INNOVATIVE SOLUTIONS & SUPPORT INC - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended December 31, 2004

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 of incorporation)			(IRS Employer 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 No

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

As of January 31, 2005, there were 11,851,395 shares of the Registrant’s Common Stock, with par value of $.001, outstanding.

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INNOVATIVE SOLUTIONS & SUPPORT, INC.
FORM 10-Q December 31, 2004
INDEX

		Page No.


PART I.	FINANCIAL INFORMATION	—

Item 1.	FINANCIAL STATEMENTS (UNAUDITED)

	Condensed Consolidated Balance Sheets – September 30, 2004	3
	and December 31, 2004

	Condensed Consolidated Statements of Operations –	4
	Three Months Ended December 31, 2003 and 2004

	Condensed Consolidated Statements of Cash Flows –	5
	Three Months Ended December 31, 2003 and 2004

	Notes to Condensed Consolidated Financial Statements	6 – 9

Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL	9 – 13
	CONDITION AND RESULTS OF OPERATIONS

Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT	14
	MARKET RISK

Item 4.	CONTROLS AND PROCEDURES	14

PART II.	OTHER INFORMATION	–

Item 6.	EXHIBITS AND REPORTS ON FORM 8-K	15

SIGNATURES

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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 December 31, 2004
ASSETS


Current Assets:
Cash and cash equivalents		$	65,867,167	$	73,340,686
Accounts receivable, less allowance for doubtful accounts of
$100,000 at September 30, 2004 and December 31, 2004			5,003,100		5,196,164
Inventories			5,191,628		5,543,742
Deferred income taxes			984,111		984,111
Prepaid expenses			665,276		580,648


Total current assets			77,711,282		85,645,351

Property and Equipment:
Computers and test equipment			3,933,326		4,011,126
Corporate airplane			2,998,161		2,998,161
Furniture and office equipment			622,364		649,931
Manufacturing facility			5,414,986		5,420,741
Land			1,021,245		1,021,245

			13,990,082		14,101,204
Less- Accumulated depreciation and amortization			(4,369,851)		(4,549,086)


Net property and equipment			9,620,231		9,552,118


	Deposits and other assets		137,114		134,114


	Total assets	$	87,468,627	$	95,331,583

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		1,347,804
	Accrued expenses		4,754,641		6,381,509
	Deferred revenue		526,023		523,732


	Total current liabilities		7,084,168		8,360,302


	Note payable		4,235,000		4,235,000

	Long-term portion of capitalized lease obligations		20,681		18,819

	Deferred revenue		261,934		244,316

	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 December 31, 2004			—		—

Common stock, $.001 par value: 75,000,000 shares
authorized, 13,515,330 and 13,532,177 shares issued and
outstanding at September 30, 2004 and December 31, 2004			13,515		13,536

	Additional paid-in capital		48,712,289		49,125,767
	Retained earnings		37,342,940		43,535,743
	Treasury stock, at cost, 1,690,026 shares		(10,613,757)		(10,613,757)


	Total shareholders’ equity		75,454,987		82,061,289


Total liabilities and shareholders’ equity		$	87,468,627	$	95,331,583

The accompanying notes are an integral part of these statements.

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

	Three Months Ended December 31, 2003			Three Months Ended December 31, 2004




Net sales	$	8,523,336		$	18,978,804
Cost of sales		3,481,411			6,182,143

Gross profit		5,041,925			12,796,661

Operating expenses:
Research and development		1,009,275			1,271,531
Selling, general and administrative		1,640,620			2,028,467

		2,649,895			3,299,998

Operating income		2,392,030			9,496,663
Interest income		(112,671)			(283,250)
Interest expense		31,855			39,738

Income before income taxes		2,472,846			9,740,175
Income taxes		(865,496)			(3,547,372)

Net income	$	1,607,350		$	6,192,803

Net Income Per Common Share:
Basic	$		0.14	$	0.52

Diluted	$		0.14	$	0.51


Weighted Average Shares Outstanding:
Basic			11,412,614		11,835,138

Diluted			11,776,015		12,180,275

The accompanying notes are an integral part of these statements.

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

	For the Three Months Ended December 31, 2003		For the Three Months Ended December 31, 2004



CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)		$1,607,350		$ 6,192,803
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization		161,864		182,235
Loss on Disposal of Fixed Assets		1,037		—
Excess and obsolete inventory expense		42,194		(6,017)
Compensation expense for stock issued to directors		39,609		57,990
Tax benefit from exercise of stock options		10,047		116,741
(Increase) decrease in:
Accounts receivable		1,310,917		(193,064)
Inventories		(504,899)		(346,097)
Prepaid expenses and other		220,676		84,628
Increase (decrease) in:
Accounts payable		178,593		(348,443)
Accrued expenses		(61,704)		1,705,926
Deferred revenue		75,439		(19,909)

Net cash provided by operating activities		$ 3,081,123		$ 7,426,793


CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(274,283)		(111,122)

Net cash used in investing activities		($274,283)		($111,122)


CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options		85,193		157,848
Proceeds from exercise of warrants		172,857		—


Net cash provided by financing activities		258,050		157,848


Net increase in cash and cash equivalents		$ 3,064,890		$ 7,473,519

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


Cash and cash equivalents, end of period		$51,854,634		$73,340,686

The accompanying notes are an integral part of these statements.

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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 December 31, 2004, the statement of operations for the three months ended December 31, 2003 and 2004 and the statements of cash flows for the three months ended December 31, 2003 and 2004 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 December 31, 2004 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 ended December 31, 2004 are not necessarily indicative of the operating results for the full year.

2. Net income per Share

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

A reconciliation of weighted average shares outstanding appears below:

	Three Months	Three Months
	Ended	Ended
	December 31, 2003	December 31, 2004

Weighted average number of shares-basic	11,412,614	11,835,138
Effect of dilutive securities:
Employee stock options	196,044	345,137
Warrants	167,357	0

Weighted average number of shares-diluted	11,776,015	12,180,275

For the three-month period ended December 31, 2004, there were 8000 options outstanding that were excluded from the computation of diluted earnings per share as the effect would be antidilutive.

3. Concentrations

For the three months ended December 31, 2004, three customers accounted for 16%, 15%, and 12% of net sales or 43% on a combined basis. For the three months ended December 31, 2003, two customers, one new and one repeat, accounted for 33% and 18%, respectively, of net sales or 51% on a combined basis.

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4. Inventories

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

	September 30,		December 31,
	2004		2004

Raw materials	$	1,928,005	$	3,094,594
Work-in-process		2,573,932		2,108,519
Finished goods		689,691		340,629

	$	5,191,628	$	5,543,742

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 December 31, 2004 is highlighted below:
Warranty accrual at September 30, 2004	$	757,476
Accrued expense for the quarter ended December 31, 2004		60,007
Warranty costs for the quarter ended December 31, 2004		(50,295	)


Warranty accrual at December 31, 2004	$	767,188

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 1,259,350 shares of Common stock for awards under the Plan.

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 123, the Company’s pro forma net income for the three-month period ended December 31, 2003 and 2004 would have been as follows:

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	Three Months		Three Months
	Ended		Ended
	December 31,		December 31,
	2003		2004
Net Income:
As reported		$1,607,350		$6,192,803
Deduct: Total stock based employee
compensation expense determined under
the fair value based method for all
awards, net of related tax effects		($181,085)		($183,411)


Pro forma		$1,426,265		$6,009,392


Basic EPS:
As reported		$0.14		$0.52
Pro forma		$0.12		$0.51

Diluted EPS:
As reported		$0.14		$0.51
Pro forma		$0.12		$0.49

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.

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 reporting period beginning after June 15, 2005. The Company will adopt Statement No. 123(R) beginning with the fourth quarter of fiscal 2005. 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.

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 proposed 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 proposed 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.

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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 re-competed 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.

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 December 31, 2004 Compared to the Three Months Ended December 31, 2003

Net sales. Net sales increased $10.5 million, or 123%, to $19.0 million for the three months ended December 31, 2004 from $8.5 million in the three months ended December 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 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 are increasing as both air transport and general aviation industry segments begin to meet the new FAA mandate.

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Cost of sales. Cost of sales increased $2.7 million or 78%, to $6.2 million, or 33% of net sales, in the three months ended December 31, 2004 from $3.5 million, or 41% of net sales, in the three months ended December 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 higher net sales in the period.

Research and development. Research and development expenses increased $0.3 million or 26% to $1.3 million or 7% of net sales in the three months ended December 31, 2004 from $1.0 million or 12% of net sales in the three months ended December 31, 2003. The absolute dollar increase was principally due to increased staffing as the Company supports its flat panel and other ongoing development programs. 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 24%, to $2.0 million, or 11% of net sales, in the three months ended December 31, 2004 from $1.6 million or 19% of net sales, in the three months ended December 31, 2003. The increase in the dollar amount was primarily the result of higher commissions and compensation expense. The decrease as a percent of net sales was the result of higher net sales in the period.

Interest income. Interest income was $283,000 in the three months ended December 31, 2004 as compared to interest income of $113,000 in the three months ended December 31, 2003. The increase in interest income in the three months ended December 31, 2004 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 $40,000 in the three months ended December 31, 2004 as compared to interest expense of $32,000 in the three months ended December 31, 2003. The increase in interest expense in the three months ended December 31, 2004 was primarily the result of higher interest rates in the period.

Income tax expense. Income tax expense for the three months ended December 31, 2004 was $3.5 million. The income tax expense for the three months ending December 31, 2003 was $0.9 million. The increase in tax expense was primarily due to higher income in the period. The effective tax rate in the December 31, 2004 quarter was 36%. In the December 31, 2003 quarter the effective tax rate was 35%. 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 2003 due to lower pre-tax income in the period ended December 31, 2003.

Net income. As a result of the factors described above, our net income in the three months ended December 31, 2004 increased $4.6 million or 285%, to $6.2 million, or 33% of net sales, from $1.6 million or 19% of net sales in the three months ended December 31, 2003.

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 $7.4 million for the three months ended December 31, 2004 as compared to $3.1 million for the three months ended December 31, 2003. The increase was due to higher net income in the period.

Our cash used in investing activities was $111,000 for the three months ended December 31, 2004 primarily consisted of laboratory test equipment, computer equipment and office furniture. Cash used in investing activities was $274,000 for the three months ended December 31, 2003 and primarily consisted of production equipment, laboratory test equipment, computer equipment and office furniture.

Net cash flow from financing activities was $158,000 for the three months ended December 31, 2004 as compared to $258,000 in the three months ended December 31, 2003. In the three month period ended December 31, 2004, the in-flow of cash was the result of proceeds from the exercise of stock options. In the period ended December 31, 2003, 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.

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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 December 31, 2004 our backlog was $36.2 million. This represents a $10.2 million or 39% increase from the December 31, 2003 backlog of $26.0 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.”