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Innovative Solutions & Support Inc. (NASDAQ:ISSC)

F4Q 2008 Earnings Call

November 20, 2008 9:30 am ET

Executives

Geoffrey S. M. Hedrick – Chairman, Chief Executive Officer

Roman G. Ptakowski – President

John C. Long – Chief Financial Officer

Analysts

Steve Denault – Northland Securities

David Campbell – Thompson, Davis & Co.

Alex Hamilton – Jesup & Lamont Securities Corp.

[Hyler Hilgo] – Fidelity and Co.

[Chad Treviso] – Aviation International News

Michael Ciarmoli – Boenning & Scattergood Inc.

Operator

Good morning. My name is [Damechis] and I will be your conference operator today. At this time I would like to welcome everyone to the Innovation Solution and Support fourth quarter earnings conference call. (Operator Instructions) Mr. Hendrick, Chairman and CEO, you may begin your conference.

Geoffrey S. M. Hedrick

Good morning. I’m Geoffrey Hedrick. I’m Chairman and CEO of Innovative Solutions and Support and I’d like to welcome you this morning to our conference call to discuss year end results for fiscal year 2008 and a forward look in 2009. Joining me today is Roman Ptakowski, our President and our Chief Financial Officer, John Long. I’d like to turn it over to John this morning to read our safe harbor message. John.

John C. Long

Thanks Geoff. Good morning. I’d like to remind our listeners that certain matters discussed in this conference call today including operational financial results for future periods are forward-looking statements that are subject to the 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. I will now turn the call back to Geoff Hedrick, Chairman and CEO. Geoff.

Geoffrey S. M. Hedrick

Thanks John. Fiscal year 2008 was a challenging year with one with our major OEM business check program, the largest and most accelerated engineering development program in the company history. In addition, the program on the C-130 and Tristar flight decks with a European customer required very high resources, especially in engineering. The resource demand of these programs exceeded previous efforts by more than 50% and staffing of these programs required us to double the size of the engineering department during that year, adding program specific contract labor and working as much as 20% over time.

In the inherent inefficiency of large staff increases and delivery pressures resulted in very high spend rates and less than optimal productivity. As we completed these efforts, we reviewed both the tasks and the process to see how we could improve them in the future. These were lessons learned and that will prove most helpful in the future. The engineering department has instituted a number of improvements in processes and tools that profoundly improve productivity. Changes in these processes has defined scope accurately and minimized rework.

In the beginning of September management submitted a budget to the board of directors. The board found this unacceptable as it seemed to have an unclear forward growth plan and unacceptable margins. The management was requested to resubmit the – to review and resubmit a revised budget, which was also found to be unacceptable for the similar reasons. The board then decided to change manage – that a management change was required as well as a revised forward strategy. I returned to assume responsibility as CEO and Chairman of the Board.

In the ensuing weeks, repeated analysis of personnel quality and staff levels and an analysis of forward programs and revenues resulted in the reduction in workforce, weighted primarily in the engineering department.

As two major programs requiring large efforts were completed and the force ranking of all individuals in the company resulted in the selection of the most talented and most productive employees, right sizing the engineering department to earlier levels prior to peak demands of the VLJ OEM and Tristar resulted in our present fiscal year 2009 budget, which reflects an approximate 33% growth in revenue, profitability in all four quarters with positive cash flow. This is achieved while still investing over 13% of the revenue in product development.

Our active efforts to solicit partnering with our customers and their contribution to modifications of our designs allow us to keep a strong, productive, right sized engineering department cost effectively. Going forward, there’s much to be optimistic about despite the very serious worldwide economic conditions and the impact broadly on manufacturing, the company’s core mission will serve us well.

As many of you are aware, the company has a central focus on retrofits, specifically modification to existing aircraft and fleets of aircraft to update their performance, to comply with changes in regulation and/or improve operating efficiency and safety. We are engaged in two large programs in air transport market with American Airlines and Federal Express to up-to-date their formidable 757, 767 fleets of aircraft.

In difficult economic conditions it is often prudent to update existing assets to increase their productivity and to serve a reduced market demand. Both crew efficiency and aircraft performance improvements drive the business case for the retrofits in progress. Our equipment is designed and especially suited for this market and not only in the air transport world but in the military and general aviation marketplaces. Our contract with Cessna to develop a flight deck to upgrade their fleet of Cessna aircraft will give existing Cessna customers a very cost effective modernization [fab].

Similarly, C-130 programs with Homeland Security and other major military customers improve the performance and reduce workload of C-130 and C-130 fleets worldwide. These fleets are almost 1,600 aircraft and we have – that are available for our system. We developed the system for the Royal Netherlands Air Force which is now presently being applied for the Homeland Security fleet of C-130s.

Our business is growing in all three segments. As of today, our FY 2009 backlog is substantially larger than last year’s sales. When I say backlog I mean released – firm, released backlog. In fact, it’s the largest percentage backlog – the largest backlog in position in the history of the company. And our 2009 budget reflects growth of one-third over last year with virtually no revenue from the VLJ OEM. Comparing 2008 to 2009 and taking out revenues for the VLJ OEM, our first quarter is double the revenue of our previous quarter.

Let me provide our expectations for the first quarter of 2009. Based on current conditions we expect to generate revenue of $9.5 to $10.5 million. EPS for that quarter is expected to be in the range of $0.03 to $0.06 profit with positive cash flow. This year’s fiscal revenue 2009 is supported on programs pursued almost two years ago, which give us some sense of the length of time between winning major programs and starting into production. And these programs are expected to run for the next two years.

The margins on these programs are proving to be just as expected and with new disciplines implemented in the manufacturing organization, we expect to dramatically reduce the inventory levels and we expect cash flow to be consistent with our historical cash flow. This is why we were able to issue the dividend at the end of last year. As we looked at our business going forward, we had more than adequate cash in place to execute not only our business plan but keep our operation goings for many years under the most adverse conditions.

The $17 million received in the legal settlement could be distributed directly to our stockholders, allowing them to make decisions on how best to invest this one-time income. You will remember that over the last two-and-a-half years we have spent and expense substantial sums in pursuit of defending our intellectual property. This has profoundly impacted our profitability or lack thereof, which in turn has impacted our stockholder interests. This money distributed directly to the shareholders allows them to use their discretion on how best to invest these proceeds.

The board of directors is presently pursuing a replacement for Mr. Wilson, who resigned from the board the beginning of the month. We have several excellent candidates with a sense of senior management and director experience. The Nominating and Corporate Government Committee is pursuing this replacement.

As you are aware, I have assumed the role of CEO and I’m committed to stay on until an appropriate replacement has been selected by the board of directors. I am fortunate to have Roman Ptakowski, our President, with me and back from service in defending our intellectual property. As many of you are aware, Roman led the internal legal defense efforts which were highly successful. Happily, a reasonable and sensible settlement was achieved with the defendant’s senior management.

We are pleased they chose to resolve this issue in a most fair and balanced way. With Roman back full time, we have a strong predictable plan for the future. I’d like to turn it over to John Long for details on last year’s performance and a quick look at next year.

John C. Long

Thanks Geoff and thank you for joining our call this morning. As you have already seen in our press release, there were a number of unusual or non-recurring items that affected both the fourth quarter and full year results. In our release, we provided a reconciliation of their effect on our GAAP and adjusted net income. As I go through our results this morning, I will try to make a more – or give a more granular description of these various items and how they affected our margins and overhead.

Our goal is to help investors best develop a better understanding of our normalized results, as well as to provide perspective on the future level of gross margins and fixed overhead expenses. Revenues in the fourth quarter were $10.2 million, up 100% from $5.1 million a year ago and consistent with the revised guidance that was issued on August 20. Revenues were also up sequentially for the third consecutive quarter as we continued to ramp up growth.

Revenue growth is being driven by the performance of our Flat Panel Display systems, which delivered approximately $6.9 million for the quarter’s total revenue from a well diversified mix of solid customers in each of our three markets. For instance, commercial air transport revenues this quarter included work for Federal Express and American Airlines. General aviation included a significant increase in the Pilatus revenue and we also continued to generate steady performance in our military sector.

Air data product shipments in the quarter were approximately $1.8 million with approximately

$1.6 million in engineering modification and development revenues. Revenues in the quarter included $2.2 million from our large general aviation OEM customer, which represents shipments prior to receiving notice to reduce production as discussed during our conference call on August 20.

Looking at our performance excluding this large general aviation OEM customer, revenues in the balance of the business have been consistently trending higher. For the fourth quarter, exclusive of the large general aviation OEM, revenues were $8 million including the previously mentioned Federal Express, American Airlines, Pilatus and military contracts among many other smaller projects. That’s up considerably from $4.9 million in the third quarter exclusive of this large general aviation OEM customer.

On a GAAP basis, gross margins in the fourth quarter were 16.5%. Margins were impacted by a number of one time items in the quarter, primarily related to the suspension of production for this large general aviation OEM customer. And again in the schedules, really tried to lay that out in a way that hopefully is easy for individuals to understand the normalized run.

In the quarter gross profits were reduced by $1.9 million to establish a reserve for obsolete inventory. You can see the charge again in the press release Tables 3 and 4. Excluding these costs the adjusted gross margins were 35.5% in the fourth quarter while product only gross margins were 39%. As we leverage our fixed manufacturing overhead, we believe we can continue to achieve margins at or above these levels into the mid-40’s to high 40’s.

I’d now like to go through the R&D and SG&A for the quarter and provide a bridge between our historical performance and future expected performance. R&D was $3.8 million – total R&D for the quarter of $3.8 million. However, as a result of the completion of several major projects as Geoff mentioned, organizational changes and workforce reductions we expect total R&D that is both internally and externally funded of about $1.8 to $2 million in the first quarter of fiscal ’09. That level R&D investment will be closer to our historical levels.

SG&A spending totaled $8.4 million in the fourth quarter of 2008. SG&A in the fourth quarter includes a $4.1 million reserve for doubtful accounts for the general aviation OEM customer. Again, this allowance for doubtful accounts is shown on the press release Tables 3 and 5. In addition, the fourth quarter SG&A includes approximately $900,000 of costs associated with the reduction in workforce, including the company’s September termination of its CEO as well as

$307,000 of legal fees and other expenses associated with the trade secret matter.

Including these charges, adjusted selling general administrative expenses in the quarter were

$3.1 million. And you can see Table 5 for the breakdown. Based upon our workforce reduction and other cost savings initiatives that we’ve already implemented going into this fiscal year, we expect SG&A of approximately $2.5 to $2.7 million for the first quarter of fiscal 2009.

The settlement of our trade secret lawsuit resulted in other income of $17 million in the quarter. The settlement was included in our press release Table 3 in order to reconcile to adjusted net income. As a result of the settlement, our pretax income for the quarter was approximately

$8 million. And due to the availability of accumulated net operating losses, taxes in the quarter were only $418,000. As a result, we reported fourth quarter 2008 net income of $7.6 million or

$0.45 per fully diluted share.

Our financial position remains strong. At September 30, 2008 we had $5 million in cash,

$4.3 million in debt related to our facility and shareholder equity of approximately $46.8 million or $2.80 per share. In the quarter as mentioned we received $17 million in proceeds from the trade secret settlement case and paid out approximately $16.7 million in dividends. The company repurchased 166,000 shares of our common stock during the quarter under the previously announced share repurchase plan at an average price of $5.95 per share.

Let me summarize the various one time items in the quarter and how they affected the various income statement accounts. Severance and other costs associated with our reduction in force and other severance of $900,000 which is in SG&A; $307,000 of legal fees and other expenses associated with the closure of the trade secret matter which is again in SG&A; and the

$17 million legal settlement is included in other non-operating income.

And just to conclude here, as pertains to our large general aviation OEM customer contract, the total direct charges associated with the suspension of this contract were $6 million in the quarter.

This does not consider any indirect, lateral impact such as a reduction in force, severance and other costs. Based upon our assessment of the risks associated with this customer, we took the following actions. We established a reserve for obsolete inventory of $1.9 million which is reflected in cost of goods sold.

We established a reserve for doubtful accounts of $4.1 million which is in SG&A. We also incurred research and development expense of approximately

$170,000 directly related to this OEM customer pursuant to an NRE agreement which is in research and development.

I’d now like to turn the call over to Roman.

Roman G. Ptakowski

Thank you John. I would like to tell you about the progress we are making in each of our market segments; that is commercial air transport, military and business and general aviation. In commercial air transport, our Flat Panel Display systems are in revenue service in both American Airlines and FedEx Express. We continue to ship product to their installation service providers to support the ongoing upgrades of their fleets.

We have a number of outstanding proposals at both domestic and international carriers for their retrofit of Boeing 757 and 767 aircraft with our Flat Panel Display systems. IS&S has received amended SPC’s for the Boeing 757, 767 platforms from the FAA adding increased functionality for the Cockpit/IP Flat Panel Display system, giving it even more utility for the operators.

In the military segment, the company’s Cockpit/IP solutions continue racking up flight hours both domestically and internationally for the C-130 and (NYSE:K)DC-10 military air transport. The operators are upgrading additional aircraft. We have increased the work we are conducting for Homeland Security. Our previous efforts on both the Pilatus PC-12 and Lockheed Martin C-130 aircraft are expanding the application of our products on these fleets. The company successfully concluded all testing of its newly introduced, large format mission displays for military aircraft.

These are high resolution, 20 inch diagonal displays. We commenced shipping during the fourth quarter. These displays interface with a variety of video formats, providing the on aircraft tactical officer with the readability needed for successful mission completion.

In the general aviation segment, a number of innovations were introduced at the recent NBAA tradeshow. IS&S announced in addition to its Cockpit/IP product lines the IS&S Vantage, an open architecture flat panel cockpit display system capable of interfacing with most third party avionics. Designed specifically for business aircraft, the Vantage system is available on two or three 10 inch Flat Panel Display architectures.

The Vantage system allows operators to upgrade their aircraft to a new Flat Panel Display system while leaving existing third party avionics installed in the aircraft, thus minimizing the cost of the upgrade. It also provides the owner the opportunity to upgrade for new radios, transponders, GPS or other third generation avionics. You can select from the best of breed from all the major vendors. The Vantage system provides versatility and selection unmatched by any other supplier. The Vantage system accommodates options such as Class 3 e-charts provided by Jeppesen, Enhanced Vision Systems and XM Satellite Weather.

Like all Cockpit/IP systems manufactured by IS&S, the Vantage system provides users with enhanced situational awareness and increased functionality, enables reduced crew workload and lowers aircraft weight. We are in discussion with a number of fixed space operators that provide installation services to retrofit the Vantage system into a variety of air frames such as Falcon, Hawker, King Air and Learjet Aircraft.

Also at that NBAA tradeshow, IS&S launched a wide area augmentation system also known as WAAS with lateral and vertical precision performance with a fully coupled autopilot for its PC-12 Flat Panel Display system. Three-D approaches have been successfully flown on a number of occasions with this added functionality. What is significant about this is that WAAS capability allows PC-12 operators to fly precision approaches at smaller airports.

There are more than 1,000 WAAS approaches in use and we expect that number to grow by about 600 each year moving forward. In coupling the autopilot with the LPZ approaches, we offer PC-12 pilots the ability to fly precision approaches which will open up even more airfields for their use. This capability is available on other platforms as well.

In mid-December, Cessna will initiate formal flight testing for the Flat Panel Display system upgrade. We expect they will receive an SPC in the first half of calendar year 2009. We continue to receive orders for Pilatus PC-12 retrofit applications from both general aviation and Homeland Security.

We are in a business period where operators transition their spending from new aircraft procurement to a focus on retrofitting existing aircraft. We believe this is good for the company. Backlog, system enhancements and broadened aircraft platforms using IS&S products support our expectations of increasing revenues and profits in the current fiscal year.

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

Geoffrey S. M. Hedrick

Thanks Roman. In a few minutes, we’ll start a Q&A session that will run about 35 to 45 minutes at which time you can present your individual questions. I’d like to summarize on a couple of things.

We’ve instituted two new developments, both we expected to be covered by patents. A new display system – head up display system will be initiated this year as well as a patented approach to a proprietary runway intrusion program, both of which are critical safety features for all aircraft. And it will have applicability to all our present aircraft. These coupled with the substantial developments we’ve made and the breadth of our product offering, especially with the new Vantage system, I believe positions us for a significant long term growth as we long expected.

Again, we’re fortunate that our mission and our fundamental core strategy for the business has centered on retrofit programs which seem to be perfect for today’s environment. I’d like to now turn it over to the Q&A session. Go ahead please. First question.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Steve Denault – Northland Securities.

Steve Denault – Northland Securities

The first question is the – you know when you back out some of the one time items in the quarter, the product gross margins for 38% I believe, almost 39, but then John you made reference to some inefficiencies in terms of indirect costs associated with your OEM contract. What would be a true pro forma sort of product gross margin in the quarter if you could provide that direction?

John C. Long

Sure. Yes, there were – in year end we took a hard look at the inventory, looked at obsolescence across the board and what we would anticipate for the first quarter would be into the mid-40’s on the low end actually for product margins, net of again the one time event that occurred in this fourth quarter.

Steve Denault – Northland Securities

It sounds like R&D and SG&A for the first quarter you made reference to $1.9 million on R&D and SG&A of about $2.6. Is that a normalized number going forward? Or are there – is it possible that it goes lower into the second quarter?

John C. Long

A couple points there, Steve. I want to be careful. That is total R&D, meaning both funded and internally and externally funded. And again we – in splitting that out, probably about $1 to

$1.2 million is what we would anticipate as internally funded for Q1.

Beyond that we want to be very careful with the whole environment in going out and speaking in any kind of granular detail about run rates, Q2 and forward because again we intend to adjust and adapt to the environment as best we can to hit the profit [partics] that Geoff laid out earlier and the sales partics that he laid out earlier. So I’m trying to avoid, I guess, going beyond Q1 in any way, shape or form at this point, given the environment.

Steve Denault – Northland Securities

But when you referenced Q1 internally funded of $1 to $1.2 million, that’s the R&D line item with the balance of what, you know, the $1.9 you talked to it being up in engineering? Modification involvement?

Geoffrey S. M. Hedrick

We only get confused in engineering when we talk about internally funded. We don’t sell engineering as a commodity. We do accept and we try to get some of our customers participation in the product. So to differentiate, the engineering is on a common product. It’s identical engineering. We’re just getting some funding externally for the funding. So there’s no differentiation between the two engineering.

John C. Long

Right. The accounting forces us to break it and Geoff’s point is it’s $1.8 to $2 million in total spend for research and development is what we’re spending. And again the accounting, Steve, I can get with you separate on. But that is the spend.

Geoffrey S. M. Hedrick

Because of the nature of our product, we’re able to – we have customers who want modifications; in some case symbology, in some case interface characteristics. And they contribute to some of those modifications and changes. But we don’t provide unique and separate engineering product or services to them out of the company. So they’re all directly related to product.

Steve Denault – Northland Securities

And said another way, you expect to get reimbursement to the tune of $6 or $700,000?

Geoffrey S. M. Hedrick

Yes. We’re – it was a smart idea to try and get our customers to help us fund the necessary modifications that they would require. It allows us to keep a significantly larger staff of engineering than would normally be supported by the company’s revenues.

Steve Denault – Northland Securities

Steve Denault – Northland Securities

How should we think about Air Data in fiscal ’09 in terms of, you know, similar to levels we recognized in fiscal ’08?

John C. Long

Yes. Again we’re staying to Q1, Steve, and I would say you know, it’s going to be very much a parallel sequential universe here; you know, $1.8 to $1.9 I believe is what we would anticipate for Q1.

Geoffrey S. M. Hedrick

The only comment is that on Air Data since the lawsuit’s been resolved, we no longer have to compete with our own technology. And we’re pleased that that’s resolved and it’s now starting to open up additional businesses that we wanted to – additional businesses in Air Data. So it’s unclear. And to be blunt with you, looking forward and projecting a book and build at this point is difficult because we still don’t know what’s happening to the world economy and how it may indirectly or directly impact our – so we’re being, I guess, cautious and providing only a look at this coming quarter.

Operator

Your next question comes from David Campbell – Thompson, Davis & Co.

David Campbell – Thompson, Davis & Co.

John, do you have an EPS number for the fourth quarter excluding the special items?

John C. Long

Yes, David, I believe if you go to Table 3 there’s actually a normalized calculation in there. It comes to a loss of $0.13 per that table.

David Campbell – Thompson, Davis & Co.

And the backlog has gone down since June from 71 to 57 as of the end of September. The revenues weren’t down that much. What’s out of the backlog that was in there in June?

John C. Long

Factors the Eclipse, any and all Eclipse that we had in our backlog is removed and basically the sales that occurred in the quarter reduced the backlog somewhat, David.

David Campbell – Thompson, Davis & Co.

And of course you said the 10-K has been filed so we can check that for how the cash went down since most of these charges are non-recurr – I mean non-cash. I’m surprised the cash went down that much.

John C. Long

Yes, David, we will be filing the 10-K the early part of December. That is still a work in progress. I mentioned, as part of the forward-looking statements to refer to the 10-K that is on file currently which is last year’s. So we’re working to finish that up right now and yes the cash flow statement will be in there. And if you’d like separately I can walk you through the cash flow as soon as we complete that, you know, what the changes in cash were for the quarter.

David Campbell – Thompson, Davis & Co.

But I was surprised to see the cash go down since a lot of these charges are non-cash.

John C. Long

Yes, the again inventory we’re working to basically bring the inventory down and run more – turn our inventory more effectively, drive the accounts receivable more rapidly. But your point – again, I’ll go through the cash flow with you separately.

Geoffrey S. M. Hedrick

John, I mean, I think it’s notable that the inventories climbed to record levels. And we have to get that down. And remember it’s including the large VLJ inventory that was caused either obsolete or unusable. The levels had grown over 13 million. And so that in part consumed a fair amount of cash. The differences between the two cash numbers aren’t as significant as they may seem so I don’t think there’s a lot of significance in there, but we’re happy to provide you that data when we get the detail on it.

John C. Long

Yes. We’re finishing that up, David, and I’ll come back around and work through that with you.

David Campbell – Thompson, Davis & Co.

And how much of this inventory do you think will go down in the first quarter? Or is it a longer term project?

Geoffrey S. M. Hedrick

I think it’s going to be a full year project. We’re – you can imagine I’m inspiring the guys to work the problem and try to get it under a – we think we can get it down to less than half of what it was at the peak and still sustain a very large business. I mean, if you look at our historical data that would suggest that we can do that. There’s been some significant changes in the department since that inventory grew to that level.

David Campbell – Thompson, Davis & Co.

I see you bought stock back in – you mentioned 166,000 shares in the first quarter?

John C. Long

Yes. At $5.95 per share average.

David Campbell – Thompson, Davis & Co.

Is that going to continue and was that a special program? What’s the idea here?

John C. Long

Well, as I had mentioned before on one of the calls there is a committee, the board of directors, that regularly reviews the position of the company as well as the equity markets. And I look to that committee and to Geoff for guidance as to whether or not we’re going to be in the market actively. So it’s really a work in progress or work in progress as we go.

David Campbell – Thompson, Davis & Co.

But there hasn’t been any further purchases since the September quarter?

Geoffrey S. M. Hedrick

No, but we distributed $17 million so that was probably focused our attention a bit.

David Campbell – Thompson, Davis & Co.

And in terms of the new programs, it sounds like a lot of them will be in private aircraft. Is that correct?

Geoffrey S. M. Hedrick

No, a lot of them are going to be in the same markets that we defined; military, commercial air transport and general aviation. And I think there’ll be a significant number of both military and commercial air transport so we have really an almost ideal segmentation of our backlog in our business. We have, as I’ve always said you focus the struggle to get a third and a third and a third. And once in awhile you actually get there, but we’re happy that we’re seeing strong demand and we have an excellent backlog in commercial air transport area.

The military backlog is growing and we see further significant growth in that area. And general aviation will – is a strong backlog. We expect that to grow as well. So it isn’t any specific area. And happily that makes it a little less economy sensitive.

Operator

Your next question comes from Alex Hamilton – Jesup & Lamont Securities Corp.

Alex Hamilton – Jesup & Lamont Securities Corp.

First question for John in terms of and this is just a modeling question, and so I apologize. The tax rate in first quarter are we still burning through NOL’s or should there be a different expectation?

John C. Long

Different expectations since we spoke last. With the trade secret proceeds, the settlement of the trade secret in Q4 that $17 million did pretty much utilize or use up the NOL’s that were coming over. And I would assume a 34 to 35% tax rate in Q1.

Alex Hamilton – Jesup & Lamont Securities Corp.

And I guess lastly I just wanted to clarify or have you clarify if you could, is the Eclipse completely written off or is there still some liability associated with it?

John C. Long

I don’t – Geoff, Roman do you want?

Roman G. Ptakowski

Yes. We have, Alex, we have no expectations from the suspended situation we have with that VLJ OEM.

Geoffrey S. M. Hedrick

And we wouldn’t have any expectations until it’s cleared up. We took a conservative and we think a prudent approach, especially in the existing economic conditions of saying okay, when we have a clear understanding of what goes forward we will be able to re-establish what we believe are our –

Alex Hamilton – Jesup & Lamont Securities Corp.

Okay. Great. No I would agree that was a great move. And just a last kind of more of a macro question, you’re talking about pursuing some opportunities with the commercial airlines and I guess some of the general av airlines. Can you talk about what their appetite has been as of late? Or has it changed? Has it improved since oil has come down or are you just basically keeping your heads down and pursuing those opportunities?

Geoffrey S. M. Hedrick

Remember what we do. It’s retrofit. And think about probably the hottest sale item right now in the commercial air transport industry I think Winglets which are all being retrofitted; a huge, huge amount of Winglets being done. Some of the things that our air transport package does is take over 200 pounds out of the airplane. I’ll remind you that one airlines specifically no longer provides any in flight movies because they took out all of the equipment just to remove a few hundred pounds.

So there is a real demand for our equipment. There is a significant restructuring of the fleets from older aircraft like old 737’s and old 727’s which are, you know, late 1950’s, early 1960’s aircraft, especially in freighter applications. And replacing it with the far more fuel efficient 757. And by the way, what we do is we build retrofit equipment that saves 200 pounds in a 757. So what we’re seeing is application for our if anything an increasing demand for our equipment in that area, because it pays for itself. It is a strong business case for the equipment.

Operator

Your next question comes from [Hyler Hilgo] – Fidelity and Co.

Hyler Hilgo – Fidelity and Co.

Just going back to the backlog question before just I guess I’m a little bit surprised, maybe my understanding on this is a little incorrect, but I thought the Eclipse business was all kind of book and ship. I mean, I thought how you guys previously characterized the backlog was basically didn’t really hit the actual backlog numbers.

Roman G. Ptakowski

Hyler, we can’t comment on Eclipse. If you want, we’ll comment on backlog though.

Hyler Hilgo – Fidelity and Co.

Fine.

John C. Long

With the – as we’ve spoken in the past, we have not beyond firm fixed scheduled shipments and deliveries included items in backlog. With respect to one of our OEM customers, we did have both product for a short window as well as some NRE in the backlog. And again we took that out and your point is exactly on point. It was nothing beyond what was scheduled for I believe it’s an eight week forward-looking period. However, there was an NRE agreement which again had to be also de-booked associated with that large OEM customer.

And again in reconciling the backlog from Q3 to Q4, the sales that we did make which were pretty significant, very significant $10.3 million in the quarter, also reduced the backlog a bit. So there’s a couple of moving parts there to think about but your point is right on point and that’s exactly how we’ve been treating the backlog.

Geoffrey S. M. Hedrick

And the fourth quarter about 20 odd percent of the shipments in the fourth quarter were on that OEM program as well. So it would have reduced the backlog through that but I think your understanding is correct. I don’t know how you worked the numbers, but you may not have included an NRE and a few other things.

Roman G. Ptakowski

I’ll say a couple of the commercial transport customers are starting to – it’s a big part of our quarter and it’s going to be a big part of our foreseeable future here, they’re beginning to come out of backlog and translate into real sales and cash flow.

Hyler Hilgo – Fidelity and Co.

I guess a follow on to that. What is your expectation for the backlog? I mean, going forward over the next four quarters do you expect to see that backlog kind of trend down? Or do you see some pretty decent bookings opportunities going forward that could potentially drive that higher?

Geoffrey S. M. Hedrick

Well, our shipment rates are up as you well know over 30%. We’ve lost a revenue source that provided over $12 million last year. And extracting $12 million out of last year’s revenue, our year-over-year growth is 100%. So what we would expect is, having said all of that, we still have well over a year of released backlog which in these times is pretty good. In fact, in any times is very good. How it’ll grow I can’t imagine having too – we don’t expect to have two or three years worth of backlog.

I don’t think anybody in this business community especially now as most of us are happy if we have three months. And in this case we’re very, very fortunate to have a year and a half’s worth of backlog released. So we’re not, to be blunt with you, we’re not sure how it’s going to go. We think we would be happy if we could maintain a year or a year and a half worth of released backlog going forward. And that automatically presumes next year as we further grow we would expect the backlog to necessarily grow with it.

Hyler Hilgo – Fidelity and Co.

But I guess you’re saying that of the $57.3 million backlog today kind of stretches you out for a year and a half? Is that – did I catch that right?

Geoffrey S. M. Hedrick

Well, I mean certainly if you take last year’s revenues and you look at it, it’s almost two years. So somewhere between two years and a year in that area. Yes. I’m trying to avoid being very specific about – because we’re not giving a full, accurate forecast but that’s pretty close. So about a year and a quarter or so, in that general range. And please understand that many of our contracts, especially when you do 200 aircraft can be in some cases a single, very large contract.

So you don’t – when we watch the backlog, unlike book and ship or consumer products where you’re getting an order that gets shipped out within a month or two so that you have this constant trickle of orders supplementing your backlog as you ship it, the backlog will go down. And then when you get a large order, it’ll jump back up. So there’s going to be a fairly coarse granularity potential in that backlog.

Hyler Hilgo – Fidelity and Co.

I understand that. Thanks.

Geoffrey S. M. Hedrick

It obviously varies but an approximation.

Roman G. Ptakowski

In summary from my vantage point, you know operational vantage point, we feel very good that we’ve got tremendous coverage against our internal forecasts. We feel good about bookings opportunities. We’re not prepared to discuss what those are at this point, but we’re very optimistic about what’s going to happen for the company.

Geoffrey S. M. Hedrick

We’ve had some very strong years where we went into the beginning of the year with about 15 to 20% coverage. That tends to be uncomfortable. We’re very pleased with what we have. But most importantly it allows us to invest in the future and show some really strategic perspectives in our decision making. So it’s an enviable situation to be in and we’re using – we’re focusing on disciplines within the business to make sure that it’s operating efficiently and effectively and aggressively and actively pursuing both product development and new business. So it’s a nice place to be right now.

Roman G. Ptakowski

And keep in mind we’re going to make money. We’re going to be cash positive. We’re going to grow. And that I think is three points that we’re not over-emphasizing but we think is very important to the business, to the shareholders.

Geoffrey S. M. Hedrick

You betcha.

Hyler Hilgo – Fidelity and Co.

Since you have given guidance for the first quarter of fiscal ’09, how much coverage do you think you have in just terms of the revenue guidance that you provided within kind of the backlog that you have there?

John C. Long

I’ll just say we’re extremely comfortable. We won’t get into percentages specifically. We’re extremely comfortable with the first quarter and I’ll just leave it at that.

Geoffrey S. M. Hedrick

We wouldn’t be giving a number if we weren’t very comfortable. And one of the reasons we’re able to give you the number is recognize that we’re halfway through the quarter. So we have some decent visibility. I mean, traditionally in the other quarters, you’re running three weeks in the quarter when we’re giving our quarterly conference call. This is clearly year end and we’re halfway into the quarter. And if we don’t know what we’re going to ship then we have a bigger problem than any of us want.

Operator

Your next question comes from [Chad Treviso] – Aviation International News.

Chad Treviso – Aviation International News

I want to get some clarification on the suspension of the production for Eclipse. Is this a suspension – is this a termination of the contract or is the contract still in play?

Roman G. Ptakowski

Chad, as I’ve kind of mentioned we are not able to comment on Eclipse. There’s no comment from us, you know, to that question. On anything dealing with Eclipse I recommend you speak directly with the company.

Geoffrey S. M. Hedrick

We’ve had no terminations of any significant contracts broadly. So we’ll leave it at that. It would be inappropriate and by agreement – by contractual obligations, we’re not able to discuss these.

Chad Treviso – Aviation International News

Okay. Also in regards to the Cessna R&D retrofit program you’re talking about, is this for the Piston, Turbo Prop or Jet line?

Geoffrey S. M. Hedrick

Jets.

Roman G. Ptakowski

Jet. This is for the Citation 5 and 6 series of aircraft.

Geoffrey S. M. Hedrick

Twenty-five hundred aircraft opportunity Cessna plans on doing in their 34 worldwide centers. We’re ready to go. We’re waiting for an airplane out of Cessna. It’s not being held up by us and clearly they’re not interested in holding it up. Basically there’s an excellent opportunity to serve the customers, provide them immediate performance enhancement and keep them as a customer for them the next step to buy a new aircraft. So it’s good for them and it’s obviously good for the customer to have this significant upgrade ability.

And as you are aware, it’s unique to have the kind of open architecture we have in that we operate with a 3 or 4 or 5 different radio transponder, other system, autopilot manufacturers. And that capability goes back to the old days of the aerospace industry when we used to – when people used to be asked what kind of radios and what kind of radar did they want in their airplanes?

And the aircraft manufacturers would do it. That stops about 20 years ago, but now in a retrofit format you can literally put and choose when you retrofit, you can put remotely two radios that tune right on the display panels and obviate the needs for things like radio management units because that’s integrated into the system. It’s quite spectacular.

Chad Treviso – Aviation International News

When do you expect to do first installation and when do you expect the [FTC] for that?

Geoffrey S. M. Hedrick

As you know, Cessna makes the airplane available for us the beginning of next month. And we start doing – they start doing the installation in that aircraft and they expect an [STC] sometime next year, hopefully the earlier the better. We would like – we’re ready to go because it’s a derivative product. This was a product that we originally developed the system called the Vantage system. It wasn’t called Vantage until somebody in house got creative.

But it was a system that would have some of the features that we invested heavily into developing for some OEM programs. And now we have used some of the best of those features into this new retrofit package. Most significantly, it’s the same – it will be the same display part number for things like Cessnas and Learjets and Hawkers and Falcons; same part number, which means that the FBO’s will be able to inventory spares and support, a broad range of aircraft. Probably 20 or 30 different kinds of aircraft.

Operator

Your first question comes from Michael Ciarmoli – Boenning & Scattergood Inc.

Michael Ciarmoli – Boenning & Scattergood Inc.

Just again on the backlog, did you actually define how much of that is shippable in the next 12 months? I know you’ve got the FedEx and American in there which are longer term in nature. So do you have a number that is a 12 month out of that 57 million?

Geoffrey S. M. Hedrick

No, what we said was that we had 80% coverage for the year. That is of backlog, we have 80% of our expected shipments for this coming year are covered by backlog.

Michael Ciarmoli – Boenning & Scattergood Inc.

Earlier you said you’re going to grow revenues 33% in ’08 so you’ve got about 24 million of that is 12 month backlog?

Geoffrey S. M. Hedrick

No, that’s not correct. It’s more than that. I said that we expect to grow 30% over last year, which is – and we have 80% of that covered in backlog.

Michael Ciarmoli – Boenning & Scattergood Inc.

So you’ve got 32 million in backlog.

Geoffrey S. M. Hedrick

I also said we had more in covered backlog than we shipped last year.

John C. Long

Michael, it’s not that easy to make those calculations. You have, you know, remember we’re halfway through this quarter and everything.

Michael Ciarmoli – Boenning & Scattergood Inc.

Do you expect that backlog number to go down below 50 million next quarter?

Roman G. Ptakowski

I’m not going to comment on that.

John C. Long

Yes, earlier I think when someone had asked that exact question and again –

Geoffrey S. M. Hedrick

When we know what the price of oil is, we’ll let you know. The thing that we absolutely know is we were able to settle our lawsuit without a protracted litigation and happily that worked out well for us. So that’s one thing that we got under our belt. And it’s a very optimistic view.

Michael Ciarmoli – Boenning & Scattergood Inc.

On the Cessna opportunity, you guys sound pretty excited about that. Are there any mandatory commitments yet from Cessna? I mean obviously they’re struggling. They’ve announced layoffs, they’re going to start their holiday shutdown earlier than usual in December, is there any concern about that program being delayed or the amount of uptake being slower than anticipated given that, you know, obviously most of their customers are probably going to be feeling an economic pinch and might not be aggressively in the market to upgrade or retrofit their aircraft?

Geoffrey S. M. Hedrick

Au contraire. I mean, the people they’re laying off don’t retrofit anything right now. The people they layoff are building new aircraft. And what it means specifically is that people who are building new aircraft are finding the demand for aircraft may be slowing which is not unusual. It is historically relevant that when you don’t buy new aircraft, you probably want to fix the aircraft that you’re flying. And that’s why historically in this business for over 20 years has been so successful in that it has focused on retrofits. And so when business is slow, you end up doing retrofits.

So I think if anything, Cessna would probably be and I can’t speak for them, probably would be more than interested in putting as much attention on this retrofit program as possible.

Michael Ciarmoli – Boenning & Scattergood Inc.

And then just the last question, on American and FedEx do you have any numbers in terms of how many planes you’ve installed the product on and how many planes are remaining?

Geoffrey S. M. Hedrick

There’s a lot of planes remaining, probably 80 or 90% of the fleet and a fair number have been installed. They’ve taken delivery on a fair number of test the stage. I think American’s going to try to put five lines in place and do a fair number of aircraft. So we don’t have any specific numbers on that we’re prepared to release because we don’t know from day to day. Again, there’s a significant number still to be delivered.

Operator

There is a follow up question from David Campbell – Thompson, Davis & Co.

David Campbell – Thompson, Davis & Co.

Back to the Cessna situation, it sounds like because the [SCC’s] not been awarded yet and the program is just getting underway that you don’t have that in your backlog or in your revenue plan for ’09, but what could give you some upside in your revenue plan. Is that the way to look at it?

Roman G. Ptakowski

David, we have Cessna in our backlog. We have a contract with them. We also expect to be delivering product as soon as they receive the STC. That’s accounted for in our FY 2009 outlook.

Geoffrey S. M. Hedrick

It’s obviously toward the end of the year, not the beginning of the year.

Operator

There are no further questions at this time. I would like to turn the call back over to Mr. Hendrick for a closing remark.

Geoffrey S. M. Hedrick

Mr. Hendrick isn’t available but Mr. Hedrick is and I’m happy to respond. Gentlemen, I appreciate your attending the meeting today. I hope we were able to provide a clearer picture on the company and its business and where we’re going. We’ve got a very strong and an optimistic future and I’m pleased to help to contribute to that. I’m also pleased to have a really competent team of people to work the problem with. So we appreciate your interest and we’re going to go back to work. So thank you. Bye-bye.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Innovative Solutions & Support Inc. F4Q 2008 (Qtr End 9/30/08) Earnings Call Transcript

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