Innovative Solutions and Support Inc (ISSC) 2004 Q3 法說會逐字稿

Good morning and welcome to your Innovative Solutions and Support third quarter earnings conference call. At this time, all participants have been placed in a listen only mode and the floor will be opened for questions following the presentation. It is now my pleasure to turn the floor over to your host, Jeffrey Hedrick. So, you may begin.

Good morning, I'm Jeffrey Hedrick, Chairman and Chief Executive of Innovative Solutions and Support, and with me this morning is Jim Riley our CFO, Roman Pitkowski, our President and Jeff Bonham our controller. We have some -- I'm sure most of you have seen some great news. I'm delighted at our performance.

The business has done exceptionally well and we continue to see a very impressive future. Before we get started, I'd like Jim to readout safe harbor message. Go ahead, Jim.

Thanks Jeff, and thanks everybody for being on the call. Certain matters discussed in this conference call, including operating and financial results for future periods, are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially, either better or worse from those discussed, including other risks and uncertainties reflected in the Company's prospectus and 10k on file with the SEC. Thank you, and Jeff, back to you.

Thanks Jim. It really was a wonderful quarter. We virtually -- in every parameter, we set a new record. Sales of $12.3 million for the quarter. Exceptional gross margins, record income of $3.3 million, and 27 cents a share, almost $28 million backlog, and notably 94% of that is commercial and about 6% military, which is almost a complete flip-flop from two years ago.

It speaks to one of the really -- real strengths of the business, and that is our ability to create a product that's applicable to both military and commercial markets, and for the business itself to swing from military to commercial seamlessly. That agility, and that unique ability is really a cornerstone of our ability to grow at the rates that we have.

Again, the cash generation was wonderful. We have an incredible balance sheet, with almost $5.00 a share, or most $60 million, with total assets of almost $80 million, and the shareholders equity, obviously, increases. So to make money, generate cash, everything looks good.

The strong accomplishments of the quarter included the painting TSO on our flat-panel. That is significant and a real breakthrough, and team understanding, it's the only large format flat-panel system in the world to be TSO with no limitations for Part 25 applications. Part 25 is a more stringent requirement for commercial air transport or airline application, as opposed to a more traditional Part 23, which is for business jets and not nearly as stringent.

One of the interesting things is as we watched the business virtually double year over year in sales and profits, the organization didn't run around like one-armed paperhangers. We were delighted that the business absorbed it, and I believe could have absorbed substantially more than that.

So we continue to see that the hard work we've spent the last three or four years, creating a strong management team and a strong product line, is paying off.

So without any ado, I will turn it over to questions.

Thank you sir. The floor is now opened for questions. If you do have a question, you may press "*" followed by "1" on your touchtone phones at this time. If at any point your question is answered, you may remove yourself from the queue by pressing the pound key. Questions will be taken in the order they are received, and we do ask that, while posing your questions, you pick up the handset to provide optimum sound quality. Once again, ladies and gentlemen, to register your questions, you may press "*" followed by "1" on your touchtone phones at this time.

Our first question will be coming from Chris Versace of SBR.

Good morning gentlemen. Congratulations on the quarter.

Thank you very much.

Just two questions. The first would be with the record backlog, can you just kind of describe the burn rate of that backlog, particularly the release backlog in the coming, you know, two, three, four quarters?

Substantially in Q4 and Q1. Next six months roughly.

OK. And then I noticed you know that you quickly escaped giving any kind of guidance, Jeff. Are we going to continue with that ...

I think it's appropriate, and I think it's difficult to give guidance when we're still in a very very rapid growth rate.

OK.

I can you know confidently tell you that we are still -- we are geared for you know good -- good being more than 10% double-digit growth rate, and that's what we see both in earnings and in revenue. We're building the top line now and I believe we will continue to make major investments. Since we're making record profits, investing in engineering is one of the finest returns.

If you look at the investments we've made in engineering over the last several years, is paying off in a very very big way and we're going to continue to do that.

Yes. That actually is my next question, which if you look on the op ex, you know, particularly the breakdown between SG&A and R&D, it kind of flip-flop from where it's been for the last couple of quarters. Is this something we should think about going forward, these kinds of rates or levels I should say?

We've sought in terms generally of 12% of sales engineering, and you know we've discussed that as you know sort of, we would prefer not to go below 10 over an average of a one-year period, and above 12 to 15 often it is diminishing returns. I would, depending on the level of profits we generate, I would be inclined to invest more money in engineering as a percent of sales.

Right, and it looks like you did that this quarter. I mean you were right around 17%. Is a lot of that going for the -- now that you have the TSO done, is a lot of that ...

No, no and I understand that. What I'm saying is I intend - 12% was. I would expect to go above 12%. The 17% was the TSO effort. We had a massive amount of B&B, as you know, and an unusually high -- I'm getting a note here. Unusually high expenditure in engineering, and a lot of that was -- a good portion of it was consultants during the B&B cycle.

OK. And let me just ask one more than I'll bow out for other people, that level, that -- you know, whether it's $2.1 million, 17%, I understand it was -- you know, you had a lot of extra people in there, but you also have the STC in front of you ...

Hey Chris, this is Jim. Let me interrupt for just a second.

Sure.

I think the $2.1 million you're referring to is the SG&A line.

Oh, I might have -- there's a chance I flip-flopped on the math.

Yes.

But either way then, I mean it sounds like with what's going on, I'm just wondering on the R&D line, are we going to -- or sorry, on the op ex line, let me rephrase, are we going to continue to see it running you know kind of the level sits at? Because we have STC work to do. Or is it looked like, you know, now with the big push you just mentioned, for the TSO behind us, it might trend down a little bit.

Well, let me say, there could be a number of onetime expenses that we could potentially capitalize over a 100-chipset order or something like that, but in general, we think there will be some significant investments for STCs, as you know, on airplane types. And those -- if our profitability permits, I would tend to take a conservative line and expense in the period.

OK, all right.

So that would force that number up. It's probably -- it's a discretion to do it one way or the other, but unless we have a good compelling reason to capitalize it, we would tend to expense it. And if we do, those onetime charges would look like period blips.

OK, thank you.

Sure.

Our next question will be coming from Jason Allen of Atlanta Equity.

Hey, congratulations on a great quarter. I wanted to ask you in terms of the flat-panel display product, can you give us a sense for you are with the sales effort of that products? I mean how far along are you in, you know, discussions with potential customers? When do you think we'll start to see some sort of meaningful sales level from that product?

We're quite far along on the number of areas, and we expect meaningful production to occur next year. But we do plan to have orders in place and potential shipments before the end of the calendar year that has not changed. In fact, if -- you know, it may be more probable now.

Recognize that the way it faced now, it looks very promising to -- we've discussed this for a long time, that as the air data business settles to a more normal level over the huge demand that has occurred maybe in the last -- that will occur in the last -- next couple of months, the flat-panel business looks to be may be starting to come in just about at an ideal point. So we're really pretty optimistic. We had an enormous amount of interest at the Farnborough Air show, and you know, we've got universal industry accolades and interest as a result of our TSO.

How significant was achieving the TSO in terms of sales effort? Our customers sort of sitting back to -- you know, waiting to see that you receive that before they make any commitments or is that just another step along the process?

It was pretty significant. It was significant because the design and architecture of this flat-panel system is unique, in that we can -- it has performance levels that are unequaled in the industry in most cases of order of magnitude, more powerful than anything available. But most importantly, our patented operating system allows us to reconfigure it and adapt it to a broad range of applications very easily. And the FAA's review -- detailed review and flight -- both flight test and ground test, and approval, was significant.

And so I think for our customers, our customers are all very impressed because in most cases not our competitors even have that that have been working on it for a great deal longer period. And additionally, although ISNS (ph) is now becoming well recognized, but compared to some of our larger competitors who are well-known, customers assume that they will get the appropriate approvals from the FAA because they have done this before. In our case this was basically a first test.

Yes, it was very important and, yes, we hope that this will allow us to develop our new orders more rapidly. Additionally, the industry generally -- commercial industry is recovering and we see the military business starting to get strong. So I mean general business looks good, as well as our credibility with our customers. We had a number of people who came over to us at the show because they saw ads about our TSO, and complimented us, including a number of our competitors. The simple answer is yes it is important.

Can you tell us if there's anything in the backlog figure that you reported for the flat-panel display product?

Yes, there is.

There is? OK. And then last question is have you recognize any revenue yet? I presume you haven't, but if you haven't, when do you think you'll recognize any revenue from the military customers that have already sort of signed on fully flat-panel display product in terms of the Air Force global transport tanker program and the Navy landing craft program?

We've already recognized a small amount of $1 million.

OK.

And that program's going on well. Our customer's happy and we hope to get some more in that area. It's interesting, we see -- some years ago, we projected that there would be a significant transaction to flat-panels. In the last couple of years, during our development, we were able to significantly lower the price point, size, and power consumption, so that now it makes it an ideal and an easy alternative, desirable alternative to the existing flight deck that are out there. Some even electronic display flight deck.

Great, thank you very much.

You're welcome.

As a reminder ladies and gentlemen, to register your questions, that's star followed by one on your touchtone phones. Our next question will be coming from Fellman Acule of Stesil Nicholas.

Good morning. Congratulations on a nice quarter.

Thank you.

Can you talk a little bit about -- the military budget I guess -- or I guess if you can talk about the tanker program in general for Boeing and all the controversy that's going on, where do you see that in terms of, you know, potential of you getting on that, and in the other half of that, is I guess there was $100 million in the budget for modifying existing tankers or, you know, some are at the disposal for the KC-135 I believe. If you can talk a little bit about that also.

Two things, the GTTA tanker program is moving along. Boeing, as you know, is funding it, as well as having a couple of customers -- the Japanese and the Italian -- and so Boeing continues to be very optimistic.

The work that we're doing on the program would be applicable as an example to the KC-135, which is also a Boeing airplane. And they did a -- Boeing came up and was charged to select an RVSM solution, selecting us by the way, so that certainly an opportunity on KC-135. You know, I still think that they're going to have to put money into the KC-135 because even with the new tanker program, that's 10 years away, and the existing KC-135s are still going to have to be flying. So we see opportunities, significant opportunities, in that area, especially with the work that we've done on the 6-7 tanker.

All right, thank you.

Thank you Fellman.

How next question comes from Mark Rosa of Thompson Davis.

Hey guys. Good morning.

Good morning Mark.

My first question, was there anything unusual about the tax rate in the quarter?

Just a little bit, Mark. We recorded another benefit from our research and development tax credit that usually happens around the third quarter.

OK, so what should be the normal rate that we should use going forward?

Well, the normal rate probably going forward's going to be a little bit higher because our income is increased significantly. I would say it's probably going to be north of 35%, Mark.

OK. And could you tell me what your cash from operations was in the quarter?

Yes, it was -- for the quarter, it was $6 mil, is that right?

Cash from operations ...

Oh, cash from ...

$4.7 mil.

$4.7 from operations, and year-to-date, it's $9.1.

OK. And had a couple more questions about the R&D. Is it being spent mostly on these contracts for flat panels that are in the backlog that you mentioned earlier?

I mean I don't -- mostly for sure, but we -- the nice part about the contracts is the work on the contracts is work that tends to have a foundation for other programs. So it is mostly for contract -- for -- you know, for existing contracts, but we have some forward-looking generic development work that's looking very good at this point.

So some of this money being spent isn't currently producing revenues, but it will or could at the end of the year?

Well, not necessarily the end of the year, but I mean we have some portion that's pure R&D -- IR&D -- which is enabling technologies and things like that. And that would maybe generate revenues a year from now and probably not much more than two years from now and as soon as maybe six months from now. But it's usually enabling technology - fundamental technology applicable to displays, let's say. Graphics generation is broadly applicable.

One of the things you may notice -- they had Congressional hearings this week on whether they will be putting -- whether it makes sense to put cameras in the cabins and whether to make it mandatory. One of the things our system uniquely does is it's capable of taking a simple NTSC or RS170 video feed and display it on the primary flat panel.

And because of our patented architecture, we can do that without compromising the integrity of the primary flight displays. So I mean it'll be those kinds of things which will, we hope, accelerate some of the demand for our product.

Is the ability to have that video feed something unique to your flat panels?

It's certainly unique to the panels that are put in. It's not only -- it's not just simply putting it up. If you put it on a primary flight display, the traditional approaches -- the traditional approach -- approaches used today have a possibility of compromising the integrity of the primary flight systems, and therefore, the FAA has been reluctant - and I think in every case, refused to allow that to happen -- to actually be put on a primary flight display, which leaves the operators to put another display off on the side somewhere so that they can look at that information.

With our system, you can put it right on. Just touch a button -- it brings up the video display. And that is unique.

OK. Thanks a lot, guys. Appreciate it.

Sure.

Our next question comes from David Bowles of Paradigm Capital.

Hi. Great quarter. I wanted to ask about the flat-panel market. Could you just talk about that a little bit -- like the size of the market and will our product go to the OEM market or is it the after-market?

Well, the size of the market is -- varies a lot, but I -- it's a multibillion dollar market. Defining it takes a great deal of time, but it's a multibillion dollar market. That's our opportunity. It's -- it's applicable to the military, commercial, and general aviation.

It -- when we talk about flat-panel displays, we will do primary flight displays, engine displays, and essentially replace the existing round dials that are 20, 30, 40 years old. That equipment is becoming unsupportable because you can't even get the electronic components that were originally designed in there.

So we see a very strong market. I think everybody does. A lot of people attempted to get into that business. We did some good pioneering work and were able to get the fundamental intellectual property patents, et cetera, that strengthen our product offering. We think that - you know, we don't see that being our only product by any means, but it'll represent a significant opportunity in the future.

And when we talk about flat panels, we're not talking about simply the panel and the display like a terminal. We're talking about the systems associated with that, which may include engine monitoring fuel, gauging, refueling systems, and primary flight and air data displays. So, it's a broad application of displays both for the front of the airplane and for reconnaissance airplanes and surveillance ASW kind of applications in the back of the airplane as well as shipboard applications, submarine application, and army vehicles.

The market is very big, and I'm not sure how to define it. I can tell you that our immediate opportunity is multibillion.

Is it the OEM market or the after-market?

It's after-market principally. The after-market, as -- I guess you may not be familiar, but the after-market represents ten times the volume of the OEM market. In a great year, the primary manufacturers make 900 airplanes, you know, in a year. There are 25 to 35,000 aircraft as opportunity for retrofit in any given year. So the primary opportunity certainly for us is in retrofit -- not OEM.

And what drives someone to retrofit? What's the catalyst there?

Well, operating cost. As I mentioned, some of the equipment is not supportable. So, you can't fly an airplane without an altimeter. The cost to repair one could be two or three times the original cost of the product, and you may not be able to get spares or you may not be able to modify -- to maintain it.

And a compelling reason to upgrade any piece of equipment, especially an airplane, recognize a modern airplane -- the 767 was designed and built 25 years ago or more. You -- and that's a modern airplane. There's many DC-9s and 737s that are 35 years old -- 40 years old still flying -- still vital for revenue service.

And the equipment that was originally designed for that was designed probably ten years before. So to try to maintain something that's 40 years old is extremely costly. Its reliability is poor and there's enormous savings to get rid of that equipment. If you put flat-panel displays, you typically eliminate 20 to 25 different parts and you replace them with three.

Wow.

It's huge. Now, it's always been the cost of that retrofit. Ten years ago or eight years ago, one of the major suppliers retrofitted a large fleet of older airplanes for a package carrier who spent well over $1 million upgrading it to what we would look at today as antiquated technology. Today you could do that same update for a tenth of the price. That starts to make the retrofit very compelling even on airplanes that the operator may believe there's only five years left in the airplane.

Great. That's helpful. Thank you.

You're welcome.

As a reminder, to pose your question, that is "*" followed by "1" on your touch-tone phone. We have a question from Dave Starkey from Smith Barney.

It was partially answered with the last question related to the market potential for the flat panel. It's really a question in how you plan on processing the transition from the altimeter business as that becomes, you know, peaked out over the next few months here and you go into the flat-panel business. Do you think you're going to be able to kind of structure the business to continue to grow on a steady plan or plane over that period of time the next few years?

Yes, you may find some minor variations, but I'll go back in our history. You know when 9/11 buried everybody else in the industry, and I say buried -- you know, major manufacturers lost money or made almost nothing and struggled as they imploded. Our revenues went -- ceased to climb -- went from a peak of $34 down to about $28 million. By the way, we generated cash and produced 20% net after tax, while our competitors were struggling to make 1% or 2%.

That transition -- that ability to respond is what makes this business unique, and we believe that we will be able to accommodate that transition from one kind of program to another. KC-135 was a major -- represented 70% or 80% of our revenues and it stopped abruptly. I mean, in a month it went from total production to 0 basically, and we had only the most minor hiccup of about a month while we transitioned to producing a totally different product for the business in general aviation.

So, is it going to be easy? No, it's never easy. But we focus on that problem every day, and the strategy that we have in place I'm not free to divulge. But I would only answer you and say that is clearly a focus of our energies and we are confident that we can continue to grow the business at a relatively smooth rate. Any time you have growths of -- as we have this year of almost 100% growth -- 70%, you expect some roughness in the growth curve. But we do not -- we do not expect to see a huge downside.

In the ...

Let me put it this way -- we're working very hard to make sure that doesn't happen.

Right. And you see this new market as actually much, much bigger than the altimeter-related market?

Well, yes, it is, of course, by many, many, many times. But the data business is still going to be a very strong business because I'll go back to saying that most of the equipment flying today was designed and/or built 20 to 40 years ago, and that includes the height measuring equipment. That equipment becomes more and more difficult to maintain and unsupportable, and we intend -- we see that as a huge opportunity in the longer term for us, as well.

So the good part of that -- I mean we expect to have OEM business, as well, but we see the opportunities to be vast in that marketplace and the flat-panel business to be significant. The opportunity is, on a conservative basis, four or five times the opportunity that was presented in RBSM.

Great. And how far ahead of other competitors, because of your patent positions and your early work in this product, do you think you are in terms of, you know, six months, a year, two years...?

It's hard to tell, but I'll tell you there are -- you know, our competition is formidable and they will get a good portion of the market. But I think what we've been able to do is, by pushing ourselves ahead and during the period of time we had hoped -- after 9/11, we had -- prior to 9/11, we would have -- and when I say 9/11, that's a generic explanation.

I don't believe that simply the disaster in New York created the problem with our economy in the air transport. Clearly a competitor. But we were -- the economy was going in a recession of sorts even before that happened. It just compounded it and made the aerospace industry that much more vulnerable to its effect.

But during that period of time, we had hoped to develop our market. When the market was clearly not there because our customers had no money and other priorities, we went back and looked at the design we were in the process of certifying, and rather than go ahead and certifying what we knew at that time could be improved by -- significant, we did improve it and reduced our costs enormously and performance enormously.

So during that period, we didn't let things sort of wait, and we actually gained a tremendous strength in both -- of advantage and cost and in performance during that period. And I think it'll pay off well as we go forward. I believe our customers are very pleased with our product offerings.

That's great. And one last question related to your cash on your balance sheet which continues to build up. Can you give us some idea of what your plans are at this point for some of that?

Look, we continue to look at acquisitions, and we continue increasingly to see opportunities where -- and this time I think I'm a little bit more focused than I have been able to in the past -- one of the things that we see or at least I see is opportunities to do acquisitions -- mergers and/or acquisitions with companies where we can infuse our technology that we've developed and vastly reduce their manufacturing costs, therefore the profits of an acquired business.

I've always said for the last three or four years that we're going to be successful if we find businesses that we can give them as much opportunity as they give to us. And we have now a product and technology that I think is immensely transportable and can be hugely beneficial to acquisitions. And that's not only the flat panel, but some of our other technologies.

So we are looking for the right acquisition because all -- you all, properly, will be looking very carefully at our first acquisition -- major acquisition. We're going to be very prudent that it's going to be a good, accretive acquisition.

Do you anticipate anything this fiscal year there?

I can't comment on that.

OK.

I just -- there's too many variables.

But you are looking at ...

I would be delighted to do one. This fiscal year is getting a little short.

Yes.

It ends in -- but I'm saying this calendar year or within the next twelve months I'm hopeful that we can do that. I'm intent on trying to do that, but I will not nor do we need to -- that's the good news -- make an acquisition to grow the business. We've done this all organically.

Right.

So that's the best shape to be in -- not to have to do it.

Exactly.

And I'm hoping to find the right business and increasingly we're closer to finding really good matches with businesses. And so I'm far more optimistic.

Sounds great. Doing a good job.

Thank you.

Sir, there appear to be no further questions at this time. I'd like to turn the floor back over to you for any closing comments.

Gentlemen, thank you very much. We -- I'm incredibly proud of this team who work -- their remarkably well together. The performance is remarkable. We were -- we had some really good luck, but as they say, you know, the prepared mind is advantageous to exploit the luck. And we've been able to do that. We continue to grow the business.

Our future looks, I think, strong, but everyday we have to get up and work very hard. And we continually hear the footsteps, so we're running. That's the best we can do. The team's committed to do it. We're all stockholders and we're delighted with the performance of the company. And we're delighted that you all have seen it that way and supported our stock so well. So thank you very much. Appreciate your time. Good-bye.

Thank you, ladies and gentlemen. This concludes today's teleconference. You may disconnect your lines at this time, and enjoy the rest of your day.