Innovative Aerosystems, Inc. (ISSC) Earnings Call Transcript & Summary

Good day, and welcome to the Innovative Solutions & Support First Quarter Fiscal 2024 Financial Results Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Dr. Shahram Askarpour, Chief Executive Officer and member of the Board of Directors. Please go ahead.

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.

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 represented describe these assumptions, risks, and uncertainties. I also remind our listeners that plans and expectations we express 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.

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 lines to be nearly completed this fiscal year. First quarter results were in line with the expectations expressed previously. Data side, 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 and to add new capabilities to existing technologies and to 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 administration 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 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 have 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 site 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 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 quarters. I will turn the call over to Rell for a closer look at numbers.

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 and 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 has 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 0 a year ago, although we do not expect interest expense -- although we do 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 were being accrued at a rate of [ 21.8% ] 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 that 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 the daily cash balance sweep component of the company's line of credit is required to be classified as a current liability on the balance sheet. During the 3 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 Instructions] The first question comes from Theodore O'Neill with Litchfield Hills Research.

Thank you very much. I just have 2 questions. The first one is about on 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 might change and what would be the driver for it?

Some of it is seasonal. Some of it is we're introducing a new product line in that market. We should begin -- or finish the certification this quarter, and we should begin to see some revenues from it from next quarter. But we've anticipated that on the cargo market, as these airplanes get older and older, that eventually we think we will see a slowdown in these op rates. And because of that, we developed some additional products and put a larger emphasis on our military efforts, which were kind of not -- in some ways, they were not a priority before. We were focusing on the autothrottle product lines, so we've put that emphasis over the last couple of years on the military side of things we got. Because the OEM, new OEM contract from Boeing on the T7 training, we continue to work on a lot of new opportunities that are coming, both OEM as well as the aftermarket on the military side. We're looking at that over the next few years to essentially be a larger driver than the air transport side. On the air transport side, what we're doing is that we're offering a lot of upgrades, which as we talked before leads to more automations within the cockpit and eventually to the single pilot operation for these Part 25 airplanes. The single part of the operation is the longer-term strategy. Meanwhile, we will be seeing some revenues from some of these additional features that we are offering on these cockpits. But the big ticket items of completely retrofitting a cockpit of a 5-7/6-7 aircraft, that has slowed down. And like I said, we had anticipated it.

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?

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

Generally, our auditing fees and vehicle fees have been declining…

Quarter-to-quarter, they were fine.

As the acquisition winds down.

The next question comes from Andrew Rem with Odinson Partners.

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

In what way? Typically, it's been higher.

Right. if we look at the fourth quarter rate, 68.5%, and in fiscal '23 year-to-date it had been running 71%. And so I don't know if -- I mean, you mentioned some under-absorption, but you had much higher revenue this quarter than first, second or third quarter of last year.

Right, but it's -- go ahead, sorry.

No, I'm just trying to understand some of the nuances.

Yes. Well, you got…

Andrew, can you repeat that, please? You said we had gross margins of 71%?

Well, if the year-to-date through the first 3 quarters of fiscal '23 was running 70%, 71%, then fourth quarter was 68.5%, and then now you have 59%. I'm just trying to understand the nuance, what moves the gross margin around, and this quarter's revenue in customer service was higher than the revenue run rate in the first 3 quarters of last year.

Right. But the customer service revenue is a bigger piece of the whole. It's going to end up with more overhead absorption into it. As well as we've seen material as you can understand, has -- cost of material, the price, has increased. We have to keep increasing our standards, so it's -- and it's mix. Depends on what you're repairing. But yes, it is down from previous. But like I say, your -- half of your sales almost is customer service, so that's going to get a bigger piece of everything if that makes any sense to you.

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

To get some what? Can you repeat that? I missed that.

On the cost of materials, how long does it take you to get this recovery?

It doesn't take -- on the customer service side, not too much because a lot of what we do other than warranty is cost up. As we've been increasing those, it's going to flow through to what we charge the customer.

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?

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

Can we expect in the second half of the year kind of inventory kind of normalizes? You get past the product transition, you get that behind you, you've brought in all the Honeywell inventory. Is that reasonable?

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

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

Okay. And then just on CapEx -- go ahead…

You're going to order and that kind of thing, right?

On CapEx, can you just comment on -- it was pretty high this quarter. How should we think about that for the full year?

I mean, look, we've -- CapEx, we've increased the building and done some work in the building, things like that, so that's going to be a part of it.

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

Yes. Well, we probably bought some machinery. Now we're working on -- usually…

We bought a lot of benches.

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

Yes, that should all level off. Stabilize.

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

Some investment in our IT structure as well. Because as you know, this cybersecurity now is becoming a thing, and so we're doing some…

Operating servers.

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

Can you guys comment then on -- like if we just think about CapEx and what the incremental components, so you mentioned IT infrastructure would be incremental for this year and then some incremental CapEx related to everything that you're doing around Honeywell. Can you kind of help me -- if you've got a base CapEx spend a couple of hundred thousand and then how much incremental from these IT and Honeywell related?

Not a whole lot. $100,000, $150,000 maybe. We're pretty much done that, if you will. Like I say, typically for us, some more than others, $250,000 maybe on average, I guess.

Going forward, you've also got to look at the air conditioning system, which is 20 years old. You've got to look at some loops.

That's a whole different potential…

We're going to be addressing.

All right. Well, I guess that's it for me, but I did want to say I think you guys have done a pretty amazing job. You've generated good cash flow here. You've taken a turn and a half out of your debt. I had speculated that maybe you guys could exit this fiscal year below 1x. I think it looks like if you maintain the current trajectory, you guys are going to blow right through that. Kudos to you guys and the team for doing a great job improving the balance sheet so quickly. Anyway, thanks a lot. Appreciate it.

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

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?

Well, when the window is open, yes. The window opens actually on for us it's the third business day after earnings on Monday. And it closes a couple of weeks before the end of the quarter, so as a Monday, there is an open window, yes.

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 really 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.

Thank you. Thank you for your support.

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.