Innovative Aerosystems, Inc. (ISSC) Earnings Call Transcript

Good morning, and welcome to the SHARE Series. I'm Dan Aldridge, Founder and Managing Partner of the SHARE Series. And with us today, we have 2 individuals that will be speaking. We have the CEO, Shahram Askarpour; and CFO, Michael Linacre, both of IS&S, they're going to go through some opening comments, and then I'll kick it back for questions. Remember to use the Ask Questions button at the top of the video player to submit questions throughout. Any questions that don't get asked, we'll follow up on. As we go through, there's also information on the right-hand side that has bio information and other pertinent company information. So with that, I will turn it over to Shahram for opening comments. Shahram?

Thank you, Dan, and welcome, everyone. IS&S was founded in 1988 on an idea that aircraft operators will frequently upgrade their avionics as electronic technology grows. We are an IP-rich company that generates an average of 7 patents per year to protect our inventions and product technologies. We serve 3 market segments with our avionics products being business aviation, air transport and military. We also provide avionics, a new aircraft production, which we refer to as OEM as well as aftermarket or workforce. A year ago, we had a transition in the leadership of the company from a founder to me. As the result, we have made some adjustments in our growth strategy. I've been with IS&S for 20 years, initially as Head of Engineering and later as the President, while playing a key role in product development and marketing strategy. Our previous growth strategy has been focused on organic product development. For example, we initially developed and certified the utility management system for the Pilatus PC-24 and we plan to utilize this existing certified system as a platform for autonomous flow. We also plan to leverage our strong financial position and our underutilized infrastructure to augment the successful organic growth with targeted product acquisitions that help accelerate our growth as our current production infrastructure can triple our sales with little to non-CapEx requirement. In the past 5 years, we've had top line CAGR of 15%. As a result of our organic growth strategy, we have a rich product portfolio that has been designed and certified to the highest level of safety, Level A, and is utilized in some of the world's most prestigious aircraft such as the Boeing 767. We are vertically integrated in our facility in Exton, Pennsylvania. We internally perform all aspects of product development and qualification. We manufacture all products, including all sub assemblies in-house. We have an automated surface mount technology laboratory that produces all our electronic circuit cards. We machine our mechanical parts, we even paint our equipment in-house and our direct cost of labor is less than 5% of our revenue. We achieved this through innovation in product design and automation in the factory. The reduced labor content is what allows us to achieve attractive gross margins of 60% as well as enable us to significantly increase our revenue without significant increase in skilled labor. As I mentioned before, we are calling a 30% capacity in our production. Our early products mainly consisted of individual primary flight instruments designed for military aircraft such as our highly reliable and accurate air data computers that sense and compute aircraft speed and altitude as well as engine instruments that measure and display critical aircraft engine parameters. In early 2000s, it was demanded by the FAA to reduce vertical separation of aircraft from 2,000 feet to 1,000 feet when flying at and above 29,000 feet. The IS&S data products met and exceeded the accuracy requirements. We shared the market with 2 larger competitors and yet captured over 60% of the world's business aircraft, generated $100 million in cash and invested that money over the years to grow our product portfolio. Example of our system integration products range from business aviation aircraft to large air transport, civil and military aircraft. Our 757, 767 cockpit is installed in over 500 aircraft, including fleets of FedEx, Amazon, DHL and American Airlines. We have integrated individual cockpit instruments inside the large LCD displays, adding high-performance deviation systems, utilizing our precise Beta-3 GPS receiver that allows for highest navigation level of accuracy of a 1/10 of a nautical mile in flight as well as precision approach for landing, thus resulting in high integrated cockpit solutions. In the last 10 years, we've been developing products for flight control, such as our ADAHRS which is an integrated computer that senses and provides all aircraft primary flight, including aircraft attitude, altitude, airspeed, outside air temperature and vertical speed. Our utility management system, or UMS, that replaces 22 control and monitored subsystems in the aircraft and our autothrottle product line that significantly reduces pilot workload to text the engine and aircraft envelope from safety critical and over and underspeed conditions. The utility management system, or UMS, and our autothrottle product line have provided us with unique actuation and monitoring technology that is the engine for our near-term organic growth strategy. We are currently in discussion with other aircraft manufacturers to incorporate our UMS product line in their various platforms as well as expanding the platforms for autothrottle product line. Organic growth will also be realized through our aftermarket solutions that replace other obsolete and inadequate systems in all 3 market segments. The acquisition strategy is to incorporate, established cockpit and cabinet product lines in our production facility, gaining significant operating leverage. I would now like to talk about our long-term growth strategy. The future of aviation is in autonomous flight with the 2 major milestones being first, reduce the pilot count to 1; and second, to eliminate the pilot in the aircraft. Our focus is on the lucrative near-term opportunity of reducing the pilot count on Part 25 aircraft. That is aircraft with growth rate of over GBP 2,500, which covers most of the multi-engine aircrafts out there. These aircraft are currently required to fly with 2 or more pilots on board. The business case is compelling. Starting a larger business aircraft such as the Citation XLS and above, where the ROI is less than 2 years to passenger and cargo airline operations where a typical passenger airliner has an average of 10 to 16 full-time pilots on staff per aircraft and the ROI is less than a year. Reducing that count to half is a highly attractive proposition for all operators of Part 25 aircraft. The aircraft operators have been demanding a solution that reduces pilot count from 2:1 and the certification authorities are reacting to that demand. So we look at the initial phase of the flight autonomy to be one pilot in the aircraft with fully autonomous system capable of performing all phases of flight and ground activities. The automated system communicates with a ground station that includes pilots monitoring many aircraft and assisting the flying pilot through the automated flight system. Two product lines developed by IS&S are the existing certified equipment that enable Phase 1 operations of autonomous flying, being our integrated cockpit system and the utility management system. Our integrated cockpit system is a central display and control hub for all aircraft functionalities including a highly accurate navigation computer. The system provides pilot commands in the digital format to all aircraft subsystems making it ideal for automation of the pilot activities. The utility management system monitors and controls all aircraft functions and subsystems by directly monitoring sensors as well as driving and monitoring the position of actuators that control the aircraft path. This is the basis for the Phase 1 of automation. Both systems have been successfully fielded on business jet aircraft for many years. As I mentioned, Phase 1 is an achievable and highly lucrative proposition for the market, and we are well positioned with our technology to take advantage of this opportunity. We believe that we are well positioned, given our strong balance sheet and financial stability to take advantage of the upcoming short-term changes in the industry as well as accelerate our current growth by targeted acquisitions that yield similar to our 60% gross margin products. We have a strong balance sheet, being cash flow positive for the last 4 years, we have generated over $8 million in cash in 2022 with $6 million in free cash flows. We have over $17 million in cash, no debt. We own our facility, our airplane and equipment and our facility is at 30% utilization, allowing us to leverage acquiring products to accelerate the growth. Thank you for attending our seminar. I will now open the floor to questions.

Shahram, that's a great overview. Thank you for that. So let's dig in a little bit. Let's talk about the key differentiators with IS&S, particularly in the products you sell at the end markets that you serve.

So being a small business, competing with companies that are orders of magnitude larger than us, we tend to focus on developing products where we have a technological advantage. We take our IP seriously protected and enforce our patents. In the aftermarket side, we take into consideration the ease of installation, minimizing the aircraft downtime and reducing the pilot training time since all these are factors that build the total cost to the operators. As I mentioned, we serve 3 market segments being military, air transport and business aviation. We have been staying away from the low end of the general aviation aircraft because there are relatively lower barriers to entry. Dan, you are...

Yes, got it. So you mentioned a couple of global customers that you already have. How do we think about that in terms of potential growth? And then when you think about growth, how do you prioritize organic versus inorganic?

So in the new aircraft market, we see our main areas of growth being based on our standby instrument and utility management system product lines. We are marketing those aggressively to a number of international aircraft manufacturers. On the aftermarket side, our autothrottle install base is growing. We are launching a new engine and crew alerting system for the 757, 767 aircraft, and we are experiencing increased demand for our display and air data products for the military market. In terms of inorganic growth, we have hired a business development professional that leads the team that identifies and evaluates product opportunities for acquisitions. In terms of how we prioritize, each year we allocate funding for IR&D that is the source of our organic growth. And we plan to use the excess cash for product acquisitions.

Sorry, I keep going on mute. We've had a dog in the neighborhood barking. But let's kick it over to Mike so he can get some questions. And Mike, can you walk us through revenue mix a little bit? How much is commercial versus defense government, how that evolved over time?

Yes. Thanks, Dan. When you look at our revenue mix, you really can look at this in a couple different ways. Our OEM was our new manufacturing airplane business, our aftermarket and our repairs. When you kind of slice it those 3 ways, it's about 40% OEM, 40% aftermarket, 20% repairs. You can also look at it by business aviation, air transport and military really is the defense government portion. And really, when you look at it that way, it's about 1/3, 1/3, 1/3. And really how this has evolved over time. If you look at our financial results, I guess, pre-2018, there's a lot of revenue fluctuations from year-to-year. A lot of that is in the air transport aftermarket segment where really changes from year-to-year depending on industry mandates and items such as that. So since 2018, we've invested in product development and develop relationships to get more on the OEM business, where the revenue is more steady and predictable. So in the history -- historically, the OEM portion, business aviation, those parts were a little bit lower as a percent of total sales. But with OEM, we have that more predictability. And actually, with OEM and repairs, roughly 60% of our business is relatively predictable with the other 40% changing slightly from period to period.

Okay. So Michael, I'll stick with you for the next one. So given your strong financial position and liquidity, what are your priorities for capital allocation as we move forward?

Yes. So we tend to, I guess, in short, we really want to take the capital and reinvest it back into the business. That's where we see the most value created to the company. And as Shahram mentioned, some of our long-term and short-term growth strategies, organic and nonorganic and mainly with our inorganic strategies of growing the acquisitions of product lines, we certainly plan to develop or bring funds aside for that. I mentioned we have $17 million in cash. We also plan on continuing our product development as part of our organic short-term and long-term goals. We plan on increasing our R&D to add that value. We've seen recently more R&D of about 10%, but really that needs to be around 13% to 15%. And overall, our business doesn't really require a whole lot of capital on an annual basis as far as machinery and equipment. So a lot of our capital will be dedicated to achieve both our, as mentioned, long-term and short-term organic and inorganic strategies.

Shahram, let's switch back over to the product side. Can you talk a little bit about what you're most excited about in the portfolio?

Sure. So our autothrottle product lines are many valuable and unique features that make them desirable for the market. We provide protection for the engine that has significant cost saving potentials on these nonfaded turboprop aircraft. We provide for safety critical aircraft on the underspeed and overspeed protection. Now in the twin engine turboprops like the King Air's, we provide what we call VMCa protection. That is in case of loss of an engine, we control the power of the remaining engine to avoid deadly loss of control due to unbalanced thrust. And these are all patented algorithms that we have -- that provide us with a lot of rich IP in the market. When we look at our long-term product strategy, the utility management system, or our UMS, is the exciting product. We see a lot of potential for this unique product. Essentially, it provides the aircraft manufacturers with an open architecture platform to integrate the aircraft controls into 1 system, replacing as much or over 22 federated boxes in the aircraft. So as a result of that, it provides rate savings, power savings, significantly improved aircraft reliability, it handles a lot of obsolescence issues that some of the aircraft manufacturers struggle with. And it increases the mission readiness of the aircraft. Long-term benefits of this product is that it makes the aircraft ready for autonomous flight. And as we talked earlier, autonomous flight is pilot reduction, I guess, is the kind of the key word these days at certification of authorities, handling the pilot shortages and increased demand in their transport flights. So autonomy -- flight automation is key and utility management system is designed to ease that transition. Our system is certified to the highest level of safety, it's all certified to level A designed for flight controls. And we've got over 1,000 units fielded. I'm flying every year, we delivered a couple of hundred more of these things. So there's a good foundation there for that product. And we see a lot of potentials there. So that kind of what makes me excited. It's a great product for the market and we see good potential there.

So obviously, there's been a lot of progress in the EBITDA market. Is there an opportunity for you guys to capture additional market share, right, as they come online?