Innovative Solutions and Support, Inc. (NASDAQ:ISSC) Q3 2023 Earnings Conference Call August 10, 2023 10:00 AM ET
Shahram Askarpour - Chief Executive Officer
Mike Linacre - Chief Financial Officer
Conference Call Participants
Tim Moore - EF Hutton
Good day and welcome to Innovative Solutions & Support Third Quarter Fiscal 2023 Financial Results Call. [Operator Instructions] Please note that this event is being recorded. I’d now like to turn the conference over to Mr. Shahram Askarpour, CEO. Please go ahead, sir.
Good morning. This is Shahram Askarpour, Chief Executive Officer of Innovative Solutions & Support. Welcome to our conference call to discuss our performance for the third quarter of fiscal 2023, current business conditions and outlook for the coming year. Joining me is Mike Linacre, our CFO.
Before we begin, I’d like Mike to read the Safe Harbor statement.
Thank you, Shahram and good morning, everyone. I would remind our listeners that certain matters discussed in the conference call today, including 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 the impact of the Honeywell product line license and asset acquisition and other acquisitions as well as other risks and uncertainties reflected in our company’s 10-K, which is on file with the SEC and other public filings.
Now I will turn the call back to Shahram.
Thank you, Mike. I will begin today with remarks on our performance in the fiscal third quarter of 2023, followed by comments on our long-term growth plan and strategy, including the recent acquisitions from Honeywell. I will then turn the call over to Mike, who will take us through the financials.
Revenues in the third quarter increased 15% to $8 million and were also up sequentially from the second quarter. This improvement was driven by the steady contribution of our production contracts and the growth in revenue from our aftermarket products, including our King Air Autothrottle and flat panel displays for the air cargo market. We are also generating revenues from new programs or services, including our new autothrottle installation services and ThrustSense Autothrottle for the Beechcraft King Air 200 and 300 aircraft, with this new STC has opened a new market of potentially 700 additional aircraft. Margins were also up from a year ago, which led to another strong quarter of bottom line results. All in all, financial performance that continues to illustrate steady, profitable growth.
In addition, at the end of the third quarter, we licensed and acquired several product lines from Honeywell Aerospace. The products both enhance our current offering and leverage our existing infrastructure, making this an ideal fit with the acquisition strategy we have articulated. These products can be found on literally thousands of aircraft in our target air transport and business aviation market, and we believe we have the potential to expand them into the military market as well. This acquisition, together with continued strong organic revenue, represents an important inflection point in our revenue growth rate.
Once fully integrated in 2024, we expect these new products to drive consolidated revenue growth to approximately 40% with an even more significant impact on earnings, where we expect EBITDA to increase by 75% with accretive EPS in 2024. These anticipated results clearly illustrate that we are committed to our strategy to better leverage our existing infrastructure by layering on new revenues that have a similar margin profile as our existing operations and that can utilize our current excess capacity in manufacture. The integration of these operations is proceeding as planned and is on track to being – adding to our – to begin adding to our financial performance starting in the fourth quarter.
Although we have just completed this acquisition, we are still focused on identifying and acquiring additional products and technology that implement – that complements our existing portfolio. As a reminder, we are targeting smaller bolt-on acquisitions that are around $25 million and continue to be actively engaged in evaluating potential acquisitions. There is still another 50% excess capacity to be leveraged as we anticipate generating more cash from the increased revenues combined with additional borrowing capacity we will have more than sufficient resources to continue to implement our strategy. Mike will walk you through more on license and asset acquisition.
In addition to the progress achieved on our short-term objectives, we also continue to invest in our long-term vision. Our primary competitive advantage is in cockpit automation where we have already introduced many new technologies that reduce pilot workload and improve safety, most recently our autothrottle programs. This is a stepping stone to a reduction in the number of pilots in the aircraft. It is an area where we have significant intellectual property and intimate knowledge.
Consequently, we have been increasing our research and development budget to leverage this competitive advantage and as shown by increase in our R&D spending, have recently been adding new engineers for this explicit purpose. Our research and development expenses may further increase in future quarters. However, this is a long-term program, and we believe we are responsibly managing the balance, which means investing for the long term while delivering attractive returns for our shareholders in the near term.
We are excited by the success we’ve achieved so far this year, growing organically, completing and accretive acquisition, investing for the future while continuing to consistently deliver quarter after quarter of strong earnings. For over 30 years, we got the reputation through the industry for developing some of the industry’s most compelling flat price for performance products. This remains our formula for success. Thank you for your time and interest, and we look forward to updating you 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 third quarter of fiscal 2023. Revenue growth in the third quarter was 15%, an acceleration relative to the second quarter revenue growth. This quarter, we once again generated revenues from both our stable OEM production contracts, which offer a solid base of predictable recurring revenue as well as an increase in aftermarket sales. Revenue was also well diversified among our target commercial air transport business and military markets.
In particular, we saw new orders from the air cargo market for commercial air transfer Boeing 757 and 767 flat panel display conversions, an increase at our production military contract and strong autothrottle installations revenue, which is a new business this year. The company completed an acquisition of several Honeywell product lines on June 30, 2023. The company did not recognize any revenues and net income related to those product lines in the third quarter of 2023. Keep in mind that both quarterly financial performance and new bookings are subject to variation in the timing of purchase orders, especially with our aftermarket products. On average, 40% of our revenues are from aftermarket sales. Consequently, as a management team, we evaluate our performance on an annualized basis, and we encourage our investors to do the same.
Third quarter gross margin was 59.5% compared to 58.5% in the third quarter a year ago. This improvement in gross margin reflects better absorption of our fixed overhead as a result of revenue growth, a favorable product mix similar offset by a slight increase in direct material costs. Overall, for the year, margins continued to trend in line with historical averages with any fluctuation from quarter-to-quarter, primarily attributable to product mix as well as leveraging of our fixed manufacturing costs achieved through revenue growth. We don’t anticipate the addition of the Honeywell product lines to have a material effect on future margins.
Operating profit in the current quarter was $1.4 million or 17.9% of sales, down on a relative basis from both the year ago and prior quarter, primarily due to a step-up in general and administrative, research and development expenses. This quarter, SG&A again includes non-cash stock-based long-term incentive compensation as well as a few one-time items associated with the closing of the Honeywell acquisition, including expenses for commissions and legal costs related to our new bank term loan.
In the fourth quarter, overhead will include the legal, accounting, audit, professional and other one-time expenses associated with the Honeywell product line acquisition. At the same time, any of the one-time items that impacted the last few quarters, such as the immediate vesting of non-cash long-term incentive compensation awards have been recognized and will not impact future quarters. Our goal is to decrease our overhead run rate to approximately 20% over time, which will be aided by the increase in revenues from the Honeywell acquisition. That entails little incremental overhead as well as the absence of the many one-time items over the past few quarters.
We continue to fund research and development at a higher level than a year ago as we work on our long-term vision. This quarter, having added several new engineers dedicated to this program. We still expect to spend 13% of our revenue on R&D by the end of the year. Interest income was up in the quarter due to an increase of interest rates on our interest-bearing cash accounts. We do expect this to come down as cash balances will be lower as a result of the Honeywell acquisition.
Tax expense in the third quarter of fiscal 2023 was $0.4 million compared to the same amount in the third quarter of fiscal 2022. Third quarter net income was $1.4 million or $0.08 per diluted share, in-line with the $1.4 million $0.08 per diluted share we achieved in the third quarter of fiscal 2022. Backlog as of June 30, 2023, was $13.8 million and new orders in the third quarter of fiscal 2023 were approximately $6.9 million. This is a bit of a step down from the previous quarter when orders benefited from some pull forward as customers lock in orders for a longer-term.
As always, quarterly orders can vary due to a number of factors and are not meant to provide an indicator of future revenues. Virtually all of the Honeywell revenues are from primarily intra-quarter book and ship orders. Cash on hand on June 30, 2023, was $2.6 million after utilizing approximately $16 million in the quarter for the acquisition of the Honeywell product lines. In the fiscal third quarter, to further strengthen our financial position and provide additional liquidity, we secured a $20 million term loan. IS&S was able to maintain a strong financial condition with sufficient cash on hand to run the operations of the business with ample liquidity with access to increased borrowing capacity.
Let me quickly review the Honeywell acquisition. The purchase price was $36 million, which included inventory valued at approximately $10 million, equipment value of approximately $4 million with the balance categorized as intangibles. These have been added to our balance sheet as of June 30, 2023. The purchase was paid in part with $16 million of our cash with the remainder borrowed under the new term loan I just mentioned. In addition to financing the acquisition, the term loan provides additional liquidity for ongoing operations and potential future acquisitions. While we expect cash flow from both our existing and acquired operations to enable us to quickly produce our borrowings, we nevertheless do expect annual interest expense to be in the range of approximately $1.6 million for the fiscal 2024.
These product lines have attractive margin profile characteristics that are similar to our current product portfolio is an essential element of our strategy. Consequently, once they have been integrated into our operations in 2024, we expect the transaction to materially contribute to our revenues and EBITDA. Revenues are expected to grow over 40%, while EBITDA is expected to grow roughly 75%. We also expect the resulting EPS to be accretive in fiscal 2024 with potential for additional net income increases in future years from various synergies. For the remainder of fiscal 2023, we’re anticipating generating strong cash flows with similar or higher gross margin levels as capacity utilization and operating leverage expand against backdrop of revenue growth from organic and inorganic opportunities.
With that, operator, we’d like to open it up for any questions.
First question me from Tim Moore, EF Hutton. Please go ahead.
Thanks and congratulations on the strong impressive organic sales growth in the quarter in your core business. And Mike, thanks for the color on the September quarter commentary, that’s appreciated. Maybe, Shahram, I got a question for you. Is there any update on the UMS? I know you gave comments on the King Air autothrottle progress and the great progress of flat display panels for air cargo, but just wondering if there is any update on UMS or even more ThrustSense autothrottle incoming inquiries or interest by new possible customers, are them trying it out?
Sure. Yes. I mean the UMS is a long-term program. We are actually in the process of developing the next generation of that product line in partnership with Pilatus. With regards to autothrottle, we are looking at additional platforms, actually, some of them in the regional airline market that we are in current conversations, but pretty preliminary with regards to the kind of the market that we are in on the King Air side, we are expanding our sales activities internationally and we are seeing good interest coming from organizations across the world on the King Air platforms. Obviously, as more and more aircraft is produced by Textron with our autothrottle in it, some of these customers who already have existing fleets, they look into upgrading their existing aircraft to bring them in line with the new aircraft that they are taking delivery results. So, the prospects look promising.
Great. That’s very helpful insights and details. And just related to that, you have started to touch on it maybe with King Air going nationally, but can you maybe talk a little bit about the change or the enhancement in business development opportunities, innovative solutions. I recall maybe you added a VP of Sales about a year ago, and it sounds like there are some really good development opportunities to cross-sell with Honeywell and penetrate both of your sides better. Is there any kind of progress or tactics you are thinking about for that?
Yes. I mean we have just added another VP of Technical Sales as well to our business development activities to increase, obviously, with the acquisition of the product lines from Honeywell we need to strengthen our sales force. A lot of international sales are going to result from the Honeywell acquisition. So, we have hired the sales guy full-time in the Australia, New Zealand area that would also support some of our Southeast Asia region. We are also looking at strengthening our partnership in Europe. And we are in conversations, actually, our new VP of Sales is actually in Europe this week to talk about partnerships as well as sort of finding a place where we would maybe inventory, some equipment in Europe to support these new product lines that we acquired. So, we are busy growing our sales and marketing group as well as customer service and customer support group, it’s exciting times for us.
Well, that’s a great update, really that added color on the sales and technical team development build out. I mean you have such a good opportunity set and you are investing in the proper hiring. Just a quick question. Your core business from what I recall, and Mike mentioned this pre-acquisition, Honeywell and pre-license was about 40% aftermarket. What will the pro forma mix be, and was Honeywell a bit more book and ship? Is it higher aftermarket? And do you think the company’s overall mix will be about 50% aftermarket?
Yes. But we have also been – we are also busy with OEMs to get new OEM content. We have certainly got another OEM program, which we haven’t been able to announce yet because the aircraft hasn’t been announced. So – but that’s about a year out in terms of production revenues. But I like the mixture of 40-40-20 is good because, obviously, on the aftermarket, margins are better than OEM. So, we will rebuild the OEM side of it to get us to – back to 40-40-20. And through maybe the next acquisition that we do, we will have some more OEM contents on it. And that would help as well.
That’s interesting. Thanks for taking my questions sharing that color and looking forward to that next OEM award announcement, the aircraft gets announced. And my last question is, I know this is probably not a fair question. I realize it’s only six weeks into the acquisition of some Honeywell products and the license deal. But given that the team got there very quickly, I think they were there the first week of July, and that their experience from the heritage that they have with the Honeywell lines, how is integration going and the progress with the new team, just kind of curious about that?
Actually, it’s progressing well according to our plan. So, we have been fortunate that the team at Honeywell have been very cooperative. We have a very good relationship with them. They have been very supportive of this. Obviously, they want this to be successful. Again, this acquisition wasn’t about the highest bidder, it was about who is actually going to be able to work well with Honeywell and their customers to have a successful transition. And we were chosen based on that. And everything is progressing well and we continue executing it.
Great. That’s wonderful. Well, thanks Shahram and that’s it for my questions. I will follow-up with Mike, offline later on.