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** **

 

** **

**UNITEDSTATES**

**SECURITIESAND 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 December 31,2008**

 

**OR**

 

| **o** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|---------------------------------------------------------------------------------------------------------|

 

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

 

**Commission File No. 0-31157**

 

**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

(Exact name of registrant as specified in itscharter)

 

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

 

**(610) 646-9800**

(Registrant’s telephone number, includingarea code)

 

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

 

Yes  x    No  o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

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

 

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

 

Yes  o    No  x

 

Asof February 4, 2009, there were 16,743,209 shares of the Registrant’sCommon Stock, with par value of $.001 per share, outstanding.

 

 

** **

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

### **FORM 10-Q December 31, 2008**

### ** **

**INDEX**

 
| ** **        |                                                                                                        | **Page No.** |
|-------------------|-------------------------------------------------------------------------------------------------------------|-------------------|
|              |                                                                                                        |              |
| **PART I.**  | **FINANCIAL INFORMATION**                                                                                   | —            |
|              |                                                                                                        |              |
| Item 1.           | Financial Statements (Unaudited)                                                                            |              |
|              |                                                                                                        |              |
|              | Condensed  Consolidated Balance Sheets — December 31, 2008 and September 30,  2008           | 1                 |
|              |                                                                                                        |              |
|              | Condensed  Consolidated Statements of Operations — Three Months Ended December 31,  2008 and 2007 | 2                 |
|              |                                                                                                        |              |
|              | Condensed  Consolidated Statements of Cash Flows — Three Months Ended December 31,  2008 and 2007 | 3                 |
|              |                                                                                                        |              |
|              | Notes to Condensed Consolidated Financial Statements                                                        | 4 – 10       |
|              |                                                                                                        |              |
| Item 2.           | Managements Discussion and Analysis of Financial  Condition and Results of Operations                       | 11 – 15      |
|              |                                                                                                        |              |
| Item 3.           | Quantitative  and Qualitative Disclosures about Market Risk                                                 | 15                |
|              |                                                                                                        |              |
| Item 4.           | Controls and  Procedures                                                                                    | 16                |
|              |                                                                                                        |              |
| **PART II.** | **OTHER INFORMATION**                                                                                       |              |
|              |                                                                                                        |              |
| Item 1.           | Legal Proceedings                                                                                           | 17                |
|              |                                                                                                        |              |
| Item 1A           | Risk Factors                                                                                                | 17                |
|              |                                                                                                        |              |
| Item 2.           | Unregistered  Sales of Equity Securities and use of Proceeds                                                | 18                |
|              |                                                                                                        |              |
| Item 3.           | Defaults upon  Senior Securities                                                                            | 18                |
|              |                                                                                                        |              |
| Item 4.           | Submission of  Matters to a Vote of Security Holders                                                        | 18                |
|              |                                                                                                        |              |
| Item 5.           | Other Information                                                                                           | 18                |
|              |                                                                                                        |              |
| Item 6.           | Exhibits                                                                                                    | 18                |
|              |                                                                                                        |              |
| **SIGNATURES**    | 19                                                                                                          |

 

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**PART I—FINANCIAL INFORMATION**

**Item 1—Financial Statements**

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                          | ** ** | **December 31,  2008** | ** ** | **September 30,  2008** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                          |       |                        |       |                         |       |
| Current Assets:                                                                                                                                                                                                                     |       |                        |       |                         |       |
| Cash and cash equivalents                                                                                                                                                                                                           |       | $                           | 33,725,670 |                         | $          | 35,031,932 |   |
| Accounts receivable, net                                                                                                                                                                                                            |       | 6,871,967                   |       | 4,218,443                    |       |
| Inventories                                                                                                                                                                                                                         |       | 7,668,241                   |       | 9,361,257                    |       |
| Deferred income taxes                                                                                                                                                                                                               |       | 346,581                     |       | 414,636                      |       |
| Prepaid expenses and other current assets                                                                                                                                                                                           |       | 1,249,384                   |       | 1,406,260                    |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total current assets                                                                                                                                                                                                                |       | 49,861,843                  |       | 50,432,528                   |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Property and equipment, net                                                                                                                                                                                                         |       | 8,816,417                   |       | 8,958,346                    |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Other assets                                                                                                                                                                                                                        |       | 460,010                     |       | 505,840                      |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total assets                                                                                                                                                                                                                        |       | $                           | 59,138,270 |                         | $          | 59,896,714 |   |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                      |       |                        |       |                         |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Current Liabilities                                                                                                                                                                                                                 |       |                        |       |                         |       |
| Current portion of capitalized lease  obligations                                                                                                                                                                                   |       | $                           | 9,908      |                         | $          | 9,908 |   |
| Accounts payable                                                                                                                                                                                                                    |       | 2,009,655                   |       | 2,349,981                    |       |
| Accrued expenses                                                                                                                                                                                                                    |       | 2,812,888                   |       | 5,130,463                    |       |
| Deferred revenue                                                                                                                                                                                                                    |       | 374,033                     |       | 450,923                      |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total current liabilities                                                                                                                                                                                                           |       | 5,206,484                   |       | 7,941,275                    |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Note payable                                                                                                                                                                                                                        |       | 4,335,000                   |       | 4,335,000                    |       |
| Long-term portion of capitalized lease  obligations                                                                                                                                                                                 |       | 35,041                      |       | 37,633                       |       |
| Deferred revenue                                                                                                                                                                                                                    |       | 99,870                      |       | 114,075                      |       |
| Deferred income taxes                                                                                                                                                                                                               |       | 346,581                     |       | 414,636                      |       |
| Other liabilities                                                                                                                                                                                                                   |       | 277,030                     |       | 249,969                      |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total liabilities                                                                                                                                                                                                                   |       | 10,300,006                  |       | 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  December 31, 2008 and September 30, 2008 |       | —                      |       | —                       |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Common stock, $.001 par value: 75,000,000  shares authorized, 18,179,659 and 18,177,024 shares issued at  December 31, 2008 and September 30, 2008                                                                        |       | 18,179                      |       | 18,177                       |       |
| Additional paid-in capital                                                                                                                                                                                                          |       | 45,978,710                  |       | 45,767,960                   |       |
| Retained earnings                                                                                                                                                                                                                   |       | 21,976,001                  |       | 20,152,615                   |       |
| Treasury stock, at cost, 1,445,510 shares  at December 31, 2008 and September 30, 2008                                                                                                                                    |       | (19,134,626                 | )          | (19,134,626                  | )          |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total shareholders’ equity                                                                                                                                                                                                     |       | 48,838,264                  |       | 46,804,126                   |       |
|                                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                                     |       | $                           | 59,138,270 |                         | $          | 59,896,714 |   |

 

Theaccompanying notes are an integral part of these statements.

 

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**INNOVATIVE SOLUTIONS AND SUPPORT,INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(unaudited)**

 
| ** **                                 | ** ** | **Three months ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                 | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Net sales:                                 |       |                                                    |       |   |   |
| Product                                    |       | $                                                       | 8,889,118  |   | $ | 3,899,788 |   |
| Engineering - modification and development |       | 1,686,228                                               |       | 835,859 |   |
| Total net sales                            |       | 10,575,346                                              |       | 4,735,647 |   |
| Cost of sales:                             |       |                                                    |       |   |   |
| Product                                    |       | 4,995,094                                               |       | 2,770,099 |   |
| Engineering - modification and development |       | 260,079                                                 |       | 888,960 |   |
| Total cost of sales                        |       | 5,255,173                                               |       | 3,659,059 |   |
|                                       |       |                                                    |       |   |   |
| Gross profit                               |       | 5,320,173                                               |       | 1,076,588 |   |
|                                       |       |                                                    |       |   |   |
| Operating expenses:                        |       |                                                    |       |   |   |
| Research and development                   |       | 1,280,501                                               |       | 1,740,668 |   |
| Selling, general and administrative        |       | 2,359,307                                               |       | 5,935,906 |   |
| Total operating expenses                   |       | 3,639,808                                               |       | 7,676,574 |   |
|                                       |       |                                                    |       |   |   |
| Operating income (loss)                    |       | 1,680,365                                               |       | (6,599,986 | ) |
|                                       |       |                                                    |       |   |   |
| Interest income                            |       | 201,086                                                 |       | 589,361 |   |
| Interest expense                           |       | (35,474                                                 | )          | (50,539 | ) |
| Other income                               |       | 50,073                                                  |       | — |   |
| Income (loss) before income taxes          |       | 1,896,050                                               |       | (6,061,164 | ) |
|                                       |       |                                                    |       |   |   |
| Income taxes expense (benefit)             |       | 72,664                                                  |       | (1,939,223 | ) |
|                                       |       |                                                    |       |   |   |
| Net income (loss)                          |       | $                                                       | 1,823,386  |   | $ | (4,121,941 | ) |
|                                       |       |                                                    |       |   |   |
| Net income (loss) per common share:        |       |                                                    |       |   |   |
| Basic                                      |       | $                                                       | 0.11       |   | $ | (0.24 | ) |
| Diluted                                    |       | $                                                       | 0.11       |   | $ | (0.24 | ) |
|                                       |       |                                                    |       |   |   |
| Weighted average shares outstanding:       |       |                                                    |       |   |   |
| Basic                                      |       | 16,734,149                                              |       | 16,893,547 |   |
| Diluted                                    |       | 16,769,933                                              |       | 16,893,547 |   |

 

The accompanying notes are an integral part of these statements.

 

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**INNOVATIVE SOLUTIONS AND SUPPORT,INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)**

 
| ** **                                                                                                                         | ** ** | **For the Three  Months Ended  December 31  2008** | ** ** | **For the Three  Months Ended  December 31  2007** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                                                          |       |                                                              |       |                                                              |       |
| Net income (loss)                                                                                                                  |       | $                                                                 | 1,823,386  |                                                              | $          | (4,121,941 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: Depreciation and  amortization |       | 259,530                                                           |       | 245,239                                                           |       |
| Share-based compensation expense:                                                                                                  |       |                                                              |       |                                                              |       |
| Stock options                                                                                                                      |       | 143,644                                                           |       | 129,136                                                           |       |
| Nonvested stock awards                                                                                                             |       | 50,089                                                            |       | 50,000                                                            |       |
| Tax benefit from share-based arrangements:                                                                                         |       |                                                              |       |                                                              |       |
| Stock options                                                                                                                      |       | —                                                            |       | 10,439                                                            |       |
| Nonvested stock awards                                                                                                             |       | 17,019                                                            |       | 6,286                                                             |       |
| Excess tax benefits from share-based  payments arrangements                                                                        |       | —                                                            |       | (9,685                                                            | )          |
| (Gain) loss on disposal of property and  equipment                                                                                 |       | 260                                                               |       | (3,000                                                            | )          |
| Excess and obsolete inventory expense                                                                                              |       | 557,312                                                           |       | —                                                            |       |
| Deferred income tax benefit                                                                                                        |       | —                                                            |       | (448,586                                                          | )          |
| (Increase) decrease in:                                                                                                            |       |                                                              |       |                                                              |       |
| Accounts receivable                                                                                                                |       | (2,653,524                                                        | )          | 1,139,366                                                         |       |
| Inventories                                                                                                                        |       | 1,135,704                                                         |       | (273,435                                                          | )          |
| Prepaid expenses and other current assets                                                                                          |       | 155,866                                                           |       | (1,540,588                                                        | )          |
| Other non current assets                                                                                                           |       | 3,000                                                             |       | (6,180                                                            | )          |
| Increase (decrease) in:                                                                                                            |       |                                                              |       |                                                              |       |
| Accounts payable                                                                                                                   |       | (340,326                                                          | )          | 1,014,465                                                         |       |
| Accrued expenses                                                                                                                   |       | (1,654,208                                                        | )          | (984,307                                                          | )          |
| Income taxes payable                                                                                                               |       | (635,296                                                          | )          | —                                                            |       |
| Deferred revenue                                                                                                                   |       | (91,095                                                           | )          | (405,484                                                          | )          |
| Net cash used in operating activities                                                                                              |       | (1,228,639                                                        | )          | (5,198,275                                                        | )          |
|                                                                                                                               |       |                                                              |       |                                                              |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                                                          |       |                                                              |       |                                                              |       |
| Purchases of property and equipment                                                                                                |       | (75,031                                                           | )          | (158,549                                                          | )          |
| Proceeds on sale of property and equipment                                                                                         |       | —                                                            |       | 3,000                                                             |       |
| Net cash used in investing activities                                                                                              |       | (75,031                                                           | )          | (155,549                                                          | )          |
|                                                                                                                               |       |                                                              |       |                                                              |       |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                                                          |       |                                                              |       |                                                              |       |
| Proceeds from exercise of stock options                                                                                            |       | —                                                            |       | 14,933                                                            |       |
| Repayment of capitalized lease obligations                                                                                         |       | (2,592                                                            | )          | (2,414                                                            | )          |
| Excess tax benefits from share-based  payments arrangements                                                                        |       | —                                                            |       | 9,685                                                             |       |
| Net cash (used in) provided by financing  activities                                                                               |       | (2,592                                                            | )          | 22,204                                                            |       |
|                                                                                                                               |       |                                                              |       |                                                              |       |
| Net decrease in cash and cash equivalents                                                                                          |       | (1,306,262                                                        | )          | (5,331,620                                                        | )          |
| Cash and cash equivalents, beginning of period                                                                                     |       | 35,031,932                                                        |       | 49,151,078                                                        |       |
|                                                                                                                               |       |                                                              |       |                                                              |       |
| Cash and cash equivalents, end of period                                                                                           |       | $                                                                 | 33,725,670 |                                                              | $          | 43,819,458 |   |
|                                                                                                                               |       |                                                              |       |                                                              |       |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION**                                                                              |       |                                                              |       |                                                              |       |
| Cash paid for interest                                                                                                             |       | $                                                                 | 25,374     |                                                              | $          | 40,439 |   |
| Cash paid for income tax                                                                                                           |       | $                                                                 | 690,942    |                                                              | $          | — |   |
| Cash received for income tax refunds                                                                                               |       | $                                                                 | —     |                                                              | $          | 4,593 |   |

 

The accompanying notes 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**

 

***Description of the Company***

 

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

 

***Basis of Presentation***

 

Theaccompanying unaudited condensed consolidated financial statements arepresented pursuant to the rules and regulations of the United StatesSecurities and Exchange Commission in accordance with the disclosurerequirements for the quarterly report on Form 10-Q and therefore do notinclude all of the information and footnotes required by generally acceptedaccounting principles for complete annual financial statements. In the opinionof the management of the Company, the unaudited condensed consolidatedfinancial statements reflect all adjustments (consisting of normal recurringadjustments) necessary to fairly state the results for the interim periodspresented. The condensed consolidated balance sheet as of September 30,2008 is derived from audited financial statements. Operating results for thethree months ended December 31, 2008 are not necessarily indicative of theresults that may be expected for the fiscal year ending September 30,2009. These unaudited condensed consolidated financial statements should beread in conjunction with the audited consolidated financial statements andnotes of the Company included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended September 30, 2008.

 

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

 

***Use ofEstimates***

 

Preparation of consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect reported amounts of assets and liabilities, and disclosure ofcontingent assets and liabilities, as of the date of the financial statementsand the reported amounts of revenues and expenses during the reporting period.Actual results could differ materially from those estimates.

 

***Cash andCash Equivalents***

 

Highly liquid investments purchased with anoriginal maturity of three months or less are classified as cash equivalents.Cash equivalents at December 31, 2008 and September 30, 2008 consist offunds invested in money market accounts with financial institutions.

 

***Propertyand Equipment***

 

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

 

***Long-LivedAssets***

 

The Company assesses the impairment oflong-lived assets in accordance with SFAS No. 144, *“Accounting for the Impairment or Disposal ofLong-Lived Assets”.* This statement requires that long-lived assetsbe reviewed for impairment whenever events or changes in circumstances indicatethe carrying amount of an asset may not be recoverable. Also, in general,long-lived assets to be disposed of should be reported at the lower of thecarrying amount or fair value less cost to sell. The Company considershistorical performance and future estimated results in its evaluation ofpotential impairment and then compares the carrying amount of the asset toestimated future cash flows expected to result from use of the asset. If thecarrying amount of the asset exceeds the estimated expected undiscounted futurecash flows, the Company measures the amount of the impairment by comparing thecarrying amount of 

 

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the asset to its fair value. The estimationof fair value is generally measured by discounting expected future cashflows.  No impairment charges wererecorded during the quarter ended December 31, 2008 or 2007.

 

***RevenueRecognition***

 

The Company recognizes revenue when all ofthe following criteria are met: persuasive evidence of an arrangement exists,delivery has occurred or services have been rendered, the seller’s price to thebuyer is fixed or determinable, and collectability is reasonably assured.

 

The Company enters into sales arrangementswith customers that, in general, provide for the Company to design,develop, manufacture and deliver flight information computers, large flat-paneldisplays, and advanced monitoring systems that measure and display criticalflight information, including data relative to aircraft separation, airspeed,altitude as well as engine and fuel data measurements. The Company may alsoenters into sales arrangements for the provision of engineering and designservices that do not result in the delivery of products.

 

For sales arrangements where software is notmore than incidental, the Company identifies all goods and/or services that areto be delivered separately under the sales arrangement and allocates revenue toeach deliverable based on relative fair values. In general, fair values areestablished based on the prices charged when sold separately by the Company, orbased on pricing information in the marketplace for similar products orservices. Deliverables typically include product design and developmentservices, products, and may include maintenance services, extended warranties,or other deliverables. For sales arrangements that contain software that ismore than incidental and which include multiple elements, revenue is allocatedto the various elements based on vendor-specific objective evidence (“VSOE”) offair value. The allocated revenue for each deliverable is recognized usingrevenue recognition methods applicable to the specific deliverable.

 

The Company recognizes its engineering anddesign contracts using either the proportional performance method or completedperformance method of accounting.  TheCompany records sales relating to these contracts using the proportionalperformance method when the Company determines that progress toward completionis reasonable and reliably estimable and the contract is long-term in nature;the Company uses the competed performance method for all others.  Anticipated losses on contracts arerecognized in full in the period in which losses become probable and estimable.Changes in estimates of profit or loss on contracts are included in earnings ona cumulative basis in the period the estimate is changed.

 

Revenue recognized related to product designand development services and related to the provision of engineering and designservices is included in Engineering — Modification and Development (“EMD”)revenue on the accompanying consolidated statements of operations.

 

The Company offers its customers extendedwarranties for additional fees. These warranty sales are recorded as deferredrevenue and recognized as sales on a straight-line basis over the warrantyperiod.

 

***Warranty***

 

Estimated cost to repair or replace productsunder warranty is provided when sales of product are recorded.

 

***IncomeTaxes***

 

Incometaxes are recorded in accordance with Statement of Financial Accounting Standards(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 valuationallowance is established when it is more likely than not that all or a portionof a deferred 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), theCompany adopted Financial Accounting Standards Board (FASB) Interpretation No. 48,“*Accounting for Uncertainty in Income Taxes”*(FIN 48).  FIN 48 prescribes acomprehensive model for how a company should recognize, measure, present anddisclose in its financial statements uncertain tax positions that the companyhas taken or expects to take on a tax return. The Company has elected to recordany interest or penalties from the uncertain tax position as income taxexpense.

 

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***Researchand Development***

 

Research and development charges incurred forproduct enhancements and future product development are recorded as expense asincurred. Product development and design charges incurred related to a specificcustomer agreement is charged to cost of sales — engineering modification anddevelopment.

 

***ComprehensiveIncome***

 

Pursuant to SFAS No. 130, *“Reporting Comprehensive Income,”* the Company would berequired to classify items of other comprehensive income by their nature in afinancial statement and display the accumulated balance of other comprehensiveincome separately from retained earnings and additional paid-in capital in theequity section of a statement of financial position. Comprehensive incomeconsists of net income and there were no items of other comprehensive income forany of the periods presented.

 

***FairValue of Financial Instruments***

 

The estimated fair value amounts of financialinstruments presented in these consolidated financial statements weredetermined by the Company using available market information and appropriatemethodologies. The Company’s financial instruments consist primarily of cashand cash equivalents, accounts receivable, accounts payable, and accruedliabilities. The carrying values of these assets and liabilities are consideredto be representative of respective fair values based on pertinent informationavailable to management as of December 31, 2008 and September 30,2008.

 

***Stock-BasedCompensation***

 

TheCompany account for stock-based compensation under SFAS No. 123 (revised2004), *“Share-BasedPayment”*(SFAS 123(R)). SFAS 123(R) requires the Companyto measure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award using anoption pricing model. That cost is recognized over the period during which anemployee is required to provide service in exchange for the award.

 

***Concentrations***

 

*MajorCustomers and Products*

 

Forthe three months ended December 31, 2008, four customers accounted 66% ofnet sales on a combined basis, the largest customer accounted for 30% and theother three each accounted for approximately 12% of net sales. For the threemonths ended December 31, 2007, one customer accounted for 71% of netsales.

 

*MajorSuppliers*

 

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

 

*Concentrationof Credit Risk*

 

Financial instruments that potentiallysubject the Company to concentration of credit risk consist principally of cashbalances and accounts receivable. The Company invests its excess cash wherepreservation of principal is the major consideration. The Company’s customerbase principally consists of companies within the aviation industry. TheCompany routinely requests advance payments and/or letters of credit from newcustomers.

 

The Company has maintained a reserve fordoubtful accounts in the amount of $0 and $4.1 million, as of December 31,2008 and September 30, 2008, respectively. The balance in the reserve fordoubtful accounts at September 30, 2008 was directly related to accountsreceivable from Eclipse Aviation, a customer that filed for bankruptcy underChapter 11 subsequent to the Company’s year end.  During the three months ended December 31,2008 the Company wrote off the Eclipse Aviation receivable.

 

***Recent Accounting Pronouncements***

 

InJune 2006, the Financial Accounting Standards Board issued FASB InterpretationNo. 48, *“Accounting for Uncertainty in Income Taxes —an interpretation of FASB Statement No. 109.”* FIN 48 prescribesa recognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN 48 also provides 

 

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guidanceon accounting for de-recognition, interest, penalties, accounting in interimperiods, disclosure and classification of matters related to uncertainty inincome taxes and transitional requirements upon adoption of FIN 48. The Companyadopted FIN 48 effective October 1, 2007, which resulted in a decrease inthe Company’s other non-current liabilities for unrecognized tax benefits of$587,000 (including interest and penalties of $30,000 and a correspondingincrease in shareholders’ equity.

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes 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 anyimpact on the Company’s financial statements.

 

In February 2008,the FASB issued FASB Staff Position (“FSP”) 157-2, “Effective Date of FASBStatement No. 157” which delays the effective date of SFAS 157 for nonfinancialassets and nonfinancial liabilities, except those that are recognized ordisclosed at fair value on a recurring basis, at least annually, until fiscalyears beginning after November 15, 2008, and interim periods within thosefiscal years.  The Company does notexpect the adoption to have any impact on the Company’s financial statements.

 

InDecember 2007, the FASB issued SFAS 160, “*NoncontrollingInterests in Consolidated Financial Statements—Amendment of ARB No. 51.”*SFAS 160 establishes accounting and reporting standards for ownership interestsin subsidiaries held by parties other than the parent, changes in a parent’sownership of a noncontrolling interest, calculation and disclosure of theconsolidated net income attributable to the parent and the noncontrollinginterest, changes in a parent’s ownership interest while the parent retains itscontrolling financial interest and fair value measurement of any retainednoncontrolling equity investment. SFAS 160 is effective for financialstatements issued for fiscal years beginning after December 15, 2008 (theCompany’s fiscal year 2010). The Company does not expect the adoption to haveany impact on its financial statements.

 

InMarch 2008, the FASB issued SFAS 161, “*Disclosures aboutDerivative Instruments and Hedging Activities.”* The new standard isintended to improve financial reporting about derivative instruments andhedging activities by requiring enhanced disclosures to enable investors tobetter understand their effects on an entity’s financial position, financialperformance and cash flows. It requires disclosure of the fair values ofderivative instruments and their gains and losses in a tabular format. It alsoprovides more information about an entity’s liquidity by requiring disclosureof derivative features that are credit risk—related, and requirescross-referencing within footnotes to enable financial statement users tolocate important information about derivative instruments. It is effective forfinancial statements issued for fiscal years and interim periods beginningafter November 15, 2008. The Company is currently in the process ofassessing the impact of the adoption of SFAS 161 on its financial statementdisclosures.

 

InMay 2008, the FASB issued SFAS 162, *“The Hierarchy of GenerallyAccepted Accounting Principles.”* This statement identifies thesources of accounting principles and the framework for selecting the principlesto be used in the preparation of financial statements of nongovernmentalentities that are presented in conformity with generally accepted accountingprinciples in the United States. This statement was effective on November 15,2008. The adoption did not have any impact on the Company’s financialstatements.

 

**2.****Detail ofCertain Balance Sheet Accounts**

 

***Inventories***

 

Inventories are stated at the lower of cost(first-in, first-out) or market, net of reserve for excess and obsolete, andconsist of the following:

 
| ** **      | ** ** | **December 31,  2008** | ** ** | **September 30,  2008** | ** ** |
|-----------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **      | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Raw materials   |       | $                           | 3,927,421  |                         | $          | 4,705,134 |   |
| Work-in-process |       | 2,496,918                   |       | 3,046,451                    |       |
| Finished goods  |       | 1,243,902                   |       | 1,609,672                    |       |
|            |       | $                           | 7,668,241  |                         | $          | 9,361,257 |   |

 

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***Prepaid expenses and othercurrent assets***

 

Prepaid expenses and othercurrent assets consist of the following:

 
| ** **                          | ** ** | **December 31,    2008** | ** ** | **September 30,  2008** | ** ** |
|-------------------------------------|------------|-------------------------------|------------|------------------------------|------------|
|                                |       |                          |       |                         |       |
| Revenue recognized not yet invoiced |       | $                             | 548,119    |                         | $          | 747,789 |   |
| Other                               |       | 701,265                       |       | 658,471                      |       |
|                                |       | $                             | 1,249,384  |                         | $          | 1,406,260 |   |

 

***Property and equipment***

 

Property and equipment, netconsists of the following balances:

 
| ** **                                       | ** ** | **December 31,  2008** | ** ** | **September 30,  2008** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Computers and test equipment                     |       | $                           | 5,943,513  |                         | $          | 5,879,362 |   |
| Corporate airplane                               |       | 3,082,186                   |       | 3,076,400                    |       |
| Furniture and office equipment                   |       | 1,074,029                   |       | 1,074,029                    |       |
| Manufacturing facility                           |       | 5,576,536                   |       | 5,576,536                    |       |
| Land                                             |       | 1,021,245                   |       | 1,021,245                    |       |
|                                             |       | 16,697,509                  |       | 16,627,572                   |       |
| Less- Accumulated depreciation and  amortization |       | (7,881,092                  | )          | (7,669,226                   | )          |
|                                             |       |                        |       |                         |       |
|                                             |       | $                           | 8,816,417  |                         | $          | 8,958,346 |   |

 

Depreciationand amortization related to property and equipment was approximately $217,000and $237,000 for the three months ended December 31, 2008 and 2007,respectively.

 

***Other assets***

Otherassets consist of the following:

 
| ** **                                                                                                                                     | ** ** | **December 31,  2008** | ** ** | **September 30,  2008** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
|                                                                                                                                           |       |                        |       |                         |       |
| Intangible assets, net of accumulated  amortization of $132,780 and $89,950 at December 31,2008 and  September 30, 2008, repectively |       | $                           | 246,220    |                         | $          | 289,050 |   |
| Other                                                                                                                                          |       | 213,790                     |       | 216,790                      |       |
|                                                                                                                                           |       | $                           | 460,010    |                         | $          | 505,840 |   |

 

Intangible assets consist of licensing andcertification rights which are amortized over a defined number of units.

 

Total amortization expense was approximately$43,000 and $8,000 for the three months ended December 31, 2008 and 2007,respectively. Because the intangible assets are being amortized over a definednumber of units, the future amortization expense over the next five yearscannot be determined at this time.

 

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***Accrued expenses***

 

Accruedexpenses consist of the following:

 
| ** **                             | ** ** | **December 31,  2008** | ** ** | **September 30,  2008** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
|                                   |       |                        |       |                         |       |
| Warranty (a)                           |       | $                           | 703,426    |                         | $          | 736,815 |   |
| Reduction in workforce / Severance (b) |       | 594,164                     |       | 904,163                      |       |
| Salary, benefits and payroll taxes     |       | 350,382                     |       | 904,904                      |       |
| Professional fees                      |       | 317,585                     |       | 474,730                      |       |
| Materials on order                     |       | 282,547                     |       | 467,759                      |       |
| Income taxes payable                   |       | 135,434                     |       | 798,801                      |       |
| Other                                  |       | 429,350                     |       | 843,291                      |       |
|                                   |       | $                           | 2,812,888  |                         | $          | 5,130,463 |   |

 

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(a)          The Company provides for the estimated cost ofproduct warranties at the time revenue is recognized. Warranty cost is recordedas cost of sales and the reserve balance recorded as an accrued expense in thefinancial statements. While the Company engages in extensive product qualityprograms and processes, the Company’s warranty obligation is affected byproduct failure rates and the related material, labor, and delivery costsincurred in correcting a product failure. Should actual product failure rates,material or labor costs differ from the Company’s estimates, further revisionsto the estimated warranty liability would be required.

 

Warrantycost and accrual information for the three months ended December 31, 2008is highlighted below:

 
| Warranty accrual at September 30, 2008                        |   | $        | 736,815 |   |
|--------------------------------------------------------------------|--------|----------|---------|--------|
| Accrued expense for the three months ended  December 31, 2008 |   | 78,010   |    |
| Warranty costs for the three months ended  December 31, 2008  |   | (111,399 | )       |
| Warranty accrual at December 31, 2008                         |   | $        | 703,426 |   |

 

(b)         The amount included in Reduction in workforce/ Severance as of December 31, 2008 is severance relating to the formerChief Executive Officer.

 

***Notes payable***

 

The Company entered into a $4,335,000 loanagreement dated August 1, 2000 with the Chester County, PennsylvaniaIndustrial Development Authority. The purpose of the loan was to fund theconstruction of the Company’s new office and manufacturing facility. The loanmatures in 2015 and carries an interest rate set by the remarketing agent thatis consistent with 30-day tax-exempt commercial paper. The loan agreementincludes an optional redemption schedule allowing the Company the option offorgoing any principal pay-down until such time the bonds expire in 2015. TheCompany has exercised its option not to pay-down the outstanding balance andaccordingly, the balance of the notes payable will be due in 2015.

 

Effective November 30, 2007 the loancovenants require the Company to maintain at all times unencumbered cash andmarketable securities having a market value of at least $20.0 million and aminimum Tangible Net Worth of $65.0 million. The lender, however, agreed on January 10, 2008 to discontinue theTangible Net Worth covenant so that the only remaining requirement is that theCompany maintain at all times unencumbered cash and marketable securitieshaving a value of at least $20.0 million.

 

The interest cost related to this debt forthree months ending December 31, 2008 and 2007 was $25,000 and $39,000respectively. The interest rate on this debt was 1.06% at December 31,2008. The Company is also required to maintain a letter of credit in the amountof $4.4 million covering the debt.

 

**3.Income Taxes**

 

Theincome tax expense for the three months ended December 31, 2008 was$73,000 as compared to a benefit of $1.9 million for the three months ended December 31,2007. The income tax expense for the three months ended December 31, 2008,was the result of positive forecasted earnings before income tax as compared toa forecasted loss before income tax resulting in an income tax benefit for thethree months ended December 31, 2007.

 

Theeffective tax rate for the three months ended December 31, 2008 was 4%.The effective tax rate for the three months ended December 31, 2007 was abenefit of 32%. The effective tax rate differs from the statutory rate for thethree months ended December 31, 2008 due to the reversal of certaindeductible temporary differences which at September 30, 2008 were offsetby a valuation allowance, such amounts will be deductible for income taxpurposes in the current year based on forecasted earnings.  Additionally, in each quarter the effectivetax rate differs from the statutory rate due to the utilization of research andexperimentation tax credits.

 

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**4.Capital Stock**

 

AtDecember 31, 2008, our Articles of Incorporation provide us the authorityto issue 75,000,000 shares of common stock and 10,000,000 shares of preferredstock.

 

***Share-based compensation***

 

EffectiveOctober 1, 2005, the Company adopted the provisions of SFAS No.123(R),using the modified prospective approach and now accounts for share-basedcompensation applying the fair value method for expensing stock options andnon-vested stock awards.

 

Totalshare-based compensation expense was $194,000 and $179,000 for the three monthsended December 31, 2008 and 2007, respectively. The income tax benefitrecognized in the statement of operations for share-based compensationarrangements was $17,000 and $57,000 for the three months ended December 31,2008 and 2007, respectively. Compensation expense related to share-based awardsis recorded as a component of general and administrative expense.

 

The Company maintains the 1998 Stock OptionPlan (the “Plan”) and the 2003 Restricted Stock Plan (the “Restricted Plan”).These plans were approved by the Company’s shareholders. The Plan expired on November 13,2008.

 

***Stock options***

 

The Plan provides for thegranting of incentive and nonqualified stock options to employees, officers,directors, and independent contractors and consultants. Through December 31,2008, no stock options have been granted to independent contractors orconsultants under this Plan.  Totalcompensation expense was $144,000 and $129,000 for the three months ended December 31,2008 and 2007, respectively.  Incentivestock options granted under the Plan have exercise prices that must be at leastequal to the fair value of the common stock on the date of grant. Nonqualifiedstock options granted under the Plan have exercise prices that may be lessthan, equal to or greater than the fair value of the common stock on the dateof grant. The Company has reserved 3,389,000 shares of Common Stock for awardsunder the plan. The Plan expired on November 13, 2008 and no additionalshares may be granted under the Plan after that date.

 

***Stock repurchase program***

 

OnFebruary 21, 2008 the Company’s Board of Directors approved a common stockrepurchase program to acquire up to 1,000,000 shares of our outstanding commonstock. Purchases of the stock were to be made from time to time, subject tomarket conditions and at prevailing market prices. The program will remain ineffect until February 21, 2009, unless extended by the Board ofDirectors.  We did not make any commonstock repurchases during the three months ended December 31, 2008.  As of December 31, 2008 the maximumnumber of shares that may yet be purchased under this program was 827,000shares.

 

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

 

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

 

Forthe three month periods ended December 31, 2008 and 2007, there were440,000 and 569,000 options to purchase common stock outstanding, respectively,excluded from the computations of diluted earnings per share as the effectwould be anti-dilutive.

 

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

 

**CAUTIONARY STATEMENT REGARDING****FORWARD-LOOKING STATEMENTS**

 

*This report containsforward looking statements within the meaning of Section 21E of theSecurities Exchange Act of 1934. We have based these forward looking statementslargely on our current expectations and projections about future events andtrends affecting our business. In this report, the words “believe,” “may,” “will,”“estimate,” “continue,” “anticipate,” “intend,” “forecast,” “expect,” “plan,” “should,”“is likely” and similar expressions, as they relate to our business or ourmanagement, are intended to identify forward looking statements, but they arenot exclusive means of identifying them.*

 

*The forward lookingstatements in this report are only predictions and actual events or results maydiffer materially. In evaluating such statements, a number of risks,uncertainties and other factors could cause our actual results, performance,financial condition, cash flows, prospects, and opportunities to differmaterially from those expressed in, or implied by, the forward lookingstatements. These risks, uncertainties and other factors including thefollowing factors:*

 

·                  *market acceptance of ourflat panel display systems, or COCKPIT/IPTM system or other planned products forproduct enhancements;*

 

·                  *difficulties in developingand producing our COCKPIT/IPTM system or other planned products for productenhancements;*

 

·                  *continued market acceptanceof our air data systems and products;*

 

·                  *the availability ofgovernment funding and customer requirements;*

 

·                  *our ability to gainregulatory approval of our products in a timely manner;*

 

·                  *delays in receivingcomponents from third party suppliers;*

 

·                  *the competitiveenvironment;*

 

·                  *the impact of generaleconomic trends on our business;*

 

·                  *the bankruptcy orinsolvency of one or more key customers;*

 

·                  *the termination of programsor contracts for convenience by customers;*

 

·                  *failure to retain keypersonnel;*

 

·                  *new product offerings fromcompetitors;*

 

·                  *potential futureacquisitions;*

 

·                  *protection of intellectualproperty rights;*

 

·                  *our ability to service theinternational market; and*

 

·                  *other factors disclosedfrom time to time in our filings with the Securities and Exchange Commission.*

 

*Except as expresslyrequired by the federal securities laws, we undertake no obligation to publiclyupdate or revise any forward looking statements, whether as a result of newinformation, future events or otherwise after the date of this report. Ourresults of operations in any past period should not be considered indicative ofthe results to be expected for future periods. Fluctuations in operatingresults may also result in fluctuations in the price of our common stock.*

 

*Readersare cautioned not to place undue reliance on these forward-looking statements,which speak only as of the date of this Form 10-Q. The Company does notundertake any obligation to publicly release any revisions to theseforward-looking statements to reflect events, circumstances or changes inexpectations after the date of this Form 10-Q, or to reflect theoccurrence of unanticipated events. The forward-looking statements in thisdocument are intended to be subject to the safe harbor protection provided bySections 27A of the Securities Act and 21E of the Exchange Act. For adiscussion identifying some important factors that could cause actual resultsto vary materially from those anticipated in the forward-looking statements,see the Company’s Securities and Exchange Commission filings including, but notlimited to, the discussions of “Risk Factors” contained in the Company’s AnnualReport on Form 10-K for the fiscal year ended September 30, 2008.*

 

*Investors should also beaware that while we do, from time to time, communicate with securitiesanalysts, it is against our policy to disclose any material non-publicinformation or other confidential commercial information. Accordingly,shareholders should not assume that we agree with any statement or reportissued by any analyst irrespective of the content of the statement or report.Furthermore, we have a policy against issuing or confirming financial forecastsor projections issued by others. Thus, to the extent*

 

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*that reports issued bysecurities analysts contain any projections, forecasts or opinions, suchreports are not the responsibility of Innovative Solutions and Support, Inc.*

 

**CompanyOverview**

 

Innovative Solutions and Support was foundedin 1988. The Company designs, develops, manufactures and sells flightinformation computers, large flat-panel displays, and advanced monitoringsystems that measure and display critical flight information, including datarelative to aircraft separation, airspeed, altitude as well as engine and fueldata measurements.

 

Our sales are derived from the sale of ourproducts to the retrofit market and, to a lesser extent, original equipmentmanufacturers. Our customers include the United States Department of Defense(DoD) and their commercial contractors, aircraft operators, aircraftmodification centers and various OEMs. Although we occasionally sell ourproducts directly to the DoD, we primarily have sold our products to commercialcustomers for end use in DoD programs. Sales to defense contractors are oncommercial terms, although some of the termination and other provisions ofgovernment contracts are applicable to these contracts.

 

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

 

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

 

We intend to continue investing in thedevelopment of new products that complement our current product offerings andwill expense associated research and development costs as they are incurred.

 

Our selling, general and administrativeexpenses consist of sales, marketing, business development, professionalservices, and salaries and benefits for executive and administrative personnelas well as facility costs, recruiting, legal, accounting, and other generalcorporate expenses.

 

Wesell our products to agencies of the United States and foreign governments,aircraft operators, aircraft modification centers and original equipmentmanufacturers.  Our customers have been and may continue to be affected bythe ongoing adverse economic conditions that currently exist both inthe United States and abroad.  Such conditions may cause ourcustomers to curtail or delay their spending on both new and existingaircraft.  Factors that can impact general economic conditions and thelevel of spending by our customers include but are not limited togeneral levels of consumer spending, increases in fuel and energy costs,conditions in the real estate and mortgage markets, labor and healthcare costs,access to credit, consumer confidence and other macroeconomic factors affectingspending behavior.  In addition, spending by government agencies may inthe future be further reduced due to declining tax revenues associated withthis economic downturn.  If our customers curtail or delay their spendingor are forced to declare bankruptcy or liquidate their operations due tocontinuing adverse economic conditions, our revenues and results of operationswill be adversely affected.  However, we believe that in a decliningeconomic environment a customer that may have otherwise elected to purchasenewly manufactured aircraft will instead be interested in retrofitting existingaircraft as a cost effective alternative, which will create a marketopportunity for our products.

 

**Critical Accounting Policies and Estimates**

 

Ourdiscussion and analysis of our financial condition and consolidated results ofoperations are based upon our condensed consolidated financial statements,which have been prepared in accordance with generally accepted accountingprinciples in the United States. The preparation of our condensed consolidatedfinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenue and expenses and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates based upon historical experience and various otherassumptions that we believe to be reasonable under the circumstances, 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.

 

Webelieve that our critical accounting policies affect our more significantestimates and judgments used in the preparation of our consolidated financialstatements. Our Annual Report on Form 10-K for the year ended September 30,2008 contains a discussion of these critical accounting policies. There havebeen no significant changes in our critical accounting policies since September 30,2008. See also Note 1 to our unaudited condensed consolidated financialstatements for the three month period ending December 31, 2008 as setforth herein.

 

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**RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDEDDECEMBER 31, 2008 AND 2007**

 

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

 
| ** **                                 | ** ** | **Three months ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                 | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Net sales:                                 |       |                                                    |       |   |   |
| Product                                    |       | 84.1                                                    | %          | 82.3 | % |
| Engineering - modification and development |       | 15.9                                                    | %          | 17.7 | % |
| Total net sales                            |       | 100.0                                                   | %          | 100.0 | % |
| Cost of sales                              |       |                                                    |       |   |   |
| Product                                    |       | 47.2                                                    | %          | 58.5 | % |
| Engineering - modification and development |       | 2.5                                                     | %          | 18.8 | % |
| Total cost of sales                        |       | 49.7                                                    | %          | 77.3 | % |
|                                       |       |                                                    |       |   |   |
| Gross profit                               |       | 50.3                                                    | %          | 22.7 | % |
|                                       |       |                                                    |       |   |   |
| Operating expenses:                        |       |                                                    |       |   |   |
| Research and development                   |       | 12.1                                                    | %          | 36.8 | % |
| Selling, general and administrative        |       | 22.3                                                    | %          | 125.3 | % |
| Total operating expenses                   |       | 34.4                                                    | %          | 162.1 | % |
|                                       |       |                                                    |       |   |   |
| Operating income (loss)                    |       | 15.9                                                    | %          | (139.4 | )% |
|                                       |       |                                                    |       |   |   |
| Interest income                            |       | 1.9                                                     | %          | 12.4 | % |
| Interest expense                           |       | (0.3                                                    | )%         | (1.1 | )% |
| Other income                               |       | 0.5                                                     | %          | 0.0 | % |
| Loss before income taxes                   |       | 17.9                                                    | %          | (128.0 | )% |
|                                       |       |                                                    |       |   |   |
| Income taxes expense (benefit)             |       | 0.7                                                     | %          | (40.9 | )% |
|                                       |       |                                                    |       |   |   |
| Net income (loss)                          |       | 17.2                                                    | %          | (87.0 | )% |

 

**ThreeMonths Ended December 31, 2008 Compared to the Three Months Ended December 31,2007**

 

*Net sales.* Net sales increased $5.8 million, or 123%,to $10.6 million for the three months ended December 31, 2008 from $4.7million in the three months ended December 31, 2007. For the three monthsended December 31, 2008, product sales increased $5.0 million and EMDsales increased $0.8 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 ofsales.* Cost of salesincreased $1.6 million or 44%, to $5.3 million, or 50% of net sales in thethree months ended December 31, 2008 from $3.7 million, or 77 % of netsales in the three months ended December 31, 2007. The increase wasprimarily the result of the additional product sales during the quarter whichaccount for $2.2 million of the increase and was offset by a $0.6 milliondecrease in EMD related costs.

 

*Researchand development.*Research and development expense decreased $0.4 million or 26% to $1.3 millionor 12% of net sales in the three months ended December 31, 2008 from $1.7million or 37% of net sales in the three months ended December 31,2007.  The decrease in research anddevelopment expense in the quarter was primarily due to the impact of thereduction in workforce that occurred in the fourth quarter of fiscal 2008 and adecrease in third-party subcontractors and other indirect costs.

 

*Selling,general, and administrative.* Selling, general and administrative expenses decreased $3.6 million,or 60%, to $2.4 million, or 22% of net sales in the three months ended December 31,2008 from $5.9 million or 125% of net sales in the three months ended December 31,2007. The decrease was primarily due to reduced legal fees incurred during thequarter. During the three months ended December 31, 2007 the Companyincurred $3.5 million of legal fees in connection with litigation related toprotecting its Intellectual Property.

 

*Interestincome.* Interestincome was $201,000 in the three months ended December 31, 2008 ascompared $589,000 in the three months ended December 31, 2007. Thedecrease in interest income was primarily the result of our reduced averagecash balance in the current quarter as compared to the same period in the prioryear as well as lower interest rates in the quarter as opposed to the same periodin the prior year.

 

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*Interestexpense.* Interestexpense was $35,000 in the three months ended December 31, 2008 ascompared $51,000 in the three months ended December 31, 2007. Thereduction was primarily due to the lower interest rates in effect during theperiod compared to the same period in the prior year.

 

*Incometax expense (benefit).*The income tax expense for the three months ended December 31, 2008 was$73,000 as compared to a benefit of $1.9 million for the three months ended December 31,2007. The income tax expense for the three months ended December 31, 2008,was the result of positive forecasted earnings before income tax as compared toa forecasted loss before income tax resulting in an income tax benefit for thethree months ended December 31, 2007.

 

Theeffective tax rate for the three months ended December 31, 2008 was 4%.The effective tax rate for the three months ended December 31, 2007 was abenefit of 32%. The effective tax rate differs from the statutory rate for thethree months ended December 31, 2008 due to the reversal of certaindeductible temporary differences which at September 30, 2008 were offsetby a valuation allowance, such amounts will be deductible for income taxpurposes in the current year based on forecasted earnings.  Additionally, in each quarter the effectivetax rate differs from the statutory rate due to the utilization of research andexperimentation tax credits.

 

**Liquidityand Capital Resources**

 

Thefollowing table highlights key financial measurements of the Company:

 
| ** **                                    | ** ** | **December 31,  2008** | ** ** | **September 30,  2008** | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Cash and cash equivalents                     |       | $                           | 33,725,670 |                         | $          | 35,031,932 |   |
| Accounts receivable, net                      |       | $                           | 6,871,967  |                         | $          | 4,218,443 |   |
| Working capital                               |       | $                           | 44,655,359 |                         | $          | 42,491,253 |   |
| Current ratio                                 |       | 9.58                        |       | 6.35                         |       |
| Deferred revenue                              |       | $                           | 473,903    |                         | $          | 564,998 |   |
| Total debt and other non-current  liabilities |       | $                           | 5,003,560  |                         | $          | 5,047,146 |   |

 
| ** **                                          | ** ** | **Three  Months Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                          | ** ** | **2008**                                  | ** ** | **2007** |   |
| **Cash flow activites:**                            |       |                                      |       |   |   |
| Net cash used in operating activites                |       | $                                         | (1,228,639 | ) | $ | (5,198,275 | ) |
| Net cash used in investing activites                |       | (75,031                                   | )          | (155,549 | ) |
| Net cash (used in) provided by financing  activites |       | (2,592                                    | )          | 22,204 |   |
|                                                     |            |                                           |            |  |  |  |  |

 

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

 

***Operating activities***

 

Ourcash used in operating activities was $1.2 million for the three months ended December 31,2008 as compared to $5.2 million for the three months ended December 31,2007. The decrease was primarily due to a net income of $1.8 million for thethree months ended December 31, 2008 versus a net loss of $4.1 million inthe prior period. The cash used in operating activities during the three monthsended December 31, 2008 was primarily due to an increase in accountsreceivable, a decrease in accrued expenses, decrease in income taxes payable,and a decrease in accounts payable of $2.7 million, $1.7 million, $0.6 millionand $0.3 million, respectively. This was partially offset by a decrease ininventories and prepaid expenses and other current assets of $1.1 million and$0.2 million, respectively.

 

***Investing activities***

 

Ourcash used in investing activities was $75,000 for the three months ended December 31,2008 and $155,000 for the three months ended December 31, 2007, primarilyconsisted of the purchase of production and laboratory test equipment.

 

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***Financing activities***

 

Net cash flow used in financing activitieswas $3,000 for the three months ended December 31, 2008 which consistedexclusively of repayments for capitalized lease obligations. Net cash flowprovided by financing activities was $22,000 for the three months ended December 31,2007, the primary source of cash was from proceeds from the exercise of stockoptions.

 

The Company entered into a $4,335,000 loanagreement dated August 1, 2000 with the Chester County, Pennsylvania IndustrialDevelopment Authority. The purpose of the loan was to fund the construction ofthe Company’s new office and manufacturing facility. The loan matures in 2015and carries an interest rate set by the remarketing agent that is consistentwith 30-day tax-exempt commercial paper. The loan agreement includes anoptional redemption schedule allowing the Company the option of forgoing anyprincipal pay-down until such time the bonds expire in 2015. The Company hasexercised its option not to pay-down the outstanding balance and accordingly,the balance of the notes payable will be due in 2015.

 

Effective November 30, 2007 the loancovenants require the Company to maintain at all times unencumbered cash andmarketable securities having a market value of at least $20.0 million and aminimum Tangible Net Worth of $65.0 million. The lender, however, agreed on January 10, 2008 to discontinue theTangible Net Worth covenant so that the only remaining requirement is that theCompany maintain at all times unencumbered cash and marketable securitieshaving a value of at least $20.0 million.

 

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

 

**Backlog**

 

Asof December 31, 2008 and September 30, 2008, our backlog was $46.5million and $57.3 million, respectively. The subsequent decrease in backlog primarilyreflects steps taken by management during the quarter to re-evaluate certaincustomer bookings in light of the current economic environment and feasibilitythat these booking would result in actual revenues. Although we had no customercancellations, we have de-booked approximately $6.0 million during the quarterended December 31, 2008.

 

**Off-Balance Sheet Arrangements**

 

Wedo not participate in transactions that generate relationships withunconsolidated entities or financial partnerships, such as special purposeentities (“SPEs”) or variable interest entities (“VIEs”), which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother limited purposes. As of December 31, 2008 and September 30,2008, we were not involved with any unconsolidated SPEs or VIEs.

 

Wecurrently have a standby letter of credit of $4.4 million with PNC Bank, N.A.The stand by letter of credit is one of the requirements as part of the loanagreement with Chester County, Pennsylvania Industrial Development Authority.

 

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

 

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

 

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**Item 4. Controls and Procedures**

 

(a)          An evaluation was performed under the supervision and with theparticipation of the Company’s management, including its Chief ExecutiveOfficer, or CEO, and Chief Financial Officer, or CFO, of the effectiveness ofthe Company’s disclosure controls and procedures, as such term is defined underRule 13a-15e under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) as of December 31, 2008. Based on that evaluation, the Company’smanagement, including the CEO and CFO, concluded that the Company’s disclosurecontrols and procedures are effective to provide reasonable assurance thatinformation required to be disclosed by the Company in reports that it files orsubmits under the Exchange Act, is recorded, processed, summarized and reportedas specified in Securities and Exchange Commission rules and forms andthat such information is accumulated and communicated to the Company’smanagement, including the CEO and CFO, or persons performing similar functions,as appropriate to allow timely decisions regarding required disclosure.

 

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

 

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**PART II—OTHER INFORMATION**

 

**Item 1.    Legal Proceedings**

 

Inthe ordinary course of business, we are at times subject to various legalproceedings. Except with respect to the fees incurred in connection with thematters described below, we do not believe any current legal proceedings willhave a material adverse effect on our results of operations or financialposition.

 

OnSeptember 13, 2005 the Company filed a lawsuit in the United States DistrictCourt for the Western District of Tennessee against J2, Inc., a companyfounded and jointly owned by Joseph Cesar, a former employee of the Company,and James Zachary, a former sales consultant for the Company. The complaintalleged that the J2/Kollsman/Air Data Computer then being marketed by J2 andmanufactured by Kollsman, Inc. infringed a patent assigned to IS&S.

 

OnNovember 7, 2007 the Company received a favorable jury verdict in itstrade secret misappropriation case against Kollsman, Inc. (a subsidiary ofElbit Systems Ltd.), J2 Inc., Joseph Caesar, James Zachary andZachary Technologies, Inc. in the United States District Court for theWestern District of Tennessee. The jury unanimously found that each of thedefendants had misappropriated IS&S’s air data computer technology. Thejury found that IS&S had suffered damages of just over $4.4 million inlost profits and $1.6 million in defendants’ net profits, for a total ofover $6 million. The jury also found in favor of IS&S’s claims forbreach of duty and contract, and unfair competition against J2 Inc.,Joseph Caesar, James Zachary and Zachary Technologies, Inc.

 

OnDecember 18, 2007, the court entered a temporary injunction aimed atpreventing further use of the Company’s trade secret and proprietaryinformation. On March 14, 2008, the judge presiding over the case heardthe Company’s claims for a permanent injunction as well as punitive andexemplary damages and attorneys’ fees against Kollsman and the otherdefendants.

 

OnJuly 7, 2008, the court issued several rulings in the case. In therulings, the court awarded damages, interest and fees in addition to the morethan $6 million in compensatory damages awarded by the jury when itrendered its verdict in the case in November 2007. The additional awardsbring the damages assessed against Kollsman, Inc. to a total or more than$23 million. The court also entered an order granting the Company’srequest for permanent injunctive relief.

 

OnAugust 27, 2008, the Company entered into a Settlement Agreement (theSettlement Agreement) with Kollsman, Inc. On August 29, 2008, thesettlement became effective with respect to all claims filed by the Company andKollsman against each other in the United States District Court for the WesternDistrict of Tennessee and a Consent Order was entered. Under the SettlementAgreement, all claims between the Company and Kollsman have been dismissed withprejudice, a final agreed injunction has been entered and the matter has beenfully and finally mutually settled without any admission of guilt by eitherparty. In addition, an agreed settlement payment of $17 million has beenmade by Kollsman to the Company.

 

OnOctober 9, 2008, Zachary and ZTI consented to the entry of judgmentagainst and to a permanent injunction, which resulted in the conclusion of allclaims with respect to those parties. On November 17, 2008, the courtgranted the Company’s motion to dismiss its patent infringement claims againstCaesar and J2, and dismissed Caesar and J2’s counterclaims for noninfringement,invalidity and unenforceability because there was no longer a justifiable claimor controversy with respect to those counterclaims.

 

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

 

**Item 1A.  Risk Factors**

 

Thereare no material changes to the risk factors described under Item 1A of our Form 10-Kfor the year ended September 30, 2008.

 

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| **Item 2.** | **Unregistered Sales of Equity Securities and Use  of Proceeds** |
|-------------|------------------------------------------------------------------|
|        |                                                             |
|        | None                                                             |
|        |                                                             |
| **Item 3.** | **Defaults upon Senior Securities**                              |
|        |                                                             |
|        | None                                                             |
|        |                                                             |
| **Item 4.** | **Submission of Matters to a Vote of Security  Holders**         |
|        |                                                             |
|        | None                                                             |
|        |                                                             |
| **Item 5.** | **Other Information**                                            |
|        |                                                             |
|        | None                                                             |

 

**Item 6. Exhibits**

 

(a)   Exhibits

 

10.7^@   Release Agreement by andbetween IS&S and Raymond J. Wilson dated November 10, 2008

 

31.1*       Certification of ChiefExecutive Officer Pursuant to Rule 13a-14(a)

 

31.2*       Certification of ChiefFinancial Officer Pursuant to Rule 13a-14(a)

 

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

 

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*  Filed herewith

 

†  Furnished herewith

 

^  Constitutes a management contract or compensatory plan or arrangementrequired to be filed as an exhibit to this form.

 

@  Incorporated by reference from the Registrant’s Current Report on Form 8-Kfiled with the Commission on November 13, 2008.

 

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**SIGNATURE**

 

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

 

 
| ** **                   | **INNOVATIVE  SOLUTIONS AND SUPPORT, INC.** |
|------------------------------|---------------------------------------------|
|                         |                                        |
|                         |                                        |
| Date:  February 6, 2009 | By:                                         | /s/  JOHN C. LONG |
|                         |                                        | JOHN  C. LONG |
|                         |                                        | CHIEF  FINANCIAL OFFICER |

 

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