Innovative Solutions and Support Inc (ISSC) 2008 Q1 法說會逐字稿

At this time I would like to welcome everyone to the Innovative Solutions and Support first quarter 2008 earnings conference call. (OPERATOR INSTRUCTIONS).

Certain matters discussed in this conference call today, including operational 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 10-K, which is on file with the SEC.

Thank you. It is now my pleasure to turn the floor over to Raymond J. Wilson, CEO of Innovative Solutions and Support, Inc.

Good morning. This is Ray Wilson, Chief Executive Officer of Innovative Solutions and Support, and I welcome you to our conference call this morning. In a few minutes we will discuss the results of the first quarter ending December 31, 2007. In addition, we will discuss the current business climate and outlook.

Joining me today from our corporate office In Exton, Pennsylvania is Roman Ptakowski, our President. Also here this morning is John Long, who just this past Monday joined us as our new CFO. After many years of dedicated service, Jim Reilly recently retired. And we all want to thank Jim for his contribution over the years.

Results reported in our first-quarter earnings release are consistent with the guidance provided earlier this month. As I promised on our call in December, the new Avio NG avionics package was certified in December, and shipments of our flat-panel display systems to Eclipse Aviation commenced in earnest immediately thereafter. However, we reported a loss in the quarter due to the high costs arising from our substantial legal expenses associated with the October jury trial of our trade secret misappropriation case, and lower revenues, as meaningful Eclipse deliveries were delayed until December.

Now I'll turn over the call to John, who will go through the results in a bit more detail before I return with a few concluding remarks.

Thanks, Ray, and thank you all for being on the call with us this morning. Some of you may know me from Arrow International, where as Vice President Treasurer and Secretary responsible for Financial Operations, I had extensive interaction with the investment community. I'm excited to be joining Innovative Solutions and Support at this important point in our growth, and I look forward to working with the investment community in the future.

I'd like to now take a few moments to address last night's press release.

Revenue in the first quarter was 4.7 million, up compared to 3.4 million in last year's first quarter, but marginally lower on a sequential basis. Of total quarterly revenue, 3.9 million, or over 80%, was from product shipments, with the balance coming from recoverable engineering. December quarterly revenues include 58 flat-panel display shipsets delivered to Eclipse Aviation. These are the first shipments of a prospective 2600 total units currently expected to be delivered under our Eclipse OEM agreement.

Gross margins were 22.7% in the quarter, compared to 41% in the prior-year period. Product gross margins in the quarter were 29%, down sequentially from 38% in the previous quarter, but consistent with the pressure on margins that accompanies start-up costs on new large contracts, such as Eclipse Aviation this quarter. Start-up costs were all onetime nonrecurring items. In addition, gross margins continue to be burdened by under-absorption of fixed manufacturing overhead. With the Eclipse contract now in production, we expect gross margins to begin to trend back towards our historical levels.

R&D expenses in the quarter increased 31% to 1.7 million from 1.3 million in the year prior period. Selling, general and administrative expense totaled 5.9 million in the first quarter. Despite spending 3.5 million in legal fees during the quarter, total SG&A expenses were up only 2.8 million from the first quarter of 2007. Our financial statements do not recognize any anticipated proceeds of our favorable jury verdict, although we believe the original $6 million awarded as damages will be received this year.

Interest income was 590,000 in the first quarter, compared with 816,000 last year. This decline reflects lower cash balances and a lower interest rate environment. For the quarter, we had a loss of 4.1 million, or $0.24 per fully diluted share. This compares to a net loss of about 1.1 million, or $0.07 per fully diluted share in the first quarter last year. If we exclude the significant nonrecurring legal expense that we incurred to enforce our intellectual copyrights, the net loss in the quarter would have been about even with last year, as this was the primary cause of net loss distortion in the quarter.

We remain in a very strong financial position. At December 31, 2007 we had 43.8 million in cash, or approximately $2.60 per share. Our current ratio is nearly 8 to 1, and we have virtually no debt. And shareholder equity was 66.9 million, approximately $4 per share. Clearly, we have the balance sheet and financial flexibility to handle a significant increase in production levels.

I'd now like to turn the call back over to Ray.

Thank you, John. Just a few brief concluding remarks before we take your questions.

This quarter clearly represents the transition from (inaudible) backlog to a more balanced backlog and delivery story. We are very pleased with our Eclipse relationship, and we are encouraged by the progress ramping up the Avio NG production. In December we achieved the fastest certification of a new OEM aircraft avionics platform. And as John said, we flawlessly delivered 58 shipsets in less than a month.

Over the past year we've invested in the resources needed to meet our expected production commitments, and you have seen the impact reflected as higher costs in our financial reports. However, these investment will have a significant return by sustaining our reputation for high-quality manufacturing and on-time delivery as we increasingly fill our factory.

While Eclipse currently accounts for a disproportionate share of our deliveries in short order, both the FedEx and the American Airlines projects will join Eclipse on our factory floor. And we are working very hard to bring many other projects online later this year.

In the short term, barring any changes, Eclipse production is expected to reach a run rate that should provide a solid, fairly predictable revenue stream, perhaps accounting for as much as half of our revenue this year. But now we have a solid foundation, onto which we will be layering additional revenue from the various other contracts and opportunities we have discussed. This will enable us to leverage our manufacturing and other overhead to achieve attractive financial returns.

In a very short period of time we have created many solid relationships with some of the world's most respected commercial, military and business aviation operators. We believe there is still a vast untapped opportunity to grow our flat-panel display systems, and we are pleased you have shown the confidence to join us in our journey. Thank you.

Now, we have deliberately left our remarks short today. We felt that at the last conference call we were -- seemed to be rather tight with time and closed down the proceedings rather too quickly; therefore, today we have, I think, plenty of time. We would, however, like you to restrict your questions to one each to start with so that we can get through the long list of participants on the screen here. And we have the balance of an hour available for your questions. Thanks.

(OPERATOR INSTRUCTIONS). Tyler Hojo, Sidoti & Co.

I guess my question would be, I didn't hear you kind of back the statement that you made last conference call, Ray, which was basically that you'd be able to do 50 million in revenue this year, and profitable by the back half of the year. Does that still stand?

We rather sort of turned that down a little bit. If you looked at our presentation that we disclosed in the 8-K on January the 10th, you would see that we said we will do the upside of 40 this year. We had some late adjustments to Eclipse, quite honestly, which affected us on that forecast, and that's why we turned it down.

Just in terms of, I guess, the updated revenue look, would you be able to give us an idea of how many Eclipse deliveries you're kind of modeling to get to that kind of run rate, for 2008 that is?

All I can say is we expect it to be on the order of 500, but I don't want to go into detail on it, quite honestly.

That's fine. Thanks.

Michael Ciarmoli, Boenning & Scattergood.

Can you just elaborate a little bit more on the legal expenses? I know a lot of this is you're going about this to protect some of your intellectual property on the Air Data products. But it seems over the past five quarters now, you've spent close to $10 million, and it doesn't look like we're seeing that kind of quarterly or annual run rate from that Air Data product business to justify this type of spending. Is there a significant opportunity out there, revenue opportunity that you would see that kind of, in your opinion, justifies throwing money at older technology rather than plowing it into R&D, or anything else that could give you more advantages on your flat-panel technology?

I'm going to make a general point, then hand over to Roman, who's very close to this whole subject. This is not just about something from all the technology [bank]. This is about our readiness to protect our technology against anyone who is prepared to try and take it from us. I'll let Roman elaborate on the opportunities.

I've been the Company's point man on the legal proceedings here. And as you can imagine, a lot of this is sealed testimony and so on. But to your general question, we do see a continuing future for Air Data products. There was some harm done to the Company by the defendants. The jury verdict validated that belief on our part. We've been awarded compensation for that. There are ongoing impacts from that that are now being reversed. We do see some major opportunities out there. I won't elaborate on them here. But it's not just a protection of older technology, it is actually protection of future revenue streams. We continue to do an underlying Air Data business, all of which would have been under attack if this had not been protected. And as Ray said, it's beyond just protecting our intellectual property here; it's just -- it's the strength of the Company; a lot of its core competency is the intellectual property we bring, not only to this product line but others. And we believe it's in the best interest of our stakeholders to do exactly that, protect it.

Do you guys have the Air Data revenue number for this quarter?

I believe it's 1.1 million.

What sort of run rate? Do you see it staying at that $1 million run rate going forward? I know you've said there are opportunities; you don't want to get into it. In the past, I think, the number was kind of a 10 to 20 million run rate. Is that still out there? Is that still possible for this product line?

Certainly further out it's possible. We're anticipating between 6 and 10 this year.

Last question, on the gross margins. It looks like, obviously, the work on Eclipse has put a lot of pressure on those margins due to start-up costs. Do you foresee significant start-up costs with the American Airlines, FedEx? Is this going to be --?

No.

So even future projects that come out, margins should be at that 50% level? The Eclipse was an isolated issue?

I'm not saying that each one as it starts will be right up at the top there, but certainly that's what we'll be seeing overall as time progresses. Each start-up will give us a small hit. But we don't expect it to be anything like what we've had on Eclipse.

Thanks.

David Campbell, Thomson, Davis & Co.

I wondered if you could give us the status of your certification work with 767's, 737's, and other programs at the FAA.

767 is basically certified. We are actually making some changes for the current customer base, but those are -- those will essentially reside under the current certification, although we do have to advise the FAA. The 73 we've talked about. We forecast that to be in next calendar year, Q1 next calendar year certification. The Cessna we've previously announced should be in Q4 of this financial year. I think that essentially covers your question, doesn't it? [Aren't those] the three programs you mentioned?

Ray, if I might -- 757 certification is also in hand. I'll just elaborate a little on Ray's comment that we get a baseline certification, and then as customers want specific options or slight modifications to their aircraft that are different, we do file amendments or deviations to the original certification. We're not going to, as such, publish that. These are minor changes that are done in the course of business. And this just keeps expanding the fleet. When we talk 767, I think it's important to recognize we that have certification on the -200, the 300, the ER version, the freighter versions, and so on. So it really does encompass the entire fleet sizes when we talk about that.

Were there any orders received in the December quarter or January for flat-panels, other than the Eclipse pickup?

Yes. We previously mentioned that FedEx had placed an order under their contract, if you recall. Their contract, like Eclipse, didn't put all the requirements in the order book in one go. They placed an order worth $4.5 million in January.

That's not in the $70 million (multiple speakers)

That's not in the December quarter numbers.

Thank you.

Paul Kaump, Northland Securities.

R&D jumped up a little bit in the quarter about $500,000. Is there anything -- is that related to Eclipse, or is Eclipse mainly coming through the gross margin line?

It's not related to Eclipse. There are a number of programs running, as you're aware. The big program is Cessna, but we've got several military programs we're working, not the least of which is C-130 for the UK, and hopefully for the Coast Guard here. We're working on the Dutch DC-10 tanker with Boeing, for example. So we have a lot of things going on. We're running about six programs which we consider to be major, and two or three smaller ones. We have anticipated overall that our expenditure will be up this year; it was planned to be above last year's, and that's about getting new product into the marketplace.

Okay. Last question. On the SG&A line, you pull out the $3.5 million of legal expenses -- kind of puts you, if I did the math right, 2.4, 2.5 million for the quarter. Is this kind of the baseline operating footprint that we should be thinking about going forward? It seems like it's down a little bit from prior quarters, even when you adjust for legal expenses.

In looking forward, I would say, yes, that probably 2.4 is a low base, and 3 is probably more a run rate that is in line; again, with the caveat that as we deliver against the backlog, or as we ship against the backlog, assume the margins and all stay intact, the 3 million run rate will stay. But, to the extent that things are not coming together on the top and on the margin, we'll have to take a hard look at that SG&A.

Good deal. Thanks.

(OPERATOR INSTRUCTIONS). Alex Hamilton, Jesup & Lamont.

Actually, the bulk of my questions have been answered. But can we talk about, I guess, what was the amount of deliveries revenue-wise for the Eclipse during the quarter?

I don't really want to talk (multiple speakers)

That's details that, by our contract, we're not allowed to disclose that information.

You've got the volume (multiple speakers) all the numbers you need to look (inaudible) things we don't really want you to have.

I missed the first guidance discussion that you had. You're still looking for about $40 million of revenue in fiscal '08?

The upside of 40 this financial year. yes.

I guess there's sequential improvement in the quarter, is kind of what we would look for.

The forecast that we published in the 8-K, just for your information, that 4.7 for this quarter we just reported on here, 6 plus 12 plus 16 plus, totaling 40 plus.

Thank you.

Adriano Almeida, DGHM.

I'm wondering kind of what -- I think you said -- what was the number -- 300 and something of the Eclipse units you are planning on shipping this calendar year? Is that correct?

Around 500, I said.

I think the run rate is going to match the production schedule of Eclipse. So it's difficult, I think, at this point for us to really say with certainty and try to predict. I think everyone is aware of the Eclipse status, or Eclipse situation. But it may vary. Again, it's really somewhat beyond our control.

Can you describe (multiple speakers)

There are two components to it. We match their production rates in anticipation of it. So as they ramp up, we ramp up with it. Secondly, they have a public commitment they've made to their customers who bought Avio, the pre-Avio NG product line, to retrofit the upgrade to the Avio NG with its increased capabilities. So all that business will also accrue to us. They have a timetable that they're working with their customer base on doing that upgrade, and we will support that. So that is how those numbers are given up. But anything more specific than that -- we're tied to them, but we don't disclose it because, again, of contractual agreements.

I think we can reasonably say that their current plan is to retrofit all 100 this year, this calendar year.

But from -- I guess the bigger question is how much they could actually produce of the Eclipse. Because I guess they've done 100 so far, right? And they've been plagued with some production issues. So I guess that in the past they've been much more optimistic than they've been willing -- able to deliver. So what -- are you just using whatever they're telling you they're going to produce this year in terms of projecting your units, or are you discounting that a bit? Because I've seen some numbers that they're only going to be able to do 200 this year.

We're trying to take a view. You've got all sorts of numbers, but we're pretty close to them. We know how they're running because they're calling off the requirements from us and they're refreshing every week, so that we get an eight-week view, and we have the forward and maybe more ambitious view. But the eight-week view is absolutely accurate; that's what they're going to consume in the next 16 weeks. And therefore, we know how they're running. So, yes; we've taken a view. But it's certainly more, a lot more than 200.

It is more than 200?

For sure.

Can you kind of just share with us how you view this recent investment that they've had from this European group? And I guess there's some Russian backing behind it. How does that change it? Does that change the picture at all? What was the nature of the need for that equity raise?

It would it be safer for us to really stay away from that. I think it's naturally a very good thing that they've had capital infused; it basically makes a partner, a significant partner of ours at this point anyway in this quarter, very financially healthy and so forth. But beyond that, I think going any further -- I don't (multiple speakers) I think there was a conference call recently where Eclipse talked about that, so we'll leave it at that.

Thank you very much.

Tamara Manoukian, Greenwood Investments.

I was wondering if you could quantify in your gross margin how much were the start-up expenses on the Eclipse.

We're not prepared to do it. (inaudible) last quarter that you were really asking detailed questions, Tamara, which I don't think we answered. And we're not going to be doing so today.

I will just say if you look back, clearly, the margins of the Company were in the 40% range. This quarter, obviously, product margins are stated right -- are in the high 20s. Clearly, we believe the 40s, and the mid-40s in particular, are attainable as we go forward. But we'll leave it at that. That's about the extent of our [comments there].

So would you say that most of the -- the biggest reason in the decline in gross margin was the start-up expense?

It's a combination of the start-up expense as well as the fact that you've got fixed overhead and absorption issues that both impact. When your volumes fall down and your sales volume is at a 4.7 versus a 10, for instance, in a quarter, you're going to have some impact from both sides. So how to cut that, I'll leave that to you.

I was wondering how much of Cessna is in your backlog.

Cessna?

We haven't talked about that and we're not really prepared to talk about it today.

Fair enough. I was wondering maybe you can elaborate on what are the future opportunities whether you are bidding for new projects, any kind of -- the market opportunities. I think that in the past, we've heard some numbers about what [you were] bidding for, or anything like that that could indicate what the market opportunity is for you guys.

I believe in the past the Company has announced that [we were] bidding for $100 million worth of potential orders. I'm not prepared to state the volume in those terms. What I can tell you is that we're currently talking to between six or seven major airlines in Europe and the USA, and we have others that we're beginning to work with that we can build relationships with. We have some new initiatives in our [Piladis] product that we think will yield some results this year. We have of course the relationship with Cessna, which should [come] good for us in the fourth quarter. So there's a lot going on there in the marketplace, but to quantify the total would be kind of futile, because we haven't yet established really what our bid-to-take ratio is. So I know what we're bidding, but I can't forecast what we're going to take.

I'll add to that also, Tamara, that our portfolio of proposals is balanced, very well balanced against the commercial, the military, general aviation segments. We have a number of outstanding quotes with large integrators such as Boeing, Lockheed Martin for instance. So there are many opportunities we have. Depending how the markets develop, as funds become available to the different segments, we expect to capitalize on each of them.

Thank you very much.

David Campbell, Thompson, Davis & Co.

Just a couple of follow-ups. One, if you could give us a little bit more status of -- information on the status of the legal case, and any more dollar recoveries from damages and so forth that follow on the $6 million award.

I'll give the update on that for the Company. There is a hearing on exemplary and punitive damages in front of the presiding federal district judge in March of this year, March of 2008. As we made the public aware, the defendants were found guilty of willful and malicious conduct; that's why there is an exemplary and punitive damages phase, in which we hope to recover both damages and legal fees. But that's yet to be determined. So that hearing is scheduled for March. There will be some costs associated in preparation for that hearing. As that develops, we'll certainly let our stakeholders know about that.

There was a loss of 50,000, roughly $50,000 from engineering revenues in the first fiscal quarter. What was going on here?

Roman, if you want to touch on that, it's the nonrecurring (technical difficulty)

That was a different project, a combination of different projects.

It's a multitude of projects that make up that number, so --

-- some variances to our expectations.

There's an Eclipse element there, which I know has been spoken about previously, which it's -- beyond that, basically it's a summary or a synopsis of a number of different engineering projects. And as you see, last -- the comparative period last quarter is about the same sort of breakeven, roughly, margin.

Normally you'd expect to, as I understand it, have some profit margin on those revenues.

I think, at least in my observation, only having been here three days, clearly, this is the way to build customer relationships and continue to drive the business, by meeting these needs. And the goal in many cases is to recover costs. And so, Ray, I'll leave it to you (multiple speakers)

There is clearly an issue here. I don't anticipate that we're going to be looking for profit from engineering work going forward. What we're trying to do is get cover of some of it, or as much as we can from customers. But it's not going to be profitable cover; it's just to help reduce our own expenditure and investment in the projects. So there's always going to be this danger there's a little bit of marginal negativity in the total, which is going to be absorbed. We're not exactly talking about megabucks, are we?

Last one. Do you have any idea when -- is the $6 million payment, potential payment, dependent upon the March legal continuation of the damage suit, or is it possible to get that before March?

No. It's contingent upon the March hearing. The other is that the defendants have made a reserve in their public statements for the payment of this, so we do know they can cover it. They issued that kind of a public statement, and so the timing of it really is going to be dependent on the March hearing.

Okay. Thank you.

Michael Ciarmoli, Boenning & Scattergood.

Just a couple of follow-ups. Just for clarity purposes, I think it was said earlier that SG&A going forward would probably be around the 3 million run rate per quarter, and R&D probably at that same 1.7 million. Is that accurate? And should we expect total OpEx in that $5 million range going forward, with a slight build from there as you guys ramp up?

Correct on the SG&A. The R&D, I guess, I'll say I can't answer definitively at this point. I think that is more of a --

It depends on the mix of funded and unfunded (multiple speakers)

I wish I could say with certainty, but I can't. So I'd rather (multiple speakers)

But 3 million is a good baseline for the SG&A?

Yes. Assuming again that the top is staying and the margins are intact.

And then, just an update. Is there an STC update on the 747?

We're still waiting on the FAA to make some decision about whether or not the architecture we're proposing for that is correct. It's getting kind of tight for a timescale for this year, but we're expecting an answer from them in the coming weeks.

And then, if you could just talk about how the US economic conditions, particularly with how it's impacting the domestic carriers and some of the merger talks that are out there, how is that impacting your attempt to garner business from the industry?

I think I can really talk about it in generic terms, and have done previously, to say that there's an upside for us in the downside, and there's a downside in the upside in some respects. If aircraft are being underused, then there's an opportunity for a fleet upgrade for those we've decided to keep their fleets. If people see a downturn, they're unlikely to place orders for new airplanes, and they want to keep their fleets flying for longer and they'll have to upgrade their obsolescent avionics. So I don't see that the US -- problem in the US is going to impact us greatly, besides which, it may not impact the rest of the world anyway in terms of the airlines. There's no signs that the airlines in other parts of the world have got any sort of problem.

What about the kind of potential merger activity? [Does] that slow down --

That may slow things down. I don't think we're going to get an order from Delta this week because they're kind of tied up in talking to other people, for example, if that's what you're getting at.

What about in terms of talking with the international carriers? They seem to be the players right now leading this commercial upswing and performing a lot of retrofit work. Are you guys talking with some of the international carriers?

We're certainly talking to some Europeans. As we extend ourselves further east, we will be talking to Middle Eastern and Far Eastern airlines, for sure.

But really not yet, then?

(inaudible) Europe, where we're talking to two or three major carriers currently.

Great. Thanks.

Paul Kaump, Northland Securities.

Real quick follow-up. Q2 legal expenses; what should we be expecting there?

We certainly hope a lot less (multiple speakers)

I can tell you again in [three days]. There's not a desire to continue at the prior quarter's rate, in a big way. So I would imagine it's going to be significantly less. We can't put a specific number on it.

There's some costs associated with leading up to the hearing, but it's certainly not at the activity level that we had in the first quarter. Just to kind of -- we went through a long trial, 4.5 week trial and jury verdict, during October, November. So you can see where the bulk of the expenses were. This is not that type of an event. It's a hearing scheduled for one day. Yes, the lawyers will file briefs and counterbriefs, etcetera. But it's certainly not to the extent or the intensity that we had during the trial phase.

So the costs might be closer to what we witnessed or observed early on? Just a few hundred thousand, maybe?

It's hard to predict.

Any chance that this legal scenario plays out into Q3 as well, given that the March timeframe is a court date? Or is it after March, that's it, it's done?

There's always an opportunity for defendants to appeal. We cannot predict what they will do. But from our standpoint, assuming no appeal, would be over approximately in the March/April timeframe.

Thanks.

Adriano Almeida, DGHM.

I have just a couple of follow-up, more like technical questions on the balance sheet. Last quarter, I recall that you guys had actually taken the allowance for bad debt expense down to zero. Have you changed that this quarter?

That's still in the same position. There's no need for reserve; it's zero.

I was also last quarter a bit surprised that the accounts payable had jumped up to $4 million, which is the highest you've ever had. And then this quarter it went up another $1 million sequentially (inaudible). Was there something going on on the payables there?

Again, this legal matter we've been talking about throughout the call, you can appreciate there's significant spend for -- there was an amount hanging over the end of the quarter that basically drove the payables up. So that was the big contributor to the flux in the AP quarter on quarter.

Okay. So from a run rate perspective, that number goes down to -- in the payables -- what do you think it baselines at?

It should fall back down, but that's contingent upon the other aspects of the accounts payable, which relate to inventory, inventory management, and your regular trade activities. So again, that's somewhat hard to predict. I'm not trying to walk around the question, but I'll leave it at that. The inventory is relatively flat, as you can see in the balance sheet. And I would say it's going to trend back down, because this legal bolus did move it up at the end of this quarter.

One final. I don't know if you guys are prepared to answer this, but is there a volume level on the Eclipse units where you break even? Would you share that volume level with us?

At this point, again, we really do not want to get into specific discussions around specific products such as Eclipse. Under the terms of the contract, we have to be careful.

But you're losing money at these volumes, obviously.

No comment on that.

(multiple speakers)

We're not losing money.

I think the question was answered in a different vein than you asked. No; Eclipse product is a profitable product for the Company.

It is profitable already?

Absolutely.

No question about it, yes.

Thank you.

There appear to be no more questions at this time. I will turn the floor over back to Raymond Wilson for any closing remarks.

I just want to thank you all for participating this morning, and hopefully we can look forward to the upside we are predicting. Thanks very much.

This concludes today's Innovative Solutions and Support conference call. You may now disconnect.