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.