Innovative Solutions & Support Inc Q3 FY2021 Earnings Call

Good day, and welcome to the Innovative Solutions & Support Third Quarter 2021 Earnings Conference Call. I would now like to turn the conference over to Mr. Geoffrey Hedrick. Please go ahead.

Good morning. This is Geoff Hedrick. Welcome to our conference call to discuss our performance for the third quarter of fiscal 2021, current business conditions and outlook for the coming year. Joining me are Shahram Askarpour, our President; and Rell Winand, our CFO. Before I begin, I'd like Rell to read the safe harbor message.

Thank you, Geoff, 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 other risks and uncertainties reflected in our company's 10-K, which is on file with the SEC and other public filings. Now I'll turn the call back to Geoff.

Thanks, Rell. It was another reasonable growth quarter, with revenues up both year-over-year as well as significantly on a sequential basis, with backlog increasing over 40% in the last 3 months. Margins remained strong, and we have one of the best cash flow and bottom-line profitability quarters in quite some time. Results were once again driven by a balance of OEM and retrofit programs and reflect the sales of a range of various products. We believe this strategy is both diversified markets and products that will provide a strong foundation for continued growth. In a sign of emerging rebound in general aviation, Textron Aviation reported the delivery of 33 turboprops in the second quarter, more than double the 15 delivered in the same quarter a year ago. They also noted that new equipment order activity continues to be strong and appears to be sustainable. Net result has been a strong demand for the King Air 360 and King Air 260 with our autothrottle on the production aircraft. We are pleased to be working with some of the most respected names in the aviation industry, such as Textron, Boeing, and Pilatus. A cover story in a recent issue of Flying Magazine prominently mentioned the ThrustSense Technology. In the previous issue, we were selected by Flying Magazine as an Editors' Choice Finalist, selecting 3 of the most innovative companies for that year. Among those, 2 of 3 companies were SpaceX for landing their booster rocket on an island in the North Atlantic and Garmin for automatically landing its single-engine airplane. ThrustSense Autothrottle was also recognized as one of the 3 most innovative products. The most recent issue of Flying Magazine mentioned our ThrustSense technology and its application in the King Air 360. The IS&S Full Regime Autothrottle prevents the pilot from over-torquing and over-tempering the engine. The ThrustSense provides remarkable VMCa Protection. That VMCa is, in fact, the loss of control of a twin-engine airplane when you lose one engine. This has been a problem for 100 years that has been solved in very high-thrust turbofan aircraft, but it causes more fatalities in multi-engine airplanes and even singles. We are especially pleased that the industry has embraced our Autothrottle technology. This product is covered by multiple U.S. and foreign patents and provides full authority digital engine control protection for existing installed engines on a retrofit basis. The revolutionary feature is the protection against fatal loss of control actions, in which a loss of an engine causes the pilot to lose control of the airplane, potentially causing it to flip on its back and crash. I was pleased to also note that, in an order for 11 state-of-the-art Cockpit/IP Primary Flight/Navigation Systems for our premier online retailer that is upgrading its purchased 767 Boeing Aircraft in response to the expanding demand for air cargo operations. This has been noted before, but the trend toward older aircraft being reconfigured for cargo operations remains strong, and these aircraft provide a cost-effective ease of entry for legacy air carriers and newer operators initiating or expanding their air cargo platform. While revenues are growing with an increase in demand for aircraft on which we can have long-term production contracts, we are also seeing strong demand for our legacy and retrofit products. In particular, air cargo remains robust as represented by the previously mentioned order from a well-known airline retailer. This is a very good business, utilizing our standard flat-panel displays, requiring only minor modifications as needed. We continue to book orders and add to our backlog. We continue to supply Eclipse with cockpit upgrades. In addition, they have indicated additional needs, and we are currently discussing those needs with them. The first 9 months of the year have been very good as the effects of the global pandemic were moderating. Nonetheless, we remain vigilant in watching for any signs of conditions to change, including any impact on our supply chain. With a strong order book and momentum building, we feel that we've reached an inflection point. The goal is to leverage our success for future growth and build value for our shareholders. I'd now like to turn it over to Rell.

Thank you, Geoff, and thank you all for joining us this morning. Looking at the third quarter, revenues were $6.2 million, an increase from $6 million in the same quarter a year ago, but also up over $1 million sequentially from the $5.1 million of revenue in the second quarter of this year. As Geoff mentioned, we are building momentum in the business. Revenues were generated primarily from our OEM production contracts, including the PC-24 and King Air Autothrottle programs, followed by sales to our air cargo customers. Gross margins for the quarter were 54%, consistent with our historical and recent margins. Total operating expenses for the third quarter of fiscal 2021 were $2.2 million, unchanged from the year-ago quarter. Research and development expense decreased from the year-ago quarter, primarily due to the transition of programs from primarily STC development and certification to production. Research and development expense was almost 11% of our quarterly revenues, reflecting a continued strong commitment to innovation and new product development even as production volumes increase. Selling, general and administrative expenses were up from the year-ago quarter as a result of an increase in headcount and professional fees we selectively added to our organization to support current and anticipated growth. We continue to emphasize tight operating cost controls and currently believe operating expense levels will be maintained in the current range for the balance of the year. For the quarter, operating income was unchanged from a year ago at $1.2 million. We recognized a non-cash $1.5 million or $0.09 per share tax benefit in the quarter. In the June 30, 2021 quarter, valuation allowances were released for all federal and most state deferred tax assets. The company continues to be in a 3-year cumulative income position and continues to have future forecasted income projections. As a result, net income was $2.7 million or $0.16 per share in the quarter, up from $1.3 million or $0.07 per share in the year-ago quarter. The company remains in a strong financial position. Cash flow from operations was $1.5 million in the quarter and $3.8 million on a year-to-date basis. Despite the payment of approximately $20 million in dividends this fiscal year, we've ended the period with cash and equivalents of $7.5 million. One quick note is that we did take a deposit for an order from a customer, which added to cash and is also correspondingly recorded in our current liabilities. This order is expected to be completed by fiscal year-end. We anticipate being operating cash flow positive for the full year. The company is debt-free. Consequently, we believe the company has sufficient cash to fund operations for the foreseeable future. Now I'd like to turn the call over to Shahram.

Thank you, Rell, and good morning, everyone. This was a rewarding quarter as we grew our revenues and increased our backlog. Growth indicates that the demand for our products is increasing. The increased demand is from many sectors of the market—cargo and general aviation and for both OEM production and retrofit products. Let me provide additional information around some of our revenue-generating programs that are driving our success. On the production side, we have mentioned that we have foundational OEM products that we expect to generate recurring revenues over the next several years. The Pilatus PC-24 program is continuing to grow as Pilatus steadily increases their production volumes for this successful aircraft. Our government contract on the KC-46 continues to run at expected production rates. We're also seeing interest from Boeing for additional systems for export. The conditions in the general aviation market are improving, and Textron noted the shortage of available used aircraft is driving demand for new aircraft. Consequently, we are experiencing increased production rates for our King Air ThrustSense Autothrottle. Therefore, in addition to providing a stable base of recurring revenue on the OEM side, our Autothrottle production line is also becoming a growth engine on the aftermarket side with Textron. We expect to rebound in this market to generate increased activity in the general retrofit market for the King Air as well as the PC-12 Autothrottle through our other dealer and maintenance center networks. As previously articulated and illustrated in the article by Flying Magazine, our Autothrottle is getting a lot of attention and therefore is the focus of our research and development efforts. Growth potential is very strong in many different markets, and we are in the process of responding to requests from OEMs for additional Autothrottle platforms. Despite overall market sluggishness in the air transport sector, we are having success in the retrofit market by serving the growing demand for our cargo capacity. One high-profile program is a contract we announced with a well-known retailer that continues to expand the Boeing 767 fleet and is retrofitting the cockpits with our display system. The growth of online shopping has attracted a host of players into the market as well, and a fast way to build air cargo capacity is through a 757 or 767 conversion. With over 1,000 operational 757 and 767s available for cargo conversion, we expect to see our flat-panel display business remain strong. New orders in the third quarter of fiscal 2021 were $9 million. That is a steady increase from $7.6 million in the second quarter and brings our total new orders for the year to $22 million. Backlog as of June 30 was $9.5 million, up $2.8 million from the end of last quarter. Safety protocols throughout our industry from those at the FAA to those restricting travel to certain countries have been obstacles we have had to navigate in our business development efforts. Additionally, as Geoff noted, they have all added complexity to the supply chain that burdens our production process. Fortunately, we have managed to successfully negotiate these challenges by anticipating potential issues and have minimized their impact on our business. This gives us confidence in our future as we believe the eventual relaxation of COVID-19-related restrictions will provide our business a healthy tailwind. Before turning the call back to Geoff, let me quickly applaud the ongoing efforts of our employees to integrate new safety protocols into our standard operating procedures, which has enabled us to maintain productivity without jeopardizing their health safety or well-being. I'd now like to turn the call back to Geoff for some closing remarks.

Thanks, Shahram. It was a real strong third quarter with progress achieved across virtually all of our key performance metrics. Remember earlier this year, we distributed nearly $20 million in dividends to our shareholders, and we now have been building our momentum across the business to reward our loyalty even further. We've increased our cash by 50% from operations. We expect this momentum of recovering markets and a strong balance sheet and a growing backlog to lead to continued success. Operator, please turn us over for questions.

Our first question comes from David Campbell with Thomson, Davis & Company.

Geoff, congratulations on the quarter. It's finally coming through. But I'm looking for more information.

We have a good situation. You've been a strong supporter, but things are starting to all come together. We survived the pandemic happily, so we're not in a recovery mode, but rather a continued operations mode. I give the entire team incredible credit. But importantly, this retailer we're talking about will probably build a fleet of over 500 aircraft over the next 3 to 5 years. And we're happy that they chose us to put our equipment on the latest conversions and more than 50% of their fleet.

What about FedEx? They're expanding and adding aircraft. Do you have business there?

Focusing now on buying things like MAXs, because the MAXs now, as you can imagine, are relatively inexpensive and they have a reasonable volume. So I think for FedEx and some of the other package carriers, they're focusing on new airplanes from Boeing. Boeing looks to be aware of a big demand for it. Look at Airbus; Airbus has just announced their 330 Cargo— a cargo version of the 330. So we believe we see a number of smaller package carriers sweeping in for the larger volume of 767, and that's our cockpit. The only competitive cockpit takes 4 times as long to install, almost a month, costs significantly more, and has much lower proven reliability.

I've been looking for problems, and I see supply chain problems with some companies largely because of the stories of semiconductors. Is that likely to impact your deliveries?

Well, look, I'm concerned about supply chain. We haven't had serious problems yet, but there are two problems in anything that's semiconductor-related. Increasingly, the lifetime for a given semiconductor is getting shorter and shorter. They're coming up with new technologies almost every year, which forces the obsolescence of some existing technology. That's always an issue. To date, we haven't had a serious problem, but our designs are materially different than most because we make our designs up of a series of smaller sub-assembly boards. So if we have a problem with a particular technology or circuit, we could take a small subpart and modify that readily instead of modifying an entire system. We've been doing this kind of thing for over 30 years. It helps us. It doesn't solve the problem entirely, but it certainly mitigates it. We're watching it; it's obviously an issue, but to date, we've been able to manage it very well.

That's great, that's great. And you'll probably get some Airbus conversion business, is that a possibility?

This is a possibility as well. But right now, we're delighted to be focusing on Boeing 757s and 767s. As you know, we've already completed something between 500 or 800 units. It's been a huge success. The reliability of the equipment is the best that I've ever seen in my career. So we're thrilled. We keep our fingers crossed, trying to continue to maintain our quality.

Well, based on your momentum and the $1.2 million that you earned pretax in the June quarter, I'm estimating you might make a $2.5 million pretax in the September quarter.

You know what? I feel like I'm a hurdler and you are running ahead of me and raising the hurdles over time. But that's okay. Listen, you've got great support, and we appreciate it. I mean, next time you go up to New York, let me know, and I'll meet you up there. I'll buy you lunch. I'm being very circumspect because we're talking about another potential wave of COVID. God knows what the politicians are going to do. So I think our best bet is to execute on what we've got and just keep putting our shoulders to the wheel. If we could grow faster than we have in the past, I'll be delighted, but I'm not planning on it.

Geoff, I am not visiting New York as frequently as I used to. My last trip there was canceled by the host due to the COVID situation. So I recommend you fly down to Richmond in your King Air, and I'll treat you to lunch here.

Last time I came down to see you, I took a train, and I thought—

I know.

—I didn't see any lights for two hours. It scared me. We'll see. But you're right. We have an airplane now, and we're going to do some flight testing anyway.

You didn't have.

You're right.

Now, you've got the King Air; there's no excuse—you have to come down here.

I will. We'll come down; you're right.

Our next question comes from George Marema with Pareto Ventures.

Could you guys comment on the cadence of the retrofit business now on the Autothrottle?

It's much slower than I would like. That's principally because we need to hire salespeople. All the business we have on retrofit now is principally coming through Textron and Textron service centers, and upgrades to current owners of King Airs through Textron. We now want to directly attack the FBOs separately. We believe that's a huge opportunity, and I personally am taking a greater interest in making that happen.

Okay. And on the OEM business, like Textron, for example, what is the approximate time lag between when you need to ship your product to them and when they install it into their plane and ship their product? What is it? A month, 3 months, 6 months? How far ahead do they order the Autothrottle to put in their plane?

I can't give you an exact number, but I could say it’s 6 to 9 months because, in the production cycle of the airplane, it takes that long. They phase in the installation somewhere in the middle of the manufacturing of the airplane. So it's more based on the construction timeline than anything else. In many cases, we've been servicing them in just a matter of weeks. We're currently building inventory so we can deliver in very short lead times for our FBO customers and for Textron.

Yes, looking at Textron numbers, they're planning on producing dramatically more planes in the back half of this year than in the first half. So that's why I was sort of wondering about that.

Yes, we're already looking at automating certain functions just to ensure quality and repeatability—not so much to reduce labor, but to maintain quality. We expect volume growth. If it adds any reassurance, the company has a history of growing revenue very quickly. During the RVSM period, we increased production rates month-over-month by 2:1. I don't want to do that again, but we did.

Oh, I do.

I know you do. And wait; we've seen this. The company has always been designed to accommodate rapid growth. In the retrofit business, you have to assume that you may need to respond quickly. We will be prepared for rapid growth that we believe Textron— I hope Textron appreciates. We've received tons of accolades for the Autothrottle. If you read the latest issue of Flying Magazine, it's almost as if they said, "Hey, this is a great Autothrottle, and look at what you can do with it on an airplane."

Yes. Well, the way Textron is talking, I think you're going to be ready for a big back half here. About a conference call or two ago, you mentioned a new, lighter, lower-cost version of the Autothrottle, if I have the wording right. Would this new version be applicable to smaller planes like Cessna, or what kind of plane would that be used for?

Well, as an example, the immediate target would be the Textron or Beechcraft 58, which is smaller like twin that periodically experiences these loss of control accidents. It's less critical in some of the smaller airplanes than in the King Airs. Just remember, there are 5,000 King Airs, all of which represent potential markets. It is possible to deliver 50 to 100 per month into the market for the foreseeable future, which would be a very nice achievement if we can do that.

And I'm assuming that these Autothrottles will go on the new remodeled C90.

Yes, they will. That hasn't been a prime target at this point. The reason is that it's a different certification group, so it will require significantly more work to obtain the necessary certification. It’s more about getting the FAA to approve it since they are under a different certification than the King 200 and 300.

Okay. And how is the progress on new commercial OEMs in military?

In military, it's good. Military programs typically take a long time. You start and it takes two or three years to get going, but we're progressing on several fronts, and we are currently pursuing that. As you're aware, there is a significant number of turboprop airplanes in the military all over the world. We continue to bring our technology into those areas. And to be very blunt with you, if I could find 12 salespeople today, I'd hire them all.

Okay. Well, man, you might be recruiting me if it's like shooting fish in a barrel like that.

I don't know anywhere where you can shoot fish in a barrel, but I will tell you, it's rewarding, and they do love the product. We've really enjoyed this, and we've got a lot of other products. We were in a recent show, and we presented this Autothrottle, and they said, "Oh, by the way, we'd like to take a look at your Flight Deck upgrades." So we've had a dozen inquiries on that. So this is also good business.

Yes, it's great. It sounds like you have a lot of momentum coming with all cylinders firing here.

I've been doing this for a long time, and the only thing I've ever learned is that I have to keep pushing on the wheel all the time because the minute you take your eye off it, you find out you've got an abrupt change in velocity. So far, so good. We're going to keep at it. I'm more concerned about a steady, continuous, and predictable rise in our revenues and profits. I think that's possible, and we're focusing on that. We managed to grow the business during this pandemic, but remember our customers got decimated by it. So we're optimistic that we will continue to grow now that there's some general recovery.

Our next question comes from Michael Friedrich, a private investor.

Yes, it was a great quarter. The new orders and the increase in that area are very encouraging. I wanted to revisit some points that we didn't address last time. Regarding the current state of the FAA, which is always a shifting target, I had asked last quarter if there were any pending applications. Have there been any approvals in the last quarter that you didn't inform us about?

We've gotten some STCs issued. I don't know precisely how many, but I can tell you that I haven't heard of any serious problems. So that's the good news. To be blunt with you, this is probably the best working relationship we’ve had. In the old days when I started in the industry, there was a lot of mutual respect and confidence between the manufacturer and the FAA. The FAA has, in general terms, been very cooperative but also diligent. They work hard to ensure all the work is done but gets done in a reasonable timeframe, so I can't complain about the FAA.

That's awesome. All right. So Geoff, are there any STCs right now pending that would be for other aircraft other than the PC-12 or the King Air models?

Let me think for a minute. I really need to get back to you on that.

Yes, that would be for sales, not for any of the other aircraft.

I'd be coming to that. We're constantly evaluating new aircraft opportunities. We have no new aircraft per se because they don't call for offering, but updates to existing aircraft are a priority as we try to accommodate the various versions of the King Air fleet.

Great, great. So the previous caller had mentioned the touchback on the cheaper version of the Autothrottle that might be available. Would there be more significant OEM possibilities in that area since there are so many of those planes produced out there? Is that the way you're seeing it, Geoff, or do you believe it will be kind of in line with the turboprop numbers?

I honestly don't know. I can tell you that I've looked at the possibility of coming up with a lower-cost, smaller version for application in less expensive aircraft. The King Air is probably, on average, 5 to 7 times the cost of small twins. Owners don't want to spend a lot of money. Yet, it still could be a critical component. I think people are starting to recognize that the Autothrottle isn't simply cruise control; it's a significant and very valuable reduction in pilot workload. As that is recognized by people in the industry, the market will increase. In the meantime, it took me 17 years to come up with the Autothrottle we have now. I hope that no one will take 17 years to develop another throttle, but I think we could do it. If there is a real demand for it, I believe we could fulfill that. The good news is we must have almost a half dozen patents now on the Autothrottle's various functions, giving us a strong position, I'm happy to say.

That's great. And Geoff, did you just say on the past answer that you could do 50 to 100 retrofits a month kind of ideally?

I'd love to do it. We need to engage with the MROs— not only the MROs but also directly with FBOs and individual shops across the country along with Textron. Textron has done a great job; nevertheless, we've been looking at putting together a dedicated team for installations. This means they have sufficient resources for installations for a sustained amount of time. Ultimately, Textron has been one of the most cooperative OEMs I've ever experienced, and we're working closely with them, but we want to expand our reach. We believe we can gain acceptance in the markets.

That's great, that's great. And the online retailer, who we cannot name, plans to add 400 planes, I think. Do you expect to be a player on a majority of those? I mean, would those all be 767s?

I think we will either be on all of them or none of them. Right now, we know we're on about 40 of them. So we think we're going to be on all of them. If we treat our customer the way we should, we shouldn't have a problem. You can guess it's the largest retailer of that kind in the world.

Yes, yes, yes. I could take a wild guess.

So we just have to do our job to support them. But it's a unique system that, even if one of the components fails, you can still fly the plane for 10 days. This means that if the airplane is in the middle of Croatia or something, you know you're going to be able to get it home and service it. That's really important. We just have to do our job and do it well. That's all.

Yes. And one more question, this is more for the people who might be listening today that haven't heard before. But can you quickly touch on the limited downtime these planes have when they're having a retrofit? It was an active plane as compared to a normal flat panel display switch out.

Well, there's only one other system that is certified for 757s and 767s retrofit, and from what we hear, our feedback suggests it takes about 1,400 man hours to install and roughly 30 days. Now that doesn't become a problem if you're converting from a passenger airplane to a cargo airplane because it's going to be down for 3 months anyway. However, if you want to bring an airplane in that has already been converted into a cargo airplane and want to update the cockpit with our equipment, we've had it done in as little as 24 hours. Traditionally, it takes about 3 to 5 days to install ours as opposed to 3 to 4 weeks for our competitor. We feel that gives us a strong market advantage. Currently, as far as I know, there are only 2 systems certified for the 757 and 767.

That's great. And there's a lower price point for the actual equipment, is that correct?

I think I'll just briefly address that. The price point may not be very important. We all think about it when we sell it, but if you keep a 767 on the ground, it costs you about $75,000 a day in lost revenue on that ship, on that asset. If you take down the airplane for 30 days, I can't say that we're planning on even coming close to that. You're talking orders of magnitude more. And so—no, that's not always true. A lot of time it's installed during a passenger to cargo conversion. However, if they're not, we have a distinct advantage. We do have a price advantage, but I think all the other features more than compensate for those differences, if any. It's been a good product; it has a good reputation, and it's incredibly reliable. We're looking at around 250,000 to 300,000 hours MTBF lead time. It's astounding.

Our last question for today comes as a follow-up from David Campbell with Thomson, Davis & Company.

Geoff, this is David. I've been trying to reach you several times on the telephone and your office number, but no one ever answers it, and I'm not sure you're getting the messages because of the limited person around you with this COVID thing.

I'll send you—I will contact you. I think I've been spending some time in Florida now, so I'm on the road more often than not. And I've had some surgery done. And with one thing and another, I've been a little out of touch. I'll send you a note and make sure you have my number, okay?

Yes, if I can get a cell number, that would be good.

I will. But I don't want to give it to you now. Okay, I look forward to seeing you, David.

Next question comes from an unidentified analyst with Weisel Partners.

Geoff, I’m relatively new to this, but it occurred to me while listening: I wonder if you’ve had much contact with the liability insurance carriers, particularly for commercial users of King Airs, who are ensuring owners of those aircraft.

I remember the question you previously asked, and I applaud that. I would have thought that the insurance companies would be all over this. I guess, unlike everyone else, they wait until something significant happens. I suspect they're preoccupied with other things. Rell has actually talked to them and has comments, so I'll turn it over to Rell to answer your question.

Yes, we have been educating the insurance underwriters. We are sending them information and trying to talk to them. We just sent out the Flying article to many of the underwriters, but as Geoff mentioned, it’s hard to get traction. You would think it's a no-brainer, but we need to generate more interest. We continue to follow up and keep doing it, and hopefully, the light bulb will go off. If it happens to one, it may happen to many.

Sadly, I think if I were to lose a family member in a crash, I would be angry, obviously. They would probably say, 'Look, you knew this technology was available to make your airplane safer, and you didn't employ it. I'm going to go after you.' It only takes one such incident to change the perspective.

It seems like if you're a commercial user of the King Air or a corporate user of a King Air, and this technology is available, you could meaningfully reduce the prospective liability of operating that aircraft. In that case, it's a case of malfeasance if you don't take advantage.

Exactly. Of course, I would think it would be irresponsible not to use it. Well, I did inquire with an attorney in New York regarding his thoughts. The issue of malfeasance, as it becomes more obvious, could present a solid case for negligence. The recent articles in Flying Magazine have very strongly publicized the advantages and safety issues associated with the Autothrottle. It's probably approaching a tipping point; we'll see.

Well, not to belabor the point, but I encourage you to reach out to the trade publications in the liability insurance arena, as they may find this technology interesting. Your continued efforts would seem prudent, as it’s an important factor in delivering services to the 5,000 King Airs that are out there.

We're poised very well. I can tell you that when the FAA told us that they lost 100 people a year, and what we are doing to save their lives...it's humbling. I don't know about you, but I've never saved anyone's life, including my own. It is a unique opportunity to give back for the good fortune I have experienced.

This concludes the question-and-answer session. I would like to turn the conference back over to Mr. Geoffrey Hedrick for any closing remarks.

No, we're done. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.