Innovative Aerosystems, Inc. (ISSC) Q4 2014 Earnings Report, Transcript and Summary

Good morning and welcome to the Innovative Solutions and Support Fourth Quarter and Fiscal Year-End 2014 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to Mr. Geoff Hedrick, Chairman and CEO. Mr. Hedrick, you may begin.

Good morning. This is Geoff Hedrick, I'm Chairman and CEO of Innovative Solutions and Support and I would like to welcome you to this morning to our conference call to discuss fourth quarter and fiscal 2014 results, current business conditions and our outlook for fiscal 2015. Joining me today are Shahram Askarpour, our President and Ron Albrecht, our CFO. Before I begin, I would like Ron to read our Safe Harbor statement. Ron?

Thank you, Geoff and good morning everyone. I would remind our listeners that certain matters discussed in the conference call today including operational and financial results for future periods are forward-looking statements that are subject to the 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. I'll now turn the call back to Geoff.

Thank you, Ron. Revenues for the fiscal year were $44.1 million compared to the $31.6 million for 2013. Net income for the year was $200,000 or about a $0.01 a share compared to $1.9 million or $0.11 a share for 2013. Fiscal '14 net income included a $2.6 million after tax charge or $0.15 a share related to previously disclosed purported termination by Delta Airlines of a contract with the company. Fiscal 2013 included a charge of $486,000 or $0.03 a share related to a legal matter. Unfortunately our momentum has been disrupted by Delta Airline's purported termination of our contract to provide cockpit and navigation upgrade to Delta's MD88 and Delta's MD90 fleet. This matter is proceeding to non-bidding mediation. I would like to emphasize that although we have taken a charge to earnings to establish a reserve, to eliminate our balance sheet exposure related to the Delta contract, this action does not imply that we have relinquished any of our rights or remedies under the terms of our contract. We intend to pursue full recovery of all of our claims under the provisions of the agreement. In November the FFA awarded an STC for our flight management system and a flight tech upgrade to the Boeing 737 Classic upgrade. With approximately 1300 737 Classic aircraft still in service this STC opens a very large new market assuming we expect another market to open up for us when we receive certification of our C130 integrated cockpit. We’re presently in customer flight test acceptance and we’re in a process of negotiation production orders for both of these aircraft. In addition, we continue to make progress on a couple of significant new product developments, the largest of which is a utilities management system for the Pilatus PC-24. This system controls upwards to 24 systems onboard the aircraft and a quadruple redundant computer system. Coupled with a Boeing 737 Classic upgrade, the Eclipse 550 and C-130 we have several programs in which production will extend over multiple years. With regard to development programs which comprise of approximately a third of our sales in fiscal 2014, we expect these revenues to be replaced with product shipments in fiscal 2015 with an attended overall improvement in gross margin as a percentage of sales. We must rebuild our backlog. We have been in this situation in the past and have been able to adapt successfully. At this time we’re fortunate to have the benefit of the Boeing 737 STC, several new products over the past two years and improving economy and a dramatic decline in fuel prices. We expect the fuel prices to remain in this level over the next several years significantly strengthening the appeal of used aircraft. The cost of a 737 Classic is under $3 million as opposed to almost $50 million discounted price of a new one. We have adjusted our expense level to reflect and anticipate fiscal 2015 order intake and revenue expectations. Although we do not anticipate any significant improvement in production revenues in fiscal 2015 we expect gross margins to improve toward the historic 50% levels, we expect to continue a string of profitable years to fiscal 2015 although the quarters maybe variable. Fiscal 2015 will be a year of adjustment, we have a solid financial position, a growing portfolio of products offering the best price for performance in the industry and a number of additional new products under development all of which are strengthens upon which we build. If a domestic economy continues to improve it can provide strong additional impetus to our growth. Now let me turn it over to Ron.

Thank you, Geoff. In the fourth quarter we reported revenues of $9.9 million, increase of $8.0 million in the same quarter a year ago. A net loss for the fourth quarter was $2.1 million or $0.12 a share compared to a net profit of $155,000 or $0.01 per share in the same quarter a year ago. These results conclude our 6th consecutive profitable year quite recognizing the charge related to the Delta contract and generating 32% of our revenues from product development contracts which in the aggregate produced a net negative margin for the year. For the year revenues were $144.1 million, an increase from 32 million in fiscal 2013. We’re at $0.01 per share in 2014 after the effect of $0.15 charge related to Delta contract compared to $0.11 in fiscal 2013 after the effect of a $0.03 charge related to a legal matter in that year. Product sales in the fourth quarter was $6.6 million an increase from $5.5 million in the fourth quarter of fiscal 2013, a lower than third quarter product revenue of $7.6 million. Engineering development contract revenue was $3.3 million in the quarter an increase from $2.6 million a year ago and up slightly from $3 million in the third quarter. Engineering revenue peaked in the second quarter and as Geoff mentioned we expect engineering revenue decline over the course of 2015. Including our R&D we invested nearly 40% of fourth quarter revenue in product development. I would mention again that engineering revenue represents primarily [Technical Difficulty] expenditures in support of their programs. This revenue is only marginally if at all profitable a fact which reduces overall gross margin. Production margins should continue to be in the 50% range. Total operating expenses for $6.2 million included in operating expenses was the effect of recording a $3.7 million reserve against the unbilled receivables due from Delta. With this charge we have no balance sheet exposure related to the Delta contract, after excluding the effect of reserve expenses were $2.5 million essentially unchanged from the third quarter but higher than $2.1 million in the fourth quarter last year. Year-over-year increase reflected an over $300,000 increase in internally funded research and development. Sequentially operating expenses were down insignificantly from the third quarter excluding the effects of the contract charge. As Geoff mentioned we have taken our actions to better align our cost structure with our current backlog. Engineering program requirements and anticipated revenues, the full effect of these actions will be reflected beginning with the second quarter results. We reported a fourth quarter operating loss of $3.3 million, a decrease from operating income of $47,000 for the fourth quarter of 2013. Before the impact of the charge operating income was $602,000, in the fourth quarter income tax rate was a 36% benefit and included cumulative effect of adjusted provision for the first three quarter to the full year provision. Going forward the tax rate should approximate 28% drawing a congressional [ph] reinstatement of the R&D tax credit. Net loss for the fourth quarter this year was $2.1 million or $0.12 a share compared to a net income of $155,000 or 1% share a year ago. In the fiscal 2014 fourth quarter the Delta related after tax charge was $2.6 million and $0.15 a share, the establishment of the related reserve had no cash impact. At September 30, 2014 the company had $15.2 million of cash on hand compared to 14.4 million at the end of the third fiscal quarter and $16.4 million at the September 30, 2013. Cash generated from operating activities was $908,000 in the quarter, an improvement from $567,000 of cash used in the fourth quarter of fiscal 2013. For the year the company used $700,000 in operating activities, an improvement of over the $2.2 million used in fiscal 2013. [Indiscernible] operating cash primarily to support product development contracts and certain onetime inventory purchases. This usage is reflective in the increase on unreal receivable and inventory on the balance sheet at September 30, 2014. Timing differences between the company spending and customer payments on engineering contracts has resulted in the aforementioned cash usage over the past two years. During fiscal 2015, we expect many of these timing differences will reverse as these engineering programs reach billable milestones or approach completion. Before I turn the call over to Shahram Askarpour for further comments on market conditions and operations, I would like to introduce Relland Winand who will succeed me as Chief Financial Officer effective December 15, 2014 at which date I will retire. Mr. Winand has served in a number of executive financial capacities with public companies including Chief Financial Officer of ECC International Corp, a manufacturer of computer controlled maintenance simulators primarily for the department of defense and Vice President of Finance and Administration of Traffic.com, Inc a leading provider of accurate real-time traffic information in the United States. Majorly prior to joining Innovative Solutions and Support, Mr. Winand was Chief Financial Officer of ORBIT/FR Inc, the international developer and manufacturer of sophisticated microwave test measurement systems for Aerospace Defense, Wireless Satellite and Automotive industries. He has over 30 years' experience in financial management and reporting for both public, domestic and international manufacturing companies. Mr. Winand received a BS in Accounting Drexel University and an MBA in Finance from Widener University. He is presently controller of Innovative Solutions and Support. I will now turn the call over to Shahram Askarpour. Shahram?

Thank you, Ron. Good morning everyone. As Geoff Hedrick and Ron have mentioned there have especially being two sequential changes since we last spoke in addition to the relative situation which Geoff discussed. I would now like to provide some prospective on how the effect our plan to this current fiscal year and over the long term. In November the Federal Aviation administration issued us supplemental types of education [ph] for our flight management system Boeing 737 Classic Aircraft. This STC represents significant milestone of the multi-year NNSA program where we have been systems integrator. As a result of this STC we now offer the most advanced Boeing 737-300, 400 and 500 next gen retrofit. The product that includes required navigation performance, required time of arrival, localized performance with vertical guidance and wide area augmentation system, global positioning and system capability. By upgrading with our FMS operators of Classic 737 transport aircraft will enjoy the navigational capability and performance equivalent to that of a new production aircraft. In addition the FMS provides the flexibility for function of and has been as next gen requirements evolve. By our estimation approximately 1300 Boeing 737 Classic aircraft are currently in operation and candidate for our new FMS industry operates [ph]. As jet fuel prices have dropped continued service for these aircraft have become significantly attractive despite the higher [indiscernible]. If you’re not familiar with the next gen requirements, essential fact is that next gen is the center of the FAA's plan to modernize the national aerospace. The FAA is implementing the improvements the air traffic system, and take advantage of these improvements, an aircraft must be equipped for the appropriately functionality. In the relatively near feature air craft [indiscernible] with next gen capabilities are going to be an disadvantage compared to newer properly equipped aircraft. For instance, Classic Boeing 737 aircraft do not have next gen capabilities. Our building capabilities into our products that not only comply with current next gen requirements but also allow for easy operate to new requirements that the FAA may introduce. Those capabilities are important differentiators for our price per performance value proposition. In addition to the recent Boeing 737 STC we expect soon to receive FAA certification for our C-130 and L-100 integrated cockpit upgrade. Further the Eclipse 550 aircraft entered production in 2014 and the Pilatus PC-24 aircraft begins flight this coming spring. The Boeing KC-46A the fuel tank is expected to enter production in 2016. We will soon will be taking production orders for these products. These potential orders will increase as a percentage of total revenues and will lead to higher margins compared to the past couple of years during which low margin engineering development revenue has been a significant portion of our revenue. We also see a strong market for our C-130 cockpit. We have the delivered over 150 shipsets of our engine instrument primary display system for this aircraft flying over the past several years and our addition of the flight management system for this aircraft increases our market share at context [ph]. With the new production and product investment demands for the past few years we have much greater internal focus on product development and transition to production than we had in the past. 2015 we see the opportunity, begin to realize the profit potential of our product development strategy over the past several years and to capitalize on our competitive strengths. That will build our intellectual property around next gen, cockpit technology and system integration and we offer the best price for performance in the industry. I would now like to turn the call back to Geoff.

Thanks Shahram. I believe fiscal 2015 will be a year in which we adjust -- set the stage for a new growth phase. As Shahram has indicated we have the cash, technology and most importantly people to resume our growth. I'm confident in our organization and especially our management team. We can overcome the setback related to Delta program because of this upcoming year presents such a challenging situation, the Board of Directors has requested that I postpone my previously announced retirement and I’ve agreed to stay on for some period to support our efforts to complete our current engineering development programs to grow sales of our exciting products and achieve another profitable year. I would like to comment on the retirement of Ron Albrecht. I want to express both the company's appreciation and my personal appreciation. Ron and I have worked together for over 32 years since he was CFO in Smiths Aerospace. Ron has served as an invaluable role over the last year both as a counsel and as a friend. Thank you, Ron. I would like to take questions now.

[Operator Instructions]. The first question comes from David Campbell with Thompson, Davis.

Ron, I couldn’t quite hear the amount of the charge in the fourth quarter, was it?

After tax $2.6 million, David. Pretax 3.9 million.

What is that just takes reserve for the receivables, is that what it does?

3.7 million is reserve against the receivable, I didn’t mention it but there is a couple $100,000 inventory reserve as well.

So it is safe to assume that over the last year you’ve had $3.7 million of revenues?

I think that that’s spread over a couple of years David. Not just over one year.

Rather than four, few years, okay. And Geoff, I mean I don’t understand what the dispute is about with Delta. I mean they don’t want the equipment what's the fuss about? Just take the charge and go on I don’t quite understand it.

We’re similarly puzzled but the agreement is unambiguous it's very clear what happens under a varying conditions and as in this business anybody has a right to terminate it an agreement or a contract and in this case it was well spelled out and I think it's simply a -- we have to resolve how much apparently it was a fixed maximum number and I suspect they would like to discuss that. So I can't go into details on it obviously but I can only tell you that we’re puzzled, we were hopeful and reasonably optimistic that we will make clear the situation is I'm not sure they fully understood when we first discussed it.

And how do you think they are going to operate the aircraft without next gen capability?

I can't even speculate but I can tell you one thing that it has been really significant, in the last three months this plunge in oil prices and jet fuel prices is profoundly impacted used aircraft market. This makes those aircraft increasingly valuable and I think a lot of airlines that had planned on getting on rid of their older aircraft may rethink this because imagine if you can get an aircraft for well under $10 million to instead of spending it -- the list price being about 90 million and discounted maybe 50 million you can buy a whole hell a lot of fuel for $30 million. So I think it's a good thing for our products is and Shahram mentioned things like the C-130 program and which we have already delivered over a 150 systems and they are flying very successfully, that’s another very nice long term program that we started up almost eight years ago and has provided an ongoing continued revenue and we expect that revenue to grow very rapidly now that it's clear that the equipment onboard the aircraft. Now it seriously inhibits the deployability of the aircraft. So there is some good news on the Horizon. I don’t know what's going to happen but I will say that it's our intention to finish up the program and get an STC in the series aircraft as well. So we will be prepared to service it and there are now operators who I think had planned on getting rid of their aircraft may now reconsider it with the prospect of a significantly lower fuel prices and most think over an extended period of time.

[Technical Difficulty] it's probably not going, probably decided not to keep those MD88s and now may rethink that and what about the--?

I can't tell but we’re trying to -- quite frankly the MD88 program was, we took on as a service to Delta in anticipation of other business in their fleet and it was -- we always knew that it was a smaller opportunity that certainly is a 737. So we still have a 737, and that program is going on successfully and as I said the flight testing on the C-130 right now is going on for the last two weeks apparently going very well.

And what about the Delta 757s and the 767s, there was a time when I saw maybe they would need these next gen capability in those aircraft, is that not right?

I remember, they have yet to make that determination but you know you’ve got three year's until the active implementation of the first phases of next gen and the culture we get, we’re used to that. Remember, RVSM was not a similar situation. So we don’t know -- we know that we have products that will service it and now with the acceptance of the flight management system it looks very positive. We have a complete CNS/ATM upgrade path now for an operator at a significantly lower cost.

You’re not the only one that’s seeing and according to reports I’ve Rockwell Collins has developed a flight management system for the Beechcraft King Air and hopes to get certification soon.

Well Beechcraft King Air is not a commercial air transport flight management system. To give you some sense we had a far more comprehensive system installed and certified over four years ago and the Eclipse, it included things like auto-throttle which this Collins one does not have and a huge number of very advanced features and it still took us probably $8 million or $10 million and an additional four years to come up with a commercial air transport version. The difference between the King Air and an air transport is profound.

I got that, but the point is that they are new competitor for Part 23 aircraft.

They are only a competitor in the King Air.

Right. And according to them other aircraft will be certified in the future, so?

They attempted to do this over 20 years ago and bought flight management system technology for a substantial amount of money and apparently we’re not able to get it certified in the system. They are very confident, very seasoned competitor but they are not a new competitor. I will remind you they made the primary flight equipment that we replaced on 500 aircraft.

Ron, you mentioned that the expense levels -- you implied that they would remain high in the first fiscal quarter?

Yes we took actions to reduce the cost base during the first quarter and needless to say a significant portion of that was personnel and there is severance associated with that. So you won't see the full effect until the second quarter.

Right. And primarily your SG&A expenses are in your cost of product?

Throughout, certainly in production overheads, engineering and SG&A.

Okay. Just so we’re likely and Shahram I think you mentioned that product revenue growth will offset the decrease in engineering revenues in the fiscal '15 year, is that or will not be that much?

I think I would like to reflect that the ratio is going to weigh more towards production than it was in the past.

But overall you expect revenues to go down, system revenues to go down in fiscal '15?

Well we know that the -- we expect significantly for the NRE revenues to go down in 2015 that we know.

I'm sorry, what's NRE?

Engineering development contracts, it's about 14 million [ph].

That will go down and it won't be offset by completely by product growth rate?

Not at all.

Thank you. And the next question comes from Scott Lewis with Lewis Capital Management.

You mentioned during the call that on the 737 FCC it was currently in flight test with an operator -- are you referring to the NNSA or a different operator?

What I talked about is, I talked about 737 and I think you’re referring to the C-130 flight test program that’s also going on the same time and that we have the customer already so that’s customer acceptance. The 737 certification occurred on NNSA airplane and we see significant opportunity, near term opportunity on 737.

Okay and on the 737 there was an announcement about a year ago I think it was 7 shipsets, was that a different -- was that not the FMS?

Yes that included our flight management system, our display system, the standby system, and [multiple speakers].

And that’s the one under flight testing?

Right, that’s correct.

And then I'm just thinking back to when the Delta contract was announced I think it was in 2012, right before that, before Delta you’re further along now it sounds like than you were then as far as all these other engineering projects have gotten further along. I mean it seems to me you’re now in kind of better shape now than you were before Delta, or did something drop out that I'm not remembering?

We’re in better shape broadly, obviously the direct impact of a significant production program like that is difficult but at the same time production program such enormous amount of engineering resources that is assigned other opportunities that so that we can now focus on those other opportunities which we think are significantly larger than the Delta one but honestly back then a bird in a hand was better than one in a bush.

Thank you. And the next question comes from [indiscernible].

Couple of questions, does the Delta agreement require arbitration?

Not arbitration, mediation, non-binding mediation.

And so you can go from mediation to courts where if you guys agreed then you can go to arbitration but there is no arbitration requirement. Typically it's mediation and then arbitration in the way these things are written up. In your agreement it's just mediation and then you go to the court system.

That’s correct.

I imagine and I was looking for it but maybe I’ve just missed it that the Delta contractors in terms to one of your filings, did I miss it somewhere?

I'm not quite sure I understand the question.

Sure. So the contract obviously is a significantly one both built-in in our company or public companies, so I'm imagine that you must have put the Delta agreement as an addendum or an exhibit to one of your prior public filings or maybe it's coming out in this filing.

No we didn’t. In consultation with our council we deemed it to be normal course business and therefore didn’t.

Okay. So at this point you know obviously this is a significant contract and a lot of us are trying to understand and I'm sure you guys as well are trying to you know like us, the shareholders to understand what maybe do us under the contract. It sounds like they didn’t understand that over Delta and so it seems to me it's a good idea to make the contract public and I know you guys will have to review that but I see no issue with that whatsoever and whether you’re obligated or not, it certainly feels material to me as a shareholder and the questions you’re getting you can see it's material to other shareholders. But I would like you to consider that and because I think it will be enormously helpful to investors.

I think that we will discuss it with our counsel but I think it is unlikely that we will do that and I doubt that that Delta would want that made public either. So I think the answer is probably going to be no.

Okay, well give it some thought because you might also find it helps in your negotiations with them and nothing wrong in doing it both are public companies and certainly material over here. Let me just ask you further on the write downs in Q1, when we get into Q2 based on your current order rate and business levels that you’re seeing we then return to cash as well as accounting profitability? Cash positive and accounting?

I think that over the next two and three quarters we expect to be cash positive, yes. I think we said also that profit might be variable during the course of the year.

And lastly on the cost cutting give us an order of magnitude like you’ve mentioned we’re right sizing the given our change in business level for right sizing our cost structure, what are we looking at on a [indiscernible].

I really don’t think we are going to get into that kind of detail, thanks. You will see the effects over the next couple of quarters in the financial statements.

[Operator Instructions]. And we do have a question from Rick Teller with Pemberton Research.

Unlike everyone else, I just have one question, in September what it's a 23rd? There was an article in the Wall Street Journal entitled report false roll-out of air traffic control upgrade and I guess some of the inspector general of the transportation department put out a report criticizing the whole next gen project in terms of performance and cost and so forth and it pointed out that many airlines are reluctant to spend any money on this because they think there is enough issues with the next gen that the FAA may end-up kind of putting it back on the back burner and so forth. I'm just curious what your thoughts are about that whether the problems are easily solvable or whether there is any risk that the FAA might say, oh yes we’re still going to do it but we’re not going to really start until the 2022 or something like that?

Well I can always go back in history, certainly from the start of my career there were things like Altitude Reporting Mode C which was fought by the industry and of course is now an integral part of the air traffic control system. A reduced vertical separation minima was greeted with the same reluctance and disbelief and that was successfully implemented and we produced about 60% of the retrofit equipment in the world. That was a major revenue generator. Most recently I forget what was from the FAA was asked about whether they anticipated a delay in the 2018 implementation start of next gen and he reiterated he said absolutely not, there will be no slip in the 2018. So it's anytime you have a massive change like this you get some reluctance to get involved. Secondly, inevitably the initial anticipated cost is about double of what it actually turns out to be. Certainly RVSM was anticipated to be $0.25 million to a $0.5 million per aircraft upgrade and it ended up being in most cases well under a $100,000. So they are seeing the same kinds of things as other people including ourselves get involved and they previously quoted prices to comply have plummeted. So I would have anticipated it happening, I would also say it's both a 45 year old pilot and an aerospace executive that next challenge is not only a good idea there is no alternative. We must have a massive upgrade to the air traffic control system. Keeping a clipboard on your knee to record clearances is beyond crazy. So I think it will be a huge asset both in safety and in operational efficiency. I'm not biased though.

Thank you. And we have a follow-up question from [indiscernible].

Just getting back to the Delta agreement and just to share with your counsel, I know in their corporate setting, my knee-jerk reaction would be as yours I'm not putting that out into the public but from - and I will be happy to chat this with your counsel if you would like but I do think it's material and then secondly the other thing to keep in mind is that since you’re not going to arbitration if the meditation sales but will be going to the court system obviously that agreement would become public as soon as you file a claim against Delta. So it's already on it's way to being public and if you do end up going that route to make it easier for our shareholders rather than have to dig through the court documents. I think there is way to access it there, put it out there and we have got nothing to hide on it. You can read any information you want meaning black it out [ph] and it is an important document given that--

It's an important document but it's not our document, it's not our document and that’s --

It's an agreement, you’re a party to an agreement it sure is your document, if I sent you a letter it's your document.

It is a contract from Delta.

Yes right. Well check with your counsel, but if that’s what's your hold up they will assure you that it is your document and I think a hard look at it, will tell you that it's material to shareholder. So and I'm not saying this to challenging you to it, but just to be informative. The fact that you’re a signatory of the document makes it your document and unless it has in there a non-disclosure you cannot put this document out to the public which would be bizarre for few public companies. You can. So I would check it, do your best to not have the knee jerk that says, Oh gosh, I don’t want this out because I think it actually will help you and you indeed may be required to do it but either way I think it's helpful for the company. If you would just give it a calm rational analysis and I think counsel will maybe view it as something that’s helpful, not harmful. I don’t see any harm in it and I think you’re actually required to do it. Just if you would give it a good hard look I sure would appreciate it.

Thank you.

Thank you. And this concludes our conference for today. Thank you for attending today's presentation. You may now disconnect your lines.