Good morning, and welcome to the Innovative Solutions & Support Second Quarter 2014 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like turn the conference over to Mr. Geoff Hedrick, Chairman and CEO. Mr. Hedrick, you may begin. .

Thank you, and good morning. This is Geoff Hedrick, Chairman and CFO of Innovative Solutions & Support. I would like to welcome you this morning to our conference call to discuss our second quarter financial 2014 results, current business conditions and our outlook for 2014.

Joining me today in our Exton headquarters is Shahram Askarpour, our President; and Ron Albrecht, our CFO. Before I begin, I'd like Ron to read our Safe Harbor message.

Ron?.

Thank you, Geoff, and good morning, everyone.

I would like to 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 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 will now turn the call back to Geoff. .

Thank you, Ron. In the second quarter, we reported sales of $12.5 million, a 52% increase compared to the second quarter of fiscal 2013. Net income was $784,000 or $0.05 a share compared to $1.1 million or $0.07 a share in the second quarter of 2013. In the quarter, both production and engineering development sales increased compared to a year ago.

But more importantly, production sales grew over the first quarter as certain engineering programs began to enter their production phases..

Gross margins on the new products remain in line with historical levels. We expect that as the level of engineering development programs is completed, production levels increase and margins will improve..

Engineering sales grew in the past quarter to the highest level in recent years to over 35% of total sales for the quarter. While engineering sales are contributing to our overall sales growth, they are primarily customer reimbursement of our research and development costs and are only marginally, if at all, profitable..

Including internal R&D, we invested 38% of total sales in product development this quarter. This quarter represents a peak in engineering development sales. We expect these sales to begin to decrease both in absolute and relative basis, as product resulting from development programs are certified..

We expect production sales to continue to grow and become a greater portion of our total sales. We expect that this change in sales mix will result in a higher margin as a percent of sales..

And the recent strengthening of our manufacturing leadership enables us to meet the simultaneous increase in production to support both customer, product deliveries and significant engineering development requirements.

As we continue to transition programs from development to production, we believe we have the resources in place to achieve high levels of productivity and higher margins. Our operating efficiency and expense control are important elements of that strategy..

In the second quarter, we received new orders from production and modifications to existing engineering development programs. Total backlog remains well in excess of 1.5 years sales. We estimate that we have $90 million of long-term sole-sourced production opportunities associated with our various engineering development programs.

Eclipse is the first program of which development is now transitioning to recurring production..

We remain focused on execution, which is the key to both completing our engineering development programs and to growing production sales. We are pleased that the high levels of engineering development over the past 2 years are coming to fruition and increased production.

Shahram will speak in greater detail about the status of these engineering development programs..

We have characterized 2014 as a transition year. With Eclipse moving to production and other programs progressing, the transition is underway. We continue to prepare for further increases in production. We anticipate new opportunities to emerge from our engineering development programs.

We expect new opportunities to arise not only from the release of sole-sourced orders, but from follow-on of existing development contracts, but also from a growing market interest in the products developing from these contracts..

In the near future, we will have a broader portfolio of OEM and retrofit products for an array of commercial, air transport, military and business jet. We believe that our price for performance strategy will attract new customers..

Let me turn it over to Ron for a detailed description of our financial performance. .

Thank you, Geoff, and thank you, all, for joining us this morning. For the 3 months ended March 31, 2014, the company reported its ninth consecutive profitable quarter. For the quarter, sales were $12.5 million, up 52% from sales of $8.2 million in the second quarter of 2013.

The company reported 2014 second quarter net income of $784,000 or $0.05 a share compared to net income of $1.1 million or $0.07 per share in the same quarter a year ago..

Product sales, including flat-panel display, air data and other hardware and software sales, accounted for approximately 65% of total sales. $4.4 million or 35% of second quarter sales resulted from our engineering development programs. Compared to the same quarter a year ago, engineering development sales increased 224%.

And compared to the first quarter of the current fiscal year, it increased $1 million or approximately 32%. This is the highest level of engineering development sales in any quarter in recent years..

As Geoff mentioned, engineering development sales are peaking. Consequently, we expect sales to shift to a more favorable mix of higher-margin production sales, even as total sales flatten or modestly declined as a result of decreasing engineering development sales..

Total operating expenses in the quarter were $2.7 million, essentially unchanged from a year ago. Expenses include $661,000 of internally funded research and development. Our combined spend on Engineering Development Contracts and internally funded engineering development approximated $5 million or 40% of total sales for the quarter..

Selling, general and administrative expense in the quarter was $2 million, up from $1.9 million in the second quarter of last year. The underlying level of SG&A expense has remained relatively unchanged for 6 consecutive quarters, notwithstanding the overall sales growth of the company.

Second quarter operating income was $1.1 million, down from $1.2 million in the second quarter of last fiscal year..

For the quarter, we provided taxes at an effective rate of 29%, which we estimate will be the full year rate, unless the government reinstates the R&D tax credit.

Last year, the effective tax rate for the quarter was 10%, as a result of the year-to-date catch up effect, which resulted from the government's reinstatement of the R&D tax credit in January 2013 retroactive to January 1, 2012..

Net income for the quarter was $784,000 or $0.05 per share, compared to $1.1 million or $0.07 per share in the second quarter of 2013. Operating activities consumed $585,000 of cash related primarily to timing differences between expenditures on engineering product development programs and related receipts from those customers.

These differences appear as unbilled receivables on the balance sheet. These unbilled receivables will be reduced as programs reach contractual billing milestones..

The company ended the quarter with over $15 million of cash on hand and remains debt-free. We believe that the company has sufficient cash to fund operations for the foreseeable future..

For the fiscal year ending September 2014, we expect increased sales and generated profit, which would represent our sixth consecutive profitable year. Transition is certain. Programs from development to their production phases should improve margins..

I will now turn the call over to Shahram Askarpour for further comments on market conditions and operations.

Shahram?.

Thank you, Ron, and good morning, everyone. Last quarter, I noted that we have restructured and strengthened our manufacturing leadership in order to improve efficiency and to increase our engineering and production output.

Partly as a result, we were able to increase total sales more than 50% in the quarter compared to the same quarter last year, increase investment in product developments and report our ninth consecutive profitable quarter..

I would now like to review progress on our various engineering development programs. Eclipse is our first engineering development program to transition to production. In the second quarter, we continued to receive orders and ship production units to Eclipse..

Margins on early production units are in line with historical levels. As volume increases to anticipated levels, we expect operating efficiencies to improve and margins to increase correspondingly..

The first Boeing 737 classic aircraft is undergoing company ground and flight tests in preparation for final certification testing. We expect to receive an STC on this program in the next quarter. The Pilatus PC-24 business jet program is proceeding well.

The aircraft has generated extraordinary market interest, and the rollout of the first aircraft is scheduled for August 1 of 2014..

We have also delivered the second ship set to aircraft integration of the Foreign C-130 transport program. The MD 88, MD 90 upgrade program for Delta Air Lines is progressing, and we anticipate FAA certification towards the end of this calendar year..

New orders for the quarter were $6.7 million for both existing products and engineering product development. Backlog at March 31, 2014, remains well in excess of our year's [ph] sale at roughly $81 million.

In addition to backlog, we anticipate approximately $90 million of sales from sole-sourced OEM production, which we expect to deliver over the next decade..

We continue to see substantial opportunities in the various engineering development programs and are allocating engineering resources to bring these programs to fruition. On the military side, we anticipate substantial future sales from U.S.

and international operators of the C-130 and P-3 aircraft from our Integrated Flight Deck and Flight Management System..

We also expect increased sales from our military air data products in the near future. On the commercial side, we are seeing much increased interest in our next-generation Flight Management System and our Integrated Standby Unit.

We have enhanced our manufacturing organization so that as these engineering product development programs enter production, we expect to produce value for our shareholders..

I would now like to turn the call back to Geoff. .

Thank you, Shahram. With half of the year complete, we are progressing toward our fiscal 2014 growth and profitability objectives. The first 6 months of the year, sales and net income were up 60% and 26%, respectively, year-over-year.

In the next 6 months, we expect to continue to make progress on our engineering development program, which, when completed, we'll expect to supplement the sales already in backlog..

As production sales increase as a percentage of total sales, we expect margins to improve.

This past year, we invested 40% of our sales in research and development, demonstrating our continued commitment to creating advanced progress and addressed both OEM and retrofit market opportunities for the future and commercial, air transport, military and business jet markets..

In particular, as U.S. defense budgets remain under pressure, we see opportunities for competitively priced solutions. These cuts will necessarily increase the interest and the price for performance offering that we'll present to the government today..

Although we have made significant progress this year, we remain focused on the execution of both the engineering and development and production programs. Our goal is to achieve the growth in production sales that will generate the levels of profit that we have experienced in the past..

By bidding -- by building on the success of our price for performance product strategy, we are committed to grow the business and deliver attractive return for our shareholders..

At the end of the Q&A session, I will have an announcement.

In the meantime, operator, would you please open the call for questions?.

[Operator Instructions] And our first question will come from David Campbell of Thompson, Davis & Company. .

Shahram, you mentioned the FAA certification of the MD 88 and 90 should be received by the end of the calendar year. My understanding was that the initial deliveries of the equipment were to begin this month and that there would be significant production revenues in the September quarter from that program.

Has that all been delayed?.

No, no, we still -- you got to realize, before we get even to an airplane, we deliver production hardware to be installed in their simulators. And then there are total of 8 stimulators at Delta Air Lines for the MD 88 and MD 90. And then before they would introduce an airplane into revenue service, they will buy substantial amount of spares.

So does that answer your question?.

And all of that before the FAA has certified it?.

Absolutely, yes. .

Okay, okay. So there will be production revenues in this fiscal year. It's just the... .

That's correct. .

Delivery of the operating aircraft will not be until next year. .

Well, we're hoping in this year, but you're in the hands of the FAA at the end of the day, yes?.

Right, right, right. And Ron, you weren't very specific. I think you mentioned increasing revenues in fiscal -- in the fiscal year. That's the least that you should say. I mean, you shouldn't -- can't you be more specific now that we have 2 quarters... .

What was your latest forecast, David?.

Well, my latest forecast did not include $12 million of revenues in the second quarter, second fiscal quarter, but my forecast was, before that reported, I was estimating $44 million for this fiscal year. .

Also, in my remarks -- and I wouldn't argue with your number. I won't confirm or deny it, but I won't argue with it. But also in my comments, I said we expected sales from engineering programs to start to diminish over the -- as the year progressed. And so that should reconcile your question to my comment in the script. .

Right, right. But you also seem to imply that production revenues should increase from where they are in the second quarter. .

I wouldn't argue with that, David. .

Right now, your forecast is accurate. As we enter into the third quarter, and perhaps we'll amend it as appropriate. I hate to [ph] miss... .

Okay. And Ron, you mentioned that the SG&A was relatively unchanged from previous quarters. But it did go up to $8 million -- it did go up to $2 million in the June -- in the March quarter.

Do I -- should I assume that $8 million is the new annual rate for that expense?.

When -- I think it went from $1.8 million to $1.9 million in the same quarter last year to $2 million. I don't regard -- I mean, that number will bounce around a little bit from quarter to quarter.

I don't think you can -- I think we'll -- what we're saying is and I -- and consistent with what I said in my comments was that we expect the SG&A expenses to remain at relatively stable levels. Of course, they're going to trend up slightly, but -- and they may vary a bit from quarter to quarter.

But in general, they're going to remain under reasonably good control as sales go up. .

Okay. Also, you mentioned that, of course, the Eclipse has moved from engineering and development into production phase. So I thought as that happened, backlogs would go up because backlogs were more significant as -- in production than they were in engineering and development. .

Well, with respect to the Eclipse program, we receive orders and deliver relatively -- it's a relatively short cycle, if that explains it. I mean, you're not going to expect -- they'd order units -- a number of ship sets at a time, but not a year's production or 2 years' production at a time. So the revenue cycle is fairly quick. .

Okay, okay. So that's why backlogs may stay at the $90 million -- $80 million, $90 million level until we get maybe the Delta program in a bigger phase.

Would that be right?.

That would be our hope, yes. .

Excuse me?.

That would be our hope and expectation, yes. .

Do you have other -- any other programs -- or any other programs out there that you have bids on? Or just -- I know military is uncertain. But I'm talking about commercial programs. .

Military is actually -- we see some real promise in it. With -- as I mentioned in the written section, we -- the big -- there's no other word for it, big budget cuts in the military are going to force the military to become far more conscious of the price performance ratio.

They're not going to have the budget to fund all the things they would like to do. And we believe -- and secondly, the biggest impact is inevitably new weapon systems. Well, with the reduction in new weapon systems opportunities and the -- necessitates the maintenance of the existing aircraft, and that's what we do.

So we actually think that this will increase our -- significantly increase our market opportunities in the military market.

In addition, programs that we started, literally in the '90s, the development of the standard altimeter for the Air Force and Navy, appear to have come to fruition, and are going to start -- we hope to have some production deliveries on those programs into the military. So we still -- I still see the military as a very strong opportunity.

Business and general aviation in a -- in specific areas is starting to recover. And of course, the commercial air transport market is humming because there's a huge demand. And frankly, there's airplanes -- new airplanes can't be delivered fast enough to meet the lift needs that the airlines have right now. .

All right.

Now are you working on any new commercial programs other than what's been publicly announced?.

Well, yes. But it's very early stage. We're focused -- right now, we're focused in military and the completion of our air transport programs that we have in -- on our plate right now. .

In the engineering development expenditures or sales, I understood they would be obviously in the second quarter in Eclipse and Delta and the 737 programs and the Boeing programs.

Those are all part of the engineering development revenues?.

Yes. .

Yes. .

There's nothing else in those revenues?.

What you're seeing is -- in those engineering revenues, you're talking about really supporting or helping to support the engineering development cost. So that's all you're seeing there. Didn't we -- we didn't ship the 737 this last quarter, but we will be shipping 737 shortly. So you'll start seeing some more in that area as well. .

That 737 is the program for -- remind me again, that's the military program?.

The cockpit -- no, it's for NNSA, but it's a commercial cockpit upgrade, including a Flight Management System. .

NNSA is National Nuclear Security Agency. .

Right, right, right.

You haven't had any commercial orders for the cockpit there?.

We expect them as soon as we get the STC issued. .

Right.

But they're not in the backlog?.

Not in the backlog, no. .

And you have said things in the past about -- you had $100 million just roughly of programs that you are -- you saw yourself getting some business in?.

Yes. Well, we -- in the past, we haven't done that. Frankly, when Roman was here, he used to use that as a bellwether. But unfortunately, it's hard to predict whether they're going to materialize or not. So we've chosen not to do that. But we have, as you can see, a huge investment in forward product development.

And unless we're completely wrong, we're going to do very well with that. .

[Operator Instructions] And our next question will come from Luisa Lau of Singular Research. .

With respect to your Eclipse deliveries, is that -- does that strictly consist of the 550?.

That's correct, yes. And retrofits, yes. .

Okay. And retrofits, okay. .

That's the 550 product. .

Okay.

And would it be accurate then, say in terms of your statement of production revenues going up and the engineering revenues coming down, would that be effective basically as of this fiscal Q3 or more accurate for Q4?.

We expect that to begin in -- a gradual decline in Q3 [indiscernible]. And we continue revenues and we continue to expect production revenues to move upward. .

In Q4, yes. .

What -- so production in Q4?.

In Q4, we're going to see a drop in engineering revenues. Transition to more productions. .

Okay, so then... .

Both in percentage and in an absolute terms. .

Okay.

So then, we could see the -- okay, the gradual decline in engineering, beginning in Q3, but gradual?.

Yes. What you'll see is the engineering -- the funding -- as long as we stay on schedule, the funding will come in and -- but the total backlog and the total performance will start going down. And it will transition to a more stable -- we've had historical engineering investments of 12% to 15%. And we'll see more and more of that.

We have had the good fortune to have our customers share in the development costs. But we're going to actually see that as -- I'm sorry -- see that as a number going on -- forward as pure IR&D. .

Right, okay.

So then what about in terms of the actual production revenue increase? Granted, you have to started your transition, are we going to expect more of that happening in the Q3 or really not until the Q4?.

Right now, it's planned for the -- to start the transitioning during the end of Q3. .

End of Q3. Okay, great.

Now in terms of this transition to production, is there any major shift in terms of your actual staffing measures at all? Or how do you accommodate for this transition to greater production relative to engineering? Is there some sort of internal employee shift or just structural shift logistically?.

I mean, substantially, the peak in the engineering demand, we've addressed that by outsourcing some of the engineering work. What we will see is that we will see some of those contracts -- outsourced contracts would wind down. And then we're not looking at touching our core engineering resources. They're valuable.

They've been with the company for a long, long time. We have very small turnaround in our core engineering group, and we like to keep them happy. .

If I could just comment on the production side.

We have the capability to increase production within present staffing, largely because we've had significant engineering requirements, engineering support requirements from production as well so that although the sales volume that you see on production is at a certain level, that they've actually -- our production manufacturing operations have actually given significant production support to engineering, which would -- which we would expect to begin to decline as these programs mature.

.

Okay.

So then, you just have a shift in terms of staffing towards production from that aspect?.

Right. The people in production will shift from -- to some extent from producing material for engineering to producing material for delivery to customers. .

Okay, got it. Okay.

And could you provide the cost of sales breakdown between production and engineering for the Q2?.

I think we do that in our 10-Q. So I won't do that now. You'll see it in a week or so in our 10-Q. .

And this concludes our question-and-answer session. I would like to turn the conference back over to Geoff Hedrick for any closing remarks. .

Yes. Ladies and gentlemen, thank you for joining us today. I did want to make a personal announcement and announce that -- my intention to retire from IS&S by the end of this calendar year. As you know, I founded the company 26 years ago. I'm getting to be an old man. I'm happy to say I've been able to get to be an old man.

And I'm looking forward to retiring at the end of this calendar year..

I'm fortunate that we have, acting now as President, Shahram Askarpour, who was -- we intend to succeed me as CEO. He's so ably capable of taking over and a man that I've grown to admire and respect over the last several years he served as President. I'm very comfortable and very happy as a major stockholder to have Shahram lead the troops.

I wish you all a great deal of gratitude. Thank you. Operator, I'll turn it back over. .

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