Earnings Call Transcript - ISSC Q1 2025

Operator, Operator

Good day, and welcome to the Innovative Solutions and Support First Quarter 2025 Results Conference Call and Webcast. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Paul Bartolai. Please go ahead.

Paul Bartolai, Investor Relations

Thank you, Michael. Good afternoon everyone, and welcome to Innovative Solutions and Support's first quarter 2025 results conference call. Leading the call today are our CEO, Shahram Askarpour; and CFO, Jeff DiGiovanni. Earlier today, we issued a press release detailing our first quarter 2025 operational and financial results. This release is publicly available in the Investor Relations section of our corporate website at www.innovative-ss.com. I would like to remind you that management's commentary and responses to questions on today's conference call may include forward-looking statements, which by their nature are uncertain and outside of the company's control. Although these forward-looking statements are based on management's current expectations and beliefs, actual results could differ materially. For a discussion of some of the factors that could cause actual results to differ, please refer to the Risk Factors section of the latest reports filed with the SEC. Additionally, please note that you can find reconciliations of all historical non-GAAP financial measures mentioned on this call in the press release issued earlier today. Today's call will begin with prepared remarks from Shahram, who will provide a review of our recent business performance and strategic outlook, followed by a financial update from Jeff. At the conclusion of these prepared remarks, we will open the line for your questions. With that, I'll turn the call over to Shahram.

Shahram Askarpour, CEO

Thank you, Paul, and good afternoon, to everyone joining us on the call today. Let's begin with a high level overview of our first quarter financial performance. During the first quarter, we delivered more than 70% year-over-year growth in revenue driven by momentum from new military programs, and contributions from our legacy platforms. Our organic growth, which was in the mid to upper single-digit range, was mainly driven by continued momentum across our military end markets, a trend we expect to continue. We are also seeing improved trends in our commercial business and expect growing momentum, as we move through the fiscal year, as our fiscal Q1 is typically a busy period for air transport. Our gross profit increased approximately 20% as our strong revenue growth was partially offset by the significant investments we are making to support our growth initiatives, which I will discuss in more detail here shortly. Our backlog was approximately $81 million as of December 31, 2024, compared to $14.6 million in the prior year. On our call last quarter, we introduced ISSCnext, our long-term value creation strategy. As a quick refresher, our strategy centers on a combination of targeting commercial growth within high value markets, improving operating leverage and a disciplined returns-driven approach to capital allocation. During the first quarter, we continued to execute against our initiatives, and I would like to take a moment to highlight just a few of the key achievements that reflect our commercial growth priorities. We continue to make significant investments in our growth initiatives, which is impacting our margins in the near term, but will place us in a strong strategic position to take advantage of some exciting opportunities in our markets and drive profitable growth in the coming quarters. Some of these investments included the following: First, as activity in our military markets continued to accelerate, we've made significant investments in both infrastructure and systems capabilities, to support the high-performance requirements of our defense customers. To that end, we have integrated a modern ERP system, a more robust IT infrastructure and strengthened our security and accounting services to make us compliant with Defense Federal Acquisition Regulation Supplement or DFARS requirements. These are critical investments as we continue to win and bid for larger DoD programs. Second, we are also continuing the expansion of our Exton, Pennsylvania facility. When completed in mid-2025, we will have doubled our footprint and increased our production capabilities by more than threefold. I watch the progress from my office window every day, and I'm happy to report that the groundwork is complete, the steel structure is up and the completion of the internal and external walls will commence shortly. As a side note, we've been funding this development out of our P&L. Importantly, we are adding this capacity with a capital investment of only $6 million, providing for the opportunity of a very strong return. We also think it's worth reminding everyone that IS&S manufactures 100% of its products in our Exton facility. We think this is important, and puts us in an enviable position as the new administration makes its significant push for reshoring of manufacturing and an America-first mentality. Third, during the first quarter, we made significant investments in support of our most recent acquisition from Honeywell. Much of the spending during the first quarter was made ahead of the expected growth from these platforms, and we also made investments that resulted in some duplicative costs as we train our staff to transition the manufacturing of the products from Honeywell into our Exton facility. The integration is on track and we are excited by the opportunities from this most recent acquisition. And finally, we also continue to strengthen our workforce across the organization to support our strategic growth initiatives. Our headcount is up over 25% from last year, which will help us as we scale the business. In terms of new product development, we remain highly focused on the opportunity within cockpit automation, leading to autonomous flight. Our next generation of our Utility Management System, or UMS II, remains on track to have our first test flight by mid-2025 for the Pilatus PC-24. We also believe the next generation of our AI-enabled Utility Management System is the ideal certifiable platform for flight automation, with our initial focus being military customers and applications. We believe the military market is the most immediate and logical market to deploy our autonomous flight capabilities. The unfortunate recent events bring to the surface the need for more automation in the flight deck to enhance safety. We are encouraged by the growth opportunities across our commercial air transportation, business aviation and military markets, and we are confident we are making the necessary investments to strategically position IS&S to win in the market. In conclusion, we are off to a solid start for our fiscal 2025 and are excited by the opportunities that lie ahead. We have made investments necessary to support our new programs. We have made important progress regarding the integration of our most recent acquisition, and we are making the necessary investments to support our organic growth initiatives. That said, we still intend to remain a strategic acquirer. While we have most recently been focused on complementary product lines from large avionics suppliers that expand our capabilities in advanced avionics, we are also evaluating opportunities to acquire smaller avionics manufacturers, where we anticipate synergies will be realized by incorporating their outsourced production in our facility. Looking ahead, we intend to build on the momentum evident within our business and remain on track to deliver both revenue and EBITDA growth of over 30% when compared to fiscal year 2024. With that, I'll turn the call over to Jeff for his prepared remarks.

Jeff DiGiovanni, CFO

Thank you, Shahram, and good afternoon to all those joining us. Today, I will provide a high-level overview of our first quarter performance, including a discussion of our working capital, balance sheet, and liquidity profile at quarter end. We generated net revenues of $16 million in the first quarter, up just over 70%, when compared to the first quarter last year. The increase was driven primarily by contributions from the recently acquired Honeywell military product line, as well as 7% organic growth due, in part, to the continued momentum of our new military programs. Product sales were $10 million during the first quarter, more than double last year's levels, driven primarily by the recently acquired military product line, offset by reduced shipments to the business aviation customers. Service revenue was $6 million, owing largely to customer service sales from the product lines acquired from Honeywell and increased NRE revenue, partially offset by lower legacy customer service revenue. Gross profit was $6.6 million during the first quarter, up from $5.5 million in the same period last year, driven by strong revenue growth partially offset by higher depreciation expense resulting from the Honeywell acquisition, duplicate costs in support of the migration of the recent Honeywell acquisitions, and continued investments in growth initiatives as Shahram discussed. Our first quarter gross margin was 41.4%, down from 59.3% in the same period last year. As I discussed last quarter, there are several factors that have been impacting our gross margin capture in recent quarters, which continued during the first quarter and will remain a factor in the near term. These factors include incremental depreciation from recent product line acquisitions, and the shift in our sales mix, as military sales will be a higher percentage of sales. More specifically, during the first quarter, the impact of the acquired Honeywell military product line volume below our margin was approximately 500 basis points, increased third-party expenses from Honeywell with respect to their transition services was approximately another 200 basis points, and higher depreciation from recent acquisitions was roughly a 500 basis point headwind to gross margins. As it relates to the product mix, generally, military sales carry a lower average gross margin versus commercial contracts. However, there are minimal operating expenses associated with these contracts, so the incremental EBITDA margins are strong. Given the significant potential we see for absolute EBITDA dollar growth in military, we believe this is good for us and work that we will continue to pursue as it advances our focus on improved operating leverage. In addition to these factors, during the first quarter, we incurred costs to support the ramp-up of recently acquired product lines from Honeywell, as well as inefficiencies due to hiring and training additional personnel. Many of these costs were duplicative in nature and will not be a factor as we fully transition the product line into IS&S. Given these factors, we continue to expect our consolidated gross margins will likely trend closer to mid-50% on a normalized basis, which is below historical levels. As we complete the integration and begin to enjoy the scale benefits of these investments, we will be able to drive increased adjusted EBITDA margin realization and net profitability over time. Operating expenses during the first quarter 2025 was $5.3 million, an increase from $3.9 million in the comparable period last year. This increase was driven by approximately $400,000 from an increase in product development efforts in support of our long-term growth initiatives, incremental expenses from Honeywell acquisitions including $700,000 of amortization expense, and $300,000 in employee costs primarily due to an increase in headcount, and another $300,000 of acquisition and certain one-time expenses. We've increased our headcount by over 25% to support our future growth initiatives across the organization. Operating expenses represented 33% of revenue during the first quarter, down from 42% in the first quarter of last year owing to improved operating leverage. First quarter net income was $700,000 or $0.04 a share, compared to net income of $1.1 million, or $0.06 per diluted share a year ago. EBITDA was $2.7 million during the first quarter, up from $2.1 million last year, or a 28% increase largely due to our revenue growth and operating expense leverage. Excluding acquisition-related costs and other one-time expenses, first quarter adjusted EBITDA was $3.1 million, up from $2.5 million last year. Moving on to backlog, new orders in the first quarter of fiscal '25 were $7.5 million, and backlog as of December 31 was $80 million, as compared to $14.6 million this time last year. The backlog includes only purchase orders in hand and excludes orders from companies OEM customers under long-term programs including Pilatus PC-24, Textron King Air, Boeing T-7, Red Hawk, the Boeing KC-46A, and the F-16 with Lockheed Martin. We expect these programs to remain in production for several years and anticipate they will continue to generate future sales. Also, due to their nature, the product lines from Honeywell do not typically enter backlog. Now turning to cash flow, during the first quarter '25, cash flow from operations was $1.8 million, compared to $4.2 million in the year-ago comparable period. This decrease is primarily due to inventory buildup in support of anticipated production, and the timing of payables and capitalized costs with the ERP implementation along with the impact of gross initiatives discussed above. Capital expenditure was $300,000 during the first quarter '25 versus $200,000 in the same period last year. As a result of these factors, free cash flow during the first quarter was $1.6 million versus free cash flow of $4 million last year. Total net debt as of December 31 was $25.9 million, and our net leverage ratio at the end of the quarter was 1.8. Our total cash and availability on our credit line was $9 million at the end of the first quarter, which provides us financial flexibility to support our ongoing operations and facility expansion. That completes our prepared remarks. Operator, we're now ready for the question-and-answer portion of the call.

Operator, Operator

The first question comes from Gowshi Sri with Singular Research. Please go ahead.

Gowshi Sri, Analyst

Hi. Congratulations guys. Can you hear me?

Shahram Askarpour, CEO

Yes.

Gowshi Sri, Analyst

Thank you for taking my call. Congratulations. In terms of this military revenue being a significant portion of the growth story, what strategies or investments are you making to remain relevant to gain market share? I know you mentioned you had a gentleman you hired a couple of years ago. What are the investments required, or spend necessary to continue to take market share in the same market?

Shahram Askarpour, CEO

So far for the most part, we've been a second-tier supplier to the DoD. That means that we've always worked through an integrator. Even on some of the OEMs, we work through an integrator. We really haven't had any large size programs directly with the DoD. In order to have those kinds of contracts and be primed for it, which part of that also applies to the product lines that we bought from Honeywell for the F-16 platform? We have to be compliant with a lot of these DFARS, the defense acquisition requirements. So being compliant with F-16 in terms of account what they call certified government accounting is one of those requirements. Being able to have an IT organization that meets the requirements of the DoD is another one. Having your system in such a way that you can obtain security clearance. You have a means of protecting government documentation. All of that is required for you to become a Tier 1 supplier to the Department of Defense. We have implemented all of those. It's all going to be completed within the next few weeks. That requires you to bring in consultants, requires you to buy new tools. We have put in a new ERP system, which has been in works for over a year, but we're putting it in place. Our ERP system, which was an MRP called MINCS, was brought to market in the 1980s, and we were at the point now where there were only two companies out there that were using this, with no support. We've put in a modern ERP system in place, which will significantly help us run the business more efficiently, because we can readily see the information that management needs to see in terms of variances, cost, and labor variances. Another important information that now, it takes a lot of people to manually generate all of these things. All of that will automatically be available by the system. It does a significant amount of time and cost saving for us. We're applying for security clearance, we're putting all that in place and it gets us to a point where we're looking at some serious military programs now. In order to be able to bid on those programs, they have to be compliant with a lot of regulations. If you put in a program, which is less than $2 million, I think, which is the Tina limits, then which is typically in the past we've done, if you don't have any of this stuff in place, as soon as you go above that, a whole bunch of regulations get applied to you. But that's where we want to go. We want to grow the business, so we got to get serious about it.

Gowshi Sri, Analyst

Okay. Awesome. In terms of. I know you guys had a foreign military engagement end of last year. How do the margin profiles of the foreign military engagements compare to the domestic market? I would assume you're able to extract better margin profiles or pricing from the foreign military programs.

Shahram Askarpour, CEO

Yes, I think if your foreign military sale doesn't go through the U.S. DoD, then you treat it as a commercial deal. If it's a procurement because our government provides funding to some of the allied nations to procure material. Essentially, that's going through the U.S. DoD budget, so it still applies to you. In areas that in the past, where we sold systems to the United Arab Emirates Air Force or Pakistan Air Force, that was not coming through U.S. funding. It's treated like a commercial deal. The benefits of Navy contracts is that once your system is on a U.S. Air Force aircraft, it puts you in a strong position to put that system on other air forces' aircraft. If it's not something that's funded by the DoD, you can get a premium price for it.

Gowshi Sri, Analyst

Okay. Got you. And so with this 40% military mix of business, as the company selection continues to shift, particularly in favor of the military. I know you guys had a 60% usual gross margin target, so what do you anticipate the new margin profile to look like, and will that be something you'll be targeting towards the end of the year?

Shahram Askarpour, CEO

Let me put it this way. When we look to buy a program or a product line, we really take a look at what EBITDA it gives us, and that's how we buy it. That's how we value a product. So at the end of the day, gross margins on military programs are significantly lower than commercial business. However, what you don't have is typical with military sales, you generally don't have any engineering expenses, because they separately pay for engineering work you have to do. As with commercial programs, we have a high engineering burden on the products to deal with obsolescence, as well as your development efforts. In the military, they pay for your obsolescence engineering; they pay for your development. So you don't have the engineering overhead. In terms of SG&A, the sales side of the SG&A is very, very minimal in military programs. You don't need to keep on reselling the same thing to the military once you've been selected and you're in there. We got programs with the U.S. Air Force now that we had 35 years ago, and they're still continuing to send you orders when they need the product. So it has a much, much lower burden on your SG&A and almost zero burden on your engineering. So in a way, the fact that gross margin is not as good, because by the nature of defense contracts, you have to justify all your costs, it dilutes your gross margin. We think it's probably going to be at best around 50-50% gross margin. What we want to do is to change focus from gross margin to actual EBITDA and profit margin of the business. We believe that even though military platforms have lower gross margin, in terms of EBITDA as a percentage of revenue, they meet the same margins as the commercial, which is what really matters.

Gowshi Sri, Analyst

Got you. And that's my final question before I jump back in line. In terms of leveraging the balance sheet, how will you balance the need for the significant infrastructure spend investments required in terms of expansion of production capacity and with the pursuit of strategic acquisitions?

Shahram Askarpour, CEO

Right now the building and even the strategic initiatives are really getting funded through operations and our credit facility that we have today. As I mentioned, right now the availability, with our cash on hand and our availability on our line, is about $9 million, which provides enough. As we look at acquisitions, that profile can change. We want to stay around the three times leverage ratio on a go-forward basis. We're being very diligent with any acquisition and being very mindful of the leverage ratios. We want to …

Jeff DiGiovanni, CFO

Yes, significantly impacted this quarter because of the investments that we made. If you were to adjust for them, it would have been significantly higher than last year.

Gowshi Sri, Analyst

Awesome. Thank you guys.

Shahram Askarpour, CEO

Thanks.

Operator, Operator

The next question comes from Doug Ruth with Lenox Financial Services. Please go ahead.

Doug Ruth, Analyst

Hi Shahram, Jeff, thank you for hosting the conference call. I was curious, could you share with us your strategy, with where the acquisition opportunities are coming from? Are you working with an investment banker? How exactly are you finding the opportunities?

Jeff DiGiovanni, CFO

So we have a Business Development Vice President that had significant experience in mergers and acquisitions. He ran mergers and acquisitions for Rockwell Collins for many years and he retired. He's working for us. We also talk to a lot of the bankers. I do and he does as well as our marketing guys who are in the field and talking to the customer. I think most of the industry by now knows our strategy for acquisitions, and we get informed of these product lines when they come out for sale or licensing, as well as small avionics companies that we get the portfolio from. There's a series of bankers that we talk to as well, that deal with our size. Most of the stuff that comes out in our industry is larger than we could afford. But when the ones within our size come about, we get to know them and we evaluate probably one or two a quarter of small companies that come up. But we're only going to do it if it makes sense. One of my thoughts is that if our government starts putting tariffs on imports from other countries, a lot of the smaller aviation manufacturers, avionics manufacturers that I know, outsource their production. They don't have production capabilities. We are kind of unique in that we cut manufacturing capabilities in-house for everything. That's been the strength of IS&S. Whether it is tariffs or supply chain issues, our cost of materials is small relative to our sale prices because of all the value-added things that we do in-house. So even if material goes up, it doesn't significantly impact our profitability. If they stop putting tariffs on imports, a lot of these guys get in trouble and we may be able to pick them up for a good price, and then bring their production in-house and benefit from it. Just an idea that we believe may pay off if you pick the right company.

Doug Ruth, Analyst

Yes. Now this one to two per quarter, has that number, has that generally been fairly stable? Is it increasing, decreasing, or what do you see there?

Shahram Askarpour, CEO

That's been pretty stable.

Doug Ruth, Analyst

Okay.

Shahram Askarpour, CEO

But for the majority of them, you look at it, and you see there's nothing that I'm interested in buying. Once you dig in a little bit, we just looked at one a couple of weeks ago, and they really have one product that is of interest. The rest of the business is losing money, and I don't think if we get it, we're going to be losing money on it as well. If you can buy that product line from them, that's good. But some of them are like this.

Jeff DiGiovanni, CFO

Yes, we're being very disciplined with the approach, and it has to fit in our bailiwick. We want to make sure it's something that makes sense for IS&S.

Doug Ruth, Analyst

Okay. Well, I appreciate you answering my questions. I want to wish you all the best, and we're looking for just this growth to continue. So thank you for taking my question.

Shahram Askarpour, CEO

Thank you.

Operator, Operator

The next question comes from Andrew Rem with Odinson Partners. Please go ahead.

Andrew Rem, Analyst

Hi gentlemen. Can you just remind us on the fourth quarter call you guys talked about this pull forward effect that you were expecting to come in the second quarter? Just any revised thoughts that you have now that we're in it?

Jeff DiGiovanni, CFO

Right. I think you're saying, Andrew, is when we talked a little bit, there might be a little bit of an uptick in Q2 around the military product line that we may see. Yes, there is a potential there might be an uptick in the revenue side from the Honeywell military product line. A lot of that is still being operated at Honeywell under the transition services agreement. So we do have visibility there. But we're in constant contact with them on a weekly basis. Some of those deliveries may begin to experience delays, and they are having some potential issues. That's why we want to get a transition to IS&S in a timely fashion. But there could be an uptick in the revenue on that product line in Q2.

Andrew Rem, Analyst

So, is it still in the plan that manufacturing will transition over in the second quarter or maybe some of that pushes into the third quarter?

Shahram Askarpour, CEO

It's going to be in the third quarter. The second quarter is the quarter we're in now. The transition is going to happen in the third quarter. I'm hoping that it will happen in the third quarter. Let me put it that way, because right now I think they're talking about May, and Honeywell has to build a sufficient amount of backlog, and deliver it to Lockheed, before they can shut down the line and go through the transition. I think there was some heatsink part that they had an issue with. We've actually told them that we can manufacture it for them here in-house to try to expedite it, but we still haven't seen the drawing for it. But it's going to be around, I would think either May or June time frame. Hopefully, it won't get into July, but definitely not this quarter.

Andrew Rem, Analyst

Okay. And then Jeff, is there any financial benefits that we can expect over time from the ERP implementation?

Jeff DiGiovanni, CFO

Yes. What does an ERP system give you? It gives you better data so management can make timely reactions to information. My expectation is that people will then be able to look at the data, to make better decisions than trying to extract data to make it usable. Now they'll have time to analyze it. We can look at labor changes, even products with suppliers too. I'm envisioning we'll have some better information for all the users of the financials.

Shahram Askarpour, CEO

I think in general today, everybody that wants anything goes in there, pulls the data, exports it to an Excel spreadsheet, and tries to manipulate it on Excel to generate charts, which takes time to do that. With the new ERP system, all of this will be available on your screen.

Andrew Rem, Analyst

Correct. All right. And then it sounds like there’s a lot going on. I mean, you’ve got the acquisition and then I guess in conjunction with that, you talked about some of the things that you are the IT system, the ERP meeting compliance with the military standards. And then obviously you've got the construction project, which is up and running. Will you be at kind of a normalized by the time you exit fiscal '25? With all of this stuff going on?

Shahram Askarpour, CEO

I like to think that by Q4, we should be in good shape with all of this.

Jeff DiGiovanni, CFO

I would echo that. I think we should be able to be normalized, depending on any other acquisitions for what we have in front of us.

Shahram Askarpour, CEO

Yes, I think by the end of Q3, we should be.

Jeff DiGiovanni, CFO

The building will be done. ERP will be there. As you put in...

Shahram Askarpour, CEO

Barring a big delay from Honeywell in the transition, we should be good. Because right now we're paying, in a way, we're paying double duty here. We're paying cost of goods sold to Honeywell. We also have a team here that are being trained to do the job. That affects our gross margins and profitability. As soon as the transition happens over here, then we don't have to pay the Honeywell technicians; we're just paying ours.

Andrew Rem, Analyst

And then Jeff, if I understood your comments right, maybe this quarter is kind of the low point for gross margin and then they can kind of improve. But I'm also kind of wondering if we should really just maybe not worry too much about the gross margin, and just maybe focus on the EBITDA margin?

Jeff DiGiovanni, CFO

Correct. I think you really want to focus on those EBITDA margins. If we have that big tick in Q2 on the military, it's volume in the product mix that's going to impact those gross margins. This quarter, depreciation expense was $500,000 higher than it was this time last year. Q1 last year. So that impacted those margins by about 500 basis points. So, yes, I would say EBITDA is the better metric to look at, from that perspective and then focusing on margins. Because again, it's going to be around product mix.

Andrew Rem, Analyst

So if we look out at a more normalized situation, what is your current expectation for what that can look like?

Jeff DiGiovanni, CFO

We're projecting EBITDA year-over-year growth of 30%. We feel confident about that number today.

Shahram Askarpour, CEO

Even with Q1…

Jeff DiGiovanni, CFO

Yes, I mean, Q1 was 28%. So we're right there. We still feel confident with the 30%.

Andrew Rem, Analyst

Okay. All right. Well, nice quarter. Thanks a lot, guys.

Shahram Askarpour, CEO

Thank you.

Jeff DiGiovanni, CFO

Thank you, Andy. I appreciate it.

Operator, Operator

This concludes our question and answer session. I would like to turn the conference back over to Shahram Askarpour for any closing remarks.

Shahram Askarpour, CEO

Thank you, operator, and thank you all for your time and interest in IS&S. Have a good day.

Operator, Operator

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