HON - Innovative Solutions and Support: Growth Fueled By Secular Tailwinds And Smart M&A

2023-12-26 07:25:15 ET

Summary

• Innovative Solutions and Support Inc. is an unknown company in the avionics industry, but it is experiencing rapid growth.
• Under the leadership of CEO Dr. Shahram Askarpour, ISSC has a refreshed management team and a pragmatic growth strategy.
• The company has recently made a transformative acquisition and is fueling growth both organically and inorganically with further M&A.
• At full factory capacity, achieved by further M&A and in-house developed autonomous solutions, shares are estimated to be $15-$25, possibly as early as FY27.

Innovative Solutions and Support Inc. (ISSC) is a business name that evokes no hype, no imagination, and no flair. The vague, generic name sounds like the boilerplate tag line used by a marketing team belonging to any company. ISSC certainly has a boring name; and the business itself - manufacturer and supplier for avionics - is just as boring. To me - it's glorious. In the words of Peter Lynch:

A company that does boring things is almost as good as a company that has a boring name, and both together is terrific. - Peter Lynch.

Throw in the fact that there are apparently no Wall St. analysts covering the company, and not even a Quant Rating by Seeking Alpha, and it's easy to see how ISSC flies under the radar in obscurity. However, under the snoozefest is a business that is rapidly growing with a refreshed management team and prudent capital allocation aligned with a pragmatic profitable growth runway. Growing sales and income 79% and 40%, respectively, in the last quarter is anything but boring - nor is growing sales at 20% CAGR over 5 years and operating income 300% since 2018.

I believe the fun meter with ISSC is just starting to turn to eleven and expect shares to hit the ~$20 mark once their factory is fully utilized, perhaps as early as FY27.

Some History . . . and Why this Opportunity Exists

Founder Geoffrey Hendrick Years

I believe that an investment in any small company requires a careful consideration of the culture, integrity, and passion of the company and its operators. Usually, a large company can survive a lousy management team - sometimes for long periods of time - but that could be the death knell for a small company. With that said, some history for ISSC is warranted to appreciate its culture, but also, to understand why this opportunity now exists.

ISSC has been a public company since 2000 - and founded in 1988. Founder Geoffrey Hedrick was an esteemed engineer and grew the company from nothing on the backs of dozens of patents that have made their way into commercial aircraft. It's no wonder that half of the company's name "Innovative Solutions" reflects this amount of inventiveness. It's the second half of the company's name - "Support" - that has allowed small ISSC to establish strong relationships with their customers and grow them over the years.

"Provide innovative solutions to technical problems," he said. Then he added: "You've got to provide support, and I said, 'Damn it, we'll put that in the name of the company, too.'" - Geoffrey Hedrick

The focus on "support" may seem like an easily overlooked aspect for any company, but in the context of aviation, it means everything. Tragedies both in the commercial world , such as the Boeing 737 Max aircraft, and military world , such as the V-22 Osprey, are constant reminders of the need for the highest levels of safety on every component and widget that make up an aircraft.

ISSC's extreme dedication to safety and support materialized into tangible results for investors when the FAA mandated that aircraft reduce vertical separation altitude from 2000-ft to 1000-ft in the early 2000s. Despite competing against much, much larger companies such as Honeywell ( HON ), Garmin ( GRMN ), and Collins Aerospace ( RTX ), ISSC's solution captured the majority of market share of retrofitting world business aircraft and generated $100 million in cash, much of which has been reinvested into the business to grow its product portfolio and factory capacity.

It would be a disservice to state that ISSC is simply under-covered, under-analyzed, and essentially unknown to the market, and chalk up opportunities that arise to that fact alone. I do not believe in the efficient market hypothesis, at least, not for small-cap companies, and there is a plethora of case-studies to that point. That said, despite his brilliance as an engineer and his dedication to customers, Mr. Hedrick was perhaps not the greatest capital allocator. He had created a steady company by 2010, and my conjecture is that he was content with the growth the company had achieved. I arrive at this postulation due to the significant special dividends the company paid out in 2008 ($16 million), 2013 ($25 million), and 2021 ($20 million). This is perhaps also due to Mr. Hedrick's conservative nature, as the company has held a substantial amount of cash (usually between $30 million and $50 million) for a company with a historical market cap between $60 million and $100 million. Of course, he was also a significant shareholder at 20% of the float. During his tenure, ISSC took on no debt.

Current Opportunity Under the Askarpour Years

Fast forward to recent times, Mr. Hedrick died in 2022, and his successor is Dr. Shahram Askarpour, who has been with the company since 2003 in various roles. Like Mr. Hedrick, Dr. Askarpour is deeply engrained in the engineering surrounding the aviation industry, and I would imagine has been heavily influenced by the mentorship of Mr. Hedrick. Dr. Askarpour continues to stress to investors during earnings calls and conference presentations that safety and dedication to customers are his priorities.

Where now-CEO Askarpour differs from the late Mr. Hedrick is in capital allocation and a reinvigorated vision for (profitable) growth. This is the key difference for why ISSC has become investable. CEO Askarpour has presented to investors a multi-faceted growth strategy fueled by both organic technological developments, based on a deep understanding of the direction the aviation industry is heading, and inorganic value-accretive M&A.

Inorganic Growth

On the inorganic side, it took ISSC nearly two years to find an acquisition that was affordable and could slot in nicely with the existing factory that the company owns. During this time, ISSC was sitting on a substantial cash pile. I take this as patient discipline because the eventual Honeywell acquisition for $36 million in Q3 2023 has - so far - done exactly what Shahram wanted: acquire products with similar ISSC gross margins of 60%+ at a reasonable multiple that complement and expand the existing ISSC offerings, while being value-accretive. It's rare to find successful M&A that doesn't destroy shareholder value, but so far, after one full quarter of acquiring the Honeywell products, integration is on pace, Y/Y sales increased 79%, and Y/Y net income increased 63%.

ISSC took on $20 million of debt to fund this acquisition - which would be unheard of under Hedrick's tenure. With current LTM EBITDA of $7.7 million, ISSC sits at a net debt to EBITDA leverage ratio of 2.2x. However, the company is capable of gushing out free cash flow. To that point, Shahram told investors in December 2023 that the company paid down a significant chunk of debt from accounts receivable converting to cash and refinanced the term loan into a revolver with their bank amounting to $12 million.

We are fortunate to have a great relationship with our bank PNC, and they have been very supportive of our growth strategy. This week, we converted our $20 million term loan to a revolving line of credit that has enabled us to reduce our total debt from $20 million to less than $12 million. - CEO Shahram Askarpour, Q4 FY23 Earnings Call .

All of this happened in less than half a year, and now the leverage ratio is at 1.6x. The great news is that even after the Honeywell products are fully integrated, ISSC expects their Exton, PA factory to still only be 50% capacity utilized, and Sharam has indicated inorganic growth remains a key part of the growth strategy.

As a reminder, we are targeting smaller bolt-on acquisitions that are around $25 million and continue to be actively engaged in evaluating potential acquisitions. There is still another 50% excess capacity to be leveraged as we anticipate generating more cash from the increased revenues combined with additional borrowing capacity. We will have more than sufficient resources to continue to implement our strategy. - Q3 FY23 Earnings Call

This means that the company does not have to invest in capex to expand manufacturing capacity to continue growing - and if they reach the point where they do, then the company is likely to be in a very strong position. Considering the ability for ISSC to spit out cash to quickly pay down debt and get back on the M&A train, as well as the recent successful execution and acquisition of the Honeywell products, I am optimistic about the continued prospects of M&A.

If this isn't a clear sign that ISSC is no longer the stodgy business of the previous era, then I'm not sure what is.

As an aside, one might wonder why Honeywell would sell these products in the first place (i.e., did ISSC get the short end of the stick?). Honeywell is developing next generation avionics, and these products are no longer core to their business. That said, there is substantial value in previous generation products - just ask Dassault Aviation ( DUAVF ), who have been selling their Rafale jet fighters like hotcakes, or Textron's ( TXT ) RQ-7B Shadow drone which has been the Army UAV mainstay since 2002. Keep in mind that Honeywell is a massive conglomerate that prints ~$5 billion in free cash flow like it's nothing. The Honeywell products generated $9.5 million in net income in FY22, so ISSC was able to acquire these products for 3.75x earnings multiple! This acquisition is a rounding error for Honeywell (but transformative for ISSC), and it is my suspicion that Honeywell was much more concerned with ensuring a strong fit and good home for their previous generation than the best offer on the table. After all, Honeywell's reputation and relationships with customers are on the line in an industry where, I remind you, safety is (and should be) second-to-none. I believe this is where ISSC's spotless reputation gave it an advantage.

Organic Growth: Autonomous Flight Solutions

Before you roll your eyes, this is not a promise of pie-in-the-sky AI-powered flight or commercial aircraft drones (as much as the airliners would love that). I encourage prospective investors to listen to Shahram speak at the November ISSC investor conference to get a more complete picture of ISSC's plans to realize autonomous flight.

In short, ISSC plans to organically develop and produce avionics that support reducing pilot workload, gradually arriving at the point where only one pilot may need to be in-flight, with another on the ground (known as fly-by-wire).

If you have never been in a cockpit of an aircraft, there is an absurd amount of information to monitor and consider - most presented with outdated displays - that commands constant diligence by the pilot(s). ISSC already has in-house developed products such as their ThrustSense Autothrottle system and Utility Management System which perform some autonomous capabilities pertaining to aircraft actuator control and monitoring, reducing pilot cognitive load. These are currently produced for their contracts with key aircraft by OEMs Boeing ( BA ) and Textron ( TXT ).

ISSC management is planning for the fly-by-wire phase to start becoming part of the conversation with airliners in the 2027-2030 timeframe. Afterward, in the 2030+ timeframe, the expectation is that demand by airliners will lead to further products and development toward full autonomous flight computers with pilots on the ground. Of course, this will be hotly contested by the pilot union - but may just be more a question of when than if. The pilot shortages of 2022-2023 (and really, it's still ongoing) are a clear sign of the upcoming demand by airliners for such solutions.

The investment thesis for ISSC does not depend on any of this becoming reality, but the incremental gains that ISSC is specifically and purposefully targeting should make in-roads for this customer demand and increase top-line sales. I expect cargo aircraft owned by logistic companies to be the avant-garde in adopting this technology. Market research suggests autonomous solutions are a multi-billion-dollar business, currently valued at ~$9 billion in 2023 and expected to grow nearly 20% CAGR into the next decade. There are major players in this space, including Textron and BAE Systems (BAESY), but ISSC doesn't need much of a slice to see outsized impact to their business. And besides, ISSC has a history of punching far above their weight.

Valuation

I present two valuations, one where ISSC hits 50% capacity utilization after complete integration of the Honeywell products, and one where ISSC reaches 100% capacity utilization.

ISSC guided for the Honeywell products in FY24 to lead to 40% revenue growth and 75% EBITDA growth - based on the latest earnings call, this is on track. This implies revenues of ~$42 million for 50% of factory capacity, which is 40% from revenues at time of acquisition of ~$30 million. Management has divulged that they have significant operating leverage in their autonomous factory, such that $50 million in sales would drop to the bottom-line with around 30% EBITDA margins. R&D is also a major part of the company culture, typically around 13% revenue. However, given the rapid growth of revenue, management stated R&D as a percentage of revenue won't keep pace, and offered 10% as the target.

For my FY24 estimate of 50% utilization, I assume revenues of $42 million, gross margins consistent with historical performance of 61% (and post-acquisition), and EBITDA margins of 26%, R&D of 10%, and CapEx of $0.3 million (consistent with historical rates).

For my FY27 estimate of 100% utilization, I assume a linear relationship to revenue growth, gross margins of 61%, EBITDA margins of 32% (which is conservative considering that ISSC is already operating well above their fixed costs and 30% margins are expected to be achieved at only 50% capacity), and CapEx of $0.5 million. Given management's recent actions to keep leverage under control, I expect the vast majority of operating cash flow to ultimately flow to equity by FY27.

ISSC has historically traded around 15x - 20x FCF. Using a range of 12x - 20x gives $5.59 - $9.32 for FY24E.

The integration for Honeywell's products is expected to complete FY24 and all messaging from management signals getting right back to M&A. I expect this experience will help to integrate the next acquisition even more smoothly. Using the same FCF multiple range brings the price range to $14.79 - $24.64, with a 15x multiple landing at $18.48. This would imply an EV/EBITDA multiple around 12x, which is far lower than peers Honeywell, Garmin ( GRMN ), and Howmet Aerospace ( HWM ) who all trade at 15x+ EBITDA multiples and experience lower growth and with worse balance sheets.

ISSC is also small enough to be acquired by any of the big manufacturers as a simple bolt-on. For precedence, the much larger Collins Aerospace was acquired by UTC (now Raytheon ( RTX )) at ~16x EBITDA in 2017.

Risks

As with most small-caps, trading volume is often an issue, and that is definitely true for ISSC as well. In fact, it's been such an issue for large investors to enter the stock that when an anchor investor bought in 2022, the stock price rocketed from the $6 area to over $9. ISSC has approved an at-the-money share offering, and Shahram explained this is to address the liquidity issue for the next big-monied investor who wants to buy in to the company. Therefore, do not expect to be able to jump in and out of this stock with significant sums of cash.

The second risk to ISSC is M&A execution risk. This is always a risk for any company that considers M&A a key part of their strategy, and the best we as investors can do is examine the management team and any past M&A deals. So far, ISSC management has a good track record here, but it's still admittedly early days; the company has another 50% of factory capacity to fill up. A bigger risk may simply be that management has a hard time finding another acquisition that makes sense and is affordable and value accretive. It took management over a year to land on the Honeywell products, and while avoiding terrible acquisitions is obviously a good thing, it does prolong the growth story if acquisitions are hard to come by.

Cyclicality of the aviation industry is a moderate risk, but ISSC has a substantial aftermarket business at 40% of sales, as well as long-term (decade-long) OEM production contracts with Boeing and Textron at 20% sales. The aviation industry is in the midst of worldwide production booms, but ISSC management is prudently deleveraging while fueling its growth - avoiding the typical boom craze mentalities - which mitigates liquidity issues during a downcycle. Management also cited growing its military presence, enabled by both the Honeywell product acquisition and their in-house autothrottle technology - which will help diversify away from cyclicality in the commercial space. Lastly, when aircraft production eventually slows down, aircraft owners and operators still repair, upgrade, and retrofit their aircraft, which is the original ISSC business and bread and butter.

Conclusion

On the surface, ISSC is boring. You would be forgiven for thinking the same thing. I have also skimmed over the company when it showed up on my screeners and Aerospace & Defense industry lists. It wasn't until my curiosity eventually won over that I learned that what this company actually does is certainly not boring. At least, not if you like fast-growing, high-quality small companies, and smart management. And airplanes.

I've learned a lot during my active investing years, and perhaps the most important questions I've learned to ask myself are: "Do I trust this management team? Are they experts in this industry, and do they understand what is needed by relevant customers?" After studying ISSC, the answer to my questions, at least for me, is yes.

I rate ISSC a Strong Buy.

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