Earnings Call Transcript - ISSC Q3 2020

Operator, Operator

Welcome to the Innovative Solutions and Support Third 2020 Earnings Conference Call and Webcast. All participants will be in listen-only mode. I would now like to turn the conference over to Mr. Geoffrey Hedrick, Chairman and Chief Executive Officer. Please go ahead.

Geoffrey Hedrick, CEO

Good morning. This is Geoff Hedrick. Welcome to our conference call to discuss our performance for the third quarter of fiscal 2020, current business conditions, and our outlook for the coming year. Joining me is Shahram Askarpour, our President, and Relland Winand, our CFO. Before I begin, I would like Rell to read the Safe Harbor message. Thank you.

Relland Winand, CFO

Thank you, Geoff. Good morning everyone. I would remind our listeners that certain matters discussed in the conference call today, including 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 than 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 the call back to Geoff.

Geoffrey Hedrick, CEO

Thank you Rell. Three years ago, I announced that we would change our approach to the market by focusing only on products in which we had both the performance and technologically driven price advantage. The resulting trend in our operating performance seems to vindicate our change in direction. In the third quarter, we experienced a historically strong growth quarter with revenues up 28% quarter-over-quarter and 30% from a year ago, generating sequential revenue growth in 7 of the last 8 quarters. In addition, revenues this quarter included production deliveries to our newest OEM customer Textron. We are pleased to be supplying Textron with our ThrustSense autothrottle with lifeguard protection. On the new King Air 360 twin turboprop production aircraft, we intend to build on this relationship in our joint pursuit of retrofitting and upgrading the very large fleet of King Airs, expanding the number of production aircraft to include a ThrustSense autothrottle as standard equipment and upgrade existing fleets. The company has the industry's first FAA Supplemental Type Certificate for its groundbreaking and patented ThrustSense autothrottle system with lifeguard protection on 200s and 300s with Rockwell's ProLine 21 avionics. The full regime autothrottle ThrustSense system with lifeguard VMCa protection is available for immediate retrofit and promoted at Textron service centers, as well as all King Air maintenance facilities. This safety feature can offer protection against catastrophic upsets with the loss of an engine if the pilot fails to maintain adequate air speed. Excuse me for a second. In the process, we have overcome and continued to overcome many challenges, most notably the coronavirus pandemic. We remain focused on protecting our employees, partners, and customers, and remain ever vigilant as to its potential effect on our end markets, supply chain, and other aspects of our business. To this date, the impact has been immaterial. I am extremely proud of our team and their ability to execute in these difficult circumstances. Let me turn it over to Rell for financial details.

Relland Winand, CFO

Thank you Geoff, and thank you all for joining us this morning. Revenues for the third quarter of fiscal 2020 were $6 million, up 30% from a year ago and also up on a sequential basis from $4.8 million in the second quarter of 2020. Growth this quarter was primarily in product revenue. We also had some engineering development revenue associated with final engineering on the F5 development contract, while customer service revenue was down from a year ago, mainly due to our prioritization of resource allocation. Gross margin for the quarter was 57% up from both 55% in the third quarter in 2019 as well as 47.5% in the second quarter of 2020. We indicated that the drop in last quarter's margins was going to be temporary as a result of product mix, an increase in warranty costs, and higher labor expense as we staffed up ahead of future product production demands. As anticipated, margins bounced back and we are in line with margins achieved in the past few quarters. Total operating expenses for the third quarter of fiscal 2020 were $2.2 million flat with the second quarter and up incrementally from the third quarter a year ago. I would like to once again mention that all the revenues have been increasing this year, most recently growing 30% in the third quarter, while operating expenses have not increased. Research and development expense was up approximately $150,000 from a year ago, reflecting an increase in the amount of internally funded R&D primarily related to obtaining FAA certification for the King Air autothrottle systems. Despite our 30% growth this quarter, selling, general and administrative expenses were down from a year ago, mainly due to lower travel expenses, professional fees, and trade show expenses. Most of these reductions are a result of restrictions arising from coronavirus. For the quarter, we generated operating income of $1.2 million or slightly over 20% of revenue. Due to the continued availability of loss carry backs, we recognized minimal tax expense in the quarter. We reported net income of $1.3 million or $0.07 per share. This was the most profitable quarter in 13 quarters. In the first five months of the year, both net income and earnings per share increased by 137% and 140% respectively as compared to the first nine months of fiscal 2019. The company remains in a strong financial position and generated positive operating cash flow of $340,000 in the quarter and $567,000 year-to-date, such as the news recently to fund accounts receivable, which are correspondingly higher due to the significant growth in revenues. On June 30, 2020, we had $23 million of cash on hand and no debt. We believe that the company has sufficient cash to fund operations for the foreseeable future. I'd like to turn the call over to Shahram.

Shahram Askarpour, President

Thank you, Rell. Good morning everyone. Reporting on Q3, the revenues are up significantly. The general aviation industry's most prestigious manufacturers, including Textron, contracted with us to install our proprietary ThrustSense autothrottle as standard equipment on the production of King Air aircraft. We have achieved this progress in spite of the COVID-19 pandemic by implementing new safety policies and procedures that have kept all of our employees safe and productive, as well as protecting our partners and customers. During the month of April, in order to safeguard the health of our employees, we provided our production workers with paid time off and alternate working schedules to minimize congestion in our plant. We have installed automated personnel temperature monitoring at our main facility entrance with facial recognition software in conjunction with daily and in-between break sanitization and weekly antiviral fogging of the entire facility to minimize the risk of an outbreak. The organization has adapted to these changes and in the third quarter, as Rell reviewed, margins were up significantly from the second quarter as our operating conditions have normalized from these actions. In fact, we are continuing with hiring to meet the growing demand in areas of production, sales, product support, and engineering. The contract for the Beechcraft King Air represents our third OEM production contract, joining the Boeing KC-46A and the Pilatus PC-24. These contracts provide an ongoing stream of revenue consistent with their respective delivery schedules. The aggregate represents the potential for future revenues that are multiples of our stated backlog, so we consider them fundamental to our business. Textron clearly recognizes the important risk mitigation nature of our autothrottle on twin-engine aircraft, and for that reason, they are making it standard equipment on their King Air. They believe the extra safety offered by ThrustSense provides Beechcraft with an advantage in the highly competitive general aviation market. Annual King Air production rates are higher than those of the PC-24, but in the case of King Air, there are already over 5,000 airplanes in service. Textron is also beginning to actively market our autothrottle at the service centers so it can be offered to owners as a retrofit option. Parallel to this, we are also aggressively marketing our retrofit package autothrottle to government entities and our portfolio of fixed-base operators (FBOs). We have already delivered production units for Textron which are included in the third quarter revenues. Simulators for the production of King Air aircraft are currently being upgraded, and they will be used to train King Air pilots within a couple of months. First, we continue to market our autothrottle to Textron and other OEMs beyond twin turboprop aircraft as we see applicability for some of its safety enhancements to twin jets. We are in discussion with OEMs to include our ThrustSense autothrottle in several other production aircraft. We believe Textron's recent public announcement will attract attention from other general aviation aircraft manufacturers and, as Geoff mentioned, will transform the Pilatus from a potential lifesaving system into standard equipment on their fleet. Now, quickly reviewing our ongoing program, the PC-24 program remains on track to deliver approximately 50 Pilatus aircraft this year. As with all our long-term production contracts, we are specified for the installation of autothrottles on all of the PC-24s Pilatus manufactures, which is already over 100 units. These are generally only a quarter or two of deliveries carried in our backlog and therefore only a fraction of OEM delivery potentials are visible through that channel. We believe the PC-24 program represents a long-term opportunity, and now the similar contract with Textron could significantly enhance that potential. In the commercial transport market, air cargo delivery services keep buying 757 and 767 planes and converting them. As part of their conversion, we are seeing steady demand for flat panel displays. As noted, we finished up development work for the F5 air data computer this past quarter, and we will start production deliveries for the US Navy fleet retrofit this quarter. With this contract successfully completed, we are now turning our attention to foreign military, which also fly the F5 and could become a large new market for this versatile drama. Our KC-46 program has also resumed production and continues to make a steady contribution to our top and bottom lines. New orders in the third quarter were $2.7 million and our backlog was $6.5 million at quarter end. Rell mentioned that our travel and trade show expense was down this year, so we have had fewer opportunities to personally meet with our new prospects. The FAA continues to work from home, which has added complexity we are managing. Despite these conditions, the FAA personnel have been very supportive of our efforts, diligently reviewing our submittals and timely issuing certifications, such as the most recent certification for production in King Air. Overall, we don't believe the pandemic will have a material impact on our business and are excited about the prospects of our portfolio of products. Let me turn the call back to Geoff for some closing remarks.

Geoffrey Hedrick, CEO

Thank you, Shahram. As pleased as I am with the performance of this quarter and the past couple of quarters, we must be very diligent that we keep our pursuit and our nose to the grindstone, as I say, to make sure that we realize the opportunities that have been presented to us. This will require vigilance in our growing requirements for personnel and investments in technology. You know, we're pleased that we performed as well as we did in the middle of the COVID-19 pandemic. Our team in our plant and the things that we did to the plant created a work environment which essentially had zero impact from the pandemic. I'm very proud of the people in this company who made it happen and I'm pleased that our work environment has changed for the better. Our focus remains on strengthening our organization and opening up those new relationships that have been provided to us with some of this technology and further growth in our portfolio, our price for performance products. Thank you for your attention today. Please operator, open us up for discussions.

Operator, Operator

The first question is from David Campbell with Thompson Davis & Company. Please go ahead.

David Campbell, Analyst

Hey guys, congratulations on a good quarter. You actually got to my forecast revenues, and your profits were better than my forecast, thanks to G&A being less than expected. Over the long-term, it seems to me that the biggest contribution will come from aircraft production that competes with the King Air. I mean the King Air has been around for about 30 years, so I don't know how many new King Airs you will be producing, so it seems like the biggest protection will be for competing aircraft that don't have that capability. And for retrofit of existing gears, can you give us any thoughts about how the company views the marketplace?

Geoffrey Hedrick, CEO

Well, a couple of things. First of all, there are not a lot of twin-engine airplanes coming out. The King Air is a proven standard, and as we said, the large market is not so much ongoing production, but rather the existing 5,000 units out there that we can offer, and these are valuable aircraft. These are well-maintained and people are interested in protecting their families and protecting the airplane are likely to be interested in our autothrottle, and that's in part why Textron is promoting it through their retrofit centers. The King Air is still a strong airplane and the new aircraft are performing well. The market opportunity, in our opinion, is very large, and the King Air is an ideal aircraft because it's high value and we provide real performance advantages and safety to both the airplane and the flight crews as well. We also find opportunities not just in general aviation, but in military aircraft and air transports. Our system is capable of retrofitting multi-engine airplanes as well. We think we have a very strong advantage, and I will remind you, our market direction has always been focused on retrofitting, because when business was bad, they stopped buying new airplanes and they fixed the old ones; when business was good, they couldn't get the new airplanes fast enough, so they had to fix the old ones. That formula worked out extremely well for us in the past, and I believe that it will continue to work for us.

David Campbell, Analyst

Alright. Did you have any King Air retrofit revenues in the quarter?

Geoffrey Hedrick, CEO

We're just beginning to actively market. We didn't have an STC until three weeks ago, but we see it as a strong market opportunity. We shipped 13 units, 13 ship sets of production equipment and similar items.

David Campbell, Analyst

And Textron is now more aggressively marketing the retrofit than they were three or four months ago?

Geoffrey Hedrick, CEO

They didn't do it all three or four months ago for two reasons. First of all, they wanted to make sure that they announced their new airplane, which just came out two days ago with the autothrottle, and they didn't want to undermine that announcement. Secondly, we haven't finished certification of the units to deliver the production units yet, so they were preparing. This is a big deal; they had to get their service centers ready. The COVID-19 pandemic also compounded matters, as they were shut down in the plant and at the service centers. Nobody was bringing their airplanes in due to the pandemic. However, we're seeing that clearing up, and frankly, we are very optimistic.

David Campbell, Analyst

Yeah, it sounds like you'll get some good new business in the fourth quarter, which would be the September quarter, as I'm reading it right.

Geoffrey Hedrick, CEO

Immediate retrofit opportunities are about $300 million worth of opportunities.

David Campbell, Analyst

Alright.

Geoffrey Hedrick, CEO

So, we have the teams out; we're hiring a guy in Wichita, opening an office in the center of the United States to promote this, and by the way, to support Textron. Textron has done an excellent job in implementing this technology on their airplane with remarkable speed and support. We're very pleased with Textron and the FAA, who acknowledge that this is a very valuable addition for safety and want to get it implemented as quickly as possible.

David Campbell, Analyst

And Rell, I have one last question. What about the taxes? When will you begin to accrue taxes for your income?

Relland Winand, CFO

Alright, well, we're right at the tipping point with the unused credits. I would say this year it will be something small, but probably going into next year, I will probably realize a lower margin tax expense. So tax credits can be used again next year.

David Campbell, Analyst

What about the fourth quarter? Do you expect some tax accruals in the fourth quarter?

Relland Winand, CFO

I think if it is, it will be small. It depends; we're right there at the tipping point with our NOLs and such. If we do it, it will be small.

David Campbell, Analyst

Okay, well that's it for me. Thanks again for everything you're doing. It’s a great job.

Geoffrey Hedrick, CEO

Ladies and gentlemen, thanks again for your support. You've been great.

David Campbell, Analyst

Go to hell.

Geoffrey Hedrick, CEO

Take care of yourself. Good to talk to you.

David Campbell, Analyst

Thank you.

Operator, Operator

The next question is from the line of George Marema with Pareto Ventures. Please go ahead.

George Marema, Analyst

Good morning, thanks for taking my call.

Geoffrey Hedrick, CEO

Good morning.

George Marema, Analyst

I had a question regarding Textron. Are you doing the new production part, or just the 360s, or are you also doing their new production of other platforms like the 200s and C9s?

Geoffrey Hedrick, CEO

Their intention is to do all of them. They're doing one at a time, and as you can understand, when they bring this on to the production line, it's a major task. They are trying to get this done in a matter of months, rather than the usual timeline which is a year and a half or more. The 360 is the important one, but as you can see in the announcement, the first is the IS&S autothrottle for the 360, and then they are turning over another instance because it's a significant improvement. It's worthwhile looking at that announcement.

George Marema, Analyst

For what it's worth, if you look at the company's website on their brochures, your product is already pictured on the C9s and 200 series.

Geoffrey Hedrick, CEO

That's wonderful.

George Marema, Analyst

So, they obviously planned to move quickly.

Geoffrey Hedrick, CEO

I have been in the business longer than I want to admit, but Textron has shown grit and thrives, which is incredibly refreshing and totally atypical. They've done a remarkable job. They've not just given us an order, but they have really attacked this in a highly professional and aggressive manner—much more than I expected.

George Marema, Analyst

So when you last quarter mentioned the opportunity from Textron, were you just talking about the 360 series, or were you also factoring in their other platforms like the 200s and C9s?

Geoffrey Hedrick, CEO

Honestly, we looked at the largest opportunity for new aircraft, the retrofit opportunities they have acknowledged, and it is a significant market. Our company was built on retrofits and we have significant experience in this area.

George Marema, Analyst

On the retrofit market for next year with Textron, do you have any feelings on the cadence of that?

Geoffrey Hedrick, CEO

Well, our opening is going to be a strong supply, but it's always a surprise in the retrofit market. However, we have strong demand for incoming retrofit opportunities from various military applications.

George Marema, Analyst

Are you in more advanced stages of talks with other OEMs and military at this point or is this still at the early stage?

Geoffrey Hedrick, CEO

I'd prefer not to comment, but you can presume if that’s possible. The market is there, and we have a number of demonstrations that have been very successful.

George Marema, Analyst

That's great to hear. I've noticed on your website that you're doing some aggressive hiring. However, it seems your new orders have been a bit lumpy. I'm assuming this previous quarter was lumpy due to COVID-19, but have the orders picked up with all this hiring?

Geoffrey Hedrick, CEO

We haven't done a lot of hiring; we've done a lot of advertising for people. We typically hire 1 out of 20 or 30 applicants, so you need to bring numerous candidates in. We initiate hiring campaigns six to twelve months in advance of the specific start date. It takes time to get good candidates. We focus on hiring the right fit for the company.

George Marema, Analyst

So it sounds like you believe that after it ramps up, the Textron retrofit annual business could be more than the OEM business for new production?

Geoffrey Hedrick, CEO

Yes, I think Textron is committed to this path.

George Marema, Analyst

In terms of production numbers, regarding King Air 360 versus 200s and C9s, are there C9s and 200s vastly lower in production numbers or is the demand somewhat similar?

Geoffrey Hedrick, CEO

Well, the 360 just got released, so we will see how the numbers pan out.

Shahram Askarpour, President

Roughly about a hundred King Airs are produced per year.

Geoffrey Hedrick, CEO

Remember, we are not only focused on the 360. Textron has already made a commitment to implement our retrofitting system on all the other aircraft as well.

George Marema, Analyst

That's good to hear.

Geoffrey Hedrick, CEO

We are currently teaming with Textron as we speak on a proposal to the military.

George Marema, Analyst

Sounds good. Thank you.

Geoffrey Hedrick, CEO

Thank you.

Operator, Operator

The next question is from the line of Derek Bubble with Abbott Downing. Please go ahead.