Innovative Solutions and Support Inc (ISSC) 2014 Q1 法說會逐字稿

Good morning, and welcome to the Innovative Solutions and Support first-quarter 2014 earnings conference call. (Operator Instructions). Please note, this event is being recorded. I would now like to turn the conference over to Mr. Geoff Hedrick, Chairman and CEO. Mr. Hedrick, the floor is yours, sir.

Thank you, and good morning. This is Geoff Hedrick, Chairman and CEO of Innovative Solutions and Support. I'd like to welcome you this morning to our conference call to discuss first-quarter fiscal 2014 results, current business conditions, and our outlook for 2014.

Joining me today in our extant headquarters is Shahram Askarpour, our President; and Ron Albrecht, our CFO. Before I begin, I would like Ron to read our Safe Harbor statement. Ron?

Thank you, Jeff, and good morning, everyone. I would like to remind our listeners that certain matters discussed in the conference call today, including operational and financial results for future periods, are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially, either better or worse, than those discussed, including other risks and uncertainties reflected in our Company's 10-K, which is on file with the SEC. I'll now turn the call back to Jeff.

Thank you, Ron. In the first quarter, we reported revenues of $11.1 million, or a 70% increase to the first-quarter fiscal 2013. Net income was $1 million, or $0.06 per diluted share, up about 300% from the $318,000 earnings, or $0.02 per diluted share, in quarter one of 2012.

The revenue growth was attributable to an increase in shipments of various products to the significant progress achieved in our engineering development programs. Product sales grew 42% compared to the fourth quarter of 2013, up 63% from Q1 last year. Gross margins improved to 34%, up 25%, or 7 points from last quarter. Continued expense management grew net income faster than revenues. We achieved these results while investing 37% of revenue in product development.

The recent reorganization and strengthening of our leadership and manufacturing organization contributed to the improvement in production volume this quarter. Our increased productivity enabled us to provide the required manufacturing support to our engineering and development programs. We anticipate that the completion of these development programs will result in new orders of an estimated $90 million over the long-term OEM production. This is in addition to our currently -- our current backlog of $87 million. In addition, we expect FAA certification and the start of production of several of these programs will attract additional new customers.

Our growing portfolio of products -- including flight management systems, GPS sensors, and other next-gen aircraft air traffic control products with industry-leading ease of retrofit -- continues to offer the industry's best performance for price value. As a result, our customer base includes some of the world's largest commercial air transport and business jet operators, both domestically and internationally; foreign and domestic militaries.

We continue to develop advanced technologies that improve the performance, reliability, and efficiency of increasingly sophisticated new and existing aircraft. Our object is to capture a greater share of an expanding addressable market by increasing the functionality of our products to provide state-of-the-art technical solutions at a very competitive price.

Given the strong start to the year and our healthy backlog, we remain optimistic that fiscal 2014 will be another year of increased revenues and earnings.

Let me now turn it over to Ron for a detailed description of our financial performance.

Thank you, Jeff. And thank you all for joining us this morning. For the three months ended December 31, 2013, the Company reported its eighth consecutive profitable quarter. For the quarter, revenue was $1.1 million -- $11.1 million, up 70% from revenue of $6.5 million in the first quarter of fiscal 2013. The Company reported fiscal 2014 first quarter-net income of $1 million, or $0.06 a share, compared to net income of $318,000, or $0.02 per share, in the same quarter a year ago.

Product sales -- including flat-panel display, air data, and other hardware and software sales -- accounted for approximately 70% of total revenues. The other 30% of first-quarter revenues of $3.4 million resulted from customer support of our product development programs.

Gross margins in the first quarter were 34%, down from 46.5% a year ago but up nearly 7% sequentially from 27.2% in fiscal 2013 fourth quarter. Compared to the preceding quarter, margins reflect increased production volumes.

Over the course of this year, we expect to complete the engineering divestment -- investment in several of these product development programs, at which point they will transition to higher-margin product sales.

Total operating expenses in the quarter were $2.4 million, down from $2.7 million a year ago. The decrease was primarily attributable to a $200,000 decrease in spending on internal --internally funded research and development. However, the combined spend on customer support and an internally funded engineering development was approximately $4 million, or 37% of revenue. Selling, general, and administrative expense in the quarter was $1.7 million, down from $1.8 million in the first quarter of last year and also down sequentially from $1.8 million in the fourth quarter, principally because of an adjustment to a lower -- to lower an accrual related to the settlement of a legal matter.

As a percentage of sales, SG&A was 16% in the quarter. As revenues have increased, the underlying level of SG&A expense has remained relatively stable over the last four quarters, and we do not expect those expenses to increase appreciably in the near-term.

We reported first-quarter operating income of $1.4 million, an improvement of over $1 million compared to the $385,000 of operating income reported in the first quarter of last fiscal year. For the quarter, we provided taxes at a 29.2% rate, a rate which we expect to remain in effect for the full year unless Congress reinstates the expired R&D tax credit.

Net income for the quarter was $1 million, or $0.06 a share. This net income compares favorably with both the first and last quarters of fiscal 2013 at $318,000 and $155,000 respectively. Earnings per share of $0.06 in the first quarter compared favorably with the first and last quarters of fiscal 2013 of $0.02 and $0.01 respectively.

Operating activities used $223,000 of cash in the first quarter, primarily related to timing differences between expenditures on customer-supported product development programs and related receipts from those customers, and unbilled receivables grew as a result. These timing differences will reverse as these programs reach contractual milestones.

The Company ended the quarter with almost $16 million in cash on hand and remains debt free. We believe that we have sufficient cash to fund operations for the foreseeable future. During the first quarter, we collected the entire $760,000 pre-bankruptcy receivable from American Airlines.

I should mention that, following a competitive process, the audit committee of the Company's Board of Directors voted unanimously to engage Grant Thornton LLP as the Company's new auditors effective January 18, 2014. As a result of one of its periodic reviews, the audit committee concluded that Grant Thornton would better serve the Company's requirements at its present stage of development.

The transition to the new audit firm delayed the earnings release and conference call, as Grant Thornton spent time reviewing the Company's accounting records, internal controls over financial reporting, and financial results for the first quarter.

For the fiscal year ended September 2014, we expect to increase sales and generate profit, which would represent our sixth consecutive profitable year. The transition of certain programs from their development to their production phases should improve margins.

Now I'll turn the call over to Shahram Askarpour for further comments on market conditions and operations. Shahram?

Thank you, Ron, and good morning, everyone. For the first quarter, revenues increased significantly both from a year ago and sequentially from the fourth quarter. The first-quarter revenues also exceeded our targeted long-term growth objectives. This growth resulted from increase in product shipments and customer support of our product development programs.

In anticipation of over 20% increase in annual revenues year-over-year and manufacturing support to engineering programs, we restructured and strengthened the leadership in our manufacturing organization. Although we felt it might take a quarter or two to see improvement, first-quarter results reflect our progress in productivity and efficiency.

In the past, we demonstrated an ability to manage rapid production increases with quarterly production as high as $19 million. We believe that we can maintain and increase the level of output that we achieve this past quarter to support our growth strategy.

Also during this quarter, we made excellent progress on all of our product development programs, several of which are nearing completion. Among our most significant accomplishments, we obtained STC's for both the auto throttle and standby displays for the Eclipse aircraft. Development on this program has progressed to the point that we are shipping Eclipse EA500 production units. We have delivered and upgraded Boeing 737 Classic aircraft to the National Nuclear Security agency. The airplane is now in customer's possession and undergoing flight testing in advance of final certification.

With respect to some of our other development programs, during the first quarter we produced the first batch of pre-production orders for the Pilatus PC-24 business jet aircraft to be used for aircraft and qualification testing. We also delivered the first ship set for aircraft integration on the foreign military C-130 transport program.

The KC-46 tanker is in the midst of a lengthy qualification period, followed by support of customer flight testing. The MD-88 and the MD-90 upgrade program for Delta Airlines is progressing well, and we anticipate the receipt of FAA certification this year.

Our contracts with OEM customers consist of agreements to provide engineering to develop products and to be the sole-source manufacturer of the related product once development is complete. During the next two years, we expect the current OEM development programs to transition from engineering to production. At that point, some of the approximately $90 million of anticipated sole-source OEM production contracts will begin to add to the potential revenues already included in our backlog.

As an example, once it is development and certified, we have a contract to furnish the aerial (technical difficulty) control display units with a roughly 180 planned KC-46A aircraft. Our backlog does not contain any of that potential future revenues, which we expect to stretch over a decade or more. Revenues from the product sales from these OEM contracts should enable us to achieve margins consistent with our historical performance.

As we discussed during the last quarter conference, the product development programs have placed a requirement for additional resources. We are currently outsourcing a significant amount of engineering development work to cope with this demand. We expect that the same level of outsourcing and engineering expenditure will be required for the remainder of this year to complete some of the major programs in hand.

As of December 31, backlog is a healthy $87 million, down only slightly from $91 million at September 30, 2013. We continue to add backlog to new orders, which totaled $7 million during the first quarter of fiscal 2014.

In summary, in the first quarter we increased production to a higher sustainable level through improved productivity so that we can both increase our production volumes and support our new product development initiatives. As a result, we grew revenues in excess of our long-term objectives, expanded margins, and grew earnings at a greater rate than revenues.

Current backlog delivery schedule and increased customer support of our new product development efforts have created the demand that we expect to increase revenues this year compared to fiscal 2013. As we complete our product development programs and transition to production, we continue to expand our product portfolio and increase market recognition of our performance for price strategy.

Our production revenues for the first quarter grew by 42%, compared to the fourth quarter of fiscal 2013. We are beginning to see improvements in gross margins and operating profits as a direct result of increased production volume. These improvements provide us with optimism that our strategy is sound and increases our confidence that we are in the right path to continue to achieve meaningful growth this year and beyond.

I would now like to turn the call back to Geoff.

Thank you, Shahram. For the fiscal year ending September 30, 2014, we expect to report our sixth consecutive profitable year with sales, operating income, and net income, all of which expect to increase compared to fiscal 2013. This year should be a transition year, with revenues from production volume increasing as engineering development completes and products receive FAA certification and enter production.

Our number one focus is on execution. We need to continue to improve our productivity and efficiency to optimize the value of our development and production opportunities. In order to continue on our momentum, we anticipate investing 30% to 35% of our revenue in research and development as we continue to expand our product portfolio into new markets that benefit from our performance and price strategy. This ability to deliver results in the near-term while investing in long-term is a formula to create value for shareholders. We are fortunate to have customers who partner and share in the cost of that development.

Operator, I'd like to open the call for questions.

(Operator Instructions). David Campbell, Thompson Davis.

Thanks for the excellent first-quarter results. However, I assume from your comments that everybody has made that quarterly revenues will not increase 60% the rest of this year. Is that a good assumption?

I don't know yet (laughter). Yes, that's true.

That would be more than I was assuming in my previous forecasts.

We are pleased that we are starting to make the transition to a business that we are used to and are planning. We have made some good moves and Shahram has done some great work in redirecting and restructuring the organization. We've been fortunate with good business. So now the question is just focus on the business and, as they say, execution.

You mentioned, Shahram, that you had $7 million of new orders in the first quarter. I assume that means $7 million of more engineering modification contracts?

No, no, those were approved were mainly production.

Those were for production.

Yes.

Okay. But you're not supposed to get more production orders until the engineering contracts are over. So --

Well, no, you get production orders from existing products.

Existing products that we've had around for 20 years. We [don't] sell our data equipment. We still sell altimeters. We still sell displays for 5767. And we got -- and those are all production orders. That's great stuff.

Right, right.

Those are great orders.

Okay. So Shahram, I think you mentioned that the engineering work will be continuing throughout the balance of this year. Does that mean at the first-quarter levels which were -- I don't have in front -- $3 million or $4 million?

We don't expect it to increase. We expect it to be around that -- just maintain that level of engineering. We have a fair amount of product development going on right now, and some of which are -- we have not spoken about it. But we believe that it's absolutely required so we can sustain our over 20% growth year after year. And because of that we are not -- we are going to continue with this level of engineering, at least until the end of this year. But as our production grows, what we'll see is that we'll see improvements in our gross margins and profit because we don't plan to grow the engineering expenditure beyond what it is -- what we've seen in the first quarter.

I understand. I understand. But you did say that the FAA approval or STC certification for the MD-88/90 work will come during this year. But the production phase, I thought it was starting in late April.

So -- again and I don't want to go to too much into the details of that contract but we are and we anticipate some shipments prior to the final receipt of the final certification.

Delta is good -- that's probably for testing of equipment or testing the aircraft with the new --?

And simulators and things like that.

Okay. Now, the PC-12, there was a recent article about the PC-12 upgrades with new engines. I assume that your new contract -- or your new equipment for the PC-12 there, is that anything to do with the new engines, or is it separate program?

No. Actually, the Company that does the engine upgrade on the PC-12 and also do [proper] upgrades -- propeller upgrades for the PC-12. We partner on them with some of the upgrades. But it's not tied into our display system. Some people choose to do them both together; other people choose to do one or the other.

But did the display systems for the -- the new display systems, have they been -- have you begun to deliver those yet?

Yes. We are delivering those. Our first customer on that is the US government, and we've been delivering those to them.

Okay. The -- you mentioned the Eclipse, and you said Eclipse 500 production (multiple speakers) has been shipped. It's 550, isn't it?

That's right. Eclipse 550. We've actually started shipping production units to them.

Right, right, right. And that -- you've got [STC] approval on those?

Yes. We have TSO. But we also have STC on that. That's good.

Right, right, right.

Now, that's the TC that Eclipse has to do on the 550 (multiple speakers). The 550 is going to be a tax certification done by Eclipse. But what they're doing is they are taking our STC and converting it into their TC, and then they are going to start shipping airplanes to their customers.

Okay.

So we are in the process of doing that with them right now.

Well, Ron, my revenue forecast looks a little low for fiscal 2014. I don't think the earnings are, but because of the heavy -- heavier revenues from engineering contracts -- but it looks a little low.

Well, refresh my memory on your forecast.

Well, my forecast was $38 million in revenues for the year.

Yes. Okay.

That looks low.

We hope it is.

We hope it is, but I would also remind you that we don't have 100% of that work order covered yet. So about [$38 million], we probably do, right?

So, right now I would -- if I would -- I would suggest that we see what happens the next quarter. Everything looks very good, but the thing we don't want to do is overreact to good news. We are very pleased with the performance, and we think we are going to do continue to do very well. And we will keep everybody updated with progress know on the order book and product development.

Yes well, I don't really think that my earnings are that far off estimates, but the revenues seem to be. The revenues seem to be. So I'm just -- if you continue to -- if you continue to generate this much in EMD engineering revenues.

The issue was always when you are growing at 25% or so, it's very hard to be precise with what -- because you're growing so rapidly, one incident can make a big difference in the revenues. So --.

I do -- I have a question about the C-130s. There was an article at the -- there's a dispute in Congress about upgrading the C-130 cockpits, and I was wondering if that's not a problem for you.

That's a problem for Boeing because that -- that is really the problem, whether they want to spend $17 million on airplanes and have Boeing do their amp upgrade or go to people like us for a fraction of that.

The dispute was that the Air Force went ahead with an upgrade, so-called AMP program, aircraft modernization program. That was -- by everybody, including the Joint Chiefs of Staff, was taken out of the budget by the military and put back in by the Congress. It is -- the costs were running almost $15 million to $17 million for the upgrade. When it's priced competitively in the marketplace, it's about $1 million. So, needless to say, it's difficult to justify. Now that's the biggest problem.

We expect something like $2.5 billion or $3 billion coming up with a technical solution that's so expensive that it makes the -- makes it virtually impossible to do. So that's why we have received a number of orders starting the upgrade of the cockpit by a number of the services independently because they don't have $17 million to upgrade their aircraft.

So you are the alternative to the expensive Boeing solution?

Pardon me?

You're the alternative to the expensive Boeing solution.

(Inaudible) using the alternative.

(Inaudible) alternative.

But nobody's using the Boeing solution yet. It's not -- look, it's not a Boeing issue. It was -- unfortunately when you have a large development program like that, things grow and grow and grow. And I'm sure Boeing did what they were asked to do. In view of the cutbacks in the budgets and the -- just there is no money for that. And that's not uncommon.

Yes, sorry. Right. But doesn't sound like anything is going to hurt you.

Running out of money is -- when we have a much more cost-effective solution, it is good news for us.

Right.

I remind you, I started the business in 1988. Everybody told me the last thing you want to do is get into the military because there's going to be no -- there is no military budget. At the time, I concluded that if there was no money the first thing that would be cut would be new procurement of new weapons systems. Well, it turned out to be right, and the retrofits that we ended up building the business on were very successful.

So when things get cut back, people get very serious about getting best value for money. They want -- when you don't have much money to spend, you end up being very frugal.

And you think that as the -- as you complete deliveries of initial deliveries of displays to Delta for the MD-88 and MD-90 program that that may promote -- that may contribute to additional orders from new customers for commercial aircraft.

That's correct. We believe virtually every program that we work on today results in an expanded market opportunity, because we consciously select programs to go after that are -- that leverage us into an expansion of our market offering.

And why is that, because the commercial operators want to actually see the operation of the display units before they get --

Not so much the display unit. It's the total solutions and the performance that we offer.

Right, right. I know it's more than display. But the potential new orders come because they want to actually see the new equipment working.

I know. Look. Think about -- what would you do if you spent $100 million? You probably would like to see what color the paint was. So I mean, it is -- what we are able to demonstrate by an installation is the fact that the equipment works well, that everybody is happy with it, and then it gives other people the idea that they can do the same thing very cost-effectively. And that's how it's sort of builds.

We are fortunate to have a customer like Delta, whose technical and business savvy is industry standard. As you know, they were Airline of the Year, so -- internationally. Yes. They're an amazing success story.

I don't like to fly them, but they are doing okay (laughter).

What?

I don't like to fly them. Those MD-80s drive me nuts. But anyway, that's another story. But thank you very much. Appreciate the help. Keep up the good work in being so efficient.

(Operator Instructions). Scott Lewis, Lewis Capital Management.

Congratulations on a very nice quarter. My question is about the 737 program. Now that you've moved along a little bit, can you talk about the prospects for the market there?

So we have a fair amount of interest, both internationally as well as within the US, for that solution. Again, the key is to finalize the certification, and we believe once that is finalized that we have other customers who are interested to procure that solution.

Okay. And do you have a timeframe in mind for getting the final certification?

It's within the next two months.

Okay. Super. And then my second question relates to the backup display that I believe is going in the Eclipse 550. But that can go into other aircraft, right? And are you having success selling that into other models?

It's going into (multiple speakers) it's going (multiple speakers) --

It was sold into the Delta Airlines for their MD-80/MD-90. It's going into the C-130 platform. And we are seeing a significant amount of interest from various OEMs for helicopter as well as fixed-wing aircraft, as well as other airline operators that they're going to use the standby for their regional and air transport fleet.

Okay. So I assume when you -- if you put a lot of volume through that product, it's the gross margins get better and better.

Absolutely. Absolutely. When you look at like the gross margins, we increased our production revenue this quarter, and we saw a significant increase in the gross margin for (multiple speakers) production.

Understand, we are fortunate to have customers who are willing to partner and share in the cost of product development. We don't make -- there is no intention to make a big profit off of engineering development. We're not in the engineering business. We are fortunate to have customers who will help us in the development of these products.

If the gross margins are affected directly by production, where we have intrinsically a very large available gross margin in all of our production products. So as we transition into more and more production, we will -- which is the core of our business -- we will -- our gross margins will grow accordingly.

Okay. Super. Well, congratulations on (multiple speakers) --

When you're looking at our historical gross margins, they are not much different than they were eight years ago. We used to have gross margins in the 60% range.

Okay. Well, let's hope we see them back in the 60% range when August production (multiple speakers) --

Remember, we are not focused so much on gross margin. We are focused on earnings-per-share, which is what we are interested in doing mostly; and we've always had that discussion. If we get gross margins in the -- as we've talked about, 50%, we'll be delighted.

Okay. Super. Well, it's nice to see it all coming to fruition, all these years of R&D. Keep up the good work.

Mike Fredericks, Bonding & Insurance Specialists.

My question was about the -- and I'm sorry, I tuned in about 15 minutes late, so I don't know if you touched on it or not. But on the FAA and whether or not you guys think there is going to be any movement on the priority landings at certain airports that might really help you guys with the uptake in getting some of this equipage into some of these other airlines.

The FAA is interested in what we are doing. In other words, directly interested. Because with Delta, they -- the RNP, the required navigational performance, will enable far more traffic to manage the same airspace. And they've taken a great interest in a very cost-effective solution to next-gen air-traffic control. So, and the short is yes.

Okay. And I realize there's been some early adopters here with these things, and I'm sure that their patience is getting a little bit short with the FAA because they've obviously done some upgrades that they are really not able to take care -- take advantage of. Do you think there's enough pressure they can generate to speed up this process? Because I think I read a few weeks ago that Newark had put a new policy in where they were actually going to be slowing down the in-and-out traffic.

Well, they may slow it down. What will happen is that, inevitably, the equipped aircraft will start getting priorities. And as the equipped aircraft get priorities, the other aircraft will be slowed down and the incentive to put the equipment on will grow very quickly. And that's what happened with reduced vertical separation. So, a similar situation where they got priorities going over the North Atlantic when they were RVSM equipped. And it didn't take people very much time to figure out that they wanted to do that quickly and put the equipment in the airplane.

Look. The only reason you put equipment in the airplane in the long-term is so that you can make the equipment more effective and more efficient. And that's what this equipment does, period.

Sure. And it does appear that even outside of any sort of FAA next-gen deadline that the equipment you're talking about has a market as soon as -- well, it has a market right now, but a much bigger market at the time where the FAA actually starts to take advantage of these equipments. Correct?

Well, I think -- it's a cat and mouse in a little bit. What you have got to do is you have to have enough -- you have enough equipment on the aircraft to have a viable RNP procedures -- precision procedure into the airports. And when that -- when enough equipment exists, then they'll offer priority to those aircraft with that equipment.

It's the same thing happened in Europe. Eventually you couldn't get into certain airports without the RNP equipment. Initially you got preferential treatment. And if you circle for 10 minutes or 20 minutes, it inspires you to get the right equipment quickly.

Absolutely. Do you think -- do you have any -- do you guys have any thoughts on a timeframe where they are going to start to amp that up a little bit more?

I have no idea. Trying to guess what the government is going to do is really tough to do. All I know is that it's inevitable because it's absolutely required. And so the best thing we can do is keep working on it and working hard. Our equipment, we hope will be in -- by the time that acute demand comes, our equipment should be very easily installed and very competitively priced.

Great, great. Thank you, gentlemen.

Since there are no more questions, this concludes our conference for today. First, we'd like to thank the management team for your time. And we thank you all for attending today's presentation. At this time, you may disconnect your lines. Thank you, and have a great day everyone.

Thank you.