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

Good day, and welcome to the Innovative Solutions & Support First Quarter 2025 Results Conference Call and Webcast. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Paul Bartolai. Please go ahead.

Thank you, Michael. Good afternoon, everyone, and welcome to Innovative Solutions & Support's first quarter 2025 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 first quarter 2025 operational and financial results. This release is publicly available in the Investor Relations section of our corporate website at www.innovative-s.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 our 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, who will provide a review of our recent business performance and strategic outlook, followed by a financial update from Jeff. 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.

Thank you, Paul, and good afternoon to everyone joining us on the call today. Let's begin with a high-level overview of our first quarter financial performance. During the first quarter, we delivered more than 70% year-over-year growth in revenue, driven by momentum from new military programs and contributions from our legacy platforms. Our organic growth, which was in the mid to upper single-digit range was mainly driven by continued momentum across our military end markets, a trend we expect to continue. We are also seeing improved trends in our commercial business and expect growing momentum as we move through the fiscal year as our fiscal Q1 is typically a busy period for air transport. Our gross profit increased approximately 20% as our strong revenue growth was partially offset by the significant investments we are making to support our growth initiatives, which I will discuss in more detail here shortly. Our backlog was approximately $81 million as of December 31, 2024, compared to $14.6 million in the prior year. On our call last quarter, we introduced ISSC Next, our long-term value creation strategy. As a quick refresher, our strategy centers on a combination of targeting commercial growth within high-value markets, improving operating leverage and a disciplined returns-driven approach to capital allocation. During the first quarter, we continued to execute against our initiatives, and I would like to take a moment to highlight just a few of the key achievements that reflect our commercial growth priorities. We continue to make significant investments in our growth initiatives, which is impacting our margins in the near term, but will place us in a strong strategic position to take advantage of some of the exciting opportunities in our markets and drive profitable growth in the coming quarters. Some of these investments included the following: First, as activity in our military markets continue to accelerate, we've made significant investments in both infrastructure and systems capabilities to support the high-performance requirements of our defense customers. To that end, we have integrated a modern ERP system, a more robust IT infrastructure and strengthened our security and accounting services to make us compliant with Defense Federal Acquisition Regulation Supplement or DFARS requirements. These are critical investments as we continue to win and bid for larger DoD programs. Second, we are also continuing the expansion of our Exton, Pennsylvania facility. When completed in mid-2025, we will have doubled our footprint and increased our production capabilities by more than threefold. I watch the progress from my office window every day, and I'm happy to report that the groundwork is complete, the steel structure is up and the completion of the internal and external walls will commence shortly. As a side note, we've been funding this development out of our P&L. Importantly, we are adding this capacity with a capital investment of only $6 million, providing for the opportunity of a very strong return. We also think it's worth reminding everyone that IS&S manufactures 100% of its products in our Exton facility. We think this is important and puts us in an enviable position as the new administration makes its significant push for reshoring of manufacturing and an America first mentality. Third, during the first quarter, we made significant investments in support of our most recent acquisition from Honeywell. Much of the spending during the first quarter was made ahead of the expected growth from these platforms, and we also made investments that resulted in some duplicative costs as we train our staff to transition the manufacturing of the products from Honeywell into our Exton facility. The integration is on track, and we are excited by the opportunities from this most recent acquisition. And finally, we also continue to strengthen our workforce across the organization to support our strategic growth initiatives. Our head count is up over 25% from last year, which will help us as we scale the business. In terms of new product development, we remain highly focused on the opportunity within cockpit automation leading to autonomous flight. Our next generation of our Utility Management System, or UMS 2, remains on track to have our first test flight by mid-2025 for the Pilatus PC-24. We also believe the next generation of our AI-enabled Utility Management System is the ideal certifiable platform for flight automation with our initial focus being military customers and applications. We believe the military market is the most immediate and logical market to deploy our autonomous flight capabilities. The unfortunate recent events bring to the surface the need for more automation in the flight deck to enhance safety. We are encouraged by the growth opportunities across our commercial air transport, business aviation and military markets, and we are confident we are making the necessary investments to strategically position IS&S to win in the market. In conclusion, we are off to a solid start for our fiscal 2025 and are excited by the opportunities that lie ahead. We have made investments necessary to support our new programs. We have made important progress regarding the integration of our most recent acquisition, and we are making the necessary investments to support our organic growth initiatives. That said, we still intend to remain a strategic acquirer. While we have most recently been focused on complementary product lines from large avionics suppliers that expand our capabilities in advanced avionics, we are also evaluating opportunities to acquire smaller avionics manufacturers where we anticipate synergies will be realized by incorporating their outsourced production in our facility. Looking ahead, we intend to build on the momentum evident within our business and remain on track to deliver both revenue and EBITDA growth of over 30% when compared to fiscal year 2024. With that, I'll turn the call over to Jeff for his prepared remarks.

Thank you, Shahram, and good afternoon to all those joining us. Today, I will provide a high-level overview of our first quarter performance, including a discussion of our working capital, balance sheet and liquidity profile at quarter end. We generated net revenues of $16 million in the first quarter, up just over 70% when compared to the first quarter last year. The increase was driven primarily by contribution from the recently acquired Honeywell military product line as well as 7% organic growth due to, in part, including the continued momentum of our new military programs. Product sales were $10 million during the first quarter, more than double last year's levels, driven primarily by the recent acquired military product line, offset by reduced shipments to the business aviation customers. Service revenue was $6 million, owing largely to the customer service sales from the product lines acquired from Honeywell and increased NRE revenue, partially offset by lower legacy customer service revenue. Gross profit was $6.6 million during the first quarter, up from $5.5 million in the same period last year, driven by strong revenue growth, partially offset by higher depreciation expense resulting from the Honeywell acquisition, duplicative costs in support of the migration of the recent Honeywell acquisitions and continued investments in growth initiatives, as Shahram discussed. Our first quarter gross margin was 41.4%, down from 59.3% in the same period last year. As I discussed last quarter, there are several factors that have been impacting our gross margin capture in recent quarters, which continued during the first quarter and will remain a factor in the near term. These factors include incremental depreciation from recent product line acquisitions and the shift in our sales mix as military sales will be a higher percentage of sales. More specifically, during the first quarter, the impact of the acquired Honeywell military product line volume lower margin was approximately 500 basis points, increased third-party expenses from Honeywell with respect to their transition services was approximately another 200 basis points and higher depreciation from recent acquisitions was roughly a 500-basis point headwind to gross margins. As it relates to the product mix, generally, military sales carry a lower average gross margin versus commercial contracts. However, there is minimal operating expenses associated with these contracts, so the incremental EBITDA margins are strong. And given the significant potential we see for absolute EBITDA dollar growth in military, we believe this is good for us and work that we will continue to pursue as it advances our focus on improved operating leverage. In addition to these factors, during the first quarter, we incurred costs to support the ramp-up of recently acquired product lines from Honeywell as well as inefficiencies due to hiring and training additional personnel. Many of these costs were duplicative in nature and will not be a factor as we fully transition the product line into IS&S. Given these factors, we continue to expect our consolidated gross margins will likely trend closer to mid-50% on a normalized basis, which is below historical levels. As we complete the integration and begin to enjoy the scale benefits of these investments, we will be able to drive increased adjusted EBITDA margin realization and net profitability over time. Operating expenses during the first quarter of 2025 was $5.3 million, an increase from $3.9 million in the comparable period last year. This increase was driven by approximately $400,000 from increase in product development efforts in support of our long-term growth initiatives, incremental expenses from Honeywell acquisitions, including $700,000 of amortization expense and $300,000 in employee costs, primarily due to increases in head count and another $300,000 of acquisition [indiscernible] onetime expenses. We've increased our head count by over 25% to support our future growth initiatives across the organization. Operating expenses represented 33% of revenue during the first quarter, down from 42% in the first quarter of last year, owing to improved operating leverage. First quarter net income was $700,000 or $0.04 a share compared to net income of $1.1 million or $0.06 per diluted share a year ago. EBITDA was $2.7 million during the first quarter, up from $2.1 million last year or 28% increase, largely due to our revenue growth and operating expense leverage. Excluding acquisition-related costs and other onetime expenses, first quarter adjusted EBITDA was $3.1 million, up from $2.5 million last year. Moving on to backlog. New orders in the first quarter of fiscal '25 were $7.5 million and backlog as of December 31st was $80 million as compared to $14.6 million this time last year. The backlog includes only purchase orders in hand and excludes orders from company's OEM customers under long-term programs, including Pilatus PC-24, Textron King Air, Boeing T-7 Red Hawk, the Boeing KC-46A and the F-16 with Lockheed Martin. We expect 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. Now turning to cash flow. During the first quarter of '25, cash flow from operations was $1.8 million compared to $4.2 million in the year ago comparable period. This decrease is primarily due to inventory buildup in support of anticipated production and the timing of payables and capitalized costs for the ERP implementation, along with the impact of growth initiatives discussed above. Capital expenditure was $300,000 during the first quarter of '25 versus $200,000 in the same period last year. As a result of these factors, free cash flow during the first quarter was $1.6 million versus free cash flow of $4 million last year. Total net debt as of December 31 was $25.9 million. Our net leverage ratio at the end of the quarter was 1.8. Our total cash and availability on our credit line was $9 million at the end of the first quarter, which provides us financial flexibility to support our ongoing operations and facility expansion. That completes our prepared remarks. Operator, we're now ready for question-and-answer portion of the call.

[Operator Instructions] The first question comes from Gowshi Sri with Singular Research.

Congratulations. In terms of this military revenue being now being a significant portion of the growth story, what strategies or investments are you making to be -- remain relevant to gain market share? I know you mentioned you had a gentleman you hired a couple of years ago. What other investments are required or spend necessary to continue to take market share in [Technical Difficulty]?

So far, for most part, we've been a second-tier supplier to the DoD. That means that we've always worked through an integrator. Even on some of the OEMs, we've worked through an integrator. We really haven't had any large-sized programs directly with the DoD. And in order to have those kind of contracts and be primed for it, which part of that also applies to the product lines that we bought from Honeywell for the F-16 platform, we've got to be what they call -- we've got to be compliant to a lot of these DFARS, the defense acquisition requirements. And so being compliant in terms of account -- what I call a certified government accounting is one of those requirements. Being able to have an IT organization that meets the requirements of the DoD is another one. Having your system in such a way that you can obtain security clearance, you have a means of protecting government documentation. So all of that is required for you to become a Tier 1 supplier to the Department of Defense. And we have implemented all of those -- and it's all going to be completed within the next few weeks. That requires you to bring in consulting, requires you to buy new tools, new -- where we put in a new ERP system, which has been in works for over a year, but we're putting it in place. Our ERP system, which was an MRP, old Minx was -- came into market in the 1980s. And we were at the point now where there were only 2 companies out there that we were using this with no support. So we've put in a modern ERP system in place, which would significantly help us run the business more efficiently because we can readily see information that management needs to see in terms of variances, cost and labor variances and other important information. But now it takes a lot of people to manually generate all of these things. All of that will automatically available by the system. So it does a significant amount of time and cost saving for us the implementation of that. So -- and we're applying for security clearance. We're putting all of that in place. And it gets us to a point we're looking at some of the serious military programs now. And even in order to be able to bid on those programs, they have to be compliant with a lot of default regulations. If you are doing a program which is less than $2 million, I think, which is the [ PENA ] limit, then which is typically in the past, we've done. You don't have to have any of this stuff in place. As soon as you go above that, a whole bunch of regulations get applied to you. But that's where we want to go. We want to grow the business. So we're very serious about it.

In terms of -- I know you guys had a foreign military engagement end of last year. How does the margin profiles of the foreign military engagements compare to the domestic market? I would assume you're able to extract better margin profiles or pricing from the foreign military programs.

Yes. I think if your foreign military sale doesn't go through the U.S. DoD, then you treat it as a commercial deal. If it's a procurement through the -- because our government buys -- I guess, gives funding to some of the allied nations to procure material. Essentially, that's going through the U.S. DoD budget. So it still applies to you. But in areas that kind of in the past where we sold systems to the United Arab Emirates Air Force or Pakistan Air Force that was not coming through U.S. funding, it's treated like a commercial deal. And some of the benefits of DoD contracts also that once your system is on a U.S. Air Force aircraft, it puts you in a strong position to put that system in other air forces' aircrafts. And if it's not something that's funded by the DoD, you get a premium price for it.

And so with this 40% military mix of business, as the company's [indiscernible] business continues to shift particularly in favor of the military, I know you guys had a 60% usually gross margin target. So what would you anticipate the new margin profile to look like kind of -- and will that be something you'll be targeting towards the end of the year?

I think -- let me put it this way. When we look to buy a program, buy say a product line, we really take a look at what EBITDA it gives us. And that's how we buy -- that's how we value a product. So at the end of the day, gross margins on military programs are significantly lower than commercial business. But here's what you don't have. You typically don't have any engineering expense because they separately pay for any engineering work you have to do. As with commercial programs, we have a high engineering burden on the products to deal with obsolescence and as well as your development efforts. In the military, they pay for your obsolescence engineering, they pay for your development, that gets paid. So you don't have the engineering overhead. In terms of SG&A, the sales side of the SG&A is very, very bare minimal military programs. You don't need to go to -- you don't need to keep on reselling the same thing to the military. Once you've been selected and you're in there, we got programs with U.S. Air Force now that we had 35 years ago, and they're still continuing. And they just send you their equipment, they give you orders when they need the product. So it has a much, much lower burden on your SG&A and almost 0 burden on your engineering. So in a way, the fact that the gross margin is not as good because by the nature of defense contracts, you have to justify all your costs. It kind of dilutes your gross margin. We think it's probably going to be at best around 50% gross margin. What we want to do is focus on gross margin to actual EBITDA and profit margin of the business. We believe that even though the military platforms have lower gross margin, in terms of EBITDA as a percentage of revenue, they meet the same margins as the commercial, which is what really matters.

And just my final question before I jump back in line. In terms of leveraging the balance sheet, how will you balance the need for the significant infrastructure spend, investments required in terms of expansion of production capacity and with the pursuit of strategic acquisitions?

Yes. So right now, the building and even the strategic initiatives are really getting funded through operations and our credit facility that we have today. As I mentioned right now, the availability with our cash on hand and our availability on our line is about $9 million, which provides enough. As we look at acquisitions, that profile can change. But we want to stay around the 3x leverage ratio on a go-forward basis. We're being very diligent with any acquisition and kind of being very mindful of the leverage ratios we want to [indiscernible].

Yes. I mean our -- yes, it definitely impacted this quarter because of the investments that we made. But if you were to adjust for them, it would have been significantly higher than last year.

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

I was curious, could you share with us your strategy with where the acquisition opportunities are coming from? Are you working with an investment banker? How exactly are you finding the opportunities?

So we have a Business Development Vice President that has significant experience in merger and acquisitions. He ran mergers and acquisition for Rockwell Collins for many years. And he retired, he is working for us -- retired from Rockwell Collins, he is working for us. We also talked to a lot of the bankers, I do, and he does as well as we have our marketing guys that are in the field and talking to the [ cust ]. I think most of the industry by now knows our strategy for acquisitions, and we get informed of these product lines when they come out for sale or licensing. As well as small avionics companies, we get the portfolio from -- there is a series of bankers that we talk to as well that deal with our pipe size. I mean most of the stuff that comes out in our industry is orders of magnitude larger than we could afford. But when the ones that are within our pipe size come about, we get to know them, and we evaluate probably 1 or 2 a quarter of small companies that come up. But I mean, we're only going to do it if it makes sense. I mean one of my thoughts is that if our government starts putting tariffs on imports from other countries, a lot of the smaller aviation manufacturers, avionics manufacturers that I know, they outsource their production. They don't have production capabilities. We are kind of very unique in that area that we had manufacturing capabilities in-house for everything. And that's kind of always been the strength of IS&S when it comes to whether there is tariffs, whether there is supply chain issues, our cost of material is small relative to our sales prices because of all the value-added things that we do in-house. So even if material goes up, it doesn't significantly impact our profitability. So that combination and that formula allows us to -- if they stop putting tariffs and a lot of these guys getting the boards made in Southeast Asia, their prices are going to go up. And we may be able to pick them up for a good price and then bring their production in-house and benefit from it. Just an idea that we believe may pay off if we pick the right company.

Yes. Now this 1 to 2 per quarter, is that number -- has that generally been fairly stable? Is it seem like it's increasing? Is it decreasing? Or what do you see there?

That's been pretty stable. That's been pretty stable. I mean for majority of them, you look at it and you see there's nothing that I'm interested in buying there. Once you dig in a little bit into -- we just looked at one a couple of weeks ago and kind of they're really -- they've got one product that is of interest. The rest of the business is losing money. And I don't think -- if we get it, we're going to be losing money on it as well. If you can buy that product line from them, that's good. But some of them are like this.

Yes. We're being very disciplined with the approach, and it has to fit in our bailiwick. So I really want to make sure it's something that makes sense for IS&S.

The next question comes from Andrew Rem with Odinson Partners.

Can you just remind us on the fourth quarter call, you guys talked about this pull-forward effect that you were expecting to come in the second quarter, just any revised thoughts that you have now that we're in it?

Right. So what I think you're saying, Andrew, is when we talked a little bit, there might be a little bit of an uptick in Q2, around the military product line that we may see. So yes, there is a potential there might be an uptick in the revenue side from the Honeywell military product line. A lot of that is still being operated at Honeywell under the transition services [indiscernible] agreement. So we do have visibility there. But we're in constant contact with them on a weekly basis. Some of those deliveries may begin delayed a little bit and they're having some potential issues. That's why we want to get a transition to IS&S in a timely fashion. But there potentially could be an uptick in the revenue on that product line in Q2.

So is it still in the plan that the manufacturing will transition over in the second quarter or maybe some of that pushes into the third quarter?

So it's going to be in the third quarter. Second quarter is the quarter we're in now. And so the transition is going to happen in the third quarter. I'm hoping that it will happen in the third quarter. Let me put it that way. Because right now, I think they're talking about May. And they have -- Honeywell has to build sufficient amount of backlog and deliver it to Lockheed before they can shut down the line and go through the transition. And I think there was some heat sink part or whatever that they had issued. We've actually told them that we can manufacture it for them here in-house to try to expedite it, but we still haven't seen the drawing for it. But it's going to be somewhere around, I would think, either May or June time frame. Hopefully, it won't get into July, but definitely not this quarter.

And then, Jeff, is there any financial benefits that we can expect over time from the ERP implementation?

Yes. So I think when you have an ERP system. What does that give you? It gives you better data, so management can make on-time reaction to information. So I think we'll see efficiencies throughout the organization, how we manage the business. So my expectation is people will then be able to look at the data to make better decisions than trying to -- I don't want to say create the data, but trying to extract data to make it a usable form. So now they'll have time to analyze it, we can look at labor changes, even products with suppliers too. So I'm envisioning we'll have some better information for all the users of the financials.

I think in general, today, everybody that wants anything, they go in there, they pull the data, export it to Excel spreadsheet, and they try to manipulate it on Excel and then generate...

Right. Time consuming.

Generate charts and it takes time to do that as with the new ERP system. All of these are all available on your screen.

Correct.

And then it sounds like there's a lot going on. I mean you've got the acquisition. And then, I guess, in conjunction with that you talked about some of the things that you -- the IT system, the ERP, getting in compliance with the military standards. And then obviously, you've got the construction project, which is up and running. Will you be at kind of a normalized by the time you exit fiscal '25 with all of this stuff going on?

I'd like to think that by Q4, we should be in good shape with all of this.

I would add. I think we should be able to be normalized depending on any other acquisitions for what we have in front of us.

Yes. I think by end of Q3, we should be...

Yes. Building will be done, ERP will be. And listen, I mean as you put in...

Barring a big delay from Honeywell…

Yes.

To do the transition, we should be -- because right now, we're paying -- in a way, we're paying double duty here. We're paying cost of goods sold to Honeywell. We also have a team here that are getting trained to do the job. So that affects our gross margins and profitability. As soon as the transition happens over here, then we don't have to pay the Honeywell technicians. We're just paying ours.

And then, Jeff, if I understood your comments right, maybe this quarter is kind of the low point for gross margin and then they can kind of improve. But I'm also kind of wondering if we should really just maybe just thinking about this business, don't worry too hyper focused on gross margin and just maybe focus on EBITDA margin.

That's correct. I think you really want to focus on those EBITDA margins because, again, if we have that big tick in Q2 on the military, it's volume and the product mix that's going to impact those gross margins. But even as I mentioned, this quarter, depreciation expense was $500,000 higher than it was this time last year, Q1 last year. So that impacted those margins about 500 basis points. So you have things like that with these acquisitions. So yes, I would say EBITDA is a better metric to look at from that perspective than focusing on margins because, again, it's going to be around product mix.

So if we kind of look out at a more normalized, what is your current expectation for what that can look like?

EBITDA margin?

Yes.

So we're actually projecting EBITDA year-over-year by 30%, and we feel confident about that number today.

Even with Q1 numbers...

Yes. I mean Q1 was 28%, so we're right there. So we still feel confident with the 30%.

This concludes our question-and-answer session. I would like to turn the conference back over to Shahram Askarpour for any closing remarks.

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

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.