Mercury Systems Inc

Good day, everyone, and welcome to the Mercury Systems first quarter fiscal 2022 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 Rupert. Please go ahead, sir.

Good afternoon, and thank you for joining us. With me today is our president and chief executive officer, Mark Aslett. If you've 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 and presentations. Please turn to slide two in the presentation. Before we get started, I would like to remind you that today's presentation includes forward-looking statements. including information regarding Mercury's financial outlook, future plans, objectives, business prospects, and anticipated financial performance. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward-looking statements should be considered in conjunction with the cautionary statements on slide two in the earnings press release and the risk factors included in Mercury's SEC filings. I'd also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles, or GAAP, during our call we will also discuss several non-GAAP financial measures, specifically adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue, and acquired revenue. A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release. I'll now turn the call over to Mercury's President and CEO, Mark Aslett. Please turn to slide three.

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. Our results for the first quarter of fiscal 22 were in line with our expectations. Total revenue exceeded our guidance, and adjusted EBITDA came in above the midpoint. Our impact transformation efforts are progressing well and we continue to execute strategically. During the quarter, we signed an agreement to acquire Avalex Technologies while continuing to invest in the business organically. Our outlook for fiscal 22 remains unchanged. Reflecting the lower bookings and backlog exiting last fiscal year, we continue to expect flat organic revenue growth versus fiscal 21. We expect total company revenue to grow 10% in fiscal 2022, eclipsing $1 billion for the first time. Due to the timing of the expected close, our Q2 and fiscal 2022 guidance excludes RLX, as well as only future M&A. We also anticipate margin expansion and record adjusted EBITDA. We expect to deliver substantial year-over-year growth in bookings in fiscal 22, weighted towards the second half and especially Q4. This should lead to a positive book-to-bill for the year and solid growth in our backlog, setting the stage for strong results in fiscal 23. That said, the risk levels have become elevated in three areas since last quarter. First, the potential for a prolonged defense budget continuing resolution. Second, the White House vaccination mandate for the defense industry and the resulting impact on our employees and operations. And third, inflation and supply chain constraints in the semiconductor industry. We're working diligently to mitigate risk wherever we can and anticipate a return to high single-digit to low double-digit organic growth in fiscal 23. This growth, coupled with margin expansion driven by improved operating leverage and our impact efforts, should lead to strong fiscal 2023 results overall. We're optimistic about our growth prospects over the longer term. We believe that mercury is well aligned with the national defense strategy. The government continues to push for modernization, speed, and affordability in both sensor and effect emission systems and C4I. The needs for secure processing, trusted microelectronics, and open mission systems are increasing. We're well positioned to benefit from the longer-term secular growth trends that we've discussed in the past. Supply chain delaying by the government and the primes, the flight to quality suppliers, the shift to outsourcing by our customers at the subsystem level, and the government's increased focus on supply chain reshoring for microelectronics. Our vision of being the leading commercial provider of trusted and secure devices to systems is what our customers are seeking. They're looking to partner more with companies like Mercury and buy less from traditional suppliers. As a result, our engagements are becoming larger and more strategic for our customers and for us. Our five-year plan remains intact, that is, to deliver high single-digit to low double-digit organic revenue growth, averaging 10% over time, coupled with M&A and margin expansion. Taking a quick look at the financial highlights on slide four, Q1 is typically our seasonally weakest quarter. Bookings were down slightly year-over-year as expected, and our book-to-bill for the quarter was 0.89%. We feel confident that Q1 represents the low watermark for bookings in fiscal 22. Our largest bookings programs in the quarter were F35, a classified EW program, a classified C2 program, F18, and F16. Total revenue was up 9% year over year, above the high end of our guidance. Organic revenue was down 11%, slightly better than anticipated. Our largest revenue programs in the quarter were MH60, a classified C2 program, a classified radar program, P8, and F35. We continue to see high levels of new business activity. Our pipeline remains strong with design wins in Q1 totaling nearly $500 million in estimated lifetime value. Free cash flow for the quarter was slightly negative. On the bottom line, however, adjusted EPS came in at higher end of our Q1 guidance and adjusted EBITDA at the midpoint, down 20% and 10% year-over-year, respectively. Turning to slide five, we expect Mercury's total company revenue to continue growing faster than overall defense spending over time. We focus the business on large and faster-growing parts of the defense market. and we now participate in more than 300 different programs. We're designed in on our top programs with the majority being sole source positions. No single program is more than 5% of total company revenue in fiscal 21. Looking ahead to the next five years, no single program is expected to be more than 6% of total revenue. For fiscal 22, we expect bookings and revenue to increase as we move through the year. As I said earlier, risk levels have increased related to the defense budget CR, COVID vaccine mandates, and the supply chain. We successfully manage COVID-related risks throughout the pandemic. During the second quarter, we intend to comply with the White House vaccine mandates. This should enhance the resiliency of the business by protecting our employees and strengthening our ability to deliver on our commitments. In the short term, however, it may result in higher employee turnover and impacts to our operations. Beyond the challenges associated with COVID, we continue to see the effects of inflation and semiconductor supply chain constraints. The team is working daily with our suppliers to address these challenges. Over time, we believe the vaccine mandates will help alleviate programmatic delays as our employees, our customers, and the DoD ultimately return to on-site work. The vaccines could also have a positive effect on some of the supply chain issues we're facing. As a result, we're cautiously optimistic that bookings will grow substantially year over year in fiscal 22, leading to a positive book to bill and growth in backlog. We anticipate double-digit growth in bookings in the second half of fiscal 22, driven by our top 20 programs. This growth should be led by programs such as S35, LTAMS, which is now called Ghost Eye, Filthy Buzzard, CWIP, and various FMS programs. In addition to these franchise program bookings, we expect growth from recently acquired programs to accelerate in the second half also. Looking ahead to fiscal 23, we expect bookings from our top 20 programs to ramp yet again. We anticipate seeing fewer delays in key programs, among them F35, TR3, and Block 4, as well as naval and airborne upgrades such as CWIP and Silky Bossard. As I've said, this should lead to strong results in fiscal 23, driven by a return to high single-digit to low double-digit organic growth. Turning to slide six, since fiscal 14, we've completed 13 acquisitions, deploying $1.2 billion of capital, dramatically scaling and transforming the business as a result. We've grown total company revenue 4.4 times, and through synergy, adjusted EBITDA more than nine times over that period. This has resulted in substantial value creation for shareholders. we believe there's additional value to be had going forward. As we discussed last quarter, early this calendar year, we proactively launched a company-wide effort, which we called Impact, to lay the foundation for our next phase of value creation at scale. The goal is to achieve Mercury's full growth, margin expansion, and adjusted EBITDA potential organically and through M&A over the course of the next five years. The first opportunity is to streamline and simplify our organizational structure, which we began in Q4 and have now largely completed. We're anticipating a $22 million net benefit in total for fiscal 22 related to this impact activity. The Q1 actions alone accounted for $14 million of that total. To lead the impact, during the first quarter, we hired Thomas Hoover, previously with Boston Consulting Group, McKinsey, and Bain, as our Chief Transformation Officer. As impact progresses over the course of the next two to three years, in addition to growth, we'll be focusing on six major areas aimed at incremental EBITDA uplift, leading to margin expansion over time. We're beginning to move from planning into the execution phase in several of these areas. We continue to target $30 to $50 million of incremental adjusted EBITDA by fiscal 25 as a result of this activity. Again, this includes a $22 million net benefit in fiscal 22. Complementing impact, we've also strengthened the leadership team. In addition to Thomas Huber, Mitch Stevenson joined Mercury from Raytheon as Chief Growth Officer early last month. Yesterday, we announced that Roger Welles has joined us from FLIR Teledyne as president of our microelectronics division. We're very pleased to have Thomas, Mitch, and Roger aboard. Turn to slide seven. Over the past seven years, our acquisitions and integration processes have generated significant cost and revenue synergies, creating tremendous value. We believe that deploying impact will accelerate and increase the value we create through M&A going forward. Impact could also allow us to increase our deal cadence and potentially the size of our transactions. Combined with the synergies generated, this could have a compounding effect on future value creation. The M&A environment continues to be extremely active, and our pipeline is strong. We remain disciplined in our approach in terms of deal pursuits, diligence, pricing, and integration. We were very busy from an M&A perspective in Q1, resulting in the acquisition of Avilex, which we expect to close early this month. Avilex continues to build out our avionics and mission computing business, complementing our recent acquisition of Physical Optics Corporation. As we discussed last quarter, potentially our most important fiscal 21 design win related to the Army's AMCS program, a win that was enabled by POC as well as prior acquisitions. Like those transactions, we expect Avilex to leverage supply chain de-layering and further strengthen our position in platform and mission management. We look forward to welcoming the Avilex team to Mercury. Turning to slide eight, We remain strategically committed to delivering strong margins while growing the business organically and supplementing this organic growth with disciplined M&A and full integration. This strategy is working extremely well. We believe it will continue to generate significant value for our shareholders over the longer term as we execute our plans in five areas. The first is to grow our revenues organically at high single digits to low double digits, averaging 10% over time, supplemented by growth from acquisitions. The second is to invest in new technologies, our facilities, manufacturing assets and business systems, as well as in our people. Third is manufacturing insourcing, as well as driving stronger operating performance across our manufacturing locations and supply chain. Fourth, we're seeking to grow revenues faster than operating expenses. This should allow us to continue investing in organic growth while maintaining strong operating leverage in the business. And finally, we're fully integrating the businesses we acquire to generate cost and revenue synergies over time. These synergies, combined with impact and other areas of the plan, should produce attractive returns for our shareholders. Turning to slide nine, We're expecting substantial growth in bookings and backlog in fiscal 22. This should lead to a stronger year in fiscal 23 as organic growth returns to more normal levels and margins expand as a result of impact. In the short term, risks have increased related to the defense budget, COVID vaccine mandates and the supply chain. However, looking ahead longer term, we remain very optimistic. We've aligned our business with the national defense strategy in the industry's key market trends. Our model, sitting at the intersection of the high-tech industry and defense, is exceptionally well positioned. Our strategy and investments in secure processing, trusted microelectronics, and open mission systems are serving as the engines of growth in the business. Our M&A pipeline is robust, positioning us for continued acquisition-related growth. We've streamlined our organizational structure, strengthened our leadership team, and launched impact. As a result, we believe that we can replicate what we've done successfully since fiscal 14 and achieve Mercury's full growth and adjust the potential organically and through M&A over the next five years. Before I turn the call over to Mike, I'd like to welcome Mercury's newest director, Deborah Plunkett. Deborah was elected to the board at our annual meeting, October the 27th. Her extensive experience in cyber, national security and information assurance will be a significant asset to Mercury. In addition, as planned, Vince Vito has retired from the board. Vince has contributed valuable insight and counsel as a director for more than 15 years, the last 10 of them in his role as chairman. On behalf of all of us at Mercury, I extend our deep appreciation to Vince for his dedicated service and leadership. At the same time, I'd like to welcome Director Bill O'Brien as our new chairman. I look forward to working with Bill to achieve Mercury's full potential in the years ahead. Finally, I'd like to recognize the entire Mercury team for a tremendous effort during these challenging times. My sincere thanks for your outstanding work and all of your contributions. With that, I'd like to turn the call over to Mike. Mike?

Thank you, Mark, and good afternoon again, everyone. As usual, I'll start with our first quarter results and then move to our Q2 and fiscal 22 guidance. As Mark said, Mercury's Q1 results were in line with our expectations. Total revenue exceeded our guidance, While adjusted EBITDA exceeded the midpoint and adjusted APS came in at the high end of guidance. We remain on track towards achieving our previously announced revenue and adjusted EBITDA guidance for full year fiscal 22. We expect a double digit increase in bookings versus fiscal 21, a positive book to build for the year and strong growth in our backlog. We continue to expect the year to be weighted towards H2 and especially Q4. We expect margins to expand in the second half of the year and free cash flow to begin to normalize. Looking farther ahead to fiscal 23, we expect a return to high single-digit, low double-digit organic revenue growth driven by bookings and backlog growth in fiscal 22. We expect this organic growth, coupled with improved operating leverage and the impact initiatives, to result in strong margin expansion and EBITDA growth in fiscal 23 versus fiscal 22. Turning to our Q1 results on slide 10, bookings in Q1 were 199 million, down 1% compared to Q1 21. Our book-to-bill was 0.89. Our backlog at the end of the quarter was 884 million, up 7% from Q1 21 and down 2.8% compared to Q4 21. While our total backlog declined from last quarter, our 12-month backlog was up 4.5% compared to last quarter as a result of bookings shifting into nearer-term revenue. As a result, we have better visibility into the second half of fiscal 22. Coupled with bookings on key programs that we expect to receive in Q2, we're optimistic about our results for the full year. Revenue in Q1 increased 9% from Q1 2021, exceeding the top end of our guidance of $210 to $220 million. Organic revenue was $184 million, down 11% year over year, but better than anticipated, driven by timing and mix on several of our larger programs. Acquired revenue, which included Physical Optics Corporation and Pentac, was $41.3 million. The AVALEX acquisition that we announced in September and is expected to close in early November and therefore was not in our Q1 results. Gross margins for Q1 were 39.3% compared to 42.9% in Q1 fiscal 21, down 360 basis points. This was primarily driven by the inclusion of POC, which had a 240 basis point impact. We also had more new program starts in development work compared to a year ago. These programs tend to have lower margins in the near term, but are the precursor to higher margin production work over time. Operating expenses in Q1 were up 35.5% compared to last year. This was primarily driven by an increase in restructuring and other charges. It also reflected higher amortization expense associated with the recent acquisitions, as well as acquisition-related expenses. In Q1, we recorded $12.3 million of restructuring and other charges, reflecting a workforce reduction in the quarter, as well as third-party consulting costs associated with our impact program. Our investments in R&D continue to exceed the industry average as we continue to invest for growth. R&D for Q1 was 28.9 million, up 5% compared to 27.4 million in Q1-21. The biggest drivers of R&D in Q1 were in mission computing and secure processing. Since fiscal 17, we've now invested over $400 million in new technologies such as secure processing, trusted microelectronics, and mission computing that will drive our growth going forward. In Q1, we incurred a gap net loss of $7.1 million, or negative 13 cents per share. The loss was driven primarily by $12.3 million of restructuring and other charges in the quarter. Adjusted EBITDA for Q1 was $38.3 million, within our guidance range of $36.8 to $39.6 million. Our adjusted EBITDA margins were 17% for the quarter. down 380 basis points from 20.8% in Q1 fiscal 21. This was primarily driven by program mix. Free cash flow for Q1 was an outflow of $7.4 million, driven primarily by our net loss, including cash outflows associated with restructuring and other charges. We also saw some changes in customer payment patterns. We believe these resulted from the debt ceiling negotiations and potential government shutdown coinciding with quarter end. Slide 11 presents Mercury's balance sheet for the last five quarters. We ended Q1 with cash and cash equivalents of 96 million compared to 114 million in Q4 21. The reduction was primarily driven by our negative free cash flow during the quarter. We also used cash for the net share settlement of vested restricted stock units in connection with our annual grant basket. We ended Q1 with $200 million of debt funded under our $750 million revolving credit facility. We expect the AVALEX acquisition to close this month and to finance the $155 million cash purchase price using the revolver. Following the acquisition, we will have approximately $355 million of debt and leverage of 1.3 times net debt to adjusted EBITDA. From a capital structure perspective, we remain well positioned with continued flexibility and great access to capital. Upon closing the Avilex acquisition, we will have invested $530 million in capital in the last 12 months towards M&A, marking the largest capital deployment in a 12-month period in Mercury's history. We continue to invest in strategic acquisitions that are aligned with our R&D investments. Turning to cash flow on slide 12. Free cash flow for Q1 was an outflow of $7.4 million. Our net loss in Q1 was the biggest driver of our cash flow compared to previous periods. Q1 is typically seasonally lower due to employee bonus and tax payments. However, this quarter, we also had cash outflows for restructuring and other charges associated with impact, as well as acquisition-related expenses primarily associated with AVALEX. As previously noted, we experienced some changes in customer payment patterns. We also invested in inventory related to forecasted revenue growth in the second half of the year. I'll now turn to our financial guidance, starting with Q2 on slide 13. Our guidance for the second quarter in the full fiscal year assumes no incremental acquisition-related expense. Our guidance for Q2 includes restructuring and other charges of $5.2 million related to the impact initiatives. Our Q2 and Fiscal 22 guidance does not reflect AVALEX, which we expect to close this month. As we announced, AVALEX is expected to generate approximately $40 million in revenue for the 12 months ended December 31, 2022, with adjusted EBITDA margins of approximately 25% or $10 million. Assuming we close the acquisition at the beginning of this month, we would expect revenue and adjusted EBITDA of approximately $3,750,000 in Q2, respectively. For the second half of our fiscal year, we expect AVALEX to contribute approximately $20 million in revenue and $5 million in adjusted EBITDA. Since the acquisition is not yet closed, this is not included in our Q2 or full-year guidance. Heading into Q2, we expect a rebound in bookings, with Q1 being the low point for the year. In Q2, we expect a book to bill above 1, which will drive the revenue growth and margin expansion in the second half of the fiscal year. Exiting Q2, we expect our backlog to increase and have even greater visibility into the revenues expected for the remainder of the year. For Q2, we currently expect revenue in the range of $215 to $225 million. This is approximately 4% growth at the midpoint compared to the second quarter last year. At the midpoint, we expect organic revenue to be down approximately 15% from Q2 last year as a result of bookings in the last few quarters. We currently expect gross margins in Q2 to be in line with Q1 due to similar program mix between development programs and production programs. In the second half of fiscal 22, we expect gross margins to increase as we complete several of our lower margin development contracts. The revenue growth in H2 is expected to be driven by higher margin production programs. Q2 gap net income is expected to be $300,000 to $1 million, or break even to $0.02 per share. The year-over-year declines reflect the expected incremental impact related expenses. Q2 adjusted EPS is expected to be 39 to 43 cents per share. We expect adjusted EBITDA for Q2 to be 38 to 41 million, representing approximately 18% of revenue at the midpoint. This is about 100 basis points higher than Q1, even as gross margins are similar. As sales ramp up in the second half of the year, we expect an increase in gross margin combined with operating leverage to result in EBITDA margin expansion. We expect free cash flow to adjusted EBITDA for Q2 to be approximately 15% driven by continued impact cash outflows. Turning to slide 14, we're maintaining our guidance for fiscal 22 for revenue and adjusted EBITDA. We're increasing our guidance for adjusted EPS primarily as a result of lower expected depreciation expense compared to our prior guidance. Our updated gap net income and gap EPS guidance reflects the restructuring and other charges, as well as acquisition-related expenses incurring Q1, in addition to the incremental known impact-related expenses expected in the year. As Mark discussed, there is continued uncertainty associated with the defense budget and contracting environment, COVID, as well as the supply chain. The team is working diligently to minimize these risks and to date has been able to do so. Our guidance assumes that we'll be able to continue to manage these risks without material impact to our results. For the full fiscal year 22, we're expecting double digit bookings growth and a book to bill above one. We expect total company revenue of one to 1.03 billion. This represents eight to 11% growth from fiscal 21 in line with our previous guidance and flat organic growth year over year. Again, our revenue guidance does not include the AVALEX transaction and is prior to additional acquisitions. We expect our revenue in fiscal 22 to be weighted heavily toward the second half and in particular Q4. Total gap net income on a consolidated basis for fiscal 22 is expected to be 54.6 to 59.7 million or 98 cents to $1.7 per share. Gap net income and earnings per share are lower year over year as a result of expected restructuring and other charges, as well as non-operating activity and discrete tax benefits in fiscal 21, which are not guided for fiscal 22. Adjusted EPS for fiscal 22 is expected to be in the range of $2.51 to $2.60 per share, an increase of 4% to 7% compared to fiscal 21. Adjusted EBITDA for fiscal 22 is expected to be in the range of $220 to $227 million, up 9% to 12% from fiscal 21. Adjusted EBITDA margins are expected to be approximately 22%. As Mark said, we've included approximately $22 million of savings in our fiscal 22 guidance related to the impact actions taken in Q4 and Q1. Like revenue, we expect adjusted EBITDA and EBITDA margins to be heavily weighted towards the second half, and in particular Q4. As revenue ramps throughout the year, we expect an increase in gross margins and operating leverage to lead to adjusted EBITDA margin expansion. From a free cash flow perspective, we're targeting approximately 30% free cash flow to adjusted EBITDA in fiscal 22. We expect cash flow to begin to normalize in each two, driving improved conversion for the year. We have guided certain additional costs associated with impact that are incorporated into this estimate, although we may incur additional expenses that are not yet probable or estimable. Turning to slide 15, in summary, our Q1 revenue exceeded expectations and adjusted EBITDA was in line with expectations as we continued to invest in the business. For the rest of the year, we expect a rebound in bookings, solid revenue growth, and margin expansions. We believe our fiscal 22 bookings and backlog growth will position us for a strong fiscal 23 as organic growth returns to our target high single-digit, low double-digit range, and margins expand as a result of positive operating leverage and impact. Looking further ahead, we're well positioned for accelerated growth and continued adjusted EBITDA margin expansion. We've invested significantly in CapEx, R&D, and M&A over the last few years, driving key design wins on franchise programs. As a result, we have high confidence in our ability over the next five years to continue executing on our strategy for long-term value creation. With that, we'll be happy to take your questions. Operator, you can proceed with the Q&A now.

Thank you, sir. Ladies and gentlemen, if you would like to ask a question, you will need to press star then 1 on your telephone keypad. Again, star 1 to key for a question. To withdraw your question, press the pound key. In order to allow as many callers as possible to ask a question, management requests that you limit yourself to one question. Thank you. And our first question is going to come from the line of Peter Skibitsky with Alembic Global.

Hey, good evening, Mark and Michael. Thanks for calling. I guess just a quick one, I guess, for me, you know, nice revenue quarter. You hit your adjusted EBITDA guidance here for the first quarter. Michael, you touched on the adjusted EBITDA margin below your expectation. But was that just the incremental revenue that came through? Was it just maybe a little bit more CRAT revenue than expected? Is that kind of what you meant by program mix?

Yeah, that's the right way to think about it, Pete. It really is just program mix and the the higher revenue was associated with the lower margin development programs or CRAT.

Okay.

Okay. CRAT was up 13% year-over-year.

Okay. Okay. That's great. If I could stick one last one in, but looking into the second quarter, Mark, what are you kind of most concerned about? You know, is it the CR? Is it the semi-shortage? Is it the vaccine mandate? Is there a way to kind of rank kind of what you guys are most concerned about?

Yeah, it's a good question. It's actually all of those things. So as I said on the call and the prepared remarks, the risk level has elevated across all of those areas. Now, I think we still feel pretty good that Q1 is the low watermark for bookings this fiscal year, and we're going to see progressive growth in both bookings and revenue as the year progresses. But we're very mindful of the risks in those three areas, and we'll see how things evolve, Peter.

Thank you. Our next question will come from the line of Seth Seisman with J.P. Morgan.

Hey, thanks very much, Shad. Good afternoon. Maybe just to follow up there, digging in on the question of the CR, if it gets punted out through the first calendar quarter of 2020, fiscal, or I guess if it gets funded out through the first calendar quarter of 2022, what does that mean in terms of the bookings you expect in your second half, and to what degree is your bookings target reliant upon an appropriations bill, and in what time period do you need that?

Sure. So, you know, in our guidance, Seth, we've actually assumed a one-quarter CR We don't have that many new program starts and much of the bookings growth in the second half is actually tied to growth in our existing core markets and largely around our top 20 programs, which are existing programs. So it's hard to say for sure what the risk could be. Yeah, because there are unknown unknowns, but, you know, we've assumed one level, sorry, one quarter of CR in the guidance.

Thank you. Our next question will come from the line of Peter Arment with Baird Equity Research.

Yes, good evening, Mark and Mike. Mark, maybe if you could just circle back a little bit to Pete's question about the second half. Yeah. You know, the EBITDA margins that you're having in the first half, obviously below your historical, you know, what you've enjoyed. And the second half obviously implies kind of a big step up. So maybe if you could just highlight a couple of the key things that are going to drive that. I know you talked about maybe less CRAT or some of the development programs. Thanks.

Yeah, let me kind of go through just a little bit H2 versus H1 kind of overview from a, From a high level and then, you know, maybe kind of Mike could kind of dig in a little and tease things apart. So, you know, for the second half from a revenue perspective, as we said, we're expecting double digit growth in revenue versus the first half and year over year. Pretty much like the growth that we're expecting for the full year, we're expecting that the growth will be driven sequentially by the two major market segments in which we're participating, which is sensor and effect emission systems, as well as C4I. And the growth is going to come primarily from our top 20 programs, which are largely expected to grow at a much higher rate. And it's really this that I think is the primary driver of the margin expansion. So taking it down a level, if we look at in the second half from a programmatics perspective, the growth, what the programs that are going to drive growth are LTAMs, F18, CWIP, F16 Sabre, F35, and that large FMS program. that moved from Q1 of last year. Other programs, large programs in the second half are ALR56, a classified C2 program, as well as T45. So it's kind of in line with what Mike said, right? It's really the program mix H1 versus H2. Do you want to add anything?

Yeah. Yeah, and Peter, I think Mark just went through all the programs. I think as you look at the EBITDA for the year, you know, the midpoint of our guidance is still, you know, 22% between our Q1 and our Q2, kind of midpoint of our guidance, we're running about 17.5%. So we clearly expect to pick up in the second half, and as I said in the prepared remarks, in Q4 specifically as well. And That's going to be driven by a couple things. Number one is the gross margin expansion, and Mark just talked about some of the specific programs. But at a high level, the program mix between the development programs that we had in H1 compared to production programs in H2 is going to drive a lot of that. The second thing is operating leverage. And we're continuing to invest in R&D in H1 at levels that are consistent with what we've done in the past. Because of that, we're seeing some negative operating leverage, which is putting pressure on margins. We expect that to reverse in the second half and really drive margins as well. So those are the two big things is program mix and operating leverage driving the EBITDA margins in H2.

Thank you. Our next question will come from the line of Sheila Coagulu with Jefferies.

Hey, good afternoon, guys, and thanks for the time. Just staying on the implied margin ramp, when we think about the first half, how much of the margin pressure is coming from new program mix? Is it like 500 bps? Is it 100 bps? And you also talked about elevated supply chain risk and inflation as a watch item. How are you kind of thinking about that into the second half?

So why don't I hit on the margin question first. The preponderance of the lower gross margin, Sheila, in H1 is related to the program mix and the new development programs. And as we go through the second half of the year, we're going to see a ramp up in gross margins. I think when we get to Q4, we're going to see gross margins that can look back at where we were in fiscal 20 for the year around 40, 45%. I think that's where we'll be around Q4. And again, we don't specifically guide gross margins, but at the year level, I think we're going to be, you know, slightly above where we were in fiscal 21, which, you know, implies that ramp up in gross margins in H2, which is related to the programs that Mark was talking about.

Yeah, and then on the supply chain side of things, Sheila, we clearly are seeing what many other companies have talked about in this earnings season with substantial increases in lead times and price inflation. I would say the team to date has done a very, very good job navigating around that. We missed very little revenue in the first quarter associated with it, But we do expect that the inflationary environment and the risks associated with revenue will be around for quite some time. That was one of the reasons that in the first quarter we did make additional raw material purchase commitments that was tied to revenue in the second half that also was able to take advantage of some better pricing. You know, the team's doing a great job. You know, it's challenging, and, you know, we're managing through it.

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

Good afternoon. I just wanted to maybe understand a little bit more about your comments around sort of the vaccine mandate and potentially how that could impact your business. Can you give us a sense of how much additional churn you're looking at and maybe your thoughts around sort of skill shortages, difficulty hiring workers, how you think about managing that process? Thank you.

Yeah, so as you know, Jonathan, I think we did a very good job kind of managing through the initial stages of the pandemic. We're obviously now in a different phase with the White House mandating the vaccines. So we're working through that. A very large majority of the population is vaccinated currently, but there's still a portion that is not. So we're working to educate those and cajole and coax them to actually get the vaccine. It's unclear at this stage exactly how many of those choose not to get vaccinated. And it's still a little unclear, just given some of the change in the tone coming out of the White House as to what companies are going to be able to do and what flexibility that they have with respect to the mandates themselves. So We've notified employees that we intend to comply. We're communicating with them in a two-way dialogue. But at this point, it's unclear as to the exact impact it will have. We are preparing mitigants to actually offset any disruptions that we may have, which includes overtime and temporary labor like other people. We haven't had any issues with respect to hiring. I think time to hire is still pretty strong, and we have the labor that we need. So right now, we're doing okay, but this is an important quarter with respect to those potential changes.

Thank you. Our next question will come from the line of Michael Ciaramoli with Touristic Securities.

Hey, guys. Good evening. Thanks for taking the questions. So I guess, Mark and Mike, maybe what was the thought process? I mean, we've obviously seen the larger defense peers here, you know, report, call out these risks, lower their guidance. You know, you guys are still calling for substantial strength. Your fiscal year doesn't exactly align well with some of these risks. I mean, it would seem like you're a bit more vulnerable, but you've obviously decided to keep the stake in the ground and not maybe account for some of these risk factors and maybe reducing the guidance. I mean, can you walk us through, you know, kind of the confidence level and, you know, calling out these risks, but not maybe reflecting them in the guidance?

Sure. Let me let me kind of step back and just do a little bit of a recap in terms of kind of how we ended up here. So, you know, as we said on the call, I think overall, we're pretty encouraged by the defense budget trends and the longer term effects associated with the vaccine mandates. Notwithstanding that, as we said in the prepared remarks, I think in the short term, risk levels have increased due to the potential of the prolonged CR, the impacts that the vaccine mandates could have on employee turnover and operations, as well as the supply chain constraints and inflation that we just discussed. As we reflected coming out of 2021 and as we built the forecast, What we did, Mike, as you know, is we examined the areas that impacted organic growth the most last year and believe that as we came into this year, you know, we've planned more conservatively. Now, that doesn't mean that, you know, a plant has zero risk. You know, as the year is clearly back in loaded and, you know, the environment is more challenging. But to recap what happened in 2021, Yeah, we saw really a six-point reduction in organic growth last year. This was led by a three-point reduction in organic revenue growth due to delays in naval modernization, particularly programs like CWIP. We saw a two-point reduction due to the now well-publicized Lockheed supply delays on the F-35 TR-3 and Block IV programs. as well as a greater than a one-point reduction to various FMS programs. So to risk adjust these, as well as other areas, coming into this year, we lowered organic revenue growth expectations by eight points. And this decline resulted in the guidance that we currently have, which is flat organic revenue growth for the year, but a belief that bookings will grow as the year progresses, leading to a positive book-to-bill trend for the year as a whole and hence a return to more normal levels of organic growth in 23. And that's still very much our plan. So let me talk a little bit about some of the programs that were impacted and just give you an update on some of those. So the programs that we further reduced in 22 were LTAMs, CWIP and other naval upgrades, the F-35 just due to the impacts that we were seeing, as well as various FMS programs. And so if you look at LTAMs, we're still expecting substantial growth in bookings year over year, despite us lowering our original bookings forecast, given that the LTAMs award moved to fiscal 23. On the Naval Fleet Modernization Schedule, that has and continues to be impacted. For us, this affected several programs, including CWIP, and as a result of that, we lowered our revenue expectations and moved this year's CWIP award to the fourth quarter, which typically comes in Q3, which actually helped to de-risk the plan further. Probably the biggest shift was on the F-35, and here, again, we kind of lowered revenues due to the ongoing engineering delays you know, associated with F-35, TR-3 and Block 4. The good news is that in Q1, we actually received a large order and expect additional awards in both Qs 3 and 4. Now, the bookings this year are far more weighted towards H-1 than what they were in, you know, last year, which is a positive. And overall... Yeah, we expect double-digit growth in F-35 bookings this year versus a 50% decline in 21. And in Q1 alone, we booked nearly as much on the F-35 as we did for the whole of last year. So that says, yeah, there's still risk, right? Because although we booked a large order in Q1, the associated second-half revenue is tied to long-lead funding. which in itself is tied to TR3 safety of flight test. So that revenue associated with F-35 currently sits in Q4 and is still in the plan, which is part of why the year is back-end loaded. On the FMS side, the biggest impact that we had last fiscal year was in Q1. It's when that very large FMS order moved out of the year. Now, the good news is that we received an initial award for that program in the fourth quarter earlier than we'd expected, and we expect a substantial follow-on order in Q2, which will help for the year. So, yeah, so overall, although there's elevated risk in the second half, you know, due to a potential of a prolonged, you know, CR, the COVID vaccine mandates and supply chain, we're actually pretty pleased with the progress that we made in the first quarter and our goal remains the same. So a lot of answers to a short question, but yeah, we've made some pretty good progress, Mike.

Thank you. Our next question will come from the line of Austin Mulder with Canaccord Genuity.

Good evening, Mark and Mike. Just on the note about the impact of inflation, I know there's a lot of expectation here that organic growth will manage to remain strong in fiscal year 23. But are you concerned about the impact of inflation on either the current defense budget or the future defense budget and that cost growth leading to a reduction in procurement quantities for key weapon systems? Or alternatively, do you think that that will benefit Mercury by driving DoD to further engage in de-layering of the supply chain and allow you to negotiate with them directly as opposed to through the prime?

Yeah, so I think it's probably going to be a little bit of both. We're clearly seeing, you know, the de-layering trends, you know, We're also seeing a flight to quality suppliers, in particular in RF as well as secure processing, where our customers are seeking to deal with those companies that have automated or modernized their manufacturing capabilities as well as those that are willing and have the capacity to invest in new technologies and capabilities. So it's a little bit of both.

Our next question will come from the line of Noah Poppenack with Goldman Sachs.

Hi, good evening. Hi, Noah. Mark, I just wanted to follow up on all that detail you just gave on some of your largest programs that have had the delays. I guess it seems concentrated into CWIP and then F-35, TR-3, and then LTAMs. Notwithstanding the fact that you already gave a lot of detail there, what's actually transpired with those programs? Have there been meaningful stake in the ground, hard milestones you can point us to? Have you had conversations with the prime about the order timing that you can point us to? Because otherwise it feels a little bit like we're still just guessing on the timing and you don't know if it'll slip out of your 4Q and your 1Q. Are there concrete things that have transpired that you can point us to that get us a little more comfortable?

So, yeah, I'd kind of just reiterate, you know, to some extent, Noah, what we basically said, right? I think there's been a tremendous amount of disclosure that was previously maybe not out in the public domain around the delays, you know, on TR3 and Block 14. that resulted in substantial cost increases, delays to the program, and potentially a change in the production levels. Maybe we were a leading indicator to seeing the effects of that. Hard to tell. I think many of the updates that I think has been discussed publicly suggest that the TR3 development and integration efforts are actually doing better than what they were. There's still some important milestones to go. One of those is obviously the integration of the capabilities and the flight safety certification testing that is likely going to begin or occur early in the new calendar year. you know, which would bode well for, you know, our revenues in the second half. So that's kind of new information. You know, on CWIP, you know, I think it's, again, generally understood that, you know, there's been a pretty significant impact to the ship modernization upgrade cycle that affected, you know, both CWIP as well as for our other naval programs. You know, we have taken that into account recently. you know, in our forecast. And, you know, the fact that we typically get the order in the third quarter, which our customer still intends to do, we've been even more conservative pushing it into Q4, again, kind of de-risking the plan. You know, on LTAMs, you know, that... that shift moved the next production order into our next fiscal year. However, we're still expecting significant bookings associated with LTAMs around certain upgrades and other development efforts that should lead to substantial growth in bookings year over year. So, yes, we've been having dialogues with customers. Yes, it's a very dynamic environment and you know, we've tried to reflect those changes and to communicate, you know, the latest information in the remarks that I've just said.

Once again, to ask a question, press star one. Our next question comes from Pete Skidiski with the One Bit Global.

Yeah, thanks, guys. I just want to go further on the F-35 outlook, just because Lockheed put out that updated production kind of profile, and Mark, you talked at length about TR-3. But it sounds like as we head into maybe fiscal 23, your F-35 revenue, it'll be a fairly easy comp for you, given the delays in the TR-3. So, but how should we think about, you know, with a new production profile, how should we think about the profile for you guys through the midterm? In other words, is F-35 going to be a growth program for you guys for, you know, for quite a long time? Or will you, you know, you know, in the near term, let's say, run into kind of this production flattening profile that some of the bigger guys are running into? Yeah.

So, you know, we think that F-35 is, you know, going to be, obviously, continue to be a really important program for us. You know, unlike, you know, say Lockheed, right, that, you know, the growth is obviously dependent upon, you know, the growth in the production rate. You know, there's a few things going on with Mercury. Yeah, so... The first is obviously getting beyond the issues that we've experienced around TR3. TR3 becomes an enabler for Block 4, and Block 4 for us enables content expansion across different parts of the system that should lead to growth in both processing as well as RF content. The second thing is that it's likely that the existing systems, both TR1 and TR2, will be retrofitted over time, which could be a pretty substantial opportunity for us as well. And then obviously over time there's likely going to be continued tech refreshes. So we're not a platform provider. Our business is really tied to both the electronic systems on new platforms as well as the ongoing modernization of existing systems. And, you know, TF35 is a great example. It's already on the third tech refresh of the underlying processing and memory subsystem, which we'll benefit from. So hopefully that answers your question.

Thank you. That's all the time we have for our question and answer session. I'd like to turn the call back to Mark Aslett for closing comments.

Okay. Well, thanks very much, everyone, for joining us this evening. We look forward to speaking to you again next quarter. Take care.

Once again, we would like to thank you for participating on today's conference call. You may now disconnect.