Earnings Call Transcript - ISSC Q4 2024

Operator, Operator

Good evening. Welcome to the Innovative Solutions & Support's Fourth Quarter Fiscal 2024 Financial Results Conference Call. All participants will be in listen-only mode. 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. Welcome to Innovative Solutions & Support's fourth quarter and full year 2024 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 fourth quarter and full year 2024 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 Askarpour, who will provide a review of our recent business performance and strategic outlook, followed by a financial update from Jeff DiGiovanni. 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 fourth quarter and full year financial performance. This was a transformative year for IS&S, one in which we delivered significant year-over-year growth in revenue, net income, EBITDA, and free cash flow. We generated net income of $7 million, which was up 16% from the prior year. In addition, total EBITDA was approximately $12 million, which was up 36% from the prior year and is up nearly threefold from just three years ago. During the fourth quarter, we delivered more than 18% year-over-year growth in revenue, driven by momentum from new military programs and recently acquired platforms. In recent quarters, demand across our military end markets has increased, supported by orders from both the U.S. Department of Defense and allied foreign militaries. As a higher volume of backlog converts to revenue, we've realized improved operating leverage, a dynamic we expect to continue into the coming year. At a strategic level, we continue to build a growth platform centered exclusively on advanced avionics solutions for both commercial and military markets. Over time, our systems integration expertise has positioned IS&S as a preferred partner in the fleet modernization and retrofit markets, one whose in-house design, manufacturing, installation, and support capabilities provide customers with safe, compliant, and cost-effective solutions that enhance aircraft safety, compliance, and mission readiness. We've built a strong reputation in the market that positions us to further scale our business moving forward. Today, we are introducing IS&S Next, a long-term value creation strategy. We consider this strategy the guiding framework for our next chapter of growth, as we'll outline over the coming quarters. At a high level, our strategy centers on a combination of targeted commercial growth within high-value markets, improving operating leverage, and a disciplined returns-driven approach to capital allocation. While many of these elements are already at work in our existing business, we intend to provide more transparency around our progress under the strategy each quarter moving forward. The first pillar of our growth strategy centers on targeted commercial growth within our core advanced avionics market verticals. Looking ahead, we expect commercial growth will come from several key areas, including the expansion of existing platforms, new original equipment manufacturer (OEM) and retrofit programs, new product development, and strategic product line acquisitions. In 2024, we delivered significant commercial growth through an expansion of our military business, continued growth in existing platforms, and realized synergies resulting from our recent Honeywell product line acquisitions. Our military end markets were very strong last year, and given our leadership in cockpit automation, we anticipate a continuation of this trend into 2025. Earlier this year, we announced a new foreign military platform with a major aerospace OEM to supply multifunction displays with an integrated mission computer. We've already begun executing under this contract and realized revenues in 2024. We also recently announced that our ThrustSense Autothrottle system was selected by the U.S. Army to be installed on their C-12 aircraft. This advanced technology will provide full flight envelope protection from takeoff to landing, including go-around, enabling pilots to automatically control engine power settings for enhanced safety and efficiency. Entering 2025, we are seeing several other similar opportunities with commercial customers entering our pipeline, and we anticipate our work with both the U.S. DoD and allied foreign militaries will remain a significant growth engine for us in the year ahead. Within our commercial end markets, we continue to experience solid growth across existing platforms and OEM contracts. This includes Pilatus for our utility management system, Textron for our standby instrument and our autothrottle, and on the military side, Boeing on KC-46A, KC-767, and the T-7 platforms. On the heels of our recent Honeywell product line acquisitions, cross-selling synergies have increased as expected. These acquisitions have brought us the opportunity to cross-sell our existing products into new customer relationships acquired in the transactions while also selling new product lines to our legacy customers. New product development remains integral to our long-term growth. We continue to expand the sophistication of our cockpit automation technology through functionalities that enhance safety and reduce pilot workloads. The integration of AI functionality to enhance cockpit automation remains a major area of focus for our industry over the coming years. In early 2025, we will begin flight testing our new generation utility management system (UMS) on the PC-24 platform with Pilatus. In layman's terms, the UMS is to an aircraft what a CPU is to a laptop computer. It guides, controls, and powers the most critical operating systems. Additionally, in 2025, we plan to launch our UMS II, which is a cutting-edge, certifiable flight monitoring and control system. UMS II is an AI-capable system, one whose integrated neural network processing capabilities significantly enhance crew efficiency by enabling additional cockpit automation. As our UMS II is platform agnostic, we see significant growth potential for this product line over the next several years, particularly within the military and business aviation markets. The second key pillar of our value creation strategy focuses on driving increased operating leverage across the organization. As we layer on a higher base of revenue within our business, we anticipate improved fixed cost absorption and ultimately a higher sustained run rate of EBITDA dollars. During 2025, we intend to increase the volume of maintenance, repair, and overhaul work we handle at our Exton facility while also increasing the volume of sub-assemblies that are being manufactured internally. More on this shortly. The final pillar of our value creation strategy focuses on a returns-driven approach towards capital allocation. We demonstrated our ability to successfully allocate capital during 2024, including both investments in our organic growth initiatives, as well as the deployment of capital for product line acquisitions. Our organic growth investments included the addition of R&D staff and increased manufacturing headcount as we prepare to capitalize on higher sales volumes across our business. In 2025, we intend to increase our manufacturing capacity by more than 100% through a $6 million facility expansion. This investment will add a second sub-assemblies line as part of the 40,000 square foot addition. Subsequently, we anticipate this will provide us with the opportunity to acquire other strategic product lines in the future, further supporting my point earlier on increased operational efficiency. The highlight of our capital allocation strategy during 2024 was clearly the additional acquisitions from Honeywell. We invested nearly $20 million in the two additional acquisitions during the year, positioning us to expand our capabilities, add new customers, and open the door to significant cross-selling synergies entering 2025. In July 2024, we acquired additional key assets for certain communication and navigation product lines from Honeywell for roughly $4 million in consideration. This was followed in September 2024 with the acquisition of various generations of military display generators and flight control computers from Honeywell for $14 million in cash. As we have discussed, these acquisitions provide us with several unique opportunities to drive profit uplift through the insourcing of certain components, the potential to bring more maintenance and repair work in-house, as well as attractive revenue synergy opportunities. In conclusion, 2024 represented over 30% growth in revenue and adjusted EBITDA, and we expect similar growth in 2025 exclusive of any future acquisition opportunities. We intend to remain an opportunistic acquirer of complementary product lines that expand our capabilities in advanced avionics. We believe our collective focus on commercial growth, operational efficiency, and disciplined capital allocation position IS&S for sustained value creation in the year ahead, and we look forward to having you join us on that journey. 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 fourth quarter performance, including a discussion of our working capital, balance sheet, and liquidity profile at quarter end. We generated net revenues of $15.4 million in the fourth quarter, up 18% when compared to the fourth quarter last year. The increase was driven by contributions from the recently acquired Honeywell product lines, growing momentum in new military programs, as well as revenue synergies from the Honeywell platforms acquired last year. It is worth noting that our fourth quarter 2024 revenues were impacted by a $1.7 million true-up payment for services performed by third parties. Additionally, we were pleased to see continued stabilization in the air transport market and saw sequential growth in this market when compared to the first half of the year. Product sales increased to $9.8 million during the fourth quarter, driven by contributions from our commercial air transport programs. Customer service revenue was $5.5 million owing largely to the customer service sales from the product lines acquired from Honeywell. Gross profit was $8.5 million during the fourth quarter, up from $8.1 million in the same period last year, driven by strong revenue growth, partially offset by the higher depreciation and amortization expense resulting from the Honeywell acquisitions and continued investments in growth initiatives. On that note, I think it's important to recalibrate expectations around our recent gross margin performance and our anticipated margin outlook entering 2025. There are two primary factors that have impacted gross margin capture in recent quarters. The first factor is related to the incremental depreciation and amortization that has resulted from recent product line acquisitions. As we continue to complete product line acquisitions in the future, we expect that this will be an ongoing margin headwind. The second factor involves the forward shift in our sales mix. Historically, military sales represent less than a third of sales, while in 2025, due to the recent acquisition, it will be a higher percentage of sales. Generally, military sales carry a lower average gross margin compared to commercial contracts. However, given the significant potential we see for absolute EBITDA dollar growth in military, we believe this is beneficial and is work that we will continue to pursue as it advances our focus on improved operating leverage. Given these factors, we expect our consolidated gross margins will likely trend closer toward mid-50% on a normalized basis over the intermediate term, which is below historical levels. However, we anticipate that with our improved top-line growth profile, we'll be able to drive increased adjusted EBITDA margin realization and profitability over time. Consequently, we believe adjusted EBITDA margin expansion will be a comparably better measure of our relative performance over time than gross margins. Research and development expense during the fourth quarter of 2024 was $1.1 million, an increase from approximately $740,000 in the comparable period last year. This increase was driven by growth in our product development efforts in support of our long-term growth strategy. Fourth quarter 2024 selling, general, and administrative expenses were $3.1 million, a decrease of $3.7 million from last year. The decrease in SG&A expense in the quarter was primarily the result of some one-time expenses included in the prior year results, partially offset by incremental amortization expense related to the acquired Honeywell product lines. Fourth quarter net income was $3.2 million, or $0.18 per diluted share, compared to net income of $2.6 million, or $0.15 per diluted share a year ago. Adjusted EBITDA was $5.6 million during the fourth quarter, up from $4.8 million last year due to our strong revenue growth and operating expense leverage. Moving on to backlog. New orders in the fourth quarter of fiscal 2024 were $95.4 million, which includes $74.3 million of backlog acquired as part of the product line acquisition announced on September 27, 2024. Backlog as of September 30, 2024, was $89.2 million. This backlog includes only purchase orders in hand and excludes orders from the company's OEM customers under long-term programs, including Pilatus PC-24, Textron King Air, Boeing T-7, the Boeing KC-46A, and Lockheed Martin. We expect these programs to remain in production for several years and anticipate that they will continue to generate future sales. Furthermore, the nature of the product lines from Honeywell does not typically enter backlog. Now turning to cash flow. During fiscal 2024, cash flow from operations was $5.8 million, up $2.1 million in the year-ago comparable period. The improvement was driven by higher cash earnings and improved working capital efficiency. Capital expenditures were $700,000 during fiscal 2024, versus $300,000 in the same period last year. As a result of these factors, free cash flow for the full year 2024 was $5.1 million, up from $1.8 million last year. Total net debt as of September 30, 2024, was $27.5 million, up from $16.4 million at the end of 2023, reflecting the incremental debt to fund the recent Honeywell transactions. This was partially offset by our strong free cash flow generation during the year. Our net leverage at the end of the fourth quarter was 2 times. We recently amended our credit agreement with PNC Bank to expand the facility to $35 million. Our total cash and availability under our credit lines was $7.5 million at the end of the fourth quarter, providing 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

We will now begin the question-and-answer session. The first question comes from Andrew Rem with Odinson Partners.

Andrew Rem, Analyst

Maybe if I could start, I'm going to call it the Honeywell acquisition number three, the one you announced in early October. Can you give us a perspective on like the revenue and EBITDA contribution, or just give us some sense of what that acquisition looks like and impact on FY25?

Shahram Askarpour, CEO

Well, first of all, Andrew, yes, we did the acquisition in September. Are we going to be putting our backlog information?

Jeff DiGiovanni, CFO

Yes. So Andrew, a couple of things on that one. Under that acquisition, the backlog came on around $74 million. So in our backlog, you include about $74 million of backlog acquired on that acquisition, and which is production. So that's going to bleed off over probably a three to four year period. And military has lower margins than commercial.

Shahram Askarpour, CEO

In terms of EBITDA, the margins we believe are going to be similar to our EBITDA margins…

Andrew Rem, Analyst

Just to clarify, you're saying that, I think you said it in your prepared remarks as well, gross margin is lower. But were you saying EBITDA margins are closer to being similar or those also are a little lower?

Shahram Askarpour, CEO

We see this as an addition, and it doesn't significantly impact our SG&A or engineering costs. In many respects, the gross margins align with EBITDA.

Andrew Rem, Analyst

And on the backlog, should we consider whether it burns off consistently or if it may vary significantly from one year to the next?

Shahram Askarpour, CEO

Yes. I mean, part of the backlog being what it is, was that there was an obsolescence issue that Honeywell resolved a few months ago. And because of that obsolescence issue, the deliveries over the prior year or so were very limited. So there is a catch-up that's going to be done in 2025. And it's still a little bit too early for us to be able to accurately say how much of that is going to be done in 2025, because Honeywell is going to continue operating this product line at least for another three to four months before it comes to us, and there's going to be a shutdown period as we experienced before while all the test equipment gets transferred here. So if I was to be a guessing man, I would say our Q2 is going to see a big bump in revenue from this. Q3 probably would be the transition quarter, and will have a little bit of a dip and kind of hopefully recover by Q4. But I think some of the backlog is clear that performance is over four years, and some of this is just behind the eight ball that we got to ship as soon as we can.

Andrew Rem, Analyst

And then, Jeff, you mentioned the $1.7 million true-up payment. Which segment does that fall in?

Jeff DiGiovanni, CFO

That will fall in the customer service segment.

Andrew Rem, Analyst

And then on CapEx, I think you guys said $6 million. Is that all in FY25?

Shahram Askarpour, CEO

Some of it we already spent in FY24, yes…

Jeff DiGiovanni, CFO

Some will occur in 2024, but the majority will take place in fiscal 2025.

Shahram Askarpour, CEO

All the architectural work and all the design work and preliminary to get timing permissions and all of that, I think we paid for all that in '24.

Andrew Rem, Analyst

And when do you expect to complete all that work in fiscal '24?

Shahram Askarpour, CEO

Last June, if any construction is completed on time.

Operator, Operator

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

Doug Ruth, Analyst

I also want to congratulate you on the strong quarter. You really provided us with a lot of information. Can you share any projections for what Q1 might look like in terms of revenue?

Shahram Askarpour, CEO

For the quarter that we're in right now…

Jeff DiGiovanni, CFO

Unfortunately, we don't provide the forward-looking statements…

Shahram Askarpour, CEO

Yes, I think I'll wait until February for that.

Doug Ruth, Analyst

And is this the norm in your business to say that the backlog could take up to four years to earn out?

Shahram Askarpour, CEO

It depends on some of these being military and production contracts. Typically, for IS&S, we receive releases for production contracts, which can be around 18 months or a year. Our backlog is usually not this large. These are military contracts, and some involve Lockheed. They have issued purchase orders for the next four years for certain contracts. While this situation is not typical for us, it is a new development.

Doug Ruth, Analyst

You mentioned that you thought Q2 was a big bump. Could you explain that a little bit more and share what you see happening in that quarter?

Shahram Askarpour, CEO

So I mean, if you remember when we did the acquisition from the first acquisition from Honeywell, the first quarter for it was our Q4 of 2023 where we got like a $6 million revenue that came from Honeywell. And that was because the next quarter they were planning on packing all the test equipment and shipping it to us. So they typically do as much pull in as they can in the prior quarter before shipping their equipment to make sure the customer has enough equipment to support them while we go through this transition phase. That quarter where that's going to happen looks like it's going to be Q2 of our financial 2025. So between January to March, we anticipate Honeywell is going to ship a lot of this equipment to Lockheed before they tear down the equipment to send it to us.

Doug Ruth, Analyst

And my final question, could you tell us what the three highest priorities are for fiscal 2025?

Shahram Askarpour, CEO

We have outlined our product development plans, focusing on launching our latest generation of products that incorporate advanced artificial intelligence capabilities, which is currently unique in our industry. We plan to finish the flight test with Pilatus for the PC-24 version of our utility management system. Another key priority is to bring more of our sub-assemblies in-house to potentially increase our gross margins. We expect our gross margins to reach a low in the low 50% range by mid last year, but as we improve efficiency and our technicians gain experience, we have been able to raise them to the mid-50s. Our goal is to maintain that level over the long term. Increasing our in-sourcing of sub-assemblies is essential for this. Lastly, we aim to continue our capital allocation efforts by opportunistically identifying and acquiring products that align with our strategy. These are our three main priorities.

Operator, Operator

The next question comes from Gowshi Sri with Singular Research.

Gowshi Sri, Analyst

The first question is about your recent successes with the U.S. Army. Can you share what excites you in the military sector, what strategies you are employing to gain market share, and what factors contribute to your competitiveness in this area? Additionally, how do you plan to build momentum in this sector?

Shahram Askarpour, CEO

We have made a strategic shift over the past few years, moving our focus from military to commercial sectors due to prior budget cuts in the military. When I took over, I prioritized building our military business development team to enhance our military presence. Although it takes time to see results, we've begun to see positive outcomes. For example, the autothrottle we developed years ago is now being recognized; we are selling it to Textron for their King Air, and it can also benefit the U.S. Army and U.S. Air Force, which operate several King Air C-12s. Recently, we were chosen by METS for the U.S. Navy and the U.S. Army has selected us for their C-12 platforms. We are actively marketing these products in the military sector. Additionally, we've secured a program for a mission computer and display, and we have several other opportunities in mission computing that we aim to explore. Our recent acquisition from Honeywell for the F-16 flight control computer and mission computer is expected to open many doors for us, allowing us to collaborate with Lockheed on various product lines they are considering.

Gowshi Sri, Analyst

Given the increasing military presence, what challenges might arise from a longer sales cycle and a more complex procurement process? Can you provide insight on how you manage responses in your R&D and product development areas?

Shahram Askarpour, CEO

I mean, the sales cycles are longer. But like I said, we started that down that line about three years ago, and we're beginning to see fruits of those efforts, and we're going to continue down that path. I mean, some of the things we're doing now in our organization in anticipation of some of the new contracts we're getting is making our facility more secure. We're putting a lot of controls in place so we can take on secret programs from our military, as well as putting in systems that can withstand government accounting, audits and all of that. So we've changed our MRP system, which is going to go live early 2025. We've been working on it for about a year now. And because our ERP system is kind of old and antiquated, that would allow us to be able to easily show kind of costs to the government and categorize expenses differently the way the government wants to see. So we've put in a lot of efforts into the infrastructure that would get us to a point where we can become a serious defense contractor.

Gowshi Sri, Analyst

Given your mentioned strategy, what percentage of revenue do you anticipate will come from the military sector in one to three years?

Shahram Askarpour, CEO

So I think on average, just about less than a third of our business used to be military. I guess, last year that went down because of the acquisitions we did with Honeywell that were mainly focused on the commercial side. I think this year, military is going to be pretty large because of that new acquisition we did from Honeywell on the F-16. I think long term, we like the idea of having a third military, a third business aviation, and a third air transport. That formula has worked for us for over 35 years, and we like to see it that way. But, you know, as you grow you got to grow every sector. And when you say I'm going to grow my military fivefold because I'm going to grow the business fivefold, then that becomes significant enough that you need to put some controls in place.

Gowshi Sri, Analyst

You mentioned the UMS in relation to the COGS space. How do you see the relationship between military and commercial technologies developing? Are there any specific synergies or cross-pollination opportunities you are aiming for?

Shahram Askarpour, CEO

Our product development strategy from the start has been to create a single product that we sell to the military, commercial aviation, and transport sectors. There are variations of this product for military use; for example, we use the same display in the 757 and 767 as well as in the C-130, although the C-130 version includes night vision capabilities with dual lighting for nightlight sensing. The core technology remains consistent. Moving forward, we are continuing to enhance our products, such as the UMS we developed for Pilatus. This was a tailored platform specifically for them, and as they sought a more advanced UMS, we have collaborated to develop it, which is set for flight testing in March or April. We considered how to make this product more universal for both military and business aircraft. A key insight was that when integrating a flight control computer into military aircraft today, there is a demand for artificial intelligence capabilities. Consequently, we incorporated an artificial intelligence core into this product line, enabling us to market it effectively in both military and business aviation sectors while enhancing cockpit automation.

Gowshi Sri, Analyst

And my last question is, given the issues at Boeing, do you see any kind of potential lift in terms of retrofit opportunities, or how do you see that playing out, if there's any?

Jeff DiGiovanni, CFO

So I think your question is saying, the Boeing issues they're having, how does that affect IS&S…

Shahram Askarpour, CEO

No, it's very good for IS&S. It's not that we want them to have issues. But as long as they come make new airplanes, people are going to fix their old airplanes.

Jeff DiGiovanni, CFO

So you are going to see that aging airframes still have a lot of repairs and maintenance, parts sales, and spare sales in the market overall going up in aerospace because of that.

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. Please go ahead.

Shahram Askarpour, CEO

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

Operator, Operator

This conference is now concluded. Thank you for attending today's presentation. You may now disconnect.