ISSC - Innovative Solutions: Deal With Honeywell International Could Accelerate Business

2023-09-27 21:54:36 ET

Summary

• Innovative Solutions and Support, Inc. recently signed a deal with a large conglomerate, acquiring new intellectual property, contracts, and recognition.
• Shipments of displays for retrofit programs to commercial air transport customers are accelerating, and the ThrustSense Autothrottle systems are receiving positive industry feedback.
• The company's financial position is healthy, with increased assets and a successful acquisition financed by long-term debt.

Innovative Solutions and Support, Inc. ( ISSC ) recently signed a deal with a large conglomerate, which brought the company new intellectual property, contracts, and recognition. In 2023, the shipments of displays for retrofit programs to commercial air transport customers seemed to accelerate at a double digit. Besides, there seem to exist beneficial opinions in the industry about the ThrustSense Autothrottle systems. Even taking into account risks from capacity constraints, regulatory issues, or failure in the security systems, in my view, the stock price could be a bit higher.

Innovative Solutions

Innovative Solutions and Support, Inc. is a company that develops, designs, manufactures, and markets various types of integrated systems for the end markets of aviation, systems engineering, and the equipment industry in general, having among its clients a large number of manufacturers for the airline industry.

The company has oriented its positioning towards a system integrator that has both design and manufacturing capabilities, facilitating the integration of new technologies into its products. These clients are generally participants in the field of commercial aviation, and Innovative Solutions' products are dedicated to telecommunications systems that are part of this industry such as pilot panels, radio systems, and different elements that also serve the aviation industry of the United States.

The products are marketed by both original manufacturers and companies dedicated to the modernization of air fleets. In particular, the company has achieved a series of tenders to develop products within some of the most used aircraft models in the world, ensuring continued demand in the short term.

Despite the diversity of integrated systems and different product lines, all the company's operations are grouped under a single operating segment. We can say that the activity of this segment is highly concentrated within the United States, which reported 98% of sales during 2022.

The Total Amount Of Assets Increased Significantly As A Result Of A Recent Acquisition Of Assets From Honeywell International ( HON ).

As of June 30, 2023, the company reported $2 million in cash, prepaid inventory worth $10 million, and total current assets of about $26 million. Total current assets decreased as compared to that in September 2022, however both the total amount of assets and goodwill increased at a double digit thanks to inorganic growth. Goodwill increased to up to $4 million, and intangible assets also increased. Considering these figures, in my view, if the recent M&A activity is successful, we could expect more transactions and more inorganic growth.

The new intellectual property acquired is related to a transaction with Honeywell with regards to inertial, communication, and navigation product lines. With new assets and a connection to Honeywell, I believe that the demand for the stock could increase. Keep in mind that the company received certain customer contracts as well as exclusive and non-exclusive licenses to use certain Honeywell intellectual property.

On June 30, 2023, the Company entered into an Asset Purchase and License Agreement with Honeywell International, Inc. whereby Honeywell sold, certain assets and granted perpetual license rights to manufacture and sell licensed products related to its inertial, communication and navigation product lines to the Company. Source: 10-Q

The Transaction involves a sale of certain inventory, equipment and customer-related documents; an assignment of certain customer contracts; and a grant of exclusive and non-exclusive licenses to use certain Honeywell intellectual property related to its inertial, communication and navigation product lines to repair, overhaul, manufacture sell, import, export and distribute certain products to the Company. Source: 10-Q

Innovative Solutions financed the acquisition with long-term debt with $18 million, so total liabilities stood at close to $26 million in the last quarterly report. With an asset/liability ratio of more than 2x, I believe that the financial position is quite healthy.

I Assumed That The Current Strategy Will Most Likely Lead To Net Sales Growth

The current objective of the company is to grow towards turning the products into leaders within the instrumentation and integrated systems markets for Aviation cabins. For this, the key points are of course to continue technological innovation and safety adaptation of its products as well as the company's strategy towards the fleet modernization market. Likewise, Innovative Solutions seeks to expand its position within the flat panel display systems markets that make up the majority of its annual sales.

ThrustSense Autothrottle May Bring Significant Net Sales As New Pilots Learn About The New Innovations

I believe that the company’s ThrustSense Autothrottle is quite innovative in reducing pilot workload and bringing a new level of convenience. In my view, as pilots learn about the new system demand for the product, net sales would most likely creep up north. The following lines offer the words from the last quarterly report and a comment from an expert in the field. I saw very good commentary in jet forums and other media channels.

The Autothrottle computes and controls appropriate power levels thereby reducing overall pilot workload. The system computes thrust, holds selected speed/torque, and implements appropriate speed and engine limit protection. Source: 10-Q It’s a very easy adaptation of the King Air system for these platforms, which have full-authority digital engine controlled engines. So it is a subset of that, and we don’t have to worry about things like temperature control, but we will be providing thrust and speed control. Autothrottle Offered For Citations And Phenoms | Aviation Week Network

Collaboration With Large Operators Will Most Likely Bring Net Sales Growth

In 2023, investors saw net sales growth driven by the sale of retrofit programs and increased sales to large OEM customers like Pilatus, Textron (TXT), and Boeing (BA). In my view, the products appear to be a bit under the radar after the deal with HON. If the beneficial trend continues, I do not see why net sales growth would decline in the coming years. In my view, the following lines are a must-read for any shareholder and investors interested in the future of Innovative Solutions.

This increase in product sales for the three months ended June 30, 2023 was primarily the result of additional shipments of displays for retrofit programs to commercial air transport customers. The increase was also due to increase of shipments of OEM sales to Boeing under the KC-46A platform. Source: 10-Q

This increase in product sales for the nine months ended June 30, 2023 primarily resulted from increased sales to our OEM customers, which include Pilatus, Textron and Boeing. Sales increases were also seen in our new auto-throttle installations. Source: 10-Q

Large Competitors

The industry is highly competitive, and is made up of participants who, in most cases, have greater resources than Innovative Solutions. Honeywell International Inc., Collins Aerospace, Thales Defense & Security, Inc. (THLEF), and Garmin Ltd. ( GRMN ) are the main competitors in the development of aerial data collection systems, while when it comes to flat screens, the main competitors are Honeywell International Inc., Collins Aerospace, L3Harris Technologies, Inc. (LHX), Garmin Ltd., and GE Aviation Systems (GE). The company also believes that due to the increase in demand for flat screen display systems, competition will also increase in the short term.

Expectations And Valuation

A number of analysts out there are expecting double digit sales growth and earnings growth in 2023 and 2024. Analysts expect net sales growth of close to 40% in 2024, net income growth of 21% in 2024, and FCF of about $9 million in 2024. I took into consideration some of these figures in my FCF forecasts, so I believe that readers may want to have a look at them.

I also had a look at previous net income growth, which includes significant growth since 2005, but also large decreases in net income. I assumed that with the recent acquisition of assets from HON and customer contracts, net income and FCFs will most likely remain relatively more stable.

Considering previous net income growth and assumptions from other analysts, I made several projections. With lowering net income growth from 11% in 2024 to 6.7% in 2032, 2032 net income would stand at about $15 million.

I also assumed 2032 D&A of about -$1 million, but no stock options or stock awards, or no gain on disposal of property and equipment.

Besides, if we also expect excess and obsolete inventory costs of about -$1 million, deferred income taxes worth $8 million, changes in accounts receivable of $6 million, and changes in inventories of -$6 million, 2032 CFO would be close to $35 million. Finally, with purchases of property and equipment of -$1 million, I obtained 2032 FCF of $35 million.

In the past, the company traded at somewhere between 18x and 24x, so I believe that a terminal EV/FCF of 17x-20x would make sense.

With the previous assumptions, I ran a pessimistic case scenario with a WACC of 12.5% and a terminal EV/FCF of 20.055x, which implied a fair price close to $17.75 per share and an IRR of 17.55%.

In the best case scenario, with a WACC of 12.5% and a terminal EV/FCF of 17x, I obtained an implied equity valuation of $277 million, a fair price close to $15-$16 per share, and an IRR of 14%.

Risks

First of all, we must point out the great concentration that the company has on some clients since the top five accounted for 58% of sales revenue in 2022. In this sense, we find in its risk statement that the increase in customers is subject to the company's productive capacities, and may suffer from delays or the inability to meet this increase in demand. It is also good to add that the contracts that the company maintains active can be terminated without prior notice. Also, being agreed with fixed rates in advance, they can, if not applied with an efficient pricing strategy, generate significant losses for the company.

The competition in the market generates a series of risks due to the market environment. It is also good to point out that any disruption in the air market can likewise affect the company's operating margins.

In addition, due to the sophisticated technologies related to the products of the company, any failure in the security systems can damage the name of the company, and possibly lead to a series of serious complications in the relationship with its customers. Due to these security elements, there are a large number of legal regulations in the development of products, and often the certification of these for their launch in the market can generate delays or very long new product cycles, affecting the operating margins of the company in the short term.

My Takeaway

Innovative Solutions is a small company, but appears to have connections with large and established aviation conglomerates. With this in mind and taking into account that net sales only come from the United States, I believe that there is significant potential in terms of internationalization and net sales growth. I would also expect beneficial growth numbers from the new innovative ThrustSense Autothrottle, which seemed to be welcomed by pilots. Additionally, the new deal with HON and customer contracts acquired will most likely have a beneficial effect in the coming years. I obviously see risks from revenue concentration from a few clients, capacity restrictions, failure in the security systems, or even brand deterioration. With that, I think that Innovative Solutions appears undervalued. Future FCFs would most likely lead to richer valuations.

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