Mercury Systems, Inc.
Q1 2021 Earnings Call Transcript

Published: 4 May 2021

[Operator:]

Good day, everyone, and welcome to the Mercury Systems Third Quarter Fiscal 2021 Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the company's Executive Vice President and Chief Financial Officer, Mike Ruppert. Please go ahead, sir.

[Mike Ruppert:]

Good afternoon and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you have not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events & Presentations.

[Mark Aslett:]

Thanks Mike. Good afternoon everyone and thanks for joining us. I'll begin with the business update, Mike will review the financials and guidance, and then we'll open it up for your questions. Mercury delivered a strong third quarter of fiscal 2021. That's an outstanding effort by the team, total revenue and adjusted EBITDA came in above the high end of our guidance. We continue to execute strategically investing in R&D and CapEx to drive organic growth, while supplementing this growth with strategic M&A. Looking back at Q3, it was a strong quarter for new design wins, and we delivered record revenues, adjusted EPS and adjusted EBITDA, but the timing of bookings remained a challenge. Our results continue to reflect the impact of COVID, the change in administrations, delays in foreign military sales, as well as customer program execution issues. We've already closed a number of the orders delayed in Q3 and expect substantially increased bookings and a positive book-to-bill for the fourth quarter. For fiscal 2021 in total, we're anticipating a slight decline in bookings year-over-year and a book-to-bill approaching one. We now expect to deliver approximately 6% organic growth year-over-year and at a total company level 14% to 15% growth. All in all, we're pleased with this strong performance in a difficult year.

[Mike Ruppert:]

Thank you, Mark, and good afternoon, again, everyone. Mercury delivered solid results in Q3. Total revenue, adjusted EBITDA and adjusted EPS all exceeded our guidance. Total revenue and adjusted EBITDA were both records for Mercury. And while Q3 bookings were impacted by the factors Mark discussed, our backlog remains healthy. We’re positioned for a strong fourth quarter and another record year in fiscal 2021. Looking further ahead, our recent design win activity and sole-sourced designed in positions on well-funded programs set the stage for strong revenue growth and margin expansion going forward. Let's turn now to our Q3 results on Slide 11. Total bookings for Q3 were $210 million, down 16% year-over-year. This compares to a strong Q3 2020, where we had near record bookings and a book-to-bill of 1.2. Q3 bookings were flat compared to last quarter. Our book-to-bill for Q3 was 0.82, and for the last 12 months, our book-to-bill was 1.01. As Mark said, Mercury bookings and book-to-bill this quarter and year-to-date have been impacted by COVID, the change in administration and FMS delays. Looking ahead in Q4, we expect a book-to-bill above 1, and for the full year, we now expect a book-to-bill approaching 1. Mercury ended the third quarter with backlog of $894 million, up 16% from Q3 2020. Backlog expected to ship within the next 12 months was $546 million, equating to 61% of total backlog. Over 95% of total backlog is expected to be delivered within the next 24 months. Total company revenue increased 23% from Q3 last year to a record $257 million, exceeding the high end of our guidance of $245 million to $255 million. Our revenue base continues to be highly diversified. No single program represented more than 10% of total revenue in the quarter. POC, which is considered acquired revenue in Q3 performed well, contributing $38.5 million of revenue during the quarter. We’re already seeing new opportunities as a result of POC being part of Mercury. Organic revenue grew 5% year-over-year in line with expectations. Organic growth was driven primarily by the C4I and radar markets. Gross margin for Q3 was 41.1%, compared to 44.9% in the third quarter fiscal 2020. This reflected $2.5 million of direct COVID-related expenses charged to cost of goods sold as well as the inclusion of POC for a full quarter. COVID expenses and POC impacted Q3 gross margins by approximately 100 and 180 basis points, respectively.

[Operator:]

Thank you. Thank you. And our first question will come from the line of Peter Arment with Baird Equity Research.

[Peter Arment:]

Thank you. Hi, Mark. Hi Mike. Mark, so just, I guess everyone's going to focus on organic growth. So I'm also just tick that off. I mean, can you just maybe talk about, what we've seen the last several quarters has been kind of a deceleration and you're kind of alluding to it continuing. But when we try to square that against kind of outsourcing, delayering, all the kind of trends that you talk about, maybe you could just provide us, with any kind of more details that get us to kind of square that all up. Thanks.

[Mark Aslett:]

Sure. So, I mentioned really what is happened for bookings perspective throughout the year and it's clearly being more challenging than what we'd anticipated, we've been impacted by COVID delays, the change in administrations, delays in after mass as well as now customer program execution issues. So we had been – we now expect 6% organic growth for fiscal 2021, which is lower than what we previously thought. We saw some bookings delays in particular in the third quarter on a Naval large Naval EW program that's in production that was around about $18 million that basically slipped from Q3 into our Q4, but it didn't just affect bookings in the quarter. It also lowered our organic growth rate for the years. Probably, one of the other that I would kind of touch upon is this, as I mentioned, we've started or we seen a customer in particular program execution issue on a large add-on programs which in itself lowered our organic revenue growth by about 1.5% for the whole year. So just those two things alone, cancels 2.5 points of organic growth, compared to what we thought coming in. And you add those back and we're back at a goal of high single-digit to low double-digit organic revenue growth. Now that said the programs themselves are fine. They're well-funded programs they're just experiencing different delays actually for different reasons. So outlook going forward as I mentioned for fiscal 2022 is now kind of mid to high single digits organic growth with 14 – mid-teens growth in total next fiscal year. So fundamentally, there's nothing really changed with respect to our outlook, but we are experiencing some delays.

[Peter Arment:]

Appreciate the extra color. Thanks, Mark.

[Operator:]

Our next question is going to come from the line of Sheila Kahyaoglu with Jefferies.

[Sheila Kahyaoglu:]

Thanks for the time. Yes, I mean, just thinking on that, Mark, appreciate the color on the airborne program and that’s deflating your growth this year and somewhat coming back next. Can you maybe just talk about how you think about your accelerating growth in a thought lining budget environment? What are you seeing in your bookings and your design wins? And can you maybe elaborate on that, what gives you confidence in the out years for high-single-digit growth?

[Mark Aslett:]

Yes. So I think, as I said in the prepared remarks, we do expect that the environment that we're currently in is likely going to continue into the first half of next fiscal year hence the guidance that we gave. If I look at what’s going to drive organic growth next fiscal year to offset some of the headwinds that we faced, it’s really a number of different things. So, we’re expecting various FMS program to drive growth, if you remember back in the first quarter of fiscal year 2021 we had a $35 million FMS sale that moved from Q1 into next fiscal year. In addition, we’ve seen some very strong demand related to our secure product – our secure processing product line. We’ve involved in various radar upgrades that some of which are moving into production for the tech refreshes F-16 SABR, E2D Hawkeye have both expected drive growth next year. Probably the largest driver of organic growth both next fiscal year as well as over the next five years is growth that we’re seeing in the C5 domain and that’s really spread across multiple different programs in both C2 comes as well as platform and mission management. And then finally, yes, we’re expecting continued growth in EW organically on programs such as ALR-69 as well as . So it’s really across the board, but we do have some head wins not only this year, but coming into next, but not one program that the large airborne program where our customer seen some tech delays, as I mentioned, is lowered our organic growth by two points next year for the – it is encompassed in that mid-to-high single-digit organic growth numbers that, okay.

[Operator:]

Thank you. And our next question will come from the line of Pete Skibitski with Alembic Global.

[Pete Skibitski:]

Yes, good afternoon guys. Good evening. So Mark for fiscal 2022, if we end fiscal 2021 with a one or approaching one book-to-bill, and you’re saying the environment is going to be the same in the first half, is it – mid-to-high single-digit organic growth in fiscal 2022? Is that still a pretty risky target right now? How should we think about that?

[Mark Aslett:]

So, yes, I mean, again, we haven’t kind of finished full of budget, but based upon the work that we’ve done today, kind of going over all the individual line items from the – in the various programs and feel pretty good about the outlook that we’ve given. We’re expecting that backlog exiting fiscal 2021 will got high single-digits year-over-year. Yes. We are on some strong programs. We’ve got a number of programs that are transitioning from the development phase into production. And so although we do expect that the environment in the first half could be, it could remain somewhat challenging. I think the guidance that we gave for at least the early outlook we feel good about Pete.

[Operator:]

Thank you. And our next question will come from the line of Seth Seifman with JPMorgan.

[Seth Seifman:]

Well, thanks very much. Good afternoon. Just to follow-up quickly on Pete’s question. That outlook for next year is there much risk to that from a continuing resolution?

[Mark Aslett:]

So – yes, we do believe that there's going to be a relatively short continuing resolution, which we baked into account in terms of the outlook that we've given so.

[Seth Seifman:]

Okay. And then just as a follow-up with regard to semiconductors more broadly and some of the shortages in that area, how if at all is that affecting Mercury and to what extent is it a watch item?

[Mark Aslett:]

Sure. So I think the supply chain team has done a pretty good job, really navigating two challenges. Obviously the first is just the impacts that we’ve seen with COVID throughout the supply base. I think we've been able to manage that pretty effectively, hasn't really impacted our topline. And most recently the team has been very focused obviously on the semiconductor space and we're managing our way through that as well. So no specific impacts today, but it's certainly something that they're working literally every week.

[Operator:]

Thank you. And our next question will come from the line of Michael Ciarmoli with Truist Cap Securities.

[Michael Ciarmoli:]

Hey, good evening guys, thanks for taking the question. Just to clarify, first the organic growth in 4Q does anything change with the POC run rate? Are you going to be negative in the – negative year-over-year in the fourth quarter?

[Mike Ruppert:]

No, we are expecting flat organic growth in the fourth quarter Mike, largely due to the strong fourth quarter last year as well as the various program delays that I mentioned. So the large Naval EW program as I mentioned is expected to impact organic growth by more than a point.

[Michael Ciarmoli:]

Okay. And then just the other one, gross margin its looks like an all-time low, any – I know you called out maybe mix in POC, but I know you don't – you're focused more on EBITDA margin these days, but anything as we think about the longer-term trend to you and gross margins, and the continuous decline there, any other thoughts or color or anything we should be mindful of there on the gross margins going forward into 2022?

[Mark Aslett:]

Hey, Mike let me jump in and just correct something that I just said, the large Naval EW program that I mentioned is delaying, we are staying in slight reduction in the order quantities and it will affect organic growth in the fourth quarter by around three points, not one as I previously stated. So Mike, do you want to talk about the gross margin?

[Mike Ruppert:]

Yeah. So Mike, I think you hit it. I don't think there's anything specific in terms of gross margins that's fundamentally changing, the two drivers during the quarter were POC which as you know has lower gross margins than us. I mentioned in my prepared remarks that has a 180 basis point impact to that 41.1, and then the COVID expenses, which had 100 basis point impact, so if you kind of adjust for those, you would have been 43, 43.9 somewhere around that. The rest is program mix this quarter, we had the CRAD was up significantly year-over-year, was up 18% organically, so excluding POC. And that's what's really driving it. If you step back and Mike look at where we were gross margin in fiscal 2020 at 44.8. I think when you look at the year level for us and you take into account COVID, which we think will probably have about 100 basis point impact on gross margins for the year. And you take into account POC which we'll have about 100 basis point impact on gross margins for the year that you're going to be at very similar levels to where we were in fiscal 2020.

[Michael Ciarmoli:]

Got it. Thanks, guys.

[Operator:]

Thank you. Our next question will come from the line of Jonathan Ho with William Blair & Company.

[Jonathan Ho:]

Hi, good afternoon. I just wanted to, I guess, dig into your comment around potentially discretionary dollar competition leading to some additional outsource trends. Can you maybe elaborate a little bit more on what you're hearing out there and maybe what the potential could look like if we were to start to see that budget pressure play out?

[Mark Aslett:]

Sure. So yes, I think clearly we are all seeing just the continued stimulus on the proposals under the new administration. I think overall, we were pretty pleased with the – what the overall budget submission was and the outlook there. But over time, I think we could continue to see pressure on the defense budget. And that's obviously offset by what happens from a national security perspective. Yes, I think the growth that we're seeing is being continued to be driven by growth in subsystems or outsourcing at the subsystem level. In the third quarter, our subsystems revenue was actually up 55% to now 76% of the total. And over the last 12 months, it's up 49% to 66% of the total. So I think it's reflecting what we're seeing more generally happening, Jonathan, where our customers are seeking more rapid and more affordable and open solutions. And with the investments that we're making in R&D, we're able to do that more quickly and more affordably than they can do it in house. So if there are additional pressures on the defense budget, we think that outsourcing will continue. And we think that they're well positioned to be able to take advantage of that.

[Jonathan Ho:]

Thank you.

[Operator:]

And our next question is going to come from the line of Noah Poponak with Goldman Sachs.

[Noah Poponak:]

Hi, good evening, everyone.

[Mark Aslett:]

Hi, Noah.

[Noah Poponak:]

Mark, maybe you can help me better understand how this came up on you seemingly kind of quickly because you've had some positive updates to the market recently, including the last earnings period and the categories of things you're citing have been going on for a while, COVID delays, the change in administration. And we're not really seeing those impact other hardware companies. So, just kind of better help me understand how this, I guess maybe snuck up quickly. And if you could more precisely quantify these buckets and when you get them back, I think that would be really helpful, because otherwise it kind of just looks and sounds like general buckets while there's a deceleration happening in the end market. So if we could just put a little more detail around that, that'd be helpful. And then Mike, what are you spending on COVID because the absolute dollar numbers in the margins, and then, you started the year with 40% to 45% on the free cash EBITDA, and you had that in the middle of the year. So the rate of change there in an absolute dollar sense is pretty large for what you're attributing it to, if you can tell us what you're spending on there?

[Mark Aslett:]

Sure. So let me begin with the bookings and kind of maybe step back and, so the second half of the year as we came into was more second half weighted. And I guess the challenge that we face with bookings now is kind of builds the progress and right out of the gate in the first quarter, if you remember we had a challenge related to FMS. We had a $35 million order move out of Q1 into next fiscal year as our customer ended up having to re-engineer the solution with the end customer. We saw continued impacts as the year progressed in particularly in the weapons systems arena. As the new administration reviewed the sale of various offensive systems into the Middle East that impacted FMS sales, but in weapon systems we've seen various delays associated with the Navy, not just the large EW Naval program that I mentioned. But we saw some Naval Airborne programs also get pushed from what was going to be the start of the year Q2, then it moved to Q3, now it's in Q4. So there's been kind of a sliding effect throughout the year. The one that I guess is for us somewhat new is the impact that we saw around this large airborne program where our customer was impacted by delay from one of their suppliers. That to put a number on it was a reduction of $20 million for the year. So it's not being one large thing, it's been a number of things that I guess built as the year progressed. And yes, we're at a point obviously being in the fourth quarter where it's unlikely that some of these deals are going to pop-up in the final quarter of the year. So some of them have moved into fiscal year 2022 and some of them will impact us, because the order moved to 2023. And as our large airborne program, in effect what's happening is that we're skipping a year, which is why we've actually reduced our organic growth nearby 2 points on that program to give that mid- to high-single digit next fiscal year. So it's a number of different things, some of which are moved throughout the year and remained inside it. Some of which have moved to the next fiscal year and that one, particularly one which as I mentioned is $20 million moved to 2023 for us.

[Noah Poponak:]

Mark, what happened on that program?

[Mark Aslett:]

So – our customer supplier is substantially delayed in providing three different types of technologies that are associated with the major tech refresh. There are two parts of it that affect us. So, right now we think it’s been pushing to the right, pushing to the right, push into the right. They believe that they’re making progress, but the refresh itself is pretty significantly delayed.

[Noah Poponak:]

Okay. And Mike, can you, can you help me out with it, what you’re spending on related to COVID that you’re referring to?

[Mike Ruppert:]

Yes. I mean, so if you step back now, you mentioned the 40%, 40% to 45% guidance at the beginning of the year, as we discussed that that didn’t include the COVID expenses and you’re right, that that’s one of the big aspects of our cash use for the year. I mentioned in my prepared remarks that we’re expecting 25% conversion for the year. The expansion CapEx is about 10 points, so it’d be 35%. If COVID investments we’re looking at about $10 million to $11 million of cash outflow this year. That’s primarily related to the testing, the PTR testing that we’re doing at our facilities. That’s the biggest piece of that. We also have the employee relief fund and some other things this year that probably had a five point impact on the conversion, or we’ll have a five point impact on the conversion for the year. Also related to COVID we talk about, we invested in inventory to de-risk the supply chain. So that’s really the COVID investments. And I know there’s been a handful of, kind of one-off items this year we’ve been, if you look at the acquisition expenses in Q2 and Q3, we’ve been incredibly busy that’s been a cash outflow. And then I’ve mentioned a couple of the others here and there payment for kind of shareholders on the $1 million to $3 million. We change our healthcare provider that was the $3 million. So just a handful of things, but the big two really are the expansion CapEx and the COVID investments.

[Noah Poponak:]

Okay. Thank you.

[Operator:]

Our next question will come from the line of Austin Moeller with Canaccord Genuity.

[Austin Moeller:]

Hi guys. This is Austin on for Ken. All right. So just a question for me and this was somewhat implied in a prior question. So obviously right now, we’ve got the chip shortage going on and reasonably the Biden administration had met with various officials from the semiconductor industry, the White House and they’re looking to figure out how to meet this chip shortage. And then you had recent commentary within the last week from Intel CEO that it could take two years or more to ramp back up to pre-COVID levels. So from Mercury’s perspective, obviously you guys there’s, concerns about downward pressure on the DoD top line. So, potentially how could Mercury or could Mercury use the Arizona and the New Hampshire facilities to maybe provide some of the supply to meet the unmet demand in the consumer electronics sector and could that be done within that two year timeframe?

[Mark Aslett:]

Yes, it’s probably no Austin. So the focus on the trust of microelectronics facility in Phoenix is to be able to provide very specialized capabilities on – for next generation applications primarily for DoD use. So, it’s not a high volume facility that where we’re providing silicon for commercial applications. Yes, we’re really have positioned ourselves at the intersection of tech and defense to be able to take the commercially available silicon and then transform it for use for, for defense applications. So unfortunately I don’t think that we’re really going to be able to provide much assistance.

[Austin Moeller:]

Okay, got it. Thank you guys.

[Operator:]

And our next question will come from the line of Ronald Epstein with Bank of America. Ron, your line is open.

[Ronald Epstein:]

Hey, just a couple of questions for you guys, sorry about that, I was on mute. On R&D and tax, I mean, what impact do you expect to see in the next fiscal year, given the change in the tax code, if it's not somehow reversed where you're going to advertise your R&D expense now over five years? What headwind does that present for you guys?

[Mike Ruppert:]

Yes. So Ron, we do it's countered to what the U.S. is looking to encourage, which is investment in the U.S., so it may be reversed, we'll see. That having been said, assume the law stays as is written, we have to amortize our R&D over five years. We estimate that it’s $30 million to $40 million impact to our fiscal 2023, so the law would go into effect in calendar 2022 or fiscal year taxpayer, so it would be a $30 million to $40 million impact to fiscal 2023 cash flow.

[Ronald Epstein:]

Got it. And then some of the COVID expenses you talked about, are they billable to the customer or do you guys just have to heat them?

[Mike Ruppert:]

We really – since we're selling most of our products on commercial terms, we're not billing these back to the government we're investing – this is investment that we're making and there is no reimbursement from 36, 10 or anything like that.

[Ronald Epstein:]

Got it. And then maybe a bigger picture question. When you look at folks like Taiwan Semi, potentially it looks like maybe high probability potentially of building a fab in Arizona and more, how can I say it more commercial, so it can be in fabricated in the U.S., what opportunity does that present for you guys to work with the commercial manufacturers in the defense end market? Right, I mean – because, the defense end market is so small compared to the broader silicon market. Is there a role that you guys can play as these companies start to onshore fabs?

[Mark Aslett:]

Yes, absolutely Ron. So even if they do bring back more of the fabs and the manufacturing here domestically Intel is obviously doing that in Arizona, TSMC is talking about it. TSMC is obviously the fab polymer for companies such as Xilinx and others. The Dawson's alone solve the problem, because I think the capabilities for use in defense as you'll look at the way in which the market is evolving to more triplet base architectures means that there needs to be a party that sits between those silicon manufacturers or developers, as well as the defense end market and mercury has kind of positioned ourselves to be that company. So we're partnering with some of the biggest silicon companies in the industry getting access to the raw silicon itself and we're looking to be able to combine those silicon from different vendors to secure using our IP, and then package it here domestically for the specific end use cases in defense. So we play a really important role and obviously I think it'd be even better, if the domestic manufacturing does come back. And so we're able to get that silicon here domestically, as opposed to it coming offshore and us just packaging it and securing it in the Phoenix facility. So there is still absolutely a role to play, even if they do build those fabs in Phoenix like they're talking about.

[Ronald Epstein:]

Got it. All right. Great. Thank you guys.

[Mark Aslett:]

Thanks Ron.

[Operator:]

Mr. Aslett, it appears there are no further questions. So I would like to turn it over to you for any closing comments.

[Mark Aslett:]

Okay. Well, thank you very much for joining this evening, we look forward to speaking to you again next quarter. Thank you.

[Operator:]

Once again, we'd like to thank everyone for participating in today's Mercury Systems conference call. We appreciate your participation and ask that you please disconnect. Thank you.