INNOVATIVE SOLUTIONS & SUPPORT INC - Quarter Report: 2004 March (Form 10-Q)

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Interest Income. Interest income was $117,000 in the three months ended March 31, 2004 as compared to interest income of $146,000 in the three months ended March 31, 2003. The decreased interest income in the three months ended March 31, 2004 was primarily the result of lower interest rates in the period.

Interest Expense. Interest expense was $31,000 in the three months ended March 31, 2004 and 2003.

Income Tax Expense. Income tax expense for the three months ended March 31, 2004 was $1.4 million. The income tax expense for the three months ending March 31, 2003 was $0.7 million. The effective tax rate for both periods was 35% and the increase in income tax expense was due to higher income in the period.

Net Income. As a result of the factors described above, our net income in the three months ended March 31, 2004 increased $1.3 million or 102%, to $2.6 million, or 24% of net sales.

Six Months Ended March 31, 2004 Compared to the Six Months Ended March 31, 2003

Net sales. Net sales increased $7.9 million, or 68%, to $19.4 million for the six months ended March 31, 2004 from $11.5 million in the six months ended March 31, 2003. This increase in net sales was mainly due to increased RVSM system deliveries to both the commercial air transportation and general aviation market segments. The increase reflects an industry wide response to an FAA mandate requiring RVSM equipment installations on aircraft flying between 29,000 and 41,000 feet by January 20, 2005. The Company’s equipment provides RVSM compliance and equipment deliveries related to the FAA’s mandate are increasing as both air transport and general aviation industry segments begin to meet the new FAA mandate.

Cost of sales. Cost of sales increased $2.1 million or 43%, to $7.1 million, or 37% of net sales, in the six months ended March 31, 2004 from $5.0 million, or 43% of net sales, in the six months ended March 31, 2003. The absolute dollar increase in cost of sales was related to our increase in net sales. As a percentage, the decrease was the result of both higher net sales in the period coupled with a favorable change in the Company’s estimate of accrued warranty liability in the period.

Research and development. Research and development expenses increased $0.7 million or 41% to $2.5 million or 13% of net sales in the six months ended March 31, 2004 from $1.8 million or 15% of net sales in the six months ended March 31, 2003. Both the absolute dollar and percent to sales increase was principally due to increased spending on the flat panel program as the Company prepares to submit its TSO application to the FAA.

Selling, general, and administrative. Selling, general, and administrative expenses increased $0.8 million or 28%, to $3.5 million, or 18% of net sales, in the six months ended March 31, 2004 from $2.7 million or 24% of net sales, in the six months ended March 31, 2003. The increase in the dollar amount was the result of higher commissions due to increased net sales and salaries, including the salary of an additional executive officer hired by the Company on March 31, 2003. The decrease as a percent of net sales was the result of higher net sales in the period.

Interest Income. Interest income was $230,000 in the six months ended March 31, 2004 as compared to interest income of $329,000 in the six months ended March 31, 2003. The decreased interest income in the six months ended March 31, 2004 was primarily the result of lower interest rates in the period.

Interest Expense. Interest expense was $63,000 in the six months ended March 31, 2004 as compared to $69,000 in the six months ended March 31, 2003. The decrease was due to lower interest rates in the period.

Income Tax Expense. Income tax expense for the six months ended March 31, 2004 was $2.3 million. The income tax expense for the six months ending March 31, 2003 was $0.8 million. The effective tax rate for both periods was 35% and the increase in income tax expense was due to higher income in the period.

Net Income. As a result of the factors described above, our net income in the six months ended March 31, 2004 increased $2.7 million or 180%, to $4.2 million, or 22% of net sales.

Liquidity and Capital Resources

Our main sources of liquidity have been cash flows from operations and the proceeds of our initial public offering (IPO) in August 2000. We require cash principally to finance inventory, accounts receivable and payroll.

Our cash flow provided from operating activities was $4.3 million for the six months ended March 31, 2004 as compared to $1.1 million for the six months ended March 31, 2003. The increase was due to higher net income while a $1.1 million improvement in accounts receivable was offset with a $1.1 million inventory increase. The increase in inventory was primarily due to additional purchases of raw material and increased production in response to increased order backlog and in anticipation of an increased demand for RVSM equipment in light of the industry wide response to the FAA’s mandate discussed above.

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Our cash used in investing activities was $502,000 for the six months ended March 31, 2004 as compared to $66,000 for the six months ended March 31, 2003. The increase was primarily due to the purchase of additional manufacturing and engineering equipment.

Net cash flow from financing activities was $448,000 for the six months ended March 31, 2004 as compared to $2.3 million in usage in the six months ended March 31, 2003. The primary use of cash in the six month period ended March 31, 2003 was to acquire treasury stock. In the six month period ended March 31, 2004, the in-flow of cash was the result of proceeds from the exercise of stock options and warrants.

Our future capital requirements depend on numerous factors, including market acceptance of our products, the timing and rate of expansion of our business, acquisitions, joint ventures and other factors. We have experienced increases in our expenditures since our inception consistent with growth in our operations, personnel and product line, and we anticipate that our expenditures will continue to increase in the foreseeable future. We believe that our cash and cash equivalents, together with the net proceeds from our IPO will provide sufficient capital to fund our operations for at least the next twelve months. However, we may need to raise additional funds through public or private financings or other arrangements in order to support more rapid expansion of our business than we now anticipate either through acquisitions or organic growth. Further, we may need to develop and introduce new or enhanced products, respond to competitive pressures, invest in or acquire businesses or technologies or respond to unanticipated requirements or developments. If additional funds are raised through the issuance of equity securities, dilution to existing shareholders may result. If insufficient funds are available, we may not be able to introduce new products or compete effectively in any of our markets, which could hurt our business.

Backlog

At March 31, 2004 our backlog of released business was $27.0 million. This represents a $3.9 million or 17% increase from the March 31, 2003 backlog of $23.1 million. Our backlog consists solely of orders that we believe to be firm. In the case of contracts with government entities, orders are only included in backlog to the extent funding has been obtained for such orders.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. The Company’s most critical accounting policies are revenue recognition, income taxes, allowance for doubtful accounts, inventory valuation and warranty reserves.

The Company recognizes sales for products when the following revenue recognition criteria are met: persuasive evidence of an arrangement exists, product delivery and acceptance has occurred, pricing is fixed or determinable, and collection is reasonably assured. The Company recognizes sales upon shipment of products to customers.

Sales related to certain long-term contracts requiring development and delivery of products over several years are accounted for under the American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We consider the nature of these contracts as well as the types of products and services provided when determining the appropriate accounting treatment for a particular contract. Certain long-term contracts are recorded on a percentage of completion basis using cost-to-cost methodology to measure progress towards completion.

The Company offers its customers extended warranties for additional fees. These warranty sales are recorded as deferred revenue and recognized as sales on a straight-line basis over the warranty period.

The Company enters into certain sales arrangements that include multiple deliverables as defined in Emerging Issues Task Force (EITF) Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. Effective July 1, 2003, the Company identifies all goods and/or services that are to be delivered separately under a sales arrangement and allocates revenue to each deliverable based on fair value that is established with the customer during contract negotiations. In general, revenues are separated between product sales and non-recurring engineering services. The allocated revenue for each deliverable is then recognized using appropriate revenue recognition methods.

 

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Effective for transactions entered into after October 1, 2003, the Company accounts for transactions with software and non-software components under EITF Issue 03-5, “Applicability of AICPA Statement of Position 97-2, Software Revenue Recognition, to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software.”

Income taxes are recorded in accordance with SFAS No. 109, Accounting for Income Taxes. Provisions for federal and state income taxes are calculated on reported financial statement pre-tax income based on current tax law. The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities and expected benefits of utilizing net operating loss carryforwards. The impact on deferred taxes of changes in tax rates and laws, if any, applied to the years during which temporary differences are expected to be settled, are reflected in the consolidated financial statements in the period of enactment.

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. These allowances are determined by analyzing historical data and trends. If actual losses are greater than estimated amounts or if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, future results from operations could be adversely affected.

Inventories are written down for estimated obsolescence equal to the difference between the cost of inventory and the estimated net realizable value based upon assumptions about future market conditions. If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

We offer warranties on some products of various lengths. At the time of shipment, we establish a reserve for the estimated cost of warranties based on our best estimate of the amounts necessary to settle future and existing claims using historical data on products sold as of the balance sheet date. The length of the warranty period, the product’s failure rates and the customer’s usage affects warranty cost. If the actual cost of warranties differs from our estimated amounts, future results of operations could be adversely affected.

Business Segments

We operate in one principal business segment which designs, manufactures and sells flight information computers, flat panel displays and advanced monitoring systems to the Department of Defense, government agencies, commercial air transport carriers and corporate/general aviation markets. We currently derive virtually all our net sales from the sale of this equipment. Almost all of the net sales, operating results and identifiable assets are in the United States.

New Accounting Pronouncements

In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities an Interpretation of ARB No. 51. FIN 46 addresses consolidation by business enterprises of variable interest entities. The FASB then issued FIN 46(R), Consolidation of Variable Interest Entities an Interpretation of ARB No. 51, which replaced FIN 46. Application of FIN 46(R) is required in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. The Company has adopted both FIN 46 and FIN 46(R), and their adoption had no impact on the Company’s financial position or results of operations.

In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company adopted the provisions of SFAS 150, including the deferral of certain effective dates as a result of the provisions of FASB Staff Position 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests Under FASB Statement No. 150, ‘Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.’” The Company does not have any significant financial instruments with characteristics of both liabilities and equity as of March 31, 2004.

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FORWARD-LOOKING STATEMENTS

This Form 10-Q contains statements, which, to the extent that they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. The words “believe,” “estimate,” “anticipate,” “project,” “intend,” “expect,” “plan,” “outlook,” “forecast” and similar expressions are intended to identify forward-looking statements. Numerous factors, including potentially the following factors, could affect the Company’s forward-looking statements and actual performance:

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continued market acceptance of our air data systems products;

	•	the ability to obtain or the timing of obtaining future government awards;

	•	the availability of government funding and customer requirements both domestically and internationally;

	•	difficulties in developing and producing our flat panel display systems (CIP) or other planned products or product enhancements;

	•	market acceptance of our CIP system or other planned products or product enhancements;

	•	our ability to gain regulatory approval of our products in a timely manner;

	•	delays in receiving components from third party suppliers;

	•	the competitive environment;

	•	the timing and customer acceptance of product deliveries and launches;

	•	the termination of programs or contracts for convenience by customers;

	•	failure to retain key personnel;

	•	new product offerings from competitors;

	•	potential future acquisitions;

	•	protection of intellectual property rights;

	•	our ability to service the international market;

	•	other factors disclosed from time to time in our filings with the Securities and Exchange Commission.

Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Form 10-Q. The Company does not undertake any obligation to publicly release any revisions to these forward-looking statements to reflect events, circumstances or changes in expectations after the date of this Form 10-Q, or to reflect the occurrence of unanticipated events. The forward-looking statements in this document are intended to be subject to the safe harbor protection provided by Sections 27A of the Securities Act and 21E of the Exchange Act.

For a discussion identifying some important factors that could cause actual results to vary materially from those anticipated in the forward-looking statements, see the Company’s Securities and Exchange Commission filings including, but not limited to, the discussions of “Risk Factors” contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2003.

Item 3.      Quantitative and Qualitative Disclosures About Market Risk

The Company’s operations are exposed to market risks primarily as a result of changes in interest rates. The Company does not use derivative financial instruments for speculative or trading purposes. The Company’s exposure to market risk for changes in interest rates relates to its cash equivalents and an industrial revenue bond. The Company’s cash equivalents consist of funds invested in money market accounts, which bear interest at a variable rate, while the industrial revenue bond carries an interest rate that is consistent with 30-day, tax-exempt commercial paper. As the interest rates are variable, and we do not engage in hedging activities, a change in interest rates earned on the cash equivalents or paid on the industrial revenue bond would impact interest income and expense along with cash flows, but would not impact the fair market value of the related underlying instruments.

Item 4.      Controls and Procedures

An evaluation was performed under the supervision and with the participation of the Company’s management, including its Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, of the effectiveness of the Company’s disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of March 31, 2004. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported as specified in Securities and Exchange Commission rules and forms. There were no significant changes in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II–OTHER INFORMATION

Item 6.      Exhibits and Reports on Form 8-K.

(a) Exhibits

	31.1			Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)
	31.2			Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)
	32.1			Certification Pursuant to U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K.

None

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	INNOVATIVE SOLUTIONS & SUPPORT, INC.
Date: April 26, 2004	By:	/s/    JAMES J. REILLY
		James J. Reilly      Chief Financial Officer

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EXHIBIT INDEX

Exhibit Number			Description of Exhibit
31.1			Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)
31.2			Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)
32.1			Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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