Mercury Systems Inc

Good day, everyone. Welcome to the Mercury Systems Second 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 Adler. 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 Aslan. Please turn the slide to Ray.

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 solid results for the second quarter of fiscal 22. Booking dropped substantially from what we believe was the low watermark in Q1, resulting in a 1.08 book-to-bill. We remain confident in achieving even stronger bookings in the second half, leading to substantial growth for the year. As a result, we expect to exit fiscal 2022 well-positioned for return to our normal levels of growth and margin expansion. This should lead to a strong performance overall in fiscal 2023 as planned. Looking further ahead at our five-year plan, the impact program we launched in fiscal 21 is providing the foundation for our next phase of value creation at greater scale. We expected to deliver high single-digit to low double-digit organic revenue growth over time, coupled with margin expansion and M&A. Our long-term model, sitting at the intersection of the high-tech industry and defense, has positioned Mercury exceptionally well. Our strategy and investments in secure processing, trusted microelectronics, and open mission systems are serving as the engines of growth in the business. Turn to the numbers on slide four. Total revenue for Q2 was up 5% year over year, reflecting the anticipated challenging industry conditions. Our largest revenue programs in the quarter are a classified C2 program, MH60, P8, CDS, Argonne, and X16. We continue to see high levels of new business activity, and our pipeline remains strong. Designers in Q2 total more than $160 million in estimated lifetime value. Through the first half of fiscal 22, we've won 13 new designs with an estimated lifetime value of more than $580 million. Pre-cash flow for Q2 was improved from Q1, but slightly negative due to supply chain challenges. Adjusted EPS and adjusted EBITDA were in line with our guidance. Turning to slide 5. For fiscal 22, we continue to expect total company revenue to grow approximately 10%, exceeding $1 billion for the first time. This outlook reflects a slightly more conservative forecast for organic revenue growth, reflecting the industry headwinds, offset by potential upside from the recent Ablex and Atlanta Micro acquisitions. On the bottom line, we're still expecting to deliver record adjusted EBITDA, Mercury began to see the impact of COVID and program-related effects in the back half of fiscal 21. It's clear from the most recent earnings season that these challenges, as well as the now extended CR, have caught up to the industry overall. Over the past two quarters, we've seen substantial changes in actual results versus forecast, guidance, and outlook by many of our peers and customers. In essence, Mercury experienced these challenges early on, and we believe that we were a leading indicator for the industry. It's taken a year for these challenges to filter through the defense industry as a whole. Despite the impact of the CR, we saw substantial progress in the second quarter as anticipated, and expect even stronger bookings in Q3 and Q4. We expect the issues around the CR to be rectified in March if Congress passes the Defense Appropriations Bill. As we discussed last quarter, the team is working closely with our suppliers as well as our customers to mitigate supply chain risks. These risks are related to longer lead times for semiconductor components and materials, supply decommits, as well as price inflation. We've been largely successful in those efforts to date, and to further mitigate risk, we've placed orders for accelerated material procurement to meet our second half demand. Since our last call in November, risks have clearly become elevated with respect to the pandemic. We've worked to educate, assist, and motivate unvaccinated employees to get the vaccine with good results and minimal financial and operational disruption. Currently, 98% of our U.S. employees are either fully vaccinated or have received an exemption. While it's possible we could see an impact from COVID in Q3, we've kept all of our facilities open and operational throughout the pandemic and expect to continue doing so. I'll note two other emerging risks. First, possible FMS order delays, and second, ensuring we have the qualified people we need to support our growth objectives. On the latter, while Mercury continues to be seen as a destination employer of choice, we're currently contending with challenging labor markets. We continue to evaluate and implement initiatives aimed at attracting top talent. Turning to slide six, In April 2021, we proactively launched our IMPACT program to lay the foundation of our next phase of value creation at scale. We began IMPACT because we knew that we needed to do things differently to achieve Mercury's full growth and adjusted EBITDA potential organically and through M&A over the course of the next four years. To be clear, our decision to launch Impact 10 months ago was not related to the industry challenges that began shortly thereafter. Impact is about transforming the business to operate at a greater scale than what we are today. The program is led by Thomas Huber, who serves on our leadership team and reports directly to me. We continue to expect impact to generate $30 to $15 million of incremental adjusted EBITDA by fiscal 25. This includes a $27 million net benefit related to impact actions taken in fiscal 22. We're on track to meet our targets with upside opportunities that would allow us to deliver value in excess of our targets and quicker than originally expected. Impact is aimed at improving our organic growth as well as the fundamentals of the business over and above what we've done in the past. It's enabling us to better align our investments with our customers' priorities and to partner with them on larger opportunities. As a result, we expect to continue to take share and grow faster than the industry over time. In addition to optimizing our balance sheet by improving our capital and asset efficiency, we see substantial potential through impact to expand our margins. We're focusing on five major areas. First, organizational efficiency and scalability. Second, procurement and supply chain. Third, facilities optimization. And fourth, scalable common processes and systems. The fifth area is R&D investment efficiency and returns. Mercury's significant investment in research and development is a pillar of our growth strategy. Prior to the current industry headwinds, this investment resulted in organic growth well above the industry average over a multi-year period. A strong commitment to R&D is also in line with where the defense industry is headed. Mercury has proven that a high-tech investment model can operate successfully at scale on behalf of all stakeholders. As it relates to M&A, impact is about leveraging our proven ability to integrate and grow acquired businesses, but at a greater scale going forward. Since fiscal 14, we've completed 15 acquisitions deploying $1.4 billion of capital. We dramatically scaled and transformed the business as a result, growing total company revenue 4.4 times from FY14 through FY21. We fully integrated these acquired entities by moving them to common collaboration and engineering platforms, as well as common ERP, HRIS, and CRN systems, while also consolidating facilities. We've also unified these 15 businesses under the Mercury brand with a combined Salesforce and single go-to-market strategy, as well as the shared culture and values. As a result of these actions, over the past seven fiscal years, we've extracted substantial cost and revenue synergies, leading to adjusted EBITDA growing more than nine times or twice the growth in revenues. This has resulted in substantial value creation for shareholders. We intend to apply the impact methodology to future M&As. In addition to accelerating and increasing the value we create, we believe that deploying impact could also allow us to increase our deal cadence and potentially the size of our transactions. Combined with the increased synergies generated, this could have a compounding effect on value creation. For example, six of our 15 acquisitions now comprise our mission business. Here, we're combining our integration, growth, and value capture efforts as part of impact. Turning to slide seven, we continued our M&A momentum in the quarter, closing the Avilex Technologies and Atlanta Micro acquisitions in November. As a result, we've now deployed $620 million in capital since December of 2020. This marks the largest 12-month M&A capital deployment in Mercury's history, and we're excited about the future. Avalexis touchpoints with all our prior mission acquisitions. It positions us to compete more effectively for integrated displays, communications management, and mission computing programs in the avionics domain. It also aligns well with the need for open mission systems driven by industry de-layering. Atlanta Micro is an innovative, high-margin semiconductor business. It fits well with our RF, NIC signal, and trusted microelectronics businesses. Both integrations are progressing well, as are the integrations of POC and Pentek, which we acquired last year. As it relates to future transactions, the M&A environment continues to be active, and our pipeline is strong. we will remain disciplined in terms of our deal pursuits, diligence, pricing, and integration. Merkur has built an enviable in-house M&A capability and is a proven track record of acquiring and integrating significant acquisitions. Through integration of our acquisitions, we've been able to average down the multiples we've paid through the recognition of both cost and revenue synergies, creating substantial value for our shareholders as a result. Coupled with the strength of our balance sheet, we believe we can continue to execute on the M&A strategy that's been so successful for us over the past seven years. Turning to slide eight, we expect Mercury's total company revenue to continue growing faster than overall defense spending over time, with organic growth being the core driver. We focus the business on larger and faster growing parts of the defense market. And we now participate in more than 300 different programs. We designed in on our top programs with the majority being sole source positions. No single program was more than 5% of total company revenue in fiscal 21. And looking ahead to the next five years, no single program is expected to be more than 6% of total revenue. We believe that our longer-term secular growth trends remain favorable. The significant actions we have taken over the last several years have aligned us well with the national defense strategy. The government continues to push for modernization, speed, and affordability in sensor and effect emission systems and C4I. Needs for secure processing, trusted microelectronics, and open emission systems are growing. We believe it will also continue to benefit from the ongoing effects of supply chain delaying and reshoring, as well as increased outsourcing at the subsystem level by our customers. The move to subsystems has been the driver of our low-risk content expansion growth strategy, which has allowed us to grow organically at a rate far in excess of the industry. Back in 2016, with an eye towards expanding our margins, we acquired various assets from the MicroSemi Corporation. This was the genesis of our trusted microelectronics strategy. Mercury's focus here has been to create highly differentiated, secure, and trusted microelectronics capabilities, as well as radiation-tolerant devices for space applications, both developed and produced domestically. These capabilities now represent the highest margin part of our business as planned. We expect our trusted microelectronics strategy to continue driving growth and margin expansion over time. Our vision of being the leading commercial provider of trust 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, which are non-competitive with our customers' offerings, are becoming larger and more strategic for both parties. We believe this vision, combined with our low-risk content expansion strategy, will continue to drive organic growth in the business. During the second quarter, our largest bookings programs were a classified platform mission management program, Argonne, two classified EW programs, and CPS. As I said, we anticipate accelerated growth in bookings in the second half, leading to a positive book-to-bill and growth in backlog for fiscal 22 as a whole. Recent updates suggest that the development and integration efforts related to the F-35 TR-3 are doing better. We believe this improvement is mirrored in our bookings. Year-to-date, we booked as much on the F-35 as we did for the whole of fiscal 21, and we're expecting a strong second half. In addition to the F-35, we continue to expect our bookings to be led by programs including LTAMS, Filthy Buzzard, CWIP, F-18, F-16, P-8, and T-45. We're also expecting a significant booking related to a classified trusted microelectronics program. In addition, we expect to receive a second, substantially larger order for the FMS program that was delayed in Q1 of last fiscal year. A change since our last call relates to LTAMs, which is now called GoSci. In response to our customer, we have previously moved the next booking related to GoSci domestic and international production from our fiscal 22 to fiscal 23. Based on recent customer input, this may have moved to our fiscal 25, with the possible exception of unobligated funds for pre-production activities. Like the F-35, GoSci is an important program. It's the largest single design win in the company's history to date. We expect it to be a significant driver of growth beginning in fiscal 25. Looking specifically at fiscal 23, we expect bookings from our top 20 programs to ramp yet again. We anticipate seeing fewer delays in key programs, among them the F-35, as well as continued naval and airborne upgrades, such as CWIP, a subsurface combat system upgrade, filthy buzzard, F-18, T-45, and other classified programs. 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 second quarter results and then move to our Q3 and fiscal 22 guidance. The team worked in Q2 to deliver solid financial results despite the external challenges that Mark discussed. We saw a significant rebound in bookings from Q1 and finished the quarter with a book to bill above one. The bookings momentum in Q2 is expected to accelerate, resulting in a strong second half of the fiscal year. For full fiscal 22, we're maintaining our prior guidance for revenue, adjusted EBITDA, and adjusted EPS. Our updated guidance incorporates the acquisitions of Avalex and Atlanta Micro, as well as a more cautious organic revenue outlook, primarily due to elevated supply chain risk. We continue to expect fiscal 22 to be weighted towards H2, and especially Q4 as margins expand and free cash flow begins to normalize. Given our backlog at the end of Q2 and forecasted Q3 bookings, we expect to exit Q3 with strong visibility into Q4. Looking ahead to fiscal 23, we continue to anticipate a return to above industry average organic revenue growth driven by the strong bookings and backlog growth in fiscal 22. We expect this organic growth, coupled with improved operating leverage in our impact initiatives, to result in margin expansion and increased adjusted EBITDA versus fiscal 22. Turning to our Q2 results on slide 9, bookings were up 13% compared to Q2 21 and up 19% from last quarter. During the quarter, we had over 25 million of bookings move from Q2 into Q3 as a result of contracting delays. we've already received a majority of those orders in Q3. Despite these delays, our book-to-bill was still strong at 1.08. Our backlog at the end of the quarter was 954 million, up 8% compared to Q1. Revenue in Q2 increased 5% from Q2-21 to 220 million. Organic revenue was 183 million, down 13% year-over-year, and slightly better than our expectations coming into the quarter. Acquired revenue, which included POC, Pentec, Avelex, and Atlanta Micro, was $37.5 million. The Avelex and Atlanta Micro acquisitions together contributed approximately $6 million of revenue in Q2. Acquired revenue was slightly below expectations due to the contracting delays that I just mentioned. Gross margins for Q2 were 39.6% compared to 42.1% in Q2 fiscal 21, down 250 basis points. This was impacted by the inclusion of POC, which had 100 basis point impact. It also reflected program mix with a higher proportion of new program starts and development work compared to Q2 last year. In H2 and heading into fiscal 23 and beyond, We expect gross margins to expand as more of our programs transition into production. Operating expenses in Q2 were up 24.2% compared to last year, primarily driven by the recent acquisitions, as well as higher amortization expense and acquisition-related expenses. We recorded $3.8 million of restructuring and other charges in Q2, primarily related to third-party consulting costs associated with our impact programs. Our growth-focused R&D investments continue to exceed the industry average. R&D for Q2 was 12.9% of sales. Since fiscal 17, we've now invested over $450 million in secure processing, trusted microelectronics, and open mission systems. These investments, coupled with our strategic acquisitions, have provided us differentiated technologies in fast-growing segments of the markets. We incurred a gap net loss of $2.6 million, or negative $0.05 per share, in Q2. This was driven primarily by $6.5 million of acquisition-related and restructuring and other charges, as well as incremental amortization expense associated with Avelex and Atlanta Micro. Adjusted EBITDA for Q2 was $38.1 million. Our adjusted EBITDA margins were 17.3%. down 420 basis points from 21.5% in Q2 fiscal 21. This was driven by lower gross margins compared to a year ago, as well as negative operating leverage as organic revenue declined year over year while we continued to invest for growth. Free cash flow for Q2 was an outflow of $1.2 million, driven by restructuring and other charges, as well as impacts from supply chain delays. Slide 10 presents Mercury's balance sheet for the last five quarters. We ended Q2 with cash and cash equivalents of $105 million compared to $96 million in Q1, with the reduction from our free cash outflow being offset by cash associated with recent acquisitions. Mercury ended the quarter with approximately $452 million of debt funded under our $750 million revolving credit facilities. up approximately $252 million from Q1, driven by the acquisitions of Avalix and Atlanta Micro. From a capital structure perspective, we remain well-positioned to continue executing on disciplined M&A transactions that will create additional value for shareholders. From a working capital perspective, we continue to be focused on improving efficiencies in key accounts, including unbilled receivables and inventory. Unbilled receivables, excluding our Q2 acquisitions and purchase accounting adjustments, decreased approximately $5 million from Q1 as we completed several significant program milestones. As Mark said, from fiscal 2014 through fiscal 2021, our total revenue increased 4.4 times. However, due to the success of our low-risk content expansion strategy, our subsystems revenue increased 7.5 times, As a result of this strategic shift to larger integrated subsystems, as well as the acquisition of POC a year ago, our proportion of overtime revenue to total revenue has increased to just below 50%. Our unbilled receivables balance has naturally increased as well. We expect to continue to make progress in reducing our unbilled receivables as a percentage of overtime revenue in future quarters. Inventory, excluding our Q2 acquisitions, increased approximately $7 million. This was due to accelerated purchases to support customer demand and mitigate supply chain risk in the second half. We expect inventory terms to improve as we move into fiscal 23. However, going forward, we will always consider pre-buys for key components where we believe our supply chain could be at risk. We see this as a cost-effective short-term insurance policy. Turning to cash flow on slide 11, free cash flow for Q2 was an outflow of $1.2 million. This reflected restructuring and other charges associated with impact, as well as acquisition-related expenses primarily associated with Avilex and Atlanta Micro. We also saw an impact on our cash flow as a result of supply chain delays that impacted our revenue and milestone linearity, and therefore billings. Supplier delays related to milestone payments had an approximate $20 million impact on free cash flow during the quarter. This was partially offset by other working capital accounts. Let's now turn to our financial guidance, starting with the third quarter on slide 12. I'll begin by noting that our guidance for both Q3 and the full fiscal year assumes no incremental acquisition-related expense. The guidance includes both Avalix and Atlanta Micros. As I've said, we're maintaining our full-year fiscal 22 guidance for revenue, adjusted EBITDA, and adjusted EPS, reflecting the incremental acquired revenue from AVALEX and Atlanta Micro, offset by the elevated risk we expect to continue through the second half of the year. While the team has worked diligently to manage headwinds observed across the industry, Our Q2 results were impacted by supply chain constraints, the defense contracting environment, COVID, and workforce retention. As a result, while we are working to mitigate the impact from these risks, our Q3 and updated full-year fiscal 22 guidance does reflect them going forward. I'll also note that our GAAP net income and GAAP EPS guidance for Q3 and fiscal 22 reflects restructuring and other charges related to impact. In addition, Fiscal 22 includes acquisition-related expenses incurred in H-1. With that as background, looking at Q3 specifically, we expect continued growth in bookings and a book-to-bill materially above 1 for the quarter, driven by the programs Mark discussed. We expect our backlog to increase exiting Q3, providing us with even greater visibility into the revenues expected for Q4, as I'll discuss in a moment. We currently expect revenue for Q3 in the range of $245 to $255 million. This is an approximate 3% decline at the midpoint compared to the third quarter last year. At the midpoint, we expect organic revenue to be down approximately 9% from Q3 last year as a result of the lower bookings in fiscal 21. We expect a significant increase in our total and organic revenue growth in Q4. Q3 gap net income is expected to be 8.2 to 10.4 million, or 15 to 19 cents per share. The year-over-year declines reflect the expected incremental impact-related expenses and amortization expenses. Our guidance for Q3 includes restructuring and other charges of 3.7 million related to the impact initiative. Q3 adjusted EPS is expected to be 55 to 59 cents per share. We expect adjusted EBITDA for Q3 to be $50 to $53 million, representing approximately 20.6% of revenue at the midpoint. This is over 300 basis points higher than Q2, driven primarily by higher gross margins, as well as operating leverage on sales growth. We expect free cash flow to adjusted EBITDA for Q3 to be approximately break-even, driven by continued impact cash outflows, working capital investments associated with quarter-over-quarter revenue growth, as well as additional interest expense. Turning to slide 13, for the full fiscal year 22, as I've said, we're expecting double-digit bookings growth and a book-to-bill above 1. We expect total company revenue of $1 billion to $1.03 billion, representing 8% to 11% growth from fiscal 21. This is in line with our previous guidance and includes our recent acquisitions. Organically, the midpoint is a 3% revenue decline year over year, reflecting the supply chain and other risks I previously mentioned. Gab net income for fiscal 22 is expected to be 44.8 to 50.1 million or 80 to 90 cents per share. The declines year over year reflect expected restructuring and other charges as well as acquisition-related and amortization expenses. They also reflect 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%. Like revenue, we expect adjusted EBITDA and EBITDA margins to be heavily weighted towards Q4. From a free cash flow perspective, we expect free cash flow to adjusted EBITDA conversion to normalize in Q4. Based on our estimated cash flow through Q3, this would result in approximately 15% to 20% free cash flow to adjusted EBITDA in fiscal 22. This conversion includes impact expenses through Q3 and assumes no additional impacts from supply chain delays in Q4. Turning to slide 14, I want to touch on Q4, which we expect to be a record quarter for mercury across all key metrics. While we will not formally guide Q4 until next quarter, based on H1 actuals and our Q3 and updated fiscal 22 guidance, we can back into an implied forecast for the quarter. Looking at the midpoints of our fiscal 22 and Q3 guidance ranges, Q4 revenue at the midpoint would be approximately $320 million. This is an increase of approximately 28% from Q4-21 and organic growth of approximately 20%. GAAP net income and GAAP EPS would be approximately $48 million and $0.86 respectively. In addition, Q4 adjusted EBITDA would be approximately $96 million and adjusted EBITDA margins would be approximately 30%. On slide 15, I want to provide the key reasons why we're comfortable in guiding toward record results in Q4. In essence, it's about our strong visibility into the fourth quarter today, which we expect to be even clearer by the end of Q3. The implied Q4 guidance represents significant growth over Q4 21 and Q3. That said, between our strong current backlog and expected bookings in Q3, we expect to enter Q4 with forward backlog coverage in line with previous quarters. In addition to Q3 bookings, we have visibility into the major Q4 bookings that are expected to drive the remainder of the implied Q4 forecast. Some of the key H2 programs include F35TR3, CWIP, F18, FMS programs, and a variety of other programs that Mark discussed. We're designed into these programs and we remain closely aligned with our customers. As such, our Q4 guidance is based on existing backlog, as well as the expected timing of H2 bookings informed by the best available information we have today. From a gross margin perspective, we also expect a strong Q4. The mix of programs we expect to drive our growth is weighted towards production programs and licensing revenue, which tend to have higher margins. As a result, we're expecting significant growth margin expansion in Q4. In addition, we expect R&D and SG&A on a dollar basis to be relatively flat compared to Q3, despite the significant growth in revenue in Q4, thereby driving adjusted EBITDA margins. So our comfort in the outlook is a result of the visibility into our Q4 programs and the associated profitability. With that, I'll turn the call back over to Mark.

Turning to slide 16, Q2 was a strong quarter for Mercury. We're confident this will lead to a strong year in fiscal 23 as organic growth returns to normal levels and impact drives margin expansion. Looking ahead longer term, our model, sitting at the intersection of the high-tech industry and defense, is exceptionally well-positioned. We believe that our strategy and investments in secure processing, trusted microelectronics, and open mission systems will continue to drive growth in the business. While we're mindful of the potential risks associated with the defense budget and industry headwinds, we expect to continue to benefit from key secular trends such as outsourcing, de-layering, and reshoring. We're well aligned with our customers and the DOD. Our design wind cadence is strong, and new business activity remains robust. Our strategy is to deliver strong margins while growing the business organically and supplementing this organic growth with disciplined M&A and full integration. By executing on this strategy, we've created significant value for shareholders for nearly a decade, and we expect to continue doing so. In closing, I'd like to extend my appreciation to the entire Mercury team for the outstanding work they've done during this challenging time. My sincere thanks to all of you. Before we move to questions, I'd like to address the recent public disclosures by two of our shareholders, Jarna Partners and Starboard Value. At Mercury, we frequently engage and maintain an ongoing dialogue with shareholders and have a history of seeking, considering, and incorporating their feedback where appropriate. As we communicated today, we'll focus on executing our strategic plan, and we'll continue to evaluate opportunities to enhance value for all shareholders as we do so. The purpose of today's call is to discuss our second quarter earnings results and outlook, and we ask that you please keep your questions focused on these topics. With that, operator, please proceed with the Q&A.

Thank you, sir. At this time, we would like to inform everyone, if you would like to ask a question, please press star then one on your telephone keypad. And as a reminder, we will limit your questions to one question in order to allow as many callers as possible to ask a question. Again, limit to one. Our first question is going to come from the line of Pete Skibitsky with Olympic Global.

Hey, good afternoon, everyone. Hey, guys, I just wanted to get a better sense with regard to this big ramp in the fourth quarter. You know, it sounds – I guess I'm trying to figure out to what degree you're predicating this fourth quarter revenue ramp on kind of a timely end to the current CR. In other words, you know, if we get a full year CR, you know, what kind of revenue chunk might we expect shifts to fiscal 23th?

Sure. Let me take a crack at that, Pete. So we don't believe that there's a lot of risk associated with the CR itself. I think we've gone through the programs and we feel pretty good. The ramp in Q4, I think although there's no forecast without risk, we've got a significant amount of Q4 revenue already in backlog. And I think this backlog combined with the expected ramp in Q3 bookings is what really gives us the visibility and the comfort to the implied Q4 revenue and EBITDA that Mike discussed in the plan. And So Q3 bookings is an important quarter for us, and we're expecting continued momentum based on what we delivered in Q2.

Thank you. Our next question is going to come from the line of Seth Seifman with J.P. Morgan.

Thanks very much. Good evening. I wonder – I wonder if you guys could talk a little bit more about the risk on the execution side, on the manufacturing side. You talked about sort of, I guess, you think about headcount, you think about the supply chain challenges that you mentioned, and those are still ongoing through much of the economy and will probably be ongoing in the June quarter as well. And so to what degree does that level of kind of operational cadence or execution need to, you know, return to something like normal for you to deliver on the Q4 targets and, you know, kind of what gives you confidence in that.

Yeah, so a few things there, Seth. So, you know, clearly I think we've seen a pretty turbulent environment. And right now, you know, we're not anticipating that things will be fully resolved likely until next calendar year. That said, I think we've been very, very proactive working with our suppliers wherever we possibly can to minimize the risk going forward. And we don't currently expect that the uncertainties around the supply chain will actually grow materially in the second half. We've been very, very focused on doing whatever we can. We mentioned in the prepared remarks that We've purchased an additional $10 million of materials that is linked to second-half revenue. Those materials are flowing in. We flow down D-pass ratings where appropriate. We're in daily contact with the suppliers. And obviously we've taken into account what we believe to be the highest risks, from both the supply chain as well as a labor perspective in the current guidance. So the team's doing a pretty good job overall, but it is quite challenging out there.

Thank you. Our next question is going to come from the line of Sheila Coaglu with Jefferies.

Hi. Good afternoon, guys. Thanks for the time. Obviously, a lot going on this quarter. Hey, guys. And you talked about this in your prepared remarks a lot in terms of opportunities and your M&A pipeline, both historically and going forward. You have one impact going on as well. Maybe can you give us a quantitative and qualitative outlook on your historical and going forward M&A and how You know, Mercury is added value both from a revenue and EBITDA perspective, because when we look at it, the growth is great. It's up 20 percent, both on the top line and the bottom line. So I guess maybe can you talk about the potential opportunities you have going forward, whether it's through one impact or on future opportunities?

Yeah, look, great question. I think, as we said, we built, I would say, an enviable M&A organization. Our ability to source diligence, close, and then integrate deals is very, very strong. To me, the impact about leveraging that proven ability that we have to integrate and grow future acquired businesses, we're doing it at a greater scale going forward. And I think as we said in the prepared remarks, since fiscal 14, we've now acquired 15 businesses deploying a billion four in capital. That's dramatically scaled Mercury as a business, transformed the capability set that we have, as well as the importance to our customers. And as a result of the acquisitions, but more importantly, through the synergies that we've generated, through full integration, we've been able to actually grow total company revenues by over 4.4 times over the course of the last seven or so years. And because integration and full integration is such an important element of the strategy and impact about taking that to the next level, we've been able to actually grow adjusted EBITDA at nine times or twice the growth in revenues. And I think it's really this organic growth strategy that we have that's been driven by the shift to soft systems coupled with M&A and full integration is what's delivered the value creation over the course of the period where we've been very, very active. Impact to me is about taking it to the next level. And so it's about, you know, Mercury kind of achieving its full growth and adjust the potential, doing what we've been doing, but doing it at a greater scale and potentially even better than what we've done in the past.

Thank you. Our next question is going to come from the line of Peter Arment with Baird.

Yeah, good evening, Mark and Mike. Hey, Mark, obviously there's questions about, you know, kind of the timing and how this is all going to kick into kind of the fourth quarter. You have a lot of confidence around that. You've in the past, I guess, talked about kind of returning to high single-digit or low double-digit growth. And I wanted to say maybe just more qualitatively, do you think that's still possible in 23, just given the lingering effects of the CR, if Pete's right, about a full-year CR or whether you get – you know, just lingering effects from the supply chain, just how you're thinking about kind of the return to the growth model?

Yeah, look, it's a great question. Thanks for that. So, you know, obviously notwithstanding the, you know, the elevated industry risks that we're facing, you know, for fiscal 22, you know, I think we continue to expect, you know, very substantial growth in bookings year over year. You know, bookings and backlog expectations for the year have actually improved since last quarter. And, you know, we continue to remain pretty confident for the second half, just given the timing of the deals that we see. You know, the expected growth in bookings, you know, as we see right now, should lead to a positive book to bill for the year as a whole, as well as, you know, double-digit growth in total in 12-month backlogs. And it's really these bookings and the increase in backlog exiting this fiscal year that we believe positions us for a return to our more normal levels of growth you know, organically in fiscal 23. And, you know, this organic growth coupled, you know, with the margin expansion that, you know, we expect associated with the impacted initiatives really do set us well for pretty substantial value creation next year. So I think right now, you know, we feel pretty confident in the second half. You know, we're seeing the, you know, the bookings momentum coming out of Q2. As we said, we thought that Q1 was the low watermark. You know, we're pleased with the progress and, you know, we're expecting even faster growth, you know, in the second half.

And Peter, I would just add to that, you know, You know, we just went through our update to our five-year forecast as part of our mid-year strategic planning exercise. And Mark just talked about fiscal 23. But when you look at the five-year, it's very strong as well. And that growth is supported. by the major programs we're on, the markets that we've been investing in. So, you know, a clear path to return to the organic growth model. And then on top of that is impact, you know, ramping up not just in fiscal 23, but margin expansion over the five-year period.

Thank you. Our next question is going to come from the line of Ken Herbert with RBC.

Hey, good afternoon, Mark and Mike. Two-part question, if I could. First, when you look, Mark, at the new business opportunities today, your business development pipeline, how has that changed relative to maybe a year or two ago? Is it possible to quantify that as we think about the impact maybe of the budget on some of the new program starts and your organic investment opportunities. And then second, I was just wondering if you could put a finer point on sort of how much of the fourth quarter revenues are currently in backlog with the $25 million, it sounds like, you've largely booked that slipped out of the second to the third quarter and sort of what you expect to book in the third quarter. Thank you.

sure so uh yeah mike i don't know if you want to you know take the yeah the q4 backlog one uh and then you know talk a little bit about you know the uh you know what we see over you know the five years and and why we feel confident yeah so ken you know as we talked about in the prepared remarks if you look at q4 it's really driven by the the key programs that we're designed into uh they're well supported so this really is about uh timing

If you look historically, we've had about 50% to 60% of the next 12 months in 12-month backlog entering a year. We haven't given out guidance on how much backlog coverage we have entering a quarter because it can typically range anywhere from 70% to the mid-80% range. That depends on contract mix, et cetera. As we look at our Q4 right now and why we're comfortable with the guidance we put out, we currently have about 70% of our Q4 in backlog today. And if you look at the bookings that we see in Q3, we anticipate having over 80% of Q4 in backlog by the end of Q3. So even though we're forecasting a very big Q4, the coverage we expect going into Q4 is at the high end of the range that we normally see. So we've got a lot of insight into the programs. And we feel like we've got a lot of insight into the timing, as I said in our prepared remarks, that we're staying close with our customers on that.

Thanks, Mike. So let me kind of just talk a little bit about the longer term. So we've been investing heavily for growth, and we've grown the business significantly organically over a multi-year period. And so despite the headwinds that we're experiencing now, you know, in the latter half of 21 and 22 to date, you know, we absolutely believe that our long-term business model is intact, as Mike said. You know, we've just updated, you know, our five-year plan at the mid-year mark and continue to believe in our ability to grow the business at high single-digit to low double-digit rates on average over time, you know, as we have done for many, many years now. And the reason that we believe so is that, you know, to begin with, I mean, we're positioned in large and well-funded and high-priority programs of record that we believe are very much aligned with the National Defense Strategy as well as DOD priorities. You know, we designed in on many of these programs, and, you know, by far the majority are actually sole source supply positions. None of our programs have been cancelled. And I think, in fact, as we look forward, we think that the funding associated with the programs It remains strong. We continue to out-invest our competition from an internally funded R&D, which we believe is in line with the direction that the industry is headed. And this is allowing us to deliver innovations far more quickly, far more affordably than what we're seeing other companies doing, which in turn means that we're taking share. Our largest secular growth driver, which we've been focused on for quite some time now, which is outsourcing at the subsystem level, is occurring by our traditional customers as well as the government as they are seeking to delay the supply chain to gain access to innovative products. tech-oriented mid-tier companies such as Mercury. And so although clearly we may be a leading indicator for one of the challenges that we're seeing more broadly across the industry, we do believe that many of those are temporary in nature and that we can continue to grow the business the way in which we have in the past. And again, probably the biggest driver of that is outsourcing. So

Thank you. Our next question is going to come from the line of Michael Ciaramoli with Truist Securities.

Hey, good evening, guys. Thanks for taking the questions. Just, I guess, Mark or Mike, not sure which one of you want to take this, but just to, you know, you talked about sort of the industry-related risks, and I guess just at the programmatic level, you know, we've seen some press about, you know, some CWIP Block 2 shortfalls. And then I guess even thinking about your comments on LTAMs and kind of that first booking order sliding out. I mean, just knowing how big that program was. Has that changed or has anything changed on the programmatic side? I mean, you know, six, eight months ago, as we were looking to 23 for a reacceleration of organic growth, presumably LFAMS was going to be a part of that. Is it, you know, was that the case? Is it easy to backfill that or just... if you can talk about some of these big programs, you know, and how, you know, they're trending given, you know, what we're seeing, I guess, a slide out and maybe some operational shortfalls there.

Yeah. So, you know, the changes that we've talked about, right, or the outlook, Mike, actually, you know, encompasses what we've seen programmatically, you know, based upon the best possible information to date. you know, CWIP, as we said, we started to see some impact, you know, last fiscal year, here in the second half, just based on, you know, the impact of COVID on the shift upgrade, you know, cycles. And, you know, we're seeing that again, you know, this year in terms of lower numbers, which is encompassing our numbers. LTAM's We were originally expecting to get a large booking this year that now, again, has moved out. That is also encompassed in both our outlook for this year as well as over the five years. And, yeah, we do think that actually LTAMs, even though it's nowhere near as large as what we thought it was going to be for this fiscal year, the bookings are still going to be up 3x compared to what it was last year. So fundamentally, I don't believe anything has changed. I think we've got some great – we're on some great programs. You know, we're seeing ramps in a number of those over the five-year period, and it's really the growth in the top 20 programs – as well as some of the new design wins transitioning into production over time that gives us the confidence in the outlook. So we feel pretty good, you know, that we've done the work and, you know, that we're well positioned, Mike.

And our next question is going to come from the line of Jonathan Ho with William Blair & Company.

Hi. Good afternoon. I just wanted to, I guess, maybe get a sense for whether you've heard anything from your customers. I think you've referenced you staying in close contact with them. But has anything changed, or is there anything that's maybe giving you some additional confidence as we start to look at sort of this Q4 ramp and going into 2023? I just want to get a sense from you, Mark, on how to think about what the customers are saying.

Yeah, so, I mean, we've spent a fair amount of time, obviously, you know, with customers just looking at, you know, our major programs and just diligencing them, you know, as we continue to look at the ramp in H2. You know, I think the major programs, right, the feedback that we've given supports the forecast, right, and the guidance that we've just given overall. So, you know, I think when we look at the forecast for H2 from a bookings perspective, you know, Jonathan, I think it's really been driven by double-digit growth across, you know, our two major market segments, which, as you know, are C4I and sensor and effect emission systems. And the growth in both those markets are really, again, being driven by our top 20 programs. And in the top 20 programs, we're actually expecting the bookings from them are likely going to more than double versus H1. primarily because there's actually more of them producing, and the ones that are producing are producing at a higher rate. And, you know, so when I look at those programs, you know, we've got the large FMS program that moved from Q1 of last year You know, we've got a substantial ramp in the F-16, of which, you know, that was one of the orders that moved from Q2, sorry, Q1 into Q2. You know, and we've already received that order. You know, we've got F-18. You know, we've got a ramp on L-TAMs. You know, CWIP, although it's lower, is in the second half as well. So I think our programs, you know, we feel good about them. They're stable, well-funded programs that, you know, we don't expect them to be affected by the CR. And, you know, we have got the best possible information from the customers as we, you know, looked at the second half.

Our next question comes from Austin Moeller with Canaccord Genuity.

Good evening, Mark and Mike. I just have a question here. If Russia launches an invasion into Ukraine, do you anticipate that we could have an expansion of F-35 sales towards some of our NATO allies? And If we see an increase in F-35 sales and the number of customers that are already assigned to the F-35, as well as a large amount of electronic warfare and radar equipment being sent to Eastern Europe for use by NATO allies and DOD, do you anticipate that could yield upside in your fiscal year 23?

So it's hard to say exactly what obviously is going to happen in the Ukraine and specifically relating to the F-35. But if I just kind of talk a little bit about what we see happening with our program, overall, we are expecting double-digit growth in bookings this fiscal year, greater than 40%, as opposed to a 50% decline that we saw last year. So we do think that as a result of the TR3 and kind of getting through the reprogramming, we're seeing a pretty substantial uptick. Year-to-date on the program, we've booked as much as what we did throughout the whole of last year, and we're expecting a strong second half, as well as a substantial increase in bookings next fiscal year. So that was one of the major programs that obviously... There's now a lot of information out in the public domain around what happened with TR3 and Block 4 and the production reprogramming. But from what we can see right now, things appear to be back on track, and we're seeing our bookings and our revenue, and we feel pretty good about the growth in the program longer term. you know, just given some of the design wins that we've already won, you know, that TR3 and Block 4 will enable. So overall, yeah, I think it's a really important program for us and for the industry. And, you know, we're seeing a substantial pickup this year compared to last.

Thank you. Our next question comes from Christopher Rieger with Barenberg Capital Management.

Hi, guys. Thank you very much for taking the question. Just with regard to the elevated supply chain risk that you've been seeing and the lengthening lead times, could you talk about sort of where you're seeing the pinch the most? Like, which programs are more or less affected than others? Any color you could provide there would be appreciated. Thanks.

Yeah. really not necessarily at a specific program level, but I think the biggest challenges that we faced you know, was delays and in-quarter decommits, you know, from suppliers and distributors. And a lot of that was around, you know, semiconductors and in particular FPGAs. And so I think, you know, Mike said, you know, we saw a greater than $5 million revenue impact, you know, in the second quarter associated with that. But we also saw, you know, revenue churn uh you know is as uh suppliers were kind of decommitting and yeah we were ending up you know that pushed the uh some of the revenue you know towards the back end of the quarter uh which in turn impacted you know some of our cash collections so it's a very dynamic environment um it's the reason that you know we've yeah uh this past quarter, another $10 million in component buys to de-risk the revenue in the second half when we're already getting those materials in. And that's on top of what we previously did. So most of what we're seeing, the issues around are in semiconductors. And again, most of that is FPGA-based.

And our next question will come from Ron Epstein with Bank of America. Hey, good evening, Greg.

Could you walk through why do you see yourself as a leading indicator? What about your business would make you a leading indicator?

Yeah, to some extent, Ron, I think it's just where we sit in the tier from an industry perspective and the fact that we've got a relatively short cycle business and And so, you know, when we started to see, you know, the impacts associated with F-35, right, you know, on TR-3, you know, that's a significant program for us. And it wasn't until really... Nine months after that we started to see the impact, a lot of the other companies started to describe what was happening and then demonstrate the impact that was having on them as well. So it's largely due to, I think, where we sit in the supply chain, some of the program concentration that we have, and short-cycle businessman.

Thank you. And our final question for the day will come from the line of Noah Poponek with Goldman Sachs.

Hey, everyone.

Hi, Noah.

You know, Mark, I wanted to ask a similar question, and so I'll try it again, which is, you know, everybody in the industry, you know, is seeing a continuing resolution and supply chain and labor hurdles. And the order of magnitude of decline in your revenues organically is much larger than pretty much every other company in the industry. And I, you know, if you could spend a little bit more time on, on, on why that is, I mean, is being short cycle with a commercial model and a lack of multi-year contracts, you know, does that mean when there's a delay on a program that the prime can just kind of almost turn you off completely and then pick it back up a year down the road? And if you could just get a little more specific on LTAMs too, the length of delay you're talking about there is quite long. I'd love to be able to better understand what's going on in that program.

Yeah, so look, you know, I think when we kind of assess kind of what happened in fiscal 21, the biggest challenge that we had last fiscal year from a bookings perspective, and remember the bookings slowdown that we saw in the second half of fiscal 21 and in the first half of this fiscal year, which we expect to ramp, is largely what has driven the slowdown in organic revenue growth. So the largest bookings impact that we had last year was on the F-35. And as I mentioned, bookings on the F-35 We're down 50% year over year compared with the prior year, which caused a three-point decline in organic bookings overall. We have that large FMS contract that was delayed from Q1, which we now expect in the second half. That had a roughly three-and-a-half point decline. impact as well. So literally just there in two programs, you know, we saw some pretty substantial, you know, impacts overall that has affected the growth, you know, in fiscal year 22. And I could go on, you know, with a few others. As it relates to LTAMs, You know, I think, yeah, we – yeah, it's based upon the information that we got from our customer to date. I think, yeah, our understanding is that the next L-Times production award for Raytheon will be in 24. You know, that's based on what we're hearing from PEO Space and Missile, and that is – what's currently in the Army plan. Because we didn't get a fit of last year, we don't know for sure how the budget has moved out of 22 based upon the Army's portfolio and decisions around that. So we'll have more information hopefully in the next few months as to what the actual plans for LTAMs are. I would say, however, that I think the U.S. Army continues to stress the importance of all times as a cornerstone of next-generation air and missile defense, and it's one of the Army's six priority areas. So although we've kind of moved it out again in time and we're expecting a substantial ramp in bookings in this fiscal year compared to last, we're not going to see the big ramp in production orders, we believe, until our fiscal 25. So the time that it takes Raytheon to get the order, get it to us, and the difference in the timing in fiscal years puts it out into our fiscal 25 versus fiscal 24. So that's what we know right now.

Thank you. I would now like to turn the call over to Mr. Mark Aslett for closing comments.

Okay. Well, it's been great to speak to everyone. Thank you very much for joining the call. We look forward to speaking to you again soon.