|Shares Out. (in M):||17||P/E||0.0x||0.0x|
|Market Cap (in $M):||77||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-17||EBIT||0||0|
|TEV (in $M):||60||TEV/EBIT||0.0x||0.0x|
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Are you using a computer more than five years old, or one made recently but unchanged in design or specs from that of ten years ago? Of course not. Then it might surprise you that most commercial, military, and general aviation planes in the air today rely on computers and information displays made or designed from five to twenty five years ago. Even the most modern planes have most component design frozen years before the plane starts production, so the new 787, for example, has cockpit displays based upon state of the art five years ago, with fewer pixels and slower speed than whatever device you are probably using to read this.
ISSC, which recently celebrated its 25th birthday, is a provider of advanced airplane avionics and data displays. Its equipment is used to upgrade older aircraft to meet newer FAA mandates, and to improve safety, fuel efficiency, and pilot control. Although its products are mostly designed for retrofitting in older planes, its growing reputation for quality, design and value has has gained ISSC several new OEM customers for models coming out starting this year, with joint development programs funded by OEMs underway that should lead to much more penetration of the new plane market.
As a stock, ISSC is a very illiquid and overlooked microcap, partially I think because its generic sounding name provides no clue as to what business it is in. Its numbers in the last seven years haven’t helped; after peaking at $63MM in the FY ending 9/2005, revenues have bounced around at much lower levels, and seems headed to roughly $28-$30MM this FY. It has been profitable for the last four years, but not so much as to justify a higher stock price on that alone.
What makes it an interesting story is that when revenues peaked at $63MM in 2005, ISSC was a company getting a huge percentage of revenues from just one product line, equipment to allow tighter vertical separation between planes, that the FAA required to be installed on every commercial airplane flying in the continental US. In the years since then, ISSC has spent extremely heavily on R&D (counting OEM financed engineering expenses, R&D is currently running at about 30% of revenues) and has developed a much broader product line. Demand will be helped by new FAA requirements as they come along, but most of ISSCs products appeal to users of older planes even without a mandate. Particularly promising are its newer control systems that make use of an advanced GPS engine to control the plane’s course more precisely, providing a one year payback to its customers from fuel savings alone.
The vast majority of the commercial and military planes flying today have yet to be significantly modernized in terms of controls and displays. Much of the world’s fleet gets information from CRT displays of the sort you had on the home computer but that you threw out years ago. ISSC has a range of offerings from individual instruments to complete cockpit suites that can be retrofit into an aging aircraft in 24 hours and give as good or better performance than what a newly manufactured plane of that model would have.
The combination of ISSCs expanded product line addressing more models of planes and more instruments per plane, and its increasing acceptance as an OEM supplier, should provide at least several years of solid sales growth, plausibly in the 20%-25% range as a rough guess. Although overall corporate gross margin has been held down to the mid 40% range because of OEM sponsored R&D that ISSC does with gross margins in the mid 20% area, the products themselves carry gross margins a good 30 points higher, reflecting the fact that competition for avionics equipment is limited to relatively few highly trusted and approved suppliers.
Without trying to be particularly precise on timing, ISSC appears a few years away from revenues over $50MM and EPS in the 50 cent range or more. The balance sheet is strong, with no debt and about $1/share in cash despite a special cash dividend of $1.50/share last December. The latter was quite large as a percentage of the then stock price, a sign of a Board responsive to shareholders’ interests. That suggests that were a larger aerospace firm interested in acquiring ISSC, the offer would be given fair consideration. During the last fiscal year the company bought back 212,000 shares at an average price of $3.77/share, not easy given how lightly it trades.
Business: Before going on at any length about ISSC’s specific products, I recommend looking at its website (http://www.innovative-ss.com/index.asp), and start under the tab “Platform and Systems” to see pictures and descriptions of ISSC’s products. As you might expect, the website is designed for an audience of aircraft engineers and managers, so unless you have that background I recommend this screen to help translate: (http://en.wikipedia.org/wiki/Acronyms_and_abbreviations_in_avionics#T) For a more thorough description of the business, here is my heavily edited version of that from the 10-K:
The Company is a systems integrator that designs, manufactures, and sells flight guidance and cockpit display systems for OEMs and retrofit applications. The Company supplies integrated Flight Management Systems and advanced GPS receivers. The strategy is to leverage the latest technologies developed for the computer and telecommunications industries into advanced and cost-effective solutions for the general aviation, commercial, and US and foreign military markets, to enhance both the safety and efficiency of flying.
ISSC sells to the DoD and its commercial contractors, aircraft operators, aircraft modification centers, foreign militaries, and various OEMs. Customers have been and may continue to be affected by the ongoing adverse economic conditions that currently exist both in the United States and abroad. However, the Company believes that in a declining economic environment a customer who may have otherwise elected to purchase newly manufactured aircraft will be interested instead in retrofitting existing aircraft as a cost effective alternative.
A wide range of information is critical for proper and safe operation of aircraft. With advances in technology, new types of information to assist pilots are becoming available for display in cockpits, such as satellite based weather and ground terrain maps. The Company believes that aircraft cockpits will increasingly become information centers, capable of delivering additional information that is either mandated by regulation or demanded by pilots to assist in the safe and efficient operation of aircraft.
There are three general types of flight data: 1) aircraft heading and altitude information, 2) flight critical aircraft control data, and 3) navigation data. Aircraft heading and altitude information includes aircraft speed, altitude, and rates of ascent and descent. Flight critical aircraft control information includes engine data such as fuel and oil quantity, and other engine measurements. Navigation data includes radio position, flight management, GPS, and information not originating on the aircraft, including weather depiction maps, GPS navigation, and surface terrain maps.
Traditionally, flight data and other cockpit information were displayed on a series of separate analog mechanical instruments. In the early 1980s, digital displays using Cathode Ray Tubes ("CRT") began to replace some individual analog instruments. Presently, the industry offers high resolution color flat panels to replace traditional analog instruments or CRT displays.
ISSC expects that the ability to display more information in a space efficient and custom platform will become increasingly important if additional information, such as weather depiction maps, traffic information, and surface terrain maps, becomes mandated by regulation or demanded by pilots. Accordingly, the Company believes flat panel displays, which can integrate and display a "suite" of information, will increasingly replace individual instruments, CRTs, and clusters of analog mechanical instruments as the method for displaying information in cockpits.
History: ISSC was founded in 1988 by the current CEO Geoffrey Hedrick, who had previously founded an aerospace supplier acquired by a British outfit subsequently acquired by GE. ISSC went public in 2000 and hit its peak of revenues with the mandate that all planes flying in the US comply with Reduced Vertical Separation Minima (“RVSM”) rules, that cut the standard vertical separation of flying planes in half to 1000 feet, increasing the number of aircraft that could safely fly in a particular volume of airspace. This was done because newer altimeters, air data computers, and autopilots had gotten a lot better at keeping vertical distances under control. To comply with that mandate, though, aircraft owners could no longer procrastinate about updating their systems. ISSC had equipment considered high performance and relatively inexpensive, and its sales surged in the two years leading up to the 2005 deadline, and collapsed soon thereafter. It has since taken the company a long time and a lot of R&D to build its current much broader product line.
In general, ISSC positions its products as both higher performance and lower price than competition. That seems a contradiction, but is possible because many of its larger competitors aren’t active themselves in the retrofit market. For example, the owner of certain Boeing jets could get Boeing to retrofit new Honeywell products, but would be paying a price that includes Boeing’s as well as Honeywell’s markups.
In addition, ISSC designs its retrofit products with rapid installation in mind. ISSC is not an OEM supplier to Boeing, but its products, by using the plane’s already existing wiring, are designed to be retrofit into 737-747-757-767s with a 24 hour turnaround, which is extremely valuable to airlines. Depending on the size of the model, it can cost from $35,000-$75,000 per day in lost income, so when there is a five day installation process, as is the case with most competitors’ products, the airline’s loss from that can exceed what they are paying for the new equipment, giving ISSC room to earn decent margins and still undercut the total cost of competitors products.
To be clear, ISSC is not itself in the installation business. Most aircraft owners have their own mechanics on staff that can do the job, as can independent service outfits. Occasionally a customer will ask ISSC to provide the retrofit on a turnkey basis, in which case it will use an independent installer for that.
Growth drivers: Having spent very heavily on R&D in recent years, both on its own and financed by OEMs, ISSC is now poised to get the benefit of that in sales as new products hit the retrofit market and OEMs introduce aircraft with ISSC’s systems sole sourced inside. I’ll highlight three opportunities that look particularly promising:
One application that represents a very large retrofit application is the use of GPS signals to control an aircraft’s course. In a day when 90% of all cars on the road have GPS either installed or available in the cell phone of the driver, it seems surprising that the only GPS available on most aircraft would be on the cell phones of the flight crew, and only then if they violate their own command about keeping phones in “airplane mode.” Yet it should seem obvious that GPS can offer a much more precise control of the flight path, that over the course of a NY-LA flight would save many thousands of dollars of fuel over a path that a pilot might choose without that guidance. The plan to convert to GPS control is called NextGen, and here is a brief quote from the wiki article (http://en.wikipedia.org/wiki/Next_Generation_Air_Transportation_System):
“The Next Generation Air Transportation System (NextGen) is the name given to a new National Airspace System due for implementation across the United States in stages between 2012 and 2025. The Next Generation Air Transportation System (NextGen) proposes to transform America’s air traffic control system from an aging ground-based system to a satellite-based system. GPS technology will be used to shorten routes, save time and fuel, reduce traffic delays, increase capacity, and permit controllers to monitor and manage aircraft with greater safety margins. Planes will be able to fly closer together, take more direct routes and avoid delays caused by airport “stacking” as planes wait for an open runway.”
As the article points out (with the usual aerospace acronym overload,) implementation of the complete system involve changes in airports as well as in planes, and it doesn’t look like there are any deadlines anytime soon that will give ISSC a burst of demand as happened in 2003-5 with the RVSM mandate. The good news for ISSC, though, is that the plane operator need not wait until the entire integrated system is running before accruing benefits. ISSC estimates that installation of its high performance, low cost GPS system will provide a one year payback even now from fuel savings alone.
A second growth driver for ISSC is its potential as an OEM supplier, exemplified by its becoming the exclusive supplier of avionics for the Eclipse 550 model, a fast, very fuel efficient, and relatively reasonably priced business jet that the US Air Force is considering as a training jet. This is a product that ISSC has been developing for two years. Production of the 550 has begun, and Eclipse has released for ISSC’s production an order for the first 50 of an initial order of 300 ship sets. (Only the first 50 will count in ISSC’s backlog.) As the 550 is a new aircraft, Eclipse has said it will increase production in a deliberate fashion, so revenues to ISSC from those first 50 units will probably grow quarter by quarter into 2014, when Eclipse expects to hit its full production rate. ISSC retains ownership rights the technology, and is allowed to offer it to business jets from other companies.
A third area with good promise is standby instrumentation, designed to provide approximately the same information as the main avionics suite but operating independently so as to be available if the main system fails for any reason. This is something that is likely to be standard equipment on most new airplanes and retrofit on many. ISSC has competition for that business, but is positioned to be the cost effective high performance solution.
Outlook: I have trouble making projections independent of management guidance, for a variety of reasons. ISSC’s main customers, operators of commercial, business, and military jets, don’t make known in advance their equipment refurbishment plans, and may not know them themselves as yet. Even if they did, there is a culture of secrecy such that selling prices, margins, and even names of customers tend to be undisclosed except as one can infer from from financial statements and other clues. Looking back over the last couple years worth of financial statements and conference call transcripts on Bloomberg, management of ISSC seems reasonably accurate in its general guidance. For this fiscal year ending 9/13, the company has indicated sales rising from last year’s $24.6MM to something approaching $28-$30MM. Pre-tax earnings will probably be up from last year’s $0.6MM, but not way up because extremely heavy R&D as a percentage of sales will hold that down.
Longer term, the company is getting set for very strong growth in sales and earnings, probably starting later this calendar year. The need is there amongst the various customer groups to upgrade their avionics for safety and efficiency reasons. The years of heavy company and OEM sponsored R&D is resulting in an increasing number of new product introductions that expand the number of aircraft that can use ISSC’s products and increase the number of tasks its products can take on within a given airplane. Some of the new products that are initially designed for use in one jet don’t need a lot of further development before they can be offered for others. The Eclipse 550 looks like a strong competitor in the small jet market, and other OEM products will be coming soon. The company’s currently tiny profits can turn quickly to large profits once the volume kicks in, as product gross margins north of 50% and the reduction of R&D as a percent of sales both work their positive effect on operating margins when sales rise.
Risks: To some extent the business risks are obvious. A bad economy would be bad for ISSC’s airline and business jet customers, and by reducing tax revenues might result in spending cuts for its defense customers. But with most of ISSC’s business being retrofit, it may be that a bad economy might cause a customer to not invest in new jets but pay much less to upgrade those they already own. And as a scrappy independent with higher performance and lower prices, ISSC might take retrofit business from the higher priced OEMs in tougher times.
In addition, the company is currently marginally profitable and isn’t likely to show big jumps in EPS until later this year or next at the earliest. That leaves plenty of room for a bear market to cause some damage to the stock price in the interim.
ISSC’s largest commercial aviation customer, providing 13% of revenues last quarter despite being in bankruptcy, has been American Airlines, which is merging with USAir, which has not been a significant ISSC customer. It is unknown as yet whether that relationship will survive the merger.
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