Innovative Solutions & Support (NASDAQ:ISSC) supplies flight information computers, electronic displays and advanced monitoring systems to the civil, military, business and commercial markets.
A false start before rapid growth
Although ISSC jumped 22% after releasing earnings last month, it has since given back almost two-thirds of the gains, providing an attractive entry point.
In the mrq, revenue increased 70% to $11.1 million driven primarily by higher display shipments for retrofit programs and customer support of its engineering development programs while operating income increased 266%. These results are even more impressive considering that 37% of revenue was invested in product development.
Management expects continued top and bottom line growth in FY14 during the transition from product development to production, which should accelerate the revenue run rate shown in the chart below.
For example, in April 2013 ISSC received a >$60 million order from Delta for a complete systems integration, navigation and cockpit avionics upgrade of its MD88 and MD90 aircraft with production deliveries expected to begin mid 2014.
There are three key takeaways from this order, which is largely responsible for the 4.6x increase in the backlog from 2012. First, this retrofit provides capabilities that will become increasingly in-demand given the new air traffic management regulations (see below). Second, this order highlights the value (and long-tail nature) of its engineering programs. Third, this order should attract other carriers given the high visibility of Delta and the multiple tangible benefits including reduced fuel consumption, more on time arrivals, simplified maintenance and reduced crew workload.
The growing backlog is significantly understated and should provide higher revenue visibility. For example, the current backlog of $86.7 million excludes potential sole-source orders that could last for a decade. Moreover, management said on the most recent conference call that its engineering development programs should generate ~$90 million of new orders once development is complete.
The mixed margin picture shown in the chart below is actually more bullish than it appears as the 7% sequential gross margin increase likely represents a trough. However, the recent pullback in the stock suggests investors assume the gross margin will stay at the current cyclical low rather than return to its historically higher level as production accelerates.
The combination of a higher top line, expanding gross margin, the lowest SG&A expense in >5 years (as a percent of revenue) and stable engineering expenses should result in significant operating leverage and EBITDA growth over the next two years, driven by the following three factors:
First, the aging global aircraft fleet and continuing changes in aircraft electronic equipment requires either buying a new plane or retrofitting (e.g. replacing older displays with more efficient and modern flat panels with greater functionality). However, the latter is obviously significantly cheaper yet provides the same functionality. Moreover, manufacturers may be unable to deliver new aircraft due to a backup in orders or production delays while ISSC can retrofit with minimal down time. As a result, ISSC is actually a counter-cyclical play on the air transportation industry and should be awarded a higher multiple for its inherent risk-averse profile.
Second, ISSC continues to move up the value chain through product development/expansion and by becoming a systems integrator (instead of just a manufacturer), which significantly expands the potential market. For example, ISSC is now beginning to ship Eclipse 550 advanced avionics units (one of the most advanced cockpits available) after obtaining a Supplemental Type Certificate from the FAA. Moreover, international revenue (only 15% of overall in FY13) should continue to increase as the demand drivers are largely the same.
Third, new global air traffic regulations designed to address increasingly crowded airports/skies and the desire to reduce carbon emissions should drive higher demand. For example, its products help reduce the possibility of collisions (through improved navigation and situational awareness) and reduce carbon emissions (through flying shorter flight paths and improved control of engine power). Moreover, aircraft equipped with its flight management systems and flat panel displays are qualified to land at more airports and meet new FAA mandates for required navigation performance and automatic dependent surveillance-broadcast navigation.
Being paid to wait
The strong balance sheet (e.g. no debt and $15.8 million of cash), previously mentioned expected growth and a shareholder-friendly board increase the possibility of another special dividend or resumption of share repurchases under a new 250,000 share program, especially given that no shares were repurchased in the last quarter or year compared to 211,722 shares in FY12.
The current asymmetric opportunity is reinforced by the fact that the board said the stock price was "significantly below our intrinsic value" when it authorized the expanded repurchase program, even though the price at the time was 20% above the current price.
The following are the primary risks to the investment thesis, in order of importance:
- A decline in global economic growth would most likely result in reduced or delayed aircraft spending, although as previously mentioned this would also most likely increase demand for retrofitting.
- ISSC is vulnerable to government budget cuts given that government contractors/agencies accounted for ~28% of revenue in FY13.
- There is a high degree of customer concentration as the top five customers accounted for 64% of revenue in FY13.
- Although its engineering development contracts (~26% of FY13 revenue) enable ISSC to recover a portion of engineering expenses, there is a risk of cost overruns given the fixed-price nature of the contracts.
- Its markets are subject to rapid technological change (e.g. cathode ray tubes to liquid crystal displays to active matrix liquid crystal displays) as well as evolving industry and government standards, although again the latter is more of an opportunity.
An EBITDA-based multiple/valuation based on trailing numbers would not be meaningful given the depressed level (e.g. only $3.5 million on a ttm basis) during the development phase. However, there should be significant EBITDA growth over the next two years given the transition to production, which should result in at least a 20% return. Moreover, the gains should be amplified by the low float as the CEO (who has been with the company since it was founded in 1988) owns ~21% and four institutional holders own a collective 34%.
The pullback to the confluence of the 50 and 200 DMA is a natural place for a tight stop loss. Risk can be further reduced by going long put options.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.