Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

| **x****      QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                             |
| **For the quarterly period ended  June 30, 2008**                                                                                           |
| ** **                                                                                                                                       |
| **OR**                                                                                                                                           |
| ** **                                                                                                                                       |
| **o****      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 itscharter)

 

| **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’s telephone number, including  area code) |

 

Indicateby check mark whether registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 day.

 

Yesx     Noo

 

Indicate bycheck mark whether the registrant is a large accelerated filer, an acceleratedfiler, a non-accelerated filer, or a smaller reporting company. See definitionsof “large accelerated filer,” “accelerated filer,” and “smaller reportingcompany” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated filer o                      |   | Accelerated filer x          |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated filer o                        |   | Smaller reporting  company o |
| (Do not check if a smaller  reporting company) |   |                              |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

 

Yeso     Nox

 

Asof August 1, 2008, there were 16,904,514 shares of the Registrant’s CommonStock, with par value of $.001 per share, outstanding.

 

 

 

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

### **FORM 10-Q June 30, 2008**

### ** **

**INDEX**

 
| ** **        | ** ** | ** **                                                                                                              | ** ** | **Page No.** |
|-------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|-------------------|
|              |       |                                                                                                                    |       |              |
| **PART I.**  | ** ** | **FINANCIAL INFORMATION**                                                                                               |       |              |
|              |       |                                                                                                                    |       |              |
| Item 1.           |       | Financial Statements (Unaudited)                                                                                        |       |              |
|              |       |                                                                                                                    |       |              |
|              |       | Condensed Consolidated  Balance Sheets – June 30, 2008 and  September 30, 2007                           |       | 3                 |
|              |       |                                                                                                                    |       |              |
|              |       | Condensed Consolidated  Statements of Operations – Three  Months and Nine Months Ended June 30, 2008 and 2007 |       | 4                 |
|              |       |                                                                                                                    |       |              |
|              |       | Condensed Consolidated  Statements of Cash Flows – Nine  Months Ended June 30, 2008 and 2007                  |       | 5                 |
|              |       |                                                                                                                    |       |              |
|              |       | Notes to Condensed  Consolidated Financial Statements                                                                   |       | 6 – 11       |
|              |       |                                                                                                                    |       |              |
| Item 2.           |       | Managements  Discussion and Analysis of Financial Condition and Results of Operations                                   |       | 12 – 17      |
|              |       |                                                                                                                    |       |              |
| Item 3.           |       | Quantitative  and Qualitative Disclosures about Market Risk                                                             |       | 18                |
|              |       |                                                                                                                    |       |              |
| Item 4.           |       | Controls and  Procedures                                                                                                |       | 18                |
|              |       |                                                                                                                    |       |              |
| **PART II.** | ** ** | **OTHER INFORMATION**                                                                                                   |       |              |
|              |       |                                                                                                                    |       |              |
| Item 1.           |       | Legal Proceedings                                                                                                       |       | 19                |
|              |       |                                                                                                                    |       |              |
| Item 1A           |       | Risk Factors                                                                                                            |       | 19                |
|              |       |                                                                                                                    |       |              |
| Item 2.           |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                            |       | 19                |
|              |       |                                                                                                                    |       |              |
| Item 3.           |       | Defaults  upon Senior Securities                                                                                        |       | 19                |
|              |       |                                                                                                                    |       |              |
| Item 4.           |       | Submission  of Matters to a Vote of Security Holders                                                                    |       | 19                |
|              |       |                                                                                                                    |       |              |
| Item 5.           |       | Other Information                                                                                                       |       | 20                |
|              |       |                                                                                                                    |       |              |
| Item 6.           |       | Exhibits                                                                                                                |       | 20                |
|              |       |                                                                                                                    |       |              |
| **SIGNATURES**    |       |                                                                                                                    |

 

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**PART I–FINANCIALINFORMATION**

**Item 1–Financial Statements**

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(unaudited)**

** **
| ** **                                                                                                                                                                                                                      | ** ** | **As of**              | ** ** | **As of**                   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                                                                                      | ** ** | **June 30, 2008** | ** ** | **September 30, 2007** | ** ** |
| **ASSETS**                                                                                                                                                                                                                      |       |                        |       |                             |       |
| Current Assets:                                                                                                                                                                                                                 |       |                        |       |                             |       |
| Cash and cash equivalents                                                                                                                                                                                                       |       | $                           | 41,070,896 |                             | $          | 49,151,078 |   |
| Accounts receivable                                                                                                                                                                                                             |       | 4,963,603                   |       | 6,248,606                        |       |
| Inventories                                                                                                                                                                                                                     |       | 10,953,948                  |       | 9,363,795                        |       |
| Deferred income taxes                                                                                                                                                                                                           |       | 46,343                      |       | 899,895                          |       |
| Prepaid expenses and other current assets                                                                                                                                                                                       |       | 1,274,872                   |       | 6,208,804                        |       |
| Total current assets                                                                                                                                                                                                            |       | 58,309,662                  |       | 71,872,178                       |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Property and Equipment:                                                                                                                                                                                                         |       |                        |       |                             |       |
| Computers and test equipment                                                                                                                                                                                                    |       | 5,877,489                   |       | 5,444,737                        |       |
| Corporate airplane                                                                                                                                                                                                              |       | 3,076,400                   |       | 3,058,627                        |       |
| Furniture and office equipment                                                                                                                                                                                                  |       | 1,074,029                   |       | 1,016,954                        |       |
| Manufacturing facility                                                                                                                                                                                                          |       | 5,576,536                   |       | 5,557,048                        |       |
| Land                                                                                                                                                                                                                            |       | 1,021,245                   |       | 1,021,245                        |       |
|                                                                                                                                                                                                                            |       | 16,625,699                  |       | 16,098,611                       |       |
| Less- Accumulated depreciation and  amortization                                                                                                                                                                                |       | (7,439,886                  | )          | (6,721,274                       | )          |
| Net property and equipment                                                                                                                                                                                                      |       | 9,185,813                   |       | 9,377,337                        |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Deferred income taxes                                                                                                                                                                                                           |       | —                      |       | 328,060                          |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Other assets                                                                                                                                                                                                                    |       | 505,780                     |       | 3,008,210                        |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Total assets                                                                                                                                                                                                                    |       | $                           | 68,001,255 |                             | $          | 84,585,785 |   |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                  |       |                        |       |                             |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Current Liabilities                                                                                                                                                                                                             |       |                        |       |                             |       |
| Current portion of capitalized lease  obligations                                                                                                                                                                               |       | $                           | 9,908      |                             | $          | 9,908 |   |
| Accounts payable                                                                                                                                                                                                                |       | 2,941,848                   |       | 4,077,789                        |       |
| Accrued expenses                                                                                                                                                                                                                |       | 3,107,057                   |       | 4,670,832                        |       |
| Deferred revenue                                                                                                                                                                                                                |       | 489,750                     |       | 660,415                          |       |
| Total current liabilities                                                                                                                                                                                                       |       | 6,548,563                   |       | 9,418,944                        |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Note payable                                                                                                                                                                                                                    |       | 4,335,000                   |       | 4,335,000                        |       |
| Long-term portion of capitalized lease  obligations                                                                                                                                                                             |       | 40,170                      |       | 47,542                           |       |
| Deferred revenue                                                                                                                                                                                                                |       | 2,949                       |       | 50,520                           |       |
| Deferred income taxes                                                                                                                                                                                                           |       | 46,343                      |       | —                           |       |
| Other liabilities                                                                                                                                                                                                               |       | 223,893                     |       | —                           |       |
| Commitments and contingencies                                                                                                                                                                                                   |       | —                      |       | —                           |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Total liabilities                                                                                                                                                                                                               |       | 11,196,918                  |       | 13,852,006                       |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Shareholders’ Equity:                                                                                                                                                                                                      |       |                        |       |                             |       |
| Preferred stock, 10,000,000 shares  authorized, $.001 par value, of which 200,000 shares are authorized as  Class A Convertible stock. No shares issued and outstanding at  June 30, 2008 and September 30, 2007 |       | —                      |       | —                           |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Common stock, $.001 par value: 75,000,000  shares authorized, 18,174,394 and 18,161,172 shares issued at June 30,  2008 and September 30, 2007                                                                        |       | 18,174                      |       | 18,161                           |       |
| Additional paid-in capital                                                                                                                                                                                                      |       | 45,619,362                  |       | 44,607,993                       |       |
| Retained earnings                                                                                                                                                                                                               |       | 29,310,407                  |       | 44,194,053                       |       |
| Treasury stock, at cost, 1,279,510, shares  at June 30, 2008 and 1,272,510 shares at September 30, 2007                                                                                                               |       | (18,143,606                 | )          | (18,086,428                      | )          |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Total shareholders’ equity                                                                                                                                                                                                 |       | 56,804,337                  |       | 70,733,779                       |       |
|                                                                                                                                                                                                                            |       |                        |       |                             |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                                 |       | $                           | 68,001,255 |                             | $          | 84,585,785 |   |

 

Theaccompanying notes are an integral part of these statements.

 

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**(unaudited)**

 
| ** **                                         | ** ** | **Three Months** | ** ** | **Three Months** | ** ** | **Nine Months** | ** ** | **Nine Months** | ** **  |
|----------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------------|------------|----------------------|-------------|
| ** **                                         | ** ** | **Ended**             | ** ** | **Ended**             | ** ** | **Ended**            | ** ** | **Ended**            | ** **  |
| ** **                                         | ** ** | **June 30**      | ** ** | **June 30**      | ** ** | **June 30**     | ** ** | **June 30**     | ** **  |
| ** **                                         | ** ** | **2008**              | ** ** | **2007**              | ** ** | **2008**             | ** ** | **2007**             | ** **  |
| Net sales:                                         |       |                  |       |                  |       |                 |       |                 |        |
| Product                                            |       | $                     | 7,178,212  |                  | $          | 3,981,660            |       | $                    | 17,290,973  |   | $ | 10,316,479 |   |
| Engineering - Modification &  Development |       | 1,573,097             |       | 1,862,745             |       | 3,020,343            |       | 2,911,872            |        |
| Total net sales                                    |       | 8,751,309             |       | 5,844,405             |       | 20,311,316           |       | 13,228,351           |        |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Cost of sales                                      |       |                  |       |                  |       |                 |       |                 |        |
| Product                                            |       | 3,850,657             |       | 1,985,572             |       | 10,331,738           |       | 6,027,327            |        |
| Engineering - Modification &  Development |       | 717,646               |       | 1,653,663             |       | 1,686,285            |       | 2,663,881            |        |
| Total cost of sales                                |       | 4,568,303             |       | 3,639,235             |       | 12,018,023           |       | 8,691,208            |        |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Gross profit                                       |       | 4,183,006             |       | 2,205,170             |       | 8,293,293            |       | 4,537,143            |        |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Operating expenses:                                |       |                  |       |                  |       |                 |       |                 |        |
| Research and development                           |       | 3,221,698             |       | 1,107,385             |       | 7,738,942            |       | 3,912,480            |        |
| Selling, general and administrative                |       | 3,282,183             |       | 4,192,013             |       | 13,952,535           |       | 11,124,795           |        |
| Asset Impairment                                   |       | 2,475,000             |       | —                |       | 2,475,000            |       | —               |        |
| Total operating expenses                           |       | 8,978,881             |       | 5,299,398             |       | 24,166,477           |       | 15,037,275           |        |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Operating loss                                     |       | (4,795,875            | )          | (3,094,228            | )          | (15,873,184          | )          | (10,500,132          | )           |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Interest income- net                               |       | 251,015               |       | 728,454               |       | 1,193,036            |       | 2,234,718            |        |
| Other income                                       |       | —                |       | —                |       | 300,000              |       | —               |        |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Loss before income taxes                           |       | (4,544,860            | )          | (2,365,774            | )          | (14,380,148          | )          | (8,265,414           | )           |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Income tax expense (benefit)                       |       | (255,989              | )          | (1,014,917            | )          | 1,090,821            |       | (3,456,967           | )           |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Net loss                                           |       | $                     | (4,288,871 | )                     | $          | (1,350,857           | )          | $                    | (15,470,969 | ) | $ | (4,808,447 | ) |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Net loss per common share:                         |       |                  |       |                  |       |                 |       |                 |        |
| Basic                                              |       | $                     | (0.25      | )                     | $          | (0.08                | )          | $                    | (0.92       | ) | $ | (0.29 | ) |
| Diluted                                            |       | $                     | (0.25      | )                     | $          | (0.08                | )          | $                    | (0.92       | ) | $ | (0.29 | ) |
|                                               |       |                  |       |                  |       |                 |       |                 |        |
| Weighted average shares outstanding:               |       |                  |       |                  |       |                 |       |                 |        |
| Basic                                              |       | 16,893,499            |       | 16,881,900            |       | 16,897,313           |       | 16,857,164           |        |
| Diluted                                            |       | 16,893,499            |       | 16,881,900            |       | 16,897,313           |       | 16,857,164           |        |

 

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** | ** **  | **For the Nine** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------------------------|-------------|----------------------------|------------|
| ** **                                                                                          | ** ** | **Months Ended**      | ** **  | **Months Ended**      | ** ** |
| ** **                                                                                          | ** ** | **June 30**           | ** **  | **June 30**           | ** ** |
| ** **                                                                                          | ** ** | **2008**                   | ** **  | **2007**                   | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                           |       |                       |        |                       |       |
| Net loss                                                                                            |       | $                          | (15,470,969 | )                          | $          | (4,808,447 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                       |        |                       |       |
| Depreciation and amortization                                                                       |       | 761,666                    |        | 619,786                    |       |
| Share-based compensation expense:                                                                   |       |                       |        |                       |       |
| Stock options                                                                                       |       | 809,792                    |        | 361,869                    |       |
| Nonvested stock awards                                                                              |       | 149,940                    |        | 170,000                    |       |
| Tax benefit from share-based arrangements:                                                          |       |                       |        |                       |       |
| Stock options                                                                                       |       | 12,491                     |        | 164,680                    |       |
| Nonvested stock awards                                                                              |       | 6,286                      |        | 37,449                     |       |
| Excess tax benefits from share-based  payments arrangements                                         |       | —                     |        | (156,442                   | )          |
| (Gain) loss on disposal of fixed assets                                                             |       | (3,000                     | )           | 2,486                      |       |
| Excess and obsolete inventory expense                                                               |       | 78,913                     |        | 100,000                    |       |
| Asset impairment                                                                                    |       | 2,475,000                  |        | —                     |       |
| Deferred income taxes                                                                               |       | 1,227,955                  |        | (458,113                   | )          |
| (Increase) decrease in:                                                                             |       |                       |        |                       |       |
| Accounts receivable                                                                                 |       | 1,285,003                  |        | 1,545,161                  |       |
| Inventories                                                                                         |       | (1,669,066                 | )           | (1,245,857                 | )          |
| Prepaid expenses and other current assets                                                           |       | 4,933,932                  |        | (3,751,173                 | )          |
| Other non current assets                                                                            |       | (6,180                     | )           | —                     |       |
| Increase (decrease) in:                                                                             |       |                       |        |                       |       |
| Accounts payable                                                                                    |       | (1,135,941                 | )           | 3,639,053                  |       |
| Accrued expenses                                                                                    |       | (976,452                   | )           | 478,290                    |       |
| Deferred revenue                                                                                    |       | (218,236                   | )           | (419,108                   | )          |
| Other non current liabilities                                                                       |       | 223,893                    |        | —                     |       |
| Net cash used in operating activities                                                               |       | (7,514,973                 | )           | (3,720,366                 | )          |
|                                                                                                |       |                       |        |                       |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                           |       |                       |        |                       |       |
| Purchases of property and equipment                                                                 |       | (536,532                   | )           | (596,698                   | )          |
| Purchases of other assets                                                                           |       | —                     |        | (2,477,500                 | )          |
| Proceeds on sale of fixed assets                                                                    |       | 3,000                      |        | —                     |       |
| Net cash used in investing activities                                                               |       | (533,532                   | )           | (3,074,198                 | )          |
|                                                                                                |       |                       |        |                       |       |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                           |       |                       |        |                       |       |
| Proceeds from exercise of stock options                                                             |       | 32,873                     |        | 487,218                    |       |
| Repayment of capitalized lease obligations                                                          |       | (7,372                     | )           | (6,141                     | )          |
| Purchase of treasury stock                                                                          |       | (57,178                    | )           | —                     |       |
| Excess tax benefits from share-based  payments arrangements                                         |       | —                     |        | 156,442                    |       |
| Net cash provided by (used in) financing  activities                                                |       | (31,677                    | )           | 637,519                    |       |
|                                                                                                |       |                       |        |                       |       |
| Net decrease in cash and cash equivalents                                                           |       | (8,080,182                 | )           | (6,157,045                 | )          |
| Cash and cash equivalents, beginning of  year                                                       |       | 49,151,078                 |        | 62,984,829                 |       |
|                                                                                                |       |                       |        |                       |       |
| Cash and cash equivalents, end of period                                                            |       | $                          | 41,070,896  |                       | $          | 56,827,784 |   |
|                                                                                                |       |                       |        |                       |       |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION**                                               |       |                       |        |                       |       |
| Cash paid for interest                                                                              |       | $                          | 92,066      |                       | $          | 123,701 |   |
| Cash paid for income taxes                                                                          |       | $                          | 9,073       |                       | $          | — |   |
| Cash received from income tax refund                                                                |       | $                          | (5,107,269  | )                          | $          | (2,314,697 | ) |

 

The accompanying notes are an integral part of these statements.

 

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**InnovativeSolutions and Support Inc.Notes to Condensed Consolidated Financial Statements**

 

**1.Basis of Presentation:**

 

InnovativeSolutions and Support, Inc. (the “Company”) was incorporated inPennsylvania on February 12, 1988. The Company’s primary business is thedesign, manufacture and sale of flat panel display systems, flight informationcomputers and advanced monitoring systems for military, government, commercialair transport and corporate aviation markets.

 

Thebalance sheet as of June 30, 2008, the statement of operations for thethree months and nine months ended June 30, 2008 and 2007 and thestatements of cash flows for the nine months ended June 30, 2008 and 2007have been prepared by the Company without audit. In the opinion of management,all adjustments, consisting of normal and recurring adjustments, necessary topresent fairly the financial position, results of operations and cash flows at June 30,2008 and for all periods presented have been made.

 

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted. It is suggested thatthese financial statements be read in conjunction with the financial statementsand notes thereto included in the Company’s Form 10-K for the year ended September 30,2007 as filed with the Securities and Exchange Commission. The results ofoperations for the three months and nine months ended June 30, 2008 arenot necessarily indicative of the operating results for the full year.

 

**2. New Accounting Pronouncements**

 

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) No. 157, *Fair Value Measurements* (“SFAS 157”). SFAS 157 defines fairvalue, establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair value measurements.This statement does not require any new fair value measurements; however, theapplication of this Statement may change current practice for some entities.SFAS 157 is effective for fiscal years beginning after November 15, 2007.The Company is currently evaluating the impact of this pronouncement.

 

**3.Concentrations**

 

Forthe three months ended June 30, 2008, three customers accounted for 44%,15% and 14% of net sales or 73% on a combined basis. For the three months endedJune 30, 2007, three customers accounted for 31%, 22% and 13% of net salesor 66% on a combined basis. For the nine months ended June 30, 2008, onecustomer accounted for 52% of net sales. For the nine months ended June 30,2007, two customers accounted for 22% and 19% of net sales or 41% on a combinedbasis.

 

**4.Inventories**

 

Inventoriesare stated at the lower of cost (first-in, first-out) or market, net of reservefor excess and obsolete, and consist of the following:

 
| ** **      | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-----------------|------------|-------------------|------------|------------------------|------------|
| ** **      | ** ** | **2008**          | ** ** | **2007**               | ** ** |
| Raw materials   |       | $                 | 6,991,180  |                   | $          | 6,420,184 |   |
| Work-in-process |       | 2,850,703         |       | 2,216,111              |       |
| Finished goods  |       | 1,112,065         |       | 727,500                |       |
|            |       | $                 | 10,953,948 |                   | $          | 9,363,795 |   |

 

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**5. Prepaid Expenses and Other Current Assets**

 

Prepaidexpenses and other current assets consist of the following:

 
| ** **                      | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|---------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                      | ** ** | **2008**          | ** ** | **2007**               | ** ** |
| Prepaid income taxes            |       | $                 | 36,564     |                   | $          | 5,017,794 |   |
| Revenue recognized - not billed |       | 683,527           |       | 284,740                |       |
| Other                           |       | 554,781           |       | 906,270                |       |
|                            |       |              |       |                   |       |
|                            |       | $                 | 1,274,872  |                   | $          | 6,208,804 |   |

 

**6. Accrued expenses**

 

Accruedexpenses consist of the following:

 
| ** **                         | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                         | ** ** | **2008**          | ** ** | **2007**               | ** ** |
|                               |       |              |       |                   | ** ** |
| Salary, benefits and payroll taxes |       | $                 | 1,112,260  |                   | $          | 603,565 | ** ** |
| Warranty                           |       | 706,813           |       | 592,524                | ** ** |
| Professional fees                  |       | 341,820           |       | 1,515,630              | ** ** |
| Other                              |       | 946,164           |       | 1,959,113              | ** ** |
|                               |       |              |       |                   | ** ** |
|                               |       | $                 | 3,107,057  |                   | $          | 4,670,832 | ** ** |

 

**7. Warranty**

 

TheCompany provides for the estimated cost of product warranties at the timerevenue is recognized. Warranty cost is recorded as cost of sales and thereserve balance recorded as an accrued expense 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 therelated material, labor and delivery costs incurred in correcting a productfailure. Should actual product failure rates, material or labor costs differfrom the Company’s estimates, further revisions to the estimated warrantyliability would be required.

 

Warrantycost and accrual information for the three months ended June 30, 2008 ishighlighted below:

 
| Warranty accrual at March 31, 2008                        |   | $       | 673,198 |   |
|----------------------------------------------------------------|--------|---------|---------|--------|
| Accrued expense for the three months ended  June 30, 2008 |   | 83,138  |    |
| Warranty costs for the three months ended  June 30, 2008  |   | (49,523 | )       |
|                                                           |   |    |    |
| Warranty accrual at June 30, 2008                         |   | $       | 706,813 |   |

 

Warrantycost and accrual information for the nine months ended June 30, 2008 ishighlighted below:

 
| Warranty accrual at September 30, 2007                   |   | $        | 592,524 |   |
|---------------------------------------------------------------|--------|----------|---------|--------|
| Accrued expense for the nine months ended  June 30, 2008 |   | 233,126  |    |
| Warranty costs for the nine months ended  June 30, 2008  |   | (118,837 | )       |
|                                                          |   |     |    |
| Warranty accrual at June 30, 2008                        |   | $        | 706,813 |   |

 

**8.Notes Payable**

 

TheCompany entered into a $4,335,000 loan agreement dated August 1, 2000 withthe Chester County, Pennsylvania Industrial Development Authority. The purposeof the loan was to fund the construction of the Company’s new office andmanufacturing facility. The loan matures in 2015 and carries an interest rateset by the remarketing agent that is consistent with 30-day tax-exempt

 

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commercialpaper. The loan agreement includes an optional redemption schedule that allowsthe Company the option of forgoing any principal pay-down of the outstandingbalance and, accordingly, the balance of the notes payable will be due in 2015.

 

InNovember 2007, the Company and the lender signed an amendment to the loanagreement which deleted existing financial covenants and replaced them withonly one restrictive covenant that requires the Company to maintain at alltimes unencumbered cash and marketable securities having a market value of atleast $20 million.

 

**9.Share-Based Compensation**

 

EffectiveOctober 1, 2005,  the Companyadopted the provisions of SFAS No.123(R), *Share-Based Payment*(“SFAS 123(R)”), using the modified prospective approach and now accounts forshare-based compensation applying the fair value method for expensing stockoptions and non-vested stock awards.

 

Totalshare-based compensation expense was $400,000 and $198,000 for the three monthsended June 30, 2008 and 2007, respectively. The income tax benefitrecognized in the statement of operations for share-based compensationarrangements was $0 and $85,000 for the three months ended June 30, 2008and 2007, respectively. Total share-based compensation expense was $960,000 and$532,000 for the nine months ended June 30, 2008 and 2007, respectively,and the income tax benefit recognized in the statement of operations for sharebased compensation arrangements was $0 and $222,000, respectively. Compensationexpense related to share-based awards is recorded as a component of general andadministrative expense.

 

TheCompany maintains the 1998 Stock Option Plan (the “Plan”) and the 2003Restricted Stock Plan (the “Restricted Plan”). These plans were approved by theCompany’s shareholders.

 

**StockOptions**

 

ThePlan provides for the granting of incentive and nonqualified stock options toemployees, officers, directors and independent contractors and consultants.Through June 30, 2008, no stock options have been granted to independentcontractors or consultants under this Plan. Total compensation expense was $350,000 and $138,000 for the threemonths ended June 30, 2008 and 2007, and $810,000 and $362,000 for thenine months ended June 30, 2008 and 2007, respectively.  Incentive stock options granted under thePlan have 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 reserved3,389,000 shares of Common Stock for awards under the plan. As of June 30,2008 there were 1,325,000 shares remaining and available for grant under thePlan.

 

Asummary of option activity under the Plan as of June 30, 2008 and changesduring the nine months ended June 30, 2008 is as follows:

 
| ** **                             | ** ** | ** **  | ** ** | ** **                | ** ** | **Weighted Average** | ** ** | **Aggregate** | ** ** |
|----------------------------------------|------------|-------------|------------|---------------------------|------------|---------------------------|------------|---------------|------------|
| ** **                             | ** ** | ** **  | ** ** | **Weighted Average** | ** ** | **Remaining**             | ** ** | **Intrinsic** | ** ** |
| ** **                             | ** ** | **Options** | ** ** | **Exercise Price**   | ** ** | **Contractual Life** | ** ** | **Value**     | ** ** |
| Outstanding at September 30, 2007 |       | 572,959     |       | $                         | 10.30      |                      |       |          |       |   |
| Granted                                |       | 409,000     |       | 10.16                     |       |                      |       |          |       |
| Exercised                              |       | (4,497      | )          | 7.31                      |       |                      |       |          |       |
| Cancelled                              |       | (49,554     | )          | 14.26                     |       |                      |       |          |       |
|                                   |       |        |       |                      |       |                      |       |          |       |
| Outstanding at June 30, 2008      |       | 927,908     |       | $                         | 10.04      |                      | 7.16       |          | $          | 474,337 |   |
| Exercisable at June 30, 2008      |       | 417,808     |       | $                         | 8.06       |                      | 4.70       |          | $          | 469,155 |   |

 

Theweighted-average grant date fair value of individual options granted during thenine months ended June 30, 2008 and 2007 was $5.05 and $14.38,respectively. The total intrinsic value of options exercised during the ninemonths ended June 30, 2008 and 2007 was $33,000 and $609,000,respectively.

 

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The following table summarizes information about stock options underthe Plan at June 30, 2008:

 
| **Options  Outstanding**        | ** ** | **Options  Exercisable** | ** ** |
|---------------------------------|------------|--------------------------|------------|
| ** **                      | ** ** | ** **               | ** ** | **Weighted-** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Outstanding**          | ** ** | **Average** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                      | ** ** | **As of**           | ** ** | **Remaining** | ** ** | **Average** | ** ** | **As of** | ** ** | **Average** | ** ** |
| **Range of Exercise** | ** ** | **June 30,**        | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | **June 30,** | ** ** | **Exercise** | ** ** |
| **Prices**                      | ** ** | **2008**                 | ** ** | **Life** | ** ** | **Price** | ** ** | **2008** | ** ** | **Price** | ** ** |
|                            |       |                     |       |   |   |   |   |   |   |   |   |
| $0.00                           | -          | 5.00                     |       |   | 201,909 |   | 4.54 |   | $ | 4.22 |   | 201,609 |   | $ | 4.22 |   |
| $5.01                           | -          | 10.00                    |       |   | 209,699 |   | 5.65 |   | 7.81 |   | 122,199 |   | 7.69 |   |
| $10.01                          | -          | 15.00                    |       |   | 413,600 |   | 9.10 |   | 11.25 |   | 43,300 |   | 13.84 |   |
| $15.01                          | -          | 20.00                    |       |   | 44,700 |   | 6.81 |   | 16.77 |   | 29,500 |   | 16.82 |   |
| $20.01                          | -          | 26.97                    |       |   | 58,000 |   | 8.21 |   | 24.62 |   | 21,200 |   | 22.75 |   |
|                            |       |                     |       |   |   |   |   |   |   |   |   |   |   |
|                            |       | 927,908                  |       | 7.16 |   | 10.04 |   | 417,808 |   | 8.06 |   |
|                                 |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes option pricing model. Options are exercised over amaximum term of ten years from the date of grant and vest over periods of twoto five years from the grant date. The expected term of options represents theperiod of time that the options granted are expected to be outstanding and isbased on historical experience. Expected volatility is based on historicalvolatility of the Company’s stock. The risk free interest rate is based on U.S.Treasuries with constant maturities in effect at the time of the grant.Compensation expense for employee stock options also includes an estimate forforfeitures and is recognized ratably over the vesting term. The table belowsets forth the fair value assumptions used to record compensation expense forthe period identified:

 
| ** **                               | ** ** | **Nine Months**        | ** ** | **Nine Months**        | ** ** |
|------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                               | ** ** | **Ended**                   | ** ** | **Ended**                   | ** ** |
| ** **                               | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
|                                     |       |                        |       |                        |       |
| Expected lives (years)                   |       | 7.39                        |       | 9.06                        |       |
| Weighted average risk-free interest rate |       | 2.2                         | %          | 2.1                         | %          |
| Expected volatility                      |       | 60.1                        | %          | 65.3                        | %          |
| Expected dividend rate                   |       | —                      | %          | —                      | %          |

 

As of June 30, 2008, there was approximately $2.5 million ofunrecognized compensation cost, net of forfeitures, related to non-vested stockoptions, which is expected to be recognized over a period of approximately 5years.

 

**Non-vested Stock**

 

TheRestricted Plan for non-employee directors was approved by shareholders at theCompany’s February 26, 2004 Annual Meeting of Shareholders. The Plan callsfor an annual award of non-vested stock having a fair market value of $40,000as of the close of business on October 1 of the current fiscal year forall eligible non-employee directors. The stock is awarded in four quarterlyinstallments during the fiscal year provided the director is still serving onthe board on the quarterly issue date. Total expense was $50,000 and $60,000for the three months ended June 30, 2008 and 2007 and $150,000 and$170,000 for the nine months ended June 30, 2008 and 2007, respectively.As of June 30, 2008, there was an estimated $50,000 of unrecognizedcompensation expense related to nonvested stock awards under the Company’sRestricted Plan. That cost is expected to be recognized over the balance of thefiscal year. The following table outlines restricted stock awards for the ninemonths ended June 30, 2008:

 

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| ** **                         | ** ** | **Non-vested**        | ** ** | **Weighted Average** | ** ** |
|------------------------------------|------------|-----------------------|------------|---------------------------|------------|
| ** **                         | ** ** | **Stock Awards** | ** ** | **Share Price**      | ** ** |
| Balance at September 30, 2007 |       | 3,465                 |       | $                         | 14.43      |   |
| Granted                            |       | 10,525                |       | 19.00                     |       |
| Issued                             |       | (8,725                | )          | 17.19                     |       |
| Cancelled                          |       | —                |       | —                    |       |
| Balance at June 30, 2008      |       | 5,265                 |       | $                         | 19.00      |   |

 

**10.Stock Repurchase Program**

 

On February 21, 2008, the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of itsoutstanding common stock. The program will remain in effect until February 21,2009, unless extended by the Board of Directors. For the three months ended June 30,2008, there were no purchases of the Company common stock.

 

**11. Asset Impairment**

 

Inaccordance with SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets (“SFAS 144”)*the Companyrecorded an asset impairment of $2.5 million, the full carrying value of theasset, during the three months ended June 30, 2008. The impairment wasrelated to previously acquired engineering software which is no longer part ofthe Company’s product offering and will generate no future cash flows.

 

**12.Loss per Share**

 

Lossper share (“EPS”) is calculated using the principles of SFAS No. 128, *Earnings Per Share.*

 

Forthe nine month periods ended June 30, 2008 and 2007, there were 928,000and 576,000 options to purchase common stock outstanding, respectively,excluded from the computations of diluted earnings per share as the effectwould be antidilutive.

 

**13.Income Taxes**

 

TheCompany adopted the provisions of FASB Interpretation 48, *Accountingfor Uncertainty in Income Taxes* (“FIN 48”), on October 1, 2007.Previously, the Company had accounted for tax contingencies in accordance withSFAS No. 5, *Accounting for Contingencies.* Atthe adoption date of October 1, 2007, the Company applied FIN 48 to alltax positions for which the statute of limitations remained open. As a resultof the implementation of FIN 48, the Company recognized a decrease ofapproximately $587,000 in the liability for unrecognized tax benefits, whichwas accounted for as an increase to the October 1, 2007 balance ofretained earnings.

 

Theamounts of unrecognized tax benefits as of October 1, 2007 wereapproximately $330,000, all of which, if ultimately recognized, would reducethe Company’s annual effective tax rate.

 

TheCompany is subject to income taxes in the U.S. federal and various statejurisdictions. Tax regulations within each jurisdiction are subject to theinterpretation of related tax laws and regulations and require significantjudgment to apply. With few significant exceptions, the Company is no longersubject to U.S. federal or state and local examinations by tax authorities forthe years ending on or before September 30, 2003.

 

TheCompany recognizes interest accrued and penalties related to unrecognized taxbenefits in income tax expense for all periods presented. The Company hadaccrued approximately $30,000 for the payment of interest and penalties, net ofdeferred tax benefits, at October 1, 2007.

 

Forthe nine months ended June 30, 2008, the Company recognized $10,000 ofinterest and penalties within income tax expense.

 

Duringthe quarter ended June 30, 2008, the Company recognized a tax benefit of$256,000 primarily related to the unrecognized tax benefit previously recordedthat as a result of examination by the Internal Revenue Service, are consideredeffectively settled under FASB Staff Position FIN 48-1, *Definitionof Settlement in FASB Interpretation No. 48(“FSP FIN 48-1”).*

 

TheCompany’s financial statements contain certain deferred tax assets which havearisen primarily as a result of tax benefits associated with the loss beforeincome tax incurred during the nine months ended June 30, 2008, as well asdeferred income tax assets resulting from temporary differences in prior taxyears.  SFAS No. 109, *Accounting for Income Taxes (“SFAS 109”)*, requires theconsideration of a valuation allowance to reflect the likelihood of realizationof deferred tax assets.  Significantmanagement judgment is required in determining any valuation allowance recordedagainst net deferred tax assets.  TheCompany considered all of the available positive and negative evidence,including the significant operating losses incurred in 2006 and 2007, thecontinued operating 

 

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losses in 2008, uncertainty as to the extentand timing of profitability in future periods, and ongoing tax planningstrategies.  Based on the weight of available evidence, the Companyrecorded a full valuation allowance against deferred tax assets during the quarter ended March 31,2008. There were no significant changes in management’s judgment during thequarter ended June 30, 2008 and the Company continues to carry a fullvaluation allowance.

 

Ifthe realization of deferred tax assets in the future is considered more likelythan not, a reduction to the valuation allowance related to the deferred taxassets would increase net income in the period such determination is made.  The amount of the deferred tax assetconsidered realizable is based on significant estimates, and it is possiblethat changes in these estimates could materially affect the financial conditionand results of operations.  The Company’seffective tax rate may vary from period to period based on changes in estimatedtaxable income or loss; changes to the valuation allowance; changes to federalor state tax laws; and as a result of acquisitions.

 

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**Item 2. Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

**Overview**

 

Wedesign, manufacture and sell flat panel display systems, flight informationcomputers and advanced monitoring systems to the military, government,commercial air transport and corporate aviation markets.

 

Ourrevenues are derived from the sale of our products to the retrofit market andto original equipment manufacturers (OEMs). Our customers include governmentand military entities and their commercial contractors, aircraft operators,aircraft modification centers and various OEMs. Although we occasionallysell our products directly to government entities, we primarily sell ourproducts to commercial customers for end use in government and militaryprograms. Sales to defense contractors are on commercial terms, although someof the termination and other provisions of government contracts are applicableto these contracts.

 

Wecontinue to invest in and seek additional opportunities for our Flat PanelDisplay System product line. In October 2005, the FAA awarded the Companya second Technical Standard Order (TSO) for our flat panel display systemCOCKPIT/IPTM. This TSO establishes our flat panel displaysystem as meeting FAA requirements that have been put in place to ensure safeflight on a variety of aircraft types and, additionally, it addresses the moststringent Commercial Air Transport market requirements as provided in Title 14of the Code of Federal Regulation, subpart 25, Commercial Air Transport. TheTSO states “It has been noted that this display system employs an integritymonitoring system that assures integrity to a catastrophic/Level A designcondition with the use of commercial graphic processors.”

 

InOctober 2005, the Company in a teaming arrangement with ABX Air receivedFAA Supplemental Type Certification (STC) of its Flat Panel Display System foruse on B-767 aircraft. The STC provides B-767 operators with a low cost,rapidly implemented retrofit of their cockpit avionics with a modern pilot andcopilot suite of high resolution multi-color LCD flat panel displays. Operatorswill benefit from improved dispatch reliability, logistics savings andadaptability to future requirements. The receipt of the STC positions theCompany to pursue more than 1,700 B-757 and B-767 aircraft with similar needsfor Flat Panel Display System upgrades. In January 2007, the Company in ateaming arrangement with ABX Air received another STC from the FAA on its FlatPanel Display System for use on B-757 aircraft. Similar to the prior STC, itprovides B-757 operators with the same low cost, rapidly implemented retrofitof their cockpit avionics. The STC’s also provide a foundation forincorporation into other airplanes as well.

 

Costof sales related to product sales is comprised of product material purchasedthrough our supplier base and direct in-house assembly labor and overheadcosts. Many components used in assembling our products are standard, althoughcertain parts are manufactured to meet our specifications. The overhead portionof cost of sales is primarily comprised of salaries and benefits, buildingoccupancy, supplies, and outside service costs related to our production,purchasing, customer service, material control and quality departments as wellas warranty costs.

 

Costof sales related to Engineering-modification and development (EMD) is comprisedof engineering labor, consulting services and other costs associated withspecific design and development projects.

 

Weintend to continue to invest in development of new products and enhancement ofour existing product lines and will expense research and development costs asincurred.

 

Selling,general, and administrative expenses consist of marketing and businessdevelopment expenses, professional expenses, salaries and benefits forexecutive and administrative personnel, facility costs, recruiting, legal,accounting, and other general corporate expenses.

 

TheCompany’s financial statements contain certain deferred tax assets which havearisen primarily as a result of tax benefits associated with the loss beforeincome tax incurred during the nine months ended June 30, 2008, as well asdeferred income tax assets resulting from temporary differences in prior taxyears.  SFAS No. 109, *Accounting for Income Taxes (“SFAS 109”)*, requires theconsideration of a valuation allowance to reflect the likelihood of realizationof deferred tax assets.  Significantmanagement judgment is required in determining any valuation allowance recordedagainst net deferred tax assets.  TheCompany considered all of the available positive and negative evidence,including the significant operating losses incurred in 2006 and 2007, thecontinued operating losses in 2008, uncertainty as to the extent and timing ofprofitability in future periods, and ongoing tax planning strategies. Based on the weight of available evidence, the Company recorded a fullvaluation allowance againstdeferred tax assets during the quarter ended March 31, 2008. There were nosignificant changes in management’s judgment during the quarter ended June 30,2008 and the Company continues to carry a full valuation allowance.

 

Ifthe realization of deferred tax assets in the future is considered more likely thannot, a reduction to the valuation allowance related to the deferred tax assetswould increase net income in the period such determination is made.  The amount of the deferred tax assetconsidered realizable is based on significant estimates, and it is possiblethat changes in these estimates could materially affect the financial conditionand results of operations.  The Company’seffective tax rate may vary from period to period based on changes in 

 

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estimatedtaxable income or loss; changes to the valuation allowance; changes to federalor state tax laws; and as a result of acquisitions.

 

**ThreeMonths Ended June 30, 2008 Compared to the Three Months Ended June 30,2007**

 

*Netsales.* Net salesincreased $2.9 million, or 49%, to $8.8 million for the three months ended June 30,2008 from $5.9 million in the three months ended June 30, 2007. For thethree months ended June 30, 2008, product sales increased $3.2 million andEMD sales decreased $0.3 million from the same period in the prior year. Theincrease in product sales was primarily related to increased sales of FlatPanel Display System to a major customer.

 

*Cost ofsales.* Cost of salesincreased $1.0 million or 28%, to $4.6 million, or 52% of net sales in thethree months ended June 30, 2008 from $3.6 million, or 61 % of net salesin the three months ended June 30, 2007. The overall dollar increase incost of sales consists of $1.9 million in cost of sales related to productsales and a decrease of $0.9 million related to EMD sales. The $1.9 millionincrease in cost related to product sales is attributable to increased productsales. The decrease in cost related to EMD sales was primarily related toimproved margins on the EMD sales.

 

*Researchand development.*Research and development expense increased $2.1 million or 191% to $3.2 millionor 36% of net sales in the three months ended June 30, 2008, from $1.1million or 19% of net sales in the three months ended June 30, 2007.

 

Theincrease in research and development expense in the quarter was in part due tothe reduction in the cost allocation associated with EMD cost of sales for theperiod. This allocation was necessary to match non- recurring engineering costwith corresponding non-recurring engineering sales in the period. Overall, whenresearch and development expenses are combined with EMD cost of sales, totalengineering, research and development related cost for the three months ended June 30,2008 increased $1.2 million from the same period in the prior year and reflectsthe Company’s continued commitment to product development, research andengineering.

 

*Selling,general, and administrative.* Selling, general and administrative expenses decreased $0.9 million,or 21%, to $3.3 million, or 38% of net sales in the three months ended June 30,2008 from $4.2 million or 71% of net sales in the three months ended June 30,2007. The decrease in the dollar amount of selling, general and administrativeexpenses for the three months ended June 30, 2008 from the same period inthe prior year was primarily the result of a $1.3 million decrease in legalfees offset by $0.5 million increase for employee related expenses. The legalfees were largely incurred to protect the Company’s intellectual property.

 

*Assetimpairment.*TheCompany recorded an asset impairment of $2.5 million in the three months ended June 30,2008. The impairment was related to previously acquired engineering softwarewhich is no longer part of the Company’s product offering and will generate nofuture cash flows.

 

*Interestincome – net.*Interestincome of $284,000 was partially offset by interest expense of $33,000 in thethree months ended June 30, 2008. Interest income of $781,000 waspartially offset by interest expense of $52,000 in the three months ended June 30,2007. The decrease in interest income was primarily the result of reducedaverage cash balances and lower interest rates in the current quarter asopposed to the same period in the prior year.

 

*Income tax expense (benefit).* The Company recorded income tax benefits of $0.3 million and $1.0million for the three months ended June 30, 2008 and 2007, respectively.The decrease in the amount of income tax benefit year over year is a directresult of the establishment of a valuation allowance. (See Note 13, IncomeTaxes)  During the quarter ended June 30,2008 the Company recognized a tax benefit of $256,000 primarily related to theunrecognized tax benefit previously recorded that as a result of examinationare considered effectively settled.

 

Theeffective tax rate for the three months ended June 30, 2008 and 2007 was6% and 43%, respectively. The difference in effective tax rates relates to theestablishment of the full valuation allowance on deferred tax assets. (See Note13. Income Taxes)

 

 *Net loss.* As aresult of the factors described above, our net loss in the three months ended June 30,2008 was $4.3 million, an increase of $2.9 million from the net loss of $1.4million for the three months ended June 30, 2007.

 

**Ninemonths Ended June 30, 2008 Compared to the Nine months Ended June 30,2007**

 

*Netsales.* Net salesincreased $7.1 million, or 54%, to $20.3 million for the nine months ended June 30,2008 from $13.2 million in the nine months ended June 30, 2007. For thenine months ended June 30, 2008, product sales increased $7.0 million andEMD sales increased $0.1 million from the same period in the prior year. Theincrease in net sales was primarily related to increased Flat Panel DisplaySystems sales to a major customer.

 

*Cost ofsales.* Cost of salesincreased $3.3 million or 38%, to $12.0 million, or 59% of net sales in thenine months ended June 30, 2008 from $8.7 million, or 66 % of net sales inthe nine months ended June 30, 2007. The overall dollar increase in costof sales consists of $4.3 million in cost of sales related to product sales anda decrease of $1.0 million related to EMD sales. The increase of 

 

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$4.3million in cost related to product sales is attributable to increased productsales. The decrease of $1.0 million in cost related to EMD sales was primarilyrelated to improved margins on the EMD sales.

 

*Researchand development.*Research and development expenses increased $3.8 million or 97% to $7.7 millionor 38% of net sales in the nine months ended June 30, 2008 from $3.9million or 30% of net sales in the nine months ended June 30, 2007. Theincrease in research and development expense for the nine month period wasprimarily related to the increase in development requirements related to ourFlat Panel Display System for new applications. Overall, when research anddevelopment expenses are combined with EMD cost of sales, total engineering,research and development related cost for the nine months ended June 30,2008 increased $2.8 million from the same period in the prior year and reflectsthe Company’s continued commitment to product development, research andengineering.

 

*Selling,general, and administrative.* Selling, general, and administrative expenses increased $2.9 million,or 26%, to $14.0 million, or 69% of net sales in the nine months ended June 30,2008 from $11.1 million or 84% of net sales in the nine months ended June 30,2007. The increase in the dollar amount of selling, general and administrativefor the nine months ended June 30, 2008 from the same period in the prioryear was primarily the result of an increase of $1.3 million in employeerelated expenses and an increase of $0.7 million of legal fees incurred inconnection with litigation relating to the defense of our intellectualproperty.

 

*Assetimpairment.*TheCompany recorded an asset impairment of $2.5 million in the nine months ended June 30,2008. The impairment was related to previously acquired engineering softwarewhich is no longer part of the Company’s product offering and will generate nofuture cash flows.

 

*Interestincome – net. *Interest income of $1.3 million was offset byinterest expense of $0.1 million in the nine months ended June 30, 2008.Interest income of $2.4 million was offset by interest expense of $0.2 millionin the nine months ended June 30, 2007. The decrease in net interestincome was primarily the result of our reduced average cash balance and lowerinterest rates in the current period as opposed to the same period in the prioryear.

 

*Otherincome.*In March 2008,the Company received a payment of $0.3 million in settlement of a claim againsta shareholder for short swing profit liability to the Company pursuant to Section 16(b) ofthe Securities Exchange Act of 1934, as amended.

 

*Incometax expense.* Theincome tax expense for the nine months ended June 30, 2008 was $1.1million as compared to an income tax benefit of $3.5 million for the ninemonths ended June 30, 2007. The increase in the amount of income taxexpense was the result of the establishment of a valuation allowance related tothe deferred tax assets the Company had accumulated on the balance sheet. Asrequired by SFAS No. 109, this valuation allowance was recorded based onthe weight of available positive and negative evidence, including two years offinancial statement losses, its current projection of a pre-tax loss for thecurrent year, and consideration of the Company’s ongoing tax planningstrategies. If the realizationof deferred tax assets in the future is considered more likely than not, areduction to the valuation allowance related to the deferred tax assets wouldincrease net income in the period such determination is made.

 

Theeffective tax rate for the nine months ended June 30, 2008 and 2007 was 8%and 42%, respectively. The difference in the effective tax rates relates torecording of the full valuation allowance on the deferred tax assets. (See Note13. Income Taxes)

 

InDecember of 2006, an additional two-year extension of the Research andExperimentation (R&E) Tax Credit was enacted into law. This retroactiveextension is for amounts paid or incurred from January 1, 2006 to December 31,2006.  The entire impact of this retroactive extension has been recognizedin the nine months ended June 30, 2007, as required by SFAS 109.

 

*Netincome (loss).* As aresult of the factors described above, our net loss in the nine months ended June 30,2008 was $15.5 million, an increase of $10.7 million from net loss of $4.8million for the nine months ended June 30, 2007.

 

**Liquidityand Capital Resources**

 

Ourmain source of liquidity has been cash flows generated in prior years. Werequire cash principally to finance inventory, accounts receivable and payroll.

 

Ourcash used in operating activities was $7.5 million for the nine months ended June 30,2008 as compared to $3.7 million for the nine months ended June 30, 2007.The increase of $3.8 million was due primarily to higher net loss ($10.7million), decreased accounts payable ($4.8 million) and increased inventory($0.5 million) which was partially offset by decreased prepaid expenses andother current assets ($8.7 million), asset impairment ($2.5 million) anddecreased deferred tax benefit ($1.7 million).

 

Ourcash used in investing activities was $534,000 for the nine months ended June 30,2008 and primarily consisted of the purchase of production and laboratory testequipment. Cash used in investing activities was $3.1 million for the ninemonths ended June 30, 2007. This consisted of spending $2.5 million onlicensing fees and $0.6 million for production and laboratory equipment.

 

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Netcash flow used in financing activities was $32,000 for the nine months ended June 30,2008 as compared to net cash provided by financing activities of $638,000 inthe nine months ended June 30, 2007. The primary use of cash for financingactivities was attributable to our repurchase of 7,000 shares of our stock at atotal cost of $57,000. In both periods the primary source of cash was fromproceeds from the exercise of stock options.

 

TheCompany entered into a $4,335,000 loan agreement dated August 1, 2000 withthe Chester County, Pennsylvania Industrial Development Authority. The purposeof the loan was to fund the construction of the Company’s new office andmanufacturing facility. The loan matures in 2015 and carries an interest rateset by the remarketing agent that is consistent with 30-day tax-exemptcommercial paper. The loan agreement includes an optional redemption schedulethat allows the Company the option of forgoing any principal pay-down of theoutstanding balance and, accordingly, the balance of the notes payable will bedue in 2015.

 

InNovember 2007, the Company and the lender signed an amendment to the loanagreement, which deleted existing financial covenants and replaced them withonly one restrictive covenant that requires the Company to maintain at alltimes unencumbered cash and marketable securities having a market value of atleast $20 million. The Company was in compliance with this covenant as of June 30,2008.

 

Ourfuture capital requirements depend on numerous factors, including marketacceptance of our products, the timing and rate of expansion of our business,acquisitions, joint ventures and other factors. We have experienced increasesin our expenditures since our inception consistent with growth in ouroperations, personnel and product line, and we anticipate that our expenditureswill continue to increase in the foreseeable future. We believe that our cashand cash equivalents will provide sufficient capital to fund our operations forat least the next twelve months. However, we may need to raise additional fundsthrough public or private financings or other arrangements in order to supportmore rapid expansion of our business than we now anticipate either throughacquisitions or organic growth. Further, we may need to develop and introducenew or enhanced products, respond to competitive pressures, invest in oracquire businesses or technologies or respond to unanticipated requirements ordevelopments. If additional funds are raised through the issuance of equitysecurities, dilution to existing shareholders may result. If insufficient fundsare available, we may not be able to introduce new products or competeeffectively in any of our markets, which could hurt our business.

 

**Backlog**

 

Asof June 30, 2008 and 2007, our backlog was $71.4 million and $72.7million, respectively. The Flat Panel Display System components of backlog were$64.9 million and $65.2 million as of June 30, 2008 and 2007,respectively.

 

**CriticalAccounting Policies**

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amount of revenues and expenses duringthe reporting period. The Company’s most critical accounting policies arerevenue recognition, income taxes, inventory valuation, share-basedcompensation and warranty reserves.

 

*Revenue recognition*

 

TheCompany recognizes revenue under the provisions of Staff Accounting Bulletin (“SAB”)No. 104, *Revenue Recognition* (“SAB104”).

 

TheCompany enters into certain sales arrangements that include multipledeliverables as defined in Emerging Issues Task Force (“EITF”) Issue No. 00-21,*Revenue Arrangements with Multiple Deliverables*(“EITF00-21”). The Company identifies all goods and/or services that are to bedelivered separately under a sales arrangement and allocates revenue to eachdeliverable based on fair value. In general, revenues are separated betweenproduct sales and EMD sales. The allocated revenue for each deliverable is thenrecognized using appropriate revenue recognition methods.

 

TheCompany accounts for transactions with software that is more than incidental tothe products under Statement of Position (“SOP”) 97-2, *SoftwareRevenue Recognition*(“SOP 97-2”) and EITF Issue 03-5, *Applicability of AICPA Statement of Position 97-2, Software RevenueRecognition, to Non-Software Deliverables in an Arrangement ContainingMore-Than-Incidental Software*(“EITF 03-5”*).*  Accordingly, revenue is recognized when allof the following criteria are met: 1) there is persuasive evidence that anarrangement exists; 2) delivery has occurred or services have been rendered; 3)the seller’s price to the buyer is fixed or determinable; and 4) collectibilityis reasonably assured.

 

Salesrelated to certain long-term contracts requiring development and delivery ofproducts over several accounting periods are accounted for under the AmericanInstitute of Certified Public Accountants (“AICPA”) SOP 81-1, *Accounting for Performance of*

 

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*Construction-Typeand Certain Production-Type Contracts*(“SOP 81-1”). We consider the nature of these contracts as well as thetypes of products and services provided when determining the appropriateaccounting treatment for a particular contract. Certain long-term contracts arerecorded on a percentage of completion basis using cost-to-cost methodology tomeasure progress towards completion.

 

TheCompany offers its customers extended warranties for additional fees. Thesewarranty sales are recorded as deferred revenue and recognized as sales on astraight-line basis over the warranty period.

 

*Income taxes*

 

Incometaxes are recorded in accordance with SFAS No. 109*.*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.

 

A valuation allowance is recorded to reducedeferred tax assets when it is more likely than not that a tax benefit will notbe realized.  In evaluating our ability to recover our deferred tax assetswe consider all available positive and negative evidence, including ouroperating results, ongoing tax planning, and forecasts of future taxableincome. In the event we were to determine that we would be able to realize ourdeferred tax assets in the future in excess of their net recorded amount, wewould make an adjustment to the valuation allowance which would reduce theprovision for income taxes.

 

*Inventories*

 

Inventoriesare written 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.

 

*Share-basedcompensation*

 

EffectiveOctober 1, 2005, the Company adopted the provisions of SFAS 123R, usingthe modified 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.

 

*Warranty reserves*

 

Weoffer 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 bestestimate of the amounts necessary to settle future and existing claims usinghistorical data on products sold as of the balance sheet date. The length ofthe warranty period, the product’s failure rates and the customer’s usageaffects warranty cost. If the actual cost of warranties differs from ourestimated amounts, future results of operations could be adversely affected.

 

**BusinessSegments**

 

Weoperate in one principal business segment which designs, manufactures and sellsflight information computers, flat panel displays and advanced monitoringsystems to the military, government, commercial air transport and corporateaviation markets. We currently derive virtually all our net sales from the saleof this equipment. Almost all of the net sales, operating results andidentifiable assets are in the United States.

 

**NewAccounting Pronouncements**

 

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles and expands disclosuresabout fair value measurements. This statement does not require any new fairvalue measurements; however, the application of this Statement may changecurrent practice for some entities. SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007. The Company is currently evaluating theimpact of this pronouncement.

 

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**FORWARD-LOOKING STATEMENTS**

 

ThisForm 10-Q contains statements, which, to the extent that they are notrecitations of historical fact, constitute forward-looking statements withinthe meaning of the Securities Act of 1933 and the Securities Exchange Act of1934. The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,”“plan,” “outlook,” “would,” “should,” “guidance,” “potential,” “continue,” “project,”  “forecast” and similar expressions areintended to identify forward-looking statements. Forward-looking statements arenot guarantees of future performance and involve risks, uncertainties andassumptions, which are difficult to predict. Therefore, actual outcomes andresults may differ materially from what is expressed or implied by thesestatements.  Numerous factors, includingpotentially the following factors, could affect the Company’s forward-lookingstatements and actual performance:

 

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

 

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

 

·      continuedmarket acceptance of our air data systems products;

 

·      theability to obtain future contracts and awards;

 

·      theavailability of government funding and customer requirements;

 

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

 

·      delays inreceiving 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.

 

Readersare 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 notundertake 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 theoccurrence of unanticipated events. The forward-looking statements in thisdocument are intended to be subject to the safe harbor protection provided bySections 27A of the Securities Act and 21E of the Exchange Act.

 

Fora discussion identifying some important factors that could cause actual resultsto vary materially from those anticipated in the forward-looking statements,see the Company’s Securities and Exchange Commission filings including, but notlimited to, the discussions of “Risk Factors” contained in the Company’s AnnualReport on Form 10-K for the fiscal year ended September 30, 2007.

 

Investorsshould also be aware that while we do, from time to time, communicate with securitiesanalysts, it is against our policy to disclose any material non-publicinformation or other confidential commercial information.  Accordingly, shareholders should not assumethat we agree with any statement or report issued by an analyst irrespective ofthe content of the statement or report. Furthermore, we have a policy against issuing or confirming financialforecasts or projections issued by others. Thus, to the extent that reports issued by securities analysts containany projections, forecasts or opinions, such reports are not the responsibilityof Innovative Solutions and Support, Inc.

 

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

 

TheCompany’s operations are exposed to market risks primarily as a result ofchanges in interest rates. The Company does not use derivative financialinstruments for speculative or trading purposes. The Company’s exposure tomarket risk for changes in interest rates relates to its cash equivalents andan industrial revenue bond. The Company’s cash equivalents consist of fundsinvested in money market accounts, which bear interest at a variable rate,while the industrial revenue bond carries an interest rate that is consistentwith 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 earnedon the cash equivalents or paid on the industrial revenue bond would impactinterest income and expense along with cash flows, but would not impact thefair market value of the related underlying instruments.

 

**Item 4. Controls and Procedures**

 

(a)   An evaluation was performed under the supervision and with theparticipation of the Company’s management, including its Chief ExecutiveOfficer, or CEO, and Chief Financial Officer, or CFO, of the effectiveness ofthe Company’s disclosure controls and procedures, as such term is defined underRule 13a-15e under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) as of June 30, 2008. Based on that evaluation, the Company’smanagement, including the CEO and CFO, concluded that the Company’s disclosurecontrols and procedures are effective to provide reasonable assurance thatinformation required to be disclosed by the Company in reports that it files orsubmits under the Exchange Act, is recorded, processed, summarized and reportedas specified in Securities and Exchange Commission rules and forms andthat such information is accumulated and communicated to the Company’smanagement, including the CEO and CFO, or persons performing similar functions,as appropriate to allow timely decisions regarding required disclosure.

 

(b)   There were no changes in the Company’s internal control over financialreporting identified in connection with the evaluation of such controls thatoccurred during the Company’s most recent fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

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**PART II–OTHER INFORMATION**

 

**Item 1.****   ****Legal Proceedings**

 

Inthe ordinary course of business, we are at times subject to various legalproceedings.  Except with respect to thefees incurred in connection with the matters described below, we do not believethat any of the current legal proceedings will have a material adverse effecton our results of operations or financial position.

 

OnSeptember 13, 2005 the Company filed a lawsuit in the United StatesDistrict Court for the Western District of Tennessee against J2, Inc., acompany founded and jointly owned by Joseph Cesar, a former employee of theCompany, and James Zachary, a former sales consultant for the Company. Thecomplaint alleged that the J2/Kollsman/Air Data Computer then being marketed byJ2 and manufactured by Kollsman, Inc. infringed a patent assigned to theCompany. After learning additional information regarding the activities ofCaesar and Zachary during the development of the J2/Kollsman Air Data Computer,the Company added to its complaint claims of trade secret misappropriation,breach of contract and breach of fiduciary duty, based on the Company’s beliefthat confidential and proprietary information, including trade secretinformation, had been used in the development and marketing of the J2/KollsmanAir Data Computer. On January 31, 2006, Kollsman, Inc., and Caesarand Zachary, as individuals, were added to the lawsuit as defendants.

 

OnNovember 7, 2007, the Company received a favorable jury verdict in itstrade secret misappropriation case against Kollsman, Inc. (a subsidiary ofElbit Systems Ltd.),  J2 Inc., JosephCaesar, James Zachary and Zachary Technologies, Inc. in the United StatesDistrict Court for the Western District of Tennessee.  The jury unanimously found that each of thedefendants had misappropriated the Company’s air data computer technology.  The jury found that the Company had suffereddamages of just over $4.4 million in lost profits and $1.6 million indefendants’ net profits, for a total of over $6 million.  The jury also found in favor of the Company’sclaims for breach of duty and contract, and unfair competition against J2 Inc.,Joseph Caesar, James Zachary and Zachary Technologies, Inc.

 

OnDecember 18, 2007, the court entered a temporary injunction aimed atpreventing further use of the Company’s trade secret and proprietaryinformation.  On March 14, 2008, thejudge presiding over the case heard the Company’s claims for a permanentinjunction as well as punitive and exemplary damages and attorneys’ feesagainst Kollsman and the other defendants**.  **TheCourt also is considering post-judgment motions by which Kollsman, J2 andCaesar seek to overturn the verdict against them.

 

OnJuly 7, 2008, the court issued several rulings in the case.  In the rulings, the court awarded damages,interest and fees in addition to the more than $6 million in compensatorydamages awarded by the jury when it rendered its verdict in the case in November 2007.  The additional awards bring the damagesassessed against Kollsman, Inc. to a total of more than $23million.  The court also entered an ordergranting our request for injunctive relief.

 

OnJanuary 17, 2007, the Company filed suit in Pennsylvania state courtagainst Strathman Associates, a former software consultant for the Company,alleging that Strathman had improperly used the Company’s trade secret andproprietary information in assisting J2 and Kollsman in developing theJ2/Kollsman Air Data Computer. The case is ongoing.

 

Forthe nine months ended June 30, 2008 the Company has incurred approximately$5.4 million in legal fees in connection with the two matters discussed abovecompared to $4.5 million in the nine months ended June 30, 2007.

 

**Item 1A.  Risk Factors**

 

Thereare no material changes to the risk factors described under Item 1A of our Form 10-Kfor the year ended September 30, 2007.

 

I**tem 2.**** ****UnregisteredSales of Equity Securities and Use of Proceeds**

 

None

 

**Item 3.  Defaults upon Senior Securities**

 

None

 

**Item 4.********Submission of Matters to a Voteof Security Holders**

 

None

 

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**Item 5.****   ****Other Information**

 

None

 

**Item 6. Exhibits**

 
| (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 |

 

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
| ** **                 | **INNOVATIVE  SOLUTIONS AND SUPPORT, INC.** |
|----------------------------|---------------------------------------------|
|                       |                                        |
|                       |                                        |
| Date:  August 6, 2008 | By:                                         | /s/  JOHN C. LONG |
|                       |                                        | JOHN  C. LONG |
|                       |                                        | CHIEF  FINANCIAL OFFICER |

 

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