Earnings Call Transcript - ISSC Q2 2024

Operator, Operator

Hello and welcome to the Innovative Solutions & Support Second Quarter Fiscal 2024 Financial Results Conference Call. As a reminder, this conference is being recorded. I would now like to hand the call to Shahram Askarpour, CEO. Please go ahead.

Shahram Askarpour, CEO

Good morning. This is Shahram Askarpour, Chief Executive Officer of Innovative Solutions & Support. Welcome to our conference call to discuss our performance for the second quarter of fiscal 2024, current business conditions and outlook for the coming year. Joining me is Jeff DiGiovanni, our new CFO. Before we begin, I'd like Jeff to read the safe harbor statement.

Jeffrey DiGiovanni, CFO

Thank you, Shahram, and good morning, everyone. You should all have a copy of the press release we issued earlier today. If anyone does not have a copy, you can find the full press release on our website. Before we begin, as usual, I would like to remind everyone that this conference call contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements that address operating performance, events, or developments that we expect or anticipate to occur in the future are forward-looking. These forward-looking statements are based on management's beliefs and assumptions and not on information currently available to our management. Our management believes that these forward-looking statements are reasonable. However, you should not place undue reliance on any of these forward-looking statements because such statements speak only as of today's date. We do not undertake any obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results, events and developments to differ materially, either better or worse from our historical experience, our present expectations or projections. These risks and uncertainties include, but are not limited to, those described in the reports which we file with the SEC. In addition, I specifically call our listeners' attention to our disclaimer regarding forward-looking statements contained in the press release issued today. With that, I'll turn it now over to Shahram.

Shahram Askarpour, CEO

Thank you, Jeff. I will begin today with remarks on our performance in the second quarter followed by comments on our long-term growth plan and strategy, including the ongoing integration of the products acquired and licensed from Honeywell. I will then turn the call back to Jeff, who will take us through the financials. But before I do, I want to welcome Jeff DiGiovanni to IS&S and introduce him to the investment community. Jeff is a seasoned public company CFO, who joined us at the beginning of April with extensive experience in SEC filings, financial reporting and acquisitions as well as capital market interactions, all skills that are highly appropriate for the CFO role at IS&S. We're all looking forward to his contributions in helping us build shareholder value. At the same time, I want to thank Rell Winand for helping us through this transition. It's been another busy and exciting quarter at IS&S. Revenues were up 46% with net income, excluding the nonrecurring expenses, also up from a year ago. We remain on pace to meet our goal of significantly growing both the top and bottom line this year. We continue to progress with Honeywell integration. Most of the radio business has been transitioned, and we are now handling the new maintenance and repair requests out of Exton. We expect to complete the integration of the Inertial Reference Unit business before the end of the summer. There have been some delays in completion of delivery of inventory and test equipment we purchased. However, we believe that once the integration is fully completed, there will likely be opportunities to improve even more upon the financial performance of the acquired products and to leverage inherited relationships to expand our penetration with new customers. We continue to generate stable revenues and margins from our large OEM contracts with Pilatus for the Utilities Management Systems or UMS, Textron for standby instrument and autothrottle, and Boeing for the KC-46A and the T-7 products. Since its inception, IS&S has built a reputation in the industry for its portfolio of IP-rich avionics technology. This spirit of innovation to develop superior technologies is in the company's DNA, and it is the cornerstone of our long-term growth strategy. Consequently, it is no surprise we remain extremely active on the development side. Research and development activities this quarter include both customer-funded and internal programs. On the funded side, we expect to be testing the second-generation UMS with Pilatus in the near term. This is a new generation platform, and we believe has the potential to be extended into adjacent markets. This contract is another testament to our ability to provide state-of-the-art safer, reliable products and services to the industry. Recently, we've been adding new incremental cockpit automation upgrades to our product portfolio that enhance safety and reduce pilot workload, and these have also added to our revenues. As we replace obsolete cockpit technology with our product lines, we focus on cockpit automation features that enable future single-pilot operations. We believe that once the certification authorities approve single-pilot operations in Part 25 aircraft, our proven technologies would allow us to retrofit those aircraft at an attractive price for the market. We expect that air cargo operators will become the early adopters. We're also ramping up our business development efforts. With the addition of the Honeywell global business development team, we are developing plans to extend our network into new international markets. We anticipate the Honeywell development team will help us develop new relationships around the world in relevant market segments. Lately, we have experienced increased interest in our product lines in the military sector, both domestic and internationally and believe that in the near term, some of our organic growth will be military market-oriented. In order to execute our long-term plan and realize the attractive returns on an aftermarket strategy for autonomous flight, we have developed an accelerated growth strategy consisting of growth by acquisition and modest organic growth. The Honeywell acquisition has demonstrated that we can generate the cash flow to support this strategy, having reduced our borrowing by approximately $10 million in just the first 6 months after closing. Together, with a growing base of recurring revenue, we also have a model that we believe will support this strategy. We think the time is right in the market. Consequently, we will continue to opportunistically evaluate and execute additional complementary acquisitions should appropriate opportunities arise. Thank you for your time and interest, and we look forward to updating you in the upcoming quarters. I will now turn the call over to Jeff for a closer look at the numbers.

Jeffrey DiGiovanni, CFO

Thank you, Shahram, and thank you all for joining today. Before reviewing our financial highlights for the second quarter, I would first like to say that I'm glad to be part of the IS&S team at this very exciting time in the company's growth. I am confident that I can contribute to our efforts to build shareholder value based on my over 25 years as both a consultant to as well as the CFO of a publicly traded company. I'll begin with an overview of our second quarter results. As Shahram indicated, our top line finished with double-digit growth versus the prior year, which was consistent with our expectations. Total net revenues for the second fiscal quarter of 2024 were $10.7 million, representing a 46.3% increase when compared with the $7.3 million for the second fiscal quarter of 2023. Total revenues for the 6 months ended March 31, 2024, were $20 million, representing a 44.7% increase when compared with the $13.9 million for the 6 months ended March 31, 2023. Product sales decreased by $1 million or 17.7% and customer service increased by $3.7 million or 265.4% compared to the year-ago quarter. The decrease in product sales for the 3 months ended March 31, 2024, was primarily a result of reduced shipments of displays for retrofit programs to commercial air transport customers, partially offset by an increase in shipments of displays to general aviation and military customers. The increase in customer service primarily reflects customer service sales at product lines acquired from Honeywell. EDC sales increased by $700,000 compared to the year-ago quarter, reflecting increased EDC business. For the first 6 months ended March 31, 2024, product sales decreased by $1.7 million or 15.5%. Customer service sales increased by $6.9 million or 279.9% compared to the prior period quarter. The decrease in product sales for the 6 months ended March 31, 2024, was primarily the result of reduced shipments of displays for retrofit programs to commercial air transport customers, partially offset by an increase in shipments of displays to general aviation and military customers. The increase in customer service primarily reflects customer service sales of the product lines from Honeywell. EDC sales increased by $1 million or 282% compared to the prior quarter, reflecting increased EDC business. From an expense standpoint, cost of sales increased by $2.6 million or 98.3% to $5.2 million or 48% of net sales in the 3 months ended March 31, 2024, compared to $2.6 million or 35.4% of net sales in the 3 months ended March 31, 2023. The increase in cost of sales was primarily the result of an increase in customer service sales volume for the 3 months ended March 31, 2024, compared to the 3 months ended March 31, 2023. Cost of sales increased by $3.5 million or 65.8% to $8.9 million or 44.6% of net sales in the 6 months ended March 31, 2024, compared to $5.4 million or 38.9% of net sales in the 6 months ended March 31, 2023. The company's overall gross margin was 52% and 64.6% for the 3 months ended March 31, 2024, and 2023, respectively, and was 55.4% and 61.1% for the 6 months ended March 31, 2024, and 2023, respectively. This decrease in overall gross margin percentage is primarily attributable to increased material costs attributed to the product mix along with the delayed synergies with the Honeywell transaction for the acquired product lines. As Shahram briefly mentioned, the Honeywell integration continued in the second quarter, creating some production inefficiencies. In addition, some of the inventory and test equipment deliveries we expected were somewhat delayed, which negatively impacted not only our margins but our revenues as well. So while the Honeywell products are expected to have margins in line with our historical averages, they are currently a bit lower. However, as Shahram mentioned, we believe that once the integration is complete, their performance will improve. Research and development expense was $1.0 million, an increase of $100,000 or 19% in the 3 months ended March 31, 2024, from $900,000 in the 3 months ended March 31, 2023. R&D expenses were $1.9 million, an increase of $400,000 or 25.7% in the 6 months ended March 31, 2024, from $1.5 million in the 6 months ended March 31, 2023. This increase in R&D expenses was driven by higher salaries and benefits due to increased headcount. As a percentage of net sales, R&D expense decreased to 9.6% of net sales for the 3 months ended March 31, 2024. Lastly, selling, general and administrative expenses were $2.9 million, an increase of $500,000 or 18.9% in the 3 months ended March 31, 2024, from $2.4 million in the 3 months ended March 31, 2023. Selling, general and administrative expenses were $5.9 million, an increase of $1.2 million or 25.6% in the 6 months ended March 31, 2024, from $4.7 million in the 6 months ended March 31, 2023. The overall increase in selling, general and administrative expenses in the quarter ended March 31, 2024, was primarily the result of our investment in additional sales personnel to help drive increased sales. In addition, the increase was largely driven by an increase in legal and other professional fees that are onetime in nature related to the acquisition, CFO transition and others. These costs approximated $200,000 and $600,000 for the 3 and 6 months ended March 31, 2024. Additionally, SG&A was negatively impacted by approximately $200,000 and $500,000 for the 3 months and 6 months ended March 31, 2024, respectively, relating to the amortization of the customer relationship associated with the Honeywell acquisition. Interest expense was $171,000 in the quarter, down significantly on a sequential basis from the first quarter as we paid down our borrowings. Under our line of credit agreement, we used cash collections to reduce debt at the end of every day. So we don't hold much cash on the balance sheet. For modeling purposes, I will continue to expect to see interest expense decrease in future quarters. For the second quarter, we reported net income of $1.2 million or $0.07 per share compared to net income of $1.3 million or $0.07 per share in the year-ago quarter. The difference is primarily attributable to nonrecurring items previously discussed in the quarter coupled with the added amortization of customer relationship intangible acquired from the Honeywell transaction, which was $268,000. Therefore, excluding these onetime nonrecurring expenses and the amortization expense, our profitability increased from the year-ago quarter. Moving on to the backlog. New orders in the second quarter of fiscal 2024 were approximately $6.6 million, and our backlog as of March 31, 2024, was $10.4 million. Backlog includes only purchase orders in hand and excludes orders from our OEM customers under long-term programs, such as Pilatus PC-24, Textron King Air, Boeing T-7 Red Hawk and Boeing KC-46A. IS&S expects these programs to remain in production for several years and anticipate they will continue to generate future sales. Further, due to their nature, the product lines from Honeywell do not typically enter backlog. I'll turn to our cash flow and liquidity. In the first half of 2024, cash flow from operations increased from $2.2 million in the year-ago comparable period to $4.4 million, primarily due to changes in working capital and higher cash earnings. Our year-to-date cash inflows from investing activities were reflective of the cash inflow from the proceeds of $2.2 million from the sale of the company's King Air aircraft. Our year-to-date cash outflows from financing activities were $8.9 million and consisted of payments against the company's line of credit. I'd like to close by thanking all our teams for their hard work and commitment. And with that, let me turn it over to the operator to begin Q&A.

Operator, Operator

First question comes from Sergey Ginos with Freedom Financial Global.

Unknown Analyst, Analyst

The first question is for Jeff. Could you provide EBITDA financial expectations for the 2024 fiscal year, please? Especially, I'm interested in margins because I look at gross margin that decreased a little bit from the quarter a year ago due to Honeywell products acquisition.

Jeffrey DiGiovanni, CFO

Yes. So I think Shahram laid out expectations of 40% growth from a year ago and that included both inorganic and organic as well as 75% EBITDA growth. Right now, as Shahram mentioned, we experienced some synergy delays with the Honeywell acquisition, which is negatively impacting those margins as the inventory and the test equipment comes in, we would expect those margins to improve once the synergies are in full effect.

Unknown Analyst, Analyst

Okay. And the second question is for Shahram. What financial effect do you expect from UMS expanding into PC-24? What existing product lines will enhance organic revenue in the foreseeable future?

Shahram Askarpour, CEO

Yes. So yes, on the UMS right now, I mean, we continue with the production contract that we have with Pilatus for PC-24. So we're delivering those, and that platform is growing since the aircraft has been a very successful platform. On top of that, they gave us a development contract to make the second generation of the UMS. Part of what we're doing on the second-generation UMS is adding a lot more powerful microprocessors and improving on the performance of the equipment as well as opening it up for what we call space to add another channel of processing that would make it a lot more expandable into adjacent platforms. We plan on utilizing that platform for future development, including autonomous flight. This contract from Pilatus is allowing us to expand the capabilities of the product line. We're hoping that also in the business aviation side that the new platform, because of its additional capabilities, be more applicable to other aircraft platforms as well.

Operator, Operator

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

Douglas Ruth, Analyst

Can you provide a summary of the onetime costs for the quarter? Additionally, how do you believe the margins would have looked without those onetime costs?

Jeffrey DiGiovanni, CFO

So Doug, this is Jeff. So regarding the onetime costs, they're in SG&A. So those onetime costs are some acquisition-related costs, legal fees associated with the acquisition, as well as the CFO transition fees. You'll see that more disclosure in our 10-Q that's going to come out later this week. In terms of the margin impact with the synergies of Honeywell, we can't quantify it at this time because we're still working through some of the transition issues.

Douglas Ruth, Analyst

What about gross margins?

Shahram Askarpour, CEO

On the gross margins, there are two things contributing to the lower gross margin. Number one is that currently as we acquired a large amount of inventory from Honeywell on both product lines, there was something like $3.5 million of goodwill. That was calculated by our brilliant accountants that is being amortized over the inventory. So the cost of goods sold today as we bleed off that inventory appears to be higher than normal. So that's one contributor. The second contributor is that when we acquired these product lines from Honeywell, Honeywell does not build any subassemblies. They outsource all of the subassemblies to third-party vendors. Our plan is during this initial period is to continue down that path. As we move along and the integration completes, we will be building the majority of those subassemblies in-house. That would allow us to reach the 60% gross margins that we get today as we get with our own product lines because as you can imagine, your cost of goods sold is much higher when you outsource those subassemblies. We have capabilities here in our factory to build our own subassemblies.

Douglas Ruth, Analyst

Okay. How long will it take to burn off the Honeywell inventory that you acquired?

Shahram Askarpour, CEO

So obviously, some of the faster-moving inventory will burn off quicker, some of the slower-burning inventory will remain for a few years on the books. But I think it's going to be a gradual improvement as we bleed that off. But I think the big part of it is going to be as soon as we're in a position that we can start building our own subassemblies here and to do that, we're still waiting for some information, some drawings and design information from Honeywell that's due to arrive sometime soon. That would allow us to then use those to build subassemblies in-house.

Douglas Ruth, Analyst

When you think about the current, the second quarter, the period ending 3/31, is that the low period for the gross margin that it might be reasonable to think that in the third quarter, the gross margin might improve?

Shahram Askarpour, CEO

The gross margin contributed to the Honeywell products, some of it will improve because of efficiencies in our production floor as well. So when we look at the second quarter and the first quarter, these were transition quarters. In some ways, we had a set of technicians here at IS&S performing tasks while they were being trained as well as Honeywell was also executing partially on our behalf on some of these things. The margins will improve as we move forward due to some of that. The significant improvement of margin that we will see a jump coming in is going to be when we actually start manufacturing the subassemblies in-house and that will gradually happen over the next year.

Douglas Ruth, Analyst

Now when you look at the third quarter, will you be able to make any of the subassemblies? Or is that too soon of a time period? Would you be looking more towards the fourth quarter to be able to make some of the subassemblies?

Shahram Askarpour, CEO

I think that's going to be looking towards the fourth quarter as well as main contributions that are going to come in fiscal 2025.

Douglas Ruth, Analyst

Okay. Now my second question, which is my last question, is whether the management team or the Board of Directors will be eligible to buy some stock after the 2-day period, or if there will still be a blackout period.

Shahram Askarpour, CEO

No, I believe the blackout period will end in about two days. After that, any members of the Board of Directors or the management team will be able to purchase additional shares. A significant part of our management team's compensation is linked to RSUs, which also involves a considerable amount of taxes that must be paid out of pocket since the management has not been selling RSUs to cover these taxes, unlike some other companies. This situation effectively limits my available cash since I need to cover the 40% taxes on the RSUs. However, I believe our stock is currently very attractively priced.

Douglas Ruth, Analyst

I'm optimistic about the company's future.

Operator, Operator

Thank you very much. This concludes our question-and-answer session as well as the conference. Thank you for attending today's presentation. You may now disconnect your lines.