Innovative Solutions & Support Inc Q1 FY2023 Earnings Call

Greetings, and welcome to the Innovative Solutions and Support, Inc. First Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Michael Linacre. Thank you, Mr. Linacre. You may begin.

Thank you, operator, and good afternoon, everyone. I would remind our listeners that certain matters discussed in the conference call today, including information about 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 it over to our CEO, Shahram Askarpour.

Thank you, Mike, and good afternoon, everyone. I will begin today with remarks on our performance in the fiscal first quarter of 2023, followed by comments on the upcoming year and our long-term growth strategy. I will then turn the call over to Mike, who will take us through the details of the financials. We began the year on solid footing with revenues of $6.5 million, driven by stronger OEM volume and engineering development contracts. Underlying end markets remain strong, particularly with OEM customers. I'm pleased to announce that during the Q1 2023 period, we received our FAA supplemental type certificate or STC for the King Airs with the G1000 and NXI flight decks and delivered our first aircraft. This STC opens an additional 700 potential aircraft for our King Airs Autothrottle, which builds on the existing growing aftermarket King Airs platforms. As we have stated in the past quarters, our winning formula starts with excellent products in attractive growing markets. This effort is supported by more than 500 cockpit upgrades in 757, 767, and 737 platforms combined with a rapidly growing presence in general aviation. Gross profit in the first quarter was $3.7 million compared to $4 million in the prior year, mainly due to product mix. As a percentage of sales, gross margin was 57.1% compared to 59.3% in the prior year. We believe these results reflect the success of our innovative products in the market and our dedication to excellence in delivering for our customers. Turning to product development and beginning with Autothrottle, we continue to invest in additional platforms that benefit from our trusted products, as well as increased functionality that help generate additional revenue. Of these, the 757, 767 engine indication and crew alerting system upgrade development program is progressing well. We expect this additional offering on our successful 757, 767 platforms to generate solid revenue for years to come. We also remain laser-focused on the short-term opportunity to meaningfully expand margins through better facility utilization and intend to accomplish this goal through a mix of organic growth and strategic bolt-on M&A. On the organic side, we continue to expect an expansion of our R&D program in fiscal 2023 to around 13% of sales from 10% in fiscal 2022. The first quarter, our R&D ramp was below this level as we are in the process of ramping up our engineering resources. Cockpit automation remains a focus area for us, as demonstrated with the development of the Autothrottle for King Airs PC-12 and Eclipse. Beyond Autothrottle, we are expanding automation throughout our product portfolio, specifically to other areas that can drive customer value by enhancing safety and reducing operating costs. We have the key product lines and technologies to further automate cockpit operations, which would significantly enhance flight safety and eventually lead to crew reduction. In terms of inorganic opportunities, as I have noted in December, we have assembled a business development team to pursue opportunities. During the first quarter, we developed an active pipeline, and while it is too early to share any details, we now have the ability to identify and execute on attractive product line type acquisitions that complement our existing portfolio. We expect to be able to fund bolt-on acquisitions through cash on the balance sheet and free cash flows from operations which exceeded $6 million in fiscal 2022. Taken together, we believe we can grow ourselves, increase our asset utilization, and drive incremental margin to our overall business. At full capacity, we believe our infrastructure can support a meaningful increase to our operating results and total free cash generation. To conclude, we're off to a good start for the year with a strong outlook as we deliver on our legacy products and new offerings. Thank you for your time and interest, and we look forward to updating you with further details in the upcoming quarters. Now I will turn the call over to Mike for a closer look at the numbers.

Thank you, Shahram. Thank you all for joining us today. I will review our financial results for the first quarter of fiscal 2023. Revenues declined slightly by 2.7% to $6.5 million in the first quarter versus $6.7 million in the first quarter of fiscal 2022. The decrease was largely due to lower commercial aftermarket revenue, which was partially offset by growth in our general aviation OEM business. The decrease in commercial sales was primarily a function of when the sales orders were received for our aftermarket retrofit business from commercial air transport customers. These orders may fluctuate from quarter to quarter while we continue to anticipate that sales will support the short-term organic growth trajectory. Demand from our OEM business remained strong during the quarter. Sales from engineering development contracts or EDC improved as a result of two research and development projects. Customer service revenue was consistent with the prior year. New orders in the first quarter were approximately $3.3 million, and backlog was $8.5 million as of December 31, 2022. Backlog is up from $6.2 million as of December 31, 2021. We include only purchase orders in hand from the Pilatus PC-24, Textron King Air, and the KC-46A long-term programs in our total backlog. The current backlog includes a large contract with one of our general aviation OEMs that is locking in their supply chain beyond their normal advanced order. Given this increase, the total backlog level does not necessarily translate to increased future sales. We anticipate that these programs will remain in production for about a decade and should continue to add to production sales already included in the backlog. First quarter gross margin was 57.1% versus 59.3% in the first quarter of the prior year. Cost of sales increased due to the combination of higher, less profitable OEM business, lower product sales, and slightly higher direct material costs, which adversely impacted our operating leverage. Note that all our long-term OEM production contracts include escalation clauses that provide for the passing along of a portion of cost increases incurred as a result of inflationary pressures. As we've mentioned on previous calls, our optimized operating model is based on a fixed cost platform with a relatively lower employee head count. We expect our operating leverage and margin profile to improve as sales growth returns over the remainder of the year. Total operating expenses were $2.9 million in the first quarter compared to $2.5 million in the prior year’s first quarter. The uptick in general and administrative expenses in the quarter was mainly on account of non-cash long-term employee stock compensation and professional and legal fees. Higher G&A costs are expected to continue into the second quarter and moderate into the second half of the year. The growth in operating expenses was offset in part by higher interest income generated from the combination of a larger amount of balance sheet cash, higher interest rates, and the reallocation of funds into higher interest-yielding investments compared to the same period in the prior year. R&D expenses were approximately 11% of revenue and in line with the year-ago first quarter levels. Our expectation of targeting 13% of revenue for R&D in 2023 is unchanged, and we therefore expect R&D expenses to gradually rise over the coming quarters. Tax expense in the first quarter was $0.2 million compared to $0.3 million in the prior year quarter. First quarter net income was $0.7 million or $0.04 per share versus $1.1 million or $0.07 per share in the first quarter of fiscal 2022. IS&S maintains ample flexibility driven by significant liquidity and a debt-free balance sheet, which enables us to be very well positioned to capitalize on organic and inorganic opportunities. We had $19.4 million of cash on hand as of December 31, 2022, up from $17.3 million at the end of fiscal 2022. The company generated cash flows of $1.8 million from operations and received net cash of $0.4 million from financing activities from the exercise of stock options during the quarter. Looking at the remainder of fiscal 2023, we expect to continue to generate strong cash flows with the maintenance of current gross margin levels and cost control. We anticipate increasing our capacity utilization and expanding operating leverage as we drive revenue growth by capitalizing on organic and inorganic opportunities through the remainder of the year. With that, operator, we are ready for any questions.

Thank you. We will now be conducting a question-and-answer session. Our first question comes from David Campbell with Thompson Davis. Please go ahead.

Hello. Thank you for taking my question and congratulations on a solid quarter. I noticed the general and administrative expense was $2.1 million for the quarter. Does this reflect the formation of your team to explore additional opportunities or different products for potential acquisition? Will you continue to incur that $2.1 million every quarter?

Yeah. Thanks for the question, David. And yeah, the actual operating expenses were $2.9 million versus $2.5 million last year. That's part of the increase is what you mentioned. But really, a lot of this increase came as a direct result of the passing of our founder. Going forward, we have a long-term compensation and a bonus plan in place that we have not had before. That will put us more in line with our peers and the industry. Having said that, a lot of these expenses are in stock, so there's no cash impact. You can see that we generated $1.8 million in the quarter in free cash flows, so it's not affecting the company's ability to generate cash. Also, there were some one-time legal fees in there, bringing the company in line with peers as far as corporate governance and other temporary costs.

It sounds like some of this was a temporary cost related to the stock options and other expenses that you may not have in the rest of the year. So should we anticipate that ongoing general and administrative expenses should go down from where they were in the first quarter?

I would say the run rate will be — there are some temporary costs in there, some one-time costs, but they will be lower than what we ran in the first quarter. However, I think generally, they will be up from historic run rates just based on our new long-term compensation incentives as well as bonuses, as well as investing into the team for future growth.

Yeah. And you mentioned an impact from the founder's passing last year. How is that an impact?

Well, our former founder did own 20% of our shares, and we did, from time to time, issue special dividends that were effectively long-term compensation plans. So to replace that and offer our current executives and management team a long-term incentive plan, we needed to increase that G&A item.

And your interest income was a substantial amount. Is there anything non-recurring about that? I realize interest rates are higher, and that's why that happened at least some of it, but I'm surprised that it was up as much all of a sudden.

If you look at our cash, from year to year, our cash more than doubled last year. We ended the year at over $17 million. We have over $19 million in the first quarter. We only had $9 million at the end of last fiscal 2021 year-end. So it's a combination of having more cash, interest rates are also a lot higher now than they were a year ago. Additionally, we did reallocate some of the funds to higher yielding interest accounts as well.

Right. Have you had any impact from Airbus converting their cargo? More of their equipment is being converted from passenger to cargoes, which has benefited your company's Boeing contracts. Do you see any plan in Airbus developing the same relationship?

No. We currently don't have this system upgrade — cockpit upgrade system for the Airbus fleet being converted to cargo. But we continue delivering on our 737, 757, and 767 cockpits for cargo conversion, as well as other airline operators looking to upgrade their cockpits. So we see that kind of steady demand that we've had now continue in general. We're also putting together replacements for the IS&S system, which is the engine indication and crew alerting; we should augment those cockpits, as well as have the opportunity to take a chunk of those 500 airplanes that are out there and offer them an additional upgrade.

I've seen where UPS and FedEx are grounding several of their older aircraft, which tells me that their demand for capacity is down. Have you seen any impact on your customers from that trend?

Not significantly. I mean, this has always been — the aftermarket on the 757 and 767 has always been for us kind of cyclical. We get a few years up, and then it kind of goes down, and it varies between, I guess, $5 million to $7 million a year. I don't see it getting out of that range anytime soon. It's going to have — some years it's going to be more, some years are going to be less.

Well, air freight rates jumped two years ago, but they're now down to normal levels. So the airlines aren't experiencing the same demand factors as they had.

But passenger traffic is up significantly.

Yeah.

So again, our cockpit is not necessarily tied into cargo operations. It's applicable. I mean the plan is that there is one of our customers, and we provide a cockpit for the 757 and 767 for passenger use.

Thank you very much. I appreciate your hard work and keep up the good work.

Thank you, David.

Thank you, David.

Thank you.

We have no further questions at this time. This concludes today's teleconference. You may disconnect your lines now. Thank you for your participation.