INNOVATIVE SOLUTIONS & SUPPORT INC - Quarter Report: 2005 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

[For the transition period from to ]

Commission File No. 0-31157

INNOVATIVE SOLUTIONS AND SUPPORT, INC.

(Exact name of registrant as specified in its charter)

PENNSYLVANIA		23-2507402
(State or other jurisdiction		(IRS Employer
of incorporation)		Identification No.)

720 Pennsylvania Drive, Exton, Pennsylvania		19341
(Address of principal executive offices)		(Zip Code)

(610) 646-9800
(Registrant’s telephone number, including area code)

Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

As of July 29, 2005, there were 18,038,825 shares of the Registrant’s Common Stock, with par value of $.001 per share, outstanding.

INNOVATIVE SOLUTIONS & SUPPORT, INC.

FORM 10-Q JUNE 30, 2005

INDEX

			Page No.
PART I.	FINANCIAL INFORMATION

Item 1.	FINANCIAL STATEMENTS (UNAUDITED)

		Condensed Consolidated Balance Sheets – September 30, 2004 and June 30, 2005	3

		Condensed Consolidated Statements of Operations – Three Months and Nine Months Ended June 30, 2004 and 2005	4

		Condensed Consolidated Statements of Cash Flows – Nine Months Ended June 30, 2004 and 2005	5

		Notes to Condensed Consolidated Financial Statements	6

Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		9

Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		14

Item 4.	CONTROLS AND PROCEDURES		14

PART II.	OTHER INFORMATION

Item 1.	LEGAL PROCEEDINGS		15

Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS		15

Item 3.	DEFAULTS UPON SENIOR SECURITIES		15

Item 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		15

Item 5.	OTHER INFORMATION		15

Item 6.	EXHIBITS		15

SIGNATURES

PART I–FINANCIAL INFORMATION

Item 1–Financial Statements

INNOVATIVE SOLUTIONS AND SUPPORT, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(unaudited)

	As of September 30, 2004			As of June 30, 2005
ASSETS
Current Assets:
Cash and cash equivalents	$	65,867,167		$	83,219,709
Accounts receivable, less allowance for doubtful accounts of $100,000 at September 30, 2004 and June 30, 2005	5,003,100			7,510,876
Inventories	5,191,628			3,660,592
Deferred income taxes	984,111			984,111
Prepaid expenses	665,276			1,344,642

Total current assets	77,711,282			96,719,930

Property and Equipment:
Computers and test equipment	3,933,326			4,085,695
Corporate airplane	2,998,161			2,998,161
Furniture and office equipment	622,364			717,461
Manufacturing facility	5,414,986			5,420,741
Land	1,021,245			1,021,245
	13,990,082			14,243,303
Less - Accumulated depreciation and amortization	(4,369,851		)	(4,864,727		)

Net property and equipment	9,620,231			9,378,576

Deposits and other assets	137,114			128,114

Total assets	$	87,468,627		$	106,226,620

LIABILITIES AND SHAREHOLDERS’ EQUITY

CURRENT LIABILITIES:
Current portion of notes payable	$	100,000		$	100,000
Current portion of capitalized lease obligations	7,257			7,257
Accounts payable	1,696,247			409,418
Accrued expenses	4,754,641			3,683,789
Deferred revenue	526,023			735,463

Total current liabilities	7,084,168			4,935,927

Note payable	4,235,000			4,235,000
Long-term portion of capitalized lease obligations	20,681			15,035
Deferred revenue	261,934			209,081
Deferred income taxes	411,857			411,857
Commitments and contingencies	—			—

Shareholders’ Equity:
Preferred stock, 10,000,000 shares authorized-Class A Convertible stock, $.001 par value; 200,000 shares authorized, no shares issued and outstanding at September 30, 2004 and June 30, 2005	—			—

Common stock, $.001 par value: 75,000,000 shares authorized, 20,272,995 and 18,027,368 shares issued and outstanding at September 30, 2004 and June 30, 2005	20,273			18,027

Additional paid-in capital	48,705,531			41,699,407
Retained earnings	37,342,940			54,702,286
Treasury stock, at cost, 2,535,039 and 0 shares at
September 30, 2004 and June 30, 2005	(10,613,757		)	—

Total shareholders’ equity	75,454,987			96,419,720

Total liabilities and shareholders’ equity	$	87,468,627		$	106,226,620

The accompanying notes are an integral part of these statements.

INNOVATIVE SOLUTIONS AND SUPPORT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)

	Three Months Ended June 30, 2004			Three Months Ended June 30, 2005			Nine Months Ended June 30, 2004			Nine Months Ended June 30, 2005
Net sales	$	12,269,653		$	17,101,620		$	31,688,276		$	55,081,445
Cost of sales	4,056,372			5,846,912			11,200,624			17,806,327
Gross profit	8,213,281			11,254,708			20,487,652			37,275,118
Operating expenses:
Research and development	1,363,143			1,501,475			3,861,311			4,321,474
Selling, general and administrative	2,090,357			2,489,287			5,600,461			6,821,682
	3,453,500			3,990,762			9,461,772			11,143,156
Operating income	4,759,781			7,263,946			11,025,880			26,131,962
Interest income	(116,110		)	(543,857		)	(345,985		)	(1,255,431		)
Interest expense	31,197			48,796			94,201			127,930
Income before income taxes	4,844,694			7,759,007			11,277,664			27,259,463
Income taxes	1,559,086			2,860,294			3,810,625			9,894,108
Net income	$	3,285,608		$	4,898,713		$	7,467,039		$	17,365,355
Net Income Per Common Share:
Basic	$	0.19		$	0.27		$	0.43		$	0.97
Diluted	$	0.18		$	0.27		$	0.42		$	0.95

Weighted Average Shares Outstanding:
Basic	17,499,959			17,909,270			17,296,491			17,814,504
Diluted	17,941,119			18,360,921			17,801,727			18,314,568

The accompanying notes are an integral part of these statements.

INNOVATIVE SOLUTIONS AND SUPPORT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)

	For the Nine Months Ended June 30, 2004			For the Nine Months Ended June 30, 2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	7,467,039		$	17,365,355
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization	520,665			565,876
Loss (Gain) on Disposal of Fixed Assets	1,037			(14,000		)
Excess and obsolete inventory expense	62,998			52,340
Compensation expense for stock issued to directors	182,766			145,525
Tax benefit from exercise of stock options	175,982			1,628,562
(Increase) decrease in:
Accounts receivable	1,963,871			(2,493,776		)
Inventories	(1,919,997		)	1,478,696
Prepaid expenses and other	305,045			(679,366		)
Increase (decrease) in:
Accounts payable	201,486			(1,286,829		)
Accrued expenses	116,164			(989,931		)
Deferred revenue	2,290			156,587
Net cash provided by operating activities	$	9,079,346		$	15,929,039

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment	(560,105		)	(315,221		)
Net cash used in investing activities	$	(560,105	)	$	(315,221	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options	674,330			1,744,370
Proceeds from exercise of warrants	614,598
Capital lease obligations	39,119
Repayments of capital lease obligations	(9,338		)	(5,646		)
Net cash provided by financing activities	1,318,709			1,738,724

Net increase in cash and cash equivalents	$	9,837,950		$	17,352,542

Cash and cash equivalents, beginning of year	$	48,789,744		$	65,867,167

Cash and cash equivalents, end of period	$	58,627,694		$	83,219,709

The accompanying notes are an integral part of these statements.

Innovative Solutions & Support Inc.
Notes to Condensed Consolidated Financial Statements

1. Basis of Presentation:

Innovative Solutions and Support, Inc. (the “Company”) was incorporated in Pennsylvania on February 12, 1988. The Company’s primary business is the design, manufacture and sale of flight information computers, flat panel displays and advanced monitoring systems for the military, government, commercial air transport and corporate aviation markets.

The balance sheet as of June 30, 2005, the statement of operations for the three months and nine months ended June 30, 2004 and 2005 and the statements of cash flows for the nine months ended June 30, 2004 and 2005 have been prepared by the Company without audit. In the opinion of management, all adjustments, consisting of normal and recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows at June 30, 2005 and for all periods presented have been made.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. It is suggested that these financial statements be read in conjunction with the financial statements and notes thereto included in the Company’s Form 10K for the year ended September 30, 2004 as filed with the Securities and Exchange Commission. The results of operations for the three months and nine months ended June 30, 2005 are not necessarily indicative of the operating results for the full year.

On June 13, 2005, the Company’s Board of Directors approved a three-for-two split of the Company’s common stock. The stock split was effected in the form of a fifty percent (50%) stock dividend that was paid on July 7, 2005 to shareholders of record on June 23, 2005. The issued and outstanding common stock and all share and per share amounts have been retroactively restated in this report to give effect to this three-for-two stock split.

2. Net income per Share

Net income per share (“EPS”) is calculated using the principles of SFAS No. 128, “Earnings Per Share”.

A reconciliation of weighted average shares outstanding appears below:

	Three Months Ended June 30, 2004	Three Months Ended June 30, 2005	Nine Months Ended June 30, 2004	Nine Months Ended June 30, 2005
Weighted average number of shares-basic	17,499,959	17,909,270	17,296,491	17,814,504
Effect of dilutive securities:
Employee stock options	441,160	451,651	358,522	500,064
Warrants	0	0	146,714	0
Weighted average number of shares-diluted	17,941,119	18,360,921	17,801,727	18,314,568

For the three month periods ended June 30, 2005 and 2004, there were -0- and 1,846 options outstanding that were excluded from the computation of diluted earnings per share as the effect would have been antidilutive. For the nine month periods ended June 30, 2005 and 2004, there were 16,841 and 7,153 options outstanding that were excluded from the computation of diluted earnings per share as the effect would have been antidilutive.

3. Concentrations

For the three months ended June 30, 2005, three customers accounted for 19%, 15%, and 11% of net sales or 45% on a combined basis. For the three months ended June 30, 2004, three customers accounted for 17%, 11%, and 10% of net sales or 38% on a combined basis. For the nine months ended June 30, 2005, three customers accounted for 12%, 11% and 10% of net sales or 33% on a combined basis. For the nine months ended June 30, 2004, four customers accounted for 13%, 13%, 10% and 10% of net sales or 46% on a combined basis.

4. Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following:

	September 30, 2004		June 30, 2005
Raw materials	$	1,928,005	$	2,016,387
Work-in-process	2,573,932		1,102,657
Finished goods	689,691		541,548
	$	5,191,628	$	3,660,592

5. Warranty

The Company provides for the estimated cost of product warranties at the time revenue is recognized. Warranty cost is recorded as cost of sales in the financial statements. While the Company engages in extensive product quality programs and processes, the Company’s warranty obligation is affected by product failure rates and the related material, labor and delivery costs incurred in correcting a product failure. Should actual product failure rates, material or labor costs differ from the Company’s estimates, further revisions to the estimated warranty liability would be required.

Warranty cost and accrual information for the three months ended June 30, 2005 is highlighted below:

Warranty accrual at March 31, 2005	$	790,751
Accrued expense for the quarter ended June 30, 2005	46,183
Warranty costs for the quarter ended June 30, 2005	(45,459		)
Warranty accrual at June 30, 2005	$	791,475

Warranty cost and accrual information for the nine months ended June 30, 2005 is highlighted below:

Warranty accrual at September 30, 2004	$	757,476
Accrued expense for the nine months ended June 30, 2005	160,793
Warranty costs for the nine months ended June 30, 2005	(126,794		)
Warranty accrual at June 30, 2005	$	791,475

6. Stock Options

The Company’s 1998 Stock Option Plan (the “Plan”) provides for the granting of incentive and nonqualified stock options to employees, officers, directors and independent contractors and consultants.

Incentive stock options granted under the Plan must be at least equal to the fair value of the common stock on the date of grant. Nonqualified stock options granted under the Plan may be less than, equal to or greater than the fair value of the common stock on the date of grant. The Company has reserved 3,389,025 shares of Common Stock for awards under the Plan (after giving effect to the Company’s three-for-two stock split).

Stock-based employee compensation is recognized using the intrinsic value method in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees.” For disclosure purposes, pro forma net income and net income per share data are provided in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” as if the fair value method had been applied. Under SFAS No. 123, compensation cost related to stock options granted to employees is computed based on the fair value of the stock option at the date of grant using the Black-Scholes option pricing model. Had the Company recognized compensation cost for its stock option plans consistent with the provisions of SFAS No. 123, the Company’s pro forma net income for the three-month and nine-month periods ended June 30, 2004 and 2005 would have been as follows:

	Three Months Ended June 30, 2004			Three Months Ended June 30, 2005			Nine Months Ended June 30, 2004			Nine Months Ended June 30, 2005
Net Income:
As reported	$	3,285,608		$	4,898,713		$	7,467,039		$	17,365,355
Deduct: Total stock based employee compensation expense determined under the fair value based method for all awards, net of related tax effects	$	(194,088	)	$	(201,483	)	$	(568,524	)	$	(607,881	)

Pro forma	$	3,091,520		$	4,697,230		$	6,898,515		$	16,757,474

Basic EPS:
As reported	$	0.19		$	0.27		$	0.43		$	0.97
Pro forma	$	0.18		$	0.26		$	0.40		$	0.94

Diluted EPS:
As reported	$	0.18		$	0.27		$	0.42		$	0.95
Pro forma	$	0.17		$	0.26		$	0.39		$	0.91

New Accounting Pronouncements

In May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 154, “Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3”. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 also requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting principle, such as a change in nondiscretionary profit-sharing payments resulting from an accounting change, should be recognized in the period of the accounting change. SFAS No. 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date this Statement is issued. The Company will adopt the provisions of SFAS No. 154 as applicable beginning in fiscal 2007.

In December 2004, The FASB issued SFAS No. 123(R), “Share Based Payment”. Statement No. 123(R) requires all entities to recognize compensation expense in an amount equal to the fair value of share based payments granted to employees. This statement is effective for the first fiscal year beginning after June 15, 2005. The Company will adopt Statement No. 123(R) beginning with the first quarter of fiscal 2006. Adoption of the statement will require the Company to record compensation expense relating to the issuance of employee stock options. Currently, the Company follows APB No. 25 which does not require the recognition of compensation expense relating to the issuance of stock options so long as the quoted market price of the Company’s stock at the date of grant is less than or equal to the amount an employee must pay to acquire the stock. The Company is currently evaluating the impact the adoption of this statement will have on its consolidated financial position or results of operations.

In December 2004, the FASB issued FASB Staff Position (FSP) FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004”. This FSP provides guidance on the application of Statement 109 to the provisions within the American Jobs Creation Act of 2005 (the Act), which provides tax relief to U.S. domestic manufacturers. The FSP states that a manufacturer’s deduction provided for under the Act should be accounted for as a special deduction in accordance with Statement 109 and not as a tax rate reduction. The FSP also reminds preparers that the special deduction should be considered by an enterprise in (a) measuring deferred taxes when the enterprise is subjected to graduated tax rates, and (b) assessing whether a valuation allowance is necessary as required by Statement 109. This statement is effective immediately. The Company has adopted this statement and it did not have a material impact on the Company’s financial position or results of operations.

as to require treatment as current period charges…”. This Statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal”. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect the adoption of this statement will have a material impact on its consolidated financial position or results of operations.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We design, manufacture and sell flight information computers, flat panel displays and advanced monitoring systems to the Department of Defense (DOD), government agencies, commercial air transport carriers and corporate/general aviation markets.

Our revenues are derived from the sale of our products to the retrofit market and, to a lesser extent, original equipment manufacturers (OEMs). Our customers include government and military entities and their commercial contractors, aircraft operators, aircraft modification centers and various OEMs. Although we occasionally sell our products directly to government entities, we primarily sell our products to commercial customers for end use in government and military programs.

Since fiscal 1997, the majority of our revenues have come from the sale of Reduced Vertical Separation Minimum (RVSM) compliant air data systems.

We continue to invest in and seek additional opportunities for our Flat Panel Display product line. The Company’s Flat Panel Display received certification from the Federal Aviation Administration (FAA) in the form of a Technical Standard Order (TSO) on July 2, 2004. To date, we have been selected by the U.S. Navy for Flat Panel applications on their Landing Craft Air Cushion (LCAC) platforms. The Navy program has multi-year requirements that we believe will provide a solid base for future awards. Further, we were selected by Boeing to provide Flat Panels for the Boeing 767 tanker program. While Boeing’s contract with the US Air Force was recently cancelled, the program is expected to be recompeted in the future. In the near term, the Company will continue to provide Boeing with Flat Panels for installation on 767 tanker planes that will be sold to foreign customers. In addition, Lockheed Martin selected us to provide Flat Panel Systems for the retrofit of C-130 airplanes. Boeing has also recently selected our Flat Panel System for installation on The Royal Netherlands Air Force KC-10 cockpit update program. The Company has also recently teamed with ABX Air, Inc. in an agreement to upgrade B-767 cockpits with Flat Panel Display Systems. This agreement will provide B-767-200/300 operators with a single point of contact for both low cost and rapidly implemented retrofit systems.

Our “cost of sales” is comprised of material components purchased through our supplier base and direct in-house assembly labor and overhead costs. Many of the components we use in assembling our products are standard, although certain parts are manufactured to meet our specifications. The overhead portion of cost of sales is primarily comprised of salaries and benefits, building occupancy, supplies, and outside service costs related to our production, purchasing, customer service, material control and quality departments as well as warranty costs.

We continue to invest in the development of new products and the enhancement of our existing product line. We expense research and development costs related to future product development as they are incurred.

Our selling, general, and administrative expenses consist of marketing and business development expenses, professional expenses, salaries and benefits for executive and administrative personnel, facility costs, recruiting, legal, accounting, and other general corporate expenses.

Three Months Ended June 30, 2005 Compared to the Three Months Ended June 30, 2004

Net sales. Net sales increased $4.8 million, or 39%, to $17.1 million for the three months ended June 30, 2005 from $12.3 million in the three months ended June 30, 2004. 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 in net sales reflects an industry wide response to a Federal Aviation Administration (FAA) mandate. Essentially, the mandate requires RVSM equipment installations on aircraft flying between 29,000 and 41,000 feet by January 20, 2005. The Company’s equipment provides RVSM compliance. Equipment deliveries related to the FAA’s mandate continue as both air transport and general aviation industry segments meet the new FAA mandate.

Cost of sales. Cost of sales increased $1.8 million or 44%, to $5.8 million, or 34% of net sales in the three months ended June 30, 2005 from $4.1 million, or 33% of net sales in the three months ended June 30, 2004. The increase in cost of sales was primarily related to our increase in net sales.

Research and development. Research and development expenses increased $0.1 million or 10% to $1.5 million or 9% of net sales in the three months ended June 30, 2005 from $1.4 million or 11% of net sales in the three months ended June 30, 2004. The decrease as a percent to sales was due to the increase in net sales in the current period.

Selling, general, and administrative. Selling, general, and administrative expenses increased $0.4 million, or 19%, to $2.5 million, or 15% of net sales in the three months ended June 30, 2005 from $2.1 million or 17% of net sales in the three months ended June 30, 2004. The increase in the dollar amount was primarily the result of higher commissions, compensation and corporate governance expenses. The decrease as a percent of net sales was the result of higher net sales in the period.

Interest income. Interest income was $544,000 in the three months ended June 30, 2005 as compared to interest income of $116,000 in the three months ended June 30, 2004. The increase in interest income in the three months ended June 30, 2005 was primarily the result of higher interest rates in the current period and an increase in our cash balance over the prior period.

Interest expense. Interest expense was $49,000 in the three months ended June 30, 2005 as compared to interest expense of $31,000 in the three months ended June 30, 2004. The increase in interest expense in the three months ended June 30, 2005 was primarily the result of higher interest rates in the period.

Income tax expense. Income tax expense for the three months ended June 30, 2005 was $2.9 million. The income tax expense for the three months ending June 30, 2004 was $1.6 million. The increase in tax expense was primarily due to higher income in the period. The effective tax rate in the June 30, 2005 quarter was 36.9%. In the June 30, 2004 quarter the effective tax rate was 32%. In each quarter, the effective tax rate differs from the statutory rate due to the utilization of research and development tax credits. Although the credits utilized in each period were similar, the effective tax rate was lower in 2004 due to lower pre-tax income in the period ended June 30, 2004.

Net income. As a result of the factors described above, our net income in the three months ended June 30, 2005 increased $1.6 million or 49%, to $4.9 million, or 29% of net sales, from $3.3 million or 27% of net sales in the three months ended June 30, 2004.

Nine Months Ended June 30, 2005 Compared to the Nine Months Ended June 30, 2004

Net sales. Net sales increased $23.4 million, or 74%, to $55.1 million for the nine months ended June 30, 2005 from $31.7 million in the nine months ended June 30, 2004. 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 in net sales reflects an industry wide response to a Federal Aviation Administration (FAA) mandate. Essentially, the mandate requires RVSM equipment installations on aircraft flying between 29,000 and 41,000 feet by January 20, 2005. The Company’s equipment provides RVSM compliance. Equipment deliveries related to the FAA’s mandate continue as both air transport and general aviation industry segments meet the new FAA mandate.

Cost of sales. Cost of sales increased $6.6 million or 59 %, to $17.8 million, or 32% of net sales in the nine months ended June 30, 2005 from $11.2 million, or 35% of net sales in the nine months ended June 30, 2004. The absolute dollar increase in cost of sales was related to our increase in net sales. As a percentage, the decrease was primarily the result of fixed operating costs being absorbed over higher net sales in the current period.

Research and development. Research and development expenses increased $0.5 million or 12% to $4.3 million or 8% of net sales in the nine months ended June 30, 2005 from $3.9 million or 12% of net sales in the nine months ended June 30, 2004. The increase in spending was due to additional program development work while the decrease, as a percent to sales, was due to the increase in net sales in the current period.

Selling, general, and administrative. Selling, general, and administrative expenses increased $1.2 million, or 22%, to $6.8 million, or 12% of net sales in the nine months ended June 30, 2005 from $5.6 million or 18% of net sales in the nine months ended June 30, 2004. The increase in the dollar amount was primarily the result of higher commissions, compensation and corporate governance expenses. As a percentage, the decrease was primarily the result of higher net sales in the current period.

Interest income. Interest income was $1.3 million in the nine months ended June 30, 2005 as compared to interest income of $0.3 million in the nine months ended June 30, 2004. The increase in interest income in the nine months ended June 30, 2005 was primarily the result of higher interest rates in the current period and an increase in our cash balance over the prior period.

Interest expense. Interest expense was $128,000 in the nine months ended June 30, 2005 as compared to interest expense of $94,000 in the nine months ended June 30, 2004. The increase in interest expense in the nine months ended June 30, 2005 was primarily the result of higher interest rates in the period.

Income tax expense. Income tax expense for the nine months ended June 30, 2005 was $9.9 million. The income tax expense for the nine months ending June 30, 2004 was $3.8 million. The increase in tax expense was primarily due to higher income in the period. The effective tax rate in

the nine months ended June 30, 2005 was 36.3%. In the nine months ended June 30, 2004, the effective tax rate was 33.8%. In each period, the effective tax rate differs from the statutory rate due to the utilization of research and development tax credits. Although the credits utilized in each period were similar, the effective tax rate was lower in 2004 due to lower pre-tax income in the period ended June 30, 2004.

Net income. As a result of the factors described above, our net income in the nine months ended June 30, 2005 increased $9.9 million or 133%, to $17.4 million, or 32% of net sales, from $7.5 million or 24% of net sales in the nine months ended June 30, 2004.

Liquidity and Capital Resources

Our main sources of liquidity have been cash flows from operations. We require cash principally to finance inventory, accounts receivable and payroll.

Our cash flow provided from operating activities was $15.9 million for the nine months ended June 30, 2005 as compared to $9.1 million for the nine months ended June 30, 2004. The increase was due to higher net income that was partially offset by an increase in accounts receivable and a decrease in accounts payable in the period.

Our cash used in investing activities was $315,000 for the nine months ended June 30, 2005 and primarily consisted of production equipment, laboratory test equipment, computer equipment and office furniture. Cash used in investing activities was $560,000 for the nine months ended June 30, 2004 and primarily consisted of production equipment, laboratory test equipment, computer equipment and office furniture.

Net cash flow from financing activities was $1.7 million for the nine months ended June 30, 2005 as compared to $1.3 million in the nine months ended June 30, 2004. In the nine month period ended June 30, 2005, the in-flow of cash was the result of proceeds from the exercise of stock options. In the period ended June 30, 2004, the in-flow was the result of the exercise of both stock options and warrants. All remaining warrants were exercised during the fiscal year ended September 30, 2004.

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 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 June 30, 2005 our backlog was $13.7 million. At June 30, 2004 our backlog was $27.9 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. 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 November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 151, “Inventory Costs”. This Statement amends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing”, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4 previously stated that “… under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges…”. This Statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal”. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect the adoption of this statement will have a material impact on its consolidated financial position or results of operations.

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:

• 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;

• 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, and

• 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 forwardlooking 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, 2004.

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-15e under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of June 30, 2005. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures provide reasonable assurance 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.

PART II–OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

None

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

Item 3. DEFAULTS UPON SENIOR SECURITIES

None

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

Item 5. OTHER INFORMATION

None

Item 6. EXHIBITS

(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

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 AND SUPPORT, INC.


Date: July 29, 2005	By:	/s/ JAMES J. REILLY
		James J. Reilly Chief Financial Officer