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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **x**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       |                                                                                                    |
| **For the  quarterly period ended March 31, 2009**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | ** **                                                                                              |
| **OR**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | ** **                                                                                              |
| **o**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | ** **                                                                                              |
| **[For  the transition period from                                           to                                                  ]** |

 

**CommissionFile No. 0-31157**

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

(Exact name of registrant as specified in its charter)

 

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

** **

**(610)646-9800**

(Registrant’stelephone number, including area code)

 

Indicate by check markwhether registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 day. Yes x    No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files). Yes o        No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

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

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o   No x

 

As of May 1, 2009,there were 16,727,269 shares of the Registrant’s Common Stock, with par valueof $.001 per share, outstanding.

 

 

 

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

 

### **FORM 10-Q March 31, 2009**

### ** **

**INDEX**

 
| ** **        | ** **                                                                                                      | **Page No.** |
|-------------------|-----------------------------------------------------------------------------------------------------------------|-------------------|
|              |                                                                                                            |              |
| **PART I.**  | **FINANCIAL INFORMATION**                                                                                       | —            |
|              |                                                                                                            |              |
| Item 1.           | Financial Statements  (Unaudited)                                                                               |              |
|              |                                                                                                            |              |
|              | Condensed Consolidated Balance Sheets — March 31,  2009 and September 30,  2008                  | 1                 |
|              |                                                                                                            |              |
|              | Condensed Consolidated Statements of Operations — Three and Six Months Ended  March 31, 2009 and 2008 | 2                 |
|              |                                                                                                            |              |
|              | Condensed Consolidated Statements of Cash Flows — Six Months Ended March 31,  2009 and 2008           | 3                 |
|              |                                                                                                            |              |
|              | Notes to Condensed Consolidated Financial Statements                                                            | 4 – 12       |
|              |                                                                                                            |              |
| Item 2.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                     | 13 – 19      |
|              |                                                                                                            |              |
| Item 3.           | Quantitative  and Qualitative Disclosures about Market Risk                                                     | 19                |
|              |                                                                                                            |              |
| Item 4.           | Controls and  Procedures                                                                                        | 19                |
|              |                                                                                                            |              |
| **PART II.** | **OTHER INFORMATION**                                                                                           |              |
|              |                                                                                                            |              |
| Item 1.           | Legal Proceedings                                                                                               | 20                |
|              |                                                                                                            |              |
| Item 1A           | Risk Factors                                                                                                    | 20                |
|              |                                                                                                            |              |
| Item 2.           | Unregistered  Sales of Equity Securities and use of Proceeds                                                    | 20                |
|              |                                                                                                            |              |
| Item 3.           | Defaults upon  Senior Securities                                                                                | 21                |
|              |                                                                                                            |              |
| Item 4.           | Submission of  Matters to a Vote of Security Holders                                                            | 21                |
|              |                                                                                                            |              |
| Item 5.           | Other Information                                                                                               | 22                |
|              |                                                                                                            |              |
| Item 6.           | Exhibits                                                                                                        | 22                |
|              |                                                                                                            |              |
| **SIGNATURES**    |                                                                                                            | 22                |

 

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**PART I—FINANCIAL INFORMATION**

**Item 1—FinancialStatements**

 

**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                       | ** ** | **March 31, 2009** | ** ** | **September 30,  2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                       | ** ** | ** **                   | ** ** | ** **                   | ** ** |
| Current Assets:                                                                                                                                                                                                                  |       |                         |       |                         |       |
| Cash and cash equivalents                                                                                                                                                                                                        |       | $                            | 37,518,990 |                         | $          | 35,031,932 |   |
| Accounts receivable, net                                                                                                                                                                                                         |       | 5,764,620                    |       | 4,218,443                    |       |
| Inventories                                                                                                                                                                                                                      |       | 5,945,812                    |       | 9,361,257                    |       |
| Deferred income taxes                                                                                                                                                                                                            |       | 301,841                      |       | 414,636                      |       |
| Prepaid expenses and other current assets                                                                                                                                                                                        |       | 1,277,542                    |       | 1,406,260                    |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Total current assets                                                                                                                                                                                                             |       | 50,808,805                   |       | 50,432,528                   |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Property and equipment, net                                                                                                                                                                                                      |       | 8,681,807                    |       | 8,958,346                    |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Other assets                                                                                                                                                                                                                     |       | 503,114                      |       | 505,840                      |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Total assets                                                                                                                                                                                                                     |       | $                            | 59,993,726 |                         | $          | 59,896,714 |   |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                                                                   |       |                         |       |                         |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Current Liabilities                                                                                                                                                                                                              |       |                         |       |                         |       |
| Current portion of capitalized lease obligations                                                                                                                                                                                 |       | $                            | 9,908      |                         | $          | 9,908 |   |
| Accounts payable                                                                                                                                                                                                                 |       | 1,638,298                    |       | 2,349,981                    |       |
| Accrued expenses                                                                                                                                                                                                                 |       | 2,805,843                    |       | 5,130,463                    |       |
| Deferred revenue                                                                                                                                                                                                                 |       | 241,509                      |       | 450,923                      |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Total current liabilities                                                                                                                                                                                                        |       | 4,695,558                    |       | 7,941,275                    |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Note payable                                                                                                                                                                                                                     |       | 4,335,000                    |       | 4,335,000                    |       |
| Long-term portion of capitalized lease obligations                                                                                                                                                                               |       | 32,403                       |       | 37,633                       |       |
| Deferred revenue                                                                                                                                                                                                                 |       | 86,844                       |       | 114,075                      |       |
| Deferred income taxes                                                                                                                                                                                                            |       | 301,841                      |       | 414,636                      |       |
| Other liabilities                                                                                                                                                                                                                |       | 294,428                      |       | 249,969                      |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Total liabilities                                                                                                                                                                                                                |       | 9,746,074                    |       | 13,092,588                   |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| 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 March 31, 2009 and September 30,  2008 |       | —                       |       | —                       |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Common stock, $.001 par value: 75,000,000 shares authorized,  18,188,719 and 18,177,024 shares issued at March 31, 2009 and  September 30, 2008, respectively                                                          |       | 18,189                       |       | 18,177                       |       |
| Additional paid-in capital                                                                                                                                                                                                       |       | 46,148,808                   |       | 45,767,960                   |       |
| Retained earnings                                                                                                                                                                                                                |       | 23,323,531                   |       | 20,152,615                   |       |
| Treasury stock, at cost, 1,470,510 and 1,445,510 shares at  March 31, 2009 and September 30, 2008, respectively                                                                                                        |       | (19,242,876                  | )          | (19,134,626                  | )          |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Total shareholders’ equity                                                                                                                                                                                                  |       | 50,247,652                   |       | 46,804,126                   |       |
|                                                                                                                                                                                                                             |       |                         |       |                         |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                                  |       | $                            | 59,993,726 |                         | $          | 59,896,714 |   |

 

The accompanying notesare an integral part of these statements.

 

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**INNOVATIVE SOLUTIONS AND SUPPORT,INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**(unaudited)**

 
| ** **                                 | ** ** | **Three months ended March 31,** | ** ** | **Six months ended March 31,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                 | ** ** | **2009**                                             | ** ** | **2008**                                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net sales:                                 |       |                                                 |       |                                               |       |   |   |   |   |
| Product                                    |       | $                                                    | 9,365,306  |                                               | $          | 6,212,973 |   | $ | 18,254,424 |   | $ | 10,112,761 |   |
| Engineering - modification and development |       | 1,100,420                                            |       | 611,387                                            |       | 2,786,648 |   | 1,447,246 |   |
| Total net sales                            |       | 10,465,726                                           |       | 6,824,360                                          |       | 21,041,072 |   | 11,560,007 |   |
| Cost of sales:                             |       |                                                 |       |                                               |       |   |   |   |   |
| Product                                    |       | 4,915,652                                            |       | 3,710,982                                          |       | 9,910,746 |   | 6,481,081 |   |
| Engineering - modification and development |       | 301,961                                              |       | 79,679                                             |       | 562,040 |   | 968,639 |   |
| Total cost of sales                        |       | 5,217,613                                            |       | 3,790,661                                          |       | 10,472,786 |   | 7,449,720 |   |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Gross profit                               |       | 5,248,113                                            |       | 3,033,699                                          |       | 10,568,286 |   | 4,110,287 |   |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Operating expenses:                        |       |                                                 |       |                                               |       |   |   |   |   |
| Research and development                   |       | 1,610,687                                            |       | 2,776,576                                          |       | 2,891,188 |   | 4,517,244 |   |
| Selling, general and administrative        |       | 2,272,080                                            |       | 4,734,446                                          |       | 4,631,387 |   | 10,670,352 |   |
| Total operating expenses                   |       | 3,882,767                                            |       | 7,511,022                                          |       | 7,522,575 |   | 15,187,596 |   |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Operating income (loss)                    |       | 1,365,346                                            |       | (4,477,323                                         | )          | 3,045,711 |   | (11,077,309 | ) |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Interest income                            |       | 97,227                                               |       | 441,779                                            |       | 298,313 |   | 1,031,140 |   |
| Interest expense                           |       | (19,241                                              | )          | (38,580                                            | )          | (54,715 | ) | (89,119 | ) |
| Other income                               |       | —                                               |       | 300,000                                            |       | 50,073 |   | 300,000 |   |
| Income (loss) before income taxes          |       | 1,443,332                                            |       | (3,774,124                                         | )          | 3,339,382 |   | (9,835,288 | ) |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Income tax expense                         |       | 95,802                                               |       | 3,286,033                                          |       | 168,466 |   | 1,346,810 |   |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Net income (loss)                          |       | $                                                    | 1,347,530  |                                               | $          | (7,060,157 | ) | $ | 3,170,916 |   | $ | (11,182,098 | ) |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Net income (loss) per common share:        |       |                                                 |       |                                               |       |   |   |   |   |
| Basic                                      |       | $                                                    | 0.08       |                                               | $          | (0.42 | ) | $ | 0.19 |   | $ | (0.66 | ) |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Diluted                                    |       | $                                                    | 0.08       |                                               | $          | (0.42 | ) | $ | 0.19 |   | $ | (0.66 | ) |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Weighted average shares outstanding:       |       |                                                 |       |                                               |       |   |   |   |   |
| Basic                                      |       | 16,718,209                                           |       | 16,890,942                                         |       | 16,718,209 |   | 16,895,720 |   |
|                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Diluted                                    |       | 16,718,215                                           |       | 16,890,942                                         |       | 16,735,645 |   | 16,895,720 |   |

 

The accompanyingnotes are an integral part of these statements.

 

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**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**

 
| ** **                                                                                          | ** ** | **For the Six Months Ended March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2009**                                                             | ** ** | **2008** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                           |       |                                                                 |       |   |   |
| Net income (loss)                                                                                   |       | $                                                                    | 3,170,916  |   | $ | (11,182,098 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by  (used in) operating activities: |       |                                                                 |       |   |   |
| Depreciation and amortization                                                                       |       | 521,097                                                              |       | 504,594 |   |
| Share-based compensation expense:                                                                   |       |                                                                 |       |   |   |
| Stock options                                                                                       |       | 277,026                                                              |       | 459,417 |   |
| Nonvested stock awards                                                                              |       | 100,099                                                              |       | 99,974 |   |
| Tax benefit from share-based arrangements:                                                          |       |                                                                 |       |   |   |
| Stock options                                                                                       |       | —                                                               |       | 11,999 |   |
| Nonvested stock awards                                                                              |       | 3,735                                                                |       | 6,286 |   |
| (Gain) loss on disposal of property and equipment                                                   |       | 260                                                                  |       | (3,000 | ) |
| Excess and obsolete inventory expense                                                               |       | 603,916                                                              |       | — |   |
| Deferred income taxes                                                                               |       | —                                                               |       | 1,227,955 |   |
| (Increase) decrease in:                                                                             |       |                                                                 |       |   |   |
| Accounts receivable                                                                                 |       | (1,546,177                                                           | )          | 1,513,561 |   |
| Inventories                                                                                         |       | 2,811,529                                                            |       | (549,424 | ) |
| Prepaid expenses and other current assets                                                           |       | 127,708                                                              |       | 5,144,476 |   |
| Other non current assets                                                                            |       | (80,534                                                              | )          | (6,180 | ) |
| Increase (decrease) in:                                                                             |       |                                                                 |       |   |   |
| Accounts payable                                                                                    |       | (711,683                                                             | )          | (1,213,095 | ) |
| Accrued expenses                                                                                    |       | (1,759,631                                                           | )          | (627,730 | ) |
| Income taxes payable                                                                                |       | (519,521                                                             | )          | — |   |
| Deferred revenue                                                                                    |       | (236,645                                                             | )          | (295,616 | ) |
| Net cash provided by (used in) operating activities                                                 |       | 2,762,095                                                            |       | (4,908,881 | ) |
|                                                                                                |       |                                                                 |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                           |       |                                                                 |       |   |   |
| Purchases of property and equipment                                                                 |       | (161,557                                                             | )          | (428,248 | ) |
| Proceeds on sale of property and equipment                                                          |       | —                                                               |       | 3,000 |   |
| Net cash used in investing activities                                                               |       | (161,557                                                             | )          | (425,248 | ) |
|                                                                                                |       |                                                                 |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                           |       |                                                                 |       |   |   |
| Proceeds from exercise of stock options                                                             |       | —                                                               |       | 39,379 |   |
| Purchase of treasury shares                                                                         |       | (108,250                                                             | )          | (57,178 | ) |
| Repayment of capitalized lease obligations                                                          |       | (5,230                                                               | )          | (4,872 | ) |
| Net cash (used in) provided by financing activities                                                 |       | (113,480                                                             | )          | (22,671 | ) |
|                                                                                                |       |                                                                 |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                                |       | 2,487,058                                                            |       | (5,356,800 | ) |
| Cash and cash equivalents, beginning of period                                                      |       | 35,031,932                                                           |       | 49,151,078 |   |
|                                                                                                |       |                                                                 |       |   |   |
| Cash and cash equivalents, end of period                                                            |       | $                                                                    | 37,518,990 |   | $ | 43,794,278 |   |
|                                                                                                |       |                                                                 |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION**                                                |       |                                                                 |       |   |   |
| Cash paid for interest                                                                              |       | $                                                                    | 34,700     |   | $ | 69,005 |   |
| Cash paid for income tax                                                                            |       | $                                                                    | 704,486    |   | $ | 6,000 |   |
| Cash received from income tax refunds                                                               |       | $                                                                    | 25,115     |   | $ | 5,078,928 |   |

 

The accompanyingnotes are an integral part of these statements.

 

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**Innovative Solutions and SupportInc.Notes to Condensed Consolidated Financial Statements**

**(Unaudited)**

 

**1.****Summary of SignificantAccounting Policies**

 

***Descriptionof the Company***

 

Innovative Solutions andSupport, Inc. (the “Company”) was incorporated in Pennsylvania on February 12,1988. The Company’s primary business is the design, manufacture and sale offlat panel display systems, flight information computers and advancedmonitoring systems for military, government, commercial air transport andcorporate aviation markets.

 

***Basisof Presentation***

 

The accompanyingunaudited condensed consolidated financial statements are presented pursuant tothe rules and regulations of the United States Securities and ExchangeCommission in accordance with the disclosure requirements for the quarterlyreport on Form 10-Q and therefore do not include all of the informationand footnotes required by generally accepted accounting principles for completeannual financial statements. In the opinion of Company management, theunaudited condensed consolidated financial statements reflect all adjustments(consisting of normal recurring adjustments) necessary to fairly state theresults for the interim periods presented. The condensed consolidated balancesheet as of September 30, 2008 is derived from audited financialstatements. Operating results for the three and six months ended March 31,2009 are not necessarily indicative of the results that may be expected for thefiscal year ending September 30, 2009. These unaudited condensedconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements and notes of the Company included inthe Company’s Annual Report on Form 10-K/A for the fiscal year ended September 30,2008.

 

Our condensedconsolidated financial statements include the accounts of our wholly-ownedsubsidiaries. All intercompany balances and transactions have been eliminatedin consolidation.

 

***Use of Estimates***

 

Preparation of consolidated financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect reportedamounts of assets and liabilities, and disclosure of contingent assets andliabilities, as of the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ materially from those estimates.

 

***Cash and Cash Equivalents***

 

Highly liquid investments purchased with an original maturity of threemonths or less are classified as cash equivalents. Cash equivalents at March 31,2009 and December 31, 2008 consist of funds invested in money market accountswith financial institutions.

 

***Property and Equipment***

 

Property and equipment is stated at cost. Depreciation is providedusing an accelerated method over estimated useful lives of the assets (thelesser of three to seven years or over the lease term), except for the airplaneand manufacturing facility, which are depreciated using the straight-linemethod over estimated useful lives of ten years and thirty-nine years,respectively. Major additions and improvements are capitalized, whilemaintenance and repairs that do not improve or extend the life of assets arecharged to expense as incurred.

 

***Long-Lived Assets***

 

The Company assesses the impairment of long-lived assets in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*(“SFAS No. 144”)*.*This statement requires that long-lived assets be reviewed for impairmentwhenever events or changes in circumstances indicate the carrying amount of anasset may not be recoverable. Also, in general, long-lived assets to bedisposed of should be reported at the lower of the carrying amount or fairvalue less cost to sell. The Company considers historical performance andfuture estimated results in its evaluation of potential impairment and thencompares the carrying amount of the asset to estimated future cash flowsexpected to result from use of 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 six months ended March 31,2009 or 2008.

 

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*** ***

***Revenue Recognition***

 

The Company enters intosales arrangements with customers that, in general, provide for theCompany  to design, develop, manufacture  and deliver flightinformation computers, large flat-panel displays, and advanced monitoringsystems that measure and display critical flight information, including datarelative to aircraft separation, airspeed, and altitude, as well as engine andfuel data measurements.  The Company’s sales arrangements may includemultiple deliverables as defined in Emerging Issues Task Force (“EITF”) Issue No. 00-21,*Revenue Arrangements with Multiple Deliverables*(“EITF00-21”), which typically include design and engineering services and theproduction and delivery of the flat panel display and related components.

 

Multiple ElementArrangements -

 

The Company identifiesall goods and/or services that are to be delivered separately under such asales arrangement and allocates revenue to each deliverable (if more than one)based on that deliverable’s fair value.  The Company then considers theappropriate recognition method for each deliverable; deliverables undermultiple element arrangements are typically purchased engineering and designservices and product sales.  To theextent that an arrangement contains defined design and development activitiesas an identified deliverable in addition to products (resulting in a multipleelement arrangement), the Company recognizes as Engineering — Modification andDevelopment (“EMD”) Revenue amounts earned during the design and developmentphase of the contract following the guidance included in the American Instituteof Certified Public Accountants (“AICPA”) Statement of Position 81-1, *Accounting for Performance of Construction-Type and CertainProduction-Type Contracts* (“SOP 81-1”). To the extent thatmultiple element arrangements include product sales, revenue is generallyrecognized once revenue recognition criteria for the product deliverable hasbeen met based on the provisions of Staff Accounting Bulletin No. 104, *Revenue Recognition* (“SAB 104”).

 

Single ElementArrangements —

 

*Products-*

 

To the extent that asingle element arrangement provides for product sales and repairs, revenue isgenerally recognized once revenue recognition criteria for the productdeliverable has been met based on the provisions of SAB 104.  The Companyalso receives orders for existing equipment and parts.  Revenue from thesale of such products is generally recognized upon shipment to the customer.

 

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

 

  *Engineering Services -*

 

The Company also mayenter into service arrangements to perform specified design and developmentservices related to its products.  The Company recognizes revenue from thesearrangements as Engineering — modification and development revenue, followingthe guidance included in SOP 81-1. The Company considers the nature of theseservice arrangements (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.

 

The Company recordsrevenue relating to these contracts using the percentage-of-completion methodwhen the Company determines that progress toward completion is reasonable andreliably estimable and the contract is long-term in nature; the Company usesthe completed contract method for all others.

 

***Warranty***

 

Estimated cost to repair or replace products under warranty is providedwhen sales of product are recorded.

 

***Income Taxes***

 

Income taxes are recordedin accordance with SFAS No. 109,*Accounting for IncomeTaxes* (“SFAS 109”), which principally utilizes a balance sheetapproach to provide for income taxes. Under this method, the Company recognizes deferred tax assets andliabilities for temporary differences between the financial reporting basis andthe tax basis of the Company’s assets and liabilities. The impact on deferredtaxes of changes in tax rates and laws, if any, applied to the years duringwhich temporary differences are expected to be settled, are reflected in theconsolidated financial statements in the period of enactment. A valuation allowanceis established when it is more likely than not that all or a portion of adeferred tax asset will not be realized. The Company files a consolidated United States federal income tax return(see Note 3).

 

Effective October 1,2007 (the first day of fiscal 2008), the Company adopted Financial AccountingStandards Board (“FASB”) Interpretation No. 48, *Accounting for Uncertainty in Income Taxes* (“FIN 48”).  FIN 48 prescribes a comprehensive model forhow a company should recognize, measure, present and disclose in its financialstatements uncertain tax positions that the company has taken

 

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or expects to takeon a tax return. The Company has elected to record any interest or penaltiesfrom the uncertain tax position as income tax expense.

 

***Research and Development***

 

Research and development charges incurred for product design, productenhancements and future product development are expensed as incurred. Productdevelopment and design charges incurred related to a specific customeragreement that are billable are capitalized and then charged to cost of sales —engineering modification and development as the revenue related to theagreements are recognized.

 

***Comprehensive Income***

 

Pursuant to SFAS No. 130, *Reporting ComprehensiveIncome,* the Company is required to classify items of othercomprehensive income by their nature in a financial statement and display theaccumulated balance of other comprehensive income separately from retainedearnings and additional paid-in capital in the equity section of our condensedconsolidated balance sheets.  Through March 31,2009, 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***

 

The Company adopted SFAS No. 157,*Fair Value Measurements*(“SFAS 157”) inthe first quarter of fiscal 2009 for financial assets and liabilities. Thisstandard defines fair value as the price at which an asset could be exchangedin a current transaction between knowledgeable, willing parties. A liability’sfair value is defined as the amount that would be paid to transfer theliability to a new obligor, not the amount that would be paid to settle theliability with the creditor.

 

Assets and liabilitiesmeasured at fair value are categorized based upon the level of judgmentassociated with the inputs used to measure their fair value. Hierarchical levels,defined by SFAS 157 and directly related to the amount of subjectivityassociated with the inputs to fair valuation of these assets and liabilities,are as follows:

 

Level 1 — Unadjusted quoted prices that are availablein active markets for the identical assets or liabilities at the measurementdate.

 

Level 2 — Other observable inputs available at themeasurement date, other than quoted prices included in Level 1, either directlyor indirectly, including:

 

·                  Quoted prices for similar assets or liabilities inactive markets;

 

·                  Quoted prices for identical or similar assets innon-active markets;

 

·                  Inputs other than quoted prices that are observablefor the asset or liability; and

 

·                  Inputs that are derived principally from orcorroborated by other observable market data.

 

Level 3 — Unobservableinputs that cannot be corroborated by observable market data and reflect theuse of significant management judgment.  These values are generallydetermined using pricing models for which the assumptions utilize management’sestimates of market participant assumptions.

 

The following table setsforth by level within the fair value hierarchy the Company’s financial assetsand liabilities that were accounted for at fair value on a recurring basis asof March 31, 2009, according to the valuation techniques the Company usedto determine their fair values.

 
| ** **                 | ** ** | **Fair Value Measurements on March 31, 2009** | ** ** |
|----------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **Quoted Prices in**                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Active**                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Markets**                                                                 | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                 | ** ** | **for Identical**                                                      | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                 | ** ** | **Assets**                                                                  | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                 | ** ** | **(Level 1)**                                                               | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets                     |       |                                                                        |       |   |   |   |   |
| Cash and cash equivalents: |       |                                                                        |       |   |   |   |   |
| Money market funds         |       | $                                                                           | 34,719,423 |   | $ | — |   | $ | — |   |
|                            |            |                                                                             |            |  |  |  |  |  |  |  |

 

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***Stock-Based Compensation***

 

We account forstock-based compensation under SFAS No. 123 (revised 2004), *Share-Based Payment*(“SFAS 123(R)”).SFAS 123(R) requires us to measure the cost of employee servicesreceived in exchange for an award of equity instruments based on the grant-datefair value of the award using an option pricing model. That cost is recognizedover the period during which an employee is required to provide service inexchange for the award.

 

***Concentrations***

 

*MajorCustomers and Products*

 

For the three monthsended March 31, 2009, two of our customers, American Airlines and theUnited States Department of Defense accounted for 34% and 11% of net sales,respectively. During the six months ended March 31, 2009, two of ourcustomers, American Airlines and Boeing accounted for 32% and 10% of net sales,respectively.

 

For the three and sixmonths ended March 31, 2008, Eclipse Aviation Corp. (“Eclipse”) accountedfor 49% and 58% of net sales, respectively.

 

*MajorSuppliers*

 

The Company currently buys several of its components from single sourcesuppliers. Although there are a limited number of manufacturers of particularcomponents, management believes other suppliers could provide similarcomponents on comparable terms.

 

During the three and six months ended March31, 2009 one supplier, ABX Air Inc., Accounted for 37% and 31% of our totalinventory related purchases, respectively.

 

*Concentrationof Credit Risk*

 

Financial instruments that potentially subject the Company toconcentration of credit risk consist principally of cash balances and accountsreceivable. The Company invests its excess cash where preservation of principalis the major consideration. The Company’s customer base principally consists ofcompanies within the aviation industry. The Company routinely requests advancepayments from new customers.

 

The Company has maintained a reserve for doubtful accounts in theamount of $0 and $4.1 million, as of March 31, 2009 and September 30,2008, respectively. The large balance in the reserve for doubtful accounts at September 30,2008 was directly related to accounts receivable from Eclipse, a customer thatfiled for bankruptcy under Chapter 11 subsequent to the Company’s fiscal yearend.  During the three months ended December 31,2008 the Company wrote off the entire Eclipse receivable against the previouslyestablished reserve.

 

***Recent Accounting Pronouncements***

 

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles and expandsdisclosures about fair value measurements. This statement does not require anynew fair value measurements; however, the application of this Statement maychange current practice for some entities. SFAS 157 is effective for fiscalyears beginning after November 15, 2007. The adoption did not have amaterial impact on the Company’s financial statements.

 

In February 2008,the FASB issued FASB Staff Position (“FSP”) 157-2, *EffectiveDate of FASB Statement No. 157* which delays the effective dateof SFAS 157 for nonfinancial assets and nonfinancial liabilities, except thosethat are recognized or disclosed at fair value on a recurring basis, at leastannually, until fiscal years beginning after November 15, 2008, andinterim periods within those fiscal years. The Company does not expect the adoption to have any impact on theCompany’s financial statements.

 

In December 2007,the FASB issued SFAS 160, *Noncontrolling Interestsin Consolidated Financial Statements—Amendment of ARB No. 51* (“SFAS160”)*.* SFAS 160 establishes accounting andreporting standards for ownership interests in subsidiaries held by partiesother than the parent, changes in a parent’s ownership of a noncontrollinginterest, calculation and disclosure of the consolidated net incomeattributable to the parent and the noncontrolling interest, changes in a parent’sownership interest while the parent retains its controlling financial interestand fair value measurement of any retained noncontrolling equity investment.SFAS 160 is effective for financial statements issued for fiscal yearsbeginning after December 15, 2008 (the Company’s fiscal year 2010). TheCompany does not expect the adoption to have any impact on its financialstatements.

 

In May 2008, theFASB issued SFAS 162, *The Hierarchy of GenerallyAccepted Accounting Principles*(“SFAS 162”)*.*This statement identifies the sources of accounting principles and theframework for selecting the principles to be used in the preparation offinancial statements of nongovernmental entities that are presented inconformity with generally accepted accounting principles in the United States.This statement was effective on November 15, 2008.

 

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In June 2008, theFASB issued FASB Staff Position EITF 03-6-1, *DeterminingWhether Instruments Granted in Share-Based Payment Transactions areParticipating Securities* (“FSP EITF 03-6-1”). FSP EITF 03-6-1requires that unvested stock-based compensation awards that containnon-forfeitable rights to dividends or dividend equivalents (whether paid orunpaid) should be classified as participating securities and should be includedin the computation of earnings per share pursuant to the class method asdescribed by SFAS 128, “Earnings per Share.” FSP EITF 03-6-1 is effective forfinancial statements issued for fiscal years beginning on or after December 15,2008 and earlier adoption is prohibited. The Company will adopt FSP EITF 03-6-1on October 1, 2010. The Company does not expect the adoption to have amaterial impact on the Company’s financial statements.

 

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

 

***Inventories***

 

Inventories are stated atthe lower of cost (first-in, first-out) or market, net of reserve for excessand obsolete, and consist of the following:

** **
| ** **      | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|-----------------|------------|--------------------|------------|------------------------|------------|
| ** **      | ** ** | **2009**           | ** ** | **2008**               | ** ** |
|            |       |               |       |                   |       |
| Raw materials   |       | $                  | 3,389,685  |                   | $          | 4,705,134 |   |
| Work-in-process |       | 1,245,094          |       | 3,046,451              |       |
| Finished goods  |       | 1,311,033          |       | 1,609,672              |       |
|            |       | $                  | 5,945,812  |                   | $          | 9,361,257 |   |

 

***Prepaid expenses and other currentassets***

 

Prepaid expenses andother current assets consist of the following:

 
| ** **                          | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2009**           | ** ** | **2008**               | ** ** |
|                                |       |               |       |                   |       |
| Revenue recognized not yet invoiced |       | $                  | 727,338    |                   | $          | 747,789 |   |
| Prepaid Insurance                   |       | 221,366            |       | 248,799                |       |
| Deferred Engineering costs          |       | 76,555             |       | —                 |       |
| Other                               |       | 252,283            |       | 409,672                |       |
|                                |       | $                  | 1,277,542  |                   | $          | 1,406,260 |   |

 

***Property and equipment***

 

Property and equipment,net consists of the following balances:

 
| ** **                                      | ** ** | **March 31, 2009** | ** ** | **September 30,  2008** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                      | ** ** | ** **                   | ** ** | ** **                   | ** ** |
| Computers and test equipment                    |       | $                            | 6,027,089  |                         | $          | 5,879,362 |   |
| Corporate airplane                              |       | 3,082,186                    |       | 3,076,400                    |       |
| Furniture and office equipment                  |       | 1,074,029                    |       | 1,074,029                    |       |
| Manufacturing facility                          |       | 5,579,486                    |       | 5,576,536                    |       |
| Land                                            |       | 1,021,245                    |       | 1,021,245                    |       |
|                                            |       | 16,784,035                   |       | 16,627,572                   |       |
| Less- Accumulated depreciation and amortization |       | (8,102,228                   | )          | (7,669,226                   | )          |
|                                            |       |                         |       |                         |       |
|                                            |       | $                            | 8,681,807  |                         | $          | 8,958,346 |   |

 

Depreciation andamortization related to property and equipment was approximately $221,000 and$249,000 for the three months ended March 31, 2009 and 2008, respectively.

 

Depreciation andamortization related to property and equipment was approximately $438,000 and$487,000 for the six months ended March 31, 2009 and 2008, respectively.

 

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***Otherassets***

 

Other assets consist ofthe following:

 
| ** **                                                                                                                                   | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2009**           | ** ** | **2008**               | ** ** |
| Intangible assets, net of accumulated amortization of $173,210 and  $89,950 at March 31, 2009 and September 30, 2008, respectively |       | $                  | 205,790    |                   | $          | 289,050 |   |
| Installation kits                                                                                                                            |       | 118,660            |       | 118,660                |       |
| Other                                                                                                                                        |       | 178,664            |       | 98,130                 |       |
|                                                                                                                                         |       | $                  | 503,114    |                   | $          | 505,840 |   |

 

Intangible assets consist of licensing and certification rights whichare amortized over a defined number of units. No impairment charge was recorded in the six months ended March 31,2009.

 

Total intangible amortization expense was approximately $40,000 and$4,000 for the three months ended March 31, 2009 and 2008, respectively.Total amortization expense for the six months ended March 31, 2009 and2008 was $83,000 and $12,000, respectively. Because the intangible assets arebeing amortized over a defined number of units, the future amortization expenseover the next five years cannot be determined at this time.

 

***Accruedexpenses***

 

Accrued expenses consistof the following:

 
| ** **                             | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                             | ** ** | **2009**           | ** ** | **2008**               | ** ** |
|                                   |       |               |       |                   |       |
| Warranty (a)                           |       | $                  | 706,834    |                   | $          | 736,815 |   |
| Salary, benefits and payroll taxes     |       | 597,475            |       | 904,904                |       |
| Reduction in workforce / Severance (b) |       | 370,472            |       | 904,163                |       |
| Professional fees                      |       | 346,080            |       | 474,730                |       |
| Income taxes payable                   |       | 226,938            |       | 798,801                |       |
| Materials on order                     |       | 203,968            |       | 467,759                |       |
| Other                                  |       | 354,076            |       | 843,291                |       |
|                                   |       | $                  | 2,805,843  |                   | $          | 5,130,463 |   |

 

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(a)          The Companyprovides for the estimated cost of product warranties at the time revenue isrecognized. Warranty cost is recorded as cost of sales and the reserve balancerecorded as an accrued expense in the financial statements. While the Companyengages in extensive product quality programs and processes, the Company’swarranty obligation is affected by product failure rates and the relatedmaterial, labor and delivery costs incurred in correcting a product failure.Should actual product failure rates, material or labor costs differ from theCompany’s estimates, further revisions to the estimated warranty liabilitywould be required.

 
| Warranty cost and accrual information for the three months ended  March 31, 2009 is highlighted below: |   |
|-------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                        |   |   |   |
| Warranty accrual at December 31, 2008                                                                  |   | $ | 703,426 |   |
| Accrued expense for the three months ended March 31, 2009                                              |   | 69,289 |   |
| Warranty costs for the three months ended March 31, 2009                                               |   | (65,881 | ) |
| Warranty accrual at March 31, 2009                                                                     |   | $ | 706,834 |   |
|                                                                                                        |   |   |   |
| Warranty cost and accrual information for the six months ended  March 31, 2009 is highlighted below:   |   |
|                                                                                                        |   |   |   |
| Warranty accrual at September 30, 2008                                                                 |   | $ | 736,815 |   |
| Accrued expense for the six months ended March 31, 2009                                                |   | 147,299 |   |
| Warranty costs for the six months ended March 31, 2009                                                 |   | (177,280 | ) |
| Warranty accrual at March 31, 2009                                                                     |   | $ | 706,834 |   |
|                                                                                                             |        |  |  |  |  |  |

 

(b)         The amountincluded in Reduction in workforce / Severance as of March 31, 2009 isseverance relating to the former Chief Executive Officer which is payable underthe terms of the Release Agreement dated November 10, 2008.

 

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***Notespayable***

 

The Company entered into a $4,335,000 loan agreement dated August 1,2000 with the Chester County, Pennsylvania Industrial Development Authority.The purpose of the loan was to fund the construction of the Company’s newoffice and manufacturing facility. The loan matures in 2015 and carries aninterest rate set by the remarketing agent that is consistent with 30-daytax-exempt commercial paper. The loan agreement includes an optional redemptionschedule allowing the Company the option of forgoing any principal pay-downuntil such time the bonds expire in 2015. The Company has exercised its option notto pay-down the outstanding balance and accordingly, the balance of the notespayable will be due in 2015.

 

Effective November 30, 2007 the loan covenants require the Companyto maintain at all times unencumbered cash and marketable securities having amarket value of at least $20.0 million and a minimum tangible net worth of$65.0 million.  The lender, however,agreed on January 10, 2008 to discontinue the tangible net worth covenantso that the only remaining requirement is that the Company maintain at alltimes unencumbered cash and marketable securities having a value of at least$20.0 million.

 

The interest cost related to this debt for three months ended March 31,2009 and 2008 was $9,000 and $28,000, respectively. The interest cost relatedto this debt for six months ended March 31, 2009 and 2008 was $33,000 and$67,000 respectively. The interest rate on this debt was 0.8% at March 31,2009. The Company is also required to maintain a letter of credit in the amountof $4.4 million covering the debt.

 

**3.Income Taxes**

 

The income tax expense for the three and six monthsended March 31, 2009 was $96,000 and $168,000, respectively, as comparedto $3.3 million and $1.3 million for the three and six months ended March 31,2008. The decrease in the income tax expense is primarily due to theestablishment of a full valuation allowance on net deferred tax assets as ofthe period ended March 31, 2008. The establishment of the allowance as of March 31, 2008 caused theCompany to recognize income tax expense for the three months ended March 31,2008 relating to net deferred tax assets that are not likely to berealized.  The Company continues tomaintain a full valuation allowance as of the period ended March 31, 2009on its net deferred tax assets. In accordance with FAS 109 the Company willcontinue to evaluate the need for a full or partial valuation allowance on aquarterly basis.

 

The effective tax rates for the three months ended March 31,2009 and 2008 were 7% and (87%), respectively. The effective tax rate differs from the statutory rate for the threemonths ended March 31, 2009 due to: 1) the reversal of certain deductible temporary differences which at September 30,2008 were offset by a valuation allowance; such items will be deductible forincome tax purposes in the current fiscal year based on forecasted earnings,and 2) the utilization of research and experimentation tax credits. Theeffective tax rate differs from the statutory rate for the three months ended March 31,2008 due to the establishment of a full valuation allowance on net deferred taxassets during that quarter.

 

The effective tax rates for the six months ended March 31,2009 and 2008 were 5% and (14%), respectively. The effective tax rate differs from the statutory rate for the six monthsended March 31, 2009 due to:  1) thereversal of certain deductible temporary differences which at September 30,2008 were offset by a valuation allowance; such items will be deductible forincome tax purposes in the current fiscal year based on forecasted earnings,and 2) the utilization of research and experimentation tax credits.  The effective tax rate differs from thestatutory rate for the six months ended March 31, 2008 due to theestablishment of a full valuation allowance on net deferred tax assets duringthe quarter ended March 31, 2008.

 

**4. Capital Stock**

 

At March 31, 2009,our Articles of Incorporation provide us the authority to issue 75,000,000shares of common stock and 10,000,000 shares of blank check preferred stock.

 

***Share-basedcompensation***

 

Effective October 1,2005, the Company adopted the provisions of SFAS No.123(R), using the modifiedprospective approach and now accounts for share-based compensation applying thefair value method for expensing stock options and non-vested stock awards.

 

Total share-basedcompensation expense was $183,000 and $380,000 for the three months ended March 31,2009 and 2008, respectively. The tax impact for the three months ended March 31,2009 and 2008 was a decrease in excess tax benefits, which are recorded topaid-in capital, of $13,000 and $0, respectively.

 

Total share-basedcompensation expense was $377,000 and $559,000 for the six months ended March 31,2009 and 2008, respectively. The excess tax benefits recorded in additionalpaid-in capital for share-based compensation arrangements were $3,000 and $6,000for the six months ended March 31, 2009 and 2008, respectively.Compensation expense related to share-based awards is

 

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recorded as a componentof general and administrative expense.

 

The Company maintains the1998 Stock Option Plan (the “1998 Plan”) and the 2003 Restricted Stock Plan(the “Restricted Plan”). These plans were approved by the Company’sshareholders. The 1998 Plan expired on November 13, 2008 and no additionalshares may be granted under the Plan after that date.   In addition, at the Annual Meeting ofShareholders of Innovative Solutions and Support, Inc. held on March 12,2009, the shareholders of the Company approved the Company’s 2009 Stock-BasedIncentive Compensation Plan (the “2009 Plan”).

 

***Stockoptions***

 

The 1998 Plan providesfor the granting of incentive and nonqualified stock options to employees,officers, directors, and independent contractors and consultants. Through March 31,2009, no stock options have been granted to independent contractors orconsultants under this Plan.  Totalcompensation expense was $133,000 and $330,000 for the three months ended March 31,2009 and 2008, respectively. Total compensation expense was $277,000 and$459,000 for the six months ended March 31, 2009 and 2008, respectively.

 

Total compensationexpense under the Restricted Plan was $50,000 for both the three months ended March 31,2009 and 2008, respectively. Total compensation expense was $100,000 for boththe six months ended March 31, 2009 and 2008, respectively. The expenserelates to shares that are issued to non-employee members of the Board ofDirectors on a quarterly basis as part of their compensation.

 

Incentive stock optionsgranted under the 1998 Plan have exercise prices that must be at least equal tothe fair value of the common stock on the date of grant. Nonqualified stockoptions granted under the 1998 Plan have exercise prices that may be less than,equal to or greater than the fair value of the common stock on the date ofgrant. The Company had reserved 3,389,000 shares of Common Stock for awardsunder the plan.

 

Incentive stock optionsgranted under the 2009 Plan have exercise prices that must be at least equal tothe fair value of the common stock on the date of grant. Nonqualified stockoptions granted under the 2009 Plan have exercise prices that may be less than,equal to or greater than the fair value of the common stock on the date ofgrant. The Company has reserved 1,200,000 shares of Common Stock for awardsunder the plan. The 2009 Plan expires on March 12, 2019.

 

***2009Stock-Based Incentive Compensation Plan***

 

The 2009 Plan authorizesthe grant of Stock Appreciation Rights, Restricted Stock, Options and otherequity-based awards under the 2009 Plan (collectively referred to as “Awards”).Options granted under the 2009 Plan may be either incentive stock ornonqualified stock options, as determined by the Compensation Committee of theCompany’s Board of Directors (the “Committee”).

 

Subject to an adjustmentnecessary upon a stock dividend, recapitalization, forward split or reversesplit, reorganization, merger, consolidation, spin-off, combination, repurchaseor share exchange, extraordinary or unusual cash distribution or other similarcorporate transaction or event, the maximum number of shares of common stockavailable for awards under the 2009 Plan are 1,200,000, all of which may beissued pursuant to awards of incentive stock options. In addition, the Planprovides that no more than 300,000 shares may be awarded to any employee as aperformance-based award under Section 162(m) of the Internal RevenueCode.

 

The 2009 Plan will terminateon the tenth anniversary of the 2009 Plan’s adoption by the Board, unlessearlier terminated by the Board. Termination will not affect awards outstandingat the time of termination. The Board may amend, alter, suspend, discontinue orterminate the 2009 Plan without shareholder approval, provided that shareholderapproval is required for any amendment which (i) would increase the numberof shares subject to the 2009 Plan; (ii) would decrease the price at whichAwards may be granted, or (iii) would require shareholder approval by law,regulation, or the rules of any stock exchange or automated quotationsystem.

 

No options were grantedunder the 2009 Plan during the six months ended March 31, 2009.

 

***Stockrepurchase program***

 

On February 21, 2008, the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of ouroutstanding common stock. Purchases of the stock were to be made from time totime, subject to market conditions and at prevailing market prices. There wereno shares purchased under this plan during the six months ended March 31,2009. The program expired on February 21, 2009.

 

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On February 22, 2009 the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of ouroutstanding common stock. Under the repurchase program, the Company maypurchase shares of its common stock through open market transactions or inprivately negotiated block purchases or other private transactions (eithersolicited or unsolicited). The timing and amount of repurchase transactionsunder this program will depend on market conditions and corporate andregulatory considerations. The plan will expire on February 22, 2010,unless extended by the Board of Directors; however, the program may bediscontinued or suspended at any time. During the three months ended March 31,2009 we purchased 25,000 shares of common stock under the program at a cost of$108,250, or an average market price of $4.33 per share. We financed thesepurchases through our available cash. The following table sets forth the purchases made under this new planfor each month of the three months ended March 31, 2009:

 

| **Period**         | ** ** | **Total  Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum  Number of  Shares that May  Yet Be  Purchased  Under the  Program** | ** ** |
|--------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
|               |       |                                         |       |                                         |       |                                                                                                                             |       |                                                                                                    |       |
| January 2009  |       |                                         |       |                                         |       |                                                                                                                             |       |                                                                                                    | (a)        |
|               |       |                                         |       |                                         |       |                                                                                                                             |       |                                                                                                    |       |
| February 2009 |       | —                                       |       |                                         |       | —                                                                                                                           |       | 1,000,000                                                                                               |       |
|               |       |                                         |       |                                         |       |                                                                                                                             |       |                                                                                                    |       |
| March 2009    |       | 25,000                                       |       | $                                            | 4.33       |                                                                                                                             | 25,000     |                                                                                                    | 975,000    |   |
|               |       |                                         |       |                                         |       |                                                                                                                             |       |                                                                                                    |       |
|               |       | 25,000                                       |       |                                         |       | 25,000                                                                                                                           |       |                                                                                                    |       |
|                    |            |                                              |            |                                              |            |                                                                                                                                  |            |                                                                                                         |            |  |

 

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| (a) The plan was not approved until February 2009. |
|----------------------------------------------------|

 

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

 

Income (loss) per share (“EPS”)is calculated using the principles of SFAS No. 128, *Earnings PerShare.*

 

For the three and sixmonth periods ended March 31, 2009, there were 638,000 and 438,000 optionsto purchase common stock outstanding, respectively, excluded from thecomputations of diluted earnings per share as the effect would beanti-dilutive.

 

For both the three andsix month periods ended March 31, 2008, there were 969,000 options topurchase common stock outstanding excluded from the computations of dilutedearnings per share as the effect would be anti-dilutive.

 

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

 

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

 

*This report contains forward looking statementswithin the meaning of Section 21E of the Securities Exchange Act of 1934.We have based these forward looking statements largely on our currentexpectations and projections about future events and trends affecting ourbusiness. In this report, the words “believe,” “may,” “will,” “estimate,” “continue,”“anticipate,” “intend,” “forecast,” “expect,” “plan,” “should,” “is likely” andsimilar expressions, as they relate to our business or our management, areintended to identify forward looking statements, but they are not exclusivemeans of identifying them.*

 

*The forward looking statements in this report areonly predictions and actual events or results may differ materially. Inevaluating such statements, a number of risks, uncertainties and other factorscould cause our actual results, performance, financial condition, cash flows,prospects, and opportunities to differ materially from those expressed in, orimplied by, the forward looking statements. These risks, uncertainties andother factors include the following:*

 

·                  *market acceptance of our flat paneldisplay systems, or COCKPIT/IPTM system or other planned products or productenhancements;*

 

·                  *difficulties in developing andproducing our COCKPIT/IPTM system or other planned products or productenhancements;*

 

·                  *continued market acceptance of ourair data systems and products;*

 

·                  *the availability of governmentfunding;*

 

·                  *our ability to gain regulatoryapproval of our products in a timely manner;*

 

·                  *delays in receiving components fromthird party suppliers;*

 

·                  *the competitive environment;*

 

·                  *the impact of general economictrends on our business;*

 

·                  *the bankruptcy or insolvency of oneor more key customers;*

 

·                  *the deferral or termination ofprograms or contracts for convenience by customers;*

 

·                  *failure to retain key personnel;*

 

·                  *new product offerings fromcompetitors;*

 

·                  *potential future acquisitions;*

 

·                  *protection of intellectual propertyrights;*

 

·                  *our ability to service theinternational market; and*

 

·                  *other factors disclosed from time totime in our filings with the Securities and Exchange Commission.*

 

*Except as expressly required by the federalsecurities laws, we undertake no obligation to publicly update or revise anyforward looking statements, whether as a result of new information, futureevents or otherwise after the date of this report. Our results of operations inany past period should not be considered indicative of the results to beexpected for future periods. Fluctuations in operating results may also resultin fluctuations in the price of our common stock.*

 

*Readers are cautioned not toplace undue reliance on these forward-looking statements, which speak only asof the date of this Form 10-Q. The Company does not undertake anyobligation to publicly release any revisions to these forward-lookingstatements to reflect events, circumstances or changes in expectations afterthe date of this Form 10-Q, or to reflect the occurrence of unanticipatedevents. The forward-looking statements in this document are intended to besubject to the safe harbor protection provided by Sections 27A of theSecurities Act and 21E of the Exchange Act. For a discussion identifying someimportant factors that could cause actual results to vary materially from thoseanticipated in the forward-looking statements, see the Company’s Securities andExchange Commission filings including, but not limited to, the discussions of “RiskFactors” contained in the Company’s Annual Report on Form 10-K for thefiscal year ended September 30, 2008.*

 

*Investors should also be aware that while we do, fromtime to time, communicate with securities analysts, it is against our policy todisclose any material non-public information or other confidential commercialinformation. Accordingly, shareholders should not assume that we agree with anystatement or report issued by any analyst irrespective of the content of thestatement or report. Furthermore, we have a policy against issuing orconfirming financial forecasts or projections issued by others. Thus, to theextent that reports issued by securities analysts contain any projections,forecasts or opinions, such reports are **not**theresponsibility of Innovative Solutions and Support, Inc.*

 

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**Company Overview**

 

Innovative Solutions and Support was founded in 1988. The Companydesigns, develops, manufactures and sells flight information computers, largeflat-panel displays, and advanced monitoring systems that measure and displaycritical flight information, including data relative to aircraft separation,airspeed, altitude as well as engine and fuel data measurements.

 

Our sales are derived from the sale of our products to the retrofitmarket and, to a lesser extent, original equipment manufacturers (“OEMs”). Ourcustomers include the United States Department of Defense (“DoD”) and theircommercial contractors, aircraft operators, aircraft modification centers andvarious OEMs. Although we occasionally sell our products directly to theDoD, we primarily have sold our products to commercial customers for end use inDoD programs. Sales to defense contractors are on commercial terms, althoughsome of the termination and other provisions of government contracts areapplicable to these contracts.

 

Our cost of sales related to product sales is comprised of materialcomponents purchased through our supplier base and direct in-house assemblylabor and overhead costs. Many of the components we use in assembling ourproducts are standard, although certain parts are manufactured to meet ourspecifications. The overhead portion of cost of sales is primarily comprised ofsalaries and benefits, building occupancy, supplies, and outside service costsrelated to our production, purchasing, material control and qualitydepartments, and warranty costs.

 

Our cost of sales related to Engineering—modification and development (“EMD”)is comprised of engineering labor, consulting services, and other costassociated with specific design and development projects that are billableunder specific customer agreements.

 

We intend to continue investing in the development of new products thatcomplement our current product offerings and will expense associated researchand development costs as they are incurred.

 

Our selling, general and administrative expenses consist of sales,marketing, business development, professional services, and salaries andbenefits for executive and administrative personnel as well as facility costs,recruiting, legal, accounting, and other general corporate expenses.

 

We sell our products toagencies of the United States and foreign governments, aircraft operators,aircraft modification centers and original equipment manufacturers.  Ourcustomers have been and may continue to be affected by the ongoing adverseeconomic conditions that currently exist both in the United States andabroad.  Such conditions may cause our customers to curtail or delaytheir spending on both new and existing aircraft.  Factors that canimpact general economic conditions and the level of spending by our customersinclude but are not limited to general levels of consumer spending,increases in fuel and energy costs, conditions in the real estate and mortgagemarkets, labor and healthcare costs, access to credit, consumer confidence andother macroeconomic factors affecting spending behavior.  In addition,spending by government agencies may in the future be further reduced due todeclining tax revenues associated with this economic downturn.  If ourcustomers curtail or delay their spending or are forced to declarebankruptcy or liquidate their operations due to continuing adverse economicconditions, our revenues and results of operations will be adverselyaffected.  However, we believe that in a declining economic environment acustomer that may have otherwise elected to purchase newly manufacturedaircraft will instead be interested in retrofitting existing aircraft as a costeffective alternative, which will create a market opportunity for our products.

 

**CriticalAccounting Policies and Estimates**

 

Our discussion andanalysis of our financial condition and consolidated results of operations arebased upon our condensed consolidated financial statements, which have beenprepared in accordance with generally accepted accounting principles in theUnited States. The preparation of our condensed consolidated financialstatements requires us to make estimates and assumptions that affect thereported 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, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources. Ouractual results may differ from these estimates.

 

We believe that ourcritical accounting policies affect our more significant estimates andjudgments used in the preparation of our consolidated financial statements. OurAnnual Report on Form 10-K for the year ended September 30, 2008contains a discussion of these critical accounting policies. There have been nosignificant changes in our critical accounting policies since September 30,2008. See also Note 1 to our unaudited condensed consolidated financialstatements for the three and six month period ended March 31, 2009 as setforth herein.

 

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**RESULTSOF OPERATIONS FOR THE THREE AND SIX MONTHS ENDEDMARCH 31, 2009 AND 2008**

 

The following table setsforth statement of operations data expressed as a percentage of total net salesfor the periods indicated (some items may not add due to rounding):

 
| ** **                                 | ** ** | **Three Months Ending March 31,** | ** ** | **Six Months Ending March 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                 | ** ** | **2009**                               | ** ** | **2008**                             | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net sales:                                 | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product                                    |       | 89.5                                   | %          | 91.0                                 | %          | 86.8 | % | 87.5 | % |
| Engineering - modification and development |       | 10.5                                   | %          | 9.0                                  | %          | 13.2 | % | 12.5 | % |
| Total net sales                            |       | 100.0                                  | %          | 100.0                                | %          | 100.0 | % | 100.0 | % |
|                                       |       |                                   |       |                                 |       |   |   |   |   |
| Cost of sales                              |       |                                   |       |                                 |       |   |   |   |   |
| Product                                    |       | 47.0                                   | %          | 54.4                                 | %          | 47.1 | % | 56.1 | % |
| Engineering - modification and development |       | 2.9                                    | %          | 1.2                                  | %          | 2.7 | % | 8.4 | % |
| Total cost of sales                        |       | 49.9                                   | %          | 55.5                                 | %          | 49.8 | % | 64.4 | % |
|                                       |       |                                   |       |                                 |       |   |   |   |   |
| Gross profit                               |       | 50.1                                   | %          | 44.5                                 | %          | 50.2 | % | 35.6 | % |
|                                       |       |                                   |       |                                 |       |   |   |   |   |
| Operating expenses:                        |       |                                   |       |                                 |       |   |   |   |   |
| Research and development                   |       | 15.4                                   | %          | 40.7                                 | %          | 13.7 | % | 39.1 | % |
| Selling, general and administrative        |       | 21.7                                   | %          | 69.4                                 | %          | 22.0 | % | 92.3 | % |
| Total operating expenses                   |       | 37.1                                   | %          | 110.1                                | %          | 35.8 | % | 131.4 | % |
|                                       |       |                                   |       |                                 |       |   |   |   |   |
| Operating income (loss)                    |       | 13.0                                   | %          | (65.6                                | )%         | 14.5 | % | (95.8 | )% |
|                                       |       |                                   |       |                                 |       |   |   |   |   |
| Interest income                            |       | 0.9                                    | %          | 6.5                                  | %          | 1.4 | % | 8.9 | % |
| Interest expense                           |       | (0.2                                   | )%         | (0.6                                 | )%         | (0.3 | )% | (0.8 | )% |
| Other income                               |       | 0.0                                    | %          | 4.4                                  | %          | 0.2 | % | 2.6 | % |
|                                       |       |                                   |       |                                 |       |   |   |   |   |
| Income (loss) before income taxes          |       | 13.8                                   | %          | (55.3                                | )%         | 15.9 | % | (85.1 | )% |
|                                       |       |                                   |       |                                 |       |   |   |   |   |
| Income taxes expense                       |       | 0.9                                    | %          | 48.2                                 | %          | 0.8 | % | 11.7 | % |
|                                       |       |                                   |       |                                 |       |   |   |   |   |
| Net income (loss)                          |       | 12.9                                   | %          | (103.5                               | )%         | 15.1 | % | (96.7 | )% |

 

**Three Months Ended March 31,2009 Compared to the Three Months Ended March 31, 2008**

 

*Net sales.* Net sales increased $3.6 million, or53.4%, to $10.5 million for the three months ended March 31, 2009 from$6.8 million in the three months ended March 31, 2008. For the threemonths ended March 31, 2009, product sales increased $3.1 million and EMDsales increased $0.5 million from the same period in the prior year. Theincrease in product sales was primarily related to growth in flat panel displaysales to various customers. The increase in EMD sales was primarily a result ofseveral projects for a major customer that were completed during the quarter.

 

*Cost of sales.* Cost of sales increased $1.4 million or37.6%, to $5.2 million, or 49.9% of net sales in the three months ended March 31,2009 from $3.8 million, or 55.6% of net sales in the three months ended March 31,2008. The increase was primarily the result of the additional product salesduring the quarter which accounted for $1.2 million of the increase as well asby a $0.2 million increase in EMD related costs.

 

*Research and development.* Research and development expensedecreased $1.2 million or 42.0% to $1.6 million or 15.4% of net sales in thethree months ended March 31, 2009 from $2.8 million or 40.7% of net salesin the three months ended March 31, 2008. The decrease in research and development expense in the quarter wasprimarily due to a reduction in headcount related costs, a decrease inthird-party subcontractors and an increase in deferred EMD related direct costsof $0.7 million, $0.4 million and $0.1 million, respectively. The significantresearch and development costs in the prior period primarily related to theEclipse program that ended during the fourth quarter of fiscal year 2008. Sincethe termination of the Eclipse program the Company has reduced the total numberof employees in the research and development department and has streamlined theresearch and development functions. However, the Company continues to invest inon-going research and development of our core products.

 

*Selling, general, andadministrative.*Selling, general and administrative expenses decreased $2.5 million, or 52.0%,to $2.3 million, or 21.7% of net sales in the three months ended March 31,2009 from $4.7 million or 69.4% of net sales in the three months ended March 31,2008. The decrease was primarily due to a reduction in professional fees,specifically legal costs, as well as a decrease in 

 

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headcount related costsof $1.5 million and $0.4 million respectively. During the three months ended March 31,2008 the Company incurred $1.6 million of legal fees in connection withlitigation related to protecting its Intellectual Property.

 

*Interest income.* Interest income was $97,000 in the threemonths ended March 31, 2009 as compared to $442,000 in the three monthsended March 31, 2008. The decrease in interest income was primarily theresult of our reduced average cash balance in the current quarter as comparedto the same period in the prior year as well as lower interest rates in thequarter as compared to the same period in the prior year.

 

*Interest expense.* Interest expense was $19,000 in thethree months ended March 31, 2009 as compared to $39,000 in the threemonths ended March 31, 2008. The reduction was primarily due to lowerinterest rates in effect during the period compared to the same period in theprior year.

 

*Other income.*In March 2008, the Company receiveda payment of $300,000 million in settlement of a claim against a shareholderfor short swing profit liability to the Company pursuant to Section 16(b) ofthe Securities Exchange Act of 1934, as amended.

 

*Income tax expense.* The income tax expense for the three months ended March 31,2009 was $96,000 as compared to $3.3 million for the three months ended March 31,2008. The decrease in the income tax expense is primarily due to theestablishment of a full valuation allowance on net deferred tax assets as ofthe period ended March 31, 2008. The establishment of the allowance as of March 31, 2008 caused theCompany to recognize income tax expense for the three months ended March 31,2008 relating to net deferred tax assets that are not likely to berealized.  The Company continues tomaintain a full valuation allowance as of the period ended March 31, 2009on its net deferred tax assets. In accordance with FAS 109 the Company willcontinue to evaluate the need for a full or partial valuation allowance on aquarterly basis.

 

The effective tax ratesfor the three months ended March 31, 2009 and 2008 were 7% and (87%),respectively.  The effective tax ratediffers from the statutory rate for the three months ended March 31, 2009due to:  1) the reversal of certaindeductible temporary differences which at September 30, 2008 were offsetby a valuation allowance; such items will be deductible for income tax purposesin the current fiscal year based on forecasted earnings, and 2) the utilizationof research and experimentation tax credits. The effective tax rate differsfrom the statutory rate for the three months ended March 31, 2008 due tothe establishment of a full valuation allowance on net deferred tax assetsduring that quarter.

 

**Six Months Ended March 31,2009 Compared to the Six Months Ended March 31, 2008**

 

*Net sales.* Net sales increased $9.5 million, or82.0%, to $21.0 million for the six months ended March 31, 2009 from $11.6million in the six months ended March 31, 2008. For the six months ended March 31,2009, product sales increased $8.2 million and EMD sales increased $1.3 millionfrom the same period in the prior year. The increase in product sales wasprimarily related to growth in flat panel display sales to various customers.The increase in EMD sales was primarily a result of several projects for majorcustomers that were completed during the six months ended March 31, 2009.

 

*Cost of sales.* Cost of sales increased $3.0 million or40.6%, to $10.5 million, or 49.8% of net sales in the six months ended March 31,2009 from $7.4 million, or 64.4% of net sales in the six months ended March 31,2008. The increase was primarily the result of the additional product salesduring the six months ended March 31, 2009, which accounted for $3.4 millionof the increase and was offset by a $0.4 million decrease in EMD related costs.

 

*Research and development.* Research and development expensedecreased $1.6 million or 36.0% to $2.9 million or 13.7% of net sales in thesix months ended March 31, 2009 from $4.5 million or 39.1% of net sales inthe six months ended March 31, 2008. The decrease in research and development expense in the six months endedMarch 31, 2009 was primarily due to a reduction in headcount related costsand a decrease in third-party subcontractors of $1.3 million and $0.9 million,respectively. This was offset by a decrease in deferred EMD costs of $0.7million.

 

*Selling, general, andadministrative.*Selling, general and administrative expenses decreased $6.0 million, or 56.6%,to $4.6 million, or 22.0% of net sales in the six months ended March 31,2009 from $10.7 million or 92.3% of net sales in the six months ended March 31,2008. The decrease was primarily due to a reduction in professional fees,specifically legal costs, as well as a decrease in headcount related costs of$4.8 million and $0.5 million respectively. During the six months ended March 31,2008 the Company incurred $4.7 million of legal fees in connection withlitigation related to protecting its intellectual property.

 

*Interest income.* Interest income was $298,000 in the sixmonths ended March 31, 2009 as compared to $1.0 million in the six monthsended March 31, 2008. The decrease in interest income was primarily theresult of our reduced average cash balance during the six months ended March 31,2009 as compared to the same period in the prior year as well as lower interestrates during the six months ended March 31, 2009 as opposed to the sameperiod in the prior year.

 

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*Interest expense.* Interest expense was $55,000 in the sixmonths ended March 31, 2009 as compared to $89,000 in the six months endedMarch 31, 2008. The reduction was primarily due to lower interest rates ineffect during the period compared to the same period in the prior year.

 

*Other income.*In March 2008, the Company receiveda payment of $300,000 in settlement of a claim against a shareholder for shortswing profit liability to the Company pursuant to Section 16(b) ofthe Securities Exchange Act of 1934, as amended.

 

*Income tax expense.* The income tax expense for the six months ended March 31,2009 was $168,000 as compared to $1.3 million for the six months ended March 31,2008. The decrease in the income tax expense is primarily due to theestablishment of a full valuation allowance on deferred tax assets as of theperiod ended March 31, 2008.  Theestablishment of the allowance as of March 31, 2008 caused the Company torecognize income tax expense for the six months ended March 31, 2008relating to net deferred tax assets that are not likely to be realized.  The Company continues to maintain a fullvaluation allowance as of the period ended March 31, 2009 on its netdeferred tax assets. In accordance with FAS 109 the Company will continue toevaluate the need for a full or partial valuation allowance on a quarterlybasis.

 

The effective tax rates for the six months ended March 31,2009 and 2008 were 5% and (14%), respectively. The effective tax rate differs from the statutory rate for the sixmonths ended March 31, 2009 due to: 1) the reversal of certain deductible temporary differences which at September 30,2008 were offset by a valuation allowance; such items will be deductible forincome tax purposes in the current fiscal year based on forecasted earnings,and 2) the utilization of research and experimentation tax credits. Theeffective tax rate differs from the statutory rate for the six months ended March 31,2008 due to the establishment of a full valuation allowance on net deferred taxassets during the quarter ended March 31, 2008.

 

**Liquidity and Capital Resources**

 

The following tablehighlights key financial measurements of the Company:

 
| ** **                                   | ** ** | **March 31,  2009** | ** ** | **September 30,  2008** | ** ** |
|----------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| Cash and cash equivalents                    |       | $                        | 37,518,990 |                         | $          | 35,031,932 |   |
| Accounts receivable, net                     |       | $                        | 5,764,620  |                         | $          | 4,218,443 |   |
| Working capital                              |       | $                        | 46,113,247 |                         | $          | 42,491,253 |   |
| Current ratio                                |       | 10.82                    |       | 6.35                         |       |
| Deferred revenue                             |       | $                        | 328,353    |                         | $          | 564,998 |   |
| Total debt and other non-current liabilities |       | $                        | 4,973,580  |                         | $          | 5,047,146 |   |

 
| ** **                                         | ** ** | **Six Months Ended March 31,** | ** ** |
|----------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                         | ** ** | **2009**                            | ** ** | **2008** | ** ** |
| **Cash flow activites:**                           |       |                                |       |   |   |
| Net cash provided by (used in) operating activites |       | $                                   | 2,762,095  |   | $ | (4,908,881 | ) |
| Net cash used in investing activites               |       | (161,557                            | )          | (425,248 | ) |
| Net cash used in financing activites               |       | (113,480                            | )          | (22,671 | ) |
|                                                    |            |                                     |            |  |  |  |  |

 

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

 

***Operatingactivities***

 

Cash provided byoperating activities was $2.8 million for the six months ended March 31,2009 as compared to cash used in operating activities of $4.9 million for thesix months ended March 31, 2008. The improvement was primarily due to netincome of $3.2 million for the six months ended March 31, 2009 versus anet loss of $11.2 million in the prior year period. Additionally, the cashprovided by operating activities during the six months ended March 31,2009 was impacted by decreases in inventories and prepaid expenses of $2.9million and $0.1 million, respectively. This was offset by increases inaccounts receivable and decreases in accounts payable, accrued expenses, incometaxes payable and deferred revenues of $1.5 million, $0.7 million, $1.8million, $0.5 million, and $0.2 million, respectively.

 

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***Investing activities***

 

Cash used in investing activities was $162,000 for the six months endedMarch 31, 2009 and $425,000 for the six months ended March 31, 2008,which primarily consisted of the purchase of production and laboratory testequipment.

 

***Financing activities***

 

Net cash used in financing activities was $113,000 for the six monthsended March 31, 2009 which consisted of $108,000 for the repurchase ofcommon stock and $5,000 for the repayment of capitalized lease obligations. Netcash used in financing activities of $23,000 for the six months ended March 31,2008, primarily consisted of $57,000 for the repurchase of common stock, and a$5,000 repayment for capitalized lease obligations offset by proceeds from theexercise of stock options of $39,000.

 

The Company entered into a $4,335,000 loan agreement dated August 1,2000 with the Chester County, Pennsylvania Industrial Development Authority.The purpose of the loan was to fund the construction of the Company’s newoffice and manufacturing facility. The loan matures in 2015 and carries aninterest rate set by the remarketing agent that is consistent with 30-daytax-exempt commercial paper. The loan agreement includes an optional redemptionschedule allowing the Company the option of forgoing any principal pay-downuntil such time the bonds expire in 2015. The Company has exercised its optionnot to pay-down the outstanding balance and accordingly, the balance of thenotes payable will be due in 2015.

 

Effective November 30, 2007 the loan covenants require the Companyto maintain at all times unencumbered cash and marketable securities having amarket value of at least $20.0 million and a minimum tangible net worth of$65.0 million.  On January 10, 2008the lender agreed to discontinue the tangible net worth covenant. As of March 31,2009 the Company was in compliance with the remaining loan covenant.

 

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

 

**Backlog**

 

As of March 31, 2009and September 30, 2008, our backlog was $39.4 million and $57.3 million,respectively. The subsequent decrease in backlog reflects steps taken by managementduring the six months ended March 31, 2009 to re-evaluate certain customerbookings in light of the current economic environment and likelihood that thesebookings would result in actual revenues. Although we had no customercancellations, we have de-booked approximately $6.5 million during the sixmonths ended March 31, 2009. In consideration of the continually changingeconomic environment the Company’s management will continue to evaluate therealizability of the backlog.

 

Backlog activity for thesix months ended March 31, 2009 (in thousands):

 
| **Balance at  September  30, 2008** | ** ** | **Additional  Bookings** | ** ** | **Recognized  in Revenue** | ** ** | **Adjustments** | ** ** | **Balance at  March 31,  2009** | ** ** |
|-------------------------------------|------------|--------------------------|------------|----------------------------|------------|-----------------|------------|--------------------------------------|------------|
|                                |       |                     |       |                       |       |            |       |                                 |       |
| $                                   | 57,373     |                     | $          | 9,561                      |       | $               | (21,041    | )                                    | $          | (6,470 | ) | $ | 39,423 |   |
|                                     |            |                          |            |                            |            |                 |            |                                      |            |  |  |  |  |  |

 

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Backlog activity for the three months ended March 31,2009 (in thousands):

** **
| **Balance at  December  31, 2008** | ** ** | **Additional  Bookings** | ** ** | **Recognized  in Revenue** | ** ** | **Adjustments** | ** ** | **Balance at  March 31,  2009** | ** ** |
|------------------------------------|------------|--------------------------|------------|----------------------------|------------|-----------------|------------|--------------------------------------|------------|
|                               |       |                     |       |                       |       |            |       |                                 |       |
| $                                  | 46,487     |                     | $          | 3,678                      |       | $               | (10,466    | )                                    | $          | (276 | ) | $ | 39,423 |   |
|                                    |            |                          |            |                            |            |                 |            |                                      |            |  |  |  |  |  |

 

**Off-BalanceSheet Arrangements**

 

We do not participate intransactions that generate relationships with unconsolidated entities orfinancial partnerships, such as special purpose entities (“SPEs”) or variableinterest entities (“VIEs”), which would have been established for the purposeof facilitating off-balance sheet arrangements or other limited purposes. As ofMarch 31, 2009 and September 30, 2008, we were not involved with anyunconsolidated SPEs or VIEs.

 

We currently have astandby letters of credit of $4.4 million with PNC Bank, N.A. The stand byletter of credit is one of the requirements of the loan agreement with ChesterCounty, Pennsylvania Industrial Development Authority.

 

**Item 3. Quantitative and Qualitative DisclosuresAbout Market Risk**

 

The Company’s operations are exposed to market risks primarily as aresult of changes in interest rates. The Company does not use derivative financialinstruments for speculative or trading purposes. The Company’s exposure tomarket risk for changes in interest rates relates to its cash equivalents andan industrial revenue bond. The Company’s cash equivalents consist of fundsinvested in money market accounts, which bear interest at a variable rate,while the industrial revenue bond carries an interest rate that is consistentwith 30-day tax-exempt commercial paper. Assuming that the balances during thethree and six months ending March 31, 2009 were to remain constant and noactions were taken to alter the existing interest rate sensitivity, ahypothetical 1% increase in our variable interest rates would have affectedinterest income by approximately $92,000 and $176,000, respectively, and interestexpense by approximately $69,000 and $76,000, respectively. This would resultin a net impact on cash flows of approximately $23,000 and $100,000 for thethree and six months ended March 31, 2009, respectively.

 

As the interest rates arevariable, a change in interest rates earned on the cash equivalents or paid onthe industrial revenue bond would impact interest income and expense along withcash flows, but would not impact the fair market value of the relatedunderlying instruments.

 

**Item 4.Controls and Procedures**

 

(a)          An evaluation was performed under thesupervision and with the participation of the Company’s management, includingits Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, ofthe effectiveness of the Company’s disclosure controls and procedures, as suchterm is defined under Rule 13a-15e under the Securities Exchange Act of1934, as amended (the “Exchange Act”) as of March 31, 2009. Based on thatevaluation, the Company’s management, including the CEO and CFO, concluded thatthe Company’s disclosure controls and procedures are effective to providereasonable assurance that information required to be disclosed by the Companyin reports that it files or submits under the Exchange Act, is recorded,processed, summarized and reported as specified in Securities and ExchangeCommission rules and forms and that such information is accumulated andcommunicated to the Company’s management, including the CEO and CFO, or personsperforming similar functions, as appropriate to allow timely decisionsregarding required disclosure.

 

(b)         There were no changes in the Company’sinternal control over financial reporting identified in connection with theevaluation of such controls that occurred during the Company’s most recentfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

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**PART II—OTHER INFORMATION**

 

**Item 1.    Legal Proceedings**

 

In the ordinary course ofbusiness, we are at times subject to various legal proceedings. Except withrespect to the fees incurred in connection with the matters described below, wedo not believe any current legal proceedings will have a material adverseeffect on our results of operations or financial position.

 

On September 13,2005 the Company filed a lawsuit in the United States District Court for theWestern District of Tennessee against J2, Inc., a company founded andjointly owned by Joseph Cesar, a former employee of the Company, and JamesZachary, a former sales consultant for the Company. The complaint alleged thatthe J2/Kollsman Air Data Computer then being marketed by J2 and manufactured byKollsman, Inc. infringed a patent assigned to IS&S.

 

On November 7, 2007the Company received a favorable jury verdict in its trade secretmisappropriation case against Kollsman, Inc. (a subsidiary of ElbitSystems Ltd.), J2 Inc., Joseph Caesar, James Zachary and ZacharyTechnologies, Inc. in the United States District Court for the WesternDistrict of Tennessee. The jury unanimously found that each of the defendantshad misappropriated IS&S’s air data computer technology. The jury foundthat IS&S had suffered damages of just over $4.4 million in lostprofits and $1.6 million in defendants’ net profits, for a total of over$6 million. The jury also found in favor of IS&S’s claims for breachof duty and contract, and unfair competition against J2 Inc., JosephCaesar, James Zachary and Zachary Technologies, Inc.

 

On December 18,2007, the court entered a temporary injunction aimed at preventing further useof the Company’s trade secret and proprietary information. On March 14,2008, the judge presiding over the case heard the Company’s claims for apermanent injunction as well as punitive and exemplary damages and attorneys’fees against Kollsman and the other defendants.

 

On July 7, 2008, thecourt issued several rulings in the case. In the rulings, the court awardeddamages, interest and fees in addition to the more than $6 million incompensatory damages awarded by the jury when it rendered its verdict in thecase in November 2007. The additional awards brought the damages assessedagainst Kollsman, Inc. to more than $23 million. The court alsoentered an order granting the Company’s request for permanent injunctiverelief.

 

On August 27, 2008,the Company entered into a Settlement Agreement (the Settlement Agreement) withKollsman, Inc. On August 29, 2008, the settlement became effectivewith respect to all claims filed by the Company and Kollsman against each otherin the United States District Court for the Western District of Tennessee and aConsent Order was entered. Under the Settlement Agreement, all claims betweenthe Company and Kollsman have been dismissed with prejudice, a final agreedinjunction has been entered and the matter has been fully and finally mutuallysettled without any admission of guilt by either party. In addition, an agreedsettlement payment of $17 million has been made by Kollsman to theCompany.

 

On October 9, 2008,Zachary and ZTI consented to the entry of judgment against and to a permanentinjunction, which resulted in the conclusion of all claims with respect tothose parties. On November 17, 2008, the court granted the Company’smotion to dismiss its patent infringement claims against Caesar and J2, anddismissed Caesar and J2’s counterclaims for noninfringement, invalidity andunenforceability because there was no longer a justifiable claim or controversywith respect to those counterclaims.

 

On January 17, 2007the Company filed suit in Pennsylvania state court against StrathmanAssociates, a former software consultant for IS&S, alleging that Strathmanhad improperly used IS&S trade secret and proprietary information inassisting J2 and Kollsman in developing the J2/Kollsman Air Data Computer. Thecase is ongoing.

 

**Item1A.  Risk Factors**

 

There are no materialchanges to the risk factors described under Item 1A of our Form 10-K forthe year ended September 30, 2008.

 

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

 

***Stockrepurchase program***

 

On February 21, 2008, the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of ouroutstanding common stock. Purchases of the stock were to be made from time totime, subject to market conditions and at prevailing market prices. There wereno shares purchased under this plan during the three months ended March 31,2008. The program expired on February 21, 2009.

 

On February 22, 2009, the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of ouroutstanding common stock. Under the repurchase program, the Company maypurchase shares of its common stock 

 

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through open market transactions or in privately negotiated blockpurchases or other private transactions (either solicited or unsolicited). Thetiming and amount of repurchase transactions under this program will depend onmarket conditions and corporate and regulatory considerations. The plan willexpire on February 22, 2010, unless extended by the Board of Directors;however, the program may be discontinued or suspended at any time. During thethree months ending March 31, 2009, we purchased 25,000 shares of commonstock under the program at a cost of $108,250, or an average market price of$4.33 per share. We financed these purchases through our available cash.  The following table sets forth the purchasesmade under this new plan for each month of the three months ended March 31,2009:

 
| **Period**         | ** ** | **Total  Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum  Number of  Shares that May  Yet Be  Purchased  Under the  Program** | ** ** |
|--------------------|------------|-----------------------------------------|------------|------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
|               |       |                                    |       |                               |       |                                                                                          |       |                                                                           |       |
| January 2009  |       |                                    |       |                               |       |                                                                                          |       |                                                                           | (a)        |
|               |       |                                    |       |                               |       |                                                                                          |       |                                                                           |       |
| February 2009 |       | —                                  |       |                               |       | —                                                                                        |       | 1,000,000                                                                      |       |
|               |       |                                    |       |                               |       |                                                                                          |       |                                                                           |       |
| March 2009    |       | 25,000                                  |       | $                                  | 4.33       |                                                                                          | 25,000     |                                                                           | 975,000    |   |
|               |       |                                    |       |                               |       |                                                                                          |       |                                                                           |       |
|               |       | 25,000                                  |       |                               |       | 25,000                                                                                        |       |                                                                           |       |
|                    |            |                                         |            |                                    |            |                                                                                               |            |                                                                                |            |  |

 

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(a) The plan was notapproved until February 2009.

 

**Item 3.    Defaults upon Senior Securities**

 

None

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders**

 

We held our 2009 Annual Meeting of Shareholders on March 12,2009.  The matters voted upon at theannual meeting and the results of the vote on such matters, is set forth below.

 

(1)   Election of Directors. The results of thevote tabulated at the meeting for the following two director nominees were asfollows:

** **
| ** **            | ** ** | **Number of Shares** | ** ** |
|-----------------------|------------|----------------------|------------|
| ** **            | ** ** | **Voted in Favor**   | ** ** | **Withheld** | ** ** |
| Geoffrey S.M. Hedrick |       | 13,980,724           |       | 79,957 |   |
| Winston J. Churchill  |       | 13,833,550           |       | 227,131 |   |

 

Ivan M. Marks’ and RobertH. Rau’s terms as directors continue until the 2010 annual meeting ofshareholders. Glen R. Bressner’s and Robert E. Mittelstaedt, Jr.’s termsas directors continue until the 2011 annual meeting of shareholders.

 

(2) To approve theCompany’s 2009 Stock-Based Incentive Compensation Plan. The results of the votetabulated at the meeting for the proposal were as follows (including brokernon-votes):

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** | **BROKER NON-VOTE** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|---------------------|------------|
| 7,015,304 |       | 1,882,025   |       | 6,422       |       | 5,156,930           |       |

 

(3) To ratify theappointment of Deloitte and Touche, LLP as the Company’s independent registeredpublic accounting firm for the fiscal year ending September 30, 2009. Theresults of the vote tabulated at the meeting for the proposal were as follows(including broker non-votes):

 
| **FOR**    | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** | **BROKER NON-VOTE** | ** ** |
|------------|------------|-------------|------------|-------------|------------|---------------------|------------|
| 14,002,244 |       | 31,388      |       | 27,048      |       | 1                   |       |

 

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**Item 5.    OtherInformation**

 

None

 

**Item 6.Exhibits**

 

(a)   Exhibits

 
| 10.13^     | 2009 Stock-Based  Incentive Compensation Plan, attached as Appendix A to the Proxy Statement  filed with the Securities and Exchange Commission on January 28, 2009 |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                                     |
| 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                                          |

 

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*   Filed herewith

 

†   Furnished herewith

 

^   Constitutes a management contract orcompensatory plan or arrangement required to be filed as an exhibit to thisform.

 

**SIGNATURE**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
| ** **              | ** ** | **INNOVATIVE SOLUTIONS AND  SUPPORT, INC.** |
|-------------------------|------------|---------------------------------------------|
| ** **              | ** ** | ** **                                  |
|                    |       |                                        |
| Date: May 11, 2009 |       | By:                                         | /s/ JOHN C. LONG |
|                    |       |                                        |   |
|                    |       |                                        | JOHN C. LONG |
|                    |       |                                        | CHIEF FINANCIAL OFFICER |

 

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