Mercury Systems Inc

Good day, everyone, and welcome to the Mercury Systems third 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, Michael 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. Mercury continued to perform well in Q3, delivering strong results across the board. As expected, it was a challenging quarter due to order delays, as well as supply chain and labor market constraints, but our team continues to successfully manage these headwinds. It was a record quarter for bookings, leading to a 1.17 book-to-bill and record backlog. As a result, we expected to deliver a strong Q4, positioning Mercury for a return to organic growth in fiscal 23. This organic growth, coupled with margin expansion driven by our impact initiatives, as well as our M&A program, should lead to strong performance overall next year. Looking ahead longer term, our five-year plan continues to target high single-digit to low double-digit organic revenue growth over time, coupled with margin expansion and M&A. We're on track to achieve these goals. We're dismayed by the unprovoked attack and humanitarian crisis unfolding in the Ukraine and hope for a speedy resolution. Our confidence in our longer-term growth outlook has increased since the invasion, given the broader implications for Europe. We believe that over the course of the next 10 years, we'll see substantial growth in incremental defense spending, both domestically and internationally. We don't anticipate an impact on our revenues in the short term due to the nature of the military assistance provided to Ukraine. However, we do expect to see an increase in bid and proposal activity, resulting in higher bookings in the midterm and over the next five years. Turning to our Q3 results on slide four, we saw substantial bookings growth in the third quarter. Bookings increased 41% year-over-year and were up 25% sequentially. Our largest bookings programs were LTAMs, CH53K, F16, P1171, and a classified radar program. Despite its very strong performance, we did face Booking's challenges in Q3. The largest impact was the further delay in the award for the FMS program that began seeing delays in Q1 of last year. Our customer currently expects to receive their award in May, resulting in an award to Mercury in late June. The majority of the products are currently in inventory. Additionally, the F35 TR3 Lot 16 order that we received earlier in the year was partially funded in the third quarter, with the remainder expected in Q4. The biggest upside this quarter was LTAMs. In Q2, we reported that our next LTAMs booking for domestic and international production had likely moved to fiscal 25. This delay created headwinds for fiscal 23, as well as our five-year plan. That said, our customers are seeing increased demand signals associated with missiles and missile defense. In Q3, we were pleased to receive two awards for L-Towns totaling $27 million. The larger of the two awards was for long lead time materials associated with future production. These awards contributed to our strong total bookings for the quarter and helped to partially mitigate the large FMS order delay. This quarter, we expect to receive an RFP from Raytheon for additional LRIP systems, which may partially reverse the delay we reported in Q2. Mercury's total revenue for Q3 was down 1.5% from our prior year record as anticipated, reflecting the orders that slipped, as well as the supply chain and labor market challenges. Our largest revenue programs in the quarter were F35, LTAM, MH60, F16, and CDS. We'll continue to see high levels of new business activity, and our pipeline remains strong. Design wins in Q3 total more than $360 million in estimated lifetime value. Through the first three quarters, we received 22 new design wins with an estimated lifetime value of more than a billion dollars. Year to date, The total estimated lifetime value of our design wins is up 14% from the same period a year ago. Adjusted EPS and adjusted EBITDA were in line with our Q3 guidance. Free cash flow was negative and down from Q2, primarily due to the impact of supply chain headwinds on working capital. Turning to slide five, following record bookings in Q3, we expected an acceleration in Q4. leading to record bookings, a positive book-to-bill, and record backlog in revenue for fiscal 22 as a whole. Despite the industry headwinds and order delays, we anticipate total company revenue growth of approximately 8% to 10% for fiscal 22, exceeding $1 billion for the first time, together with record adjusted EBITDA. We've been largely successful in our efforts to mitigate the supply chain, labor market, and COVID-related disruptions. That said, we continue to see in-quarter supplier decommits and long lead times for semiconductor components and materials. We're also seeing the impact of inflation, some of which we can pass on and some we can't. The team is staying in close contact with our suppliers and placing orders for accelerated material procurement. Nonetheless, during Q3, the supply chain constraints increased revenue churn pushing revenue linearity to the back end of the quarter. This resulted in lower in-order cash collections, which affected free cash flow. All our manufacturing facilities have remained open and productive throughout the pandemic. Early in Q3, we did, however, see some labor productivity impacts as a result of Omicron, which peaked in January, also affecting cash flow. We expect the tight labor market, as well as supply chain constraints, to remain headwinds for some time. We're pleased that, effective yesterday, Steve Ratner joined the Mercury team, as our Senior Vice President and CHRO reporting to me. Steve was previously at Raytheon Technologies, where he led human resources for a 16,000-person, $16 billion division. Adding Steve's expertise and proven leadership couldn't be more timely. Core to our growth is having a world-class team in place. C will help lead our efforts to attract, retain, and develop the talent we need to continue growing and scaling the business. Turning to slide six, we proactively launched our IMPACT program a year ago. IMPACT's goal is to achieve Mercury's full growth and adjusted EBITDA potential organically and through M&A over the course of the next four years, and it's progressing well. we anticipate a $27 million net benefit related to impact actions taken and planned in fiscal 22. These actions have been key to our success in managing the industry headwinds and continuing to achieve strong financial results this fiscal year. As we move towards more normal conditions, we expect the benefits of impact to be additive to the savings we've been able to deliver to date. We continue to expect impact to generate $30 to $50 million of incremental adjusted EBITDA by fiscal 25. We're on track to meet this target with upside opportunities that would allow us to potentially deliver greater value earlier than originally anticipated. Impact is aimed at improving our organic growth as well as the fundamentals of the business. It's enabling us to better align 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. Impact is also aimed at optimizing our balance sheet by improving our working capital and asset efficiency. In addition, 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 investment in R&D outpaces our customers in the competition. We believe this investment is in line with where the defense industry is headed. It's allowing us to deliver innovations more quickly and more affordably, and we're taking share as a result. We've proven that a high-tech investment model can operate successfully at scale on behalf of all stakeholders. Turning to slide seven as it relates to M&A, impact is about leveraging our proven ability to integrate and to grow acquired businesses, but at a greater scale going forward. Including our recent Avalanche and Lantern micro-acquisitions, both of which are performing well, We have deployed $620 million in capital since December of 2020. Looking ahead, we believe that impact will allow us to increase our deal cadence and potentially the size of our transactions, compounding the impact on value creation. In addition to impact, we strengthened our balance sheet this quarter, and we believe that we can continue to execute successfully on our M&A strategy going forward. The environment continues to be active, and we remain focused on our existing M&A themes, secure sensor processing, open mission systems, C3, and trusted microelectronics. We intend to remain disciplined in terms of deal pursuits, diligence, pricing, and integration. Turning to slide eight, we expect Mercury's revenue to continue growing faster than overall defense spending over time, driven primarily by organic growth. We focused the business on larger and faster-growing parts of the defense market and now participate in more than 300 different programs. We designed in on our top programs with the majority being source positions. Congress has passed the FY22 Defense Appropriations Bill, which was 6% higher than the $715 billion initial request. The DOD top line submitted for FY23 is $773 billion. This represents approximately 8% growth over the original FY22 request and 2% over the appropriations bill. This growth is intended to address the effects of inflation and modernization needs, as well as the war in Ukraine. That said, we believe the FY23 budget will likely be revised upwards as the bill moves through the appropriations process later this year. Despite the expectation of a CR as a result of the midterm elections, there appears to be strong bipartisan support for increased defense spending. We believe we're experiencing a potential sea change in defense spending and priorities with profound implications for the U.S., Europe, and our allies, both in the short and long term. This is due to the war in Ukraine and the Russian threat to NATO and non-NATO countries as well as the risk associated with China and Taiwan. Our advisors estimate the U.S. growth combined with potential increases in NATO and allied partner defense spending to 2% of GDP could drive more than $1.5 trillion of additional defense spending over the course of the next decade. We don't see Mercury's revenues benefiting from this incremental spending in the short term, given the nature of our offerings. However, over time, we do expect to see increased Britain proposal activity. This should lead to higher bookings in the electronics associated with missiles and munitions, air and missile defense systems, unmanned systems, fixed-wing and rotorcraft, ground vehicles, and electronic warfare. This activity should further support the achievement of our high single-digit to low double-digit organic growth goals over the course of the next five years. With that, I'd like to turn the call over to Mike. Mike?

Thank you, Mark, and good afternoon again, everyone. As Mark discussed, we delivered record bookings and backlog in Q3. While we have updated our fiscal 22 guidance as a result of the current macro environment, we are still expecting record financial results for the fourth quarter and full fiscal year. Looking farther ahead to fiscal 23, we anticipate continued strong bookings and a return to organic revenue growth. Together with improved operating leverage and our impact initiatives, we expect this growth to result in margin expansion and increased adjusted EBITDA versus fiscal 22. Turning to our results on slide nine, Q3 was a record quarter for bookings, which were up 41% compared to Q3 21 and up 25% from last quarter. Our book-to-bill was a strong 1.17. Year-to-date, our book-to-bill is 1.05, and bookings are up 18%. We finished Q3 with record backlog of 996 million, up 4% compared to Q2. Our 12-month backlog was 638 million, up 17% year-over-year and 11% sequentially, providing improved revenue visibility into the next 12 months. Although we experienced supply chain related program delays during the quarter, the team did a great job actively managing resources to progress other programs, thereby minimizing top and bottom line impacts. As a result, Q3 revenue came in at the high end of our guidance at $253 million. Organic revenue was $234 million, down 9% year over year, and slightly better than our expectations coming into the quarter. Acquired revenue, which included Pentec, Avalex, and Atlanta Micro, was $19.3 million. Our POC acquisition, which we closed in December of 2020, is considered organic revenue in Q3. Gross margins were 39.4% compared to 41.1% in Q3 fiscal 21, primarily related to program mix. including higher engineering content associated with programs in the quarter. Operating expenses were up 7% compared to Q3 last year, in large part driven by the recent acquisitions and related amortization expense, as well as 6.3 million of restructuring and other charges, most of them related to third-party consulting costs associated with our impact program. R&D was 25.4 million, down 16% compared to Q3 last year. As a percentage of sales, R&D was 10%. This was lower than expected coming into the quarter, mainly driven by engineering resources allocated directly to customer-funded programs. Q3 GAAP net income was $4.1 million, or $0.07 per share. Adjusted net income was $32.2 million, or $0.57 per share. Adjusted EBITDA for Q3 was $52.5 million, Our adjusted EBITDA margins were 20.7% compared with 21.3% in Q3 fiscal 21. This reflects lower gross margins and negative operating leverage as organic revenue declined year over year while we continued to invest for growth. Free cash flow for Q3 was an outflow of $10.3 million. Similar to Q2, cash flow was impacted as a result of supplier delays. We also experienced direct labor shortages in January due to Omicron. This impacted the timing of deliveries in the quarter and therefore cash flow as well. Slide 10 presents Mercury's balance sheet for the last five quarters. We ended Q3 with cash and cash equivalents of $92 million compared to $105 million in Q2, driven primarily by the free cash outflow. Mercury ended the quarter with approximately 452 million of debt. During the quarter, we upsized and extended the maturity of our revolving credit facility from 750 million to 1.1 billion at attractive rates. The increased capacity provides a significant financial flexibility, and we're confident in our ability to continue to supplement our organic growth with strategic acquisitions. From a working capital perspective, unbilled receivables increased 48 million from Q2. This was driven by the growing proportion of overtime revenue in our mix as we execute on our content expansion strategy. The increase was amplified by the impacts of supply chain disruptions, which delayed delivery milestones and cash collections in the quarter. Winning more outsourcing business from our customers has been the primary driver of our above industry average growth rates. Like our customers, we recognize most of our revenue associated with the development and production of subassemblies and subsystems on an overtime or percentage of completion basis. Revenue is recognized as we perform work and progress on our performance obligations. Billings, on the other hand, are typically subject to the completion of specific milestones, such as the final delivery of an end product. As a result of our content expansion strategy, we've seen an increase in the proportion of overtime revenue to our total revenue. In Q3, overtime revenue increased to approximately 55% of total revenue compared to 47% a year ago. Also in Q3, Supplier component decommits and extended lead times delayed final shipment milestones on certain programs. To minimize the financial impact, the team did an excellent job responding by actively managing available resources across other programs wherever possible. Although we met our revenue and adjusted EBITDA goals, these component shortages did delay planned deliveries. This resulted in lower in-quarter cash collections than previously anticipated. Inventory increased approximately $8 million in Q3, mainly due to accelerated raw material purchases to support higher demand and mitigate supply chain risk in Q4 and into fiscal 23. Going forward, we will continue to consider pre-buys for key components where we believe our supply chain could be at risk. seeing it as a cost-effective short-term insurance policy. That said, we expect inventory terms to improve as we move into fiscal 23. Turning to cash flow on slide 11, free cash flow for Q3 was an outflow of 10.3 million. This was largely due to the impacts of supplier delays and direct labor shortages on our delivery and milestone linearity as well as advanced inventory purchases. In total, we saw approximately a 40 million cash flow impact in Q3 related to supplier delays, primarily within unbilled receivables, as I discussed. We expect the majority of the Q3 supplier delays to be resolved in Q4 with the timing of deliveries and billings resulting in cash conversion in either Q4 or early in fiscal 23. We continue to experience delays and extended lead times for semiconductor components and other materials in the fourth quarter. As a result, and similar to Q3, we expect a free cash outflow in Q4, primarily due to continued supply chain constraints. The team remains focused on minimizing supply chain impacts, both operationally and financially. We expect our unbilled receivables and cash conversion cycles to normalize as these headwinds subside. I'll now turn to our financial guidance, starting with full year fiscal 22 on slide 12. I'll begin by noting that our guidance for both Q4 and the year assumes no incremental acquisition-related expense. While we experienced order delays in the first half of the year, we saw continued momentum in domestic contracting activity in Q3, which we expect to continue in Q4. Program funding is also flowing down, and our conversations with our customers have been positive. Our fiscal 22 guidance is based on our current outlook on key programs driving Q4, including the large FMS sale, funding on F35 TR3, and other programs that Mark discussed. We are, however, adopting a more cautious organic revenue and margin outlook for fiscal 22, reflecting program mix and continued macro headwinds in Q4. which we expect to pressure margins. As a result, we're reducing our prior revenue and adjusted EBITDA guidance for fiscal 22 by 5 million and 10 million, respectively, at the midpoint of the ranges. We now expect total company revenue of 1 to 1.02 billion, representing 8 to 10% growth from fiscal 21. Organically, the midpoint of our revenue guidance represents a 3% decline year over year. This reflects the supply chain and other risks that have impacted our year-to-date revenue performance. Gap net income for fiscal 22 is expected to be 24.4 to 29.3 million, or 44 to 52 cents per share, reflecting year-to-date restructuring and other charges, as well as acquisition-related and amortization expenses. This also reflects 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 $2.34 to $2.44 per share. Adjusted EBITDA for fiscal 22 is expected to be in the range of 210 to 217 million, up 4 to 7% from fiscal 21. Adjusted EBITDA margins are now expected to be approximately 21 to 21.3%. This compares with our prior guidance of approximately 22%, largely due to program mix. We're expecting double-digit bookings growth and a book to bill above one in fiscal 22, providing good visibility as we enter fiscal 23. I'll now turn to our fourth quarter guidance on slide 13. While we've adjusted our guidance in light of the headwinds I discussed, we're forecasting all-time company records for revenue, net income, and adjusted EBITDA. While there are still order timing, supply chain, and labor market risks, we're entering Q4 with record backlog and forward coverage of approximately 70% of our forecasted Q4 revenues with solid visibility to the remainder. We also expect a strong Q4 from a gross margin perspective. The mix of programs we expect to drive our growth is weighted towards higher margin production programs and licensing revenue. Our current revenue forecast for Q4 is 301.5 to 321.5 million. This represents the biggest revenue quarter in Mercury's history, surpassing our prior record by nearly 60 million at the midpoint. GavNet income is expected to be 30.1 to 35.5 million, or 53 to 63 cents per share. The comparison with Q4 last year reflects the expected incremental impact-related expenses and amortization expenses. Our guidance for Q4 also includes restructuring and other charges of $3.3 million related to the impact initiative. Driven largely by higher gross margins and operating leverage on sales growth, we expect Q4 adjusted EBITDA in the range of $81.1 to $88.1 million. Margins are expected to be approximately 27% of revenue at the midpoint of more than 600 basis points from Q3. Q4 adjusted EPS is expected to be $0.96 to $1.06 per share. We expect free cash flow for Q4 to continue to be impacted by the macro environment, including continued supply chain disruption. We also expect impact program cash outflows and working capital investments associated with quarter-over-quarter revenue growth. As a result, we expect a free cash outflow in Q4. We expect free cash flow to normalize in fiscal 23. While we don't guide bookings, we are expecting record bookings in Q4 with a book to bill above 1.0, resulting in record backlog at the end of the quarter. This should position us well as we move into fiscal 23. With that, I'll now turn the call back over to Mark.

Thanks, Mike. Turning now to slide 14, Mercury enters the fourth quarter of fiscal 22 with strong backlog and bookings momentum. We believe this will set the stage for a strong fiscal 23 as we return to our organic growth, continue to manage the industry challenges, and expand margins through impact. Looking ahead longer term, our model, sitting at the intersection of the high-tech industry and defense, positions us well for a period in which the U.S. and our allies are likely to make substantially increased investments in national security. We believe that our strategy and investments in secure processing, trusted microelectronics and open mission systems will continue to drive growth in our business. Mercury is well positioned to continue to benefit from the ongoing effects of supply chain de-layering and reshoring, as well as increased outsourcing at the subsystem level by our customers. Our strategy is to improve margins while growing the business organically, supplement with disciplined M&A and full integration. By executing on this strategy, we've created significant value for our 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. Our focus continues to be executing our strategic plan and driving value for all our shareholders. The purpose of today's call is to discuss our third quarter earnings results and outlook, and we ask that you please keep your questions focused on those topics. With that, operator, please proceed with the Q&A.

Thank you. We ask today that you limit yourself to one question. In order to ask a question, press star, then the number one on your telephone keypad. If you would like to withdraw your question, again, press the star one. Your first question today comes from the line of Seth Seifman with J.P. Morgan. Your line is open.

Thanks very much, guys, and good afternoon. Hi, Seth. So, Mike, I appreciate all the color on the free cash flow outlook. And I guess if you can give us maybe a little bit more on the working capital build you expect in the fourth quarter, given kind of all the EBITDA that's coming in and, you know, why that's not converting. And maybe where working capital goes over time, because it's a pretty It's a pretty high level at Mercury. And as you do more work on a percentage of completion basis, should there be more milestone payments that aren't necessarily associated with delivery so that the advanced balance grows in a way that's more commensurate with the unbilled so that working capital isn't such a huge percentage of sales relative to the larger companies?

Yeah. So a couple questions in there, Seth. So let me try to hit on them. First of all, in terms of cash flow and as we look at Q4 and what happened in Q3 in terms of working capital, as you said, the biggest use of cash was working capital really in unbilled receivables because of supply chain delays. And as we look at Q4, we actually expect a similar impact to what we saw in Q3. So while we expect some of the unbilled to come down in Q3, we have other programs where we're seeing supply chain decommits, and we actually think unbilled are going to be up at the end of Q4 due to program timing and milestones. When you look at inventory, we expect it to be relatively flat as we continue to deal with the supply chain And then, you know, you mentioned we do have a big Q4. You know, as a result of that, at the end of the quarter, we expect billed receivables to be up due to the timing of deliveries on the heels of that large revenue quarter. So, from a working capital perspective in Q4, we do continue to expect it to be a use of cash. Now, we expect that to normalize as we go into fiscal 23. with unbilled coming down to more normal levels. We look at unbilled as a percentage of our overtime revenue, and we do think that that's going to come down over time. And a lot of the reasons that you discussed, you know, we're working with our customers on milestone payments, negotiating better milestones around those contracts, especially in this environment. And then we also expect inventory terms to increase as we get into fiscal 23, you know, as the supply chain, the pressures of the supply chain abate. Because as you know, we've been pre-purchasing inventory as a result of that. So I think that, you know, in answer to your question, you know, our business model is different than the primes and some of our customers. So we are going to have more working capital in general. That having been said, I think there's opportunities as we go into fiscal 23 for that to come down, really driven by unbilled production and inventory terms increasing.

Great. Thank you very much.

Your next question comes from the line of Peter Arment with Baird. Your line is now open.

Good afternoon, Mark and Mike. Hey, Mark, this may be an unrealistic question, but just given all the supply chain challenges, I mean, just when you think about your business model getting back to kind of high single digit or low double digit growth, is it unrealistic to think that that's back in play for fiscal 23, just given the industry-wide challenges that you guys are caught up in?

So I think overall, Peter, I think the opportunity for us to continue the model that we have, right, that high single digit, low double digit, you know, we feel good about it over time. We're not going to guide right now on fiscal year 23. But if you think about, you know, what we say in the prepared remarks and what we expect to have happen, you know, in the fourth quarter, we are expecting bookings to actually accelerate over the 41% growth that we had year over year in Q3, you know, resulting in, you know, substantial growth at the year level, as well as a huge increase in terms of backlog as well. So I think it positions us well for a return to, you know, organic growth next fiscal year. But, you know, as I say, I'm not going to guide, you know, specifically 23. You know, we'll hold that for the next call. Appreciate it.

Thanks.

Yeah.

Your next question comes from the line of Pete Skibitsky with Olympic Global. Your line is now open.

Hey, good evening, guys. Can we drill down more, Michael, into gross margin? I feel like there's a couple things going on there. One is some of the acquisitions you guys have wanted time to improve, kind of fundamental margins there. And also you talked about mix a little bit also. I'm wondering as you head into 4Q, do you expect those two items to move in the right direction for you in the fourth quarter and into 23 in terms of, particularly in terms of mix? Are you fundamentally kind of changing to a more production-focused mix, or is it a little volatile? And are we heading out to, you know, greater than 40% kind of from here on out? I was just wondering if you could clarify that. Thanks.

Yeah.

Yeah, so when you look back at the gross margins over the last couple of years, Pete, we have seen a lot of moving parts. Fiscal 20, kind of pre our physical optics acquisition, we were closer to 45% gross margins or 44.8%. In fiscal 21, we were 41.7%. What you saw there was the physical optics acquisition, which has a different business model than ours. was slightly dilutive to gross margins. It had 110 basis point impact on gross margins, and we only owned it for half of the year. 21, we also had 100 basis points from COVID expenses, because as we invested in testing to make sure we had business continuity during the pandemic. And then we also, in fiscal 21, we had, you know, a good mix of new program starts. So if you look at fiscal 22 and we don't guide gross margins, you're going to see that the physical optics corp is acquisition. We've now had it for a whole year. So that's going to be diluted to gross margins, probably around 200 basis points for the year. And then we're seeing some pressure due to the supply chain in terms of inflation, although we have been able to pass most of that through. But the biggest movement in fiscal 22 compared to fiscal 21 is program mix. And it's related to a lot of new program starts that we have that are in development that are going to transition into production going into fiscal 23 and beyond. So as we look into fiscal 23, we do see gross margin expanding as more of those programs transition in production. And as we, you know, look forward beyond that, a lot of the things that we're doing around impact are focused on gross margin expansion as well. So we see a lot of opportunity. And then just quickly on Q4, yes, we do in Q4 expect to see gross margin expansion from where it's been year to date. Because in Q4, we've got more production programs and some licensing fees. And that's what you're seeing driving some of the EBITDA margin expansion. in our Q4 guidance.

Okay. That's great, Collar. And last one related to that is, guys, as you look at the kind of the two new budgets, 22 and 23, is there any reason to think, you know, development mix, you know, a year out could switch dramatically because, you know, obviously you'll have things like LTAMs and whatnot, and hopefully F-35 go into production. Those are big, but you've got, you know, a lot of new R&D spend also. So I'm just wondering how you're thinking about you know, the broad opportunity for mixed changes going forward?

Yeah, I think we've won a lot of, you know, early stage programs, right? The amount of CRAT that we've had, you know, has continued to climb, you know, both this year as well as last. Yeah, we do see, you know, we pick up in certain programs next fiscal year. Yeah, I think, as you know, right, this year, or last year, sorry, we saw a substantial decline in bookings in the F-35 that impacted the business. We're clearly seeing the rebound. Similarly on other programs, Filthy Buzzard was also impacted. That's in production. We're expecting that to rebound as well as SeaWeb. The whole naval modernization franchise was impacted as part of COVID and the impact to the shipyard. So I do think that you know, the amount of business that we have in production will continue to grow. That said, you know, when you look at the 23 budget, you know, whilst procurement is flat, you know, the amount of R&D, you know, increased by over 9% to an all-time high. So I think you're seeing, you know, some shifts in the budget, you know, towards new technologies and capabilities in line with the emerging threats, in particular the peer threats, which I think bodes well for Merkur and its business model. So we've got some good programs. I think our business model is aligned, and it literally does come down to Merkur. Okay.

Thanks for the call, guys.

Yeah.

Your next question comes from the line of Jonathan Ho with William Blair. Your line is now open.

Hi, good afternoon. Just wanted to maybe drill down a little bit around some of the ability for you to pass through pricing from your customers. I think your comment was that you could pass some through, but some you could not. Can you just give us a sense of how we should think about sort of those pricing pass-throughs and your ability to execute that? Thank you.

Sure. So let me take a crack at it and maybe throw it over to Mike at the end. Yeah, I think if you look at the majority of our revenue today is fixed price and we're largely operating on the commercial terms. This year with POC, we estimate that roughly $40 million is cost plus reimbursable. The cost plus type contracts do allow you to pass on higher costs to the customer where fixed price contracts typically do not. So the effects to our margin, Jonathan, really in the short term depends upon what's in backlog and when those increased costs flow through. Unlike many of our customers who have multi-year backlogs that can help buffer the near-term impacts, that being said, we do have typically shorter production cycles, which does allow us to potentially more frequently you know, pass on the price increases, either at, you know, a next program tech insertion, you know, or during the next production run, and it really depends upon the circumstances. So, in addition to that, you know, the passing on the inflationary costs really also depends upon the contractual terms. You know, in most cases, you know, that boils down to actual inflation escalation causes. So, We've actually been doing a ton of work on that associated with impact. We've actually been reviewing every contract as it comes up for renewal and looking as part of our other impact work streams, in particular, procurement and pricing, ways in which we can manage the inflationary pressures that we're seeing.

Your next question comes from the line of Ken Herbert with RBC. Your line is now open.

Hey, good afternoon, Mark and Mike. I wondered if, Mark, I wondered if you can address one impact a little bit. I mean, it looks like from your slide, you expect by the end of this fiscal year, you're at sort of a 25 or 27 million impact. benefit of the 30 to 50 million you targeted by 25. So it seems like you're pretty well along the way. My question would be, is there the opportunity to expand this as you think about sort of what you've achieved so far? But then on the flip side, has what's happened in Eastern Europe changed your thinking at all around, you know, how you're spending this money and how you're looking at this restructuring?

Sure, so it's a good question. So I think we're pretty pleased, Ken, with the progress that we're making around impact. We started off really looking at the organizational structure, things like spans and layers, and we got through the majority of that organizational effort pretty early on, and that was the majority of the $27 million Right now, we're focused really on other, what we believe to be drivers of margin expansion going forward. So we talked a little bit about pricing. We are in the process of developing a pricing center of excellence to leverage best practices in both pricing and cost estimating across the business. We've had a tremendous amount of work going on in the procurement side of things. In particular, we're ramping up several initiatives to better drive economies of scale and enhance demand management, whilst also reducing the complexity of the supply chain. And in Q3, we implemented a new AI-based tool, which will enable much greater automation and analytics in the procurement process. which should allow us to harvest much better insights over time, you know, into the supply base. So pretty happy with what's going on there. Another big one is around, you know, footprint and operational excellence. You know, we, in the Q3, you know, we completed a consolidation of our San Jose and Fremont facilities. But we've got more to do there. When you're looking at facilities optimization, it takes time and tremendous amount of planning. And so we've got a detailed set of work underway looking at that as well. The final one is around R&D, investment efficiency and ROI. And investing in R&D is a critical area that's driven really the growth in Mercury's businesses historically. And we're always, I think, invested above the industry average, just given the fact that we're sitting at the intersection of tech and defense. As we look at Ukraine, I think in the short term, just given the nature of the capabilities that have been requested as part of the military assistance, there's probably not a tremendous amount of short-term upside That said, we do think that over the next two to three years, we are going to likely benefit with sales from new or upgraded F-16s to Eastern Europe. I think clearly there's going to be additional F-35s sold to both Western Europe and potentially Canada. I think there's opportunities in various precision munitions. And then very clearly air and missile defense systems. So we're on Patriot, we're on THAAD, we're on LTAMs, Aegis, the shore Aegis. And so I think there's really good upside potential just given the substantial increase in defense spending that we expect across Europe over the course of the next decade.

Hey, that's helpful. And if I could just real quick, Mike, I know you're not talking about fiscal 23 in detail yet, but when you refer to cash flows returning to normal levels, how should we think about sort of normal maybe on an EBITDA or conversion basis, or is that something you're prepared to provide at this point?

Yeah, I mean, we'll provide more guidance when we get to fiscal 23, you know, as we see how things play out in terms of supply chain and some of the other headwinds that we've seen. Historically, Ken, we've set a target of 50% free cash flow to adjusted EBITDA, and I think that's still a good target going forward.

Perfect. Thank you.

Your next question comes from the line of Michael Charmoli with Truth Securities. Your line is now open.

Hey, good evening, guys. Thanks for taking the question. Mark or Mike, just to play maybe devil's advocate a bit. I mean, you've got, you know, you're calling for a five-year view, calling for margin expansion. You know, we've seen some of the challenges over the past couple of years. I mean, I think at one point, you know, the deal target was 45 to 50% gross margins. I mean, I know you're talking right now about general mix and some of these new start programs, but it seems like we're going to be in an environment here of the continuous RDT&E and new start programs. I mean, you've got the savings from impact, which if we just run the model, maybe you get to 24% EBITDA margins. I guess, what can you tell us in terms of the confidence level in expanding these margins on a go-forward basis versus what we saw over the trailing three to five years?

So I think our confidence level is high, Mike. I think we have won a bunch of programs. I think those programs are expected to go into production over time. The major drivers from a margin expansion perspective as it relates to impact are the pricing initiatives. I just went through some of the things that we're doing there. Procurement, both direct and indirect, which we think is a significant opportunity. And then over time, leveraging and managing our footprint as well as driving operational excellence. So we've already got a tremendous amount of work underway with the analysis and the work streams to basically drive those. So I think we are going to see margin expansion, and it's likely above the number that you threw out on the call, Mike. I don't know if you want to comment at all from your perspective.

No, that's spot on. I, you know, I just reiterate, I think we have a lot of confidence in it over the next five years. And, you know, Mike, if you look at a lot of our programs right now, they are, and as we look at the five-year plan, we've got visibility into those transitioning into production. That's things like T45, B22, other programs like that that are in development now that are going to transition to production. So I think we're going to see gross margin expansion based on our contract mix over the next five years. We're also going to see R&D leverage as we take the investments we've made over the last couple of years and put them across our whole portfolio. And then SG&A, I think we're going to see operating leverage as well as we grow revenues faster than we grow expenses. And then on top of that is the impact initiatives that Mark discussed. I would just reiterate, I think we have a lot of confidence that we'll be able to expand margins over the next five years supported by, you know, the current product or the current program as well as impact.

Got it. Those programs, I mean, looking forward, do you see licensing revenues becoming more of a prominent driver, or is that just thinking about the high margin kind of drop through from those types of revenues? Is that in the mix going forward?

We do have some licensing revenues, Mike, going forward. That's part of our business model. But the bigger expansion that we're going to see is – these new development programs that have lower margins moving into full-rate production.

Got it. As we look out over the longer term, Mike, the other area that we think is pretty important is the trusted microelectronics business, right? So if you remember way back when the genesis of that strategy was when we acquired the microelectronics assets from MicroSemi, We've since, you know, obviously built that business out and are focused on 2.5D and 3D microelectronics capability. And as you know, a tremendous amount of focus there. So, you know, as that continues to ramp and to build, and we're at a very early stage today, and it's actually, you know, it's diluted to margins in the trusted microelectronics piece, that will also be a driver of margin expansions. Got it. Perfect. Thanks, guys. Yeah.

Your next question comes from the line of Austin Muller with Canaccord. Your line is now open.

Good afternoon, Mark and Mike. Just my first question here. Can you talk or delineate some of the key programs that drove the 17% year-over-year increase in inventory both in the quarter? I know you had mentioned an FMS program.

Yeah, so Austin, I think there was a couple things that drove the working capital balance. Inventory was one, and the other was unbilled receivables. We've had a variety of programs that drove the unbilled receivable balance up and have quite a few examples of situations where we were working on the program. We got 80% complete. Milestones were based on final delivery. and that was delayed because of supply chain disruption. And so that's really what's been driving the working capital inventory. There's not specific programs. I mean, we are buying parts for specific programs, but it's more around those parts that we use in a lot of our products. And one thing to remember is that You know, we are an electronics company. We're a computer company. And from, you know, direct material perspective, nearly 40% of our direct materials are related to semiconductors. And from an inventory perspective, that's one of the areas we've been focused in terms of pre-buying those capabilities because that's where we're seeing the longest delays and supplier decommits.

Okay, that's helpful. And then just a follow-up. Do you expect electronic warfare to sort of be the key driver of foreign military sales for the company over the coming years? Just giving you a look at the Ukraine conflict, Russia's extensive use of the Khrushchev force system, and China's almost certain to use it in the Asia-Pacific region if they're going to threaten like Taiwan or the Senkaku Islands.

Yeah, I would say right now, based on what we see, probably the biggest driver for Mercury is in the radar domain associated with air and missile defense. But we're also leveraged to EW as well, and so there's clearly going to be opportunities there also.

Okay, great. Thank you for the details. Yes.

Your next question comes from the line of Christopher Rieger with Barenberg. Your line is now open.

Hi, guys. Good evening. I'd like to ask about R&D, which over the past quarter was about 10% of sales, a bit light relative to your historical average, which you kind of addressed in your prepared remarks. But could you please sort of talk about what your current R&D spending priorities are and perhaps how these may have perhaps changed over the past several months, particularly in light of impact-related efficiency initiatives and what has transpired on the geopolitical stage. I know you've kind of touched on it a little bit, but any further color there would be appreciated. Thanks.

Yeah, so I don't think the priorities and focus areas have changed too much. I think we've got a strong belief that the investments that we're making in our focus areas around secure processing open mission systems, C2I processing, as well as trust in microelectronics is very, very well aligned with the national defense strategy and clearly aligned with the shifts that we've seen as a result of the invasion of Ukraine. The areas that we'll focus on are literally those, you know, open mission systems, secure sensor processing, trusted microelectronics, and really JADC, too. You know, it's what we've really built the company around, and our R&D is heavily focused on that.

Thanks.

Appreciate it. Yep.

Your next question comes from the line of Sheila Keregula with Jefferies LLC. Your line is open.

Good afternoon, guys. Thank you. Maybe some other questions. Can you square away what's going on with cash flow and your supply chain commentary with regards to expected revenues? The revenue decline is much less than what we're seeing in the margin contraction and the cash impact. So maybe can you talk about those dynamics and what makes them normalized?

Yeah, so Sheila, on the guidance, you're right, from a revenue and margin perspective, the revenue was down. We just brought the top end of the range down by $10 million. So the midpoint was reduced by $5 million. We brought EBITDA down guidance by $10 million. That was really associated with program mix and the timing of production getting pushed into next year on some key programs. So that's the majority of the change from a revenue and margin perspective. From a cash flow perspective in Q3, we saw more, as I've talked about, supplier component decommits and extended lead times, which delayed the final shipment milestones associated with a lot of our programs. That resulted in lower in-quarter collections than expected, which drove our our cash flow down. Now we had expected unbilled and inventory reductions to normalize in Q4. But as we look at the current quarter, we look at the programs and we're still dealing with the supply chain, we think we're going to see a similar dynamic in Q4. So it's really the supply chain that is pushing the cash into fiscal 23. And we think as we get into fiscal 23, We expect that to normalize.

So, Sheila, let me just jump in there a little bit and give you a little bit more color. When you look at the $5 million lowering of the revenue guidance, it was really two programs that moved. One was the F-18. We experienced some contracting delays in Q3 that pushed the expected award into Q4. But based upon the timing or the delay in Q3 and the timing of the award into Q4, it lowered the amount of in-quarter book and ship revenue that we previously anticipated. The second was T45. Here we had some supply delays that impacted some of the ongoing development efforts. That program We were expecting the initial production award. You know, we're now expecting that in fiscal year 23 You know those combines were way more than the actual, you know, five million drop in revenues So we were able to you know recover, you know, some of the shortfall or the delays that we saw The other thing is that from a margin perspective, you know, we did have a you know, at least one high margin licensing deal associated with certain of our capabilities that moved into next year as well. And that was, you know, clearly one of the bigger drivers, you know, in the, on the EBITDA side.

Okay. Thank you for that color. And then maybe one more, you know, I think you guys mentioned CH53K, MH60 programs I haven't heard you talk about, and CDS. I don't, I'm not sure what that one is, but... how big of contributors are they and how should we think about them going forward?

Yeah, so they came to us through the acquisition of our physical optics business. As you know, we have been focused on building out a next generation avionics and mission computing business. And we've, in essence, hand-selected six or so businesses that fit together really, really well, you know, that plays into the de-layering trend. So with that, you know, business came a host of some great programs, CH53, MH60, you know, additional work on F16, additional work on F18, additional work on the F15EX, T45, a host of different programs. So, and actually this past quarter, we just won two new design wins on the CH53. So, you know, I wouldn't say they're in the, you know, they're not in the top five programs, but they are in the top 20 going forward. So, important programs for us and, you know, are expected to grow over time.

Okay.

Thank you very much.

Yeah.

Mr. Aslett, it appears there are no further questions. Therefore, I would like to turn the call back over to you for any closing remarks.

Okay, well, thank you very much, everyone, for listening. We look forward to speaking to you again next quarter. Take care. Thank you.

This concludes today's conference call. Thank you for attending. You may now disconnect.