Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30,2010**

** **

**OR**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**[For the transition period from                           to                            ]**

 

**Commission File No. 0-31157**

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

(Exact name of registrant asspecified in its charter)

 

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

** **

**(610) 646-9800**

(Registrant’s telephonenumber, including area code)

 

Indicate by check mark whether registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 day.  Yes x No o

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months(or for such shorter period that the registrant was required to submit and postsuch files).  Yes o No o

 

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

 

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

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

 

As of August 3, 2010, there were 16,768,991shares of the Registrant’s Common Stock, with par value of $.001 per share,outstanding.

 

 

 

----

Table of Contents

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**FORM 10-Q June 30,2010**

 

**INDEX**

 
| ** **        | ** **                                                                                                      | **Page No.** |
|-------------------|-----------------------------------------------------------------------------------------------------------------|-------------------|
| ** **        | ** **                                                                                                      | ** **        |
| **PART I.**  | **FINANCIAL  INFORMATION**                                                                                      | —            |
| ** **        | ** **                                                                                                      |              |
| Item 1.           | Financial Statements  (Unaudited)                                                                               |              |
|              |                                                                                                            |              |
|              | Condensed Consolidated Balance Sheets — June 30,  2010 and September 30, 2009                    | 1                 |
|              |                                                                                                            |              |
|              | Condensed Consolidated Statements of Operations —  Three and Nine months ended June 30, 2010 and 2009 | 2                 |
|              |                                                                                                            |              |
|              | Condensed Consolidated Statements of Cash Flows — Nine  months ended June 30, 2010 and 2009           | 3                 |
|              |                                                                                                            |              |
|              | Notes to Condensed Consolidated Financial Statements                                                            | 4 – 14       |
|              |                                                                                                            |              |
| Item  2.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                     | 15 – 20      |
|              |                                                                                                            |              |
| Item  3.          | Quantitative  and Qualitative Disclosures about Market Risk                                                     | 21                |
|              |                                                                                                            |              |
| Item  4.          | Controls  and Procedures                                                                                        | 21                |
|              |                                                                                                            |              |
| **PART II.** | **OTHER INFORMATION**                                                                                           |              |
| ** **        | ** **                                                                                                      |              |
| Item 1.           | Legal  Proceedings                                                                                              | 22                |
|              |                                                                                                            |              |
| Item 1A           | Risk Factors                                                                                                    | 22                |
|              |                                                                                                            |              |
| Item  2.          | Unregistered  Sales of Equity Securities and Use of Proceeds                                                    | 22                |
|              |                                                                                                            |              |
| Item 3.           | Defaults upon Senior  Securities                                                                                | 22                |
|              |                                                                                                            |              |
| Item 4.           | Removed and reserved                                                                                            | 22                |
|              |                                                                                                            |              |
| Item 5.           | Other Information                                                                                               | 22                |
|              |                                                                                                            |              |
| Item 6.           | Exhibits                                                                                                        | 23                |
|              |                                                                                                            |              |
| **SIGNATURES**    |                                                                                                            | 23                |

 

----

Table ofContents

 

**PART I—FINANCIALINFORMATION**

**Item 1—Financial Statements**

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATEDBALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                      | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                      | ** ** | **2010**          | ** ** | **2009**               | ** ** |
| ASSETS                                                                                                                                                                                                                          |       |              |       |                   |       |
| Current Assets                                                                                                                                                                                                                  |       |              |       |                   |       |
| Cash and cash equivalents                                                                                                                                                                                                       |       | $                 | 38,019,536 |                   | $          | 35,565,694 |   |
| Accounts receivable, net                                                                                                                                                                                                        |       | 3,909,442         |       | 6,188,706              |       |
| Inventories                                                                                                                                                                                                                     |       | 5,002,468         |       | 5,306,985              |       |
| Deferred income taxes                                                                                                                                                                                                           |       | 450,113           |       | 503,993                |       |
| Prepaid expenses and other  current assets                                                                                                                                                                                      |       | 980,120           |       | 1,227,413              |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Total current assets                                                                                                                                                                                                            |       | 48,361,679        |       | 48,792,791             |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Property and equipment,  net                                                                                                                                                                                                    |       | 7,915,716         |       | 8,343,701              |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Other assets                                                                                                                                                                                                                    |       | 237,720           |       | 399,520                |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Total Assets                                                                                                                                                                                                                    |       | $                 | 56,515,115 |                   | $          | 57,536,012 |   |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY                                                                                                                                                                                      |       |              |       |                   |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Current Liabilities                                                                                                                                                                                                             |       |              |       |                   |       |
| Current portion of  capitalized lease obligations                                                                                                                                                                               |       | $                 | 9,908      |                   | $          | 9,908 |   |
| Accounts payable                                                                                                                                                                                                                |       | 991,504           |       | 1,207,990              |       |
| Accrued expenses                                                                                                                                                                                                                |       | 2,268,420         |       | 2,785,560              |       |
| Deferred revenue                                                                                                                                                                                                                |       | 145,125           |       | 164,856                |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Total current liabilities                                                                                                                                                                                                       |       | 3,414,957         |       | 4,168,314              |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Long-term portion of  capitalized lease obligations                                                                                                                                                                             |       | 18,490            |       | 26,991                 |       |
| Deferred revenue                                                                                                                                                                                                                |       | 21,714            |       | 60,792                 |       |
| Deferred income taxes                                                                                                                                                                                                           |       | 579,089           |       | 642,651                |       |
| Other liabilities                                                                                                                                                                                                               |       | 168,464           |       | 238,522                |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Total Liabilities                                                                                                                                                                                                               |       | 4,202,714         |       | 5,137,270              |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Commitments and  contingencies                                                                                                                                                                                                  |       | —            |       | —                 |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| 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, 2010 and September 30, 2009 |       | —            |       | —                 |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Common stock, $.001 par  value: 75,000,000 shares authorized, 18,236,759 and 18,206,839 issued at  June 30, 2010 and September 30, 2009                                                                               |       | 18,236            |       | 18,207                 |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Additional paid-in capital                                                                                                                                                                                                      |       | 46,900,432        |       | 46,462,135             |       |
| Retained earnings                                                                                                                                                                                                               |       | 24,658,373        |       | 25,161,276             |       |
| Treasury stock, at cost,  1,476,000 and 1,470,510 shares at June 30, 2010 and September 30,  2009, respectively                                                                                                       |       | (19,264,640       | )          | (19,242,876            | )          |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Total Shareholders’ Equity                                                                                                                                                                                                 |       | 52,312,401        |       | 52,398,742             |       |
|                                                                                                                                                                                                                            |       |              |       |                   |       |
| Total Liabilities and  Shareholders’ Equity                                                                                                                                                                                |       | $                 | 56,515,115 |                   | $          | 57,536,012 |   |

 

Theaccompanying notes are an integral part of these statements.

 

1

----

Table of Contents

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(unaudited)**

 
| ** **                                  | ** ** | **Three Months  Ending June 30,** | ** ** | **Nine  Months Ending June 30,** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| **Net sales:**                              | ** ** | **2010**                               | ** ** | **2009**                              | ** ** | **2010** | ** ** | **2009** | ** ** |
| Product                                     |       | $                                      | 7,295,526  |                                  | $          | 6,645,822 |   | $ | 16,117,839 |   | $ | 24,900,246 |   |
| Engineering - modification  and development |       | 518,290                                |       | 1,113,478                             |       | 1,676,173 |   | 3,900,126 |   |
| Total net sales                             |       | 7,813,816                              |       | 7,759,300                             |       | 17,794,012 |   | 28,800,372 |   |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Cost of sales                               |       |                                   |       |                                  |       |   |   |   |   |
| Product                                     |       | 2,890,660                              |       | 3,302,823                             |       | 8,072,055 |   | 13,213,569 |   |
| Engineering - modification  and development |       | 120,150                                |       | 318,222                               |       | 718,024 |   | 880,262 |   |
| Total cost of sales                         |       | 3,010,810                              |       | 3,621,045                             |       | 8,790,079 |   | 14,093,831 |   |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Gross profit                                |       | 4,803,006                              |       | 4,138,255                             |       | 9,003,933 |   | 14,706,541 |   |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Operating expenses:                         |       |                                   |       |                                  |       |   |   |   |   |
| Research and development                    |       | 1,274,872                              |       | 1,287,397                             |       | 3,844,282 |   | 4,178,585 |   |
| Selling, general and  administrative        |       | 1,938,411                              |       | 1,840,571                             |       | 5,965,876 |   | 6,471,958 |   |
| Total operating expenses                    |       | 3,213,283                              |       | 3,127,968                             |       | 9,810,158 |   | 10,650,543 |   |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Operating income (loss)                     |       | 1,589,723                              |       | 1,010,287                             |       | (806,225 | ) | 4,055,998 |   |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Interest income                             |       | 69,164                                 |       | 62,594                                |       | 119,774 |   | 360,907 |   |
| Interest (expense)                          |       | (562                                   | )          | (19,798                               | )          | (1,840 | ) | (74,513 | ) |
| Other income                                |       | —                                 |       | —                                |       | 50,000 |   | 50,073 |   |
| Income (loss) before  income taxes          |       | 1,658,325                              |       | 1,053,083                             |       | (638,291 | ) | 4,392,465 |   |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Income tax expense  (benefit)               |       | 270,293                                |       | (199,228                              | )          | (135,385 | ) | (30,762 | ) |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Net income (loss)                           |       | $                                      | 1,388,032  |                                  | $          | 1,252,311 |   | $ | (502,906 | ) | $ | 4,423,227 |   |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Net income (loss) per  common share:        |       |                                   |       |                                  |       |   |   |   |   |
| Basic                                       |       | $                                      | 0.08       |                                  | $          | 0.07 |   | $ | (0.03 | ) | $ | 0.26 |   |
| Diluted                                     |       | $                                      | 0.08       |                                  | $          | 0.07 |   | $ | (0.03 | ) | $ | 0.26 |   |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Weighted Average Shares  Outstanding:       |       |                                   |       |                                  |       |   |   |   |   |
| Basic                                       |       | 16,760,759                             |       | 16,727,269                            |       | 16,752,973 |   | 16,727,269 |   |
| Diluted                                     |       | 16,799,157                             |       | 16,750,308                            |       | 16,752,973 |   | 16,746,631 |   |

 

The accompanying notes are an integral part of these statements.

 

2

----

Table ofContents

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(unaudited)**

 
| ** **                                                                                | ** ** | **For the  Nine Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                | ** ** | **2010**                                     | ** ** | **2009** | ** ** |
| **CASH FLOWS  FROM OPERATING ACTIVITIES:**                                                |       |                                         |       |   |   |
| Net (Loss) income                                                                         |       | $                                            | (502,906   | ) | $ | 4,423,227 |   |
| Adjustments to reconcile  net (loss) income to net cash provided by operating activities: |       |                                         |       |   |   |
| Depreciation and  amortization                                                            |       | 632,175                                      |       | 767,849 |   |
| Deposit forfeiture, installation  kits                                                    |       | 118,660                                      |       | — |   |
| Share-based compensation  expense:                                                        |       |                                         |       |   |   |
| Stock options                                                                             |       | 283,412                                      |       | 395,006 |   |
| Nonvested stock awards                                                                    |       | 149,946                                      |       | 150,110 |   |
| Tax benefit from  share-based compensation:                                               |       |                                         |       |   |   |
| Nonvested stock awards                                                                    |       | 4,939                                        |       | 3,094 |   |
| Loss on disposal of property  and equipment                                               |       | 1,126                                        |       | 260 |   |
| Excess and obsolete  inventory cost                                                       |       | —                                       |       | 666,580 |   |
| (Increase) decrease in:                                                                   |       |                                         |       |   |   |
| Accounts receivable                                                                       |       | 2,279,264                                    |       | (529,160 | ) |
| Inventories                                                                               |       | 304,517                                      |       | 3,198,957 |   |
| Prepaid expenses and other  current assets                                                |       | 326,393                                      |       | 98,247 |   |
| Other non-current assets                                                                  |       | —                                       |       | (74,534 | ) |
| Increase (decrease) in:                                                                   |       |                                         |       |   |   |
| Accounts Payable                                                                          |       | (216,486                                     | )          | (1,402,254 | ) |
| Accrued expenses                                                                          |       | (517,140                                     | )          | (2,032,173 | ) |
| Income taxes payable                                                                      |       | (149,158                                     | )          | (718,039 | ) |
| Deferred income tax                                                                       |       | (9,682                                       | )          | — |   |
| Deferred revenue                                                                          |       | (58,809                                      | )          | (310,871 | ) |
| Net cash provided by  operating activities                                                |       | 2,646,251                                    |       | 4,636,299 |   |
|                                                                                      |       |                                         |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                |       |                                         |       |   |   |
| Purchases of property and  equipment                                                      |       | (162,173                                     | )          | (244,127 | ) |
| Net cash (used in)  investing activities                                                  |       | (162,173                                     | )          | (244,127 | ) |
|                                                                                      |       |                                         |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                |       |                                         |       |   |   |
| Purchase of treasury stock                                                                |       | (21,735                                      | )          | (108,250 | ) |
| Repayment of capitalized  lease obligations                                               |       | (8,501                                       | )          | (7,916 | ) |
| Net cash (used in)  financing activities                                                  |       | (30,236                                      | )          | (116,166 | ) |
|                                                                                      |       |                                         |       |   |   |
| Net increase in cash and  cash equivalents                                                |       | 2,453,842                                    |       | 4,276,006 |   |
| Cash and cash equivalents,  beginning of year                                             |       | 35,565,694                                   |       | 35,031,932 |   |
|                                                                                      |       |                                         |       |   |   |
| Cash and cash equivalents,  end of period                                                 |       | $                                            | 38,019,536 |   | $ | 39,307,938 |   |
|                                                                                      |       |                                         |       |   |   |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                                     |       |                                         |       |   |   |
| Cash paid for interest                                                                    |       | $                                            | 1,840      |   | $ | 44,488 |   |
| Cash paid for income tax                                                                  |       | $                                            | 121,473    |   | $ | 704,486 |   |
| Cash received from income  tax refund                                                     |       | $                                            | 1,000      |   | $ | 25,115 |   |
|                                                                                      |       |                                         |       |   |   |
| ***Noncash Investing activities***                                                        |       |                                         |       |   |   |
| Accrual for purchase of  property and equipment                                           |       | —                                       |       | 68,780 |   |

 

The accompanying notes arean integral part of these statements.

 

3

----

Table ofContents

 

**Innovative Solutions and Support, Inc.**

**Notes to CondensedConsolidated Financial Statements**

**(Unaudited)**

 

**1.****Summary of Significant AccountingPolicies**

 

***Description of the Company***

 

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.

 

***Basis of Presentation***

 

Theaccompanying unaudited condensed consolidated financial statements arepresented pursuant to the rules and regulations of the United StatesSecurities and Exchange Commission in accordance with the disclosurerequirements for the quarterly report on Form 10-Q and therefore do notinclude all of the information and footnotes required by generally acceptedaccounting principles for complete annual financial statements. In the opinionof Company management, the unaudited condensed consolidated financial statementsreflect all adjustments (consisting of normal recurring adjustments) necessaryto fairly state the results for the interim periods presented. The condensedconsolidated balance sheet as of September 30, 2009 is derived fromaudited financial statements. Operating results for the three and nine monthsended June 30, 2010 are not necessarily indicative of the results that maybe expected for the fiscal year ending September 30, 2010. These unauditedcondensed consolidated financial statements should be read in conjunction withthe audited consolidated financial statements and notes of the Company includedin the Company’s Annual Report on Form 10-K for the fiscal year ended September 30,2009.

 

Ourcondensed consolidated financial statements include the accounts of ourwholly-owned subsidiaries. All intercompany balances and transactions have beeneliminated in consolidation.

 

***Use of Estimates***

 

Preparation of consolidated financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectreported amounts of assets and liabilities, and disclosure of contingent assetsand liabilities, as of the date of the financial statements and the reported amountsof revenues and expenses during the reporting period.  Estimates are used in accounting for, amongother items, allowance for doubtful accounts, inventory obsolescence, productwarranty cost liability, income taxes and contingencies. Actual results coulddiffer materially from those estimates.

 

***Cash and Cash Equivalents***

 

Highly liquid investments purchased with an originalmaturity of three months or less are classified as cash equivalents. Cashequivalents at June 30, 2010 and September 30, 2009 consist of fundsinvested in money market accounts with financial institutions.

 

***Property and Equipment***

 

Property and equipment is stated at cost.Depreciation is provided using an accelerated method over estimated usefullives of the assets (the lesser of three to seven years or over the leaseterm), except for the airplane and manufacturing facility, which aredepreciated using the straight-line method over estimated useful lives of tenyears and thirty-nine years, respectively. Major additions and improvements arecapitalized, while maintenance and repairs that do not improve or extend thelife of assets are charged to expense as incurred.

 

***Long-LivedAssets***

 

The Company assesses the impairment of long-livedassets in accordance with Financial Accounting Standards Board (FASB)Accounting Standard Codification (ASC) Topic 360-10, “*Property,Plant and Equipment”*(ASC Topic 360-10). This statement requiresthat long-lived assets be reviewed for impairment whenever events or changes incircumstances indicate the carrying amount of an asset may not be recoverable.In addition, long-lived assets to be disposed of should be reported at thelower of the carrying amount or fair value less cost to sell. The Companyconsiders historical performance and future estimated results in its evaluationof potential impairment and then compares the carrying amount of the asset toestimated future cash flows expected to result from use of

 

4

----

Table of Contents

 

the asset. If the carrying amount of the assetexceeds the estimated expected undiscounted future cash flows, the Companymeasures the amount of the impairment by comparing the carrying amount of theasset to its fair value. The estimation of fair value is generally measured bydiscounting expected future cash flows. No impairment charges were recorded during the nine months ended June30, 2010 or 2009.

 

***Revenue Recognition***

 

TheCompany enters into sales arrangements with customers that, in general, providefor the Company to design, develop, manufacture and deliver flight informationcomputers, large flat-panel displays, and advanced monitoring systems thatmeasure and display critical flight information, including data relative toaircraft separation, airspeed, and altitude, as well as engine and fuel datameasurements.  Additionally,during the three months ended June 30, 2010 the Company began delivery inaccordance with a new arrangement with a new customer to provide, among otherdeliverables, functional upgrades to the Company’s flight information computersand flat-panel displays.  The Company’ssales arrangements may include multiple deliverables as defined in FASB ASCTopic 605-25, *“Multiple-Element Arrangements”*(ASC Topic 605-25), which typically include design and engineering services andthe production and delivery of the flat panel display and related components.

 

MultipleElement Arrangements -

 

TheCompany identifies all goods and/or services that are to be deliveredseparately under such a sales arrangement and allocates revenue to eachdeliverable (if more than one) based on that deliverable’s selling price. The Company then considers the appropriate recognition method for eachdeliverable; deliverables under multiple element arrangements are typicallypurchased engineering and design services, product sales and/or the sale offunctional upgrades.  The Company’smultiple element arrangements can typically include defined design anddevelopment activities and/or functional upgrades, along with product sales.

 

TheCompany utilizes the selling price hierarchy that has been established by FASBAccounting Standards Update (ASU) 2009-13, “*Multiple-DeliverableRevenue Arrangements—a consensus of the FASB Emerging Issues Task Force”* (ASU 2009-13), which requires that theselling price for each deliverable be based on vendor-specific objectiveevidence if available, third-party evidence if vendor-specific objectiveevidence is not available, or estimated selling price if neithervendor-specific objective evidence nor third-party evidence is available.  To the extent that an arrangement includes adeliverable for which estimated selling price is used, the Company determinesthe best estimate of selling price by applying the same pricing policies andmethodologies that would be used to determine the price to sell the deliverableon a standalone basis.

 

To the extent that an arrangement contains softwareelements that are essential to the functionality of tangible products sold inthe arrangement, the Company recognizes revenue for the deliverables inaccordance with the guidance included in FASB Accounting Standards Update2009-14, “*Revenue Arrangements That IncludeSoftware Elements*”, ASU 2009-13 and FASB ASC Topic 605, “*Revenue Recognition*” (ASC Topic 605).

 

Tothe extent that an arrangement contains defined design and developmentactivities as an identified deliverable in addition to products (resulting in amultiple element arrangement), the Company recognizes as Engineering —Modification and Development (“EMD”) revenue amounts earned during the designand development phase of the contract following the guidance included in theFASB ASC Topic 605-35, “*Construction-Type andProduction-Type Contracts”* (ASC Topic 605-35).  To the extent that multiple elementarrangements include product sales, revenue is generally recognized oncerevenue recognition criteria for the product deliverable has been met based onthe provisions of FASB ASC Topic 605, “*Revenue Recognition”*(ASCTopic 605).

 

Tothe extent that an arrangement contains software components, which include functional upgrades, that are soldon a standalone basis and the Company has deemed outside the scope the exceptiondefined by ASU 2009-14, the Company recognizes software revenue in accordancewith ASC Topic 985, “*Software*” (ASCTopic 985).

 

 

SingleElement Arrangements —

 

*Products -*

 

Tothe extent that a single element arrangement provides for product sales and repairs,revenue is generally recognized once revenue recognition criteria for theproduct deliverable has been met based on the provisions of ASC Topic605.  The Company also receives orders for existing equipment andparts.  Revenue from the sale of such products is generally recognizedupon shipment to the customer.

 

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.

 

5

----

Table of Contents

 

*Engineering Services -*

 

TheCompany also may enter into service arrangements to perform specified designand development services related to its products.  The Company recognizesrevenue from these arrangements as EMD revenue, following the guidance includedin ASC Topic 605-35. The Company considers the nature of these servicearrangements (including term, size of contract, level of effort) whendetermining the appropriate accounting treatment for a particular contract. TheCompany recognizes the revenue from these contracts using either thepercentage-of-completion method or completed contract method of accounting.

 

TheCompany records revenue relating to these contracts using thepercentage-of-completion method when the Company determines that progresstoward completion is reasonable and reliably estimable and the contract islong-term in nature; the Company uses the completed contract method for allothers.

 

***Income Taxes***

 

Incometaxes are recorded in accordance with FASB ASC Topic 740,*“IncomeTaxes”* (ASC Topic 740), which principally utilizes a balance sheetapproach to provide for income taxes.  Underthis method, the Company recognizes deferred tax assets and liabilities fortemporary differences between the financial reporting basis and the tax basisof the Company’s assets, liabilities and expected benefits of utilizing netoperating loss and tax credit carry-forwards. The impact on deferred taxes ofchanges in tax rates and laws, if any, applied to the years during whichtemporary differences are expected to be settled, are reflected in theconsolidated financial statements in the period of enactment.  The Company files a consolidated UnitedStates federal income tax return (see Note 3).

 

EffectiveOctober 1, 2007 (the first day of fiscal 2008), income tax contingencies areaccounted for in accordance with ASC Topic 740, which prescribes a comprehensivemodel for how a company should recognize, measure, present and disclose in itsfinancial statements uncertain tax positions that the company has taken orexpects to take on a tax return. Significant judgment is required in determining our provision for incometaxes and recording the related assets and liabilities.  In the normal course of our business, thereare transactions and calculations where the ultimate tax determination is lessthan certain.  The Company and itssubsidiaries are subject to examination by Federal and State taxauthorities.  The Company regularlyassesses the potential outcomes of these examinations and any futureexaminations for the current or prior years in determining the adequacy of theprovision for income taxes.  The Companycontinually assesses the likelihood and amount of potential adjustments andrecords any necessary adjustments in the period in which the facts that giverise to a revision become known.  TheCompany has elected to record any interest or penalties from the uncertain taxposition as income tax expense.

 

Avaluation allowance is established when it is more likely than not that all ora portion of the net deferred tax asset will not be realized.  The Companycontinues to maintain a full valuation allowance against its net deferred taxassets, as of the quarter ended June 30, 2010.  In accordance with ASCTopic 740, the Company will continue to evaluate the need for a full or partialvaluation allowance in future periods.

 

***Research and Development***

 

Research and development charges incurred forproduct design, product enhancements and future product development areexpensed as incurred. Product development and design charges incurred relatedto a specific customer agreement that are billable are capitalized and thencharged to cost of sales — engineering modification and development as therevenue related to the agreements are recognized.

 

***Comprehensive Income***

 

Pursuant to FASB ASC Topic 220, “*Comprehensive Income”*(ASC Topic 220) the Company isrequired to classify items of other comprehensive income by their nature in afinancial statement and display the accumulated balance of other comprehensiveincome separately from retained earnings and additional paid-in capital in theequity section of our condensed consolidated balance sheets.  For the three months ending June 30, 2010 and2009, comprehensive income consists of net income and there were no items ofother comprehensive income for any of the periods presented.

 

***Fair Value of Financial Instruments***

 

TheCompany adopted FASB ASC Topic 820, *“Fair Value Measurementsand Disclosures”* (ASC Topic 820) in the first quarter of fiscal 2009for financial assets and liabilities. This standard defines fair value as theprice at which an asset could be exchanged in a current transaction betweenknowledgeable, willing parties. A liability’s fair value is defined as theamount that would be paid to transfer the liability to a new obligor, not theamount that would be paid to settle the liability with the creditor.

 

Assetsand liabilities measured at fair value are categorized based upon the level ofjudgment associated with the inputs used to measure their fair value.Hierarchical levels, defined by ASC Topic 820 and directly related to theamount of subjectivity associated 

 

6

----

Table of Contents

 

withthe inputs to fair valuation of these assets and liabilities, are as follows:

 

Level1 — Unadjusted quoted prices that are available in active markets for theidentical assets or liabilities at the measurement date.

 

Level2 — Other observable inputs available at the measurement date, other thanquoted prices included in Level 1, either directly or indirectly, including:

·  Quotedprices for similar assets or liabilities in active markets;

·  Quotedprices for identical or similar assets in non-active markets;

·  Inputsother than quoted prices that are observable for the asset or liability; and

·  Inputsthat are derived principally from or corroborated by other observable marketdata.

 

Level 3 — Unobservable inputs that cannot becorroborated by observable market data and reflect the use of significantmanagement judgment.  These values are generally determined using pricing modelsfor which the assumptions utilize management’s estimates of market participantassumptions.

 

Thefollowing table sets forth by level within the fair value hierarchy the Company’sfinancial assets and liabilities that were accounted for at fair value on arecurring basis as of June 30, 2010 and September 30, 2009, according to thevaluation techniques the Company used to determine their fair values.

 
| ** **                 | ** ** | **Fair Value Measurement on June  30, 2010** | ** ** |
|----------------------------|------------|----------------------------------------------|------------|
| ** **                 | ** ** | **Quoted Price in**                          | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                 | ** ** | **Active Markets for**                       | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                 | ** ** | **Identical Assets**                         | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                 | ** ** | **(Level 1)**                                | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets                     |       |                                         |       |   |   |   |   |
| Cash and cash equivalents: |       |                                         |       |   |   |   |   |
| Money market funds         |       | $                                            | 36,844,666 |   | $ | — |   | $ | — |   |
|                            |            |                                              |            |  |  |  |  |  |  |  |

 
| ** **                | ** ** | **Fair Value Measurement on  September 30, 2009** | ** ** |
|---------------------------|------------|---------------------------------------------------|------------|
| ** **                | ** ** | **Quoted Price in**                               | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                | ** ** | **Active Markets for**                            | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                | ** ** | **Identical Assets**                              | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                | ** ** | **(Level 1)**                                     | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets                    |       |                                              |       |   |   |   |   |
| Cash and cash equivalents |       |                                              |       |   |   |   |   |
| Money market funds        |       | $                                                 | 34,793,543 |   | $ | — |   | $ | — |   |
|                           |            |                                                   |            |  |  |  |  |  |  |  |

 

***Stock-Based Compensation***

 

TheCompany accounts for stock-based compensation under FASB ASC Topic 505-50, *“Equity-Based Payments to Non-Employees*(ASC Topic 505-50)and FASB ASC Topic 718, *“Stock Compensation”*(ASC Topic 718), which require the Company to measure the cost of employeeservices received in exchange for an award of equity instruments based on thegrant-date fair value of the award using an option pricing model. That cost isrecognized over the period during which an employee is required to provideservice in exchange for the award.

 

***Warranty***

 

We offer warranties on someproducts of various lengths. At the time of shipment, we establish a reservefor estimated costs of warranties based on our best estimate of the amountsnecessary to settle future and existing claims using historical data onproducts sold as of the balance sheet date. The length of the warranty period,the product’s failure rates and the customer’s usage affects warranty cost. Ifactual warranty costs differ from our estimated amounts, future results ofoperations could be adversely affected.

 

7

----

Table of Contents

 

***Concentrations***

 

*Major Customers and Products*

 

Forthe three months ended June 30, 2010, two of the Company’s customers, EclipseAerospace, Inc. and Cessna Aircraft Company, accounted for 19% and 19% of netsales, respectively. During the nine months ended June 30, 2010, two of the Company’scustomers, Lockheed Martin and Cessna Aircraft, accounted for 13% and 12% ofnet sales, respectively.

 

Forthe three months ended June 30, 2009, three of the Company’s customers,American Airlines, the United States Department of Defense and WesternAircraft, accounted for 24%, 21% and 13% of net sales, respectively. During thenine months ended June 30, 2009 two of the Company’s customers, AmericanAirlines and the United States Department of Defense, accounted for 30% and 12%of net sales, respectively.

 

*Major Suppliers*

 

The Company currently buys several of its componentsfrom single source suppliers. Although there are a limited number ofmanufacturers of particular components, management believes other supplierscould provide similar components on comparable terms.

 

During the three months ended June 30, 2010 theCompany did not have any suppliers who accounted for more than 10% of totalinventory related purchases, as compared to the Company having one supplier whoaccounted for 30% of the Company’s total inventory related purchases during thethree months ended June 30, 2009.

 

During the nine months ended June 30, 2010 and 2009the Company had one supplier who accounted for 20% and 30% of the Company’stotal inventory related purchases, respectively.

 

*Concentration of Credit Risk*

 

Financial instruments that potentially subject theCompany to concentration of credit risk consist principally of cash balancesand accounts receivable. The Company invests its excess cash where preservationof principal is the major consideration. The Company’s customer baseprincipally consists of companies within the aviation industry. The Companyroutinely requests advance payments from new customers.

 

The Company has maintained a reserve for doubtfulaccounts in the amount of $0.2 million and $0.2 million, as of June 30, 2010and September 30, 2009, respectively

 

***Recent Accounting Pronouncements***

 

InMay 2009, the FASB issued Accounting Standards Codification Topic 855 (ASCTopic 855), *Subsequent Events* which establishesgeneral accounting for and disclosure of events that occur after the balancesheet date but before financial statements are issued or available to beissued. This statement also outlines the circumstances under which an entitywould need to record transactions occurring after the balance sheet date in thefinancial statements. These new disclosures identify the date through which theentity has evaluated subsequent events. ASC Topic 855 is effective for interimor annual financial periods ending after June 15, 2009.  In February 2010, the FASB amended itsguidance removing the requirement for SEC filers to disclose the date throughwhich an entity has evaluated subsequent events.  The Company adopted ASC Topic 855 on April 1,2010 and the adoption had no impact on the condensed consolidated financialstatements.

 

InOctober 2009, the FASB issued Accounting Standards Update No. 2009-13 (ASU2009-13), *Multiple-Deliverable Revenue Arrangements*whichupdates ASC Topic 605-25, *Multiple ElementsArrangements*, of the FASB codification.   ASU 2009-13 provides new guidance on how todetermine if an arrangement involving multiple deliverables contains more thanone unit of accounting, and if so allows companies to allocate arrangementconsiderations in a manner more consistent with the economics of thetransaction.  ASU 2009-13 establishes aselling price hierarchy for determining the selling price of each specificdeliverable, which includes vendor-specific objective evidence (“VSOE”) ifavailable, third party evidence if VSOE is not available or estimated sellingprice if neither VSOE nor third party evidence is available. This updateexpands the disclosure requirements regarding a vendor’s multiple-deliverablerevenue arrangements.  In accordance withASU 2009-13 the Company has chosen to adopt this guidance retrospectively forfiscal 2010 and determined that it did not have a material impact on theCompany’s financial condition or operating results, as the Company did not havea significant amount of sales that contain multiple elements.  Additionally the Company has assessed anypotential impact the new accounting guidance would have had on all priorperiods presented and determined that it would have had no impact on any of theCompany’s prior financial statements or operating results.  The Company is required to adopt, and hasadopted the amendments in both ASU 2009-13 and 2009-14 in the same period andusing the same transitional method.

 

InOctober 2009, the FASB issued Accounting Standards Update No. 2009-14 (ASU2009-14), *Revenue Arrangements That include Software Elements*which amends ASC Topic 985-605, *Software — RevenueRecognition* in regard to the scope of software guidance.  ASU 2009-14 excludes software components oftangible products that function together to provide the tangible product’sessential

 

8

----

Table ofContents

 

functionality.  While ASU 2009-14 does not create any newmethods of revenue recognition, it could significantly affect the Company’srecognition of revenue from period to period. In accordance with ASU 2009-14 the Company has chosen to adopt thisguidance retrospectively for fiscal 2010 and determined that it did not have a material impact on theCompany’s financial condition or operating results, as the Company did not previouslyhave arrangements and/or sales that were included within the scope of ASC Topic985-605, *Software-Revenue Recognition.* Additionally the Company has assessed anypotential impact the new accounting guidance would have had on all priorperiods being presented and determined that it would have hadno impact on any of the Company’s prior financial statements or operatingresults. The Company is required to adopt, and has adopted the amendments inboth ASU 2009-13 and 2009-14 in the same period and using the same transitionalmethod.

 

InJanuary 2010, the FASB issued Accounting Standards Update No. 2010-06 (ASU2010-06), *Fair Value Measurements and Disclosures*which amends ASC Topic 820, adding new requirements for disclosures for Levels1 and 2, separate disclosures of purchases, sales, issuances, and settlementsrelating to Level 3 measurements and clarification of existing fair valuedisclosures.  ASU 2010-06 is effectivefor interim and annual periods beginning after December 15, 2009, except forthe requirement to provide Level 3 activity of purchases, sales, issuances, andsettlements on a gross basis, which will be effective for fiscal years beginningafter December 15, 2010 (the Company’s fiscal year 2012); early adoption ispermitted.  The Company is currentlyevaluating the impact of adopting ASU 2010-06 on its financial statements.

 

InApril 2010, the FASB issued Accounting Standards Update No. 2010-17 (ASU2010-17), *Revenue Recognition-Milestone Method*which amends ASC Topic 605, *Revenue Recognition*,providing a consistent framework for applying the milestone method, thus addingclarity in practice on its application. The objective of ASU 2010-17 is to provide guidance on defining amilestone and determining when to apply the milestone method of revenuerecognition to research and development transactions.  ASU 2010-17 is effective for the Company, prospectively,for milestones achieved in fiscal years, and interim periods within thoseyears, beginning on or after June 15, 2010 (the Company’s fiscal year 2011);early adoption is permitted.  The Companyis currently evaluating the impact of adopting ASU 2010-17 on its financialstatements.

 

**2.****Detail of CertainBalance Sheet Accounts**

 

***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,** | ** ** |
|-----------------|------------|--------------|------------|--------------------|------------|
| ** **      | ** ** | **2010**     | ** ** | **2009**           | ** ** |
| Raw materials   |       | $            | 3,156,381  |               | $          | 3,535,109 |   |
| Work-in-process |       | 614,418      |       | 315,179            |       |
| Finished goods  |       | 1,231,669    |       | 1,456,697          |       |
|            |       | $            | 5,002,468  |               | $          | 5,306,985 |   |

 

9

----

Table of Contents

 

***Prepaid expenses and other current assets***

 

Prepaidexpenses and other current assets consist of the following:

 
| ** **                           | ** ** | **June 30,** | ** ** | **September  30,** | ** ** |
|--------------------------------------|------------|--------------|------------|--------------------|------------|
| ** **                           | ** ** | **2010**     | ** ** | **2009**           | ** ** |
|                                 |       |         |       |               |       |
| Revenue recognized not yet  invoiced |       | $            | 413,817    |               | $          | 491,417 |   |
| Prepaid insurance                    |       | 178,787      |       | 307,477            |       |
| Deferred engineering costs           |       | 14,014       |       | 81,957             |       |
| Income tax asset                     |       | 79,100       |       | —             |       |
| Other                                |       | 294,402      |       | 346,562            |       |
|                                 |       | $            | 980,120    |               | $          | 1,227,413 |   |

 

***Property and equipment***

 

Propertyand equipment, net consists of the following balances:

 
| ** **                                       | ** ** | **June 30,** | ** ** | **September  30,** | ** ** |
|--------------------------------------------------|------------|--------------|------------|--------------------|------------|
| ** **                                       | ** ** | **2010**     | ** ** | **2009**           | ** ** |
|                                             |       |         |       |               |       |
| Computer equipment                               |       | $            | 2,020,299  |               | $          | 1,986,028 |   |
| Corporate airplane                               |       | 3,082,186    |       | 3,082,186          |       |
| Furniture and office  equipment                  |       | 1,089,298    |       | 1,074,031          |       |
| Manufacturing facility                           |       | 5,576,466    |       | 5,558,553          |       |
| Equipment                                        |       | 4,114,315    |       | 4,037,689          |       |
| Land                                             |       | 1,021,245    |       | 1,021,245          |       |
|                                             |       | 16,903,809   |       | 16,759,732         |       |
| Less: Accumulated  depreciation and amortization |       | (8,988,093   | )          | (8,416,031         | )          |
|                                             |       | $            | 7,915,716  |               | $          | 8,343,701 |   |

 

Depreciationand amortization related to property and equipment was approximately $179,000and $227,000 for the three months ended June 30, 2010 and 2009, respectively.

 

Depreciationand amortization related to property and equipment was approximately $589,000and $665,000 for the nine months ended June 30, 2010 and 2009, respectively.

 

***Other assets***

 

Otherassets consist of the following:

 
| ** **                                                                                                            | ** ** | **June 30,** | ** ** | **September  30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------|------------|--------------------|------------|
| ** **                                                                                                            | ** ** | **2010**     | ** ** | **2009**           | ** ** |
| Intangible assets, net of  accumulated amortization of $241,280 and $198,140 at June 30, 2010 and  September 30, 2009 |       | $            | 237,720    |               | $          | 280,860 |   |
| Installation kits, deposit  forfeiture                                                                                |       | —       |       | 118,660            |       |
|                                                                                                                  |       | $            | 237,720    |               | $          | 399,520 |   |

 

Intangible assets consist of licensing andcertification rights which are amortized over a defined number of units.  No impairment charge was recorded in the ninemonths ended June 30, 2010.

 

Total intangible amortization expense wasapproximately $23,190 and $19,300 for the three months ended June 30, 2010 and2009, respectively. Total amortization expense for the nine months ended June30, 2010 and 2009 was $43,140 and $102,600, respectively. Because theintangible assets are being amortized over a defined number of units, thefuture amortization expense over the next five years cannot be determined atthis time.

 

10

----

Table of Contents

 

***Accrued expenses***

 

Accruedexpenses consist of the following:

 
| ** **                          | ** ** | **June 30,** | ** ** | **September  30,** | ** ** |
|-------------------------------------|------------|--------------|------------|--------------------|------------|
| ** **                          | ** ** | **2010**     | ** ** | **2009**           | ** ** |
|                                |       |         |       |               |       |
| Warranty **(a)**                    |       | $            | 877,761    |               | $          | 808,544 |   |
| Salary, benefits and  payroll taxes |       | 518,071      |       | 617,224            |       |
| Reduction in workforce /  severance |       | —       |       | 166,453            |       |
| Professional fees                   |       | 267,169      |       | 188,349            |       |
| Income taxes payable                |       | —       |       | 112,449            |       |
| Materials on order                  |       | 31,824       |       | 108,210            |       |
| Other                               |       | 573,595      |       | 784,331            |       |
|                                |       | $            | 2,268,420  |               | $          | 2,785,560 |   |

 

----

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

 

Warranty cost and accrual information for the threemonths ended June 30, 2010 is highlighted below:

 
| Warranty Accrual at March  31, 2010                       |   | $       | 790,684 |   |
|-----------------------------------------------------------|--------|---------|---------|--------|
| Accrued expense for the  three months ended June 30, 2010 |   | 137,408 |    |
| Warranty cost for the  three months ended June 30, 2010   |   | (50,331 | )       |
| Warranty Accrual at June  30, 2010                        |   | $       | 877,761 |   |

 

Warranty cost and accrual information for the ninemonths ended June 30, 2010 is highlighted below:

 
| Warranty Accrual at  September 30, 2009                  |   | $        | 808,544 |   |
|----------------------------------------------------------|--------|----------|---------|--------|
| Accrued expense for the  nine months ended June 30, 2010 |   | 256,479  |    |
| Warranty cost for the nine  months ended June 30, 2010   |   | (187,262 | )       |
| Warranty Accrual at June  30, 2010                       |   | $        | 877,761 |   |

 

***Notes payable***

 

The Company entered into a $4,335,000 loan agreementdated August 1, 2000 with the Chester County, Pennsylvania IndustrialDevelopment Authority. The purpose of the loan was to fund the construction of theCompany’s new office and manufacturing facility. The loan matures in 2015 andcarried an interest rate set by the remarketing agent that was consistent with30-day tax-exempt commercial paper. The Company exercised its option topay-down the outstanding balance during August, 2009.

 

The interest cost related to this debt for the threemonths ended June 30, 2010 and 2009 was $0 and $9,000, respectively. Theinterest cost related to this debt for the nine months ended June 30, 2010 and2009 was $0 and $42,000 respectively. The Company was required to maintain aletter of credit in the amount of $5,000,000 covering the debt, prior to theAugust, 2009 redemption.

 

**3.Income Taxes**

 

Incometax expense was approximately $270,000 and income tax benefit was $135,000 forthe three and nine months ended June 30, 2010, respectively, as compared to anincome tax benefit of $199,000 and $31,000, respectively, for the three andnine months ended June 30, 2009. The increase in the income tax expense for thethree months ended June 30, 2010 as compared to the three months ended June 30,2009, is due to an increased level of pre-tax income for the quarter relativeto the year-to-date result, as compared to the same quarter in the prior year.  The increase in the income tax benefit forthe nine months ended June 30, 2010 was the result of the pre-tax

 

11

----

Table of Contents

 

lossfor the period as compared to the pre-tax income from the same period in theprior year.  The income tax benefit inthe nine months ended June 30, 2009 reflects the impact of net discrete taxbenefits recognized in the period then ended, which offset the tax expensecalculated on pre-tax income.

 

Theeffective tax rates for the three months ended June 30, 2010 and 2009 was 16%and (19%), respectively.  The effective tax rate differs from thestatutory rate for the three months ended June 30, 2010 due to a decrease inthe overall forecast effective tax rate for the year from the previous quarter,in conjunction with a positive pre-tax income for the current quarter ascompared to prior quarters in the current year, and also a decrease in theliability related to an uncertain tax position upon the expiration of a statuteof limitations. The effective tax rate differs from the statutory rate for thethree months ended June 30, 2009 primarily due to the reversal of certaindeductible temporary differences, which were fully offset by a valuationallowance, that were deductible for income tax purposes in the fiscal yearended September 30, 2009.

 

Theeffective tax rates for the nine months ended June 30, 2010 and 2009 was 21%and (1%), respectively.  The effective tax rate differs from the statutoryrate for the nine months ended June 30, 2010 due to the forecasted netreversals of various deductible temporary differences that are fully offset bya valuation allowance, the forecasted utilization of research andexperimentation tax credit carry-forwards, and the forecasted level of pre-taxincome.  The effective tax rate differs from the statutory rate for thenine months ended June 30, 2009 primarily due to the reversal of certaindeductible temporary differences, which were fully offset by a valuationallowance, that were deductible for income tax purposes in the fiscal yearended September 30, 2009.

 

Asof June 30, 2010, the Company recognized a $79,000 current income taxasset resulting from current taxable losses that can be carried back to prioryears to offset federal income tax paid.  The Company maintains a fullvaluation allowance against its net deferred tax assets, which may not becarried back to prior taxable years, and consist primarily of deductibletemporary differences and other carry-forward items.  The Company willcontinue to maintain this valuation allowance until an appropriate level ofprofitability is sustained to conclude that it is more likely than not that aportion of these net deferred tax assets would be realized in futureperiods.  As such, improvements in pre-tax income in the future within thejurisdictions where the Company maintains a valuation allowance may result inthese tax benefits ultimately being realized.  However, there is noassurance that such improvements will be achieved.

 

**4. Capital Stock**

 

AtJune 30, 2010, the Company’s Articles of Incorporation provide the Companyauthority to issue 75,000,000 shares of Common Stock and 10,000,000 shares ofblank check Preferred Stock.

 

***Share-based compensation***

 

TheCompany accounts for share-based compensation under the provisions of ASC Topic505-50 and ASC Topic 718, using the modified prospective approach and accountsfor share-based compensation applying the fair value method for expensing stockoptions and non-vested stock awards.

 

Totalshare-based compensation expense was approximately $147,000 and $168,000 forthe three months ended June 30, 2010 and 2009, respectively. The excess(shortfall in) tax benefits recognized as a credit (charge) to additional paid-incapital in the statement of shareholders’ equity related to share-basedcompensation arrangements was approximately $8,000 and ($1,000) for the threemonths ended June 30, 2010 and 2009, respectively.

 

Totalshare-based compensation expense was approximately $433,000 and $545,000 forthe nine months ended June 30, 2010 and 2009, respectively The excess(shortfall in) tax benefits recognized as a credit (charge) to additionalpaid-in capital in the statement of shareholders’ equity related to share-basedcompensation arrangements was approximately $5,000 and $3,000 for the ninemonths ended June 30, 2010 and 2009, respectively.  Compensation expense related to share-basedawards is recorded as a component of general and administrative expense.

 

TheCompany maintains the 1998 Stock Option Plan (the “1998 Plan”), the 2003Restricted Stock Plan (the “Restricted Plan”) and the 2009 Stock-BasedIncentive Compensation Plan (the “2009 Plan”). These plans were approved by the Company’s shareholders. The 1998 Planexpired on November 13, 2008.

 

12

----

Table of Contents

 

***1998 Stock Option Plan***

 

The 1998 Plan allowed the granting of incentive and nonqualifiedstock options to employees, officers, directors, and independent contractorsand consultants. No stock options were granted to independent contractors orconsultants under this Plan.  Totalcompensation expense associated with awards under the 1998 plan was $81,000 and$118,000 for the three months ended June 30, 2010 and 2009, respectively. Totalcompensation expense associated with awards under the 1998 plan was $268,000and $395,000 for the nine months ended June 30, 2010 and 2009, respectively.

 

Incentive stock options granted under the 1998 Planhave exercise prices that are at least equal to the fair value of the commonstock on the grant date. Nonqualified stock options granted under the 1998 Planhave exercise prices that are less than, equal to or greater than the fairvalue of the common stock on the date of grant. The Company had reserved3,389,000 shares of Common Stock for awards under the 1998 Plan.  On November 13, 2008, the 1998 Plan expiredand no additional shares were granted under the Plan after that date.

 

***Restricted Plan***

 

Total compensation expense under the Restricted Planwas $50,000 for both the three months ended June 30, 2010 and 2009,respectively. Total compensation expense associated with the Restricted Planwas $150,000 for both the nine months ended June 30, 2010 and 2009,respectively. The expense relates to shares that are issued to non-employeemembers of the Board of Directors on a quarterly basis as part of theircompensation.

 

***2009 Stock-Based IncentiveCompensation Plan***

 

The 2009 Plan authorizes the grant of StockAppreciation Rights (“SARs”), Restricted Stock, Options and other equity-basedawards under the 2009 Plan (collectively referred to as “Awards”). Optionsgranted under the 2009 Plan may be either “incentive stock options” as definedin section 422 of the Internal Revenue Code (the “Code”), or nonqualifiedstock options, as determined by the Compensation Committee of the Company’sBoard of Directors (the “Committee”).

 

Subject to an adjustment necessary upon a stockdividend, recapitalization, forward split or reverse split, reorganization,merger, consolidation, spin-off, combination, repurchase or share exchange,extraordinary or unusual cash distribution or other similar corporatetransaction or event, the maximum number of shares of Common Stock availablefor Awards under the 2009 Plan shall be 1,200,000, all of which may be issuedpursuant to Awards of incentive stock options. In addition, the Plan provides that no more than 300,000 shares may beawarded to any employee as a performance-based Award under Section 162(m)of the Code.  At June 30, 2010 there were1,150,000 shares of Common Stock available for awards under the plan.

 

If any Award is forfeited, or if any Optionterminates, expires or lapses without being exercised, shares of Common Stocksubject to such Award will again be available for future grant. Any sharestendered by a participant in payment of the exercise price of an Option or thetax liability with respect to an Award (including, in any case, shares withheldfrom any such Award) will not be available for future grant under the 2009Plan.  If there is any change in theCompany’s corporate capitalization, the Committee shall proportionately andequitably adjust the number and kind of shares of Common Stock which may beissued in connection with future Awards, the number and kind of shares ofCommon Stock covered by Awards then outstanding under the 2009 Plan, the numberand kind of shares of Common Stock available under the 2009 Plan, the exerciseor grant price of any Award, or if deemed appropriate, make provision for acash payment with respect to any outstanding Award, provided that no adjustmentmay be made that would adversely affect the status of any Award that isintended to be a performance-based Award under Section 162(m) of the Code,unless otherwise determined by the Committee. In addition, the Committee maymake adjustments in the terms and conditions of any Awards, including anyperformance goals, in recognition of unusual or nonrecurring events affectingthe Company or any subsidiary, or in response to changes in applicable laws,regulations or accounting principles, provided that no adjustment may be madethat would adversely affect the status of any Award that is intended to be aperformance-based Award under Section 162(m) of the Code, unless otherwisedetermined by the Committee.

 

Total compensation expense associated with awardsunder the 2009 plan was $15,000 and $0 for the three months ended June 30, 2010and 2009, respectively. Total compensation expense associated with awards underthe 2009 plan was $15,000 and $0 for the nine months ended June 30, 2010 and2009, respectively.

 

***Stock repurchase program***

 

On February 16, 2010, the Company’s Board ofDirectors extended the Common Stock repurchase program to acquire up to1,000,000 shares of the Company’s outstanding Common Stock.  Purchases of the stock were to be made fromtime to time, subject to market

 

13

----

Table of Contents

 

conditions and at prevailing market prices.  There were no shares purchased under thisplan during the three months ended June 30, 2010.  During the nine months ended June 30, 2010the Company purchased 5,200 shares of common stock under the program at a costof $21,661, or an average market price of $4.17 per share.  The Company financed these purchases throughavailable cash.  The following table setsforth the purchases made under this new plan for each month since its inceptionthrough June 30, 2010:

 
| ** **    | ** ** | ** **    | ** ** | ** **     | ** ** | **Total Number of**     | ** ** | **Number of**        | ** ** |
|---------------|------------|---------------|------------|----------------|------------|-------------------------|------------|----------------------|------------|
| ** **    | ** ** | **Total**     | ** ** | ** **     | ** ** | **Shares Purchased as** | ** ** | **Shares that May**  | ** ** |
| ** **    | ** ** | **Number of** | ** ** | **Average**    | ** ** | **Part of Publicly**    | ** ** | **Yet Be Purchased** | ** ** |
| ** **    | ** ** | **Shares**    | ** ** | **Price Paid** | ** ** | **Announced Plans or**  | ** ** | **Under the**        | ** ** |
| **Period**    | ** ** | **Purchased** | ** ** | **per Share**  | ** ** | **Programs**            | ** ** | **Program**          | ** ** |
|          |       |          |       |           |       |                    |       |                 |       |
| January 2010  |       | —        |       | —         |       | —                  |       | —               |       |
|          |       |          |       |           |       |                    |       |                 |       |
| February 2010 |       | 4,100         |       | $              | 4.16       |                    | 4,100      |                 | 995,900    |   |
|          |       |          |       |           |       |                    |       |                 |       |
| March 2010    |       | 1,100         |       | 4.20           |       | 1,100                   |       | 994,800              |       |
|          |       |          |       |           |       |                    |       |                 |       |
| April 2010    |       | —        |       | —         |       | —                  |       | —               |       |
|          |       |          |       |           |       |                    |       |                 |       |
| May 2010      |       | —        |       | —         |       | —                  |       | —               |       |
|          |       |          |       |           |       |                    |       |                 |       |
| June 2010     |       | —        |       | —         |       | —                  |       | —               |       |
|          |       |          |       |           |       |                    |       |                 |       |
|          |       | 5,200         |       | 4.17           |       | 5,200                   |       |                 |       |
|               |            |               |            |                |            |                         |            |                      |            |  |

 

**5. Income (Loss) per Share**

 

Income(loss) per share (“EPS”) is calculated using the principles of FASB AccountingStandards Topic 260 (ASC 260), *Earnings Per Share.*

 

Forthe three month period ended June 30, 2010, there were 359,800 options topurchase common stock outstanding included in the computation of dilutedearnings per share.  For the nine monthperiod ended June 30, 2009, there were 362,500 options to purchase common stockoutstanding excluded from the computations of diluted earnings per share as theeffect would be anti-dilutive.

 

Forthe three and nine month periods ended June 30, 2009, there were 425,000 and426,000 options to purchase common stock outstanding, respectively, excludedfrom the computations of diluted earnings per share as the effect would beanti-dilutive.

 

14

----

Table of Contents

 

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

 

**CAUTIONARYSTATEMENT REGARDING****FORWARD-LOOKING STATEMENTS**

 

*This report contains forwardlooking statements within the meaning of Section 21E of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”). We have based theseforward looking statements largely on our current expectations and projectionsabout future events and trends affecting our business. In this report, the words“believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “forecast,”“expect,” “plan,” “should,” “is likely” and similar expressions, as they relateto our business or our management, are intended to identify forward lookingstatements, but they are not exclusive means of identifying them.*

 

*The forward looking statements inthis report are only predictions and actual events or results may differmaterially. In evaluating such statements, a number of risks, uncertainties andother factors could cause our actual results, performance, financial condition,cash flows, prospects, and opportunities to differ materially from thoseexpressed in, or implied by, the forward looking statements. These risks,uncertainties and other factors include the following:*

 

·                  *the impactof general economic trends on our business;*

 

·                  *thedeferral or termination of programs or contracts for convenience by customers;*

 

·                  *difficultiesin developing and producing our COCKPIT/IPTM system or other planned products orproduct enhancements;*

 

·                  *marketacceptance of our flat panel display systems, or COCKPIT/IPTM system or otherplanned products or product enhancements;*

 

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

 

·                  *failure toretain/recruit key personnel;*

 

·                  *continuedmarket acceptance of our air data systems and products;*

 

·                  *theavailability of government funding;*

 

·                  *delays inreceiving components from third party suppliers;*

 

·                  *thecompetitive environment;*

 

·                  *thebankruptcy or insolvency of one or more key customers;*

 

·                  *newproduct offerings from competitors;*

 

·                  *protectionof intellectual property rights;*

 

·                  *ourability to service the international market;*

 

·                  *potentialfuture acquisitions; and*

 

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

 

*Except as expressly required bythe federal securities laws, we undertake no obligation to publicly update orrevise any forward looking statements, whether as a result of new information,future events or otherwise after the date of this report. Our results ofoperations in any past period should not be considered indicative of theresults to be expected for future periods. Fluctuations in operating resultsmay also result in fluctuations in the price of our common stock.*

 

*Readers are cautioned not to place undue reliance on theseforward-looking statements, which speak only as of the date of this Form 10-Q.The Company does not undertake any obligation to publicly release any revisionsto these forward-looking statements to reflect events, circumstances or changesin expectations after the date of this Form 10-Q, or to reflect the occurrenceof unanticipated events. The forward-looking statements in this document areintended to be subject to the safe harbor protection provided by Sections 27Aof the Securities Act of 1933, as amended, and 21E of the Exchange Act. For adiscussion 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, 2009.*

 

*Investors should also be awarethat while we do, from time to time, communicate with securities analysts, itis against our policy to disclose any material non-public information or otherconfidential commercial information. Accordingly, shareholders should not assumethat we agree with any statement or report issued by any analyst irrespectiveof the content of the statement or report. Furthermore, we have a policyagainst issuing or confirming financial forecasts or projections issued byothers. Thus, to the extent*

 

15

----

Table of Contents

 

*that reports issued by securitiesanalysts contain any projections, forecasts or opinions, such reports are notthe responsibility of Innovative Solutions and Support, Inc.*

 

**Company Overview**

 

Innovative Solutions and Support, Inc. (The “Company”,“IS&S” or “we”) was founded in 1988. The Company designs, develops,manufactures and sells Flight Information Computers, Flat-Panel DisplaySystems, and advanced monitoring systems that measure and display criticalflight information, including data relative to aircraft separation, airspeed,and altitude, as well as engine and fuel data measurements.

 

Our sales are derived from the sale of our productsto the retrofit market and, to a lesser extent, original equipmentmanufacturers (OEMs).  Our customersinclude the United States Department of Defense (DoD) and their commercial contractors,aircraft operators, aircraft modification centers and variousOEMs. Although we occasionally sell our products directly to the DoD, weprimarily have sold our products to commercial customers for end use in DoDprograms. Sales to defense contractors are on commercial terms, although someof the termination and other provisions of government contracts are applicableto these contracts.

 

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

 

Our cost of sales related toEngineering—modification and development (EMD) is comprised of engineeringlabor, consulting services, and other cost associated with specific design anddevelopment projects.

 

We intend to continue investing in the developmentof new products that complement our current product offerings and will expenseassociated research and development costs as they are incurred.

 

Our selling, general and administrative expensesconsist of sales, marketing, business development, professional services, andsalaries and benefits for executive and administrative personnel as well asfacility costs, recruiting, legal, accounting, and other general corporateexpenses.

 

Wesell our products to agencies of the United States and foreign governments,aircraft operators, aircraft modification centers and original equipmentmanufacturers.  Our customers have been and may continue to be affected bythe ongoing adverse economic conditions that currently exist both inthe United States and abroad.  Such conditions may cause ourcustomers to curtail or delay their spending on both new and existing aircraft. Factors that can impact general economic conditions and the level of spendingby our customers include, but are not limited to, general levels ofconsumer spending, increases in fuel and energy costs, conditions in the realestate and mortgage markets, labor and healthcare costs, access to credit,consumer confidence and other macroeconomic factors affecting spendingbehavior.  Additionally, spending by government agencies may in the futurebe further reduced due to declining tax revenues associated with this economicdownturn.  If our customers curtail or delay their spending or areforced to declare bankruptcy or liquidate their operations due to continuingadverse economic conditions, our revenues and results of operations will beadversely affected.  However, we believe that in a declining economicenvironment a customer that may have otherwise elected to purchase newlymanufactured aircraft will instead be interested in retrofitting existingaircraft as a cost effective alternative, which should create a marketopportunity for our products.

 

**Critical Accounting Policies andEstimates**

 

Ourdiscussion and analysis of our financial condition and consolidated results ofoperations are based upon our condensed consolidated financial statements,which have been prepared in accordance with generally accepted accountingprinciples in the United States. The preparation of our condensed consolidatedfinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenue and expenses and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates based upon historical experience and various otherassumptions that we believe to be reasonable under the circumstances, the resultsof which form the basis for making judgments about the carrying values ofassets and liabilities that are not readily apparent from other sources. Ouractual results may differ from these estimates.

 

Webelieve that our critical accounting policies affect our more significantestimates and judgments used in the preparation of our consolidated financialstatements. Our Annual Report on Form 10-K for the year endedSeptember 30, 2009 contains a discussion of these critical accountingpolicies. During thethree month period ended June 30, 2010 the Company chose to early adopt ASU2009-13 and ASU 2009-14, for details related to the adoption of theseAccounting Standards refer to the Revenue Recognition and Recent AccountingPronouncements sections of the Notes to Condensed Consolidated FinancialStatements.  Other than the adoption ofASU 2009-13 and ASU 2009-14 there have been no significant changes in ourcritical accounting policies since September 30, 2009.

 

16

----

Table of Contents

 

Seealso Note 1 to our unaudited condensed consolidated financial statements forthe three and nine month periods ended June 30, 2010 as set forth herein.

 

**RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHSENDED**

**JUNE 30, 2010 AND 2009**

 

Thefollowing table sets forth statement of operations data expressed as apercentage of total net sales for the periods indicated (some items may not adddue to rounding):

 
| ** **                                  | ** ** | **Three  Months Ending June 30,** | ** ** | **Nine  Months Ending June 30,** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| **Net sales:**                              | ** ** | **2010**                               | ** ** | **2009**                              | ** ** | **2010** | ** ** | **2009** | ** ** |
| Product                                     |       | 93.4                                   | %          | 85.6                                  | %          | 90.6 | % | 86.5 | % |
| Engineering - modification  and development |       | 6.6                                    | %          | 14.4                                  | %          | 9.4 | % | 13.5 | % |
| Total net sales                             |       | 100.0                                  | %          | 100.0                                 | %          | 100.0 | % | 100.0 | % |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Cost of sales                               |       |                                   |       |                                  |       |   |   |   |   |
| Product                                     |       | 37.0                                   | %          | 42.6                                  | %          | 45.4 | % | 45.9 | % |
| Engineering - modification  and development |       | 1.5                                    | %          | 4.1                                   | %          | 4.0 | % | 3.1 | % |
| Total cost of sales                         |       | 38.5                                   | %          | 46.7                                  | %          | 49.4 | % | 48.9 | % |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Gross profit                                |       | 61.5                                   | %          | 53.3                                  | %          | 50.6 | % | 51.1 | % |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Operating expenses:                         |       |                                   |       |                                  |       |   |   |   |   |
| Research and development                    |       | 16.3                                   | %          | 16.6                                  | %          | 21.6 | % | 14.5 | % |
| Selling, general and  administrative        |       | 24.8                                   | %          | 23.7                                  | %          | 33.5 | % | 22.5 | % |
| Total operating expenses                    |       | 41.1                                   | %          | 40.3                                  | %          | 55.1 | % | 37.0 | % |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Operating income (loss)                     |       | 20.3                                   | %          | 13.0                                  | %          | -4.5 | % | 14.1 | % |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Interest income                             |       | 0.9                                    | %          | 0.8                                   | %          | 0.7 | % | 1.3 | % |
| Interest (expense)                          |       | 0.0                                    | %          | -0.3                                  | %          | 0.0 | % | -0.3 | % |
| Other income                                |       | 0.0                                    | %          | 0.0                                   | %          | 0.3 | % | 0.2 | % |
| Income (loss) before  income taxes          |       | 21.2                                   | %          | 13.6                                  | %          | -3.6 | % | 15.3 | % |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Income tax expense  (benefit)               |       | 3.5                                    | %          | -2.6                                  | %          | -0.8 | % | -0.1 | % |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Net income (loss)                           |       | 17.8                                   | %          | 16.1                                  | %          | -2.8 | % | 15.4 | % |

 

**Three Months Ended June 30, 2010 Compared to the Three MonthsEnded June 30, 2009**

 

*Net sales.* Net sales were $7.8 million for both the threemonths ended June 30, 2010 and 2009. For the three months ended June 30,2010, product sales increased approximately $0.6 million and EMD salesdecreased approximately $0.6 million from the same period in the prior year.The increase in product sales was primarily the result of increased productdelivery against both existing backlog orders and new orders that were bookedin the period. The decrease in EMD sales was primarily a result of a delayedcontract award.

 

*Cost of sales.* Cost of sales decreased $0.6 million or16.9%, to $3.0 million, or 38.5% of net sales in the three months ended June 30,2010 from $3.6 million, or 46.7% of net sales in the three months ended June 30,2009. The decrease was primarily driven by resumed sales associated with theEclipse E500  aircraft that had deminimis direct costs and a continued focus on cost reduction.

 

*Research and development.* Research and developmentexpense for the three months ended June 30, 2010 and 2009 was $1.3 millionand $1.3 million or 16.3% and 16.6% of net sales, respectively.  This is consistent with the Company’s strategyto continue to invest in on-going research and development of our coreproducts, consistent with revenues realized in a given period.

 

*Selling, general, and administrative.* Selling, general andadministrative expenses increased $0.1 million, or 5.3%, to $1.9 million, or24.87% of net sales in the three months ended June 30, 2010 from $1.8million or 23.7% of net sales in the three months ended June 30, 2009. Theincrease was due to increased sales and marketing expenses.

 

17

----

Table of Contents

 

*Interest income.* Interest income was $69,000 in the threemonths ended June 30, 2010 as compared to $63,000 in the three monthsended June 30, 2009. The increase in interest income was primarily theresult of higher interest rates earned on invested cash in the quarter ascompared to the same period in the prior year.

 

*Interest expense.* Interest expense was $1,000 in the threemonths ended June 30, 2010 as compared to $20,000 in the three monthsended June 30, 2009. The reduction was primarily due to the redemption ofthe Industrial Development Bond during August, 2009.

 

*Income tax expense (benefit).* Income taxexpense for the three months ended June 30, 2010 was $270,000 as comparedto the income tax benefit of $199,000 for the three months ended June 30,2009.  The increase in the income taxexpense for the three months ended June 30, 2010 as compared to the threemonths ended June 30, 2009, is primarily due to an increased level ofpre-tax income for the quarter relative to the year-to-date result, as comparedto the same quarter in the prior year.

 

Theeffective tax rates for the three months ended June 30, 2010 and 2009 was16% and (19%), respectively.  The effective tax rate differs from thestatutory rate for the three months ended June 30, 2010 due to a decreasein the overall forecasted effective tax rate for the year from the previousquarter, in conjunction with a positive pre-tax income for the current quarteras compared to prior quarters in the current year, and also a decrease in theliability related to an uncertain tax position upon the expiration of a statuteof limitations. The effective tax rate differs from the statutory rate for thethree months ended June 30, 2009 primarily due to the reversal of certaindeductible temporary differences, which were fully offset by a valuationallowance, that were deductible for income tax purposes in the fiscal yearended September 30, 2009.

 

**Nine months ended June 30, 2010 Compared to the Nine months ended June 30,2009**

 

*Net sales.* Net sales decreased $11.0 million, or 38.2%, to$17.8 million for the nine months ended June 30, 2010 from $28.8 millionin the nine months ended June 30, 2009. For the nine months ended June 30,2010, product sales decreased $8.8 million and EMD sales decreased $2.2 millionfrom the same period in the prior year. The decrease in product sales wasprimarily driven by customer delays in delivery schedules for backlog orders andthe decrease in EMD sales was primarily driven by a reduction in volume.

 

*Cost of sales.* Cost of sales decreased $5.3 million or37.6%, to $8.8 million, or 49.4% of net sales in the nine months ended June 30,2010 from $14.1 million, or 48.9% of net sales in the nine months ended June 30,2009. The decrease was primarily driven by a decrease in variable productioncosts associated with the reduced year to date sales volume, resumed salesassociated with the Eclipse E500 aircraft that had de minimis direct costs asdiscussed above and a continued focus on cost reduction.

 

*Research and development.* Research and developmentexpense decreased $0.3 million or 8.0% to $3.8 million or 21.6% of net sales inthe nine months ended June 30, 2010 from $4.2 million or 14.5% of netsales in the nine months ended June 30, 2009.  The decrease in research and developmentexpense in the nine months ended June 30, 2010 was primarily due to areduction in headcount.

 

*Selling, general, and administrative.* Selling, general andadministrative expenses decreased $0.5 million, or 7.8%, to $6.0 million, or33.5% of net sales in the nine months ended June 30, 2010 from $6.5million or 22.5% of net sales in the nine months ended June 30, 2009. Thedecrease in selling, general and administrative expense in the nine monthsended June 30, 2010 was primarily due to decreased legal and consultantfees and stock option compensation expenses, of $0.2 million and $0.1 million,respectively.

 

*Interest income.* Interest income was $120,000 in the ninemonths ended June 30, 2010 as compared to $361,000 in the nine monthsended June 30, 2009. The decrease in interest income was primarily theresult of our reduced average cash balance during the nine months ended June 30,2010 as compared to the same period in the prior year as well as lower interestrates earned on invested cash during the nine months ended June 30, 2010as compared to the same period in the prior year.

 

*Interest expense.* Interest expense was $2,000 in the ninemonths ended June 30, 2010 as compared to $75,000 in the nine months endedJune 30, 2009. The reduction was primarily due to the redemption of theIndustrial Development Bond during August, 2009.

 

*Income tax expense (benefit).* Income taxbenefit for the nine months ended June 30, 2010 was $135,000 as comparedto a benefit of $31,000 for the nine months ended June 30, 2009. Theincrease in the income tax benefit for the nine months ended June 30, 2010was the result of the pre-tax loss for the nine months ended June 30, 2010as compared to the pre-tax income from the same period in the prior year.  The income tax benefit in the nine monthsended June 30, 2009 reflects the impact of net discrete tax benefitsrecognized in the period then ended, which offset the tax expense calculated onpre-tax income.

 

Theeffective tax rates for the nine months ended June 30, 2010 and 2009 was21% and (1%), respectively.  The effective tax rate differs from thestatutory rate for the nine months ended June 30, 2010 due to theforecasted net reversals of various deductible temporary differences that arefully offset by a valuation allowance, the forecasted utilization of researchand experimentation tax credit carry-forwards, and the forecasted level ofpre-tax income.  The effective tax rate differs from the statutory ratefor the nine months ended June 30, 2009 primarily due to the reversal ofcertain deductible temporary differences, which were fully offset by a

 

18

----

Table of Contents

 

valuationallowance, that were deductible for income tax purposes in the fiscal yearended September 30, 2009.

 

**Liquidity and Capital Resources**

 

Thefollowing table highlights key financial measurements of the Company:

 
| ** **                                        | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **2010**          | ** ** | **2009**               | ** ** |
| Cash and cash equivalents                         |       | $                 | 38,019,536 |                   | $          | 35,565,694 |   |
| Accounts receivable, net                          |       | 3,909,442         |       | 6,188,706              |       |
| Current assets                                    |       | 48,361,679        |       | 48,792,791             |       |
| Current liabilities                               |       | 3,414,957         |       | 4,168,314              |       |
| Deferred revenue                                  |       | 166,839           |       | 225,648                |       |
| Total debt and other  non-current liabilities (1) |       | 775,951           |       | 918,072                |       |
| Quick ratio (2)                                   |       | 12.28             |       | 10.02                  |       |
| Current ratio (3)                                 |       | 14.16             |       | 11.71                  |       |
|                                                   |            |                   |            |                        |            |  |  |

 
| ** **                                | ** ** | **Nine  Months Ending June 30,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **2010**                              | ** ** | **2009** | ** ** |
| Cash flow activites:                      |       |                                  |       |   |   |
| Net cash provided by  operating activites |       | $                                     | 2,646,250  |   | $ | 4,636,299 |   |
| Net cash (used in)  investing activites   |       | (162,173                              | )          | (244,127 | ) |
| Net cash (used in)  financing activites   |       | (30,236                               | )          | (116,166 | ) |
|                                           |            |                                       |            |  |  |  |  |

 

----

(1)         Excludes deferred revenue

(2)         Calculated as:  (Cash and cash equivalents and Accountsreceivable, net) divided by Current liabilities

(3)         Calculated as:  Current assets divided by Current liabilities

 

Ourmain source of liquidity has been cash flow from operating activities. Werequire cash principally to finance inventory, accounts receivable and payroll.

 

***Operating activities***

 

Cashprovided by operating activities was $2.6 million for the nine months ended June 30,2010 as compared to cash provided by operating activities of $4.6 million forthe nine months ended June 30, 2009. The decrease was primarily due to anet loss of $0.5 million for the nine months ended June 30, 2010 versusnet income of $4.4 million in the prior year.

 

Thecash provided by operating activities during the nine months ended June 30,2010 was primarily due to decreases in accounts receivable, pre-paid expensesand inventories of $2.3 million, $0.3 million and $0.3 million, respectively.

 

***Investing activities***

 

Cashused in investing activities was $162,000 and $244,000 for the nine monthsended June 30, 2010 and 2009, respectively, which primarily consisted ofthe purchase of production and laboratory test equipment.

 

***Financing activities***

 

Netcash used in financing activities was $30,000 for the nine months ended June 30,2010 which consisted of $22,000 for the repurchase of common stock and $8,000for the repayment of capitalized lease obligations. Net cash used in financingactivities of $116,000 for the nine months ended June 30, 2009 primarilyconsisted of $108,000 for the repurchase of common stock and $8,000 for therepayment of capitalized lease obligations.

 

The Company entered into a $4,335,000 loan agreementdated August 1, 2000 with the Chester County, Pennsylvania IndustrialDevelopment Authority. The purpose of the loan was to fund construction of theCompany’s new office and manufacturing facility.

 

19

----

Table of Contents

 

The loan was scheduled to mature in 2015 and carriedan interest rate set by the remarketing agent that is consistent with 30-daytax-exempt commercial paper. The Company exercised its option to pay-down theoutstanding balance during August, 2009.

 

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 our cash andcash equivalents will provide sufficient capital to fund our operations for atleast 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, 2010 and September 30, 2009, our backlog was $39.2million and $34.1 million, respectively. The $5.1 million increase in backlogwas the result of $24.1 million in new business orders offset by $17.8 millionof recognized revenues and $1.2 million of de-bookings. Air Data productbacklog as of June 30, 2010 increased $0.1 million from September 30,2009; while Flat Panel Display Systems backlog, as of June 30, 2010,increased $5.0 million from September 30, 2009.  To the extent new business orders do notcontinue to equal or exceed recognized revenue from the Company’s existingbacklog, future operating results may be negatively impacted.

 

Backlogactivity for the nine months ended June 30, 2010 (in thousands):

 
| **Balance at**         | ** ** | ** **     | ** ** | ** **     | ** ** | **Balance at**    | ** ** |
|------------------------|------------|----------------|------------|----------------|------------|-------------------|------------|
| **September 30,** | ** ** | **Additional** | ** ** | **Recognized** | ** ** | **June 30,** | ** ** |
| **2009**               | ** ** | **Bookings**   | ** ** | **in Revenue** | ** ** | **2010**          | ** ** |
|                   |       |           |       |           |       |              |       |
| $                      | 34,142     |           | $          | 22,880         |       | $                 | 17,794     |   | $ | 39,228 |   |
|                        |            |                |            |                |            |                   |            |  |  |  |  |

 

Backlogactivity for the three months ended June 30, 2010 (in thousands):

** **
| **Balance at**     | ** ** | ** **     | ** ** | ** **     | ** ** | **Balance at**    | ** ** |
|--------------------|------------|----------------|------------|----------------|------------|-------------------|------------|
| **March 31,** | ** ** | **Additional** | ** ** | **Recognized** | ** ** | **June 30,** | ** ** |
| **2010**           | ** ** | **Bookings**   | ** ** | **in Revenue** | ** ** | **2010**          | ** ** |
|               |       |           |       |           |       |              |       |
| $                  | 35,038     |           | $          | 12,004         |       | $                 | 7,814      |   | $ | 39,228 |   |
|                    |            |                |            |                |            |                   |            |  |  |  |  |

 

**Off-Balance Sheet Arrangements**

 

Wedo not participate in transactions that generate relationships withunconsolidated entities or financial partnerships, such as special purposeentities (“SPEs”) or variable interest entities (“VIEs”), which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother limited purposes. As of June 30, 2010 and September 30, 2009,we were not involved with any unconsolidated SPEs or VIEs.

 

20

----

Table ofContents

 

**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. TheCompany’s cash equivalents consist of funds invested in money market accounts,which bear interest at a variable rate. As the interest rates are variable, and we do not engage in hedgingactivities, a change in interest rates earned on cash equivalents would impactinterest income and cash flows, but would not impact the fair market value ofthe related underlying instruments. Assuming that the balances during the three and nine months ending June 30,2010 were to remain constant and no actions were taken to alter the existinginterest rate sensitivity, a hypothetical 1% increase or decrease in ourvariable interest rates would have affected interest income by approximately$93,000 and $275,000, respectively, with a resulting impact on cash flows ofapproximately $93,000 and $275,000, for the three and nine months ended June 30,2010 respectively.

 

**Item 4. Controls and Procedures**

 

(a)         An evaluation was performedunder the supervision and with the participation of the Company’s management,including its Chief Executive Officer, or CEO, and Chief Financial Officer, orCFO, of the effectiveness of the Company’s disclosure controls and procedures,as such term is defined under Rule 13a-15e under the Exchange Act as of June 30,2010. Based on that evaluation, the Company’s management, including the CEO andCFO, concluded that the Company’s disclosure controls and procedures areeffective to provide reasonable assurance that information required to bedisclosed by the Company in reports that it files or submits under the ExchangeAct, is recorded, processed, summarized and reported as specified in Securitiesand Exchange Commission rules and forms and that such information isaccumulated and communicated to the Company’s management, including the CEO andCFO, or persons performing similar functions, as appropriate to allow timelydecisions regarding required disclosure.

 

(b)         There were no changes in theCompany’s internal control over financial reporting identified in connectionwith the evaluation of such controls that occurred during the Company’s mostrecent fiscal quarter that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

21

----

Table of Contents

 

**PART II—OTHERINFORMATION**

 

**Item 1.   Legal Proceedings**

 

Inthe ordinary course of business, we are at times subject to various legalproceedings and claims. We do not believe any such matters that are currentlypending will have a material adverse effect on our results of operations orfinancial position.

 

OnJanuary 17, 2007 the Company filed suit in the Court of Common Pleas forDelaware County, Pennsylvania against Strathman Associates, a former softwareconsultant for IS&S, alleging that Strathman had improperly used IS&Strade secret and proprietary information in assisting J2 and Kollsman indeveloping the J2/Kollsman Air Data Computer. The case is ongoing.

 

**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, 2009.

 

I**tem 2.   Unregistered Sales of Equity Securities andUse of Proceeds**

 

***Stock repurchase program***

 

On February 16, 2010, the Company’s Board ofDirectors extended a Common Stock repurchase program to acquire up to 1,000,000shares of the Company’s outstanding Common Stock. Purchases of the stock wereto be made from time to time, subject to market conditions and at prevailingmarket prices.  During the three monthsended June 30, 2010 the Company made no purchases of Common Stock underthe program.  During the nine months endedJune 30, 2010 the Company purchased 5,200 shares of Common Stock under theprogram at a cost of $21,661, or an average market price of $4.17 pershare.  The Company financed thesepurchases through available cash.  Thefollowing table sets forth the purchases made under this new plan for eachmonth of the six months ended June 30, 2010:

 
| ** **         | ** ** | ** **    | ** ** | ** **     | ** ** | **Total Number of**       | ** ** | **Number of**        | ** ** |
|--------------------|------------|---------------|------------|----------------|------------|---------------------------|------------|----------------------|------------|
| ** **         | ** ** | **Total**     | ** ** | ** **     | ** ** | **Shares Purchased as**   | ** ** | **Shares that May**  | ** ** |
| ** **         | ** ** | **Number of** | ** ** | **Average**    | ** ** | **Part of Publicly** | ** ** | **Yet Be Purchased** | ** ** |
| ** **         | ** ** | **Shares**    | ** ** | **Price Paid** | ** ** | **Announced Plans or**    | ** ** | **Under the**        | ** ** |
| **Period**         | ** ** | **Purchased** | ** ** | **per Share**  | ** ** | **Programs**              | ** ** | **Program**          | ** ** |
|               |       |          |       |           |       |                      |       |                 |       |
| January 2010  |       | —        |       | —         |       | —                    |       | —               |       |
|               |       |          |       |           |       |                      |       |                 |       |
| February 2010 |       | 4,100         |       | $              | 4.16       |                      | 4,100      |                 | 995,900    |   |
|               |       |          |       |           |       |                      |       |                 |       |
| March 2010    |       | 1,100         |       | 4.20           |       | 1,100                     |       | 994,800              |       |
|               |       |          |       |           |       |                      |       |                 |       |
| April 2010    |       | —        |       | —         |       | —                    |       | —               |       |
|               |       |          |       |           |       |                      |       |                 |       |
| May 2010      |       | —        |       | —         |       | —                    |       | —               |       |
|               |       |          |       |           |       |                      |       |                 |       |
| June 2010     |       | —        |       | —         |       | —                    |       | —               |       |
|               |       |          |       |           |       |                      |       |                 |       |
|               |       | 5,200         |       | 4.17           |       | 5,200                     |       |                 |       |
|                    |            |               |            |                |            |                           |            |                      |            |  |

 
| **Item 3.** | **Defaults upon Senior Securities** |
|-------------|-------------------------------------|
|        |                                |
|        | None                                |
|        |                                |
| **Item 4.** | **Removed and reserved**            |
|        |                                |
| **Item 5.** | **Other Information**               |
|        |                                |
|        | None                                |

 

22

----

Table of Contents

 

**Item 6. Exhibits**

 
| (a)    | Exhibits   |                                                                                                                           |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                                           |
|   | 3.1*       | Amended and Restated Bylaws of Innovative Solutions and  Support, Inc. as amended                                         |
|   |       |                                                                                                                           |
|   | 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 |

 

----

| *      | Filed herewith     |
|--------|--------------------|
|   |               |
| † | Furnished herewith |

 

**SIGNATURE**

 

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 5, 2010 |   | By:                                             | /s/ JOHN C. LONG |
|                      |   |                                            |   |
|                      |   |                                            | JOHN C. LONG |
|                      |   |                                            | CHIEF FINANCIAL OFFICER |

 

23

----