**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the quarterly period ended December 31, 2006**

**OR**

**o   TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**[For thetransition period from               to               ]**

**CommissionFile No. 0-31157**

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

(Exact name ofregistrant as specified in its charter)

| **PENNSYLVANIA**                                 |   | **23-2507402**       |
|--------------------------------------------------|--------|----------------------|
| (State or other  jurisdiction                    |   | (IRS Employer        |
| of  incorporation)                               |   | Identification  No.) |
| ** **                                       |   | ** **           |
| **720  Pennsylvania Drive, Exton, Pennsylvania** |   | **19341**            |
| (Address of  principal executive offices)        |   | (Zip Code)           |

**(610) 646-9800**

(Registrant’stelephone number, including area code)

Indicateby check mark whether registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes  x    No  o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer. See definition or “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.

o  Large accelerated filer     x  Accelerated filer     o  Non-accelerated filer

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

Yes  o     No  x

Asof February 2, 2007, there were 16,866,193 shares of the Registrant’s CommonStock, with par value of $.001 per share, outstanding.

 

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**INNOVATIVESOLUTIONS & SUPPORT, INC.**

### **FORM 10-Q December 31, 2006**

**INDEX**
|                | ** ** | ** **                                                                                            | ** ** | ** ** | ** ** |
|----------------|------------|-------------------------------------------------------------------------------------------------------|------------|------------|------------|
| **PART  I.**   | ** ** | **FINANCIAL  INFORMATION**                                                                            |       |       |       |
| ** **     | ** ** | ** **                                                                                            |       |       |       |
| Item  1.       |       | Financial  Statements (Unaudited)                                                                     |       |       |       |
|           |       |                                                                                                  |       |       |       |
|           |       | Condensed Consolidated Balance Sheets — September 30,  2006 and December 31, 2006                |       |       |       |
|           |       |                                                                                                  |       |       |       |
|           |       | Condensed Consolidated Statements of Operations —  Three Months Ended December 31, 2006 and 2005 |       |       |       |
|           |       |                                                                                                  |       |       |       |
|           |       | Condensed Consolidated Statements of Cash Flows —  Three Months Ended December 31, 2006 and 2005 |       |       |       |
|           |       |                                                                                                  |       |       |       |
|           |       | Notes to Condensed Consolidated Financial Statements                                                  |       |       |       |
|           |       |                                                                                                  |       |       |       |
| Item 2.        |       | Managements Discussion and Analysis of Financial  Controls and Results of Operations                  |       |       |       |
|           |       |                                                                                                  |       |       |       |
| Item 3.        |       | Quantitative and Qualitative Disclosures about Market  Risk                                           |       |       |       |
|           |       |                                                                                                  |       |       |       |
| Item  4.       |       | Controls  and Procedures                                                                              |       |       |       |
|           |       |                                                                                                  |       |       |       |
| **PART  II.**  | ** ** | **OTHER  INFORMATION**                                                                                |       |       |       |
| ** **     | ** ** | ** **                                                                                            |       |       |       |
| Item  1.       |       | Legal  Proceedings                                                                                    |       |       |       |
|           |       |                                                                                                  |       |       |       |
| Item 1A        |       | Risk  Factors                                                                                         |       |       |       |
|           |       |                                                                                                  |       |       |       |
| Item 2.        |       | Unregistered Sales of Equity Securities and use of  Proceeds                                          |       |       |       |
|           |       |                                                                                                  |       |       |       |
| Item 3.        |       | Defaults upon Senior Securities                                                                       |       |       |       |
|           |       |                                                                                                  |       |       |       |
| Item 4.        |       | Submission of Matters to a Vote of Security Holders                                                   |       |       |       |
|           |       |                                                                                                  |       |       |       |
| Item  5.       |       | Other  Information                                                                                    |       |       |       |
|           |       |                                                                                                  |       |       |       |
| Item 6.        |       | Exhibits                                                                                              |       |       |       |
|           |       |                                                                                                  |       |       |       |
| **SIGNATURES** |       |                                                                                                  |       |

 

2

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**PART I—FINANCIAL INFORMATION**

**Item 1—FinancialStatements**

**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED BALANCESHEET**

**(unaudited)**
| ** **                                                                                                                                                                                                         | ** ** | **As of**                  | ** ** | **As of**                   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                                                                         | ** ** | **December 31, 2006** | ** ** | **September 30, 2006** | ** ** |
| **ASSETS**                                                                                                                                                                                                         |       |                            |       |                             |       |
| Current Assets:                                                                                                                                                                                                    |       |                            |       |                             |       |
| Cash and cash  equivalents                                                                                                                                                                                         |       | $                               | 62,608,952 |                             | $          | 62,984,829 |   |
| Accounts  receivable, less allowance for doubtful accounts of $100,000 at December 31,  2006 and September 30, 2006                                                                                                |       | 1,760,747                       |       | 3,333,131                        |       |
| Inventories                                                                                                                                                                                                        |       | 6,211,280                       |       | 6,466,156                        |       |
| Deferred income  taxes                                                                                                                                                                                             |       | 911,822                         |       | 1,082,931                        |       |
| Prepaid expenses  and other current assets                                                                                                                                                                         |       | 5,442,347                       |       | 4,065,696                        |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Total current  assets                                                                                                                                                                                              |       | 76,935,148                      |       | 77,932,743                       |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Property and Equipment:                                                                                                                                                                                            |       |                            |       |                             |       |
| Computers and  test equipment                                                                                                                                                                                      |       | 4,616,087                       |       | 4,592,410                        |       |
| Corporate  airplane                                                                                                                                                                                                |       | 3,027,502                       |       | 3,027,502                        |       |
| Furniture and  office equipment                                                                                                                                                                                    |       | 748,827                         |       | 748,827                          |       |
| Manufacturing  facility                                                                                                                                                                                            |       | 5,426,761                       |       | 5,426,761                        |       |
| Land                                                                                                                                                                                                               |       | 1,021,245                       |       | 1,021,245                        |       |
|                                                                                                                                                                                                               |       | 14,840,422                      |       | 14,816,745                       |       |
| Less-  Accumulated depreciation and amortization                                                                                                                                                                   |       | (6,037,516                      | )          | (5,846,272                       | )          |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Net property and  equipment                                                                                                                                                                                        |       | 8,802,906                       |       | 8,970,473                        |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Deposits and other  assets                                                                                                                                                                                         |       | 324,264                         |       | 329,664                          |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Total assets                                                                                                                                                                                                       |       | $                               | 86,062,318 |                             | $          | 87,232,880 |   |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                     |       |                            |       |                             |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| CURRENT LIABILITIES:                                                                                                                                                                                               |       |                            |       |                             |       |
| Current portion  of notes payable                                                                                                                                                                                  |       | $                               | 100,000    |                             | $          | 100,000 |   |
| Current portion  of capitalized lease obligations                                                                                                                                                                  |       | 8,231                           |       | 7,891                            |       |
| Accounts payable                                                                                                                                                                                                   |       | 497,140                         |       | 358,818                          |       |
| Accrued expenses                                                                                                                                                                                                   |       | 2,731,834                       |       | 3,122,542                        |       |
| Deferred revenue                                                                                                                                                                                                   |       | 211,418                         |       | 591,626                          |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Total current  liabilities                                                                                                                                                                                         |       | 3,548,623                       |       | 4,180,877                        |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Note payable                                                                                                                                                                                                       |       | 4,235,000                       |       | 4,235,000                        |       |
| Long-term  portion of capitalized lease obligations                                                                                                                                                                |       | 2,222                           |       | 4,587                            |       |
| Deferred revenue                                                                                                                                                                                                   |       | 103,374                         |       | 120,991                          |       |
| Deferred income  taxes                                                                                                                                                                                             |       | 575,626                         |       | 490,072                          |       |
| Commitments and  contingencies                                                                                                                                                                                     |       | —                          |       | —                           |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Shareholders’ Equity:                                                                                                                                                                                         |       |                            |       |                             |       |
| Preferred stock,  10,000,000 shares authorized, $.001par value, of which 200,000 shares are authorized as  Class A Convertible stock. No shares issued and outstanding at December 31, 2006 and September 30, 2006 |       | —                          |       | —                           |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Common stock, $.001  par value: 75,000,000 shares authorized, 18,124,938 and 18,088,121 shares  issued at December 31, 2006 and September 30,2006                                                                  |       | 18,125                          |       | 18,088                           |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Additional  paid-in capital                                                                                                                                                                                        |       | 43,724,879                      |       | 43,230,352                       |       |
| Retained  earnings                                                                                                                                                                                                 |       | 51,940,897                      |       | 53,039,341                       |       |
| Treasury stock,  at cost, 1,272,510, shares at December 31. 2006 and September 30, 2006                                                                                                                            |       | (18,086,428                     | )          | (18,086,428                      | )          |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Total  shareholders’ equity                                                                                                                                                                                   |       | 77,597,473                      |       | 78,201,353                       |       |
|                                                                                                                                                                                                               |       |                            |       |                             |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                    |       | $                               | 86,062,318 |                             | $          | 87,232,880 |   |

 

The accompanying notesare an integral part of these statements.

3

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**INNOVATIVE SOLUTIONS AND SUPPORT,INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS****(unaudited)**
| ** **                            | ** ** | **Three Months** | ** ** | **Three Months** | ** ** |
|---------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **Ended**             | ** ** | **Ended**             | ** ** |
| ** **                            | ** ** | **December 31**  | ** ** | **December 31**  | ** ** |
| ** **                            | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| Net sales                             |       | $                     | 3,428,648  |                  | $          | 5,405,387 |   |
| Cost of sales                         |       | 2,033,945             |       | 2,702,018             |       |
| Gross profit                          |       | 1,394,703             |       | 2,703,369             |       |
| Operating  expenses:                  |       |                  |       |                  |       |
| Research and development              |       | 1,324,354             |       | 1,535,001             |       |
| Selling, general and administrative   |       | 3,059,015             |       | 1,896,836             |       |
|                                  |       | 4,383,369             |       | 3,431,837             |       |
| Operating (loss)                      |       | (2,988,666            | )          | (728,468              | )          |
| Interest income                       |       | 816,273               |       | 781,445               |       |
| Interest expense                      |       | (50,760               | )          | (43,512               | )          |
| Income (loss) before income taxes     |       | (2,223,153            | )          | 9,465                 |       |
| Income tax  expense (benefit)         |       | (1,124,709            | )          | 3,340                 |       |
| Net income  (loss)                    |       | $                     | (1,098,444 | )                     | $          | 6,125 |   |
|                                  |       |                  |       |                  |       |
| Net income  (loss) per common share:  |       |                  |       |                  |       |
| Basic                                 |       | $                     | (0.07      | )                     | $          | 0.00 |   |
| Diluted                               |       | $                     | (0.07      | )                     | $          | 0.00 |   |
|                                  |       |                  |       |                  |       |
| Weighted average  shares outstanding: |       |                  |       |                  |       |
| Basic                                 |       | 16,824,933            |       | 18,055,243            |       |
| Diluted                               |       | 16,824,933            |       | 18,272,423            |       |

 

The accompanyingnotes are an integral part of these statements.

4

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)**
| ** **                                                                                          | ** ** | **For the Three** | ** ** | **For the Three** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                          | ** ** | **Months Ended**       | ** ** | **Months Ended**       | ** ** |
| ** **                                                                                          | ** ** | **December 31**        | ** ** | **December 31**        | ** ** |
| ** **                                                                                          | ** ** | **2006**                    | ** ** | **2005**                    | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                          |       |                        |       |                        |       |
| Net income (loss)                                                                                   |       | $                           | (1,098,444 | )                           | $          | 6,125 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |                        |       |                        |       |
| Depreciation and amortization                                                                       |       | 199,178                     |       | 201,838                     |       |
| Stock-based compensation expense                                                                    |       | 111,871                     |       | 174,009                     |       |
| Compensation expense for stock issued to directors                                                  |       | 49,943                      |       | 60,048                      |       |
| Loss on disposal of fixed assets                                                                    |       | 551                         |       | 156                         |       |
| Excess and obsolete inventory expense                                                               |       |                        |       | 85,129                      |       |
| Deferred income taxes                                                                               |       | 256,663                     |       | 200,308                     |       |
| Tax benefit from exercise of stock options                                                          |       | 128,958                     |       | 21,378                      |       |
| Excess tax benefits from share-based payment  arrangements                                          |       | (122,811                    | )          | (8,689                      | )          |
| (Increase) decrease in:                                                                             |       |                        |       |                        |       |
| Accounts receivable                                                                                 |       | 1,572,384                   |       | 163,102                     |       |
| Inventories                                                                                         |       | 254,876                     |       | 178,004                     |       |
| Prepaid expenses and other current assets                                                           |       | (1,376,651                  | )          | (285,769                    | )          |
| Increase (decrease) in:                                                                             |       |                        |       |                        |       |
| Accounts payable                                                                                    |       | 138,322                     |       | 31,749                      |       |
| Accrued expenses                                                                                    |       | (390,708                    | )          | (1,088,554                  | )          |
| Deferred revenue                                                                                    |       | (397,825                    | )          | 15,343                      |       |
| Net cash used in operating activities                                                               |       | (673,693                    | )          | (245,823                    | )          |
|                                                                                                |       |                        |       |                        |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                          |       |                        |       |                        |       |
| Cash paid for property and equipment                                                                |       | (26,762                     | )          | (96,351                     | )          |
| Purchases of other assets                                                                           |       |                        |       | (253,333                    | )          |
| Net cash used in investing activities                                                               |       | (26,762                     | )          | (349,684                    | )          |
|                                                                                                |       |                        |       |                        |       |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                          |       |                        |       |                        |       |
| Proceeds from exercise of stock options                                                             |       | 203,792                     |       | 48,702                      |       |
| Repayment of capitalized lease obligation                                                           |       | (2,025                      | )          | (2,576                      | )          |
| Excess tax benefits from share-based payment  arrangements                                          |       | 122,811                     |       | 8,689                       |       |
| Net cash provided by financing activities                                                           |       | 324,578                     |       | 54,815                      |       |
|                                                                                                |       |                        |       |                        |       |
| Net decrease in  cash and cash equivalents                                                          |       | $                           | (375,877   | )                           | $          | (540,692 | ) |
|                                                                                                |       |                        |       |                        |       |
| Cash and cash  equivalents, beginning of year                                                       |       | $                           | 62,984,829 |                        | $          | 83,172,582 |   |
|                                                                                                |       |                        |       |                        |       |
| Cash and cash  equivalents, end of period                                                           |       | $                           | 62,608,952 |                        | $          | 82,631,890 |   |
|                                                                                                |       |                        |       |                        |       |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:**                                              |       |                        |       |                        |       |
| Cash paid for interest                                                                              |       | $                           | 40,529     |                        | $          | 31,101 |   |
| Cash paid for  income taxes                                                                         |       | —                      |       | $                           | 435,000    |   |

 

The accompanyingnotes are an integral part of these statements.

5

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**Innovative Solutions & Support Inc.Notes to Condensed Consolidated Financial Statements**

**1. Basis of Presentation:**

Innovative Solutions andSupport, Inc. (the “Company”) was incorporated in Pennsylvania on February 12,1988. The Company’s primary business is the design, manufacture and sale offlight information computers, flat panel displays and advanced monitoringsystems for the military, government, commercial air transport and corporateaviation markets.

The balance sheet as ofDecember 31, 2006, the statement of operations for the three months endedDecember 31, 2006 and 2005 and the statements of cash flows for the threemonths ended December 31, 2006 and 2005 have been prepared by the Companywithout audit. In the opinion of management, all adjustments, consisting ofnormal and recurring adjustments, necessary to present fairly the financialposition, results of operations and cash flows at December 31, 2006 and for allperiods presented have been made.

Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted. It is suggested that these financialstatements be read in conjunction with the financial statements and notesthereto included in the Company’s Form 10K for the year ended September 30,2006 as filed with the Securities and Exchange Commission. The results ofoperations for the three months ended December 31, 2006 are not necessarily indicativeof 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, “Earnings Per Share.”

A reconciliation ofweighted average shares outstanding appears below:
| ** **                                 | ** ** | **Three Months**           | ** ** | **Three Months**           | ** ** |
|--------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **Ended**                       | ** ** | **Ended**                       | ** ** |
| ** **                                 | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
| Weighted average number  of shares-basic   |       | 16,824,933                      |       | 18,055,243                      |       |
| Effect of dilutive  securities:            |       |                            |       |                            |       |
| Employee stock  options                    |       | —                          |       | 217,180                         |       |
|                                       |       |                            |       |                            |       |
| Weighted average number  of shares-diluted |       | 16,824,933                      |       | 18,272,423                      |       |
|                                       |       |                            |       |                            |       |

 

For the three-monthperiods ended December 31, 2006 and 2005, there were 282,000 and 206,000options outstanding that were excluded from the computation of diluted earningsper share as the effect would be antidilutive.

**3. Concentrations**

For the three monthsended December 31, 2006, three customers accounted for 15%, 12% and 10% of netsales or 37% on a combined basis.  Forthe three months ended December 31, 2005, three customers accounted for 28%, 10%,and 9% of net sales or 47% on a combined basis.

**4. Inventories**

Inventories are stated atthe lower of cost (first-in, first-out) or market and consist of the following:
| ** **      | ** ** | **December 31** | ** ** | **September 30** | ** ** |
|-----------------|------------|----------------------|------------|-----------------------|------------|
| ** **      | ** ** | **2006**             | ** ** | **2006**              | ** ** |
| Raw materials   |       | $                    | 3,553,089  |                  | $          | 3,006,088 |   |
| Work-in-process |       | 1,063,842            |       | 2,237,489             |       |
| Finished goods  |       | 1,594,349            |       | 1,222,579             |       |
|            |       | $                    | 6,211,280  |                  | $          | 6,466,156 |   |

 

6

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**5.Warranty**

The Company provides forthe estimated cost of product warranties at the time revenue is recognized.Warranty cost is recorded as cost of sales and the reserve balance recorded asan accrued expense in the financial statements. While the Company engages inextensive product quality programs and processes, the Company’s warrantyobligation is affected by product failure rates and the related material, laborand delivery costs incurred in correcting a product failure. Should actualproduct failure rates, material or labor costs differ from the Company’sestimates, further revisions to the estimated warranty liability would berequired.

Warranty costand accrual information for the three months ended December 31, 2006 ishighlighted below:
| Warranty accrual  at September 30, 2006                       |   | $       | 617,116 |   |
|---------------------------------------------------------------|--------|---------|---------|--------|
| Accrued expense  for the three months ended December 31, 2006 |   | 22,629  |    |
| Warranty costs  for the three monts ended December 31, 2006   |   | (66,864 | )       |
|                                                          |   |    |    |
| Warranty accrual at  December 31, 2006                        |   | $       | 572,881 |   |

 

**6. Share-Based Compensation**

Effective October 1, 2005the Company adopted the provisions of SFAS 123(R), using the modifiedprospective approach and now accounts for share-based compensation applying thefair value method for expensing stock options and non-vested stock awards.Accordingly, total share-based compensation expense was $162,000 and $234,057for the three months ended December 31, 2006 and 2005 respectively. The totalincome tax benefit recognized in the statement of operations for share-basedcompensation arrangements was $81,956 and $82,622 for the three months endedDecember 31, 2006 and 2005 respectively. Compensation expense related toshare-based awards is recorded as a component of general and administrativeexpense.

The Company maintains the1998 Stock Option Plan (the “Plan”) and the 2003 Restricted Stock Plan (the “RestrictedPlan”). These plans were approved by the Company’s shareholders.

**Stock Options**

The Plan provides for thegranting of incentive and nonqualified stock options to employees, officers,directors and independent contractors and consultants. Through December 31,2006 no stock options have been granted to independent contractors orconsultants under this plan.  Totalcompensation expense was $112,000 and $174,009 for the three months endedDecember 31, 2006 and 2005, respectively.

 Incentive stock options granted under the Planhave exercise prices that must be at least equal to the fair value of thecommon stock on the date of grant. Nonqualified stock options granted under thePlan have exercise prices that may be less than, equal to or greater than thefair value of the common stock on the date of grant. The Company has reserved 3,389,025shares of Common Stock for awards under the Plan. As of December 31, 2006 therewere 1,713,119 remaining and available for granting.

A summary of optionactivity under the Plan as of December 31, 2006 and changes during the periodthen ended is as follows:
| ** **                         | ** ** | ** **  | ** ** | ** **                | ** ** | **Weighted Average** | ** ** | **Aggregate** | ** ** |
|------------------------------------|------------|-------------|------------|---------------------------|------------|---------------------------|------------|---------------|------------|
| ** **                         | ** ** | ** **  | ** ** | **Weighted Average** | ** ** | **Remaining**             | ** ** | **Intrinsic** | ** ** |
| ** **                         | ** ** | **Options** | ** ** | **Exercise Price**   | ** ** | **Contractual Life** | ** ** | **Value**     | ** ** |
| Outstanding at  September 30, 2006 |       | 701,854     |       | $                         | 9.93       |                      |       |          |       |   |
| Granted                            |       | 9,000       |       | 16.30                     |       |                      |       |          |       |
| Exercised                          |       | (33,542     | )          | 6.08                      |       |                      |       |          |       |
| Cancelled                          |       | (108,700    | )          | 14.50                     |       |                      |       |          |       |
|                               |       |        |       |                      |       |                      |       |          |       |
| Outstanding at  December 31, 2006  |       | 568,612     |       | $                         | 9.39       |                      | 6.64       |          | $          | 4,345,213 |   |
| Exercisable at December  31, 2006  |       | 363,712     |       | $                         | 6.74       |                      | 5.69       |          | $          | 3,743,312 |   |

 

The weighted-averagegrant date fair value of individual options granted during the three monthended December 31, 2006 and 2005 was $9.64 and $7.46, respectively. The totalintrinsic value of options exercised during the three months ended December 31,2006 and 2005 was $388,401 and $59,419, respectively.

7

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The following tablesummarizes information about stock options under the Plan at December 31, 2006:
| **Options Outstanding**                | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | ** **                   | ** ** | **Weighted-** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Outstanding**              | ** ** | **Average** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                  | ** ** | **As of**               | ** ** | **Remaining** | ** ** | **Average** | ** ** | **As of** | ** ** | **Average** | ** ** |
| ** **                                  | ** ** | **December 31,**        | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | **December 31,** | ** ** | **Exercise** | ** ** |
| **Range of Exercise Prices** | ** ** | **2006**                     | ** ** | **Life** | ** ** | **Price** | ** ** | **2006** | ** ** | **Price** | ** ** |
|                                        |       |                         |       |   |   |   |   |   |   |   |   |
| $0.00 — 5.00                 |       | 205,863                      |       | 5.98 |   | $ | 4.18 |   | 203,163 |   | $ | 4.18 |   |
| $5.01 — 10.00                |       | 152,549                      |       | 4.93 |   | 7.68 |   | 113,249 |   | 7.58 |   |
| $10.01 — 15.00               |       | 126,000                      |       | 8.63 |   | 14.05 |   | 26,600 |   | 13.98 |   |
| $15.01 — 20.00               |       | 53,700                       |       | 8.43 |   | 16.70 |   | 14,600 |   | 16.68 |   |
| $20.01 — 22.35               |       | 30,500                       |       | 8.26 |   | 20.94 |   | 6,100 |   | 20.94 |   |
|                                        |       |                         |       |   |   |   |   |   |   |   |   |
|                                        |       | 568,612                      |       | 6.64 |   | $ | 9.39 |   | 363,712 |   | $ | 6.74 |   |
|                                        |       |                         |       |   |   |   |   |   |   |   |   |

 

The fair value ofeach option grant is estimated on the date of grant using the Black-Scholesoption pricing model that uses the weighted —average assumptions noted in thefollowing table. Options are exercised over a maximum term of ten years fromthe date of grant and typically vest over periods of five years from the grantdate. The expected term of options represents the period of time that theoptions granted are expected to be outstanding and is based on historicalexperience. Expected volatility is based on historical volatility of the Company’sstock. The risk free interest rate is based on U.S. Treasuries with constantmaturities in effect at the time of the grant.

|                                           | ** ** | **Three Months**           | ** ** | **Three Months**           | ** ** |
|-------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **Ended**                       | ** ** | **Ended**                       | ** ** |
| ** **                                | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|                                      |       |                            |       |                            |       |
| Expected lives (years)                    |       | 8.8                             |       | 9.3                             |       |
| Weighted average  risk-free interest rate |       | 2.1                             | %          | 1.8                             | %          |
| Expected volatility                       |       | 64.7                            | %          | 65.8                            | %          |
| Expected dividend rate                    |       | %                               |       | %                               |       |

 

As of December 31,2006, there was approximately $1.4 million of unrecognized compensation cost,net of forfeitures, related to non-vested stock options, which is expected tobe recognized over a period of approximately 5 years.

**Non-vestedStock**

The Restricted Plan fornon-employee directors was approved by shareholders at the Company’sFebruary 26, 2004 Annual Meeting of Shareholders. The Plan calls for anannual award of non-vested stock having a fair market value of $40,000 as ofthe close of business on October 1 of the current fiscal year for alleligible non-employee directors. The stock is awarded in four installmentsquarterly during the fiscal year provided the director is still serving on theboard on the quarterly issue date. As of December 31, 2006 and 2005 the Companyrecognized expense of $50,000 and $60,048, respectively. As of December 31,2006, there is an estimated $150,000 of unrecognized compensation expenserelated to nonvested stock awards under the Company’s Restricted Plan. Thatcost is expected to be recognized over the balance of the fiscal year or 9months. The following table outlines restricted stock awards for the threemonths ended December 31, 2006:

|                                | ** ** | **Non-vested**        | ** ** | **Weighted Average** | ** ** |
|--------------------------------|------------|-----------------------|------------|---------------------------|------------|
| ** **                     | ** ** | **Stock Awards** | ** ** | **Share Price**      | ** ** |
| Balance at September  30, 2006 |       | 3,275                 |       | $                         | 15.25      |   |
| Granted                        |       | 13,860                |       | 14.43                     |       |
| Issued                         |       | (3,275                | )          | 15.25                     |       |
| Cancelled                      |       |                  |       |                      |       |
| Balance at December 31,  2006  |       | 13,860                |       | $                         | 14.43      |   |
|                           |       |                  |       |                      |       |

 

 

 

 

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**7. Stock Repurchase Program**

On December 28,2005 the Company’s Board of Directors approved a common stock repurchaseprogram to acquire up to 2,000,000 shares of its outstanding common stock. Theprogram was in effect until June 30, 2006. Over the course of the program theCompany repurchased 1,272,510 shares of its common stock at an average cost of$14.21 per share.

**8. NotesPayable**

The Companyentered into a $4,335,000 loan agreement dated August 1, 2000 with the ChesterCounty, Pennsylvania Industrial Development Authority. The purpose of the loanwas to fund the construction of the Company’s new office and manufacturingfacility. The loan matures in 2015 and carries an interest rate set by theremarketing agent that is consistent with 30-day tax-exempt commercial paper.The loan agreement requires the Company to maintain certain financial covenantsincluding a ratio of liabilities to earnings before interest, taxes anddepreciation and amortization (EBITDA), a fixed charge ratio and a minimumtangible net worth.

As of June 30,2006, the Company was in violation of these financial covenants. The defaultswere subsequently waived and an amendment to the agreement was entered intowith the lender whereby the existing covenants were suspended until the fiscalquarter ending on June 30, 2008.

**9. NewAccounting Pronouncements**

In September 2006,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 157, Fair Value Measurements (“SFAS 157”).  SFAS 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles,and expands disclosures about fair value measurements.  This statement does not require any new fairvalue measurements; however, the application of this Statement may changecurrent practice for some entities.  SFAS157 is effective for fiscal years beginning after November 15, 2007.  The Company is currently evaluating the impactof this pronouncement.

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”).   SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thecurrent year’s financial statements are materially misstated.  SAB 108 is effective for the first fiscalyear ending after November 15, 2006.  TheCompany is in the process of evaluating the impact of the adoption of thisinterpretation and does not believe that the adoption of the SAB 108 will havea material impact on the Company’s financial position or results of operations.

In July 2006, theFASB issued FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes— an interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement No. 109, “Accounting for Income Taxes.”  This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a taxreturn.  This Interpretation alsoprovides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  TheCompany is currently evaluating the impact of this pronouncement.

**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

**Overview**

We design, manufactureand sell flight information computers, flat panel displays and advancedmonitoring systems to the Department of Defense (DOD), government agencies,commercial air transport carriers and corporate/general aviation markets.

Our revenues are derivedfrom the sale of our products to the retrofit market and, to a lesser extent,original equipment manufacturers (OEMs). Our customers include government andmilitary entities and their commercial contractors, aircraft operators,aircraft modification centers and various OEMs. Although we occasionally sell ourproducts directly to government entities, we primarily sell our products tocommercial customers for end use in government and military programs.

We continue to invest inand seek additional opportunities for our Flat Panel Display product line. InOctober 2005, the FAA awarded the Company a second Technical Standard Order(TSO) for our flat panel display system COCKPIT/IPTM. This TSO establishes our flat paneldisplay system as meeting FAA requirements that have been put in place toensure safe flight on a variety of aircraft types and, additionally, itaddresses the most stringent Commercial Air Transport market requirements asprovided in Title 14 of the Code of Federal Regulation, subpart 25, CommercialAir Transport. The TSO states “It has been noted that this display systememploys an integrity monitoring system that assures integrity to acatastrophic/Level A design condition with the use of commercial graphicprocessors.”

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In October 2005, theCompany in a teaming arrangement with ABX Air, received FAA Supplemental TypeCertification (STC) of its Flat Panel Display System for use on B-767 aircraft.The STC provides B-767 operators with a low cost, rapidly implemented retrofitof their cockpit avionics with a modern pilot and copilot suite of high resolutionmulti-color LCD flat panel displays. Operators will benefit from improveddispatch reliability, logistics savings and adaptability to futurerequirements. The receipt of the STC positions the Company to pursue more than1,700 B-757 and B-767 aircraft with similar needs for Flat Panel Display Systemupgrades. The STC also provides a foundation for incorporating the product intoother airplanes as well.

Our “cost of sales” iscomprised of material components purchased through our supplier base and directin-house assembly labor and overhead costs. Many of the components we use inassembling our products are standard, although certain parts are manufacturedto meet our specifications. The overhead portion of cost of sales is primarilycomprised of salaries and benefits, building occupancy, supplies, and outsideservice costs related to our production, purchasing, customer service, materialcontrol and quality departments as well as warranty costs.

We continue to invest inthe development of new products and the enhancement of our existing productline. We expense research and development costs related to future productdevelopment as they are incurred.

Our selling, general, andadministrative expenses consist of marketing and business development expenses,professional expenses, salaries and benefits for executive and administrativepersonnel, facility costs, recruiting, legal, accounting, and other generalcorporate expenses.

**Three Months Ended December 31,2006 Compared to the Three Months Ended December 31, 2005**

*Net sales.* Netsales decreased $2.0 million, or 37%, to $3.4 million for the three monthsended December 31, 2006 from $5.4 million in the three months ended December31, 2005. The decrease in net sales was primarily the result of a slower thanexpected start up of Flat Panel Display System deliveries.

*Cost of sales.*Cost of sales decreased $0.7 million or 26%, to $2.0 million, or 59% of netsales in the three months ended December 31, 2006 from $2.7 million, or 50 % ofnet sales in the three months ended December 31, 2005. The absolute dollardecrease in cost of sales was related to our decrease in net sales. As apercentage, the increase was the result of fixed operating costs not beingabsorbed over lower net sales in the current period.

*Research and development.*Research and development expenses decreased $0.2 million or 13% to $1.3 millionor 38% of net sales in the three months ended December 31, 2006 from $1.5million or 28% of net sales in the three months ended December 31, 2005.  The reduction is related to additional costsincurred during the three months ended December 31, 2005 in conjunction withobtaining the Supplement Type Certification on the PC-12. No certificationswere obtained during the three months ended December 31, 2006.

*Selling, general, andadministrative.* Selling, general, and administrative expensesincreased $1.2 million, or 63%, to $3.1 million, or 91% of net sales in thethree months ended December 31, 2006 from $1.9 million or 35% of net sales inthe three months ended December 31, 2005. The increase in the dollar amount wasprimarily the result of increased legal and other fees relating to intellectualproperty matters and increased selling cost related to trade show expenses.

*Interest income.*Interest income was $816,000 in the three months ended December 31, 2006 ascompared $781,000 in the three months ended December 31, 2005. The increase ininterest income in the three months ended December 31, 2006 was primarily theresult of higher interest rates offsetting our reduced cash position in thecurrent period.

*Interest expense.*Interest expense was $51,000 in the three months ended December 31, 2006 ascompared to $44,000 in the three months ended December 31, 2005. The increasein interest expense in the three months ended December 31, 2006 was primarilythe result of higher interest rates in the period.

*Income tax expense.*The income tax benefit for the three months ended December 31, 2006 was $1.1million. The income tax expense for the three months ending December 31, 2005was $3,000. The decrease in the amount of tax from a tax expense to a taxbenefit was due to recording a loss before taxes for the three months endedDecember 31, 2006.

The effective tax ratefor the three months ended December 31, 2006 was a benefit of 50.6 %. Theeffective tax rate for the three months ended December 31, 2005 was 35.3%. Ineach quarter the effective tax rate differs from the statutory rate due to theutilization of research and experimentation tax credits.

In December of 2006, an additionaltwo-year extension of the Research and Experimentation (R&E) Tax Credit wasenacted into law. This retroactive extension is for amounts paid or incurredafter December 31, 2005, and before January 1, 2008.  The entire impact of

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this retroactiveextension has been recognized in the first quarter ended December 31, 2006, asrequired by SFAS 109, Accounting for Income Taxes.  For the quarter endingDecember 31, 2006, the overall benefit recorded, including the impact of theR&E credit was 50.6% and would have been 43.7% without this discrete item.

*Net income.* Asa result of the factors described above, our net loss in the three months endedDecember 31, 2006 was $1.1 million a decrease of $1.1 million from net incomeof $6,125 for the three months ended December 31, 2005.

**Liquidity and Capital Resources**

Our main source ofliquidity has been cash flows from prior operations. We require cashprincipally to finance inventory, accounts receivable and payroll.

Our cash used inoperating activities was $674,000 for the three months ended December 31, 2006as compared to $246,000 for the three months ended December 31, 2005. Theincrease was due primarily to lower net income ($1.1 million) and increasedprepaid expenses ($1.1 million) which were partially offset by reduced accountsreceivable ($1.4 million).

Our cash used ininvesting activities was $27,000 for the three months ended December 31, 2006.This primarily consisted of spending for production and laboratory testequipment. Cash used in investing activities was $350,000 for the three monthsended December 31, 2005 and primarily consisted of production certification,production equipment and, laboratory test equipment.

Net cash flow fromfinancing activities was $325,000, for the three months ended December 31, 2006as compared to $55,000 in the three months ended December 31, 2005. In bothperiods the primary source of cash was from proceeds from the exercise of stockoptions.

The Companyentered into a $4,335,000 loan agreement dated August 1, 2000 with the ChesterCounty, Pennsylvania Industrial Development Authority. The purpose of the loanwas to fund the construction of the Company’s new office and manufacturingfacility. The loan matures in 2015 and carries an interest rate set by theremarketing agent that is consistent with 30-day tax-exempt commercial paper.The loan agreement requires the Company to maintain certain financial covenantsincluding a ratio of liabilities to earnings before interest, taxes anddepreciation and amortization (EBITDA), a fixed charge ratio and a minimumtangible net worth.

As of June 30,2006, the Company was in violation of these financial covenants. The defaultswere subsequently waived and an amendment to the agreement was entered intowith the lender whereby the existing covenants were suspended until the fiscalquarter ending on June 30, 2008.

Our future capitalrequirements depend on numerous factors, including market acceptance of ourproducts, the timing and rate of expansion of our business, acquisitions, jointventures and other factors. We have experienced increases in our expendituressince our inception consistent with growth in our operations, personnel andproduct line, and we anticipate that our expenditures will continue to increasein the foreseeable future. We believe that our cash and cash equivalents willprovide sufficient capital to fund our operations for at least the next twelvemonths. However, we may need to raise additional funds through public orprivate financings or other arrangements in order to support more rapidexpansion of our business than we now anticipate either through acquisitions ororganic growth. Further, we may need to develop and introduce new or enhancedproducts, respond to competitive pressures, invest in or acquire businesses ortechnologies or respond to unanticipated requirements or developments. Ifadditional funds are raised through the issuance of equity securities, dilutionto existing shareholders may result. If insufficient funds are available, wemay not be able to introduce new products or compete effectively in any of ourmarkets, which could hurt our business.

**Backlog**

As of December 31, 2006 and 2005, our backlog was$32.3 million and $18.2 million, respectively. The period over period increasein backlog principally reflects the increase in Flat Panel Display Systemorders. The Flat Panel Display System component as of December 31, 2006 is$23.5 million, an increase of $11.4 million over the December 31, 2005 balanceof $12.1 million.

**Critical Accounting Policies**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities,disclosure of contingent assets and liabilities at the date of the financialstatements and the reported amount of revenues and expenses during thereporting period. The Company’s most critical accounting policies are revenuerecognition, income taxes, allowance for doubtful accounts, inventoryvaluation, share-based compensation and warranty reserves.

The Companyrecognizes sales for products when the following revenue recognition criteriaare met: persuasive evidence of an arrangement exists, product delivery and acceptancehas occurred, pricing is fixed or determinable and collection is reasonably 

11

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assured. TheCompany recognizes sales upon shipment of products to customers.

Sales related tocertain long-term contracts requiring development and delivery of products overseveral accounting periods are accounted for under the American Institute ofCertified Public Accountants (AICPA) Statement of Position (SOP) 81-1,Accounting for Performance of Construction-Type and Certain Production-TypeContracts. We consider the nature of these contracts as well as the types ofproducts and services provided when determining the appropriate accountingtreatment for a particular contract. Certain long-term contracts are recordedon a percentage of completion basis using cost-to-cost methodology to measureprogress towards completion.

The Company offersits customers extended warranties for additional fees. These warranty sales arerecorded as deferred revenue and recognized as sales on a straight-line basisover the warranty period.

The Company entersinto certain sales arrangements that include multiple deliverables as definedin Emerging Issues Task Force (EITF) Issue No. 00-21, Accounting forRevenue Arrangements with Multiple Deliverables. Effective July 1, 2003,the Company identifies all goods and/or services that are to be deliveredseparately under a sales arrangement and allocates revenue to each deliverablebased on fair value that is established with the customer during contractnegotiations. In general, revenues are separated between product sales andnon-recurring engineering services. The allocated revenue for each deliverableis then recognized using appropriate revenue recognition methods. Effective fortransactions entered into after October 1, 2003, the Company accounts fortransactions with software and non-software components under EITF Issue 03-5, “Applicabilityof AICPA Statement of Position 97-2, Software Revenue Recognition, toNon-Software Deliverables in an Arrangement Containing More-Than-IncidentalSoftware.”

Income taxes arerecorded in accordance with SFAS No. 109, Accounting for Income Taxes.Provisions for federal and state income taxes are calculated on reportedfinancial statement pre-tax income based on current tax law. The Companyrecognizes deferred tax assets and liabilities for temporary differencesbetween the financial reporting basis and the tax basis of the Company’s assetsand liabilities and expected benefits of utilizing net operating losscarryforwards. The impact on deferred taxes of changes in tax rates and laws,if any, applied to the years during which temporary differences are expected tobe settled, are reflected in the consolidated financial statements in theperiod of enactment.

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

Inventories arewritten down for estimated obsolescence equal to the difference between thecost of inventory and the estimated net realizable value based upon assumptionsabout future market conditions. If actual future demand or market conditionsare less favorable than those projected by management, additional inventorywrite-downs may be required.

We offer warrantieson some products of various lengths. At the time of shipment, we establish areserve for the estimated cost of warranties based on our best estimate of theamounts necessary to settle future and existing claims using historical data onproducts 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. Ifthe actual cost of warranties differs from our estimated amounts, futureresults of operations could be adversely affected.

EffectiveOctober 1, 2005 the Company adopted the provisions of SFAS 123R, using themodified prospective approach and now accounts for share-based compensationapplying the fair value method for expensing stock options. Accordingly, theadoption of SFAS 123R’s fair value method results in compensation costs for theCompany’s 1998 Stock Option Plan.

**Business Segments**

We operate in oneprincipal business segment which designs, manufactures and sells flightinformation computers, flat panel displays and advanced monitoring systems tothe Department of Defense, government agencies, commercial air transportcarriers and corporate/general aviation markets. We currently derive virtuallyall 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.

**New Accounting Pronouncements**

In September 2006,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 157, Fair Value Measurements (“SFAS 157”).  SFAS 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles,and expands disclosures about fair value measurements.  This statement does not require any new fairvalue measurements; however, the application of this Statement may changecurrent practice for some entities.  SFAS157 is effective for fiscal years beginning after November 15, 2007.  The Company is currently evaluating theimpact of this pronouncement.

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In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”).   SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thecurrent year’s financial statements are materially misstated.  SAB 108 is effective for the first fiscalyear ending after November 15, 2006.  TheCompany is in the process of evaluating the impact of the adoption of thisinterpretation and does not believe that the adoption of the SAB 108 will havea material impact on the Company’s financial position or results of operations.

In July 2006, theFASB issued FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes— an interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement No. 109, “Accounting for Income Taxes.”  This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a taxreturn.  This Interpretation alsoprovides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  TheCompany is currently evaluating the impact of this pronouncement.

**FORWARD-LOOKINGSTATEMENTS**

This Form 10-Q containsstatements, which, to the extent that they are not recitations of historicalfact, constitute forward-looking statements within the meaning of theSecurities Act of 1933 and the Securities Exchange Act of 1934. The words “anticipate”“believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “outlook,” “would,” “should,”“guidance,” “potential,” “continue,” “project,” “forecast” and similar expressions are intended to identifyforward-looking statements. Forward-looking statements are not guarantees offuture performance and involve risks, uncertainties and assumptions, which aredifficult to predict. Therefore, actual outcomes and results may differmaterially from what is expressed or implied by these statements.  Numerous factors, including potentially thefollowing factors, could affect the Company’s forward-looking statements andactual performance:

·                  continuedmarket acceptance of our air data systems products;

·                  theability to obtain future contracts and awards;

·                  theavailability of government funding and customer requirements;

·                  difficultiesin developing and producing our flat panel display systems , or COCKPIT/IPTM, or other planned products or product enhancements;

·                  marketacceptance of our COCKPIT/IPTM system or other planned products or productenhancements;

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

·                  delaysin receiving components from third party suppliers;

·                  thecompetitive environment;

·                  thetermination of programs or contracts for convenience by customers;

·                  failureto retain key personnel;

·                  newproduct offerings from competitors;

·                  potentialfuture acquisitions;

·                  protectionof intellectual property rights;

·                  ourability to service the international market, and

·                  otherfactors disclosed from time to time in our filings with the Securities andExchange Commission.

Readers are cautioned notto place undue reliance on these forward-looking statements, which speak onlyas of the date of this Form 

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10-Q. The Company doesnot undertake any obligation to publicly release any revisions to theseforward-looking statements to reflect events, circumstances or changes inexpectations after the date of this Form 10-Q, or to reflect the occurrence ofunanticipated events. The forward-looking statements in this document areintended to be subject to the safe harbor protection provided by Sections 27Aof the Securities Act and 21E of the Exchange Act.

For a discussionidentifying some important factors that could cause actual results to varymaterially from those anticipated in the forward­looking statements, see theCompany’s Securities and Exchange Commission filings including, but not limitedto, the discussions of “Risk Factors” contained in the Company’s Annual Reporton Form 10-K for the fiscal year ended September 30, 2006.

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

The Company’s operationsare exposed to market risks primarily as a result of changes in interest rates.The Company does not use derivative financial instruments for speculative ortrading purposes. The Company’s exposure to market risk for changes in interestrates relates to its cash equivalents and an industrial revenue bond. TheCompany’s cash equivalents consist of funds invested in money market accounts,which bear interest at a variable rate, while the industrial revenue bondcarries an interest rate that is consistent with 30-day, tax-exempt commercialpaper. As the interest rates are variable, and we do not engage in hedgingactivities, a change in interest rates earned on the cash equivalents or paidon the industrial revenue bond would impact interest income and expense alongwith cash flows, but would not impact the fair market value of the relatedunderlying instruments.

**Item 4.Controls and Procedures**

(a)          An evaluation wasperformed under the supervision and with the participation of the Company’smanagement, including its Chief Executive Officer, or CEO, and Chief FinancialOfficer, or CFO, of the effectiveness of the Company’s disclosure controls andprocedures, as such term is defined under Rule 13a-15e under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”) as of December 31, 2006.Based on that evaluation, the Company’s management, including the CEO and CFO,concluded that the Company’s disclosure controls and procedures are effectiveto provide reasonable assurance that information required to be disclosed bythe Company in reports that it files or submits under the Exchange Act, isrecorded, processed, summarized and reported as specified in Securities andExchange Commission rules and forms and that such information is accumulatedand communicated to the Company’s management, including the CEO and CFO, orpersons performing similar functions, as appropriate to allow timely decisionsregarding required disclosure.

(b)         There were no changes inthe Company’s internal control over financial reporting identified inconnection with the evaluation of such controls that occurred during theCompany’s most recent fiscal quarter that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

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**PART II—OTHER INFORMATION**

**Item 1.    LegalProceedings**

In the ordinary course of our business, we are attimes subject to various legal proceedings. We do not believe that any currentlegal proceedings will have a material adverse effect on our results of operationsor financial position.

**Item 1A.  RiskFactors**

There are no material changes to the risk factors described under Item1A of our Form 10-K for the year ended September 30, 2006.

I**tem 2.    Unregistered Sales ofEquity Securities and Use of Proceeds**

None

**Item 3.    Defaults upon Senior Securities**

None

**Item 4.    Submission of Matters to a Vote of SecurityHolders**

No matters were submitted to a vote of our shareholders during thethree months ended December 31, 2006.

**Item 5.    Other Information**

None

**Item 6.Exhibits**

(a)   Exhibits

        31.1         Certificationof Chief Executive Officer Pursuant to Rule 13a-14(a)

        31.2         Certificationof Chief Financial Officer Pursuant to Rule 13a-14(a)

        32.1         CertificationPursuant to U.S.C. Section 1350, as Adopted Pursuant to Section 906 of theSarbanes-Oxley Act of 2002

**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                        | ** ** | **INNOVATIVE SOLUTIONS & SUPPORT, INC.** |
|------------------------|------------|----------------------------------------------|
| ** **             | ** ** | ** **                                   |
| ** **             | ** ** | ** **                                   |
| Date: February 5, 2007 |       | By:                                          |   | /s/ JAMES J. REILLY |
|                   | ** ** | ** **                                   | ** ** | **James J. Reilly Chief Financial Officer** |

 

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