives of these programs similar to the level of our current backlog. Beyond the initial production releases from Boeing, Eclipse and Pilatus, we do not include the expected production from these programs in our backlog. We expect our operating margins to improve as these programs enter production. In order to support our anticipated revenue increases, we are strengthening our organization, including new hires in engineering, operations and program management. As new employees are trained and become more productive, we expect that we will begin to achieve efficiencies, which will enhance our price-for-value strategy. In summary, the third quarter result is consistent with our plan to maintain steady growth and keep a pace to achieve the financial objectives that we set for this year, excluding the nonrecurring item mentioned earlier. At the same time, we continue to invest in the organization to ensure that we have the appropriate resources to execute our strategy and to maintain our reputation for high-quality state-of-the-art products. With this investment in the organization, we are strengthening and preparing the organization to capitalize on the opportunity to sustain our growth over the long-term. I would now like to turn the call back to Geoff.

Thanks, Shahram. The airlines are starting to make money after a long period of weak profitability because of the troubled economy. And we are seeing them to begin to invest in their fleets. However, unlike previous industry recoveries, owners and operators are placing increased emphasis on price for performance in choosing their vendors. From our perspective, their approach coincides with our philosophy for cost-effective solutions and improve -- that improve aircraft performance. Today, we have a breadth of products that provide entries into large markets, both OEM and retrofit, in all 3 of our served markets: general aviation, commercial air transport and military. These are exciting times. We have been fortunate to have customers willing to share in the development cost of new products. This revenue was intended only to mitigate the cost of the development, and not generate the high margins that our production does. This has allowed us to heavily invest in the future. We are focused on executing programs in hand. With the successful additions of these products to our present offerings, we believe we can create opportunity across our markets that will enable us to sustain attractive revenue, cash flow and earnings growth over the long-term and build value for our shareholders. Operator, can you please turn it over for questions?

[Operator Instructions] Our question is from David Campbell with Thompson, Davis and Company. David P. Campbell - Thompson, Davis & Company: My first question relates to the Aviation Week report from July 29, talking about the NextGen debate in Congress and the possibility of not funding that program by the FAA. I'm a little confused because it's the aircraft that has to be reequipped with the avionics like you are offering. What does that FAA got to do with it? Is this critical to your business?

Well, 2 things. First of all, a number of people in the industry, a large -- among them, the large, traditional suppliers of avionics systems, who have hoped and expected to get some support from the federal government in their invested cost to build the next generation equipment. We don't expect any of that from the government. We have proceeded completely with self-funding. Secondly, I think you have to be careful of looking sort of at a -- these articles that come along. I mean, I could comment that if they don't do something with the aircraft control system, that in 2020, we're -- you're not going to be able to put anymore airplanes in and out of airports, you'll get 4- or 5-hour delays. So I mean, it's absolutely necessary. If you look alone at this, the demand for new aircraft and the existing ones that are flying, we're expanding the fleet all the time. So it's absolutely imperative that we come up with this improved air traffic control system. I think what's going to happen is that the suppliers, all of us, are going to find a lot more cost-effective solutions to the problems. And as the technology improves, it will make it easier and easier to implement the so-called next-generation air traffic control system. Most of what we're doing today, that we're doing on MD 88, MD 90, deals with all -- virtually every aspect of the next-generation future air traffic control system, CPDLC, automatic communications, those kinds of things. So that's available now, and Delta is going to be putting it on their airplanes. So I'm not pessimistic, I'm very optimistic. And we believe there's going to be a big market out there and we're booking backlog right now for that market. David P. Campbell - Thompson, Davis & Company: So the answer -- it doesn't depend on the FAA -- your orders, your potential business, doesn't depend on the FAA funding?

Well, the -- mind it[ph] , but the FAA wants to change some of the airports and put in equipment that will replace the existing instrument landing system with as-fast[ph] and new systems. The cost of that equipment probably drops by 30% a year. So what we may see as a difficult problem for the government today, will probably -- and those are things that the government would reasonably do at airports -- will, I think, become significantly less difficult in the future. Well, the summary is that we're talking about NextGen going at the end of this decade. I -- this is a little blip and I wouldn't overreact to it. I don't see it being impacted, and even if it were to impact this year, certainly, I can't imagine, on the long-term, it having any kind of impact, negative-wise. And if you're asking me to project the economy, I can't do that. David P. Campbell - Thompson, Davis & Company: The $10 million in new orders in the last quarter, is that from existing, is that part of the backlog? What is that? Is it the combination of air data and other new business?

It actually is a combination of the -- some of our C-130 products, as we sold to other segments of the U.S. Military, as well as some air data products. David P. Campbell - Thompson, Davis & Company: Okay. And why is it that none of the $90 million -- not $90 million, but why is it that none of the -- well, you did say $90 million of potential business in the backlog, potential business that's not in the backlog, why is it not in the backlog? Is this too far out?

No. We don't have released orders. As you know, we only post orders that have specific delivery schedules against them. OEM orders, like whether they come from Boeing or Airbus or anybody, they give you -- even though you may be on the airplane for the next 20 years, you only have an order for the first year. So all of these OEM orders are incremental, dealing[ph] orders. And we don't show the opportunity in the future, we only show the order that has a delivery schedule associated, practically, with this next year. David P. Campbell - Thompson, Davis & Company: And speaking of Delta. Delta, you included all of it, even though it's...

Well, it's got a specific schedule of delivery of every single piece of equipment over the next 3 years, specific. We don't have that with OEM. OEM doesn't say -- well, the OEM says, "We think we're going to build another 800 airplanes, and you'll be on the airplane if you don't screw up, and here's the order for the next year." That's how they work. Now in Delta's case, they gave us an order for the fleet for a specific number of aircraft.

That meet all the requirements with contractors.

And as Ron points out, meets the GAAP required for an aircraft, for a contract.

All the legal requirements for a contract.

Yes. David P. Campbell - Thompson, Davis & Company: Okay. And this 30% increase in revenues this year -- or 20%, I guess, I can't remember, 20%.

30%. David P. Campbell - Thompson, Davis & Company: 30%, means that the your revenues in the fourth quarter would be comparable to or less than the third quarter? Is that the way you're looking at it right now?

It will be comparable to this third quarter, that's correct. David P. Campbell - Thompson, Davis & Company: And why is there no growth, given the fact that that's a...

By the way, there is growth. Because if you annualize $8.8 million, you will find out it's about $37 million a year, which is 50% or 80% higher than the previous year and still higher than this. So if you take that and extrapolate a line, and it keeps moving, you'll end up with what we believe is going to be the revenue for next year. It's a straight line, right? David P. Campbell - Thompson, Davis & Company: Right. Well, yes, I understand that. But that's year-to-year, there's no sequential revenue growth.

If you take a look at it, we will close for the first time, close the year at a rate which is pretty close to what the average rate is going to be for next year. Though it's slightly smaller, it will start off the year at a rate of about $37 million, and actually, I think, a bit more, more like $38 million, and will finish off probably in the 40s, to give us -- projecting what we talked about in the past. So essentially, very much on target. It just doesn't look that way because we did very well this past quarter.

This concludes our question-and-answer session. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.