Mercury Systems Inc

Good day, everyone, and welcome to the Mercury Systems fourth quarter fiscal 2022 conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the company's executive vice president and chief financial officer, Mike Rupert. Please go ahead, sir.

Good afternoon, and thank you for joining us.

With me today is our President and Chief Executive Officer, Mark Aslett. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. The slide presentation that Mark and I will be referring to is posted on the investor relations section of the website under events and presentations. Please turn to slide two in the presentation. Before we get started, I would like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's financial outlook, future plans, objectives, business prospects, and anticipated financial performance. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward-looking statements should be considered in conjunction with the cautionary statements on slide two. in the earnings press release, and the risk factors included in Mercury's SEC filings. I'd also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles, or GAAP, during our call we also discussed 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 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. Before we begin, I'd like to recognize the entire Mercury team for a tremendous effort through the course of an exceptionally demanding year. Thanks to your strong performance, Mercury delivered record bookings, revenue, and adjusted EBITDA for the fourth quarter. That said, the quarter and the year were more challenging than we anticipated due to lingering pandemic impacts, the extended defense budget delay, continued supply chain disruption, labor market constraints, and growing inflationary pressures. Despite these charges, our bookings increased 27% year-over-year in Q4 to a record $332 million, leading to a 1.14 book-to-bill and record backlog exiting the year. We received a large Aegis SMS order that was delayed in Q1, which was larger than we had originally expected. We also received the funding associated with the F-35, TR-3, LOC-16 as anticipated, among others. Our largest bookings programs in the quarter were Aegis, F-18, F-35, PGK, and the SDA tranche tracking layer. Total revenues up 16% year-over-year and 9% organically. Our largest revenue programs in the quarter were Aegis, F-35, P-8, MH-60, and a classified radar program. We continue to see high levels of new business activity. Design wins in Q4 total more than $680 million in estimated lifetime value. For the year, we received 33 new design wins with an estimated lifetime value of more than $1.6 billion, up 9% from fiscal 21. On the bottom line, we delivered adjusted EBITDA margins of nearly 25% on the fourth quarter and a record $71.6 million in adjusted EBITDA. This is up 36% from the third quarter and up 21% from the record set in Q4 last year. For the full year, we delivered record bookings, which grew 21%, a positive book-to-bill and record backlog. Total revenue increased 7% year-over-year, while adjusted EBITDA declined 1%. Our largest revenue programs for the year were MH60, F35, the classified C2 program, P8, and Aegis. Turning to slide four, notwithstanding these record results, we fell short of our guidance for Q4 in the year, primarily as a result of material and audit delays that affected the timing of revenue. We continue to see in-quarter supply decommits, long lead times for high-end semiconductors, and delayed supply and deliveries. In the past, we've been better able to mitigate short-term revenue risk. That wasn't possible to the same extent this year, given the supply chain and labor market disruptions. The contracting delays also resulted in the higher accounts receivable and lower in-quarter cash collections, which reduced free cash flow. Inflationary pressures, in large part related to semiconductors, became more of a challenge as fiscal 22 progressed. Semiconductors equate to 38% of our external supply spend, and we're seeing double-digit price increases. We expect to see greater impacts on material inflation and, to a lesser extent, labor inflation in fiscal 23. Given the short cycle nature of our business, however, we believe these impacts will begin to normalize over time as our future business is priced at market rates.

Clearly, these were unprecedented times.

Mercury's sophisticated end-to-end processing platform powers many of the most critical AMD missions and represents about 70% of our business today. High-end processing requires high-end semiconductors. and this is where the global supply chain has been most disrupted. That said, it's also where mercury likely has the largest opportunity to grow over the next five years. Fortunately, the issues we're experiencing are not demand-related. They're supply and timing related, they're temporary, and they're not unique to mercury. We have a plan to focus on what we can control, and we're very optimistic about the future given our positioning. The demand environment is strong and appears to be getting stronger. Although the defense industry is dealing with short-term headwinds, we expect to see a shift to tailwinds as defense spending grows and the supply chain conditions improve. We believe that we're well-positioned to deliver results more in line with our target model in fiscal 23. Looking ahead over the next five years, our plan remains intact. We believe mercury can and will continue to grow at high single-digit to low double-digit rates organically as the short-term charges diminish. The war on Ukraine, the most challenging global threat environment since the Cold War, will likely result in a sea change in defense spending, domestically and internationally. Our advisors estimate that U.S. growth, combined with increases in NATO defense spending to 2% of GDP, could drive up to $1.5 trillion of additional spending over the next decade. This should lead to higher bookings for mercury in the electronic systems associated with missiles and munitions, air and missile defense systems, unmanned systems, fixed-wing and rotorcraft, ground vehicles, and electronic warfare. The secular trends benefiting mercury remain favorable in our view. The demand environment is improving, as demonstrated by our strong bookings and design wins growth in fiscal 22. We believe that a greater percentage of the value associated with future defense platforms will be driven by electronic systems content when Mercury participates. Our addressable market continues to increase, driven in large part by our strategic move into mission systems and potential to deliver innovative processing solutions at chip scale. Our model, sitting at the intersection of high tech and defense, positions us well. As a result, we expect our business to continue growing faster organically than overall defense spending over time. In addition to organic growth, our five-year plan includes continued margin expansion driven by our impact initiatives. Turn to slide five and our expectations for fiscal 23. The defense budget outlook is improving. We expect to deliver another year of double-digit bookings growth and a positive book-to-bill. Despite the potential for an extended CR due to the midterm elections, the DoD top-line budget submitted to FY23 is up from FY22. There also appears to be strong bipartisan support for increased defense spending. Labor market conditions have improved somewhat, and the primary health effects of COVID continue to subside. However, the second-order COVID supply chain effects will likely continue in fiscal 23 and possibly beyond. We also expect to see greater impacts on material and labor inflation for the year. As I said, we believe that we're well-positioned to deliver results more in line with our target model in fiscal 23. We began the year with a record $1 billion in backlog and much improved forward revenue coverage versus fiscal 22. We expect double-digit growth in bookings for the year and improved bookings linearity, leading to a higher backlog, better visibility, and reduced risk as the year progresses. We also expect a positive book to build for the year. At the midpoint of guidance, we're expecting approximately 3.5% year-over-year growth in revenue in adjusted EBITDA versus 6% and 7% increases at the high end. We expect growth together with improved operating leverage in our impact initiatives to partially offset material and labor inflation, resulting in similar margins to fiscal 22. In addition to record adjusted EBITDA, we expect to deliver improved free cash flow. Our fiscal 22 bookings growth largely occurred in H2, and as I've said, we've seen longer semiconductor lead times. For high-end semiconductors, lead times now range from 36 to 99 weeks, three to five times pre-pandemic norms. As a result, we expect the timing of our revenue in adjusted EBITDA to be back-end loaded in fiscal 23, with Q1 being the low watermark for the year. The increased backlog we expect as the year progresses should help improve operational execution in this challenging supply chain environment and ease the recent pressure on working capital. This should result in improved cash flow over the time. Another year of expected double-digit growth in bookings and another positive book to bill in fiscal 23 give us the confidence that we can and will return to organic growth back in line with our model in fiscal 24. provided supply chain labor market conditions normalize. And again, looking ahead over the next five years, our plan remains intact. Turn to our impact program on slide six. We began the journey a little more than a year ago with the goal of amplifying the value we create as we scale the business over time. During fiscal 22, we simplified and streamlined our organizational structure and strengthened the leadership team. We also focused impact on analyzing, quantifying, developing initiatives to drive margin expansion. As we enter fiscal 23, we're taking advantage of this progress by pushing the execution of these initiatives deeper into the business. We're using the impact processes and tools that we've developed and matured to deliver on our margin expansion goals over time. We expect impact to generate $30 to $50 million of incremental adjusted EBITDA by fiscal 27. This is later than originally anticipated, given the expected impact of inflation in the short term. Over the next five years, impact should drive significant margin expansion nonetheless. As fiscal 22 evolved and things became more challenging, We pivoted impact towards areas that could help mitigate risk and deliver the most immediate financial results. This focus will continue in fiscal 23. Through impact, we're seeking to de-risk the timing and availability of materials in our supply chain and to better manage inventory. We're implementing processes and tools to make better and more timely pricing decisions. We're also prioritizing our human capital resources to the greatest effect. To counteract the inflationary pressures, we're updating our commercial price list and proactively negotiating existing contracts where possible. On new contracts, we're introducing more favorable inflation-related terms and milestones to drive improved cash conversion. Another impact initiative of fiscal 23 is R&D investment efficiency and returns, following the progress in fiscal 22. In addition, Impact is aimed at optimizing our balance sheet by improving our working capital and asset efficiency. Like many others in the industry, as a result of the environment, our unbilled receivables balance has grown. We're using Impact to focus on and improve the timeliness of our receivables cash conversion. Although we've made some progress, we have more work ahead to achieve our long-term cash flow objectives. Our digital transformation initiatives and engineering and operations will help improve our cost structure and performance over the long term as well. We'll also continue to consolidate and optimize our facilities footprint. 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. The M&A environment continues to be active and we remain focused on our existing M&A themes. With that, I'd like to turn the call over to Mike.

Mike?

Thank you, Mark, and good afternoon again, everyone. I'll discuss our Q4 and full-year results and then focus on our Q1 and fiscal year guidance. Turning to slide seven, in Q4, Mercury delivered all-time company records for bookings, revenue, and adjusted EBITDA. We exited Q4 with record backlog of more than $1 billion. Our 12-month backlog was up 22% year-over-year, providing improved revenue visibility into the next 12 months. Revenue in Q4 was up 16%, and organic revenue up 9% year-over-year. During the quarter, we recognized the revenue that we expected from the large Aegis FMS sale, F35 TR3, and other key programs that we discussed on last quarter's earnings call. We did, however, experience more supplier decommits and award delays on other programs, which had a greater than 25 million revenue impact on our Q4 results. Acquired revenue in Q4 included Pentec, Avilex, and Atlanta Micro. As a reminder, Physical Optics Corporation, which we acquired in Q2 of fiscal 21, is incorporated into organic revenue as of last quarter. Physical optics continues to perform well despite being impacted by contract delays, labor market, and supply chain decommits like the rest of the industry. In fiscal 22, physical optics had revenue in line with expectations and had a 1.27 book-to-bill, overall a strong performance. The acquisition, which was our largest in history, is a critical component of our open mission system strategy. As planned when we bought Physical Optics, we continued to transition the business from its historical small business innovation research work to subsystem development and production contracts. We're pleased with the acquisition, its growth, and its alignment with our strategy. Q4 gross margins were up slightly year over year. Growth in higher margin production and licensing revenue was partially offset by increased direct allocation of engineers to customer-funded programs, as well as the impact of material inflation that we were not able to pass through to our customers. As a result of the direct allocation of engineers, our internal R&D was lower as a percentage of sales compared to Q4 last year. In Q4, we had record adjusted EBITDA of 21% year over year. Compared to Q4 last year, our adjusted EBITDA margins increased 120 basis points to 24.7%, primarily as a result of improved operating leverage. Free cash flow for Q4 was an outflow, primarily as a result of working capital and one-time expenses, which I'll discuss further in a moment. Turning to our full-year results on slide eight, fiscal 22 was a record year for bookings. Our book-to-bill was 1.08, compared to 0.95 in fiscal 21. This rebound drove backlog higher and increases our visibility heading into fiscal 23. Fiscal 22 revenue was up 7% in total and down 5% organically. Our organic revenue was impacted by the external market conditions, including supply chain disruption, labor market constraints, and contracting delays. Despite these delays in fiscal years 21 and 22, None of our major programs have been canceled. Adjusted EBITDA for fiscal 22 was down 1% year over year. Our adjusted EBITDA margins were 20.3% compared to 21.9% in fiscal 21, primarily driven by program mix and inflation. Free cash flow in fiscal 22 was an outflow, primarily as a result of an increase in working capital as well as one-time expenses. Slide nine presents Mercury's balance sheet for the last five quarters. We ended Q4 with cash and cash equivalents of $66 million and approximately $452 million in debt funded under our $1.1 billion revolving credit facility. Our balance sheet is strong, and we have significant financial flexibility to continue to invest in the business organically and through acquisitions. Accounts receivables increased in fiscal 22. This was primarily a result of unbilled receivables, which increased approximately $61 million from Q3 fiscal 22 and $140 million compared to Q4 fiscal 21. This was primarily driven by the growing proportion of overtime or percentage of completion revenue as we execute on our content expansion strategy. In Q4, overtime revenue increased to approximately 60% of total revenue. compared to 44% a year ago. In addition, unbilled receivables were impacted by supply chain disruptions, which continue to delay delivery milestones and cash collections in the quarter. We expect unbilled receivables as a percentage of overtime revenue to return to a pre-pandemic level of approximately 35% as supply chain conditions improve and legacy contracts roll off. Inventory increased approximately $11 million in Q4 compared to Q3, and approximately $49 million from a year ago. This was primarily due to accelerated raw material purchases to support higher demand and mitigate supply chain risk in fiscal 23. It also reflected decisions by our suppliers to end of life more key components requiring us to invest in raw materials. We expect to see less of this dynamic in fiscal 23. Turning to cash flow on slide 10, free cash flow for Q4 was an outflow of $28 million and $47 million for the year. Last quarter, we forecast an expected free cash outflow in Q4, driven by one-time payments as well as working capital billed due to the record revenue quarter. The Q4 outflow was further impacted by supplier delay. primarily within unbounded receivables. In addition, in Q4, we had approximately $7 million of one-time cash outflows associated with our impact initiative, acquisition expenses, and shareholder settlement costs. When the supply chain normalizes, we expect our cash conversion cycle to normalize as well, and cash conversion to return to our target levels, which we have set at 50% free cash flow to adjust to meet the dot. We currently expect free cash flow to improve in the second half of fiscal 23 as net income grows and working capital metrics improve. I'll now turn to our financial guidance, starting with the fall fiscal year 23 on slide 11. As a June fiscal year-ended company, we are initiating guidance for the next 12 months in a very fluid environment. As such, our guidance incorporates, to the extent we can, potential risks related to continued supply chain delays and material and labor inflation, as well as the potential for another continuing resolution in a midterm election year. While these uncertainties do pose risks, they are timing related and not related to demand, which is strong. On a quarterly basis, our guidance is second half weighted. as a result of the bookings profile and supply chain delays that we've discussed. We are entering fiscal 23 with strong backlog coverage given the record bookings in the second half of fiscal 22. We also have visibility into the key programs not currently in backlog that we believe will drive our revenue. During the year, we expect to receive bookings on programs such as F-16, F-18, Filthy Buzzard, CWIP, and others. We are designed in and have sole source positions on these programs. For fiscal 23, we're guiding revenue of 1 to 1.05 billion, representing 1 to 6% growth from fiscal 22. Organically, the high end of our revenue guidance represents a 4% increase year over year. Based on the midpoint of our revenue guidance, we have approximately 63% of our forecast revenue in backlog. This compares to approximately 52% entering fiscal 22. Over 90% of our fiscal 23 revenue guidance is either from backlog or from programs where we are designed in. We expect fiscal 23 revenue to be H2 weighted, primarily as a result of award timing and supply chain lead times. We expect adjusted EBITDA margins to expand throughout the year as a result of program mix, impact initiatives, and operating leverage. While we always tend to have years weighted towards the second half, this year we expect that to be more pronounced as a result of the macroeconomic headwinds. As a result, we expect approximately two-thirds of our adjusted EBITDA in the second half. Unlike the last two years, we expect our bookings to be spread relatively evenly throughout the year. with a strong book-to-bill in H1, providing significant backlog coverage going into H2. Based on our current outlook for bookings, we expect to have nearly 80% of our H2 revenue in backlog, driven by the key bookings I mentioned. This is above historical levels of backlog coverage entering the second half of the year, supporting the strong growth we expect in H2. Our guidance range for adjusted EBITDA for fiscal 23 is $200 to $215 million, approximately flat to up 7% from fiscal 22. At the midpoint, adjusted EBITDA margins are 20.2%. These margins are approximately flat year over year as the anticipated impacts of material and labor inflation are offset by impact initiatives related to procurement and pricing. We currently expect free cash flow to adjust to the dot conversion of 30 to 40% in fiscal 23. This estimate assumes that the current R&D capitalization tax law is delayed or repealed. We expect a free cash outflow in H1 primarily as a result of continued supply chain disruption with free cash flow returning to target levels in H2 as working capital increases subside. For the year, we're expecting double-digit bookings growth and a book-to-bill above 1. I'll now turn to our first quarter guidance on slide 12. Our current revenue guidance for Q1 is 215 to 225 million. At the high end, this is flat from last year. We expect Q1 to just leave a dime in the range of 27 to 30 million. Margins are expected to be approximately 13 percent of revenue. compared to 17% in Q1 last year. This is primarily a result of continued supply chain and labor inflation as well as program mix. We expect margins to expand as we move through the year as a result of program mix, operating leverage, and impact initiatives offsetting inflation. We expect a free cash outflow in Q1 as a result of continued supply chain disruption as well as one-time cash outflows associated with impact and shareholder settlement costs. While we don't guide bookings, we are expecting strong bookings in Q1, as I said, with a book-to-bill above one resulting in record backlog at the end of the quarter. So while we expect a challenging environment to continue in the first half, we believe our backlog and expected bookings in each one will position us well heading into H2 and into fiscal 24. Over the next five years, we expect strong top line growth as well as margin expansion consistent with our target model. With that, I'll now turn the call back over to Mark.

Thanks, Mike. Turning now to slide 13. The timing challenges that we've experienced the past two years are likely to continue at least through the end of fiscal 23 as we see it today. That said, the demand environment remains strong, and we believe that strategically, Mercury could not be better positioned. We're entering fiscal 23 with record backlog and strong new business momentum as expected. We believe this positions us to deliver another year of double-digit bookings growth and a positive book-to-bill, with revenue exceeding $1 billion for the first time, while maintaining strong margins. Our five-year outlook remains intact. We expect increased defense spending through this period to positively impact the business. We're well positioned to continue benefiting from the effects of increased electronic systems content, supply chain delayering and reshoring, and increased outsourcing at the subsystem level. We believe the supply chain constraints and inflationary pressures that we're facing today are short-term in nature. Mercury's fundamentals are strong and with impact should improve over time. Executing on our long-term strategy over the past decade, we've improved margins while growing the business organically, supplemented with disciplined M&A and full integration. As a result, we've created significant value for our shareholders and expect to continue doing so. We've also added depth to the board. Continuing in that vein, I'd like to welcome Mercury's newest directors, Howard Lance and Bill Bauhaus, who were elected to the board on June the 24th. In closing, Thanks once again to the Mercury team for your outstanding work and contributions. With that, operator, please proceed with the Q&A.

Thank you. If you would like to ask a question, press star and then the number one on your telephone keypad. We ask today that you limit yourself to one question. Thank you. Your first question comes from the line of Pete Skibitsky with Alembic Global. Your line is now open.

Hey, good evening, guys. I see. Guys, if we think about, you know, fourth quarter, top line, fiscal 23 revenue guidance, can you talk maybe about, you know, quantifying what part of the headwind is labor-related, what part is supply chain-related? And then just maybe, you know, are you seeing it across all of your, you know, hundreds of programs, or are there, you know, a few key programs, sizable programs that are being unusually impacted?

Sure. So why don't we kind of give the high level and then maybe Mike can kind of fill in some of the details, Pete. So at a high level, you know, we saw, you know, greater than $35 million, you know, impact on bookings. You know, the two probably biggest impacts were around the F-18. And then, you know, we also saw that CWIP kind of slipped out of the quarter into Q1. You know, revenue, I think as Mike said in his prepared remarks, It was really due to two things. It was largely due to some of the order delays where we were actually expecting the order and to be able to recognize some revenue. See what's a good example of that. The product was built. But then, you know, also, you know, we absolutely saw, you know, some supply decommit. So we're expecting material that ended up not arriving as we'd anticipated. So, Mike, I don't know if there's anything that you'd like to add there.

Yeah, so Mark said it great. Just in terms of numbers, as we look at the impact on fiscal 22 associated with the award delays, we estimate that that was about $22 million. And then the supplier decommits and extended lead times about $20 million in terms of the revenue impact in fiscal 22.

Okay, and are you thinking, I'm sorry, and are you thinking kind of 50-50 also for fiscal 23?

So in fiscal 23, when we look at those two things, what you'll see is that, and we talked about in the prepared remarks, is that it's more about timing during the year And so what we're seeing is that the award delays that we've had this year and the supplier decommits are leading to a lower H1 from a revenue perspective and a margin perspective because of a mix of business and a bigger H2. So we're really looking at it as a fiscal 22 impact right now.

So, Pete, I'd just like to add, though, I think it's an important point, right? So we clearly saw a... pretty substantial ramp in bookings in the second half. We thought that was going to occur. We did get some impact, as I mentioned, just with some orders that didn't arrive. The good thing is that the actual demand environment and order flow remains pretty strong. We're actually expecting very strong growth in bookings in the first half. which should actually help improve the linearity as we head into fiscal year 24. So unfortunately, if you step back, we're kind of in a multi-year industry event here, and the linearity of bookings in both fiscal year 21 and fiscal year 22 hasn't helped us with respect to the timing of revenue and EBITDA. So we're trying to take that into account as we head into the new fiscal year, just given the challenges that the industry is experiencing. But overall, I think we're seeing some improvements around bookings, which we believe is going to help not only in H2, but also next year as well.

Very unusual times. And if I could ask just one last one. We've had this CHIPS Act passed, but even separate from that, Are you guys able to identify additional semiconductor capacity coming online in kind of the near term that could address the shortages that you've had, or at least lessen the impact?

It's a great question, Pete. I think, as I said in my prepared remarks, as one of our customers said on their earnings call, it's hand-to-mouth right now. It's pretty challenging. For high-end semiconductors, the lead times are 36 to 99 weeks. To put that in perspective, that's three to five times what we saw pre-pandemic. And that's just for the high-end semiconductors. But the increases in the lead times have gone up across mechanicals, components, interconnects. I mean, literally it's across the entire supply chain. The CHIPS Act won't help in the short term, right? I think it's a strategically and critically important piece of legislation for the nation. Yeah, but that's really about how do we actually bring back, reassure, you know, the chip manufacturing capability to make our supply chain more resilient. And it's very clear with what the industry is facing right now that that's the right thing to do. But it won't help us in the short term. So I think it's going to take some rollover in demand in the semiconductor space to really loosen up the challenges around availability. I think we're already starting to see some of that in certain parts of the semiconductor market. So memory is generally more available. than what it has been in the past. You know, you're seeing some freeing up of supply around lower-end semiconductors associated with, you know, consumer electronics. Unfortunately, that doesn't really help mercury because, you know, we are producing very sophisticated processing subsystems, which is where we're still seeing the tightness and the very long lead times. So, you know, I think as the economy starts to slow down And as you start to see some demand soften, I do think you'll start to see, you know, some pickup in terms of availability. What we've also seen in the past is that when there is a scarcity, you know, a lot of companies, you know, over-order, you know, because they're concerned about the ability to actually get access to the parts. And so, you know, we're hoping somewhat that, you know, as demand starts to slow, you know, the effects of, you know, the limited supply could actually turn quite quickly. But as we see it today, you know, we don't see it, you know, that occurring, you know, and we just don't have the visibility piece.

All right. Fair enough. Thanks for the call, guys.

Yeah.

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

Hey, thanks. Good afternoon, Mark and Mike. Mike, just to clarify, come first. Did you expect to be free cash flow positive this year? And then Mark or Mike wants to make a comment. Trying to understand just the dynamics a little bit that's going on with your unbilled receivables. You talk about 60% of kind of overtime revenue and getting back to 35%. What are some of the key things we need to see to begin to see it happen? Is it just availability of the supply chain? Maybe if you could just walk us through a little color, that'd be helpful.

Yeah.

So, Pete, let me start with your first question in terms of free cash flow. So, coming into the year, we weren't facing the same number of supply chain issues that we're facing today or that we did face during the year. If you look at fiscal 22, our free cash outflow was $48 million. Now, we invested in the business. We had about $27 million of one-time costs really associated with impact and some of the org redesign that we did. And I mentioned some of the other one-time costs in my prepared remarks. But the biggest impact by far has been the supplier and contracting delays, which we estimate was probably about an $80 million impact on our cash flow during the year, in addition to those one-time costs that I just mentioned. So, you know, coming into the year, we didn't expect that working capital increase that was really driven by the supply chain and the contracting delays that I mentioned. And that really shows up in Unbuilt. to answer your second question in terms of unbilled and making sure that I clarify the percentages that we've talked about. So if you look at our overtime revenue, it has increased since fiscal 20 from 27% to 55% in fiscal 22, so this year, and the 60% that you mentioned was our Q4 overtime revenue or percentage of completion revenue. And that's related to our subsystem work. And that's a natural growth as we do more subsystems consistent with our customer base. When we look at the what's the right metric for unbilled, how do we size it and say, you know, what's the right amount of unbilled? Because we're naturally going to have some. The way we look at that is the percentage of our overtime revenue. And so if you look back from fiscal 19 to fiscal 21, you'll see we averaged around 35%. And in fiscal 22, that number went up to 43%. And that's what you're seeing because of the supply chain delays. which delayed milestones, which delayed deliveries. And that's the number that as we look at normalization of our working capital, we're really going to drive down. And so that 43% that we ended the year with in 22, we think a good target is 35% over time. And we think that'll unwind in fiscal, a little bit in fiscal 23, more in the second half, and then heading into fiscal 24. Okay.

Mike, do you just want to touch around? Mike, do you sort of touch on that? I think the second part of the question was around, you know, do we expect positive free cash flow in 23?

Yeah. I'm sorry about that. Yes, we do. We talked about 30 to 40 percent free cash flow to adjusted EBITDA conversion for fiscal 23. That's going to be second half weighted. As I mentioned in my prepared remarks, we are looking at an outflow in Q1, or as we were currently forecasting. But for the year, we are looking for positive free cash flow. And then that normalizes even further as we go into fiscal 24.

So just to clarify, so if we get into like fiscal 24 and say the supply chain availability is much better, then it doesn't necessarily mean a top-line story, but you could actually start seeing a lot of these unbilled receivables unwind. Is that the right way to think about it? Absolutely.

Yeah, and it's also inventory. So if you look at our, you know, in general and step all the way back, you look at working capital as a percentage of sales, you'll see that, you know, before – fiscal 21, and even in fiscal 21, we're around 40%. Prior to that, we're around 35%. This year on an LCM basis, we jumped up closer to 56%. And that's the combination of that higher unbilled as a percentage of overtime revenue, plus inventory, because as we've talked about, we invested in inventory to defray some of the risk associated with the supply chain. And we've seen inventory as we've seen increase as we've seen contracting delays. So, yes, you're absolutely right. The right way to think about it is, you know, as we get through fiscal 23 and then into fiscal 24, you should see working capital as a percentage of sales come down.

Appreciate the caller. Thank you.

Your next question comes from the line of Seth Seifman from J.P. Morgan. Your line is now open.

Hey, thanks very much and good afternoon. Guys, I just wanted to ask about the expected EBITDA in the first quarter and that kind of 13-ish percent margin, which even last year, which you would have considered kind of a tough quarter for profitability, was 17% to 18% margin. I mean, it would seem like that's implying something like a low 30s type of gross margin in the first quarter. Is that because of inflation? Is that because of mix? And to the extent that that is the case, how does that improve through the year? And does that imply some kind of exit rate that's higher than usual, or does it imply a quick step up in the second quarter?

Yeah, so you're right. When we looked at Q1, revenue 215 to 225 is the guidance range. We don't guide, as you know, we don't guide gross margin, but we were 39% in Q1 of 22. We're going to be, and I'm Mix is going to shift, Seth, so don't necessarily hold me to this, but we're going to be about 300 basis points lower in Q1 this year than Q1 last year. So around 36% is what we currently expect. So your number is right. And so, you know, what's driving that? It is two things. First is the result of production slips. So revenues lower and gross margins are down because of the engineering work that we're looking at in the first half of the year is lower margin. And the reason for that is that the production work where we're waiting for supplies has gotten pushed to the second half. So that's one part of it. And the second part is inflation. We've tried to... take into account in our guidance some of the inflation that we won't be able to pass through. We have at least 100 basis points impact from inflation in those gross margins, but we're trying to manage that through impact and other initiatives. So, yeah, so gross margin is down about 300 basis points, and then EBITDA is down 400 basis points because we were 13% at the midpoint of our Q1 guidance. Now we're 17% in Q1-22. about 300 basis points from the gross margin that I just mentioned. And the other 100 that's associated with the negative operating leverage and labor inflation is the other piece of it. So that is what's driving Q1. As you look at the year, Seth, we are going to see a gradual increase in gross margins throughout the year. So while we're, I just mentioned 36%, or that's what we're estimating for Q1. We expect that to ramp up, probably be relatively similar, maybe a little higher in Q2. But then in the second half of the year, we have good visibility, as I said in my prepared remarks, to the programs that are going to make up the revenue in the second half, and therefore the margins on those programs too. So we see a nice margin mix in the second half of the year, seeing it closer to you know, 42%, 43% gross margins, then you also benefit from operating leverage because of the higher revenue in the second half.

If you step back, you know, Seth, it's literally, you know, what, you know, I said big picture earlier. The bookings, really, the last two years have been heavily weighted to the second half of the year. So we had a massive ramp in H2 this year. But with that, the timing of those orders combined with long lead times on the materials, even though we've pre-purchased inventories wherever, we have a strong conviction that the orders and the timing are going to come in. push the production revenue and EBITDA to the right. So it's not like we're losing anything. We're not. But from a timing perspective and the mix of business, it's skewed towards the back half of the year, like it was in fiscal year 22. Now, as I mentioned in Pete's comment, the good thing is that we saw the ramp in bookings in the second half, and that ramp in bookings or that strength in bookings is actually continuing in the first half of this year, unlike last. So we are expecting, you know, pretty good growth year over year in the first half compared to what we experienced last year. So things do seem to be, you know, moving from an order flow perspective. But right now we are being impacted from a time and mix.

Got it. Okay. I'll stick to one. Thanks very much.

Yeah.

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

Hi, good afternoon. Can you maybe help us understand or provide a little bit more color on how quickly you can push through pricing and maybe how we should think about that margin progression over the course of that second half of 2023?

Yeah, it's a good question. The biggest area that we're probably seeing from an inflation perspective is in relation to semiconductors, which I think, as I've mentioned in my prepared remarks, account for about 38% of our external spend, and that's supporting the 70% of our revenue, which is coming from processing systems. So that's the biggest impact that we're seeing. The rate at which you can pass through the inflationary pressures, you know, varies, quite honestly. So it depends upon, you know, the mix of business, right, how much is cost plus versus fixed price, how much have you already got in backlog, you know, when those materials come in. You know, I can tell you, though, that we've got a, you know, a major focus on it, and it's been a big part of what we're doing with impact. multiple different areas. We're focusing on enhancing both the pricing side of things, our cost estimation, bidding proposal practices to ensure that we're adequately pricing the effects of inflation while looking at the commercial side of the business to make sure that we're capturing the value associated with the capabilities and the value that we're providing to customers. So Right now, we just implemented a standard commercial product price increase that was effective across our microelectronics portfolio beginning July the 1st. We narrowed the validity on quotes. We are controlling discounts. We have changed our contracts. modification authorities internally, you know, leveraging the new pricing tools that we put in place. So, you know, as we see materials, you know, we're able to actually immediately, wherever possible, you know, flow those actuals into our costs. So there's a huge amount of work going on. And, you know, we're actually expecting to offset, you know, a fair amount of the inflation that we're seeing in fiscal year 23, but maybe not all.

Thank you, I'll stick to one.

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

Hi, good afternoon, Mark and Mike. My first question here, just how do you view the discussions that are going on around the new $30 billion F-35 order? It's for around 375 aircraft, which is 22% lower than the last block buy. How would you expect that to impact mercury relative to maybe what you expected? And do you think you could have higher margins on that smaller production lot?

Sure. So let me kind of step back a little bit, Austin, and kind of just give a more general update on the F-35. Because I think to some extent it answers the question, but it's important to understand, you know, all moving parts. we're obviously aware of just the production re-baselining and kind of what's going on. As you said in the past, we're on multiple parts of the F-35 system across different parts of our product line. And although we experience a pretty substantial reduction in order flow in fiscal year 21 as a result of the TR3 development delays and the COVID impacts on manufacturing that resulted in the initial production rebaselining, things have improved substantially since then. Probably one of the more important ones for us is that as L3 Harris reported on their last call, they successfully completed all of the safety of flight testing requirements and delivered the first flight ship set of what is known as the F-35 TR-3 ICP. It's the core processor associated with the F-35. They previously reported that the other elements of the systems that were a part of, which is the panoramic cockpit display and the aircraft memory system, were also well down the path. Lockheed clearly was able to actually reach an agreement on locks 15 through 17. And so I think, to me, there were some very important events that occurred during our fourth quarter that I think are not only important for Mercury, but also for the industry as a whole. Stepping back and looking at the F-35 for Mercury at a year level, You know, we saw a very substantial rebound in orders as we'd expected. So our orders on that 35 were up 123% year over year, you know, with 24 million of orders in the fourth quarter. As we'd expected and discussed in our last call, we actually received the lot 16 long lead time funding as expected. following the initial award that we got in the first quarter of 22. That's important because it actually supports our revenue plan in fiscal 23. And right now, we're actually looking at a partial lost 17 ultra-long lead time award in the first half of the new fiscal year. Now, coming back to the question you asked, right, and the the potential or the reduction in terms of the number of units. I think there's another couple of things that are important to understand, in particular with Mercury. So we've been actually very successful winning new content on the program, actually expanding our content footprint with a couple of different customers in a couple of different census suites, both of which are moving. So following an initial award on one of them in the third quarter, we actually receive additional orders in Q4 that is resulting in us substantially taking share from a competitor and that will turn into future revenues and profits. On the other customer and capability, we've actually completed qualification testing and anticipate an initial order in fiscal 23. So some of those new design wins are actually coming online and are more than expected to offset any decline in terms of the unit count. So overall for us, I think the content and the ASP continues to grow. The other thing that I think we are obviously noting is that there's clearly some impact associated with what's just happened in the Ukraine. There's far more interest. in the F-35 from our NATO allies. The Czech Republic indicated its intent to acquire 24 aircraft. Greece is requesting 20, and there's prospective sales to Canada, Germany, Finland, and Switzerland, all of which could help actually offset some of the U.S. decline. Overall, I think we made a lot of progress. You know, the program's playing out the way in which we anticipated, and I think there's, you know, strong demand internationally.

Great. And then just a follow-up on the tracking where I know you'd mentioned the SDA constellation. You know, there's 200 satellites planned for the tracking where, 684 satellites planned for the transport where, 200 for the deterrence where, and et cetera. As some of these SDA constellations start to scale, do you perceive that this could maybe become a top 10 program or a more relevant program for Mercury?

I don't think it's going to hit the top 10 as we see it today, but we're obviously very, very pleased with the win. We're providing some of our space-qualified solid-state drives and I think there seems to be high interest in that particular area. So we'll see how the space market evolves for Mercury, but clearly we're thrilled to be a part of the tracking layer with one of our customers.

Fantastic. Thanks for all the details.

Your next question comes from the line of Michael Trimoli with Truist Securities. Your line is now open.

Hey, good evening, guys. Thanks for taking the question. Just to follow up on Jonathan's question, Mark or Mike, can you tell us what percent of revenues are under fixed price contracts versus cost plus versus maybe the more commercial catalog book shift where you can get immediate price increases?

Yeah, Mike, the vast majority of our programs are either commercial terms or fixed price. So from a cost plus perspective, that only is about 40 to 50 million of our fiscal 22 revenues of all 5% of the overall business. Commercial still counts for a lot of our pricing, probably 50% plus, probably around 60%. and then 35% is non-commercial firm fixed price.

So to go back to one of the things we spoke about last quarter, Mike, right, is the fact that we've actually got a relatively short sales cycle where our customers actually order capabilities from Mercury in line with our manufacturing lead time, probably the only time that a short cycle business assists with your ability to be able to pass on those inflationary pressures versus having multi-year agreements, which is really not the way in which the industry works for the sub tiers right now.

Yeah, I guess that's what I'm trying to figure out. If 50% is commercial, it seems like there's more of an outsized impact then for you guys on the inflation where you could be passing along or maybe I've got that wrong.

No, we are passing it through. So we're seeing bigger effects internally than, you know, I think than what we actually, you know, experienced last year in terms of margin degradation. And I think it's due to the fact that we're able to pass the prices on where appropriate, you know, as a commercial company or, you know, just given the short cycle nature of the business. But it doesn't mean that we're immune. Again, 38% of our external spend is related to semiconductors. And we're seeing 10 to 20% price increases, you know, across the board in the different categories. So then ultimately becomes a matter of timing. You know, when do you absorb those costs and how quickly can you pass them through? We do believe it's tempering.

Got it. And then just on impact, I think you guys had already recognized 27 million of, of incremental kind of savings, but now you're, you're pushing the 27. Seems like you're already at that low end. Any, anything really changing on that, that incremental adjusted EBITDA there?

So there, no, I mean, I think the 30 to 50, we believe is still a good number. Uh, yeah, I think if anything, The pipeline of opportunities associated with impact is increasing. We did push out the achievement of the goal a year, largely because I think we're seeing the impact of inflation at the back end of fiscal 22 and more so in fiscal year 23. But overall, I think impact should drive substantial margin expansion over the course of the next five years. If you want to add anything, Mike.

No, I think you hit on it. The only thing I would say is the fact that we launched impact slightly over 12 months ago means we're really well positioned to face the headwinds that we've got. So while we're delaying things, I think we're in a good position to offset some of the headwinds that we're seeing.

Got it. Thanks, guys. Appreciate it. Thank you.

Your next question comes from the line of Sheila Coagula with Jefferies. Your line is now open.

Hey. Good evening, guys. Thank you. Maybe if we could just summarize some of the comments from prior, whether it was Seth's question or Mike's just now. When we think about fiscal 23 margins, how much of that comes from inflation? I think you said 100 bps earlier versus volume and efficiencies and then development programs. And, you know, Mark, last time I saw you at a facility, your facilities are pretty good. So how much of the impact comes from those development programs and what are those programs and when do they transition into production?

Yeah, so Sheila, let me take a cut at that. In terms of inflation and how we've positioned that into our guidance, we have put some inflation headwinds into the guidance that we have. And one thing to remember is we're guiding right now in a very fluid environment with the macroeconomic headwinds. And we're trying to predict what's going to happen not just over the next six months, but over the next 12 months. So we're trying to be conservative on the impact of the, let's call it the unknown unknowns, that we try to consider in our guidance. But if you look at what's in our plan, we do have about 100 basis points associated with inflation and pricing that we won't be able to pass through, as we just talked about with Mike. We're using everything we can on our impact initiatives to pass that through, but that's currently in our guidance. The rest of it really is around program mix, and that goes to what we were talking about earlier, which is a lot of the production programs that we have are pushing production into the second half of this fiscal year or into fiscal 24. But we've got growth programs. We've talked about ANCS in the past, which is still in the development phase, that in fiscal 23, that's still in the development phase, probably goes to production sometime in fiscal 24. We've got other programs, within our microlead business. We've got a classified space program that's in development that will go into production in fiscal 24 and a handful of programs like that. F18, parts of F18 that we're doing are currently in development in the higher margin production board. In that case, it's towards the second half of 23. So a handful of things that are driving the lower margin in our guidance. Inflation is part of it, but then the program mix is another part of it, which was impacted by the supply chain and contracting environments, so things were pushed to the right.

Let me just step back a little bit, because I think, yeah, obviously there's a whole bunch of things hit the industry this quarter, and To me, it feels like we're in the midst of a multi-year industry event that was precipitated by COVID. Clearly, I think we're all being measured in terms of what happens on a quarterly basis. But if you step back, we're actually, given the guidance that we've just given, we're heading into actually our fourth fiscal year of dealing with the primary and the derivative effects of COVID. And actually, each year is had a really somewhat distinct set of characteristics that have actually affected the subsequent year. And so given the relative short cycle nature of our business versus our customers and the size of their respective backlogs, the effect may not always be as readily apparent depending upon the time frame. And so it's pretty complex what's going on when you step back from it. But I think we're clearly seeing the effects now moving its way up the industry. The supply chain disruption that hit the industry pretty hard this quarter, the seas of that were so many quarters previously. It was just hard to see and even more difficult to forecast. So we began to see the effects of that in our fiscal year 20, 21, sorry. We got through the initial phase of the healthcare crisis phase of COVID in 20 pretty much unscathed, but we did see the effects of the order slow down in 21. We had a 0.95 book to bill. That obviously affected the revenue and the profits associated with 21. And we're now clearly seeing the uptick in bookings in 22, but it was back half weighted. Bookings for the year were up 33%. For the second half of 22, and for the year as a whole, we're up 21%. As I mentioned before, we're actually expecting a strong bookings cadence in the first half. And our customers just had a very strong book to bill. So it's clearly not a demand issue. But we started to see the effects from a supply chain perspective in the second quarter, and it's kind of, you know, it's continued throughout the year. We also saw the effects of the great resignation, meaning it was harder to actually find the right engineering and manufacturing talent that we needed, you know, to continue to grow the business. And those challenges, I think, became, you know, more... More of an issue is the year progressed, and I think that's what you're clearly seeing in the industry right now. We saw, begin to see the effects of inflation in the fourth quarter, and as we're now heading into the full year 23, we're expecting a greater effect. So I think given the fact that we're guiding for the full year and given how this is a multi-year effect, we are somewhat more conservative in our outlook just given everything that's going on. There are a lot of unknowns right now that we feel that we need to take into account. So they're temporary. They're short-term, we believe, and the outlook looks great going forward, but clearly the industry's been impacted.

Okay, great. Thank you so much.

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

Okay. Well, thank you very much, everyone, for joining us. We look forward to speaking to you again next quarter. Take care. Bye-bye.

This concludes today's conference call. Thank you for attending.