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Executives

Geoffrey S. M. Hedrick - Founder, Executive Chairman and Chief Executive Officer

Ronald C. Albrecht - Chief Financial Officer and Principal Accounting Officer

Shahram Askarpour - President

Analysts

David P. Campbell - Thompson, Davis & Company

Innovative Solutions & Support (ISSC) Q4 2013 Earnings Call December 5, 2013 10:00 AM ET

Operator

Good morning, and welcome to the Innovative Solutions & Support Fourth Quarter and Fiscal Year End 2013 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Mr. Jeff Hedrick, Chairman and CEO. Mr. Hedrick, you may begin.

Geoffrey S. M. Hedrick

Thank you, and good morning. This is Jeff Hedrick, Chairman and CEO of Innovative Solutions & Support. I'd like to welcome you this morning to our conference call to discuss our fourth quarter and fiscal 2013 results, current business conditions and our outlook for fiscal 2014.

Joining me today at our Exton 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?

Ronald C. Albrecht

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.

Geoffrey S. M. Hedrick

Thank you, Ron. In the fourth quarter, we reported revenues of $8.0 million, up 16% from a year ago and net income of $155,000 or $0.01 per share. The 2012 Q4 earnings of $0.17 per share benefited from a one-time $0.15 per share tax adjustment. These results conclude a strong year, in which we were profitable in each quarter and profitable for the fifth consecutive year, while we invested heavily for the future growth and profitability.

Including nonrecurring items for each year, the underlying earnings per share were $0.15 this year versus $0.03 in 2012. For the year, we increased revenues 28%, booked over $100 million in new orders and saw the backlog increase more than fourfold from just under $20 million a year ago to over $90 million today.

At this time, we invested -- at the same time, we invested $10.9 million or more than 34% of our revenues in both engineering development and internally funded R&D to bring several new programs to market. Our Engineering Development Contracts are limiting gross margins currently. However, our growth is attributable to our consistent commitment to invest a high percentage of revenues in product development to capture the many and growing opportunities. This fiscal 2014 -- as this fiscal 2014 progresses, several of these new programs and development will be completed with product certification and begin production where we expect to provide and contribute to our future growth and increased margins.

The success of our display and air data products is contributing to the growing number of satisfied customers. Our new Flight Management System, GPS sensors and other NextGen air traffic control products are attracting interest from operators seeking better performance for price value proposition.

Our combination of demonstrated value-added products and innovative new technologies is creating opportunities for us in the value-focused marketplace. We continue to be optimistic as we begin fiscal 2014. A $90 million backlog provides us with a reasonable expectation for another year of revenue growth and profitability in fiscal 2014.

Our backlog excludes $90 million of potential long-term -- additional long-term sole-source OEM production revenue. During the course of fiscal 2014, we will complete several Engineering Development Contracts, and the resulting products will receive FAA certification and enter their production phase. These products enter the market -- as these products enter the market, we expect to attract additional customers who have awaited this certification. During fiscal 2014, we expect to maintain our high level of investment in product development in the range of 30% to 35% of revenue. Our objective is to continue to capture a greater share of the expanding addressable market as we increase our number of product offerings.

Now let me turn this over to Ron for a detailed description of our financial performance.

Ronald C. Albrecht

Thank you, Jeff. The company reported its seventh consecutive profitable quarter for 3 months ended September 30, 2013. For the quarter, revenue was $8 million, an increase of 16% from $6.9 million in the fourth quarter of 2012. Net income was $155,000 or $0.01 a share compared to $2.8 million or $0.17 a share for the same quarter of last year.

Included in the results for the fourth quarter of fiscal 2012 was a nonrecurring tax benefit, which added $2.4 million or $0.15 per share to net income.

Total expenses for the quarter were $2.1 million, down from the fourth quarter of last year because of a decrease in internally funded engineering -- internally funded research and development and more -- as more engineering resource was devoted to fulfilling Engineering Development Contracts. However, the combined spend in support of Engineering Development Contracts and internally funded R&D was approximately $3.2 million, a 40% increase for the quarter, which is a 34% increase from the same period a year ago.

General and administrative expenses for the quarter were $1.8 million, down sequentially from the third quarter, which included a nonrecurring item, and up less than $50,000 from the year-ago quarter. The underlying level of general and administrative expenses has remained stable over the past 4 quarters. We do not expect it to increase appreciably in the near term.

We reported fourth quarter operating income of $47,000, down from $373,000 for the fourth quarter of 2012. In the fourth quarter, we recorded a tax benefit worth $91,000, primarily to adjust the tax expense for the year to reflect the actual full year tax rate. In the year-ago quarter, we recognized a nonrecurring benefit of $2.4 million from a reversal of an income tax valuation allowance. Net income for the fourth quarter this year was $0.01 per share compared to $0.17 per share a year ago. For fiscal 2014, we expect to return to a more normal effective tax rate of approximately 25%.

At September 30, 2013, the company had $16.4 million of cash on hand, a little change from the past 3 months, but down substantially from a year ago as a result of special tax dividend of $25 million paid to shareholders in December 2012. Cash used in operating activities was $567,000 in the quarter. The company remained debt free.

Timing differences between spending and customer payments on Engineering Development Contracts has caused fluctuations in cash flows from operations. We expect the net use of cash from operations in the first quarter of fiscal 2014. However, we believe that we have sufficient cash to fund operations for the foreseeable future. These timing differences will reverse as Engineering Development Contract programs reach payment milestones and provide a source of cash.

For fiscal 2013, revenues were $31.6 million, up 28% from the $24.6 million in fiscal 2012. Net income was $1.9 million or $0.11 per share for the year compared to a net income of $3 million or $0.18 per share for fiscal 2012. A nonrecurring legal charge reduced 2013 earnings by $657,000 pretax or $0.03 per share after tax. Net income and earnings per share for fiscal 2012 include the previously mentioned tax benefit from a reversal of an income tax valuation allowance. Cash used in operating activities was $2.2 million for fiscal 2013 compared to a positive cash flow from operating activities of $1.4 million for fiscal 2012.

In fiscal 2013, cash was used primarily to fund Engineering Development Contracts, under which we would expect to receive payment in 2014 and beyond as contract milestones are reached.

For the fiscal year ended September 2014, we expect to increase sales and generate profit, which would represent our sixth consecutive profitable year. The introduction of new products into production will result in some increase in margins. For the first quarter, we expect revenues to increase from a year ago, and we expect to be profitable, although we expect an operating cash outflow for the quarter because of the aforementioned timing differences on Engineering Development Contracts.

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

Shahram Askarpour

Thank you, Ron, and good morning, everyone. The fourth quarter reflected continued improvement across our business with year-over-year revenue growth, the new production orders for existing products and accelerated progress with our Engineering Development Contract.

For fiscal 2013, revenues were at the upper end of our 20% to 30% revenue target for the year. Profit shortfall was a result of increased demand and engineering development hardware impacting production deliveries.

In the fourth quarter, we experienced the challenge of ramping up production, while simultaneously introducing newly developed products into production, and we did not respond as well as we expected. We have since reorganized and strengthened the leadership in our manufacturing organization and expect to see significant improvements in that area.

Production shipments of Flat Panel Display products were up 31% in fiscal 2013. These products remain in high demand as 2/3 of our fourth quarter bookings were for existing line of Flat Panel Display products. Sales of our existing products represent a base upon which we build sales of our new products as they complete certification and enter production. We continue to make excellent progress on all of our Engineering Development Contracts, several of which are nearing completion.

For Delta Air Lines, we are developing a suite of navigation and display products equivalent in capability to that available in the latest generation of aircraft. We expect to begin deliveries in mid-calendar 2014.

Our new open-architecture utility management system for the Pilatus PC-24 Boeing business jet aircraft is entering the third year of a 4-year development with production expected in 2016. Upon completion of this contract, we will have developed a complete aircraft avionics suite with potential application beyond the Pilatus program.

Our development on Eclipse E550 program is nearing its final stages, which will result in an open-architecture integrated cockpit with dual flat management computer, Attitude and Heading Reference System, RVSM air data system, model throttle and radios. We are continuing to coordinate effects with Eclipse in the FAA to complete certification of the aircraft, which we expect to enter production in the first half of this fiscal year.

Our aerial refueling control display unit for the KC-468 tanker program is in the final qualification phase. We expect the completion of the qualification phase to be followed by delivery of preproduction units in the third and fourth fiscal quarters of 2014 to support Boeing flight test program, and production phase of this contract is anticipated to begin in our fiscal year 2015.

The Foreign Military C-130 transport program development is progressing well. Product deliveries are planned for initial aircraft integration in the first fiscal quarter of 2014, and that's the quarter that we are in now. The IS&S Flight Management System certification for the Classic Boeing 737 fleet of National Nuclear Security Agency is in company flight testing to be shortly followed by FAA final certification testing.

When the engineering phases of each OEM program is complete, we enter sole-source production and expect to have multiyear orders from each of these customers. New orders for the fourth quarter of fiscal 2013 were $8.2 million. These included a mix of production orders for existing display and air data products. For fiscal 2013, we received over $100 million of new orders. Backlog was $91.1 million at September 30, 2013, a greater than fourfold increase from backlog of just under $20 million a year ago. The Engineering Development Contracts have produced a requirement for additional engineering resources. The fourth quarter has supplemented our core staff with additional outsourced engineering capabilities to help us address the increased workload.

This outsourced engineering resource enables us to add skilled and technical expertise quickly, while retaining flexibility in our cost structure. We expect that these temporarily additional resources will help us with the completion of several of these engineering development contracts and transition into production phases. As each of these engineering programs enter the production phase, we expect profits to grow higher and become more consistent with our historical experience.

In summary, the fourth quarter represented the culmination of a year of growth, progress and profitability. We look forward to continuing revenue growth during fiscal 2014 at a rate of 20% or so. With a strong backlog, the completion of several Engineering Development Contracts and growing market recognition for our products, we are confident that we are positioned to continue to achieve meaningful growth this year and beyond.

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

Geoffrey S. M. Hedrick

Thanks, Shahram. The results for fiscal 2013 illustrate the growing demand for our products as we continue to offer products at an exceptional price-performance value proposition and at a time when the market has become increasingly value-sensitive. Revenues, operating profits, bookings and backlog are all substantially higher in fiscal 2013 compared to fiscal 2012. We increased both production and Engineering Development Contract revenues as we balanced delivering positive current financial results with investing for the future.

We are fortunate to have customers willing to share in the cost of these development programs and the cost of developing new products. In the near term, we have sacrificed some margin to capture the longer-term growth opportunities. These investments have not prevented us from delivering value to our shareholders, however. As our Engineering Development Contracts complete, we will enter in more profitable production phases of the related programs. We believe that we will build shareholder value as a result of our current investments. For fiscal 2014, execution on our commitments is our primary objective. I want to comment on one thing as well, the backlog. We had mentioned backlog and how it's growing, et cetera. It's important to understand that we only attribute orders which have firm release schedules to our backlog. There are many production programs in which we anticipate as much as 2x or 3x what our existing orders are. So the only thing that we have in backlog -- what we refer to backlog is orders that have a defined delivery schedule of specific quantities of products.

Okay. Operator, I want to turn it over for questions. Go ahead.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from David Campbell from Thompson, Davis & Company.

David P. Campbell - Thompson, Davis & Company

Ron, could you please explain what's going on with the balance sheet, this creation of this unbilled receivable line? It looks like you took dollars from what was in prepaid expenses and other assets?

Ronald C. Albrecht

All right. So when the amount in the unbilled receivable account reached a certain percentage of total assets, we were -- we are required to break it out separately as a line item. But an insignificant number until a couple of years ago. And then last year, it got a little larger. We left it in prepaid. But this year, it's quite a large number, so we appropriately showed it as a separate line item.

David P. Campbell - Thompson, Davis & Company

But can you define unbilled receivables? What's the difference between unbilled and accounts receivable?

Ronald C. Albrecht

So an account receivable is something where you've actually delivered something to the customer and you've sent him an invoice. An unbilled receivable, it means -- and they're related completely to Engineering Development Contracts. It means that we have spent money in advance of the time at which we can bill the customer.

David P. Campbell - Thompson, Davis & Company

So these are these unbilled -- these are these contracts that you've completed but you haven't delivered the work to the customer?

Ronald C. Albrecht

No. It means -- it's just -- David, again, this is only related to Engineering Development Contracts. It's not related to production, at least not in our context at the moment. And it basically means that we have a -- let's say, we have an engineering contract -- Engineering Development Contract that requires us to spend, let's say, $1,000, and the customer's going to pay us when we've finished the contract. So he's going to pay us $1,000 at the end of the contract. But at the moment, we've only finished $500 of the contract. So -- and we spent $500 and -- let's just say, and this assumes 0 margin for the sake of discussion. So we spent $500. There's no margin. We've recognized revenue of $500, but we haven't -- we can't bill that until we finish the contract and bill the customer the entire $1,000. Now that's an oversimplification, but just to illustrate the process.

David P. Campbell - Thompson, Davis & Company

Does it have any -- I mean, does it indicate any level of revenue in the fourth quarter, I mean, $6.5 million?

Ronald C. Albrecht

Well, if you take the difference between the revenue in the -- if you take the difference -- it doesn't really reflect revenue. It just simply reflects the timing of payments in relation to our spend. You can't simply take the unbilled at the end of the last quarter from the unbilled at the end of this quarter and say the difference was revenue because we may have gotten some payments along the way, if that makes sense.

David P. Campbell - Thompson, Davis & Company

So it doesn't imply any kind of revenue level for the December quarter?

Ronald C. Albrecht

I wouldn't draw any implications in terms of revenue levels from it. And I think when our K comes out, we'll break out the engineering development piece.

David P. Campbell - Thompson, Davis & Company

But the fact remains that you mentioned in the press release that you were -- the product deliveries were delayed because of the requirements of the engineering contracts. That means that some of these production -- delayed production revenues should fall in the December quarter.

Ronald C. Albrecht

We would hope that, that would be the case, yes.

David P. Campbell - Thompson, Davis & Company

Then given that probability, I'm estimating $0.05 in earnings in the first quarter.

Geoffrey S. M. Hedrick

Well, David, just to be clear. We have a backlog that's significant for delivery right now and in this quarter. We're attempting to step up production volume rates by up 30% quarter-over-quarter. That's big. So the limitation is, David, our ability to grow manufacturing deliveries at a rate equivalent to the new business available. So the limitation is probably our ability to produce another 30% off the production line. And quarter-over-quarter is tough to do. But -- and by the way, the potential is 50%, but we don't believe we can do that. We're trying to be as accurate and pragmatic as possible.

David P. Campbell - Thompson, Davis & Company

Right. But what does that come to in dollar -- in profits? Do you have any -- I mean, you've done -- you've got 2 months in the books, so -- of the quarter. You should have some idea what the profitability would be.

Ronald C. Albrecht

I don't think we want to be in the position of projecting profits and earnings per share and all those sort of things. At this junction, we have not done that historically.

David P. Campbell - Thompson, Davis & Company

Right, right. Well, but you seem to think you can grow the company's profits for fiscal 2014. I mean, you must have some confidence in fiscal '14. It must be based on what's happening this quarter.

Geoffrey S. M. Hedrick

It is confidence.

Ronald C. Albrecht

Well, we have confidence because we have a strong backlog, which is somewhat unusual for our company until the last year or so -- until the last year, really.

David P. Campbell - Thompson, Davis & Company

Right, right, right. And the other thing, the Eclipse 550 is -- according to press reports, deliveries begin this month. So you should have the delivery production equipment this month to Eclipse. You seem to think it's sometime in the first 6 months of the year.

Geoffrey S. M. Hedrick

That's correct.

David P. Campbell - Thompson, Davis & Company

So they're not delivering the planes? I mean, I don't understand.

Geoffrey S. M. Hedrick

We are going to deliver. We plan deliveries for this quarter.

David P. Campbell - Thompson, Davis & Company

Okay. So the December quarter...

Geoffrey S. M. Hedrick

[indiscernible] on top of this yet.

David P. Campbell - Thompson, Davis & Company

The December quarter should have revenues from Eclipse in it?

Geoffrey S. M. Hedrick

That's correct.

David P. Campbell - Thompson, Davis & Company

Which were minimal in the last quarter, okay. And let me just -- The $90 million dollars, Jeff of...

Geoffrey S. M. Hedrick

Wait a minute, David. David, hold on just a second. We will have revenues in this quarter for the Eclipse 550. We had minimal revenues for the Eclipse 550 in the fourth quarter, but we have revenues for the retrofit E500 Eclipse in the last quarter, which we'll not have in this quarter.

David P. Campbell - Thompson, Davis & Company

Right, I understand. I understand. Right, not necessarily more revenues for Eclipse because the Eclipse deliveries didn't start until December, I think. But I wanted to ask you about, Jeff, your statement about $90 million of potential new business, or what could conceive and to develop into firm production release revenues. That assumes, I guess, that during the fiscal '14 year, the new products, as they're introduced and sold, will get new business from new customers? Or is this just $90 million more revenues from existing customers?

Geoffrey S. M. Hedrick

Well, David, it will be follow-on from existing customers almost entirely, either -- in some cases, we have production programs where we have nothing booked for the production of the aircraft at all, as an example. I mean, KC-46 is roughly 170-odd aircraft that are out there, and we have none of that booked. There's nothing in our backlog. So it's that kind of thing that's sitting out there as essentially a big lock box of order opportunities that we expect to come in. It's automatic.

Ronald C. Albrecht

It's entirely follow-on from our Engineering Development Contracts. There's no anticipated new customers developing from those contracts.

David P. Campbell - Thompson, Davis & Company

And so during the course of fiscal '14, as you deliver these products, your backlog may go up?

Geoffrey S. M. Hedrick

Well, as an example, the KC-46 goes out to 2027 or something, so that kind of delivery is going to be staged over 10 years or 15 years. In other programs, there's opportunity for 10 years, but we're not going to book any of that and certainly not in 2014. The best you would expect to do is only book for the next year. As an example, Boeing, these people on their new airplanes, and they're going to sell say 800 787s in backlog. But the orders out to the suppliers are more likely releases for the coming year and not for 800 aircraft.

David P. Campbell - Thompson, Davis & Company

Right, right. Okay. And I just have a question about the gross margin on product sales in the first quarter was very low. Is that just because the product sales were low? Is that the main reason?

Ronald C. Albrecht

I think that Shahram addressed that in his comments. So Shahram, you want to repeat that?

Shahram Askarpour

This is on the fourth quarter?

Ronald C. Albrecht

Yes.

Shahram Askarpour

Yes. So essentially, what happened is that we made some deliveries of our products -- production products in the fourth quarter. Part of that was due to the production was busy billing development hardware for engineering to help complete the development programs. And that -- they took a hit there where they were developing -- they were building products that were not there for sale. Secondly, even with that, we missed shipment of some of our products. And it showed a weakness in the organization, and we've taken steps to correct that. We've made some changes in the leadership of our manufacturing, and we anticipate that, that would correct itself.

David P. Campbell - Thompson, Davis & Company

So you won't have -- you don't think you'll have comparable problems in the December quarter?

Shahram Askarpour

Not of that magnitude.

Ronald C. Albrecht

I think Jeff said it would take 1 quarter or 2 to sort itself out.

Geoffrey S. M. Hedrick

Look, what we're doing is we're ramping up, and we have people that continually ask me, quite frankly, that, "Do you anticipate any problems?" And I said, "No, we've done it before, and I expected us to be able to manage it." We had 2 problems. First problem is that a huge amount of hardware that had to be manufactured in manufacturing for the engineering development programs, and that did not ship out as revenue. Secondly, at the same time, we were trying to step up our production rates from almost 30%. So the 2 resulted in our inability to adapt rapidly enough. I think we have much better control, and Shahram, personally, is getting involved in the organization. So I think -- I'm positive for the future, and we're certainly capable of handling the volume. We need to step up to it. I'll remind you that we did in the past, well, in the same plant, $19 million in a quarter. So that's certainly obtainable, and we think we're on track to do that.

Operator

Okay. Since there are no more questions, that concludes our conference for today. Thank you for attending today's presentation. You may now disconnect.

Geoffrey S. M. Hedrick

Thank you.

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