Good morning, welcome to the Innovative Solutions and Support second quarter fiscal 2018 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, one on your touch-tone phone. To withdraw your question, please press star two. Please note this event is being recorded. I would now like to turn the conference over to Mr. Hedrick, Chairman and Chief Executive Officer. Please go ahead.
Good morning. This is Jeff Hedrick. I'd like to welcome you this morning to our conference call to discuss the second quarter fiscal 2018 results, current business conditions, and our outlook for the upcoming year. Joining me today are Shahram Askarpour, our President, and Relland M. Winand, our CFO. Before I begin, I'd like Rell to read our safe harbor message. Rell?
Thank you, Jeff, good morning, everyone. I would remind our listeners that certain matters discussed in the conference call today, including new products and 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 and other public filings. I'll turn the call back to Jeff.
Thank you, Rell. In the second quarter, both revenues and backlog were up sequentially from a weak first quarter. Revenues are down at 20% as compared to a year-ago, reflecting a lower beginning backlog in the quarter. In the quarter, we maintained our high level of investment in new product development, representing 28% of the quarter's revenue. This investment in new product development was in line with the year-ago quarter and has not significantly changed during the past year, regardless of the changes in the level of our revenue. Today, you will hear discussion about our autothrottle program. Our autothrottle is not simply a cruise control, but an important addition that enhances safety and protects vital engine components from damage. Our ThrustSense autothrottle is the only certified turboprop autothrottle available for Part 23 aircraft.
Business & Commercial Aviation referred to it in a recent feature article, and I quote, "As such, the system marks a major step in reducing pilot workload, especially in these aircraft that are typically flown by a single pilot." We continue to invest in innovative solutions. Recently, we were awarded an STC for a standalone autothrottle, which is controlled by our Integrated Standby Unit for the Pilatus PC-12. It builds on our existing STCs for turboprop autothrottles integrated with our display for the PC-12. It incorporates plug-and-play technology that reduces installation time and offers owners an economical solution to put this technology into their PC-12. As such, we expect to provide a template to reduce time required to add certifications for other aircraft platforms. We are now working on a standalone autothrottle for the King Air.
To accelerate the development, certification, and demonstrations, we purchased a 2008 King Air aircraft, which will enable us to control all aspects of the program. Consequently, we believe we can reduce the time to obtain a King Air STC so we can enter the market of more than 5,000 King Air turboprops. We continue to focus on our sales and marketing. In particular, we are continuing to build a global MRO network by signing distribution agreements with domestic and international MRO organizations. This provides a brand-new channel to market for the company. At the same time, we are also building up our internal sales and marketing resources and activity. We will strengthen our autothrottle focus with the addition of a product line director with proven product and market experience.
We are also investing in building a portfolio of new products, implementing our new sales and marketing strategy, and getting key distribution partners and sales resources in place. We believe this strategy will allow us to better control our operations while reducing the inherent risk of large engineering contracts over the long term. It is a right decision. We remain in a strong financial position to implement our strategy. Historically, we have been an operating cash flow positive. We are focused on returning us to these traditional levels of performance. Ultimately, it is about developing what we believe is the industry's most compelling price for performance products responsive to impending NextGen mandates. We believe that it is what will enable us to grow the business and create value for our shareholders. Now I'd like to turn it over to Rell for some more detailed financial discussion.
Thank you, Jeff, and thank you all for joining us this morning. For the three months ended March 31, 2018, net sales were $3.7 million compared to $4.7 million in the second quarter of fiscal 2017. Consistent with recent quarters, the majority of revenue was either from production contracts or customer service, including revenues recognized on intra-quarter book and ship orders. For the second quarter of fiscal 2018, gross margins were 44%, down from 51% in the year ago quarter. Product mix in the quarter included a high proportion of units with higher material costs and reflect the effort of lower sales volume, reducing the coverage of fixed costs. This is consistent with our observation that margins can vary from quarter to quarter as a result of changes either product mix or volume. Total operating expenses in the second quarter were $2.8 million.
In the year-ago quarter, we reported a total operating expense credit when we booked a reversal of a $3.6 million unbilled receivable reserve coincident with the settlement of the Delta lawsuit. On a sequential basis, total operating expenses were up modestly from the first quarter, reflecting some increased general and administrative spending. Research and development investment was relatively unchanged from a year-ago and has been running at a relatively consistent $1 million to $1.1 million to $1.2 million per quarter for some time now. We continue to remaining committed to funding internal new product development. Note that in the year-ago quarter, we recorded $4.1 million of the Delta settlement as other income. For the second quarter of fiscal 2018, we reported a net loss of $1.3 million or $0.08 per share.
As a result of the Delta settlement, net income and earnings per share were significantly higher in the second quarter a year-ago. Income tax expense for the second quarter of fiscal 2018 was $0.2 million, with an effective tax rate of negative 18% and reflects a change in the valuation allowance in the current period. Income tax expense was $1.2 million for the three months ended March 31st, 2017. The company remains in a strong financial position. At the quarter-end, we had $23.4 million of cash on hand and no debt, despite being somewhat operating cash flow negative for the first time in several quarters. Although capital expenditures have been relatively light in any particular quarter recently, I would note that we will have a $2.3 million purchase of a King Air airplane, which we expect to complete in the fiscal third quarter.
We believe the company has sufficient cash to fund operations in the foreseeable future. Now I'd like to turn the call over to Shahram.
Thank you, Ralph. Good morning, everyone. As Jeff mentioned, both revenues and new orders in the second quarter were up from the first quarter. This is consistent with our expectation for steady improvement over the course of this year. Orders in the quarter were $4.2 million, and backlog as of March 31st, 2018, was $3.8 million. We are undertaking a concerted effort to strengthen our autothrottle franchise. Once the STCs are obtained for the King Air series, we will have a range of autothrottles in the market that address a fleet we estimate totals 5,000 aircraft. As we increase the potential install base of our autothrottle by developing additional STCs, product recognition from industry publications, complemented with our increased emphasis on sales and marketing, is resulting in growing interest in the autothrottle product line.
We expect to broaden out from this base with products for other turboprop aircraft that leverage the technology behind the design of our standalone autothrottle. To that extent, we are in discussion with a number of potential candidates as part of the process of hiring an experienced autothrottle product manager to be the focal point for program management, marketing, and sales of this high potential product line. We also have been approached by a major engine manufacturer with an interest to team and jointly market our autothrottle with their engines. Our discussions with various aircraft OEMs with regards to offering our Utility Management System continues to gain momentum. Pilatus PC-24 is now in commercial production and is providing a steady pace of ongoing orders as we are the sole source supplier of the Utility Management System on that platform.
International opportunities continue to be a focus of our sales and marketing efforts. In fact, in the second quarter, 40% of our revenue was from international business. In China, air cargo growth continues, and many operators are looking to convert older Boeing 737, Boeing 757, and Boeing 767 aircraft into cargo planes. This is an area where we have great product and retrofit expertise. To capitalize on the local knowledge, we are partnering with MROs in that region to develop opportunities. MROs remain an important factor in our overall sales and marketing strategy. In addition to the local knowledge they can impart, they offer a cost-effective means to globally expand our distribution network. We plan to continue with growth of our MRO network within the U.S. and internationally. The number of aircraft on which we have installed equipment continues to increase.
As a result, we are experiencing a steady growth in customer service revenues. In summary, we are focused on creating value for shareholders through our strategy to develop the industry's best price for performance products, and to grow their sales by expanding our marketing reach. Let me turn the call back to Jeff for some closing remarks.
Thanks, Shahram. We are pleased that we are on our way to a steady improvement in revenues and backlog. I believe that the direction that we are taking in building a strong franchise with the development of a portfolio of autothrottles through our sales and marketing team, with the aid of our growing MRO network, we are expanding our ability to get these products in front of ready buyers around the world. In Asia, the surge in cargo air traffic is expected to be a spark for renewed growth in some of our legacy products, as well as the new ones. These are opportunities we are aggressively pursuing, through it all we are Excuse me. We maintain a strong financial position that will enable us to make strategic decisions that will create value for our shareholders over the longer term.
I appreciate your interest today. Now I open the call for questions. Thank you.
We will now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. Again, it is star then one to ask a question. At this time, we will pause momentarily to assemble our roster. The first question comes from David Campbell of Thompson, Davis & Company. Please go ahead.
Good morning, everybody. I'm glad to hear your voices. Thanks for your comments. I just wanted an update on the status of the next-gen aircraft modifications that are supposed to be going into the FAA plans at some point. I see increasing talk about companies developing products for that system, including one company that's been on the newswires, has been commercially advertising the connectivity systems between aircraft citing that this will be very much a big savings to aircraft operators in taking off and landing aircraft. I don't know if you've seen the commercial. Could you give us an update on the status of all that and what you're doing to participate?
Sure. I guess connectivity has been kind of bragged by a number of larger companies such as Honeywell, for example, where they project that all aircraft will talk to each other and tell each other about the weather up front and all of that great stuff. One of the main things of next-gen is getting in tighter airspaces, aircraft that they can closely do faster landings. To that extent, a lot of the air transport aircraft are all equipped with flight management systems that have very good vertical navigation capabilities as well as autothrottle. What we have done by developing and introducing an autothrottle into the business and general aviation market, coupled with our VNAV flight management system that we have developed, is bring that technology into those platforms. That's unprecedented by any other major avionics manufacturer or minor avionics manufacturer for that reason.
this is what we're doing for next-gen.
That combination of autothrottle and flight management systems is unique in the industry.
In the business aviation industry, it is. Follow each other tightly into landing. When we talk about in a 3D space, when we talk about doing RNP approaches
RNP
Required time of arrival, these are all the things that it's going to be. Right now, everybody's got their heads wrapped around this ADS-B Out , which is only the beginning phase, the stepping stone, the first stepping stone for NextGen. Once all of that's going to be done by December 2019, the emphasis is going to be on, now how do we take advantage of that technology? We have developed the tools to be able to take advantage of that technology by allowing the business aviation aircraft to be equipped with required time of arrival and precise three-dimensional, if you add the time to it, what they call the four-dimensional navigation. That is going to be the future of aviation.
In order to be effective, you need to have an autothrottle STC for all of the business aircraft that are used?
Well, some of the business aircraft. When you look at high-end business aircraft, like Gulfstream and some of those, they already have autothrottle in them.
A lot of them do.
In the mid-market of King Airs and the other turboprop aircraft, the PC-12, a lot of the regionals don't have autothrottle. Without autothrottle, you cannot have a very good vertical navigation capabilities. You will not be able to accurately monitor speed and time of arrival. It will be too much pilot workload to try to manage all of that. We bring that product into those markets which clearly lack. Even new airplanes that they make today don't have that capabilities in those types of aircraft.
Right. Do you see this developing during calendar 2019 and calendar 2020?
I think that's when people are going to want to take advantage of all of this money they've been spending on telling other airplanes precisely where they are and when they're going. When they start taking benefit from that, we have developed the products in order to do that.
This commercial that's been on television citing that they can do that. It seems like they're saying they can do that.
They could do it if they have An autothrottle for commercial air transport is about $200,000. It weighs upwards to 40 pounds, 50 pounds. It's big, and it doesn't fit readily in any reasonable turboprop aircraft, and that's why they're not used, and also because there was no critical requirement for speed control until NextGen came along. NextGen's coming along and already we have airports now with slot times where you're allowed to arrive and land in a two-minute window. That's going to be increased with required time of arrival. It means that you have to constantly monitor your speed and adjust it, and that when it goes to high levels of adjustment, it puts an incredible addition on the pilot's workload and also puts the engine at risk by overspeeding it or underspeeding it. That's why autothrottles are attractive.
To date, they've been heavy, expensive and difficult to install, and our unit can be installed, as an example, in a PC-12 in a few hours. That's remarkable. Instead of a week. It's those features that we believe is making it attractive. Oh, by the way, the leading BizJet periodical, part of Aviation Week, did a cover story on it, our autothrottle, in the February issue. It raved about its performance and the fact that it acted like a co-pilot. We think it's a good product. We see a lot of opportunity. For engine manufacturers, it provides a real protection of the engine, preventing overspeed and overtemperature conditions which seriously impact the life of the engine.
The OEMs already have that built into their engines, right?
No. The new engines, some of the new turbofan engines, the fan engines, are FADEC engines, full authority digital engine control. They protect the engine from overspeed and overtemperature and hot starts and a bunch of things. However, they don't automatically protect the airplane from overspeeding, which puts the aircraft at risk, or under speeding, which makes you fall out of the sky, or other serious problems. That requires an autothrottle. If you couple the new engine with the autothrottle, you can get what we produce in a single autothrottle for about a quarter of the amount of money.
How long will it take to get the King Air STC done?
A few months. Just to give you an idea, we purchased a used airplane because the modifications that were necessary, the test flying with the FAA, et cetera, we simply could not find a reasonable airplane that the owner was prepared to essentially shut down for a year and have major modifications done to it. We ended up doing it this way, and we believe we can resell it and either make money or at least break even, we hope. It's a practical way to do it. We labored looking at the alternative for about four months or five months, and it was delaying the program, and the board overwhelmingly said, "Go ahead and do it. That's why we have cash on board, and it's not going to affect the balance sheet, and we can resell it when we're finished demonstrating it." That's why we got it.
It sounds like a great idea to accelerate the King Air market, which needs an STC. That's all it needs. Then you could start using it.
You're absolutely right. We did a couple of opportunities with partners, and they tried to be very helpful, but it was compelling that it just wasn't going to work. We could not have the airplane available when we needed to actually do the installation. We got one, it's excellent. We will get delivery of the airplane sometime the end of next week or the week after, and immediately start installation of our equipment and start flight testing and demonstrating to the FAA. With the paperwork delays and the rest of it's going to take a couple of months. We're well on our way, moving quickly.
You'll put the flight management system in that plane, too?
Yeah, we will do that. Right now, we have it in the PC-12. We were looking at doing exactly the same thing in the King Air.
Right.
Yeah. It depends on the configuration. The newer ones have a flight management system, albeit not one that uses an autothrottle because the airplanes don't have an autothrottle. The FMSs that are in there don't use that feature. Ours does. In the older units where we would replace the cockpit avionics with our system, which has an integrated vertical navigation 3D navigation system, it incorporates the autothrottle. You can do things like follow the airplane in front of you by precisely two miles or three miles or four miles in complex holding patterns, and it'll do it all automatically. You could never do that manually.
Yeah.
That's all tied into the NextGen and all of that stuff. ADS-B. Coupled with ADS-B, you can sit there and follow the airplane in front of you at a precisely safe speed.
All right. Sounds great. Okay, thanks for the answers. Thank you very much.
Thanks, David. It's good talking to you.
Yeah. Thanks, Jeff.
Again, if you have a question, please press star then one on a touch-tone phone. At this time, I'd like to turn the conference back to Mr. Hedrick for any closing remarks.
Do we have anybody else in line? Looks like we have a couple of people in line.
Yes. two have just entered. If it's okay, I'll take their questions if you wish.
Go ahead.
Okay. We have a question from Jason George, private investor. Please go ahead.
Hi, there. Thanks for taking my call. Hello?
Go ahead.
Oh, thanks for taking my call. Yeah. I've been a shareholder for the last couple of years. I just had two questions, if you would. I noticed at the end of the last quarter's conference call, you spoke about other companies perhaps expressing interest in acquiring ISSC. Is there any update on that, given the compelling nature of the autothrottle?
Actually, last quarter I talked about the fact that we were considering engaging a company that we do regularly to evaluate the best use of our funds. That's all. We've had a number of people contact us, that's ongoing. That's been going on since we went public.
Nice.
There's nothing new and no progress and nothing to comment on, I guess is the answer.
Okay. All right. My other question is, this is pretty far out, just given the announcement by Uber yesterday about having flying cars in the next five years sort of thing, I was kind of curious about whether autothrottle was the type of technology that could be applied to that type of vehicle.
Yeah, I understand. I think we'll see if it's around five years.
Yeah.
The lady in Texas that's dead probably doesn't think it's a great idea.
Now they're flying cars. They're done with driving them, now they're flying them.
I'll tell you what we do do, which is very interesting, and there's an article coming out in Flying Magazine in the next month or so, in which we let one of the senior editors fly the airplane, and we showed him that from rotation, from liftoff of the airplane to flying to a destination, I don't know, 100 or 200 miles away, and going all the way down to 200 feet over the runway. He did it without touching any control of the airplane.
Wow.
The autothrottle did it all automatically. The flight management system navigated automatically at a level of precision that I don't think you can do manually, and brought the airplane precisely to the edge of the runway, 200 feet above the runway.
Wow.
We already did that. Beyond that, I'm a pilot. Trust me, if I'm sitting in the back, I want a pilot to land the airplane, although big airplanes land themselves all the time. I tell you what the hardest part is, putting it on the brakes and steering it on the ground. It's not flying in the air. That's easy. Once you get it on the ground, putting it on the brakes and making sure that you go onto the taxiway. Essentially driving the car, I guess. Go ahead.
All right. Well, thanks for taking the call. That really helps.
You're welcome.
Appreciate it.
We have a question from Charlie Pine of Van Clemens & Company. Please go ahead.
Hi. Good morning. I have a couple questions for you folks. First off, can you just give a little more clarification on the process of what's transpired over the last, say, 6-9 months about the STC for the autothrottle for the King Air? I was under the impression that last fall you had an announcement or a deal. You were partnering with a company called Blackhawk Modifications to do an install and the testing for it, and then we didn't really hear much about that. Late last year, we were informed that you were supposed to have an STC, or the testing was supposed to be completed by January or February of this year, and now we're hearing that you have to go out and buy it for your own aircraft.
I'd like to get more clarity around the process that's been occurring with this, and how much comfort you actually have now as to where you are at, and that you actually really do feel you're going to have an STC in a couple of months.
Well, the quick answer is yes, we do, and I'll explain what happened. That was what precipitated actually purchasing the aircraft. Everybody that we found as a partner had an airplane, but did not want to commit the airplane to an uncertain time and take it. In certain cases, they were modifying an airplane and selling it, and they didn't want to tie up the capital, the cash, on their credit line for an indeterminate amount of time. We kept running into this, we kept hoping that we could solve it, in fact, we couldn't. It was at that point, we finally determined, I went to the board and said, "Look, this is a problem. We can't get a commitment. They have a problem tying up or committing their aircraft." That's when we went ahead and purchased an aircraft. The aircraft-
Let me interject for a second. How many flight hours are required for the testing of this?
Not as many flight hours, you have modification hours and installation into the aircraft. It's not so much the number of hours, which probably could be done in 20 to 30 hours. That, if it was a straight contiguous time, would be easy, that's not the problem. We say, "Okay, we want the aircraft," they say, "Well, you can have it for 10 days." Well, you can't start a program with the FAA. Well, you only have 10 days to approve this, get going. It's always an open-ended process. There was no way that we could First of all, you have to dramatically modify the airplane, then we would have to de-modify the airplane and give it back to them.
That would double the amount of time, and for many of these people, they say, "Well, I'm not sure I want you to modify and then de-modify." It became a constant recurring problem, and that's why we went ahead and did it. We feel that now we can do this and move along. The airplane will be delivered. Actually, it's right now with Textron Services in Florida. That's actually the manufacturer. They have a service center, and they're going to be doing the modification as well, and they are also very interested in our product.
Okay. A couple quick follow-ons. The STC that you're going to be applying for the autothrottle on this particular King Air, is this for the standalone drop-in autothrottle, or is this the one, like the predecessor that you first got for the Pilatus PC-12, where it's the autothrottle and your flight management system? Which one is it?
It's a standalone drop-in autothrottle, and that's the first one we're doing. You could get the details from Shahram. Shahram, pick this up.
Sure. Yep. For the first STC on the King Air, we're doing the standalone autothrottle as Jeff said.
About it.
Which goes in with our standby instrument. Essentially, we replace the standby instrument in the aircraft with our standby instrument, and that provides all the controls for the autothrottle. We've done that because a lot of the more valuable whole aircraft have modern cockpits in them. This is going to give us the quickest path to revenue, is to provide this standalone autothrottle system. Once we're done with that, we will look into getting an older aircraft where we would do the full cockpit replacement for it with our display and flight management system.
Okay, great. Thanks. I have one other follow-up. This has to do with your MRO channel partners. You folks talked a lot about, over the last year, all of these MROs that you've signed agreements with. There was a big press release that you had regarding your relationship with Lufthansa Technik. I'm curious as to this point in time now, you've been involved with these MROs, and you've been more aggressive with them as far as having relationships now for about a year. Are you beginning to see some revenue lift from these relationships, or is that still yet to come? Are we starting to see that in this quarter? If not, when can we anticipate that we're going to?
Okay. Just to give you some background, when we talk about air transport, our typical sales process takes about two years. From when we start talking to an airline until we actually start seeing revenue, it takes about two years. The MRO relationships that we've had, including Lufthansa Technik, we're seeing a good progress, although has not turned into revenue. We're hoping over the next few quarters, we'll be able to see, because we've done a lot of quotes with them, we've done a lot of joint offerings, which hopefully will turn into orders.
Okay. That covers it for me then, I guess. Thank you.
Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.