Innovative Solutions & Support Inc Q2 FY2022 Earnings Call

Good day, and welcome to the Innovative Solutions & Support Second Quarter 2022 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Shahram Askarpour. Please go ahead.

Good morning. This is Shahram Askarpour, Chief Executive Officer of Innovative Solutions & Support. Welcome to our conference call to discuss our performance for the second quarter of fiscal 2022, current business conditions, and outlook for coming years. Joining me is Rell Winand, our CFO. Before we begin, I’d like Rell 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 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 Shahram.

Thank you, Rell. In the second quarter, we continued our steady growth with revenues up 34%, earnings up 135%, and nearly $2 million of cash added to our financial position. Together with our strong first quarter, this is one of the best first six months in six years. At the foundation of our aftermarket business, we believe we have excellent products in attractive growing markets, including our award-winning autothrottle on flat panel displays for air cargo convergence. As our OEM product base continues to grow, our aftermarket equipment is being installed on some of the world’s most popular aircraft by the most highly respected owners, operators, and aircraft manufacturers, both domestically and internationally. We have been known through the industry for our compelling price for performance product for over 30 years, and we plan to remain so for many more. This is our formula for success. Now let me discuss our recent results and future. Revenues in the second quarter were up 34%, which led to gross margins of over 61%, our highest margins in six years. Our model can consistently generate attractive margins as we achieve scale. This quarter, we continued to generate revenues from both our stable OEM production contracts, which offer a solid base of predictable recurring revenue, and from the air cargo retrofit market, where we are experiencing strong demand for our cockpit upgrades. Because our production OEM contracts extend over several years and there does not seem to be any decrease in pace of air cargo convergence, we believe we have a solid foundation for growth. Resultingly, our strategy to continue our growth and create shareholder value is straightforward. We will continue to innovate our existing products and develop new products. One development, which I’m enthusiastic about, is our new process to reduce autothrottle installation time on King Air retrofits. We are now in the process of receiving a certification from the FAA to introduce a product installation service for our King Air customers. Essentially, our new program flies our highly trained and FAA-certified technicians to the King Air owners' hangars, where the installation is completed at their site, saving owners both time and money. No longer will the owners need to fly their aircraft to a service center for a week or possibly longer while they schedule and ultimately perform the installation. Our marketing research results indicate that offering this service would accelerate the adoption rate of aftermarket King Air and PC-12 customers. We are also broadening our product market potential by developing new autothrottle technology, not just for table fans such as CJ aircraft but for many other variations of King Air and other aircraft as well. As part of this strategy, we will continue to invest in research and development. Note that this quarter, we maintained a high level of investment in R&D, including customer-sponsored R&D. After a long period where we were relatively dormant due to the pandemic level restrictions, we are ramping up our sales and marketing activity, attending more trade shows, meeting face-to-face with customers, and performing more customer test flights. Consequently, after our typical winter slowdown, orders picked up nicely in the last few months, and we ended the quarter with an increase in backlog compared to December 31. This has also led to an increasing level of interest from militaries around the world that rely on the dependable King Air for air ambulance and surveillance. I mentioned the military’s growing interest last quarter, and I’m encouraged by the level of intensity that those discussions have risen. Like many other manufacturers, we are battling inflation, supply chain challenges, and labor availability. We continue to support our customers. We have added safety stock to our inventory while managing to keep expense increases modest relative to our overall growth. As of today, we don’t foresee any major disruption to our operations from any of the factors, including the conflict in Ukraine or the lockdown in China. In fact, we have experienced growing sales and earnings through the pandemic, strained supply chains, inflation, and many other issues. As some of our end markets begin to improve, and pandemic-imposed restrictions are lifted, we feel confident that we are well positioned to build on this success and continue to generate steady financial results. Now I’d like to turn it over to Rell to review our financials in more detail.

Thank you, Shahram. And thank you all for joining us this morning. For the second quarter, revenues were $6.8 million, up 34% from $5.0 million a year ago. Revenues in our general aviation business in the quarter remained strong as we continue to ship products under the PC-24 and Textron King Air long term OEM contracts. In commercial air transport, there has been no let up in demand for our flat panel display systems for air cargo convergence. In addition to our PC-24 and the King Air autothrottle OEM production programs, we continue to enjoy steady predictable revenue from our Boeing KC-46A production contract. Our revenues in any one quarter are largely determined by customer production schedules, and lately, these production schedules have been on the rise, with, for instance, Textron reporting continued growth in the sale of this general aviation aircraft, while Pilatus continues to run at a high production rate. In addition, customer service revenues remained strong as sales in the quarter were up 12% from a year ago. Total new orders in the quarter were approximately $8.2 million, so we finished the quarter with a backlog of $7.5 million, compared to $6.2 million at the end of last calendar year. Gross margins for the quarter were the best in over six years at 61.1%, up from 56.7% in a year ago quarter, and sequentially up from 59.3% last quarter. Margins continued to trend in line with historical averages, with any fluctuation from quarter-to-quarter primarily attributable to product mix and the leveraging of our fixed manufacturing costs achieved through revenue growth. This better than 30% revenue growth in each of the last two quarters compared to the year-ago quarters shows that margins have been running at a very high level. As Shahram mentioned, our model can sustain attractive margins as we scale the business. Total operating expenses for the second quarter of fiscal 2022 were $2.4 million or 35% of revenue compared to $2.3 million or 45% of revenue a year ago. Research and development was down compared to a year ago. We continue to target 10% to 12% of revenue for R&D. Selling, general, and administrative expenses were up markedly from the year-ago quarter due to both our growth over the past year as well as some relaxation in public health restrictions. We have been resuming marketing spending on in-person trade shows, customer visits, and travel. We believe the quarterly operating expenses level will remain in the current range. For the quarter, we generated operating income of $1.8 million, nearly triple last year’s $611,000. Return on sales in the quarter was 26.4%, more than double the 11.9% recorded last year. We recorded taxes of $390,000 in the quarter in line with our anticipated 21% rate for the year and reflecting that we have fully utilized all of our tax net operating losses. Net income for the quarter was $1.4 million or $0.08 per share, an increase from $608,000 or $0.04 per share in the year-ago quarter. The company remains in a strong financial position. We generated $1.9 million of operating cash flow in the second quarter and $3.4 million over the first half of fiscal 2022. At quarter end, March 31, we had $11.6 million of cash on hand. As previously discussed on the fiscal year earnings call in December, the company anticipates that due to the ongoing supply chain issues and challenges resulting from the COVID-19 pandemic, we will continue to maintain a slightly higher than normal level of inventory as an added measure of precaution. The company is debt-free. We believe that the company has sufficient cash to fund operations in the foreseeable future. Now I’d like to turn the call back to Shahram for some closing remarks.

Thank you, Rell. The first half of 2022 has been one of our most profitable in many years. Our production contract customers are experiencing strong demand for aircraft where our autothrottle is standard equipment, and the air cargo convergence market remains robust. Backlog is up. We’ve increased our marketing efforts, and new products and services are underway. We have built a strong operational team dedicated to value-creating innovation and our plan to continue strengthening the organization as we grow the business. We have an arsenal of great technology at our disposal with an energetic and enthusiastic team dedicated to executing on our growth platform. We will now open the floor for questions.

Thank you. Our first question comes from David Campbell with Thompson Davis & Co. please go ahead.

Good morning, everyone, and thank you for doing such a great job managing the company without the help of our friend, Geoff Hedrick, but he’s looking on and would be very proud of what you’ve been producing. Congratulations on a great quarter. I just wanted to ask you a question – a couple of questions about the cargo market. There’s no immediate concern, I think, but what can you tell us about what aircraft types you’ve been providing the new flat panels for the conversions? I am a little concerned about the cargo conversion market because right now it’s been boosted a lot by the lack of capacity in the air freight market between the United States and China that’s found, and sooner or later, we’ll get flight capacity back there. And I don’t know whether the air cargo conversions are ready for that increase in capacity likely to come later. So do you have any comments on all that?

I mean so far, what we’ve seen is that new airlines are actually adding cargo capacity and introducing cargo services. It seems still there is a heavy reliance on the 757 and 767 platforms. We continue seeing orders on those platforms from various airlines internationally as well as domestically. Every quarter, we receive orders, and indications that we get is more cargo conversions. Obviously, what limits it is at the rate they can do cargo conversions on the 767 and 757. There are only a few places in the world that can do that conversion. But in our market, at least for the foreseeable future, there’s no slowdown of that activity. We constantly look at what other features and capabilities we can add to our existing base. We have over 500 existing customers with our cockpits in the 757 and 767 platforms, as well as the 737, and our product development efforts look at additional features that we can provide the existing customers as well as the new customers.

Have you seen any demand from 737s and Airbus models for the conversions?

Currently, we don’t have a solution for the Airbus models. We do have a solution for the 737. We see from some of our existing customers, as they’re growing their fleet, indications that there will be future procurement of some of our equipment. But right now, the majority of what we see is from the 757 and mainly the 767 conversions.

All right. There seems to be increasing interest in Airbus conversion. So is there something that keeps you from getting into that business? Do you just have to develop the product?

Yes. Again, we continually look at the market, the competition, and whether there is a need. When we see that something like that is going to become feasible, then we deploy our engineering resources towards that platform.

Right. Well, these profit margins are 61%. As long as revenues are this high, do you see any reason why those margins should go down?

I don’t see that. I mean, the only thing, and the way we quote the stuff, hopefully, it won’t affect this, would be any kind of a material cost, but we seem to be handling that very well. So I don’t see why you can’t stay in that range. We’ve been lately in what the 58%, 59%, 60% range, depending on product mix a little bit. Yes, if sales hold, I think we’ll be fine.

And what about the tax rate the rest of the year? Do you say 23%?

Well, 21%.

21%.

Or 21.4% on some state tax effect. But if you want to ballpark it, it’s 21%. I think it was 21.2% the quarter before. It’s up a little bit, but big picture, 21% works.

Well, that’s great. And the King Air conversions, I assume you’ve been getting orders for those King Air conversions. Now that you can do it faster, you’ll probably get more orders. Is that the way to look at it?

That’s what we anticipated. Once we get this – right now we’re seeking approvals from the FAA that allow us to do our own installation remotely. Once we get that again, what we’ve seen from the marketing efforts is that there is reasonable interest from the customer base to utilize that remote installation capabilities that we will have.

We like the convenience of it.

All right. The last question is with the company growing as fast as it is in demand or services increasing. Are you adding new employees in engineering or sales? Where are you looking to help speed that along?

We do that on an as-needed basis. I think it’s more important to find the right people to add on than just add on people. We spend a lot of effort in the interview process as well as judiciously looking at potential candidates. But we grow our employee base steadily, and we continue to do that as revenues grow.

All right. Thanks. I’ll let someone else ask questions.

Thanks, David.

The next question comes from Michael Friedrich, a Private Investor. Please go ahead.

Good morning, everyone. I wanted to get back to some more information on the new retrofit process. Can you give us some idea of the amount of time it will take for the conversion to take place? Last month, we talked about the idea of you folks keeping more kits on hand and there were other attempts to speed up the process. Just maybe give us an idea of how quickly this can be done and also the feedback you’ve been hearing from potential customers on how quickly the uptake will be on this.

Sure. Our internal process to do the installation is looking at a one-week installation. We’re looking at doing that at customers’ facilities. There’s a level of convenience that provides the customer. They don’t have to fly their airplane somewhere. It’s done right at their facility. They don’t have to go through the inconvenience of putting their airplane down in a third-party location and then going back home and then returning to pick up their airplane. The installation is going to be done by our factory experts, where we actually train other installers. About 75% of the people we approached directly and surveyed indicated that this would increase the decision-making process because of the convenience. So we decided, based on that, to go ahead and get approval from the FAA so we can offer this service.

Okay. And you said the install – the people performing the installation will they be ISSC employees? Or will they be a third-party vendor?

Right now, we plan on them being ISSC employees.

Okay. And then approximately how many – how many crews or how many of these can be done at a time? Will you be able to hire as needed, or are you ready to go with a couple of teams? How many are we talking about here?

We always start with one team and then grow the team as market demand dictates.

Okay. And then real quick, you had touched a little bit on the military end for the King Airs. Can you give me an idea of approximately how large that marketplace is?

I think if you look at it internationally, there are probably close to 1,000 King Airs out there in military service across various government operations. Some of the features we provide for special missions, as part of our autothrottle functionality, make it very attractive. In this last quarter, in Q2, we had a fleet operator that actually leased out their airplane to the U.S. government. They bought our autothrottle for their fleet. They’re in the process of installing it. We’re beginning to see, of course, on the military side, these processes take a long time to get approvals, and they need to put in for the budget, so it doesn’t happen overnight.

Right. I’m sure. Sure. And are you able to use – do you have to get approvals in every country? Or are you able to use FAA approvals to be able to provide these upgrades in other countries?

So it depends on the country. But right now, I think we’ve got approvals for about 40 countries.

Okay. That’s great.

They take FAA approval; some have their own. It all depends on the country.

And some of them accept the approval.

Great. Great. Well, congratulations, guys. I mean, it’s nice to see sales coming back a little bit. But there’s no question about it that looking at the income statement, the company is being run very efficiently, and hopefully, when those numbers kick in on the top line, most of that will go straight to the bottom. So keep going, guys, and congratulations.

Thank you so much.

Thank you very much.

The next question comes from Roger Goldman, a Private Investor. Please go ahead.

Good morning, and well done, guys. As you know, my dad started investing in the company about 10 years ago, and my sister and I have inherited that and also inherited the belief in the company. It feels like all systems go. So nice job, and our patience is being rewarded. Just a couple of questions. Obviously, the future is very bright. Also, you have a lot of cash, and that cash has real value particularly as we go into a recession and particularly with rising interest rates. I am not necessarily lobbying for a dividend. I am lobbying for a good use of the cash. I would hope that you guys are actively looking at acquisitions and maybe more rapidly expanding your distribution. I think in this kind of environment, with the product mix and margins you have, fortune favors the bold. With five months' worth of – assume to be six months worth of cash and no bank debt, you’re in a really great position to take advantage of this situation. I would just encourage you and, again, I certainly would like a dividend, but frankly, I’d rather see you use the money to expand faster. Sorry, you want to comment on that?

Without making too many comments on that, we do plan to use the cash judiciously. I don’t believe there are any plans on distributing dividends at the moment. But I’m in your camp with regards to the use of cash.

Yes. If you said on the next call, 'Hey, we’re going to invest $1.5 million to $2 million in something to expand our distribution network or expanded R&D or whatever,' I’d vote for that. I don’t think stock buybacks are a good idea because that implies you have nothing better to do with the money, and I don’t think dividends in a growth company are necessarily a good idea. But frankly, I don’t think six months' worth of cash on the balance sheet, with no public plans to spend it and no bank debt, is a good idea either. I’m speaking as someone who spent his career in banking. So I’d really like to see you guys be more aggressive, I guess, is what I’m saying. I think you have a lot of room to be aggressive without betting the company. I just want to encourage that.

Thank you. Thank you very much.

All right. Well, thank you for your confidence in the company and us. I appreciate it.

Thank you very much.

And there is nothing at the present time. This concludes the question-and-answer session. The conference has also now concluded. Thank you for attending today’s presentation; you may now disconnect.