**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 March 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

 

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

 

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

 

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

Yes  o      No  x

 

Asof May 1, 2008, there were 16,901,884 shares of the Registrant’s CommonStock, with par value of $.001 per share, outstanding.

 

 

----

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

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

 

**INDEX**

 
|              | ** **                                                                                                              | **Page No.** |
|-------------------|-------------------------------------------------------------------------------------------------------------------------|-------------------|
|              |                                                                                                                    |              |
| **PART I.**  | **FINANCIAL  INFORMATION**                                                                                              | 3                 |
|              |                                                                                                                    |              |
| Item 1.           | Financial Statements  (Unaudited)                                                                                       |              |
|              |                                                                                                                    |              |
|              | Condensed  Consolidated Balance Sheets – March 31, 2008 and September 30, 2007                           | 3                 |
|              |                                                                                                                    |              |
|              | Condensed  Consolidated Statements of Operations – Three Months and Six Months Ended  March 31, 2008 and 2007 | 4                 |
|              |                                                                                                                    |              |
|              | Condensed  Consolidated Statements of Cash Flows – Six Months Ended March 31, 2008  and 2007                  | 5                 |
|              |                                                                                                                    |              |
|              | Notes to  Condensed Consolidated Financial Statements                                                                   | 6 – 10       |
|              |                                                                                                                    |              |
| Item 2.           | Managements  Discussion and Analysis of Financial Condition and Results of Operations                                   | 11 – 16      |
|              |                                                                                                                    |              |
| Item 3.           | Quantitative  and Qualitative Disclosures about Market Risk                                                             | 18                |
|              |                                                                                                                    |              |
| Item 4.           | Controls and Procedures                                                                                                 | 18                |
|              |                                                                                                                    |              |
| **PART II.** | **OTHER INFORMATION**                                                                                                   |              |
|              |                                                                                                                    |              |
| Item 1.           | Legal Proceedings                                                                                                       | 19                |
|              |                                                                                                                    |              |
| Item 1A           | Risk Factors                                                                                                            | 19                |
|              |                                                                                                                    |              |
| Item 2.           | Unregistered  Sales of Equity Securities and Use of Proceeds                                                            | 19                |
|              |                                                                                                                    |              |
| Item 3.           | Defaults upon  Senior Securities                                                                                        | 20                |
|              |                                                                                                                    |              |
| Item 4.           | Submission  of Matters to a Vote of Security Holders                                                                    | 20                |
|              |                                                                                                                    |              |
| Item 5.           | Other Information                                                                                                       | 20                |
|              |                                                                                                                    |              |
| Item 6.           | Exhibits                                                                                                                | 20                |
|              |                                                                                                                    |              |
| **SIGNATURES**    |                                                                                                                    |              |

 

2

----

 

**PART I–FINANCIALINFORMATION**

**Item 1–Financial Statements**

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(unaudited)**

** **
| ** **                                                                                                                                                                                                                       | ** ** | **As of**               | ** ** | **As of**                   | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                                                                                       | ** ** | **March 31, 2008** | ** ** | **September 30, 2007** | ** ** |
| **ASSETS**                                                                                                                                                                                                                       |       |                         |       |                             |       |
| Current Assets:                                                                                                                                                                                                                  |       |                         |       |                             |       |
| Cash and cash equivalents                                                                                                                                                                                                        |       | $                            | 43,794,278 |                             | $          | 49,151,078 |   |
| Accounts receivable                                                                                                                                                                                                              |       | 4,735,045                    |       | 6,248,606                        |       |
| Inventories                                                                                                                                                                                                                      |       | 9,913,219                    |       | 9,363,795                        |       |
| Deferred income taxes                                                                                                                                                                                                            |       | —                       |       | 899,895                          |       |
| Prepaid expenses and other current assets                                                                                                                                                                                        |       | 1,053,078                    |       | 6,208,804                        |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Total current assets                                                                                                                                                                                                             |       | 59,495,620                   |       | 71,872,178                       |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Property and Equipment:                                                                                                                                                                                                          |       |                         |       |                             |       |
| Computers and test equipment                                                                                                                                                                                                     |       | 5,801,022                    |       | 5,444,737                        |       |
| Corporate airplane                                                                                                                                                                                                               |       | 3,058,627                    |       | 3,058,627                        |       |
| Furniture and office equipment                                                                                                                                                                                                   |       | 1,068,970                    |       | 1,016,954                        |       |
| Manufacturing facility                                                                                                                                                                                                           |       | 5,567,547                    |       | 5,557,048                        |       |
| Land                                                                                                                                                                                                                             |       | 1,021,245                    |       | 1,021,245                        |       |
|                                                                                                                                                                                                                             |       | 16,517,411                   |       | 16,098,611                       |       |
| Less- Accumulated depreciation and  amortization                                                                                                                                                                                 |       | (7,198,420                   | )          | (6,721,274                       | )          |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Net property and equipment                                                                                                                                                                                                       |       | 9,318,991                    |       | 9,377,337                        |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Deferred income taxes                                                                                                                                                                                                            |       | —                       |       | 328,060                          |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Other assets                                                                                                                                                                                                                     |       | 2,996,390                    |       | 3,008,210                        |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Total assets                                                                                                                                                                                                                     |       | $                            | 71,811,001 |                             | $          | 84,585,785 |   |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                   |       |                         |       |                             |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Current Liabilities                                                                                                                                                                                                              |       |                         |       |                             |       |
| Current portion of capitalized lease  obligations                                                                                                                                                                                |       | $                            | 9,908      |                             | $          | 9,908 |   |
| Accounts payable                                                                                                                                                                                                                 |       | 2,864,694                    |       | 4,077,789                        |       |
| Accrued expenses                                                                                                                                                                                                                 |       | 3,455,778                    |       | 4,670,832                        |       |
| Deferred revenue                                                                                                                                                                                                                 |       | 400,035                      |       | 660,415                          |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Total current liabilities                                                                                                                                                                                                        |       | 6,730,415                    |       | 9,418,944                        |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Note payable                                                                                                                                                                                                                     |       | 4,335,000                    |       | 4,335,000                        |       |
| Long-term portion of capitalized lease  obligations                                                                                                                                                                              |       | 42,671                       |       | 47,542                           |       |
| Deferred revenue                                                                                                                                                                                                                 |       | 15,284                       |       | 50,520                           |       |
| Commitments and contingencies                                                                                                                                                                                                    |       | —                       |       | —                           |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Shareholders’ Equity:                                                                                                                                                                                                       |       |                         |       |                             |       |
| Preferred stock, 10,000,000 shares  authorized, $.001 par value, of which 200,000 shares are authorized as  Class A Convertible stock. No shares issued and outstanding at  March 31, 2008 and September 30, 2007 |       | —                       |       | —                           |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Common stock, $.001 par value: 75,000,000  shares authorized, 18,171,164 and 18,161,172 shares issued at March 31,  2008 and September 30, 2007                                                                        |       | 18,171                       |       | 18,161                           |       |
| Additional paid-in capital                                                                                                                                                                                                       |       | 45,213,788                   |       | 44,607,993                       |       |
| Retained earnings                                                                                                                                                                                                                |       | 33,599,278                   |       | 44,194,053                       |       |
| Treasury stock, at cost, 1,279,510, shares  at March 31, 2008 and 1,272,510 shares at September 30, 2007                                                                                                               |       | (18,143,606                  | )          | (18,086,428                      | )          |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Total shareholders’ equity                                                                                                                                                                                                  |       | 60,687,631                   |       | 70,733,779                       |       |
|                                                                                                                                                                                                                             |       |                         |       |                             |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                                  |       | $                            | 71,811,001 |                             | $          | 84,585,785 |   |

 

Theaccompanying notes are an integral part of these statements.

 

3

----

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**(unaudited)**

** **
| ** **                                         | ** ** | **Three Months** | ** ** | **Three Months** | ** ** | **Six Months** | ** ** | **Six Months** | ** **  |
|----------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|---------------------|------------|---------------------|-------------|
| ** **                                         | ** ** | **Ended**             | ** ** | **Ended**             | ** ** | **Ended**           | ** ** | **Ended**           | ** **  |
| ** **                                         | ** ** | **March 31,**    | ** ** | **March 31,**    | ** ** | **March 31,**  | ** ** | **March 31,**  | ** **  |
| ** **                                         | ** ** | **2008**              | ** ** | **2007**              | ** ** | **2008**            | ** ** | **2007**            | ** **  |
| Net sales:                                         |       |                  |       |                  |       |                |       |                |        |
| Product                                            |       | $                     | 6,212,973  |                  | $          | 3,152,791           |       | $                   | 10,112,761  |   | $ | 6,334,819 |   |
| Engineering - Modification &  Development |       | 611,387               |       | 802,507               |       | 1,447,246           |       | 1,049,127           |        |
| Total net sales                                    |       | 6,824,360             |       | 3,955,298             |       | 11,560,007          |       | 7,383,946           |        |
|                                               |       |                  |       |                  |       |                |       |                |        |
| Cost of sales                                      |       |                  |       |                  |       |                |       |                |        |
| Product                                            |       | 3,710,982             |       | 2,294,539             |       | 6,481,081           |       | 4,041,755           |        |
| Engineering - Modification &  Development |       | 79,679                |       | 723,489               |       | 968,639             |       | 1,010,218           |        |
| Total cost of sales                                |       | 3,790,661             |       | 3,018,028             |       | 7,449,720           |       | 5,051,973           |        |
|                                               |       |                  |       |                  |       |                |       |                |        |
| Gross profit                                       |       | 3,033,699             |       | 937,270               |       | 4,110,287           |       | 2,331,973           |        |
|                                               |       |                  |       |                  |       |                |       |                |        |
| Operating expenses:                                |       |                  |       |                  |       |                |       |                |        |
| Research and development                           |       | 2,776,576             |       | 1,480,741             |       | 4,517,244           |       | 2,805,095           |        |
| Selling, general and administrative                |       | 4,734,446             |       | 3,873,767             |       | 10,670,352          |       | 6,932,782           |        |
| Total operating expenses                           |       | 7,511,022             |       | 5,354,508             |       | 15,187,596          |       | 9,737,877           |        |
|                                               |       |                  |       |                  |       |                |       |                |        |
| Operating loss                                     |       | (4,477,323            | )          | (4,417,238            | )          | (11,077,309         | )          | (7,405,904          | )           |
|                                               |       |                  |       |                  |       |                |       |                |        |
| Interest income- net                               |       | 403,199               |       | 740,751               |       | 942,021             |       | 1,506,264           |        |
| Other income                                       |       | 300,000               |       | —                |       | 300,000             |       | —              |        |
| Loss before income taxes                           |       | (3,774,124            | )          | (3,676,487            | )          | (9,835,288          | )          | (5,899,640          | )           |
|                                               |       |                  |       |                  |       |                |       |                |        |
| Income tax expense (benefit)                       |       | 3,286,033             |       | (1,317,341            | )          | 1,346,810           |       | (2,442,050          | )           |
|                                               |       |                  |       |                  |       |                |       |                |        |
| Net loss                                           |       | $                     | (7,060,157 | )                     | $          | (2,359,146          | )          | $                   | (11,182,098 | ) | $ | (3,457,590 | ) |
|                                               |       |                  |       |                  |       |                |       |                |        |
| Net loss per common share:                         |       |                  |       |                  |       |                |       |                |        |
| Basic                                              |       | $                     | (0.42      | )                     | $          | (0.14               | )          | $                   | (0.66       | ) | $ | (0.21 | ) |
| Diluted                                            |       | $                     | (0.42      | )                     | $          | (0.14               | )          | $                   | (0.66       | ) | $ | (0.21 | ) |
|                                               |       |                  |       |                  |       |                |       |                |        |
| Weighted average shares outstanding:               |       |                  |       |                  |       |                |       |                |        |
| Basic                                              |       | 16,890,942            |       | 16,865,098            |       | 16,895,720          |       | 16,844,795          |        |
| Diluted                                            |       | 16,890,942            |       | 16,865,098            |       | 16,895,720          |       | 16,844,795          |        |

 

The accompanying notes are an integral part of these statements.

 

4

----

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(unaudited)**

** **
| ** **                                                                                          | ** ** | **For the Six** | ** **  | **For the Six** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------|-------------|---------------------------|------------|
| ** **                                                                                          | ** ** | **Months Ended**     | ** **  | **Months Ended**     | ** ** |
| ** **                                                                                          | ** ** | **March 31**         | ** **  | **March 31**         | ** ** |
| ** **                                                                                          | ** ** | **2008**                  | ** **  | **2007**                  | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                           |       |                      |        |                      |       |
| Net loss                                                                                            |       | $                         | (11,182,098 | )                         | $          | (3,457,590 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by  (used in) operating activities: |       |                      |        |                      |       |
| Depreciation and amortization                                                                       |       | 504,594                   |        | 407,567                   |       |
| Share-based compensation expense:                                                                   |       |                      |        |                      |       |
| Stock options                                                                                       |       | 459,417                   |        | 223,742                   |       |
| Nonvested stock awards                                                                              |       | 99,974                    |        | 99,942                    |       |
| Tax benefit from share-based arrangements:                                                          |       |                      |        |                      |       |
| Stock options                                                                                       |       | 11,999                    |        | 163,979                   |       |
| Nonvested stock awards                                                                              |       | 6,286                     |        | 39,740                    |       |
| Excess tax benefits from share-based  payments arrangements                                         |       | —                    |        | (135,302                  | )          |
| (Gain) loss on disposal of fixed assets                                                             |       | (3,000                    | )           | 551                       |       |
| Excess and obsolete inventory expense                                                               |       | —                    |        | 100,000                   |       |
| Deferred income taxes                                                                               |       | 1,227,955                 |        | (367,564                  | )          |
| (Increase) decrease in:                                                                             |       |                      |        |                      |       |
| Accounts receivable                                                                                 |       | 1,513,561                 |        | 1,010,425                 |       |
| Inventories                                                                                         |       | (549,424                  | )           | 812,230                   |       |
| Prepaid expenses and other current assets                                                           |       | 5,155,726                 |        | (3,129,287                | )          |
| Other non current assets                                                                            |       | (6,180                    | )           | —                    |       |
| Increase (decrease) in:                                                                             |       |                      |        |                      |       |
| Accounts payable                                                                                    |       | (1,213,095                | )           | 1,941,077                 |       |
| Accrued expenses                                                                                    |       | (627,730                  | )           | 257,840                   |       |
| Deferred revenue                                                                                    |       | (295,616                  | )           | (415,443                  | )          |
| Net cash used in operating activities                                                               |       | (4,908,881                | )           | (2,448,093                | )          |
|                                                                                                |       |                      |        |                      |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                           |       |                      |        |                      |       |
| Purchases of property and equipment                                                                 |       | (428,248                  | )           | (380,444                  | )          |
| Purchases of other assets                                                                           |       | —                    |        | (2,500                    | )          |
| Proceeds on sale of fixed assets                                                                    |       | 3,000                     |        | —                    |       |
| Net cash used in investing activities                                                               |       | (425,248                  | )           | (382,944                  | )          |
|                                                                                                |       |                      |        |                      |       |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                           |       |                      |        |                      |       |
| Proceeds from exercise of stock options                                                             |       | 28,129                    |        | 434,938                   |       |
| Repayment of capitalized lease obligations                                                          |       | (4,872                    | )           | (4,073                    | )          |
| Purchase of treasury stock                                                                          |       | (57,178                   | )           |                      |       |
| Excess tax benefits from share-based  payments arrangements                                         |       | —                    |        | 135,302                   |       |
| Net cash provided by (used in) financing  activities                                                |       | (22,671                   | )           | 566,167                   |       |
|                                                                                                |       |                      |        |                      |       |
| Net decrease in cash and cash equivalents                                                           |       | (5,356,800                | )           | (2,264,870                | )          |
| Cash and cash equivalents, beginning of  year                                                       |       | 49,151,078                |        | 62,984,829                |       |
|                                                                                                |       |                      |        |                      |       |
| Cash and cash equivalents, end of period                                                            |       | $                         | 43,794,278  |                      | $          | 60,719,959 |   |
|                                                                                                |       |                      |        |                      |       |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION**                                               |       |                      |        |                      |       |
| Cash paid for interest                                                                              |       | $                         | 69,005      |                      | $          | 81,128 |   |
| Cash paid for income taxes                                                                          |       | $                         | 6,000       |                      | $          | — |   |
| Cash received from income tax refund                                                                |       | $                         | (5,078,928  | )                         | $          | (1,801 | ) |

 

The accompanying notes are an integral part of these statements.

 

5

----

 

**Innovative Solutions and Support Inc.**

**Notes toCondensed Consolidated Financial Statements**

 

**1.Basis of Presentation:**

 

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

 

Thebalance sheet as of March 31, 2008, the statement of operations for thethree months and six months ended March 31, 2008 and 2007 and thestatements of cash flows for the six months ended March 31, 2008 and 2007have been prepared by the Company without audit. In the opinion of management, alladjustments, consisting of normal and recurring adjustments, necessary topresent fairly the financial position, results of operations and cash flows at March 31,2008 and for all periods presented have been made.

 

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted. It is suggested thatthese financial statements be read in conjunction with the financial statementsand notes thereto included in the Company’s Form 10-K for the year ended September 30,2007 as filed with the Securities and Exchange Commission. The results ofoperations for the three months and six months ended March 31, 2008 arenot necessarily indicative of the operating results for the full year.

 

**2. New Accounting Pronouncements**

 

In September 2006, theFinancial 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 Company is currentlyevaluating the impact of this pronouncement.

 

**3. Concentrations**

 

Forthe three months ended March 31, 2008, one customer accounted for 49% ofnet sales. For the three months ended March 31, 2007, three customersaccounted for 35%, 18% and 12% of net sales or 65% on a combined basis. For thesix months ended March 31, 2008, one customer accounted for 58% of netsales. For the six months ended March 31, 2007, two customers accountedfor 22% and 10% of net sales or 32% on a combined basis.

 

**4.Inventories**

 

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

** **
| ** **      | ** ** | **March 31** | ** ** | **September 30** | ** ** |
|-----------------|------------|-------------------|------------|-----------------------|------------|
| ** **      | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Raw  materials  |       | $                 | 6,910,635  |                  | $          | 6,420,184 |   |
| Work-in-process |       | 1,984,600         |       | 2,216,111             |       |
| Finished goods  |       | 1,017,984         |       | 727,500               |       |
|            |       | $                 | 9,913,219  |                  | $          | 9,363,795 |   |

 

 

6

----

 

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

 

Prepaidexpenses and other current assets consist of the following:

 
| ** **           | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|----------------------|------------|--------------------|------------|------------------------|------------|
| ** **           | ** ** | **2008**           | ** ** | **2007**               | ** ** |
| Prepaid income taxes |       | $                  | —     |                   | $          | 5,017,794 |   |
| Other                |       | 1,053,078          |       | 1,191,010              |       |
|                 |       |               |       |                   |       |
|                 |       | $                  | 1,053,078  |                   | $          | 6,208,804 |   |

 

**6. Warranty**

 

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

 

Warranty cost and accrualinformation for the three months ended March 31, 2008 is highlightedbelow:

 
| Warranty accrual at December 31, 2007                     |   | $       | 624,481 |   |
|----------------------------------------------------------------|--------|---------|---------|--------|
| Accrued expense for the three months ended  March, 31, 2008    |   | 78,480  |    |
| Warranty costs for the three months ended  March 31, 2008 |   | (29,763 | )       |
|                                                           |   |    |    |
| Warranty accrual at March 31, 2008                        |   | $       | 673,198 |   |

 

Warranty cost and accrualinformation for the six months ended March 31, 2008 is highlighted below:

 
| Warranty accrual at September 30, 2007                  |   | $       | 592,524 |   |
|--------------------------------------------------------------|--------|---------|---------|--------|
| Accrued expense for the six months ended  March, 31, 2008    |   | 149,988 |    |
| Warranty costs for the six months ended  March 31, 2008 |   | (69,315 | )       |
|                                                         |   |    |    |
| Warranty accrual at March 31, 2008                      |   | $       | 673,198 |   |

 

**7.Notes Payable**

 

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

 

InNovember 2007 the Company and the lender signed an amendment to the loanagreement which deleted existing financial covenants and replaced them withonly one restrictive covenant that requires the Company to maintain at alltimes unencumbered cash and marketable securities having a market value of atleast $20 million. The Company was in compliance with this covenant as of March 31,2008.

 

**8.Share-Based Compensation**

 

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

 

7

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Totalshare-based compensation expense was $380,000 and $172,000 for the three monthsended March 31, 2008 and 2007, respectively. The income tax benefitrecognized in the statement of operations for share-based compensationarrangements was $0 and $62,000 for the three months ended March 31, 2008and 2007, respectively. Total share-based compensation expense was $559,000 and$334,000 for the six months ended March 31, 2008 and 2007 respectively andthe income tax benefit recognized in the statement of operations for sharebased compensation arrangements was $0 and $138,000, respectively. Compensationexpense related to share-based awards is recorded as a component of general andadministrative expense.

 

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

 

**StockOptions**

 

ThePlan provides for the granting of incentive and nonqualified stock options toemployees, officers, directors and independent contractors and consultants.Through March 31, 2008 no stock options have been granted to independentcontractors or consultants under this Plan. Total compensation expense was $330,000 and $112,000 for the threemonths ended March 31, 2008 and 2007, and $459,000 and $224,000 for thesix months ended March 31, 2008 and 2007, respectively.  Incentive stock options granted under thePlan have exercise prices that must be at least equal to the fair value of thecommon stock on the date of grant. Nonqualified stock options granted under thePlan have exercise prices that may be less than, equal to or greater than thefair value of the common stock on the date of grant. The Company has reserved3,389,000 shares of Common Stock for awards under the plan. As of March 31,2008 there were 1,285,000 shares remaining and available for grant under thePlan.

 

Asummary of option activity under the Plan as of March 31, 2008 and changesduring the six months ended March 31, 2008 is as follows:

 
| ** **                             | ** ** | ** **  | ** ** | ** **                | ** ** | **Weighted Average** | ** ** | **Aggregate** | ** ** |
|----------------------------------------|------------|-------------|------------|---------------------------|------------|---------------------------|------------|---------------|------------|
| ** **                             | ** ** | ** **  | ** ** | **Weighted Average** | ** ** | **Remaining**             | ** ** | **Intrinsic** | ** ** |
| ** **                             | ** ** | **Options** | ** ** | **Exercise Price**   | ** ** | **Contractual Life** | ** ** | **Value**     | ** ** |
| Outstanding at September 30, 2007 |       | 572,959     |       | $                         | 10.30      |                      |       |          |       |   |
| Granted                                |       | 409,000     |       | 10.16                     |       |                      |       |          |       |
| Exercised                              |       | (3,897      | )          | 7.22                      |       |                      |       |          |       |
| Cancelled                              |       | (9,354      | )          | 9.46                      |       |                      |       |          |       |
|                                   |       |        |       |                      |       |                      |       |          |       |
| Outstanding at March 31, 2008     |       | 968,708     |       | $                         | 10.26      |                      | 7.41       |          | $          | 1,935,418 |   |
| Exercisable at March 31, 2008     |       | 410,608     |       | $                         | 7.73       |                      | 4.86       |          | $          | 1,635,963 |   |

 

Theweighted-average grant date fair value of individual options granted during thesix months ended March 31, 2008 and 2007 was $5.05 and $9.64,respectively. The total intrinsic value of options exercised during the sixmonths ended March 31, 2008 and 2007 was $31,000 and $534,000,respectively.

 

The following table summarizes information about stock options underthe Plan at March 31, 2008:

 
| **Options Outstanding**    | ** ** | **Options Exercisable** | ** ** |
|---------------------------------|------------|------------------------------|------------|
| ** **                      | ** ** | ** **                   | ** ** | **Weighted-** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Outstanding**              | ** ** | **Average** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                      | ** ** | **As of**               | ** ** | **Remaining** | ** ** | **Average** | ** ** | **As of** | ** ** | **Average** | ** ** |
| **Range of Exercise** | ** ** | **March 31,**           | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | **March 31,** | ** ** | **Exercise** | ** ** |
| **Prices**                      | ** ** | **2008**                     | ** ** | **Life** | ** ** | **Price** | ** ** | **2008** | ** ** | **Price** | ** ** |
|                            |       |                         |       |   |   |   |   |   |   |   |   |
| $ 0.00                     | -          | 5.00                         |       | 201,909 |   | 4.79 |   | $ | 4.22 |   | 201,309 |   | $ | 4.22 |   |
| $ 5.01                     | -          | 10.00                        |       | 210,799 |   | 5.89 |   | 7.81 |   | 123,299 |   | 7.68 |   |
| $ 10.01                    | -          | 15.00                        |       | 445,000 |   | 9.23 |   | 11.47 |   | 42,000 |   | 13.85 |   |
| $ 15.01                    | -          | 20.00                        |       | 46,600 |   | 7.07 |   | 16.77 |   | 30,400 |   | 16.88 |   |
| $ 20.01                    | -          | 26.97                        |       | 64,400 |   | 8.30 |   | 24.18 |   | 13,600 |   | 20.68 |   |
|                            |       |                         |       |   |   |   |   |   |   |   |   |   |   |
|                            |       |                         |       | 968,708 |   | 7.41 |   | 10.26 |   | 410,608 |   | 7.73 |   |
|                                 |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

8

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

 
| ** **                               | ** ** | **Six Months**          | ** ** | **Six Months**          | ** ** |
|------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | **Ended**                    | ** ** | **Ended**                    | ** ** |
| ** **                               | ** ** | **March 31, 2008** | ** ** | **March 31, 2007** | ** ** |
|                                     |       |                         |       |                         |       |
| Expected lives (years)                   |       | 7.24                         |       | 8.82                         |       |
| Weighted average risk-free interest rate |       | 2.3                          | %          | 2.1                          | %          |
| Expected volatility                      |       | 59.9                         | %          | 64.7                         | %          |
| Expected dividend rate                   |       | —                       | %          | —                       | %          |
|                                     |       |                         |       |                         |       |

 

As of March 31, 2008, there was approximately $1.5 million ofunrecognized compensation cost, net of forfeitures, related to non-vested stockoptions, which is expected to be recognized over a period of approximately 5years.

 

**Non-vested Stock**

 

TheRestricted Plan for non-employee directors was approved by shareholders at theCompany’s February 26, 2004 Annual Meeting of Shareholders. The Plan callsfor an annual award of non-vested stock having a fair market value of $40,000as of the close of business on October 1 of the current fiscal year forall eligible non-employee directors. The stock is awarded in four quarterlyinstallments during the fiscal year provided the director is still serving onthe board on the quarterly issue date. Total expense was $50,000 and $60,000for the three months ended March 31, 2008 and 2007 and $100,000 and$110,000 for the six months ended March 31, 2008 and 2007, respectively.As of March 31, 2008, there was an estimated $100,000 of unrecognizedcompensation expense related to nonvested stock awards under the Company’sRestricted Plan. That cost is expected to be recognized over the balance of thefiscal year. The following table outlines restricted stock awards for the sixmonths ended March 31, 2008:

 
| ** **                         | ** ** | **Non-vested**        | ** ** | **Weighted Average** | ** ** |
|------------------------------------|------------|-----------------------|------------|---------------------------|------------|
| ** **                         | ** ** | **Stock Awards** | ** ** | **Share Price**      | ** ** |
| Balance at September 30, 2007 |       | 3,465                 |       | $                         | 14.43      |   |
| Granted                            |       | 10,525                |       | 19.00                     |       |
| Issued                             |       | (6,095                | )          | 16.40                     |       |
| Cancelled                          |       | —                |       | —                    |       |
| Balance at March 31, 2008     |       | 7,895                 |       | $                         | 19.00      |   |

 

**9.Stock Repurchase Program**

 

On December 28, 2005 the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 2,000,000 shares of itsoutstanding common stock. Over the course of the program the Companyrepurchased 1,272,510 shares of its common stock at an average cost of $14.21per share. The program was in effect until March 31, 2007

 

On February 21, 2008 the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of itsoutstanding common stock. The program will remain in effect until February 21,2009, unless extended by the Board of Directors. For the three months ended March 31,2008 the Company repurchased 7,000 shares of its common stock at an averagecost of $8.17 per share.

 

**10.Loss per Share**

 

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

 

Forthe six month periods ended March 31, 2008 and 2007, there were 969,000and 547,000 options to purchase common stock outstanding  excluded from the computations of dilutedearnings per share as the effect would be antidilutive.

 

9

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**11.Income Taxes**

 

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

 

Theamounts of unrecognized tax benefits as of October 1, 2007 were approximately$330,000, all of which, if ultimately recognized, would reduce the Company’sannual effective tax rate. There have been no material changes in unrecognizedtax benefits since October 1, 2007.

 

TheCompany is subject to income taxes in the U.S. federal and various statejurisdictions. Tax regulations within each jurisdiction are subject to theinterpretation of  related tax laws andregulations and require significant judgment to apply. With few significantexceptions, the Company is no longer subject to U.S. federal or state and localexaminations by tax authorities for the years ending on or before September 30,2003.

 

TheCompany does not expect the total amount of unrecognized tax benefits tosignificantly change in the next twelve months.

 

TheCompany recognizes interest accrued and penalties related to unrecognized taxbenefits in income tax expense for all periods presented. The Company hadaccrued approximately $30,000 for the payment of interest and penalties, net ofdeferred tax benefits, at October 1, 2007. Subsequent changes to accruedinterest and penalties have not been significant.

 

Forthe six months ended March 31, 2008, the Company recognized $10,000 ofinterest and penalties, net of tax benefit, within income tax expense.

 

TheCompany’s financial statements contain certain deferred tax assets which havearisen primarily as a result of tax benefits associated with the loss beforeincome tax incurred during the six months ended March 31, 2008, as well asdeferred income tax assets resulting from temporary differences in prior taxyears.  SFAS No. 109, *Accounting for Income Taxes (“SFAS 109”)*, requires theconsideration of a valuation allowance to reflect the likelihood of realizationof deferred tax assets.  Significantmanagement judgment is required in determining any valuation allowance recordedagainst net deferred tax assets.  TheCompany considered all of the available positive and negative evidence,including the significant operating losses incurred in 2006 and 2007, thecontinued operating losses in 2008, uncertainty as to the extent and timing ofprofitability in future periods, and ongoing tax planning strategies. Based on the weight of available evidence, the Company recorded a fullvaluation allowance againstdeferred tax assets during the quarter ended March 31, 2008.  The establishment of this valuation allowanceduring the quarter ended March 31, 2008 was offset by the tax benefitrealized as a result of the three month ended March 31, 2008, pre-tax lossincurred by the Company and resulted in an income tax expense of $3.3 millionfor the quarter.

 

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

 

10

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

 

**Overview**

 

Wedesign, manufacture and sell flat panel display systems, flight informationcomputers and advanced monitoring systems to the Department of Defense (DOD),government agencies, commercial air transport carriers and corporate/generalaviation markets.

 

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

 

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

 

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

 

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

 

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

 

Weintend to continue to invest in development of new products and  enhancement of our existing product lines andwill expense research and development costs as incurred.

 

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

 

TheCompany’s financial statements contain certain deferred tax assets which havearisen primarily as a result of tax benefits associated with the loss beforeincome tax incurred during the six months ended March 31, 2008, as well asdeferred income tax assets resulting from temporary differences in prior tax years.  SFAS 109 requires the consideration of avaluation allowance to reflect the likelihood of realization of deferred taxassets.  Significant management judgmentis required in determining any valuation allowance recorded against netdeferred tax assets.  As a result ofoperating losses incurred in 2006 and 2007, the continued operating losses in2008, and uncertainty as to the extent and timing of profitability in futureperiods, the Company recorded a full valuation allowance against deferred taxassets during the quarter ended March 31, 2008.  The establishment of this valuation allowanceduring the quarter ended March 31, 2008 was offset by the tax benefitrealized as a result of the three month ended March 31, 2008, pre-tax lossincurred by the Company and resulted in an income tax expense of $3.3 millionfor the quarter.

 

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

 

11

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

 

*Netsales.* Net salesincreased $2.9 million, or 74%, to $6.8 million for the three months ended March 31,2008 from $3.9 million in the three months ended March 31, 2007. For thethree months ended March 31, 2008, product sales increased $3.1 millionand EMD sales decreased $0.2 million from the same period in the prior year.The increase in product sales was primarily related to increased sales of FlatPanel Display System to a major customer.

 

*Cost ofsales.* Cost of salesincreased $0.8 million or 26%, to $3.8 million, or 56% of net sales in thethree months ended March 31, 2008 from $3.0 million, or 76 % of net salesin the three months ended March 31, 2007. The overall dollar increaseconsists of $1.4 million in cost of sales related to product sales and adecrease of $0.6 million related to EMD sales. The $1.4 million increase incost related to product sales is attributable to increased sales. The decreasein cost related to EMD sales was primarily related to lower EMD sales.

 

*Researchand development.*Research and development expense increased $1.3 million or 87% to $2.8 millionor 41% of net sales in the three months ended March 31, 2008 from $1.5million or 37% of net sales in the three months ended March 31, 2007.

 

Theincrease in research and development expense in the quarter was primarily dueto reduction in the cost allocation associated with EMD cost of sales for theperiod. This allocation was necessary to match non- recurring engineering costwith corresponding non-recurring engineering sales in the period. Overall, whenyou combine research and development expenses with EMD cost of sales, combinedengineering, research and development related cost for the three months ended March 31,2008 has increased $0.7 million from the same period in the prior year andreflects the Company’s continued commitment to product development, researchand engineering.

 

*Selling,general, and administrative.* Selling, general and administrative expenses increased $0.8 million,or 21%, to $4.7 million, or 69% of net sales in the three months ended March 31,2008 from $3.9 million or 100% of net sales in the three months ended March 31,2007. The increase in the dollar amount for the three months ended March 31,2008 from the same  period in the prioryear was primarily the result of increases of $0.8 million for employee relatedexpenses and $0.2 million in outside consulting services, offset by a $0.4million reduction in legal fees incurred to protect the Company’s intellectualproperty.

 

*Interestincome – net.*Interestincome of $442,000 was offset by interest expense of $39,000 in the threemonths ended March 31, 2008. Interest income of $791,000 was offset byinterest expense of $50,000 in the three months ended March 31, 2007. Thedecrease in interest income was primarily the result of  reduced average cash balances and lowerinterest rates in the current quarter as opposed to the same period in theprior year.

 

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

 

*Income tax expense (benefit).* The income tax expense for the three months ended March 31, 2008was $3.3 million as compared to an income tax benefit of $1.3 million for thethree months ended March 31, 2007. The increase in the amount of incometax expense was the result of the establishment of a valuation allowancerelated to the deferred tax assets the Company had accumulated on the balancesheet. As required by SFAS No. 109, this valuation allowance was recordedbased on the weight of available positive and negative evidence, including twoyears of financial statement losses, its current projection of a pre-tax lossfor the current year, and consideration of the Company’s ongoing tax planningstrategies. If the realizationof deferred tax assets in the future is considered more likely than not, areduction to the valuation allowance related to the deferred tax assets wouldincrease net income in the period such determination is made.

 

Theeffective tax rate for the three months ended March 31, 2008 and 2007 was(87%) and 36%, respectively. The difference in effective tax rates relates toestablishment of the full valuation allowance on deferred tax assets. (See Note#11. Income Taxes)

 

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

 

*Netloss.* As a result ofthe factors described above, our net loss in the three months ended March 31,2008 was $7.1 million, an increase of $4.7 million from the net loss of $2.4million for the three months ended March 31, 2007.

 

12

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**SixMonths Ended March 31, 2008 Compared to the Six Months Ended March 31,2007**

 

*Netsales.* Net salesincreased $4.2 million, or 57%, to $11.6 million for the six months ended March 31,2008 from $7.4 million in the six months ended March 31, 2007. For the sixmonths ended March 31, 2008 product sales increased $3.8 million and EMDsales increased $0.4 million from the same period in the prior year. Theincrease in net sales was primarily related to increased Flat Panel DisplaySystems sales to a major customer.

 

*Cost ofsales.* Cost of salesincreased $2.3 million or 45%, to $7.4 million, or 64% of net sales in the sixmonths ended March 31, 2008 from $5.1 million, or 68 % of net sales in thesix months ended March 31, 2007. The increase of $2.4 million in cost ofsales related to product sales was primarily related to increased sales and wasoffset by the decrease of $0.1 million related to EMD sales which was primarilydue to decreased EMD sales.

 

*Researchand development.*Research and development expenses increased $1.7 million or 61% to $4.5 millionor 39% of net sales in the six months ended March 31, 2008 from $2.8million or 38% of net sales in the six months ended March 31, 2007. Theincrease in research and development expense for the six month period wasprimarily related to the increase in development requirements related to ourFlat Panel Display System for new applications. Overall, when you combineresearch and development expenses with EMD cost of sales, combined engineering,research and development related cost for the six months ended March 31,2008 has increased $1.7 million from the same period in the prior year andreflects the Company’s continued commitment to product development, researchand engineering.

 

*Selling,general, and administrative.* Selling, general, and administrative expenses increased $3.8 million,or 55%, to $10.7 million, or 92% of net sales in the six months ended March 31,2008 from $6.9 million or 94% of net sales in the six months ended March 31,2007. The increase in the dollar amount for the six months ended March 31,2008 from the same period in the prior year was primarily the result of anincrease of $2.1 million of legal fees incurred in connection with litigationrelating to the defense of our intellectual property and an increase of $1.0million in employee related expenses.

 

*Interestincome – net. *Interest income of $1.0 million was offset byinterest expense of $0.1 in the six months ended March 31, 2008. Interestincome of $1.6 million was offset by interest expense of $0.1 million in thesix months ended March 31, 2007. The decrease in interest income wasprimarily the result of our reduced average cash balance and lower interestrates in the current period as opposed to the same period in the prior year.

 

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

 

*Incometax expense.* Theincome tax expense for the six months ended March 31, 2008 was $1.3million as compared to an income tax benefit of $2.4 million for the six monthsended March 31, 2007. The increase in the amount of income tax expense wasthe result of the establishment of a valuation allowance related to thedeferred tax assets the Company had accumulated on the balance sheet Companyrecording a full valuation allowance against all deferred tax assets. Asrequired by SFAS No. 109, this valuation allowance was recorded based onthe weight of available positive and negative evidence, including two years offinancial statement losses, its current projection of a pre-tax loss for thecurrent year, and consideration of the Company’s ongoing tax planningstrategies. If the realizationof deferred tax assets in the future is considered more likely than not, areduction to the valuation allowance related to the deferred tax assets wouldincrease net income in the period such determination is made.

 

Theeffective tax rate for the six months ended March 31, 2008 and 2007 was14% and 41%, respectively. The difference in the effective tax rates relates torecording of the full valuation allowance on the deferred tax assets. (See note# 11. Income Taxes)

 

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

 

*Netincome (loss).* As aresult of the factors described above, our net loss in the six months ended March 31,2008 was $11.2 million, an increase of $7.7 million from net loss of $3.5million for the six months ended March 31, 2007.

 

**Liquidityand Capital Resources**

 

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

 

Ourcash used in operating activities was $4.9 million for the six months ended March 31,2008 as compared to $2.4 million for the six months ended March 31, 2007.The increase of $2.5 million was due primarily to higher net loss ($7.7million), decreased accounts payable ($3.1 million) and increased inventory($1.4 million) which was offset by decreased prepaid expenses and other currentassets 

 

13

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($8.3million) and decreased deferred tax benefit ($1.6 million).

 

Ourcash used in investing activities was $425,000 for the six months ended March 31,2008 and primarily consisted of the purchase of production and laboratory testequipment. Cash used in investing activities was $383,000 for the six monthsended March 31, 2007 and consisted of the purchase of productionequipment.

 

Net cash flow used in financing activities was $23,000 for the sixmonths ended March 31, 2008 as compared to net cash provided by financingactivities of $566,000 in the six months ended March 31, 2007. The primary useof cash for financing activities was attributable to our purchase of 7,000shares of our stock at a total cost of $57,000. In both periods the primarysource of cash was from proceeds from the exercise of stock options.

 

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

 

InNovember 2007 the Company and the lender signed an amendment to the loanagreement, which deleted existing financial covenants and replaced them withonly one restrictive covenant that requires the Company to maintain at alltimes unencumbered cash and marketable securities having a market value of atleast $20 million. The Company was in compliance with this covenant as of March 31,2008.

 

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

 

**Backlog**

 

Asof March 31, 2008 and 2007, our backlog was $73.8 million and $42.7million, respectively. The period over period increase in backlog principallyreflects the increase in Flat Panel Display System orders. The Flat PanelDisplay System component as of March 31, 2008 is $62.3 million, anincrease of $28.8 million over the March 31, 2007 balance of $33.5 million.

 

**CriticalAccounting Policies**

 

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

 

*Revenue recognition*

 

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

 

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

 

TheCompany accounts for transactions with software that is more than incidental tothe products under Statement of Position (“SOP”) 97-2. *SoftwareRevenue Recognition*(“SOP 97-2”) and EITF Issue 03-5, *Applicability of AICPA Statement of Position 97-2, Software RevenueRecognition, to Non-Software Deliverables in an Arrangement ContainingMore-Than-Incidental Software*(“EITF 03-5”*).*  

 

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Accordingly,revenue is recognized when all of the following criteria are met: 1) there ispersuasive evidence that an arrangement exists; 2) delivery has occurred orservices have been rendered; 3) the seller’s price to the buyer is fixed ordeterminable; and 4) collectibility is reasonably assured.

 

Salesrelated to certain long-term contracts requiring development and delivery ofproducts over several accounting periods are accounted for under the AmericanInstitute of Certified Public Accountants (“AICPA”) SOP 81-1, *Accounting for Performance of Construction-Type and CertainProduction-Type Contracts* (“SOP 81-1”). We consider the nature ofthese contracts as well as the types of products and services provided whendetermining the appropriate accounting treatment for a particular contract.Certain long-term contracts are recorded on a percentage of completion basisusing cost-to-cost methodology to measure progress towards completion.

 

The Company offers its customers extended warranties for additionalfees. These warranty sales are recorded as deferred revenue and recognized assales on a straight-line basis over the warranty period.

* *

*Income taxes*

 

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

 

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

 

*Inventories*

 

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

 

*Share-basedcompensation*

 

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

 

*Warranty reserves*

 

Weoffer warranties on some products of various lengths. At the time of shipment,we establish a reserve for the estimated cost of warranties based on our bestestimate of the amounts necessary to settle future and existing claims usinghistorical data on products sold as of the balance sheet date. The length ofthe warranty period, the product’s failure rates and the customer’s usageaffects warranty cost. If the actual cost of warranties differs from ourestimated amounts, future results of operations could be adversely affected.

 

**BusinessSegments**

 

Weoperate in one principal business segment which designs, manufactures and sellsflight information computers, flat panel displays and advanced monitoringsystems to the Department of Defense, government agencies, commercial airtransport carriers and corporate/general aviation markets. We currently derivevirtually all our net sales from the sale of this equipment. Almost all of thenet sales, operating results and identifiable assets are in the United States.

 

**NewAccounting Pronouncements**

 

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles and expandsdisclosures about fair value measurements. This statement does not require anynew fair value measurements; however, the application of this Statement may 

 

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change current practice forsome entities. SFAS 157 is effective for fiscal years beginning after November 15,2007. The Company is currently evaluating the impact of this pronouncement.

 

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**FORWARD-LOOKING STATEMENTS**

 

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

 

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

 

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

 

·                  continuedmarket acceptance of our air data systems products;

 

·                  theability to obtain future contracts and awards;

 

·                  theavailability of government funding and customer requirements;

 

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

 

·                  delaysin receiving components from third party suppliers;

 

·                  thecompetitive environment;

 

·                  thetermination of programs or contracts for convenience by customers;

 

·                  failureto retain key personnel;

 

·                  newproduct offerings from competitors;

 

·                  potentialfuture acquisitions;

 

·                  protectionof intellectual property rights;

 

·                  ourability to service the international market, and

 

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

 

Readersare cautioned not to place undue reliance on these forward-looking statements,which speak only as of the date of this Form 10-Q. The Company does notundertake any obligation to publicly release any revisions to theseforward-looking statements to reflect events, circumstances or changes inexpectations after the date of this Form 10-Q, or to reflect theoccurrence of unanticipated events. The forward-looking statements in thisdocument are intended to be subject to the safe harbor protection provided bySections 27A of the Securities Act and 21E of the Exchange Act.

 

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

 

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

 

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

 

The Company’s operations are exposed to market risks primarily as aresult of changes in interest rates. The Company does not use derivativefinancial instruments for speculative or trading purposes. The Company’sexposure to market risk for changes in interest rates relates to its cashequivalents and an industrial revenue bond. The Company’s cash equivalentsconsist of funds invested in money market accounts, which bear interest at avariable rate, while the industrial revenue bond carries an interest rate thatis consistent with 30-day, tax-exempt commercial paper. As the interest ratesare variable, and we do not engage in hedging activities, a change in interestrates earned on the cash equivalents or paid on the industrial revenue bondwould impact interest income and expense along with cash flows, but would notimpact the fair market value of the related underlying instruments.

 

**Item 4. Controls and Procedures**

 

(a)          An evaluation was performed under the supervision and with theparticipation of the Company’s management, including its Chief ExecutiveOfficer, or CEO, and Chief Financial Officer, or CFO, of the effectiveness ofthe Company’s disclosure controls and procedures, as such term is defined underRule 13a-15e under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) as of March 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 thefees incurred in connection with the matters described below, we do not believethat any of the current legal proceedings will have a material adverse effecton our results of operations or financial position.  On September 13, 2005 the Company fileda lawsuit in the United States District Court for the Western District of Tennesseeagainst J2, Inc., a company founded and jointly owned by Joseph Cesar, aformer employee of the Company, and James Zachary, a former sales consultantfor the Company. The complaint alleged that the J2/Kollsman/Air Data Computerthen being marketed by J2 and manufactured by Kollsman, Inc. infringed apatent assigned to the Company. After learning additional information regardingthe activities of Caesar and Zachary during the development of the J2/KollsmanAir Data Computer, the Company added to its complaint claims of trade secretmisappropriation, breach of contract and breach of fiduciary duty, based on theCompany’s belief that confidential and proprietary information, including tradesecret information, had been used in the development and marketing of theJ2/Kollsman Air Data Computer. On January 31, 2006, Kollsman, Inc.,and Caesar and Zachary, as individuals, were added to the lawsuit asdefendants.

 

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

 

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

 

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

 

Forthe six months ended March 31, 2008 and 2007 the Company has incurredapproximately $4.9 million and $2.8 million, respectively, in legal fees inconnection with the two matters discussed above.

 

**Item 1A.  Risk Factors**

 

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

 

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

 

Thetable below provides information concerning our repurchase of shares of our commonstock during the quarter ended March 31 2008:

 
| ** **                  | ** ** | ** **                        | ** ** | ** **                   | ** ** | **Total Number of**  | ** ** | ** **                         | ** ** |
|-----------------------------|------------|-----------------------------------|------------|------------------------------|------------|--------------------------------|------------|------------------------------------|------------|
| ** **                  | ** ** | ** **                        | ** ** | ** **                   | ** ** | **Shares Purchased**      | ** ** | **Number of Shares**     | ** ** |
| ** **                  | ** ** | ** **                        | ** ** | ** **                   | ** ** | **as**                         | ** ** | **that May Yet be** | ** ** |
| ** **                  | ** ** | ** **                        | ** ** | ** **                   | ** ** | **Part of Publicly** | ** ** | **Purchased Under**           | ** ** |
| ** **                  | ** ** | **Total number**             | ** ** | **Average Price**       | ** ** | **Announced Plan**        | ** ** | **the Plan or**          | ** ** |
| **Period**                  | ** ** | **of Shares purchased** | ** ** | **Paid per Share** | ** ** | **or Program (1)**   | ** ** | **Programs (1)**              | ** ** |
|                        |       |                              |       |                         |       |                           |       |                               |       |
| February 1 to 29, 2008 |       | —                            |       | —                       |       | —                         |       | 1,000,000                          |       |
| March 1 to 31, 2008    |       | 7,000                             |       | $                            | 8.17       |                           | 7,000      |                               | 993,000    |   |
|                             |            |                                   |            |                              |            |                                |            |                                    |            |  |

 

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(1)          On February 21, 2008, the Company’s Boardof Directors approved a common stock repurchase program to acquire up to1,000,000 shares of its outstanding common stock. The program will remain ineffect until February 21, 2009 unless extended by the Board of Directors.

 

**Item 3.    Defaults upon SeniorSecurities**

 

None

 

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

 

OnFebruary 21, 2008, the Company held its Annual Meeting of Shareholders. Atthis meeting the shareholders voted in favor of the following items listed anddescribed in the Company’s Proxy Statement dated January 28, 2008.

 

1)              Election of Directors

 
| ** **                       | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|----------------------------------|------------|------------|------------|--------------|------------|
| Glen R. Bressner                 |       | 11,982,701 |       | 1,909.545    |       |
| Robert E. Mittelstaedt, Jr. |       | 11,896,863 |       | 1,995,383    |       |
| Raymond J. Wilson                |       | 12,031,511 |       | 1,860,735    |       |

 

Thefollowing directors’ term of office as directors continued after this meeting:

 

GeoffreyS.M. Hedrick

WinstonJ. Churchill

IvanI. Marks

RobertH. Rau

 

TheBoard of Directors withdrew the proposal for shareholder approval of the 2008Stock Based Incentive Compensation Plan prior to the meeting.

 

**Item 5.    Other Information**

 

None

 

**Item 6. Exhibits**

 

(a)   Exhibits

 
| 10.1   |   | Separation  Agreement by and between James Reilly and Innovative Solutions &  Support, Inc. dated March 25, 2008 |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                |
| 31.1   |   | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a)                                                           |
|   |   |                                                                                                                                |
| 31.2   |   | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(a)                                                           |
|   |   |                                                                                                                                |
| 32.1   |   | Certification  Pursuant to U.S.C. Section 1350, as Adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002     |

 

**SIGNATURES**

 

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

 

 
| ** **              | **INNOVATIVE  SOLUTIONS AND SUPPORT, INC.** |
|-------------------------|---------------------------------------------|
|                    |                                        |   |
|                    |                                        |   |
| Date:  May 8, 2008 | By:                                         | /s/  JOHN C. LONG |
|                    |                                        | JOHN  C. LONG |
|                    |                                        | CHIEF  FINANCIAL OFFICER |

 

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