Innovative Solutions and Support, Inc. Price & Performance (ISSC)

Thank you, Michael. Good afternoon, everyone.

And welcome to Innovative Solutions and Support's first quarter twenty twenty five results conference call.

Leading the call today are our CEO, Sharon Osgopur and CFO, Jeff DeGiovanni. Earlier today, we issued a press release This release is publicly available the Investor Relations section of our corporate website at www.innovativess.com Innovative. I would like to remind you that management's commentary 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, the press release issued earlier today. Today's call will begin with prepared remarks from Sharam, who will provide a review of our recent business performance, 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 Sharon.

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. 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 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 details here shortly. Our backlog was approximately $81,000,000 as of 12/31/2024, compared to $14,600,000 in the prior year. On our call, last quarter, we introduced [indiscernible] 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 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. SumUp 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, have integrated a modern ERP system a more robust IT infrastructure and strengthen 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-twenty twenty five, 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 field 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 and L. Importantly, we are adding this capacity with a capital investment of only $6,000,000 providing for the opportunity of a very strong winter. We also think it's worth reminding everyone that ISNS manufactures 100% of its products in our Exane 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 Excom 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 headcount 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 UMS2 remains on track to have our first test flight by mid-twenty twenty five for the Pilatus PC-twenty four. 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 our IS and S to win in the market. In conclusion, are off to a solid start for our fiscal twenty twenty five 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 avionic 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 twenty twenty four. If that's I'll turn the call over to Jeff for his prepared remarks.

Thank you, Sharon, 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 $16,000,000 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 due to impart including the continued momentum of our new military program. Product sales were $10,000,000 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 6,000,000 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 $6,600,000 during the first quarter, up from 5.5 driven by strong revenue growth partially offset by higher depreciation expense resulting from the Honeywell acquisition duplicate costs and support of the migration of the recent Honeywell acquisitions and continued investments in growth initiatives as Sharon 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 [indiscernible] 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 acquired Honeywell military product line volume [indiscernible] was approximately 500 basis points increased third party expenses from Honeywell with respect to our 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 and S. Given these factors, we continue to expect our consolidated gross margins will likely trend closer to mid-fifty percent 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 twenty twenty five was $5,300,000 an increase of from $3,900,000 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 increased in headcount and another $300,000 of acquisition and certain one time expenses. We've increased our headcount 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 $1,100,000 or $0.06 per diluted share a year ago. EBITDA was $2,700,000 during the first quarter up from $2,100,000 last year or 28% increase largely due to our revenue growth and operating expense leverage. Excluding acquisition related costs and other one time expenses, first quarter adjusted EBITDA was $3,100,000 up from $2,500,000 last year. Moving on to backlog, new orders in the first quarter of fiscal twenty twenty five were $7,500,000 and backlog as of December 31 was $80,000,000 as compared to 14,600,000.0 this time last year. The backlog includes only purchase orders in hand excludes orders from company's OEM customers under long term programs including Lattice PC-twenty four Textron King Air Boeing T7 Red Hawk, the Boeing KC-46A and the F-sixteen 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 twenty twenty five, cash flow from operations was $1,800,000 compared to $4,200,000 in the year ago comparable period. This decrease is primarily due to inventory buildup in support of anticipated production the timing of payables and capitalized costs with the European implementation along with the impact of gross initiatives discussed above. Capital expenditure was $300,000 during the first quarter of twenty twenty five versus $200,000 in the same period last year. As a result of these factors, free cash flow during the first quarter was $1,600,000 versus free cash flow of $4,000,000 last year. Total net debt as of December 31 was $25,900,000 dollars our net leverage ratio at the end of the quarter was 1.8.

Our total cash and availability on our credit line was $9,000,000 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.

We will now begin the question and answer session. The first question comes from Gaoshi Sree with Singular Research.

Please go ahead.

Congratulations guys. Can you hear me?

Yes. Thank you for taking my call. Congratulations.

In terms of the military revenue being now the significant portion of the growth story. What strategies or investments are you making to be remain relevant to being market share? I know mentioned you had a gentleman you hired a couple of years ago. What are the investments required or spend investments necessary to step continue to take market share and pay market share? So far, for most part, we've been a second tier supplier to the deal. That means that we've always worked through an integrator, even even on some of the OEMs we've worked through an integrated really haven't had any large size 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 from Honeywell for the F-sixteen platform we've got to be what they call we've got to be compliant group. To a lot of these [indiscernible] And so being a FAR 15 compliant in terms of our account, what they 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 one supplier to the Department of Defense.

And we have implemented all of those come it's all going to be completed within the next few weeks.

That That requires you to bring in consulting, requires you to buy new tools, new we put in new ERP [indiscernible] for over a year, but we're putting it in place Our ERP system, which was an MRP, called Mink's Was came into market in the 1980s And we were at the point now where there were only two companies out there that we're using is 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, Another important information that now it takes a lot of people to manually generate all of these things.

All of that will automatically be available by the system. So it does a significant amount of time and cost saving for us the implementation of that. So we're applying for security clearance we're putting all that in place [indiscernible] Yaron, 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 It's a program which is less than $2,000,000 I think which is the PINA limits, which is typically in the past we've done. [indiscernible] 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. We've got to get serious by that.

Okay. Awesome. 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 compared to the domestic market? I would assume you're able to extract better margin profile or pricing from the foreign military programs? Yes.

I think if your foreign military sale doesn't go through The U. S. DoD.

Then it's you treat it as a commercial If it's a procurement through the because our government by I guess gives funding to some of the allied nations to procure material. Essentially, that 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 [indiscernible] 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 Some of the benefits of [indiscernible] 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 [indiscernible] And if it's not something that's funded by the DoD, you get a premium price for it.

Okay, got you.

And so with this 40% military mix of business, as the company's Dixsolexis continues to ship 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, by, 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 than commercial [indiscernible] Here's what you don't have. You typically don't have any engineering expense.

Because they separately pay for engineering work you have to do.

As with commercial, commercial programs, we have a high engineering burden on the product 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, So you don't have the engineering overhead. In terms of SG and A, the sales side of the SG and A is very, very bare minimum relative programs. You don't need to go to you don't need to keep on reselling the same things to the military. Once you've been selected and you're in there that we had thirty five years ago and they're still continuing. 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 and A and almost zero burden on your engineering. So in a way, the fact that the gross margin is not as good Okay. By the nature of defense contract, 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 % gross margin. What we want to do is take the focus on gross margin to actual EBITDA and profit margin. Of the business. We believe that even though military platforms have lower gross margin in In terms of In terms of EBITDA as a percentage of revenue, then they meet the same margins as the commercial.

Which won't really matter. Got you. Got you. And that's 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 funded through operations in 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 $9,000,000 which provides enough As we look at acquisitions, that profile can change.

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 the leverage ratios we want to [indiscernible] [indiscernible] So it definitely impacted this quarter. Because of the investments that we made [indiscernible] if you were to adjust for them, it would have been significantly higher than last year.

The next question comes from Doug Rooth with Lennox Financial Services. Please go ahead. Hi, Sharma, Jeff, thank you for hosting the conference call.

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

How exactly are you finding the opportunities?

So we have 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's he retired. He's He's working for us.

Is working for us. We also talked to a lot of the bankers I do and he does, as well as we have we have our marketing guys that are in the field and talking to the cost I think most of the industry by now knows our strategy for acquisitions. And we get we get informed of these product lines when they come out when they come out for sale or licensing, As well as small avionics companies, we get the portfolio from there's a series of bankers that we talk to as well. That deal with our price size. I mean, most of the stuff that comes out in the is orders of magnitude larger than we could afford. But when the ones that are within our bite size come about, we get to know them and we evaluate probably one or two 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 If our government starts putting tariffs on imports from other countries, A lot of the smaller Small aviation manufacturers and the honest manufacturers that I know They outsource their production.

They don't have production capabilities. We are kind of a very unique in that area that we cut manufacturing capabilities in house for everything. And that's kind of always been the strength of ISRS when it comes to whether there is tariffs, whether there is supply chain issues, our cost of material is small relative to our sell prices, because of all the all the value added things that we do in house. So even if material goes up, it doesn't significantly impact our profitability. [indiscernible] that That combination and that formula allows us to if they stop putting tariffs and a lot of these guys get in the board 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 to idea that we believe may pay off if you pick the right company.

Yes. Now this this one to two 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.

Okay.

That's been pretty much I mean, for majority of them, you look at it and you see there's nothing that I'm interested in buying.

Once you dig in a little bit into We just looked that long couple of weeks ago.

And kind of [indiscernible] They're really they've got one product that's 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 we really want to make sure it's something that makes sense for IS and S. Okay. Well, I appreciate you answering my questions. I want wish you all the best and we're looking for [indiscernible] this growth to continue. So thank you for taking my question. Thank you. The next question comes from Andrew Rhem with Odinson Partners.

Please go ahead.

Gentlemen, can you just remind us On the fourth quarter call, you guys talked about this pull forward effect that you're 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, was 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 at Honeywell under the transition services 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. They're having some potential issues. That's why we want to get a transition to IS and 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 that 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 [indiscernible] [indiscernible] so the the transition is going to happen in the third quarter.

Hoping that it will happen in the third quarter. Let me put it that way. Because Because right now, I think they're talking about May. Great. 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 heating part of all of that they had issue. 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 timeframe. Hopefully, you won't it won't get into July.

But But definitely not this quarter.

Okay.

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 a European piece 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 don't want to say create the data, but trying to extract data to make it a usable form. So now 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 that are 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 in your on your screen.

Correct.

All right. And then It sounds like there's a lot going on. I mean, you've got the acquisition, I guess, in conjunction with that, you talked about some of the things that you're IT system, the ERP, getting in compliance with 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 [indiscernible] [indiscernible] 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 echo that. I think we should be able to be normalized depending on any other acquisitions.

Yes.

What we have in front of us. Yes. I think by end of Q3, we should be yes. Yes. The building will be done, ERP will be.

Listen, I mean, as you pointed Barring a big delay from Honeywell to do the the transition It should be 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 100 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 animal 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 for gross margin and then they can kind of improve. But I'm also kind of wondering if should really just maybe just think about this business. Don't worry too hyper focused on gross margin and just maybe focus on On EBITDA margin, Correct. I think you really want to focus on those EBITDA margins because again, if we had that big tick in Q2, on the military, it's volume in the product mix that's going to 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 or 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 the better metric to look at from that perspective and 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 What is your current expectation for what that can look like EBITDA margin, so we're actually our projection EBITDA year over year by 30% and we feel confident about that number today.

Even with Q Yes.

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

Okay. [indiscernible] Nice quarter. Thanks a lot guys.

Thank you, Ayesha. Appreciate it.

This concludes our question and answer session. I would like to turn the conference back over to Sharon Oskarpur for any closing remarks. Thank you, operator.

And thank you all for your time and interest in IS and S. Have a good day.

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