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 June 30, 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 August 11, 2004, there were 11,809,204 shares of the Registrant’s Common Stock, with par value of $.001, outstanding.

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INNOVATIVE SOLUTIONS AND SUPPORT, INC.
FORM 10-Q June 30, 2004
INDEX

		Page No.
		_______
PART I.	FINANCIAL INFORMATION
Item 1.	FINANCIAL STATEMENTS (unaudited)
	Condensed Consolidated Balance Sheets–September 30, 2003 and June 30, 2004	3

	Condensed Consolidated Statements of Operations– Three Months and Nine Months Ended June 30, 2003 and 2004	4

	Condensed Consolidated Statements of Cash Flows–Nine Months Ended June 30, 2003 and 2004	5

	Notes to Condensed Consolidated Financial Statements	6-8

Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	9-15

Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	15

Item 4.	CONTROLS AND PROCEDURES	16

PART II	OTHER INFORMATION

Item 6.	EXHIBITS AND REPORTS ON FORM 8-K	17

Signatures		18

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PART I–FINANCIAL INFORMATION
Item 1–Financial Statements
INNOVATIVE SOLUTIONS AND SUPPORT, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)

		As of September 30, 2003			As of June 30, 2004
ASSETS
Current Assets:
Cash and cash equivalents	$	48,789,744		$	58,627,694
Accounts receivable, less allowance for doubtful accounts of $100,000 at September 30, 2003 and June 30, 2004		6,955,207			4,991,335
Inventories		2,840,648			4,697,647
Deferred income taxes		673,134			673,134
Prepaid expenses		660,430			615,241
Total current assets		59,919,163			69,605,051
Property and Equipment:
Computers and test equipment		3,309,852			3,728,577
Corporate airplane		2,998,161			2,998,161
Furniture and office equipment		520,973			599,013
Manufacturing facility		5,368,690			5,414,986
Land		1,021,245			1,021,245
Total property and equipment		13,218,921			13,761,982
Less-accumulated depreciation and amortization		(3,670,430	)		(4,166,087	)
Net property and equipment		9,548,491			9,595,895
Deposits and Other Assets		408,971			140,113
Total Assets	$	69,876,625		$	79,341,059
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities
Current portion of note payable	$	100,000		$	100,000
Current portion of capitalized lease obligations		—			7,257
Accounts payable		578,306			779,794
Accrued expenses		3,146,409			3,270,660
Deferred revenue		98,036			153,180
Total current liabilities		3,922,751			4,310,891
Note Payable		4,235,000			4,235,000
Capitalized Lease Obligations		—			22,524
Deferred Revenue		332,407			279,552
Deferred Income Taxes		328,177			320,089
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, 2003 and June 30, 2004

Common stock, $.001 par value; 75,000,000 shares authorized, 13,080,717 and 13,462,385 shares issued at September 30, 2003 and
June 30, 2004, respectively		13,081			13,462
Additional paid-in capital		46,248,224			47,895,517
Retained earnings		25,410,742			32,877,781
Treasury stock, at cost, 1,690,026 shares		(10,613,757	)		(10,613,757	)
Total shareholders’ equity		61,058,290			70,173,003
Total Liabilities and Shareholders’ Equity	$	69,876,625		$	79,341,059

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 June 30, 2003		Three Months Ended June 30, 2004		Nine Months Ended June 30, 2003		Nine Months Ended June 30, 2004
Net Sales	$	6,519,628	$	12,269,653	$	18,064,848	$	31,688,276
Cost of Sales		2,744,729		4,056,372		7,752,467		11,200,624
Gross Profit		3,774,899		8,213,281		10,312,381		20,487,652
Operating expense:
Research and development		658,259		1,363,143		2,424,147		3,861,311
Selling, general and administrative		1,598,011		2,090,357		4,330,342		5,600,461
Operating Income		1,518,629		4,759,781		3,557,892		11,025,880
Interest Income		134,142		116,110		463,383		345,985
Interest Expense		33,090		31,197		101,680		94,201
Income Before Income Taxes		1,619,681		4,844,694		3,919,595		11,277,664
Income Tax Expense		388,723		1,559,086		1,193,694		3,810,625
Net Income	$	1,230,958	$	3,285,608	$	2,725,901	$	7,467,039
Net Income per Common Share
Basic	$	0.10	$	0.28	$	0.22	$	0.65
Diluted	$	0.10	$	0.27	$	0.22	$	0.63
Weighted Average Shares Outstanding
Basic		11,982,569		11,666,639		12,437,036		11,530,994
Diluted		12,204,971		11,960,746		12,660,902		11,867,818

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 Nine Months Ended June 30, 2003			For the Nine Months Ended June 30, 2004
Cash Flows From Operating Activities:
Net income	$	2,725,901		$	7,467,039
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		499,693			520,665
Write-off of software deposit		101,738			—
Loss on disposal of fixed assets		__			1,037
Excess and obsolete inventory expense		—			62,998
Compensation expense for stock issued to directors		99,302			182,766
Tax benefit from exercise of stock options		—			175,982
(Increase)/decrease in–
Accounts receivable		984,132			1,963,871
Inventories		(383,196	)		(1,919,997	)
Prepaid expenses and other		(356,441	)		305,045
Increase/(decrease) in–
Accounts payable		195,581			201,486
Accrued expenses		(232,161	)		116,164
Deferred revenue		(8,024	)		2,290
Net cash provided by operating activities		3,626,525			9,079,346
Cash Flows From Investing Activities:
Purchases of property and equipment		(35,990	)		(560,105	)
Net cash used in investing activities		(35,990	)		(560,105	)
Cash Flows From Financing Activities:
Proceeds from exercise of stock options		—			674,330
Proceeds from exercise of warrants		—			614,598
Purchase of treasury stock		(5,244,862	)		—
Capital lease obligations		—			39,119
Repayments of capitalized lease obligations		(14,570	)		(9,338	)
Net cash provided by (used in) financing activities		(5,259,432	)		1,318,709
Net Increase (Decrease) in Cash and Cash Equivalents		(1,668,897	)		9,837,950
Cash and Cash Equivalents, Beginning of Year		52,245,754			48,789,744
Cash and Cash Equivalents, End of Period	$	50,576,857		$	58,627,694

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 June 30, 2004, the statement of operations for the three months and nine months ended June 30, 2003 and 2004 and the statements of cash flows for the nine months ended June 30, 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 June 30, 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, 2003 as filed with the Securities and Exchange Commission. The results of operations for the three months and nine months ended June 30, 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 Ended June 30, 2003	Three Months Ended June 30, 2004	Nine Months Ended June 30, 2003	Nine Months Ended June 30, 2004
Weighted average shares outstanding:
Basic	11,982,569	11,666,639	12,437,036	11,530,994
Effect of dilutive securities:
Employee stock options	43,351	294,107	38,922	239,015
Warrants	179,051	0	184,944	97,809
Weighted average shares outstanding:
Diluted	12,204,971	11,960,746	12,660,902	11,867,818

For the nine-month period ended June 30, 2004, there were 7,153 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 June 30, 2004, three customers accounted for 17%, 11%, and 10% of net sales or 38% on a combined basis. For the three months ended June 30, 2003, two customers accounted for 17% each of revenues or 34% on a combined basis. For the nine months ended June 30, 2004, four customers accounted for 13%, 13%, 10% and 10% of net sales or 46% on a combined basis. For the nine months ended June 30, 2003, three customers accounted for 18%, 11% and 11% of net sales or 40% 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, 2003		June 30, 2004
Raw materials	$	1,412,242	$	1,982,555
Work-in-process		785,771		1,999,337
Finished goods		642,635		715,755
	$	2,840,648	$	4,697,647

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. During the period ended March 31, 2004, the Company changed its warranty accrual based upon favorable historical experience. 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 June 30, 2004 is highlighted below:

Warranty accrual at March 31, 2004	$	742,665
Accrued expense for the quarter ended June 30, 2004		45,993
Warranty costs for the quarter ended June 30, 2004		(38,702	)
Warranty accrual at June 30, 2004	$	749,956

Warranty cost and accrual information for the nine months ended June 30, 2004 is highlighted below:

Warranty accrual at September 30, 2003	$	842,541
Accrued expense for the nine months ended June 30, 2004		175,410
Warranty costs for the nine months ended June 30, 2004		(101,595	)
Change in estimate of warranty liability		(166,400	)
Warranty accrual at June 30, 2004	$	749,956

6. Stock Options

The Company’s 1988 Stock Incentive Plan terminated in 1998 consistent with its ten year life. The Company’s 1998 Stock Option 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 terminated 1988 Stock Incentive Plan and the 1998 Stock Option Plan (the “Plans”) must be at least equal to the fair value of the common stock on the date of grant. Nonqualified stock options granted under the 1998 Plan may be less than, equal to or greater than the fair value of the common stock on the date of grant. Required disclosure information regarding the Plans has been combined due to the similarities in the Plans. The Company has reserved 1,259,350 shares of Common stock for awards under the 1998 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 and nine-month periods ended June 30, 2003 and 2004 would have been as follows:

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		Three Months Ended June 30, 2003		Three Months Ended June 30, 2004		Nine Months Ended June 30, 2003		Nine Months Ended June 30, 2004
Net income:
As reported	$	1,230,958	$	3,285,608	$	2,725,901	$	7,467,039
Deduct: Total stock based employee compensation expense
determined under the fair value based method for all awards,
net of related tax effects	$	177,580	$	194,088	$	490,680	$	568,524
Pro forma	$	1,053,378	$	3,091,520	$	2,235,221	$	6,898,515
Basic EPS:
As reported	$	.10	$	.28	$	.22	$	.65
Pro forma	$	.09	$	.26	$	.18	$	.60
Diluted EPS:
As reported	$	.10	$	.27	$	.22	$	.63
Pro forma	$	.09	$	.26	$	.18	$	.58

New Accounting Pronouncements

In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities an Interpretation of ARB No. 51.” FIN 46 addresses consolidation by business enterprises of variable interest entities. The FASB then issued FIN 46(R), “Consolidation of Variable Interest Entities an Interpretation of ARB No. 51,” which replaced FIN 46. Application of FIN 46(R) is required in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. The Company has adopted both FIN 46 and FIN 46(R), and their adoption had no impact on the Company’s financial position or results of operations.

In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company adopted the provisions of SFAS 150, including the deferral of certain effective dates as a result of the provisions of FASB Staff Position 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests Under FASB Statement No. 150, ‘Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.’” The Company does not have any significant financial instruments with characteristics of both liabilities and equity as of June 30, 2004.

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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. To date, we have been selected by the U.S. Navy for Flat Panel applications on their Landing Craft Air Cushion (LCAC) platforms. Further, we were selected by Boeing to provide Flat Panels for the Boeing 767 tanker program. Both of these programs have multi-year requirements that we believe will provide a solid base for future awards. In addition, 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.

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 June 30, 2004 Compared to the Three Months Ended June 30, 2003

Net sales. Net sales increased $5.8 million, or 88%, to $12.3 million for the three months ended June 30, 2004 from $6.5 million in the three months ended June 30, 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 $1.3 million or 48%, to $4.1 million, or 33% of net sales, in the three months ended June 30, 2004 from $2.7 million, or 42% of net sales, in the three months ended June 30, 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 $0.7 million or 107% to $1.4 million or 11% of net sales in the three months ended June 30, 2004 from $0.7 million or 10% of net sales in the three months ended June 30, 2003. Both the absolute dollar and percent to sales increase was principally due to increased spending on the flat panel program as the Company prepared to submit its Technical Standard Order (TSO) application to the FAA. The FAA awarded the Company’s flat panel display a TSO on July 2, 2004.

Selling, general, and administrative. Selling, general, and administrative expenses increased $0.5 million, or 31%, to $2.1 million, or 17% of net sales, in the three months ended June 30, 2004 from $1.6 million or 25% of net sales, in the three months ended June 30, 2003. The increase in the dollar amount was the result of higher corporate governance expenses coupled with increased salaries. The decrease as a percent of net sales was the result of higher net sales in the period.

Interest income. Interest income was $116,000 in the three months ended June 30, 2004 as compared to interest income of $134,000 in the three months ended June 30, 2003. The decreased interest income in the three months ended June 30, 2004 was primarily the result of lower interest rates in the period.

Interest expense. Interest expense was $31,000 in the three months ended March 31, 2004 as compared to interest expense of $33,000 in the three months ended June 30, 2003. The decreased interest expense in the three months ended June 30, 2004 was primarily the result of lower interest rates in the period.

Income tax expense. Income tax expense for the three months ended June 30, 2004 was $1.6 million. The income tax expense for the three months ending June 30, 2003 was $0.4 million. The increase in tax expense was primarily due to higher income in the period. The effective tax rate in the June 30, 2004 quarter was 32%. In the June 30, 2003 quarter the effective tax rate was 24%. 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 June 30, 2003.

Net income. As a result of the factors described above, our net income in the three months ended June 30, 2004 increased $2.1 million or 167%, to $3.3 million, or 27% of net sales, from $1.2 million or 19% of net sales in the three months ended June 30, 2003.

Nine Months Ended June 30, 2004 Compared to the Nine Months Ended June 30, 2003

Net sales. Net sales increased $13.6 million, or 75%, to $31.7 million for the nine months ended June 30, 2004 from $18.1 million in the nine months ended June 30, 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 reflects an industry wide response to an FAA mandate requiring 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 $3.4 million or 44%, to $11.2 million, or 35% of net sales, in the nine months ended June 30, 2004 from $7.8 million, or 43% of net sales, in the nine months ended June 30, 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 both higher net sales in the period coupled with a favorable change in the Company’s estimate of accrued warranty liability in the period.

Research and development. Research and development expenses increased $1.4 million or 59% to $3.9 million or 12% of net sales in the nine months ended June 30, 2004 from $2.4 million or 13% of net sales in the nine months ended June 30, 2003. The absolute dollar increase was principally due to increased spending on the flat panel program as the Company prepared to submit its TSO application to the FAA. The Company was awarded a TSO certification for their Flat Panel Display on July 2, 2004 by the FAA. On a percent to sales basis, the 2004 period was less than 2003 by one percentage point because of higher sales in the period.

Selling, general, and administrative. Selling, general, and administrative expenses increased $1.3 million or 29%, to $5.6 million, or 18% of net sales, in the nine months ended June 30, 2004 from $4.3 million or 24% of net sales, in the nine months ended June 30, 2003. The increase in the dollar amount was the result of higher wages, commissions due to increased net sales and corporate governance. The decrease as a percent of net sales was the result of higher net sales in the period.

Interest income. Interest income was $346,000 in the nine months ended June 30, 2004 as compared to interest income of $463,000 in the nine months ended June 30, 2003. The decreased interest income in the nine months ended June 30, 2004 was primarily the result of lower interest rates in the period.

Interest expense. Interest expense was $94,000 in the nine months ended June 30, 2004 as compared to $102,000 in the nine months ended June 30, 2003. The decrease was due to lower interest rates in the period.

Income tax expense. Income tax expense for the nine months ended June 30, 2004 was $3.8 million. The income tax expense for the nine months ending June 30, 2003 was $1.2 million. The increase in income tax expense was mostly due to higher income in the period. The effective tax rate in the June 30, 2004 year to date period was 34%. In the June 30, 2003 year to date period the effective tax rate was 31%. In each year to date period, 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 June 30, 2003.

Net income. As a result of the factors described above, our net income in the nine months ended June 30, 2004 increased $4.7 million or 174%, to $7.5 million, or 24% of net sales, from $2.7 million or 15% of net sales in the nine months ended June 30, 2003.

Liquidity and Capital Resources

Our main sources of liquidity have been cash flows from operations and the proceeds of our initial public offering (IPO) in August 2000. We require cash principally to finance inventory, accounts receivable and payroll.

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Our cash flow provided from operating activities was $9.1 million for the nine months ended June 30, 2004 as compared to $3.6 million for the nine months ended June 30, 2003. The increase was due to higher net income in the period while a $2.0 million improvement in accounts receivable was mostly offset with a $1.9 million inventory increase. The increase in inventory was primarily due to additional purchases of raw material and increased production in response to a higher order backlog and in anticipation of an increased demand for RVSM equipment in light of the industry wide response to the FAA’s mandate discussed above.

Our cash used in investing activities was $560,000 for the nine months ended June 30, 2004 as compared to $36,000 for the nine months ended June 30, 2003. The increase was primarily due to the purchase of additional manufacturing and engineering equipment.

Net cash flow from financing activities was $1.3 million for the nine months ended June 30, 2004 as compared to $5.3 million in usage in the nine months ended June 30, 2003. In the nine month period ended June 30, 2004, the in-flow of cash was the result of proceeds from the exercise of stock options and warrants. The primary use of cash in the nine month period ended June 30, 2003 was to acquire treasury stock.

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, together with the net proceeds from our IPO 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 June 30, 2004 our total backlog was $44.9 million, a 19% increase from the June 30, 2003 backlog of $37.8 million.⁽¹⁾

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.

⁽¹⁾ Note that some elements of our backlog includes options for additional equipment. In the event an option is not exercised by a customer the backlog would be reduced accordingly.

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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.”

Income taxes are recorded in accordance with SFAS No. 109, Accounting for Income Taxes. Provisions for federal and state income taxes are calculated on reported financial statement pre-tax income based on current tax law. The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities and expected benefits of utilizing net operating loss carryforwards. The impact on deferred taxes of changes in tax rates and laws, if any, applied to the years during which temporary differences are expected to be settled, are reflected in the consolidated financial statements in the period of enactment.

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. These allowances are determined by analyzing historical data and trends. If actual losses are greater than estimated amounts or if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, future results from operations could be adversely affected.

Inventories are written down for estimated obsolescence equal to the difference between the cost of inventory and the estimated net realizable value based upon assumptions about future market conditions. If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

We offer warranties on some products of various lengths. At the time of shipment, we establish a reserve for the estimated cost of warranties based on our best estimate of the amounts necessary to settle future and existing claims using historical data on products sold as of the balance sheet date. The length of the warranty period, the product’s failure rates and the customer’s usage affects warranty cost. If the actual cost of warranties differs from our estimated amounts, future results of operations could be adversely affected.

Business Segments

We operate in one principal business segment which designs, manufactures and sells flight information computers, flat panel displays and advanced monitoring systems to the Department of Defense, government agencies, commercial air transport carriers and corporate/general aviation markets. We currently derive virtually all our net sales from the sale of this equipment. Almost all of the net sales, operating results and identifiable assets are in the United States.

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New Accounting Pronouncements

In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities an Interpretation of ARB No. 51. FIN 46 addresses consolidation by business enterprises of variable interest entities. The FASB then issued FIN 46(R), Consolidation of Variable Interest Entities an Interpretation of ARB No. 51, which replaced FIN 46. Application of FIN 46(R) is required in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. The Company has adopted both FIN 46 and FIN 46(R), and their adoption had no impact on the Company’s financial position or results of operations.

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FORWARD-LOOKING STATEMENTS

This Form 10-Q contains statements, which, to the extent that they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. The words “believe,” “estimate,” “anticipate,” “project,” “intend,” “expect,” “plan,” “outlook,” “forecast” and similar expressions are intended to identify forward-looking statements. Numerous factors, including potentially the following factors, could affect the Company’s forward-looking statements and actual performance:

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continued market acceptance of our air data systems products;

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the ability to obtain or the timing of obtaining future government awards;

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the availability of government funding and customer requirements;

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difficulties in developing and producing our flat panel display systems (CIP) or other planned products or product enhancements;

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market acceptance of our CIP system or other planned products or product enhancements;

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our ability to gain regulatory approval of our products in a timely manner;

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delays in receiving components from third party suppliers;

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the competitive environment;

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the timing and customer acceptance of product deliveries and launches;

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the termination of programs or contracts for convenience by customers;

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failure to retain key personnel;

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new product offerings from competitors;

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potential future acquisitions;

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protection of intellectual property rights;

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our ability to service the international market;

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other factors disclosed from time to time in our filings with the Securities and Exchange Commission.

Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Form 10-Q. The Company does not undertake any obligation to publicly release any revisions to these forward-looking statements to reflect events, circumstances or changes in expectations after the date of this Form 10-Q, or to reflect the occurrence of unanticipated events. The forward-looking statements in this document are intended to be subject to the safe harbor protection provided by Sections 27A of the Securities Act and 21E of the Exchange Act.

For a discussion identifying some important factors that could cause actual results to vary materially from those anticipated in the forward-looking statements, see the Company’s Securities and Exchange Commission filings including, but not limited to, the discussions of “Risk Factors” contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2003.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company’s operations are exposed to market risks primarily as a result of changes in interest rates. The Company does not use derivative financial instruments for speculative or trading purposes. The Company’s exposure to market risk for changes in interest rates relates to its cash equivalents and an industrial revenue bond. The Company’s cash equivalents consist of funds invested in money market accounts, which bear interest at a variable rate, while the industrial revenue bond carries an interest rate that is consistent with 30-day, tax-exempt commercial paper. As the interest rates are variable, and we do not engage in hedging activities, a change in interest rates earned on the cash equivalents or paid on the industrial revenue bond would impact interest income and expense along with cash flows, but would not impact the fair market value of the related underlying instruments.

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Item 4. Controls and Procedures

An evaluation was performed under the supervision and with the participation of the Company’s management, including its Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, of the effectiveness of the Company’s disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of June 30, 2004. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported as specified in Securities and Exchange Commission rules and forms. There were no significant changes in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II–OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K.

(a)

Exhibits

31.1			Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)
31.2			Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)
32.1			Certification Pursuant to U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K.

None

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	INNOVATIVE SOLUTIONS & SUPPORT, INC.

Date: August 11, 2004	By: /s/ JAMES J. REILLY

	James J. Reilly Chief Financial Officer