Innovative Solutions & Support Inc Q2 FY2023 Earnings Call

Greetings, and welcome to the Innovative Solutions and Support, Inc. Second 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, Chief Financial Officer. Please go ahead.

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 second quarter of 2023, followed by comments on our long-term growth plans and strategy. I will then turn the call over to Mike, who will take us through the financials. Our second quarter results demonstrated continued momentum of our business and elevated demand for our innovative products. Compared to the prior year, our net sales were up 7.2% to $7.3 million. This improvement was driven by the higher volume of our aftermarket product including our Autothrottle for the King Airs. I would like to remind our investors and stakeholders not to overanalyze our quarterly performance as it can be subject to variations in purchase order timing for our aftermarket products, which currently represent approximately 40% of our revenue. While we are pleased with our strong performance this quarter, it is crucial to take a more comprehensive and long-term view of our financial performance and growth. As we have reported on in the past, our business is well-positioned to benefit from significant operating leverage on higher sales, which was demonstrated again in the second quarter. As such, our gross margin expanded to 64% from 61% in the prior year primarily due to leverage on higher volume and a favorable product mix. Operating profits in the current quarter were $1.4 million, which was $380K lower than the previous year. The decrease in operating profit was primarily due to higher SG&A expenses, which were mostly one time in nature and related to non-cash stock-based compensation and relocation expenses. Turning to net income, we achieved $1.3 million, which is a slight decrease from the prior year of $1.4 million for the same reasons. As we continue to invest in our sales and business development initiatives, we are experiencing strong returns as indicated by our end of the quarter backlog of $14.8 million, a significant increase from a year ago and driven by new orders of $13.6 million in the quarter, which is a record in recent years. Moving forward, our goals are clear. We want to increase facility utilization to maximize our margin potential. We have a two-pronged approach to achieve this goal, through organic growth by driving new product introductions and through inorganic growth via M&A. To support our organic growth, we continue to invest in IRLG programs. Although IRLG as a percentage of sales is still below our full year target of 13%, we anticipate meeting our target on an annualized basis as we continue to expand our engineering department, selectively with highly qualified and self-motivated engineers. We believe that investing in IRLG is critical for long-term success and we remain committed to this approach. Specifically, we remain focused and see our primary competitive advantage in the area of cockpit automation, which you have seen with the introduction and broad market success of our Autothrottle programs. Our long-term plan is to provide the industry with incremental automation technology that would ultimately lead to a reduction in the number of pilots in the aircraft. To that end, I'm pleased to announce that we have shipped our initial orders on our recently awarded STC for the ThrustSense Autothrottle for the Beechcraft King Air 200 and 300 aircraft with the guard cockpit. This certification has allowed ThrustSense to be installed on an additional 700 potential platforms. On the inorganic side, we are actively seeking opportunities for M&A and have been working diligently to develop a robust pipeline. During the quarter, we made improvements and put progress by obtaining shareholder approval to amend our articles of incorporation. This strategic action will enable us to secure the financing needed to implement a more aggressive M&A program and execute our long-term goals. To this end, we are currently working closely with our banking team to evaluate the best structures for our needs and we plan to keep our investors informed of our progress in upcoming quarters. In our M&A programs, we are focused on identifying and acquiring complementary products and technologies to our existing portfolio. We are targeting smaller bolt-on acquisitions that are under $25 million. Our goal is to expand our portfolio and fill capacity in our facility and we believe that these targeted acquisitions will allow us to do so efficiently and effectively. We are constantly evaluating potential acquisition targets and look forward to providing incremental updates in the coming quarters. In summary, we believe that our performance in the second quarter demonstrates continuous momentum and strong demand for our innovative products. Moving forward, we have clear goals to increase our facility utilization and maximize our margin potential through both organic and inorganic growth. Thank you for your time and interest, and we look forward to updating you with the future details 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 today. I will review our financial results for the second quarter of fiscal 2023. Our revenues were 7.2% higher at $7.3 million in the second quarter compared to $6.8 million in the second quarter of fiscal 2022. The growth was largely driven by new orders from commercial air transport customers in the Boeing 757 and 767 aftermarket retrofit business. An increase was also seen due to new Autothrottle installations. As we noted during our last earnings call, orders in the aftermarket retrofit business fluctuate from quarter to quarter. Since it is approximately 40% of our business, our overall revenues may fluctuate from quarter to quarter. This quarter's results, for example, reflect certain orders that will carry forward into the second quarter, but were originally expected during the first quarter. While we do not anticipate any significant changes in the long-term organic growth trajectory of our business, we believe that our progress should be evaluated on an annualized basis. Second quarter gross margin was 64.6% compared to 61.1% in the second quarter period from a year ago. The improvement in gross margin reflects an expansion in operating leverage as a result of higher product sales, a favorable product mix, an increase in inventory, and a slight decline in direct material costs. The gross margin improvement is very much in line with what we have previously mentioned. Our optimized operating model is based on a fixed cost platform with relatively low employee headcount, with an operating leverage and margin profile well-positioned to benefit from revenue growth. We plan on continuing to see additional operating leverage as sales continue to grow. Operating profit in the current quarter was $1.4 million or 19.4% of sales, which was lower than the previous year's $1.8 million or 25.4% of sales. Total operating expenses were $3.3 million in the second quarter versus $2.4 million in the prior year second quarter. The rise in operating expenses were primarily related to higher SG&A. These expenses included non-cash stock-based long-term incentive compensation. Expenses were also higher as a result of additions made to the sales and business development teams, as well as marketing, investor relations, and investor-based related expenses. Higher SG&A expenses were partially offset by higher interest income generated due to larger cash balances and higher interest rates compared to the same period in the prior year. R&D expenses were 11.8% of revenue and in line with last year’s second quarter levels, we still expect to spend 13% of our revenue on R&D by the end of the year and continue to hire engineers to support product development efforts. Tax expense in the second quarter was $0.3 million compared to $0.4 million in the prior year quarter. Second quarter net income was $1.3 million or $0.08 per share versus $1.4 million or $0.08 per share in the second quarter of fiscal 2022. Net income was $1.3 million or $0.07 per diluted share, down slightly from the prior year of $1.4 million or $0.08 per diluted share. Backlog was $14.8 million as of March 31, 2023 versus only $7.5 million as of March 31, 2022. New orders for the second quarter were $13.6 million. The increase is largely due to customers locking in orders for a longer period of time, such as Pilatus, who has ordered through late 2024. Additionally, Boeing has given us larger long-term orders as well. These factors have largely contributed to the growth in our backlog. Our customers' confidence in us is reflected in these longer term orders, which in turn also enhances our visibility for future performance. We include only purchase orders in hand from the Pilatus PC-24, Textron King Air, and the KC-46A long-term programs within our total backlog. 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. We had $19.8 million of cash on hand as of March 31, 2023, up from $19.4 million of cash on hand as of December 31, 2022. Cash on hand was $11.6 million as of March 31, 2022. The company generated cash flow from operations of $0.4 million during the quarter. Our cash generation was impacted by the new IRS Section 174 R&D tax regulations that increased our estimated tax payment by approximately $0.4 million, an inventory build of $0.6 million, and $0.3 million due to the timing of accounts receivable payments received. We continue to generate cash flow and grow our cash balance without any debt on our balance sheet. This provided us with significant financial strength and flexibility as we seek to execute on our organic and inorganic opportunities going forward and deliver returns to our internal and external stakeholders. For the remainder of fiscal 2023, we anticipate generating strong cash flows with similar or higher gross margin levels as capacity utilization and operating leverage expand against the backdrop of revenue growth from organic and inorganic opportunities. With that operator, we are ready for questions.

Thank you. We will now be conducting a question and answer session. Our first question comes from Tim Moore with EF Hutton. Please go ahead.

Thanks, and congratulations on the strong orders catch up in the quarter, and it was nice to see the backlog up 24% sequentially from December, and double from a year ago with a very impressive strong book-to-bill. I do appreciate guidance into thinking of everything maybe on a 12-month rolling basis, but it was still impressive. So, my first question is, I know you elaborated a bit on the gross margin, which was amazing in the quarter. Was most of that caused by the mix? Was there more aftermarket sales there, or was it more caused by the operating leverage benefit? Just trying to wrap my head around maybe the main drivers of that margin expansion?

Yes. It's a combination, but we did in Q2 have a higher proportion of aftermarket business, which is typically a bit higher margin than our OEM business. So it was a combination between that and the increased sales overall to create that operating leverage.

Great. That's helpful. And something I just want to follow up on, you were giving good clarity on this maybe. Your SG&A expense, from what I recall, there was a bit more pressure on it in the first half of the fiscal year, which you just reported, because there were some one-off professional expenses, banking fees, maybe legal fees and some catch up. When you kind of think about the year as a whole for this year, we should probably expect SG&A as a percentage of revenues to drop in the second half of the year, right, compared to the first half of the year? Did you roll off a couple of things?

That's correct, Tim. And in Q1, you'll see – Q1 and Q2 and through the first six months, you'll see SG&A roughly around the low 30% of sales compared to our traditional run rate of about 26%. In Q3 and Q4 that will be closer to our historical run rate with the elimination of some of those one-time impacts. We'll be roughly running 27-ish percent and finishing the year probably a few basis points above our typical run rate of around the 30% range, but definitely we see relief coming in Q3 and Q4.

Thanks, Mike. That's really helpful. As I do my modeling, I just want to check that, because that will show up nicely in the operating margin expansion. What about the increased spending on R&D and the ongoing focus on product development, which has always been central to our innovative solutions support? Can you speak to the timing of any developments? I remember reading last month about the Helix Latex announcement, and I believe there might be some cargo instruments or engine innovations coming. Can you give us a sneak peek of any new products or adjacent ideas that could be in the pipeline over the next year?

Yes. To address your first question, we have been investing in our business development and sales teams to drive revenue growth. As a result, the increases in selling, general and administrative expenses will be slightly higher due to hiring skilled sales and marketing professionals. Our main goal for product development is to eventually reduce the number of pilots required in the cockpit, which we believe has significant business potential. To achieve this, we are taking an incremental approach by developing products in stages. This allows us to continuously innovate and generate revenue through improved cockpit automation, thereby decreasing pilot workload to a level where some aircraft may not need a second pilot. In parallel, we will introduce new products that enhance safety and reduce operational demands, which will also be marketable. Our strategy includes filling existing gaps by replacing outdated components in aircraft, something we have traditionally pursued. We expect to complete certification for the engine and crew alerting system for the 757 and 767 this fiscal year. Additionally, we are expanding our mobile installation teams, gaining the necessary accreditations to install not only our products but potentially those of other manufacturers at customer sites, saving them time and costs. We are also focused on developing new features for the Autothrottle, and we have recently certified two versions targeted at the military sector, which have generated positive interest from our military and government clients.

Yes, Tim, and that is, as sales increase, the margin will increase right along with it and we were just modeling this just last week, and $50 million in sales is going to get us over 30% EBITDA. So that will continue to grow. And that EBITDA number is only around 20% projected for this year on roughly $20 million less in sales. So, we do see that increasing quite a bit as sales grow.

Great. That's helpful. So, $50 million in sales, 30% EBITDA margin? Is that what I heard correctly?

Yes.

I think we will approach 30% once we get above $50 million.

Great. That makes sense. You have so much incremental leverage in that facility. If I remember it's something like a third utilized right now, the levels. Just my last question. And I know, Shahram, you mentioned this in some of your remarks about acquisitions. And it was really nice to see that shareholder approval go through last week for the majority vote for flexibility. You mentioned under $25 million bolt-on targets. Given your cash balance, it seems like almost any acquisition you make could probably be accretive or nicely accretive. I realize you're probably just in the early stages of the pipeline. But are you starting to see or encounter reasonable asking valuations out there? Or you maybe not at that stage yet? I'm just wondering, is the economy cooled off a little bit in the last year that maybe some of the sellers are getting more reasonable with what they want from multiples evaluations?

I think what we've seen is that kind of the high multiples are driven by a lot of the venture capital that's out there from people who don't have to worry about what's going to happen in a two-year timeframe for that product line. They're just kind of accumulating these things and then they're going to sell it to somebody else. It will be somebody else's problem. We look at the long-term approach in this field. Obviously, we’re not going to try to compete with that. Unfortunately, it seems that in our products sector, the aerospace industry, even though the capital market is tightening up, there's still a strong venture presence among aerospace investments because of the stability of the industry. The fact that today we have both the defense and the aerospace markets, both of them are strong. The OEMs have long grading lists for new aircraft, and obviously, we're putting a lot of money into defense. That gives investors some level of confidence that they are not too far off the market. But the multiples are there. I mean, the average multiple now they talk about in our industry is about 7.5 times EBITDA. And that's kind of where we are. But a lot of the time finding the right product line would help us justify as long as we see that within our P&L, that acquisition would yield similar gross margins that our products do, and that kind of makes it beneficial to us.

That's very helpful color, and it's good to hear that you have the cash on hand to help out with acquisition accretion. So just again, congratulations on the impressive gross margin and orders in the quarter. I look forward to seeing you at our conference on Thursday. That’s it for my questions.

Thank you, Tim.

Thank you.

There are no further questions at this time. This concludes today's teleconference. You may disconnect your line at this time. Thank you for your participation, and have a great day.