Earnings Call Transcript - ISSC Q1 2024

Operator, Operator

Good day, and welcome to the Innovative Solutions & Support First 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 Dr. Shahram Askarpour, Chief Executive Officer and a member of the Board of Directors. 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 first quarter of fiscal 2024, current business conditions and outlook for the coming year. Joining me is Rell Winand, our CFO. Before we begin, I'd like Rell to provide a cautionary statement about forward-looking information.

Rell Winand, CFO

Thank you, Shahram, and good morning, everyone. I would remind our listeners that certain statements made in matters discussed in the conference call today, including those about new products and operational and financial results for future periods contain forward-looking information. These forward-looking statements are subject to assumptions, risks and uncertainties that could cause actual results to differ materially, either better or worse from those discussed. I specifically call our listeners' attention to our disclaimer regarding forward-looking statements in our Form 10-Q filed yesterday, which disclaimer, along with our public filings, represents and describes these assumptions, risks and uncertainties. I also remind our listeners that plans and expectations we expressed speak only as of today's date, and listeners should not place undue reliance on any forward-looking statements. Now I'll turn the call back to Shahram.

Shahram Askarpour, CEO

Thank you, Rell. I will begin today with remarks on our performance in the first quarter of fiscal 2024, 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 Rell, who will take us through the financials. For the quarter, revenues were up 43% with net income increasing 51% from a year ago. This increase has us on pace to meet our goal of increasing revenues by 40% of the organic fiscal 2023 revenues due to the addition of the Honeywell product lines. At this time, we expect full integration of the Honeywell product line to be nearly completed this fiscal year. First quarter results were in line with the expectations expressed previously. That aside, results once again demonstrate the strength of our strategy, addressing the diversified military, commercial air transport and business aviation markets. Although we have experienced an anticipated slowdown in commercial air transport and cargo markets, we have countered the slowdown by renewed strength in the military markets. With the addition of the Honeywell product lines, an increasing proportion of our revenues are now recurring in nature, including our OEM production contracts with Boeing, Textron, and Pilatus. These production contracts provide a growing pace of reliable revenue that generates strong margins and strong cash flow. Margins this quarter were 59.3%, an improvement from the first quarter of fiscal year 2023. Cash flow was strong in the quarter, enabling us to reduce our debt position by nearly $9 million in the quarter. We expect the credit line balance will continue to be reduced throughout the fiscal year, barring another acquisition. We also maintained our commitment to research and development as evidenced by the increase in R&D expense. This increase includes our efforts to develop new products, add new capabilities to existing technologies, and integrate the acquired Honeywell product lines. This work is directed at our long-term vision where we believe there is increasing demand for technologies that reduce pilot workload and would ultimately lead to single pilot flights in air transport aircraft. Our funded R&D represents a contract with Pilatus to develop a second-generation UMS, a product we expect to be extended into additional airframes. This is further evidence of our strong value proposition and the confidence we gained with our customers. Part of the increase in selling, general and administrative expense in the quarter was the increase in staffing our sales organization. While we have always enjoyed a good reputation internationally, the Honeywell acquisition provided us an experienced, established global sales footprint, which we believe opens large new markets, not only for the Honeywell products but also for our legacy products. Many of the hundreds of customers that came along with the new products are new to IS&S, representing another new market that we believe offers great promise. Quickly updating the status of the Honeywell product line, all the test equipment and inventory is arriving, and the Honeywell training associated with the products has been completed. We are now processing maintenance and repair of radios in-house. Meanwhile, the transfer of the IRU inventory is progressing with the handoff of these products expected to occur by the end of the current quarter. We expect the top and bottom line benefit of these new products to begin to gradually ramp up. As I mentioned, we have increased our sales and marketing investment to support the sales of these products. As we begin to develop strategies to fully recognize the inherent synergies and potential of these products, we believe that we will realize growth from such synergies and strategies. For these reasons, we will continue to opportunistically evaluate and make plans to execute additional complementary acquisitions should appropriate opportunities arise. Our goal now is to leverage this momentum to sustain this growth over both the near and longer term organically and through additional acquisitions. Finally, I want to update you on our ongoing search for a permanent CFO. We have retained an executive search firm, and we have already completed a round of interviews that yielded several highly qualified candidates. Thank you for your time and interest, and we look forward to updating you in the upcoming quarter. I will turn the call over to Rell for a closer look at the numbers.

Rell Winand, CFO

Thank you, Shahram, and thank you all for joining today. Let me quickly review the highlights of our financial results for the first quarter of fiscal 2024. Revenue in the first quarter was up 43% due to the contribution of customer service sales of the product lines acquired and licensed from Honeywell. First quarter gross margin was 59.3%, up from a year ago but down slightly on a sequential basis in the fourth quarter, primarily due to the impact of increased material costs and overhead absorption in customer service. In the first quarter of fiscal 2024, research and development expense was approximately $900,000 or 9.7% of net sales. Note that research and development expenses have increased in absolute terms, but decreased as a percentage of net sales. When the current engineering development contract is completed, the engineers working on that development contract will return to research and development efforts. This will result in increased research and development expense in subsequent quarters. First quarter fiscal 2024 selling, general and administrative expenses increased from a year ago, primarily due to an increase in sales and marketing expense, the quarterly amortization of the intangible asset associated with the Honeywell product line license and acquisition, and professional and consulting fees. I will note that we sold the King Air airplane in the quarter for $2.3 million and the resulting gain on the sale was used to reduce total selling, general and administrative expenses. The gain was approximately $162,000. Interest income was down in the quarter, consistent with our new P&C bank line of credit account that uses daily cash balance to reduce debt at the end of every day. Interest expense in the quarter was up from zero a year ago, although we expect interest expense to trend down, not only as interest rates are anticipated to fall, but also because we're planning to use the majority of our cash flow to pay down debt. Taxes are being accrued at a rate of 12.8% versus the statutory rate of 21%, reflecting increased state tax expense due to the gain on the sale of the King Air airplane. Net income for the quarter was $1.1 million or $0.06 per share, up from $700,000 or $0.04 per share in the year ago quarter. New orders in the quarter were approximately $10.4 million, so we ended the quarter with a backlog of approximately $14.6 million. As always, quarterly orders can vary due to a number of factors and are not meant to provide an indicator of future revenues. Virtually all the Honeywell revenues are from intra-quarter book and ship orders that are not included in the backlog. For the first quarter of fiscal 2024, the company generated $4.2 million of cash flow from operations. The company's debt on December 31, 2023, was $10.6 million, down $8.9 million from $19.5 million as of September 30, 2023. As a result of the daily cash balance sweep component of the company's line of credit, it is required to be classified as a current liability on the balance sheet. During the three months ended December 31, 2023, cash also benefited from the sale of our King Air aircraft for $2.3 million. With that, operator, we're ready for questions.

Operator, Operator

We will now begin the question-and-answer session. At this time, we will pause momentarily to assemble our roster. The first question comes from Theodore O'Neill with Litchfield Hills Research. Please go ahead.

Theodore O'Neill, Analyst

Thank you very much. I just have two questions. The first one is about the sales side. The reduced shipments of displays for the retrofit in the commercial market. Do you have a view on if and when that would change? And what would be the driver for it?

Shahram Askarpour, CEO

Some of it is seasonal. We're introducing a new product line in that market, which should complete its certification this quarter, allowing us to begin seeing some revenues next quarter. We anticipate a slowdown in upgrades for older airplanes in the cargo market, which is why we've developed additional products and increased our focus on military efforts that were previously not a priority. Over the last couple of years, we have emphasized military projects, including an OEM contract from Boeing for the T-7 trainer, and we are exploring new opportunities in OEM, aftermarket, and military sectors. We expect this to become a larger driver than the air transport side in the coming years. On the air transport side, we are providing various upgrades aimed at increasing automation in the cockpit, which ultimately lead to single-pilot operations for Part 25 airplanes. The single-pilot operation is part of our long-term strategy. In the meantime, we will generate some revenue from the additional features we are offering for these cockpits. However, the demand for major retrofitting of cockpits for 5767 aircraft has slowed down as we expected.

Theodore O'Neill, Analyst

Okay. Yes, makes sense. And on the SG&A expense, the amortization of the customer relationships that was in the SG&A in the quarter? Is it a significant part of the increase? And does it continue on for many more quarters?

Rell Winand, CFO

Yes. It goes, it's a 10-year amortization. It's about $268,000 quarterly. It will continue, obviously. So that's a big driver of the increase. Of course, as Shahram mentioned, we've hired additional salespeople, so that's a big piece of it too.

Theodore O'Neill, Analyst

Okay. Thanks very much.

Shahram Askarpour, CEO

Generally, our auditing fees and legal fees have been higher...

Rell Winand, CFO

Quarter-to-quarter, they were fine.

Shahram Askarpour, CEO

Of the acquisition.

Rell Winand, CFO

Yes. Boeing staff, yes.

Theodore O'Neill, Analyst

Okay. Thanks guys.

Rell Winand, CFO

Thanks.

Operator, Operator

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

Andrew Rem, Analyst

Morning, gentlemen. I just had a question to start with. How should we think about gross margins within the customer service segment?

Rell Winand, CFO

Growth in what way? Typically, it has been higher.

Andrew Rem, Analyst

The fourth quarter rate was 68.5%, and for fiscal '23 year-to-date, it was running at 71%. I understand that there was some under-absorption, but you had significantly higher revenue this quarter compared to the first, second, or third quarter of last year?

Rell Winand, CFO

Go ahead. Sorry.

Andrew Rem, Analyst

No. I'm just trying to understand nuances.

Rell Winand, CFO

Yes. Well, you got to understand that. Andrew, can you repeat that, please? You said we had gross margins of 71%?

Andrew Rem, Analyst

Well, the year-to-date through the first three quarters of fiscal three was running 70%, 71%. Then fourth quarter was 68.5% and then now you have impacted 59%. I'm just trying to understand the nuance of what moves the gross margin around as this quarter's revenue in customer service was higher than the revenue run rate in the first three quarters of last year?

Rell Winand, CFO

Right. However, customer service revenue represents a larger portion of the overall business. Therefore, it will absorb more overhead. Additionally, we have seen an increase in material costs, so we must continue to raise our standards. The impact varies depending on what is being prepared, but it has decreased compared to before. Customer service accounts for almost half of your sales, which means it will have a greater influence on our overall performance.

Andrew Rem, Analyst

Okay. And then on the cost material side, how long does it take you to kind of get some price recovery there?

Rell Winand, CFO

It doesn't take much on the customer service side because much of what we do, aside from warranty, increases in cost. As we continue to raise those costs, it will impact what we charge the customer.

Andrew Rem, Analyst

Okay. And then on inventories, obviously, you had a pickup in the fourth quarter due to Honeywell, but you also had another pickup this quarter, about $1.7 million. Can you just help us understand what's going on? Is this related to excess inventory as you make these product transitions? Is that what's driving it?

Rell Winand, CFO

Yes. You have a couple of things. The Honeywell inventory coming in is going from prepaid. You can see the movement there into inventory. We have some last-time buys. We have items in flow, and we're going to need the inventory and flow meaning production ahead of going to produce ahead a little bit. So all that's going to increase. And obviously, as we add more Honeywell products, you're going to see that grow and grow because the prepaid Honeywell inventory was $12 million. As you receive that, it comes out of their and comes into your normal inventory, if that makes sense.

Andrew Rem, Analyst

Did we expect in the second half of the year kind of inventory will normalize, you get the product transition, you get back behind you, you brought in all the Honeywell inventory, is that reasonable?

Rell Winand, CFO

Yes, but it will be a big number because we've got...

Shahram Askarpour, CEO

It's going to be a big number, but it's going to...

Rell Winand, CFO

It should level up.

Andrew Rem, Analyst

Okay. And then on CapEx.

Rell Winand, CFO

We have increased our capital expenditures and made some improvements to our building, so that will be a factor.

Andrew Rem, Analyst

Well, I'm just looking at $182,000 versus $300,000 for the full year fiscal '23.

Rell Winand, CFO

Yes. Well, we probably bought some machinery. Now we're working on. Usually.

Shahram Askarpour, CEO

Well, love benches.

Rell Winand, CFO

Yes. I bought a lot of stuff for the Honeywell, so fitting that out as well as making upgrades a part of the building for that. So all that's adding into a little higher than normal in a period of time.

Shahram Askarpour, CEO

Yes, that should all...

Rell Winand, CFO

Actually level off.

Shahram Askarpour, CEO

It should stabilize.

Rell Winand, CFO

Yes. Typically, we don't have CapEx of $200,000, $300,000 generally a year. It's always not a big number.

Shahram Askarpour, CEO

Investment in our IT structure is important because cybersecurity is becoming increasingly relevant. We're implementing some measures...

Rell Winand, CFO

Upgrading servers.

Shahram Askarpour, CEO

A lot of upgrades as well as increasing our cybersecurity practice. I think long term, it saves us money because that reduces your insurance cost as well.

Andrew Rem, Analyst

Can you comment on the incremental components of CapEx? You mentioned that IT infrastructure would be an additional cost this year, along with some CapEx related to your work with Honeywell. If the base CapEx spend is a couple of hundred thousand, how much more will be added from the IT and Honeywell-related expenses?

Rell Winand, CFO

Not a lot. $100,000, $150,000 maybe. We're pretty much done that, if you will. I guess, say, some more, another is $250,000 maybe on average, I guess.

Shahram Askarpour, CEO

Going forward, you're also going to look at the air conditioning system, which is 20 years old.

Rell Winand, CFO

It's old.

Andrew Rem, Analyst

All right. Well, I guess that's it for me, but I did want to say that you guys have done a pretty amazing job generating good cash flow here. We've taken $1.5 million out of your debt. I had speculated that maybe you guys could exit this fiscal year below 1 time. So I think it looks like you maintain the current trajectory, you guys are going to flow right through that. Kudos to you guys and the team for doing a great job improving the balance sheet so quickly. So anyway, thanks a lot. Appreciated.

Rell Winand, CFO

Thank you, Andrew.

Operator, Operator

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

Doug Ruth, Analyst

Hi. I want to start off by congratulating you on a really strong quarter. You've done a wonderful job. I had a question. Is the management team and the Board of Directors, do you folks now have the ability to buy stock?

Rell Winand, CFO

The window actually opens on the third business day after earnings on Monday and closes a couple of weeks before the end of the quarter. So as of Monday, there is indeed an open window.

Doug Ruth, Analyst

Okay. I think the investment community would really appreciate if the Board and some of the managers could buy some stock. I think it would make a significant difference. And again, I want to congratulate you on a really strong quarter. Thank you for what you're doing for the shareholders.

Rell Winand, CFO

Thank you. Thank you for your support.

Operator, Operator

And this concludes the question-and-answer session and the Innovative Solutions & Support Conference. Thank you for attending today's presentation. You may now disconnect.