Innovative Solutions and Support Inc (ISSC) 2005 Q2 法說會逐字稿

Good morning and welcome to your Innovative Solutions and Support's second quarter year-to-date sales and earnings conference call. At this time, all lines have been placed on a listen-only mode and the floor will be open for questions following the presentation. It is now my pleasure to turn the floor over to your host, Mr. Geoffrey Hedrick. Sir, you may begin.

Good morning. This is Geoffrey Hedrick. I'm Chairman and Chief Executive of Innovative Solutions and Support. I welcome you to our conference call this morning. In just a few minutes I will discuss the second quarter and year-to-date results for the period ending March 31, 2005. Joining me at our corporate office is Roman Ptakowski, our President; and Jim Reilly, our CFO. Before we get started, I want Jim to read the conference call Safe Harbor message. After that, I'll make a brief statement regarding financial results for the quarter and year-to-date periods. And also discuss the outlook for the remainder of the year. Jim, will you please read our Safe Harbor message?

Thanks, Geoff and thank you all for being on the call this morning. 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 than discussed, including other risks and uncertainties reflected in the Company's prospectus and current 10-K on file with the SEC. Geoff, back to you.

Thanks, Jim. Another great quarter and what a remarkable first half. Record sales of 19 million, ahead of last year by 74%. Our gross margin's at record levels and net income of 6.3 million, up 144%. We continue to perform. It's a remarkable team of people and the business continues to look stronger on a daily basis.

Fully diluted earnings per share of record of $0.51. Marginally higher than the $0.51 of last quarter, which was a record as well and 132% greater than last year of 29%. And then -- really good strong cash flow plus a positive 3 million or about $0.25 a share.

Our results for the first half are 38 million, up 96%. Record gross margins, record net income of 12.5 million, ahead of last year by 198%. Record diluted earnings per share, $1.02, that was greater than all of last year and a backlog of 29.4 million, ahead of last year by 9%. The backlog is almost 75% commercial and 25% military. Actually, 74 and 26. A record first half cash flow of 10.5 million or $0.86 per fully diluted share.

We continue to have a really solid balance sheet. The cash is now 76.4 million or about $6.26 a share. Total assets of just under 100 million. Stockholder equity is now 88.7 million, or 89% of total liabilities and equity.

Looking to the future, we continue to expect strong double-digit compound earnings growth. I have said before, we targeted 25% and we continue to try to exceed that. Now, probably the most significant thing we see is a real strengthening of our flat panel and the transition to a more significant percentage of business in the flat panel arena.

Roughly 50% of our bookings in the last month, month and a half, were flat panel bookings. Not just L Cackle (ph), while that's a good strong program, but full flight decks for full range of products from business, general aviation, and in the military.

The guidance we're looking at for Q3 is a range from 16 to 18 million, up from 16 million. We believe we can go up to a range of 16 to 18 million in revenue and earnings per share in a range of 36, which was what was targeted. Now $0.36 to $0.44 guidance, up significantly.

Q4 sales are expected to be in a range of 14 to 15 million. Earnings per share $0.28 to $0.35 and FY '05, revenue will be in a range of 68 to 72 million. So, we have a very strong position. Not only has the -- if we reflect back -- the Company last year broke records when it did $1.00 a share. We're now talking about almost 70% growth in that compound growth over the last year. Virtually every front, we look very very strong. Strong enough to be looking at further expanding our building in the future.

So let me just finish up by saying that earnings per share, we're looking at a range of $1.66 to $1.80 for FY '05. And earnings per share on first-quarter of FY '06 look to be stronger than last year. So it's a very strong outlook and we turn this over to question and answer.

Is the operator there?

+++ q-and-a.

(OPERATOR INSTRUCTIONS). Mark Rosa with Thompson Davis

Good morning. On the last conference call, there was a lot of talk about gross margins and how you're more focused on the bottom line. So they were higher than I expected and I was wondering what contributed to that this quarter?

We can't spend money fast enough. The sales growth and -- sales growth has been remarkable. Our manufacturing organization continues to reduce our material costs and we have not been able to -- although we have increased our engineering department this quarter by 26%, we can't spend money in that area fast enough. We see some really good and promising results and we're hiring a lot of very good people. There are engineers and plenty of engineering people out there; but we were looking for some pretty remarkable talent and amazingly enough, we have been able to find it.

Our gross margins continue to be remarkable because we've refined -- we continue to refine our manufacturing. And that's the amazing part and our net margins increased because we can't spend money (indiscernible) fast enough.

Did the pricing stay the same for RVSM about?

Yes it did.

What about for flat panels?

Flat panels, it's unchanged as well. The margins look very strong in flat panels.

There's a couple of things I will tell you. We've actually -- one of the things you will notice in our press release is we talked to over 3000 additional aircraft that are out there for RVSM and many of these don't qualify for what is called group certifications. In other words, somebody didn't go out and get 12 or 14 airplanes and do tests on the airplanes to establish good statistical data adequate to get what is called a group certification or certification for any airplane of that configuration. So that you are restricted to doing basically individual tests. And it turns out that individual testing, that is, they call them trailing cone tests, have come down so much in price that they are actually competitive with the cost of a group certification.

We have announced a new product with a patented automatic configuration system that allows -- significantly facilitates that kind of certification and allows us to address and expand the market that we address in the RVSM world. That product is not only more versatile; but it is also less expensive and might realize some smaller gross margins. Again, it will allow us to capture business heretofore that we had not seen, but might have a lower gross margin. But again, I have always said, if you can have 50%, which is almost 20 points higher than our competitors, we'd be very happy.

For the C-130 and the King Airs, what is the average number of flat panels that the customers usually order per plane?

The C-130 will be between five and seven. And King Air is typically three to four.

Could you tell us what CapEx is for the quarter?

Got that number, Jim?

Yes, it was about 150,000 (ph). CapEx continues to run below our appreciation and amortization, Mark. So it's almost a self-funding thing right now. We really don't have a capital intensive business in front of us because we have made the investment in the infrastructure. So, it's relatively benign.

We will continue, certainly as flat panels increase as a percentage of our sales, they're going to be some unique additional capital equipment expenses in that area. But they are going to be relative to our sales. They are going to be extremely small, 1% or less of sales. But again, that's where we continue to keep and refine the business so that we can capture the margins that are there. I mean, manufacturing organization has done an amazing job to support the levels of business that we have and the growth. It's easy to sit on your hands especially when you're producing 60 odd, high 60s% gross margins to sit and pat themselves on the back and everyday they get up and try to refine both the fluidity of the manufacturing process and the material costs.

Thanks. I'm going to jump back in the queue.

Selman Akyol with Stifel Nicolaus.

Good morning. I wanted to just ask a couple of questions if I may about the forward-looking guidance, which first of all, I greatly appreciate. Number one, you sit there and you start looking out into '06. You kind of gave a first-quarter number out there saying you expected to be it stronger than it was the prior year, which was the first quarter of $0.51. Historically, you business has always strengthened throughout the year.

Yes.

Typically, Q4's higher than Q1. Would you expect that trend to continue in '06 as well?

Historically, it has been that way. This year it hasn't been because we had that huge demand for RVSM in the first, second, and even third quarters. So I would think that -- I would be very happy to see a year-end growth of about 25 plus percentage following 70% growth. I think it might grow but I can't -- right now it would be only speculation. We would hope it would but we’d be happy to see a modest growth and hope and expect to see that because we want to continue to grow in '07, to be honest with you. So we would expect growth by the end of the year.

And as we are seeing an enormous -- over the next two to four weeks, you are going to see a significant number of announcements, additional announcements of flat panel programs. It is starting to take off to our expectations. We are really extremely pleased.

Great. When you look out into Q4, and I think this is probably one of the big questions the street has right now is, on your 14 to $15 million revenue number that you gave, can you give any sort of color on how you'd expect that to be breaking down between RVSM and the flat panel and then as you're looking out into '06? How does that RVSM tail actually look from where you are sitting?

I mean there are two things that have happened. First of all, our lead times are relatively short so that our backlog does not look like a year backlog. Some of our competitors have one year lead times. So their backlogs tend to be big because people have to get into the queue a year ahead of time. For good or bad, our lead times tend to be four months to five months, in some cases two to three months. So our customers know that they don't have to place large orders that expend out five and eight months, which makes our visibility intrinsic visibility.

And to answer your question about the fourth quarter, the break down. I can't at this point. We see the flat panels -- if we're fortunate, we will get some timing -- and I have said this for a year, how that flat panel starts picking up movement one quarter (ph) of a month, one way or the other, would have a significant effect on the distribution of the sales in Q4.

The break down right now is still probably predominantly traditionally our data products. But you would see a significant increase even in that year over, in that quarter of previous quarters for flat panels. Going forward, again to reiterate, yes we would see some growth. At this point, I can not project what that could be. If the flat panel and our Air Data both take off as quickly as they are starting to look, it could be very very big. But right now we are just very comforted by the fact that -- what looks to be good solid growth in FY '06.

I'm not trying to beat the issue here, Geoff. When you say '06, would you think most of that is coming from the flat panel or is RVSM still greater than 50% number because of all the retrofits still out there to do?

There is still a significant amount of (indiscernible). It would just be speculation from my standpoint and it just wouldn't make sense. You know, I don't want to be too simplistic, but our job at this company is to try to produce results and we get business where we have to get business and where it is available. We do not have the luxury of seven-year programs, big long-term programs, where we have a very precise visibility. We also grow at orders of magnitude faster than our competitors, who have that kind of inertia and long-term perspective.

So again, I would expect to see a very strong presence in flat panel. We continue to see a good strong demand in Air Data market. If we had our druthers we would like it not to be a big peek in '06. We'd like it to distribute over the next couple of years and then we think that's probably what's going to happen. So you would see a much higher percentage of flat panel, which is what we all expected.

Patrick McCarthy with Friedman Billings.

Good morning, gentlemen. My question is also with regards to the flat panel. This may be a little redundant but I was wondering if you could just talk about the strategic implications of getting that FPO, the King Air FPO signed up and is there any opportunity to then take that contract and leverage that with other FPOs across the country?

You obviously know your business. It's huge. We see as we get business that we -- we are getting people calling us now daily asking if we will enter in an agreement to provide certification, group certification for them to supply the various kinds of airplanes. It is profound and very significant. As I noted, they made 6000, (indiscernible) magazine just said "6000 aircraft built and more on the way." It's a huge market in itself; but the credibility extends well beyond that. So you're absolutely correct. We are seeing a huge interest. And the fact is that the product is exceptional.

In our press release, I alluded to in quotes the FAA's new guidance concerning safety. The FAA has -- in our last TSO letter, which traditionally is pretty dry, appropriately dry, simply said that they accept our data. But included in that is a paragraph which says, and I'll paraphrase it because I don't have a data right in front of me, but fundamentally says that it's noted that we use a commercial graphics chip, which gives us tremendous flexibility and growth but assure the highest level of integrity to catastrophic level A (ph) through the use of our integrated integrity processor which we patented. That's a significant achievement and I believe for aircraft in the future and people providing equipment. To my mind, Collins is producing their own graphic chips to provide that kind of integrity. For us to be able to use commercial ones is a real break through. The combination of technologies and the acknowledgment by major installers has got real strategic significance and I think will drive our business strongly, very strongly, for the foreseeable future.

And so if you begin to see demand from the FBOs, is it possible that you can go back to the OEMs and say, "Hey listen, we've got a lot of after market demand here for the installation." Can we bring this as an OEM type product? Is that something you're thinking about or does that make sense, or no?

And it has happened to me before. As, I don't know if I mentioned, my first business was a similar one. We did only retrofits in making altimeters. But by the way, when United and American Airlines bought airplanes in the late '70s, they went to Boeing and said, "we want this harrow (ph) equipment on it." And that business ended up selling about 60% of all of the altimeters in the world. So yes, the OEMs, to be blunt with you, they can save a lot of money and get a lot of performance if they come and buy our equipment. We'd be delighted to sell it to them and we see opportunities. I think we can provide a great deal to the OEMs as well. But we have talked about this. The OEM market still represents probably, compared to the retrofit market, it's about 5% of the retrofit market.

Okay.

The answer is we want to do both very badly.

But it's more important to get your foot in and really establish the retrofit market?

I think what has happened is you can't force the issue. What you have to do is do the retrofits, do a very good job. Prove your competence and capability, prove the kinds of things we can do, which are unique, which is simultaneous overlays of videos on primary flight instruments and maintaining integrity. That kind of stuff clearly is the kind of thing that the OEMs should be very interested in putting in their airplanes.

My final question is on the King Air itself. It's not the highest end aircraft out there, but obviously they're willing to support the price point of your product. Was there a specific reason why the King Air was the first one wrapped up here? And does that bode well for some of the higher end aircraft as well?

The reason is that they made more King Air's than any other airplane. I mean everybody has them. There in the military and they use them a very similar airplane to the King Air. The 1900 is a commuter airplane of 800 or 900 of those out flying. Of any airplane, it's the most universal airplane. So it was one that was extremely important for us to focus on, and for us, a very important win and it bodes very well for other aircraft. And we have had a number of people in much larger airplanes, including large business jets have contacted us to work with them to do an SGC to open up 4 and 600 (ph) aircraft opportunities.

Kevin Richardson with Prides Capital.

Good quarter. And I like that you are giving guidance. I appreciate that. I just wanted to get some clarification on one thing, just on getting to the outlook. If I kind of back in to what the new orders have been the last four quarters, they've gone kind of 14, 22, 20, 12. And I'm just wondering the comfort level you have with the revenue guidance for the coming quarter? And is that dependent on some of these announcements that you're diluted to getting over the next month or so?

I think clearly it is dependent on getting any new business of course. Yes, it has varied. But remember, we're making a transition from one very large peak demand, or what was perceived as a very peaky demand, for regulatory RVSM into a more traditional operation.

I will tell you that two years ago I think we went into a year with about $8 million backlog. And I think we have produced about almost 40 million. So, we're used to that kind of thing.

How comfortable I am? I guess I'm pretty damn comfortable. I'm used to it. It's not unusual. In the last three or four quarters, we have had huge backlogs because people were dying to get into the queue to get deliveries. So, we had an unusually high backlog.

Can you breakdown at least any of the orders that have come from flat panel. I think in the last conference call, you alluded to those 10 million in revenues in the back half of the year for flat panel and are we still on pace for that?

It appears we're still on pace and, as you know, we don't break down by product line. But as I mentioned earlier in the conference call, in the last four to six weeks, 50% roughly of our new business is all in flat panel.

Bob McCullough with Summit Crest Capital.

Good morning. It appears your guidance for Q3 and Q4 are pretty much is covered by your existing backlog. So it appears your guidance is very conservative and then you mentioned some new announcements coming down the road. Would you say those new announcements would still be in the -- with regard to 50% flat panel going forward?

Just two items. I mean, I don't know how conservative we have actually raised the numbers for both Q3 and Q4 and the year. Not insignificantly. I watch the street all get excited about a 1% increase in earnings of one very large corporation. Everybody saying, "boy isn't that aggressive." I think our guidance shows a very positive growth, especially when you take into account that we're going to grow 60% or 70% this year in earnings per share. I don't know of any other company that's doing that. I think we are -- we're not being too conservative. I certainly don't feel too conservative.

The business that's coming in now would not be business that we would readily ship this quarter, certainly. We're not booking and shipping this quarter, to speak of. And next quarter, we do not have it filled at this point. We are in the process of filling that; but probably not going to fill it with too much flat panel, new kinds of flat panel business, only because the fuse is pretty short for that. We will work hard to make the numbers we provided outlook for.

Finally, I think the business that we're looking at, I think flat panel, and Air Data business, and other business we are looking at --. Remember we're looking at other kinds of equipment all the time. We don't talk about it but we will be announcing significant new products over the next six months to a year. They will all be the basis of continued growth, which I have marked at about 25% compound growth rate. We would like to exceed it. I said 25% last year and we did almost 75%. But I don't think we're going to see quite that kind of year-over-year growth. We're going to try to maintain 25% to 30% compound growth rate. I hope I answered the question. I tried to remember all the questions that you had.

You had mentioned in prior conference calls, acquisition -- you're looking at a few acquisitions. Are you close and is there any chance if you don't make an acquisition, stock buyback, buy cash?

Well, I mean, two answers. I would hope to make an acquisition and no I'm not close. But we are -- I am -- I'm spending now about a third of my time focused on acquisitions now. I am aggressively looking for the right pairing that really benefits both parties. Would we do a stock buyback? I'm not sure I wouldn't buy it back if it goes down. I think it's a very good investment. I believe the best thing for the stockholders though, is for us to make an acquisition and invest our cash into something that will significantly increase the size and profitability of the business. So buyback would not be high on the agenda. I think we can do much better things internally with the cash to expand the business.

Ashaka Juja with ICore (ph).

Let me, I guess add to the last question and again, kind of lay out potential scenarios because I'm pretty certain that when you do make an announcement of an acquisition, that we will see good results from it. So let me lay out two scenarios and ask if both are as likely if possible. One is small companies with little revenues that have good technology, which I assume is one area you would be looking at. Another is companies that potentially have fair revenue base, even up to 100 million or something. But that have good products but had not been able to execute correctly and would be available relatively cheaply. Are there both those kinds of possibilities, if you will, the two opposite ends of the spectrum that you would be looking at?

Those are both opportunities, and I have said this on other occasions. There's a third opportunity. Understand that we have a number of technologies that provide -- are the basis for our excellent margins. Imagine a company whose product lines had some similarities with our product lines; that we were able to incorporate some of our technologies into their existing orders and existing product lines. That would allow us to pay a very competitive premium for that business and make it massively accretive by significantly reducing its manufacturing cost. And that would be an ideal situation.

The limits of our -- we have assessed what our ability to purchase, what we're capable of purchasing, the size of the business and we see everything from clearly upwards of 300 million, the cost of the acquisition of 300 million, which could be anywhere from 200 to 500 million in sales theoretically. We would -- but whatever acquisition we make has got to be -- it's not just simply accretive. It's got to be accretive, substantively accretive, from a technology, from a management, from a true synergy. I have said this before, I have never heard of acquisition yet that wasn't strategic and synergistic. I think that's sort of the standard words. In our case, we actually want both of those things in a very real way. As I have said before, we don't need to make an acquisition to grow the business. We have proven that and we continue to feel extremely bullish about the future and the growth. So the last thing we want to do is make an acquisition that dilutes our energies and our focus and our ability to execute internally. So that means that it narrows down the field pretty significantly. But we are -- I can tell you confidently we’re looking at a couple of people right today that could be candidates. Now whether they are interested in being acquired is another issue.

But we offer something as a smaller business, that when we do make an acquisition, that the acquired company actually becomes a teammate in a very real sense. And unlike being acquired by a large organization where their contribution to the profitability is not ever seen, in our case it would be seen in a very real sense. So that is sort of our philosophical outline of our acquisition strategy.

Thank you and congratulations.

Thank you very much. We appreciate that.

Jason Allen with Atlanta Equity Research.

Hey guys, I just wanted to clarify a couple of things. I think someone asked earlier what the average order size per airplane was for the King Air's. I guess what I'm curious about is you said significant initial orders were placed in the press release. Can you help us quantify that or put some brackets around that? Is that 20 flat panel's? Is it 50? Is it -- can you help us sort of zero in on that a little bit?

Let me tell you why I can't do that. There's two reasons. As you can tell, we haven't said who the purchasing -- who bought the equipment because that party wants to release that information themselves. So we are not at liberty to discuss anything about the magnitude of the order, both in dollars or quantity.

We were limited very narrowly in scope to what we could release and the reason I released it as early as we did is that I wanted to make sure that there were no rumors that would get out that would unfairly advantage people. So I wanted to get some information out. So I really can't comment on the size but I will tell you that somebody asked me how many pounds per aircraft and I said the King Air is like three or four panels per airplane and C-130, obviously a bigger airplane, is like five.

Now we have configurations with 7 and we have configurations with two. But the dominant percentage would be about five or six in the C-130 and roughly three to four in a King Air. Recognizing at King Air has got a somewhat smaller cockpit.

That makes sense. Then you referred to your third customer for the C-130. Is this, I presume, a foreign government because obviously you have the United States military but --?

That's a good guess. And again, I don't mean to be evasive but I'm not allowed to divulge the order prematurely. Again, what I have done is run a very narrow fine line which I wanted to release enough information that normal rumors that come out of -- we do business with a lot of people and they know what is going on. I wanted to make sure our investors had equal access to the same kind of information. But we don't talk about it because were not really allowed to.

The last question I have, I jumped on a little bit late so I apologize, I think someone alluded to that you said that you thought the first quarter of '06 would be greater in terms of earnings than last year. Did you mean greater than the first quarter of '05 of $0.51?

No, but I think we can probably feel that we will -- traditionally, we have been able to -- what I intended to mean there is that our year-end results -- our fourth quarter and first quarter should be roughly the same and we should see a growth from there. Somebody asked how much do we expect to grow and in order to grow 25% you can speculate and it would probably be -- and I'm not giving precise numbers -- but ranging in the $0.44 kind of range. We grow from there. And to be blunt with you, we don't have hard numbers to tell you what that is. So again, I'm trying to limit my speculation but in general outlook terms, that's about what it would look like.

That makes sense. Thank you. I appreciate it.

(OPERATOR INSTRUCTIONS). Robert Schwartz (ph).

Thank you. The question was answered.

David Shecktor with Perceptive Management (ph).

Yes, actually, the last question confused me because I thought I understood it before it was asked. What is the guidance for the first quarter of '06 then?

We're saying $0.44 similar to the -- I actually provided guidance for the third and fourth quarter and a general outlook for the year. Somebody asked for an outlook on the first quarter of next year, which I was not prepared to provide, other than it would be similar greater than the previous year, which in our case, would be -- we're saying it would be roughly the same as the fourth quarter of this year.

Of this year. Maybe I'm still confused. This year's full year guidance, as I understand, is something like $1.66?

Yes. I gave you numbers of -- I've got to go back and show you precise numbers so we don't -- there we go. I talked about Q4 sales. I provided Q3 and Q4 outlook and the year-end of $1.66.

And Q3 and Q4 again were what?

Q3 was 16 to 18 and Q4 was 14 to 15 in sales. In earnings per share were -- and on Q4 were 28 to 35. And I didn't -- I had no intention of providing '06 guidance, other than to say that it isn't flushed out. I'm always apprehensive to be too speculative. It is a very strong transitionary period. And we are seeing a lot of flat panel gel so we're not quite sure, but we feel confident, that typical to previous years, that we would be very happy that Q4 and Q1 would be the same.

Right. So basically, if you have $0.44 in the Q1 of '06 --

-- go ahead.

And you wanted to do better than this year; you'd be off to a running start assuming any growth at all in the final three quarters.

Absolutely. And again, the reason I am hesitant is that the lower the backlog in any quarter, and Q1 is not a loaded quarter right now, it becomes speculative and more speculative simply because it is a transitionary period. And how much flat panel is coming in and how much are existing Air Data? And as I mentioned, because we do such a good job of short leadtimes, we don't tend to have very long backlog. But business is out there. We're very optimistic on business on both fronts, especially Air Data by the way.

One other question about the $6.00, potential acquisitions, and all of that, which was -- are there examples of other companies like yourself serving the aircraft industry, the small plane owners, etc. that have anything like the 69% margins you're currently reporting? You, yourself, didn't use to have those kinds of margins a few years ago.

Right. Nobody. I don't know anybody in the industry that's even a half of what we are.

So assuming you buy some company and they are a good company but don't have those kinds of margins, you're margins will be diluted through that acquisition, right?

Again, go back to what our direction is and what I have consistently said. I don't drive the business for gross margins. It's all earnings per share and I've repeatedly said that if I had 50% gross margins or 45% gross margins, I would be very comfortable because I would still be -- I would still have gross margins almost 40% higher than my competitors. So I have no problem and in fact I have also said that if you're not careful, you don't want to price yourself out of the marketplace and one of the ways to do that is to try to drive gross margins as high as you can.

In our case, our gross margins rose because, to be blunt with you, we established that the sell price and our manufacturing organization did an incredible job of reducing our costs by significant numbers. So we ended up with very strong gross margins. Our gross margins are high as a product of engineering design and we believe that the flat panel has opportunities for strong gross margins as well.

Any acquisition we would make would be based on some multiple of their EBITDA. And that multiple of EBITDA, if it's a strong company, might be high if we had a competitive buy. If we get the right kind of company, the value of that acquisition can be significantly improved based on what this company is capable of putting into that acquisition.

We don't buy acquisitions -- the classic was "gee you buy them because they need cash." That's probably not a criteria that we look for. We look for a company who has worked hard and developed some good products and some good relationships in the marketplace, have good distribution, and some good technology where we can bring our technology, significantly reduce their manufacturing cost, and produce significant earnings per share based on even premium EBITDAs that we pay.

Last question, again related to margins. Recently, another competitor has finally gotten their product through the FAA hoops. And yet still apparently have some problems getting installations because of other issues.

Who was that?

Shaven (ph).

That's not the same kind of product, as you well know.

Maybe I don't know. How is their RVSM solutions so different than yours?

Well, we have ten years of data that suggests that our equipment stays very stable for a long period of time. It's a very different product line and I can't comment on their difficulty getting SGCs; but we've never had any problem of course in that area.

Right, right.

However they approached it, we know that -- just very briefly, the background of our Air Data equipment started in part with being selected as the standard supplier for the standard altimeter for the tri -services. And in that development process, we did reliability demonstration testing for 20,000 hours. We spent $8 million in stability analysis and testing over three years. So the product that we produced has a test background that is unparalleled by any other person in the world. And we are confident -- and by the way, I think is a result of why our product has such good performance in the field and is universally accepted.

So I mean -- I don't know if I can -- obviously, I can't comment on anybody else's problem. I can only tell you that we spent a hell of a lot of money, time, and effort 10 12 years ago making the product as good as it is today. And that's why we have been as fortunate as we are today.

The only reason I brought it up is I wondered whether or not they are appearing in the market now, whether their low-price strategy is having any effect on you?

None. And in fact, as I noted, we have made two announcements of Air Data, both displays and units, and by the way, that going through the hoops for the FAA, you still can -- in order to get RVSM, you need to get a supplemental type certificate approval for that aircraft. That's more far more difficult than getting a TSO.

So I mean there's a lot of very difficult-- the reason why there aren't a lot of people doing this is it's very hard to do. And so we have, as I noted, are releasing two new major products, the display that is unique that a single partner can go into any airplane and be uniquely configured for those parameters. And that's a patented technology that we developed some years ago and will provide a good solid performance and low-cost solution for a large portion of the market, which could not be addressed heretofore.

Excellent. Thank you very much.

You are very welcome.

Michael Davies with Investec.

Good morning, guys. Thanks. I just have a couple of comments here. I believe -- I just want to get a clarification, one, on the backlog. I believe you said that shorter leadtimes leads to fluctuations there. And that's correct in my assumptions? Because we saw December immediately come down from 36 to 29 in March.

Well, as an example of 36 in December, you can anticipate that, among other things that you had a peaking demand for DVRVSM, and everybody discovered that gee they weren't going to extend the due dates so they all got very desperate. So we saw a large peak in the backlog at that time. Our backlog, as I mentioned before, and I don't know the specific year, but I do solidly recall an $8 million backlog going into a year that we ended up shipping somewhere about four to six times that.

Our backlogs tend to be smaller than I have been used to in other points in my career simply because our leadtimes are a third typically of what are competitors are.

With respect to operating expenses, we saw a nice increase in both R&D and SG&A. Can you just talk about that for a second? I realize you got it to the engineering staff. Maybe just give me some clarification.

Well, sure. We added about --I think the number -- Jim, is it 26% or whatever it is?

The engineering numbers have gone up nicely quarter-over-quarter. But you have to remember that the revenue is ramping so quickly, it's difficult for the expenses to really catch up with where we would like to see them.

I hope you all appreciate this as an incredible discussion where we're talking about increasing our cost as a good thing. It is representative of an important aspect of our business; which is getting good strong engineering; which it has gone up by about 26% quarter-over-quarter. But as Jim alludes to, our revenues keep growing, so we continue to out-pace, as I have said in the past, I would like as a standard, to invest about 12% of sales into product development.

I believe -- and in the past, we have invested as high as 20% or 18% in product development in any given quarterly period. You are asking, I think, for some clarification, and certainly some elucidation, and in fact, if that's the case, and we are -- have a very aggressive campaign to continue to recruit really good people. We have a remarkable team of people in place. Really remarkable and I'm pleased. We just don't have quite enough of them yet.

As far as SG&A, we have made a commitment, I said from last year or so, that we need to put more people, more boots on the ground, as it were. And we are aggressively and actively recruiting additional salespeople. We put on about 25% additional sales force in the last quarter and we continue to desire to expand that. Those are two areas that pay for themselves. Salesman, a good salesman pays for himself many times over and good engineers pay for themselves many times over. So we're happy to invest money in both those areas.

And in the SG&A area, as you can see, while the expenses continue to go up, the percent of sales continues to fall remarkably. For example, it's down to about 12% of sales in the quarter and 11% of sales for the six months and it was as high back a couple of years ago as probably 20 21%. And this obviously is reflective of the marketable increase in volume while holding expenses tight.

We decided we don't need two CEOs, two CFOs, and two Presidents.

That's good.

I mean that sort of what happens. And I'm delighted to discuss it and I appreciate it. It's a valid question. We got no mysteries. I mean, we just sort of do good commonsense things here. We like to think anyway.

One other item is looking at the gross margins as you expand the flat panel business. What is your comfort level there that you could meet the same type of ramp and as well as keeping that low marginal cost going forward?

Look, I continue to -- the real answer to that question is-- I'm going back to I don't care if my gross margins go down significantly. I'm talking going from almost 70% down to 50%; as long as my earnings per share and general productivity is excellent. And that's a reasonable possibility. But I can tell you categorically, there's nothing in the pricing model of any of our products that we have received to date, of any kind, whether it's Air Data, fuel engine or flat panel. That model is consistent across every product we have so that would imply you could theoretically get the same gross margins out of that.

I have no desire to do that. I believe that if I try to maintain gross margins at those levels, we will improperly price our product. I intend not to do that.

So it's more of a question of getting this tailored to expand the market opportunity then?

We're going to price it to get as much --if I want to price my products so that I can get 80% in market share if I can. And if that erodes my gross margin, I have got no problem with that.

I think the important issue here was, and it is something we have got to admire, we took a product, we did not increase its cost, we did not increase its price. We reduced the manufacturing cost. We exploited the fundamental engineering design, and in some cases, we made significant modifications to engineering design and reduced materials costs by as much as 30%. That's what we're supposed to do and we did it and we did it very well.

So I am delighted -- I'm sorry I keep finding myself trying to apologize for 69% gross margins.

Perhaps you could just talk about -- well, what you can discuss in any event, the market opportunities. Do you see it lending itself to the flat panel display and other types of vehicles?

We have had that discussion with a number of people. Land vehicles and marine vehicles all use a huge number of flat panel displays as well. Our designs -- and our designs continue to reduce the cost of our flat panels and improve its performance. So we're now looking broadly at other areas; but we have a -- if the last couple of months is any indication of the interest in our flat panel program for airborne, commercial, military, and air transport, we've got a bull by the tail. And we're going to run like hell to perform with that market.

But the product itself is almost transparent to move from one area to the other. It has evolved to interfaces that are as universal as you can imagine. They are perfect candidates for army vehicles, for a lot of army helicopter programs and for shipboard, both submarine and surface ships.

Excellent. Thank you very much. Nice job, guys.

Thank you. I appreciate that.

(OPERATOR INSTRUCTIONS). Don Littlewood with Littlewood Burke (ph).

One question, who are your competitors in the flat panel?

There's a lot of people.

A lot of people?

Sure. But somehow we managed to make some major breakthroughs. Competitors -- I guess everybody can make a flat panel. The question is can everybody comply to the new FAA guidance? I don't think so. We can -- we have a significant amount of patented technology. The big guys, the standards in the industry are people like Honeywell and Collins, who produce an exceptional product and they've got twenty-five years of experience so they're the pro. (indiscernible) make some flat panels. Everybody makes some flat panels. Little guys, big guys.

The flat panel itself, and we have always talked about it, that looks good, that's the pretty part. We have patented anti-reflective coatings, special lighting systems that provide exceptional performance. But that's not the real strength of the product. It's the exceptionally high integrity, a very versatile symbol generation, graphics generation. So you can probably say there are 40 people or 30 people in the marketplace. We win business at very competitive margins because our technology is better. We think.

Well, for instance with the King Airs, there must have been a competitor there, wasn't there?

There's two competitors there.

Two competitors?

There's two guys that already have STC products.

That's what --

But our product provides -- the market is an interesting one. If you have an airplane and want $1 million to upgrade it to flat panel displays, you don't get a lot of takers. Our pricepoint is profoundly lower with better than or equal to, typically better than performance. The breakthrough was to get exceptional performance at a significantly different pricepoint and that pricepoint opens up a huge market. And that's what we're seeing.

That answers my question. Thank you.

James D'Angelo with Intrinsic Investors.

Yes. Can I just ask you to hold for one second, please, Mr. D'Angelo? I just want to make an announcement. This is going to be the last call because we have overrun the one-hour already. But I'm happy to answer this call and I'd like to make this the last one please. Go ahead.

Great, guys. I appreciate it. Congratulations on a good quarter. Quick question regarding Q4 guidance. It seems that you are at 14 to 50 million, you are sort of a little below the street which is at 17, and I was wondering is that a result of the flat panel business where you seem to be getting some good traction? But is that coming on at a slower pace or working into the revenue stream at a slower pace than originally anticipated?

I mean its two things. First of all, the street guidance for 16 million and a third, and we have got our outlook looking at a couple million dollars larger than that. So it's really probably reapportioning some of the business in the Q3 and Q4.

So the Q3 --

The top end of Q3 is up by almost 2 million.

Got it. And that's related to flat panel --?

It's reapportioning that. And appreciate again, that Q4 is not firm yet, so I have a fairly firm perspective on Q3, Q4 is not yet firm. Some of that shows a shift. It's also a transitionary quarter, as you alluded to, so because of the -- some small uncertainty, there's no reason to be overly aggressive in that area. We'd like to be right. That tends to be real good for our stock if we are right. And so if you look at it practically, it's probably a reapportionment of Q3 and Q4. Importantly, the year-end number is actually going up a bit.

Would you say then the upside in next quarter, Q3, is related to more flat panel then RVSM business than you expected?

Probably more RVSM. Not necessarily RVSM. But remember we're delivering a major A-10 program now, significant amount every month. And that's nothing to do with RVSM. Again, it's an Air Data program and there are a couple of still Air Data programs that we're delivering. But you're right. It's the same kind of equipment. Again, Air Data business broadly. The only reason I make a point out of that is on the longer-term, anything we make will be RVSM compliant. It will likely not be purchased simply for RVSM. It will be purchased for support of airplanes whose equipment has gotten very old and tired. And there's a lot of that equipment. That's where we see a huge demand.

Okay. Thank you.

You are very welcome. Ladies and gentlemen, I appreciate your time and I appreciate your interest. I can simply summarize the business by saying we are especially pleased to see the estimates and the promises that we have made over the past year, of the business and its growth and its opportunity actually coming true. And I'm grateful to the team and I'm grateful to the investors who believed in us. Our future is very strong and we see a Company with a unique business model that produces one product that it sells across the board from business in general aviation to military, same product. And that's because we produce the same product which all goes through military level ESS, which is 18 hours of thermal, accelerated thermal cycling from minus 55 to plus 71 and six Gs random vibration. All three axis of every piece of equipment that we build, which leads us to things like warranty costs of being a half of one percent, 1/5 of many of our competitors. So we're proud of what we have got. We appreciate your support and we look forward to a very strong year and very strong '06. Thanks again for your help.

Thank you. This does conclude this morning's teleconference. Please disconnect your lines at this time and have a great day.