Innovative Solutions and Support, Inc.

Greetings and welcome to the Innovative Solution and Support, Inc. Second Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Michael Linacree, Chief Financial Officer. Please go ahead.

Thank you, Operator, and good afternoon, everyone. I would remind our listeners that certain matters discussed in the conference call today, including information about new products and 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 our company's 10-K, which is on file with the SEC and other public filings. Now I'll turn it over to our CEO, Shahram Askapur.

Thank you, Mike, and good afternoon, everyone. I will begin today with remarks on our performance in the fiscal second quarter of 2023, followed by comments on our long-term growth plan and strategies. I will then turn the call over to Mike, who will take us through the financials. Our second quarter results demonstrated continued momentum of our business and elevated demand for innovative products. Compared to the prior year, our net sales were up 7.2% to $7.3 million. This improvement was driven by the higher volume of our aftermarket products, including our order flow for the key years. I would like to remind our investors and stakeholders not to overanalyze our quarterly performance, as it can be subject to variations in purchase order timings for our aftermarket products, which currently represent approximately 40% of our revenue. While we are pleased with our strong performance this quarter, it is crucial to take a more comprehensive and long-term view of our financial performance and growth. As we have reported on in the past, our business is well positioned to benefit from significant operating leverage on higher sales, which was demonstrated again in the second quarter. As such, Our gross margin expanded to 64% from 61% in the prior year, primarily due to leverage on higher volume and a favorable product mix. Operating profits in the current quarter was $1.4 million, which was $380K lower than the previous year. The decrease in operating profit was primarily due to higher SG&A expenses, which were mostly one-time in nature and related to non-cash stock-based compensation and relocation expenses. Turning to net income, we achieved 1.3 million, which is a slight decrease from the prior year of 1.4 million, for the same reasons. As we continue to invest In our sales and business development initiatives, we are experiencing strong returns as indicated by our end of the quarter backlog of 14.8 million, a significant increase from a year ago and driven by new orders of 13.6 million in the quarter, which is a record in recent years. Moving forward, our goals are clear. We want to increase facility utilization to maximize our margin potential. We have a two-pronged approach to achieve this goal, through organic growth by driving new product introduction and through inorganic growth via M&A. To support our organic growth, we continue to invest in our IR&D programs. Although IR&D as a percentage of sales is still below our full year target of 13%, we anticipate meeting our target on an annualized basis as we continue to expand our engineering department selectively with highly qualified and self-motivated engineers. We believe that investing in IR&D is critical for long-term success, and we remain committed to this approach. Specifically, we remain focused and see our primary competitive advantage in the area of cockpit automation, which you have seen with the introduction and broad market success of our oral travel programs. Our long-term plan is to provide the industry with incremental automation technology that would ultimately lead to reduction in number of pilots in the aircraft. To that end, I'm pleased to announce that we have shipped our initial orders on our recently awarded STC for the ThrustSense Aeroflot for the Beechcraft King Air 200 and 300 aircraft with the Garmin Cockpit. This certification has allowed FrostSense to be installed on an additional 700 potential platforms. On the inorganic side, we are actively seeking opportunities for M&A and have been working diligently to develop a robust pipeline. During the quarter, we made important progress by obtaining shareholder approval to amend our articles of incorporation. This strategic action will enable us to secure the financing needed to implement a more aggressive M&A program and execute to our long-term goals. To this end, we are currently working closely with our banking team to evaluate the best structures for our needs, and we plan to keep our investors informed about progress in upcoming quarters. In our M&A programs, we are focused on identifying and acquiring complementary products and technologies to our existing portfolio. We are targeting smaller, wall-ton acquisitions that are under $25 million. Our goal is to expand our portfolio and fill capacity in our facility and we believe that these targeted acquisitions will allow us to do so efficiently and effectively. We are constantly evaluating potential acquisitions, targets, and look forward to providing incremental updates in the coming quarters. In summary, we believe that our performance in the second quarter demonstrates continuous momentum and strong demand for innovative products. Moving forward, we have clear goals to increase our facility utilization and maximize our margin potential through both organic and inorganic growth. Thank you for your time and interest, and we look forward to updating you with the future details in the upcoming quarters. Now I will turn the call over to Mike for a closer look at the numbers.

Thank you, Shahram, and thank you all for joining us today. I will review our financial results for the second quarter of fiscal 2023. Our revenues were 7.2% higher at $7.3 million in the second quarter compared to $6.8 in the second quarter of fiscal 2022. The growth was largely driven by new orders from commercial air transport customers in the Boeing 757 and 767 aftermarket retrofit business. An increase was also seen due to new auto throttle installations. As we noted during our last earnings call, orders in the aftermarket retrofit business fluctuate from quarter to quarter. Since it is approximately 40% of our business, our overall revenues may fluctuate from quarter to quarter. This quarter's results, for example, reflect certain orders that were carried forward into the second quarter but were originally expected during the first quarter. While we do not anticipate any significant changes in the long-term organic growth trajectory of our business, we believe that our progress should be evaluated on an annualized basis. Second quarter gross margin was 64.6% compared to 61.1% in the second quarter period from a year ago. The improvement in gross margin reflects an expansion in operating leverage as a result of higher product sales, a favorable product mix, an increase in inventory, and a slight decline in direct material costs. The gross margin improvement is very much in line with what we have previously mentioned. Our optimized operating model is based on a fixed cost platform with relatively low employee headcount with operating leverage and margin profile well-positioned to benefit from revenue growth. We plan on continuing to see additional operating leverage as sales continue to grow. Operating profit in the current quarter was 1.4 million or 19.4% of sales, which was lower than the previous year's 1.8 million or 25.4% of sales. Total operating expenses were 3.3 million in the second quarter versus 2.4 in the prior year second quarter. The rise in operating expenses were primarily related to higher SG&A. These expenses included non-cash stock-based long-term incentive compensation. Expenses were also higher as a result of additions made to the sales and business development teams, as well as marketing and investor relations and investor-facing related expenses. Higher SG&A expenses were partially offset by higher interest income generated due to larger cash balance and higher interest rates compared to the same period in the prior year. R&D expenses of 11.8% of revenue and in line with a year ago second quarter levels, we still expect to spend 13% of our revenue on R&D by the end of the year and continue to hire engineers to support product development efforts. Tax expense in the second quarter was 0.3 million compared to 0.4 million in the prior year quarter. Second quarter net income was 1.3 or 8 cents per share versus 1.4 million or 8 cents per share in the second quarter of fiscal 2022. Net income was 1.3 million or 7 cents per diluted share down slightly from the prior year of 1.4 million or 8 cents per diluted share. Backlog was 14.8 million as of March 31st, 2023, versus only 7.5 as of March 31st, 2022. New orders for the second quarter were 13.6 million. The increase is largely due to customers locking in orders for a longer period of time, such as Pilatus, who has ordered through late 2024. Additionally, Boeing has given us larger long-term orders as well. And these factors have largely contributed to the growth in our backlog. Our customers' confidence in us is reflected in these longer-term orders, which in turn also enhances our visibility for future performance. We include only purchase orders in hand from the Pilatus PC24, Textron, King Air, and the KC46A long-term programs in our total backlog. We anticipate that these programs will remain in production for about a decade and should continue to add to production sales already included in the backlog. We had 19.8 million of cash on hand as of March 31st, 2023, up from 19.4 million of cash on hand as of December 31st, 2022. Cash on hand was 11.6 million as of March 31st, 2022. The company generated cash flow from operations of $0.4 million during the quarter. Our cash generation was impacted by the new IRS Section 174 R&D tax regulations that increased our estimated tax payment by approximately $0.4 million, an inventory build of $0.6 million, and $0.3 million due to timing of accounts receivable payments received. We continue to generate cash flow and grow our cash balance without any debt on our balance sheet. This provided us with significant financial strength and flexibility as we seek to execute on our organic and inorganic opportunities going forward and deliver returns to our internal and external stakeholders. For the remainder of fiscal 2023, we anticipate generating strong cash flows with similar or higher gross margin levels as capacity utilization and operating leverage expand against the backdrop of revenue growth from organic and inorganic opportunities. With that, operator, we are ready for questions.

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your lines in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, It may be necessary to pick up your headset before pressing the start keys. One moment, please, while we pull for questions. Our first question comes from Tim Moore with EF Hilton. Please go ahead.

thanks and congratulations on the strong orders catch up in the quarter and it was nice to see the backlog up 74 percent sequentially from december and double from a year ago with a very impressive strong book to bill you know i do appreciate you you guiding to thinking of everything maybe on a 12-month rolling basis but it was still impressive um so you know my first question is i know you elaborated a bit on the gross margin which was amazing in the quarter Was most of that caused by the mix? Was there more aftermarket sales there, or was it more caused by the operating leverage benefit? I'm just trying to wrap my head around maybe the main drivers of that margin expansion.

Yep, it's a combination, but we did in Q2 have a higher proportion of aftermarket business, which is typically a bit higher margin than our OEM business. So it was a combination between that and... the increased sales overall to create that operating leverage.

Great. That's helpful. You know, and something I just wanted to follow up on, you know, you were giving good clarity on this maybe. Your SG&A expense, from what I recall, there was a bit more pressure on it in the first half of the fiscal year, which you just reported, because there was some one-off you know, professional expenses, you know, banking fees, maybe legal fees, and some catch-up. When you kind of think about the year as a whole for this year, we should probably expect SG&A as a percentage of revenues to drop in the second half of the year, right, compared to the first half of the year? Did you roll off a couple things?

That's correct, Tim. In Q1, you'll see a – Q1 and Q2 and through the first six months, you'll see SG&A – roughly around the low 30% of sales compared to our traditional run rate of about 26%. Q3 and Q4, it'll be closer to our historical run rate with the elimination of some of those one-time impacts. We'll be roughly running 27-ish percent and finishing the year probably a few basis points, a few points above our typical run rate of around the 30% range. But definitely we see a relief coming in Q3 and Q4.

Thanks, Mike. That's really helpful. As I do my modeling, I just want to check that. Yeah, that'll show up nicely in the operating margin expansion. What about, you know, I know that you're spending more on R&D and you're focusing still on your continued product development, which has always been the core of Innovative Solutions Support. Do you speak to any kind of the timing of any developments? I remember reading last month about the Helix flight decks announcement, and I think there probably could be some cargo instruments or engine innovation coming. Do you kind of give us a sneak peek of maybe some new things or adjacencies that are maybe in the pipeline over the next year?

Oh, yeah. And actually, to your first question also, We have been investing in our business development and sales organization to essentially start there where we would go the top line. So some of the increases in the SG&A from tradition, they will be slightly higher because we've hired some good, capable sales and marketing guys. to help us grow the business. With regards to product development, again, our ultimate goal for product development is to get to the point where you start reducing number of pilots in the cockpit. That has a significant... But in order to get there, we've taken an incremental approach where we would develop that would get us there in a series of steps. That way we can continue to innovate and generate revenue by increasing the automation in the cockpit, reducing the pilot workload to a point where you will get that, you know, not maybe on some of these Part 25 aircrafts, that it'll be clear that there's no need for a second pilot in there. So that's our goal. And meanwhile, we will generate new products and reduce pilot workload, increase safety, and those are marketable products. That's our main strategy for product development. We also look at developing products that will replace some of the existing obsolete products components in the aircraft. We've done that traditionally. So the closest thing we have coming, which we believe we should get the certification completed in this fiscal year, is the engine and crew alerting system for the 75767. We also continue getting certifications In terms of our installation team, we're expanding that part of our business, what we call our mobile installation teams, and adding accreditations that we can do more and more of our products and maybe other people's products installed in this way that we're doing, where we're actually going to customers and doing it at their site. saving them a lot of trips back and forth and saving them a good amount of cost. So our focus is on those areas. We continue developing new features for the oral thrall that we've recently also certified. Two of those which are aimed for the military side of the oral thrall and that they have resulted in some good interest from our military and government customers.

That's very helpful, Sharma. I appreciate that, Keller. Another catalyst for your stock and your company, and I know you mentioned this in your earlier remarks, is increasing the capacity utilization. Have you or Mike come up with you know, maybe a rough estimate of how high maybe your incremental gross margins could be, you know, when you reach, you know, a larger sales inflection point, whether it's through organic or inorganic, you know, when you get to something like a 40 million annual sales rate, could the incremental gross margins be above 70%, 75%?

Yeah, Tim, and that's, it is, you know, as sales increase the margin and will increase right along with it and, We were just modeling this just last week, and $50 million in sales is going to get us over 30% EBITDA. So that will continue to grow, and that EBITDA number is only around 20% projected for this year on roughly $20 million less in sales. So we do see that increasing quite a bit as sales grow.

Great. That's helpful. So $50 million in sales, 30% EBITDA margin. Is that what I heard correctly?

Yes.

I think we will approach 30% once we get above $50 million.

Great. That makes sense. You have so much incremental leverage in that facility. If I remember, it's something like a third utilized right now, the levels. Just my last question, and I know, Shahram, you mentioned some of your remarks about acquisitions, and it was really nice to see that. that shareholder approval go through last week for the majority vote for flexibility. You mentioned, you know, under $25 million both on targets. Given your cash balance, you know, it seems like almost any acquisition you make, you know, could probably be accretive or nicely accretive. I realize you're probably just in the early stages maybe of the pipeline, but are you starting to see or encounter reasonable asking valuations out there, or are you maybe not at that stage yet? I'm just wondering, you know, is the economy cooled off a little bit in the last year that maybe some of the sellers are getting more reasonable in what they want for multiples of valuations.

I think what we've seen is that kind of the high multiples is driven by a lot of the venture capital that's out there grown by, I guess, people who don't have to worry about what's going to happen in two years to that product line. They're just kind of accumulating these things, and then they're going to sell it off to somebody else. It'll be somebody else's problem. We look at a long-term approach in there. Obviously, we're not going to try to compete with that. Unfortunately, it seems like in our products sector, the aerospace industry, even though the capital market is tightening up, there's still a strong venture presence, venture money presence in the aerospace industry. And that's because of the stability of the industry and the fact that today we have both the defense and the kind of the aerospace market, both of them are strong. The OEMs have long rating lists for new aircraft, and obviously we're pumping a lot of money into defense. And that gives the investors some level of confidence that they're not going to be too far off the mark. And But the multiples are there. I mean, the average multiple now they talk about in our industry is about seven and a half times even. And that's kind of, that's where we are. But a lot of the times, finding the right product line would help us justify as long as we see that within our P&L, that that acquisition would yield similar gross margins as our products do, and that kind of makes it beneficial to us.

That's very helpful, Keller, and it's good to hear that you have the cash on hand to help out with acquisition accretion. So, yeah, just again, congratulations on the impressive gross margin and orders in the quarter, and I look forward to seeing you at our conference on Thursday. That's it for my questions.

Thank you, Tim. Thank you.

There are no further questions at this time. This concludes today's teleconference. You may disconnect your line at this time. Thank you for your participation and have a great day.