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spk00: Good day, everyone, and welcome to the Mercury Systems first quarter fiscal 2023 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.
spk05: Good afternoon, and thank you for joining us.
spk06: 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 Aslan. Please turn to slide three.
spk08: 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's bookings increased 34% year-over-year in the first quarter, following 27% growth in Q4 of fiscal 22. Actual results in the quarter exceeded the high end of our guidance across all metrics, and we're raising the low end of our full year outlook as a result. The largest bookings in the first quarter were LTAMs, the SDA tranche tracking layer, and AMCS. We also received the F-18 and Seaward Block II orders that moved from Q4. Driven by strong Q1 bookings, our book to build was 1.17 in Q1 and 1.14 over the last 12 months. Backlog grew 22% year-over-year. This backlog, combined with strong bookings expected in Q2 and for the remainder of the year, positioned us well to deliver increased revenue in EBITDA in Q2, and the second half of fiscal 23. Our results for the first quarter reflected the second half weighting of orders in fiscal 22, together with continued order delays, long semiconductor lead times, and other supply constraints. Q1 is also typically our seasonally weakest quarter. Total revenue increased 1% year over year. Organic revenue was down 4%, a far better result than Q1 last year. We expect organic growth to turn positive in the second quarter. Our largest revenue programs were F35, LTAMs, Aegis, F18, and CWIP. Q1 adjusted EBITDA was down 19% year-over-year as expected. This was driven primarily by the second half weighting of orders in fiscal 22 and program mix. We expect margins to increase in Q2 and as the year progresses. Free cash was an outflow of $73 million, which we believe will be the low watermark for the year. This primarily reflected order delays and supply chain disruptions that affected the timing of collections in the quarter, as well as purchase of raw materials to support future revenues. In addition, we saw customers unusually holding payments at the end of the quarter. We expect free cash flow to improve substantially in Q2, and grow through the second half of fiscal 23, resulting in positive free cash flow for the year. We continue to see high levels of new business activity. Designs within Q1 total more than $135 million in estimated lifetime value. Turning to slide four, Q1 marked the beginning of Mercury's fourth fiscal year dealing with the effects of the pandemic. In the near term, our business and the industry will continue to face challenging macro forces. However, it's clear that the issues impacting us today are not demand-related. They're supply and timing related, they're short-term, and they're not unique to mercury. We're executing our plan to control what we can, and we're optimistic about the future given our positioning. After several years of COVID-related challenges, we believe that we've entered a multi-year period of accelerating growth and profitability, similar to the period post-sequestration in 2013. Reflecting back to the beginning of the pandemic, Mercury's fiscal 20 was the healthcare crisis phase. We navigate this period well with minimal impacts on our employees, operations, and financials. Bookings, revenue, and adjusted EBITDA will up more than 20% year-over-year, In fiscal 21, we saw a COVID-related slowdown in orders. Bookings didn't grow as much in the second half as we anticipated, declining nearly 8% for the year. Our book-to-bill fell to 0.95 from the prior year's 1.2, the lowest in more than a decade. Revenue still grew 16% year-over-year, and adjusted EBITDA was up more than 14%. In fiscal 22, we saw the full effects of COVID beginning early in the year. The Delta variant reduced our manufacturing productivity, and the defense budget was delayed 165 days. We experienced significant semiconductor supply chain disruptions and high retrition, as well as inflation, all magnified by the prior year's order slowdown in the second half. As a result, total revenue grew 7% in fiscal 22, less than we had anticipated. Organic revenue declined 5%, and we ended the year with adjusted EBITDA margins roughly flat. Supply chain disruptions had an outsized impact on H1-H2 linearity. Working capital investments increased as the year progressed, with free cash flow turning negative as a result. However, bookings rebounded strongly in FY22, growing 21% year-over-year, leading to a 1.08 book-to-bill and crossing $1 billion for the first time. Most of this rebound occurred in the second half, with bookings growing 33% versus H2 of the prior year. This order timing, coupled with dramatically longer semiconductor lead times, is resulting in our fiscal 23 financial performance, also being more back-end loaded than we experienced pre-pandemic. Unlike last year, however, bookings in fiscal 23 are off to a great start. We expect faster growth in the second quarter and the first half to be much improved versus H1 of fiscal 22. This sets the stage for strong full-year bookings and a positive book-to-bill. We believe that Q1 marked the bottom in fiscal 23 for organic revenue growth, free cash flow, and margins. Given the strong order flow, we anticipate a return to organic growth in the second quarter and for fiscal 23 as a whole. We expect to deliver stronger earnings and positive free cash flow, as well as improved working capital efficiency over time as the supply chain headwinds subside. As I said earlier, what Mercury has experienced since the start of the pandemic is much the same as sequestration nearly a decade ago in terms of the multi-year impact on our financial results. The enhancements that we made in the business at that time led to accelerated growth and value creation over the next five years. For fiscal years 13 through 18, Mercury ranked second and first among our Tier 2 defense peers for compound annual growth in revenue and adjusted EBITDA, respectively. Similarly, through impact, we're strengthening our business fundamentals once again. Looking forward to fiscal 24, we believe that lead times for high-end semiconductors will begin to improve in the second half. We've already begun to see a shortening of semiconductor lead times on the low end. We expect stronger bookings and organic growth, continued margin expansion, and greatly improved free cash flow as we release working capital. all of which should position us for further growth and value creation as we move forward. Turning to slide five, we believe today's geopolitical environment is the most challenging since the Cold War. The risks related to China and Taiwan are potentially more significant than what we're experiencing today with Russia and Ukraine, and the timeline is moving to the left. The semiconductor industry and the defense industrial base in Europe and the US are not what they need to be to build the military stockpiles and the new capabilities required in this threat environment. We appear to be heading into a super cycle in US and allied defense spending. The challenge, however, for both the government and the defense industry is clearly on the supply side. whether it be the availability of semiconductors and other materials, labor, or now inflation. In the near term, the industry is dealing with an ongoing shortfall in government contracting personnel. We're also beginning the new fiscal year under a defense budget continuing resolution. This means the contracting environment will likely remain challenging in the short term. We're not expecting a defense appropriations bill until after the midterm elections. On a positive note, once that bill is passed, the GFY 23 budget is currently expected to increase year over year. That said, given inflation, the real defense spending and buying power increases could be far less. So overall, the demand environment is strong and appears to be getting stronger. Although the industry is dealing with headwinds, we believe that they're temporary. We expect to see a shift to tailwinds as defense spending grows and supply chain conditions improve. Turning to slide six, at the mercury level, the supply chain environment remains challenging but stable. Although we're still seeing supply delays and isolated quality issues, we're experiencing fewer supply decommits compared with Q4. Lead times overall have not increased, but it's still extremely long for high-end semiconductors. Mercury's sophisticated end-to-end processing platform powers some of the most critical AMD missions. High-end processing represents about 70% of our business, and it's where Mercury likely has the largest opportunity to grow over the next five years. It's also where the global supply chain has been most disrupted. High-end semiconductors are at the heart of many of our offensive and defensive weapons systems and have rapidly become the long lead time for defense development and production. Prior to the pandemic, semiconductor processor lead times were 10 to 12 weeks. They increased rapidly in the second half of fiscal 21 and now range from 52 to 99 weeks. Putting this in perspective, This means that high and semiconductor material orders that we're placing today support revenues in our third and fourth quarters of fiscal 24. It's not until this point that we believe that lead times and availability will begin to improve. Throughout this multi-year period, we've used the strength of our balance sheet to invest in working capital to mitigate supply chain risk as best we can. positioning Mercury to deliver stronger and more consistent results over time. When the supply chain conditions normalize, we expect a significant release of cash related to inventory and unbilled receivables from our balance sheet. We also continue to deal with semiconductor-related inflationary pressures. Semiconductors equate to 38% of our direct supplier spend, far more than our peers, we believe. We've taken aggressive steps to maintain the strongest possible margins in this environment, and they're working. These include repricing standard products and incorporating price adjustment mechanisms in our rates-based businesses and multi-year proposals. We've also shortened the validity of our quotes to capture any near-term inflationary effects. Given the short cycle nature of our model, it's likely that the impacts of supply chain inflation will begin to diminish over time as these actions result in more of the business being priced at market rates. We're making good progress in managing the industry headwinds through our impact program. Much like our approach to sequestration, we're laying the foundation for Mercury to achieve its full growth and profit potential over the next five years. We've seen tremendous changes since we launched impact at the beginning of fiscal 22. We began by simplifying and streamlining our organizational structure and strengthening the leadership team, and we continue to do so. Mitch Stevenson, our former chief growth officer, who joined us from Raytheon 12 months ago, recently took the helm as president of our processing division, which accounts for approximately 70% of total company revenue. Mitch knows Mercury well and has hit the ground running in his new role. We also focused impact on margin expansion initiatives in fiscal 22, and we're now pushing their execution deeper into the business. Effective October the 3rd, Alan Couture joined us to accelerate these efforts as our Senior VP of Execution Excellence. Alan was previously at Raytheon in their Missiles and Defense Division. He'll be responsible for supply chain, operations, engineering, and program management reporting to me. we're pleased to welcome Alan to the team. As the environment became more challenging in fiscal 22, we pivoted the impact towards those areas that could help mitigate risk and deliver the most immediate financial benefits. This year, in addition to pricing, we continue to focus on supply chain risk mitigation, working capital burndown, and accelerated cash release. Another initiative is R&D investment efficiency and returns, building on the progress last year. Our digital transformation initiatives and engineering operations will help improve our cost structure and performance over the long term as well. We're also making good progress in our facility footprint strategy. In Q1, we consolidated two engineering teams and a new center of excellence in Fremont, California. We're on track to consolidate our Mesa, Arizona facility into the Phoenix site in the second quarter. And we expect to release two additional buildings in California by the end of fiscal 23. 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 environment continues to be active and will remain focused on our existing M&A themes. With that, I'd like to turn the call over to Mike. Mike?
spk06: Thank you, Mark, and good afternoon again, everyone. As usual, I'll start with our first quarter results and then move to our Q2 and fiscal 23 guidance. As Mark has discussed, Mercury's first quarter results exceeded our guidance across all metrics, despite the supply chain and inflationary headwinds. Exiting Q1, from a demand perspective, we have excellent visibility into Q2 and the second half. As a result, we're raising the low end of our fiscal 23 guidance and expecting a cashflow positive year. Turning to our Q1 results on slide seven. Bookings were 267 million, up 34% compared to Q1 22. Our book to bill was 1.17 compared to 0.89 in Q1 22. For the last 12 months ended Q1 23 Our book to bill was 1.14. The rebound in our book to bill indicates the positive demand environment. Our backlog at the end of the quarter was a record 1.08 billion, up 22% from Q1 22. Our 12-month backlog was up 25% compared to last year and up 7% compared to last quarter, providing us good visibility into the remainder of fiscal 23. Coupled with bookings on key programs that we expect to receive in Q2, we're optimistic about our results for H2 and the full year. Revenue in Q1 increased 1% year-over-year to $228 million, exceeding the top end of our guidance of $215 to $225 million. Organic revenue was $216 million, and acquired revenue, which included AvalX and Atlanta Micro, was $12 million. Gross margins for Q1 were down approximately 500 basis points year over year. As expected, we had a smaller proportion of higher margin production revenue in the quarter. Q1 gross margins also reflected material and labor inflation. As we move through fiscal 23, we expect to see higher gross margins as a result of program MIPS in a gradually stabilizing macroeconomic environment. Adjusted EBITDA for Q1 was 31.2 million. above our guidance of 27 to 30 million. Our adjusted EBITDA margins were 13.7% for the quarter, down 330 basis points from 17% in Q1 fiscal 22, primarily driven by gross margins. Adjusted EBITDA margins exceeded our Q1 guidance range. As I'll discuss shortly, free cash flow for the first quarter was an outflow of approximately 73 million. This was primarily due to award timing and continued supply chain disruption. We also observed delayed payment behavior across our customer base. Slide 8 presents Mercury's balance sheet for the last five quarters. Our balance sheet remains strong with significant capacity under our $1.1 billion revolving credit facility. Driven by the anticipated strong cash flow generation in H2, we expect to be well positioned to de-lever the balance sheet while continuing to invest in the business. We ended Q1 with cash and cash equivalents of $52 million and approximately $512 million of debt funded under our revolver. The sequential increase was primarily related to the free cash outflow. During the quarter, we swapped $300 million of our floating rate debt to fixed rate. We now have fixed SOFR at 3.79%. At our current leverage levels, that implies approximately 5% interest on a majority of our funded debt, which positions us to continue to allocate capital at attractive rates. As a result of the macroeconomic environment, over the last five quarters, we've invested approximately $250 million in working capital to support performance obligations to our customers and ensure delivery on critical programs. This investment primarily consists of accelerated material purchases to mitigate the risks associated with the supply chain volatility and contracting delays that Mark discussed. This has resulted in increased unbilled receivables and inventory. The majority of these material purchases are for programs that are aligned with the DoD's strategic priorities and on which Mercury is a sole source supplier. As supply chain conditions normalize and our customer performance obligations are completed, We expect unbilled receivables and inventory to convert to cash and decrease substantially as a percentage of annualized sales. Turning to the specifics, accounts receivable in Q1 were $495 million, a $47 million increase from Q4 22. Within that increase, billed receivables were up approximately $20 million, primarily as a result of customer payment behavior. Unbilled receivables increased approximately 27 million. With our intentional strategic shift to more integrated subsystems, which meet the criteria of overtime revenue recognition, our unbilled receivables have naturally increased. At the same time, macroeconomic conditions across the contracting environment, supply chain, and to a lesser extent, labor market are impacting our ability to complete program building milestones and putting further pressure on unbilled receivables. We continue to take a disciplined and proactive approach to unlocking unbilled receivables, including negotiating legacy contract terms to incorporate progress or performance-based payments. We're including these payment structures in all new contract awards. We expect these actions to drive unbilled receivables down as a percentage of annualized overtime revenue throughout fiscal 23 and fiscal 24. Inventory increased approximately $17 million in Q1-23 compared to Q4-22. High-end semiconductor lead times ranged from 52 to 99 weeks, as Mark discussed. We continue to lean forward on accelerating raw material purchases to support customer delivery schedules and mitigate supply chain risk in future quarters. Additionally, as with unbilled receivables, shortages in key parts have hindered our ability to deliver finished goods to our customers. We're working with our supply partners to accelerate deliveries of key components in order to deliver finished goods to our customers. Turning to cash flow on slide nine, last quarter we forecasted a free cash outflow in Q1, driven by lower net income, one-time payments, as well as working capital build associated with continued supply chain constraints. However, the outflow was larger than expected at $73 million. primarily due to customer contracting delays within the quarter. Reflecting the proximity of award receipts to quarter end, expected billings and cash collections in the quarter were lower than expected. We expect a majority of these Q1 delays to result in billings or cash collections in Q2. We also observed delayed payment behavior across our customer base in Q1. With payments due as of quarter end, not being paid until the first weeks of Q2, resulting in an increase in billed receivables. Although it wasn't used in Q1, we've put an accounts receivable factoring facility in place to address this in the future if necessary. As Mark said, we believe Q1 was the low point of fiscal 23 free cash flow. We expect free cash flow to improve in Q2 and grow through the second half, leading to positive free cash flow for the year. Looking forward, we believe that our financial results for fiscal 23 will reflect the early impacts of a potentially substantial longer-term release of working capital from our balance sheet, especially as the supply chain headwinds subside. On an alternative to our financial guidance, starting with Q2 on slide 10, forecasting the current environment remains challenging. Our guidance incorporates, to the extent we can, potential impacts associated with ongoing supply chain constraints and material and labor inflation, as well as a continuing resolution in the midterm election year. For Q2, we currently expect revenue in the range of 225 to 240 million. This is approximately 6% growth at the midpoint compared to the second quarter last year. We currently expect gross margins to increase from Q1 So we continue to be cautious with regard to supply chain variability and material inflation. In the second half of fiscal 23, we expect gross margins to increase as we complete several of our lower margin development contracts. The revenue growth in H2 is expected to be driven by higher margin production programs. We expect adjusted EBITDA for Q2 to be $38 to $42 million, representing 17.2% of revenue at the midpoint. This is approximately 350 basis points higher than Q1 and in line with Q2 fiscal 22 actual market. For Q2, we currently expect free cash flow to be near break even to slightly positive, with Q1 marking the low point in fiscal 23. I'll now turn to our guidance for full year fiscal 23 on slide 11. In Q1, the team worked to mitigate risks within our control. resulting in mercury exceeding the high end of guidance. Our updated full-year guidance builds on the Q1 overperformance, but remains cautious based on our risk outlook for the remainder of the year. The near-term outlook for the industry and the macroeconomic environment remains far from certain. However, the demand environment continues to improve, and we believe our strong Q1 will be, in retrospect, mercury's low point for organic growth and margins in fiscal 23. As a result, we're raising the low end of our previous guidance for revenue and adjusted EBITDA for the year. Driven by 34% year-over-year bookings growth, we ended Q1 with a 12-month book-to-bill of 1.14 in record backlog. For fiscal 23, we expect double-digit growth in bookings and improved bookings linearity, leading to continued growth in our backlog and greater visibility to our forecasted revenues. We also expect a positive book to bill for the year. From a revenue perspective, we now expect total company revenue of 1.01 to 1.05 billion in fiscal 23. This represents 2% to 6% growth year over year and approximately flat to 4% organic growth. While this organic revenue guidance is still below our target business model, we're beginning to see the rebound driven by the strong bookings momentum over the last 12 months. We continue to expect fiscal 23 to be second half weighted. Based on the midpoint of our guidance ranges, we expect approximately 45% of revenue in H1 and 55% in H2, with organic growth accelerating in H2 and into fiscal 24. As I mentioned, our current backlog and expected Q2 bookings should provide strong visibility and backlog coverage as we enter H2. Adjusted EBITDA for fiscal 23 is expected to be in the range of $202.5 to $215 million, up 1% to 7% from fiscal 22. Adjusted EBITDA margins are expected to be approximately 20% to 20.5%. The increase in our EBITDA guidance for fiscal 23 is driven by Mercury's outperformance in Q1. Like revenue, we expect adjusted EBITDA and EBITDA margins to be heavily weighted towards the second half. As revenue ramps through the year, we expect an increase in gross margins and operating leverage to lead to adjusted EBITDA margin expansion. From a free cash flow perspective, we're targeting approximately 30% of adjusted EBITDA in fiscal 23. This estimate assumes the current R&D capitalization tax law is delayed or repealed. As I've said, we expect cash flow to begin to normalize in H2, driving improved conversion for the full year. With that, I'll now turn the call back over to Mark. Thanks, Mike.
spk08: Turning now to slide 12. We believe that Mercury couldn't be better positioned strategically. We entered fiscal 23 with a record backlog and strong new business momentum. We anticipate strong bookings, a positive book to build, and a return to organic growth. with revenue eclipsing $1 billion for the first time. We expect to deliver improved margins, better working capital efficiency, and positive free cash flow. This should lead to improved fiscal 23 results, positioning us for a stronger year in fiscal 24 as the supply chain headwinds begin to recede. Looking further ahead, our plan for the next five years remains intact. Mercury's fundamentals are strong and with impact should improve over time. Defense budgets domestically and internationally are poised for rapid growth. We believe that we're well positioned to continue benefiting from industry trends, including supply chain delaying and reshoring, as well as increased outsourcing at the subsystem level. We anticipate that a greater percentage of the value associated with future defense platforms will be driven by electronic systems content where Mercury participates. We're building the company we set out to create from a capability perspective, and our addressable market continues to expand as a result. This has been driven in large part by our strategic move into mission systems and the potential to deliver innovative processing solutions at chip scale. Our model, sitting at the intersection of high-tech and defense, positions us well. We believe that Mercury can and will continue to grow at high single-digit to low double-digit rates organically as the current headwinds diminish. In addition to organic and M&A-related growth, our five-year plan includes continued margin expansion driven by impact, leading to stronger adjusted EBITDA, as well as improved working capital efficiency and cash conversion. Executing a long-term strategy over the past decade, We've improved margins by 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. In closing, I'd like to recognize the entire Mercury team for a tremendous effort during these challenging times. My sincere thanks to all of you.
spk05: With that operator, please proceed with the Q&A.
spk00: Thank you. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. We ask today that you limit yourself to one question and one follow-up. Thank you. Your first question today comes from the line of Jonathan Ho with William Blair. Your line is now open.
spk03: Hi. Congratulations on the strong quarter. One thing I wanted to understand a little bit better is, you know, can you maybe help us understand how your pricing actions maybe flow through for the balance of the year and, you know, what that could mean in terms of, you know, either improvements to gross margins or on the cash flow side?
spk08: Sure. So we've done a fair bit, Jonathan. So, you know, as part of impact, we had two major initiatives, one related to where we set up a procurement organization and seeking to purchase things more efficiently. And then the second is that we set up a pricing team to initially be able to price our products more in line with the value that we provided. Both of those areas have actually ended up really helping to offset some of the inflationary pressures that we're seeing. And I think we're actually being pretty successful doing that. So in our microelectronics business, at the very start of the year, we actually did a pretty much an across-the-board price increase associated with our commercial products. And then in our non-commercial business, we have also pretty aggressively looked at passing on the costs associated with the inflationary pressures to all of our customers, as well as actually addressing contracts going forward to make sure that we're capturing the inflationary pressures on a go-forward basis as well. So, Mike, I don't know if you'd like to maybe comment further from a financial perspective.
spk06: No, I think you hit it, Mark. Jonathan, the only thing I would add is that as you look at our guidance, We do have some inflation pressure embedded in our guidance, but at the same time, as Mark said, we're working to offset that through pricing. So there is some in there, but we're mitigating a piece of it in our guidance as well.
spk03: Great. And then just as a quick follow-up, You know, when it comes to some of the customer behavior around payments, you know, do you have any concerns at all around collections quality or receivables? And, you know, when does that sort of maybe start to normalize in terms of the cash conversion? Thank you.
spk06: Yeah, so I'll take that one. So, Jonathan, no, we feel very good about the quality of the assets that are on the balance sheet and the collectability of both the unbilled receivables as well as the inventory. Because if you step back, the majority of that is material purchases that we've made for programs that are aligned with the DOD strategic priorities that were designed in on. And so it really is just a matter of time as the balance sheet unwinds once we deliver on those final performance obligations to our customers.
spk08: Hey Mike, let me jump in there because I think it's important to just kind of step back and really, you know, maybe delve into this in a little bit more detail. So, you know, most of the challenges that we've had, you know, from both the working capital perspective and cash flow are clearly due to the, you know, very challenging supply chain environment. And, you know, we expect that those challenges are actually going to continue throughout 2023. Yeah, we've seen some improvement. I think the in-quarter supply decommits have improved somewhat versus the fourth quarter, which we're grateful for. However, I think the challenge is still very much related to extremely long semiconductor lead times, particularly on the high end and the general scarcity of those devices overall. I think we're also seeing more rapid and frequent end-of-life for older devices, which is particularly challenging in the defense industry given life cycles, as well as now both material and labor inflation. And it's hit us probably more than most because 70% of our business is related to processing. So as a reminder, in fiscal 22, 45% of our business is actually recognized as point-in-time revenue recognition. Or put another way, when we recognize revenue, when we actually deliver the product, that's actually a much larger percentage than other companies in the industry. The remainder of the revenue recognition is really over time. And unfortunately, we don't get to choose what type of revenue recognition we use, it's really due down to the accounting rules that dictate that. So let me talk a little bit about the business model and why cash flow has been impacted so you really get a better understanding of what's going on and why in particular working capital is built and why we believe our cash flows have been impacted, but really on a temporary basis. So with point-in-time revenue, we typically purchase inventory to support future customer deliveries, and we get orders largely based on our manufacturing lead times, which for products have historically been quite short. The models actually work really well in the past and given us tremendous flexibility to deal with mixed changes and quarter-to-quarter revenue volatility. And it's also a reason why actually our guidance track record historically has been so strong. over many years because we've been able to actually absorb some of the bumps in the road from period to period. However, if I look back into 2021, 2021 is when semiconductor lead times quite suddenly and dramatically lengthened, which really disrupted our model as well as actually the whole industry. And, you know, unlike our customers and given our position in the industry, we typically don't receive multi-year rewards. So this became, you know, these lead times became a challenge for the industry last quarter, and it's clearly continued into this quarter as well. And it's a major reason that many of our customers' top and bottom lines have suddenly been impacted. The truth is, however, if you look at the, you know, what's actually happened, the seeds of this were so many quarters ago, you know, likely back in 2021 itself. It's just taken a little bit of time for it to actually show up. at the prime contractor level. So, you know, the approach of short-term duration contracts for lower tiers in the defense industrial base is really an artifact of defense industrial policy. And it's pretty clear that it needs to change if we're actually to build a resilient supply chain and industrial base as the industry moves more towards a war production footing. So back to mercury. The programs that we're buying inventory for are typically defense programs of record, where we're designed in and typically have sole source positions. These programs are usually in L-rate or full-rate production. And for these types of programs and products, we've definitely seen a build in inventory of semiconductor lead times dramatically lengthened during the pandemic. And we needed to purchase additional inventory way sooner than we normally would have to support our customer as well as our financial commitments. In addition, the semi-industry more rapidly ended like the older legacy components, which meant we had to stock up on those too. As others have commented this earnings season, semiconductor part shortages also held up planned product deliveries, which created more, you know, whip, inventory whips. So the cash consumption has largely been in raw materials and whipped, precipitated by the change in the semi-industry. Now, we view it as an investment in our future and that of our customers, but it's absolutely consumed cash. On the other side, related to unbilled or overtime revenue recognition, that's the remainder of how we recognize revenue. This is by far the most common type of revenue recognition in the industry and the default for many of our customers. Now, we've used this model, it being the correct accounting treatment, as we've been successful in winning larger subsystems business, which has really been a significant driver of growth in the business. And in this area, we're buying inventory, but we're pegging it to a specific program. The challenge here, again, has really been supply-related, including challenging supply quality, labor shortages, and the dramatically longer semiconductor lead times, as I just mentioned. Also, certain of our legacy contracts meant that we couldn't collect cash until we'd actually shipped the final units. And with the part shortages, we've ended up with partially built units that have also tied up working capital. So, you know, we believe that the cash tied up in inventory and unbuilt receivables should start to release over time, you know, dramatically improving our cash flow and conversion rates. Yeah, but we thought it was pretty important to really kind of dig down a level and just help people understand what's going on.
spk05: So thanks for the question, Jonathan. Thank you.
spk00: Your next question comes from the line of Sheila K. Uglow, WISP. Jefferies, your line is now open.
spk01: Hi, it's actually Scott on for Sheila, but Mark, you talked about some of the importance of M&A for kind of the impact initiative. I mean, given the movement in rates we've seen year to date, how has M&A environment shifted, and how are you kind of thinking about any change to the return profile you're looking at?
spk05: Yeah, Mike, do you want to take that one? Yeah, sure, Scott.
spk06: I think that, listen, we've definitely seen a move in rates over the last couple of weeks, months, and quarters. And, you know, it's impacted the industry. I think that, you know, when you look at valuations in the industry, just definitionally, based on higher discount rates, those could come down. That having been said, there are a scarcity of assets out there. And for good assets, I think that they're going to continue to garner good multiples, and we've seen some of that recently. I think from our perspective, we're just going to keep doing what we've been doing, and we're pretty disciplined in our M&A approach. We're very careful with the cases we're underwriting when we're doing our evaluations, especially in the environment that we're in right now with a lot of uncertainty. So I think that from our perspective, we've got to good capability when it comes to M&A. And as I mentioned in my prepared remarks, when you look at the revolver we have, the $1.1 billion revolver, it does give us a lot of capacity to focus on M&A at attractive rates when the time is right.
spk01: And then maybe just a quick follow-up on impact. You're over a year into it now. I mean, what successes have you really been able to point to? And are there any areas where it's maybe been a little more challenging than you had previously expected?
spk08: Yeah, so good question. So I think we've actually achieved a lot, right? So it began by us really simplifying, streamlining the business into the structure that we have today. We dramatically strengthened the leadership team. And then we set about really focusing on some key areas. One was procurement. We set up a centralized procurement organization to help us actually take advantage of the scale that we have today. We put in place an AI machine learning-based procurement tool that has actually paid huge dividends, you know, in this supply, challenging supply chain environment. We still have a pricing organization inside of the business as well, you know, to be able to, you know, price our products more appropriately. Now, those two items, you know, in the short term, have really helped to mitigate, you know, the 10 to 20% increases that we're seeing in, you know, semiconductor inflationary pressure So we've been able to mitigate that a fair bit. We've also, I think, done a fair amount of work looking at R&D investment efficiency, kind of going through project by project, eliminating any low return projects to be able to ensure that we're focused in the right areas. We've done a good job from an employee engagement and from a retention perspective. As you know, the labor market is very, very challenging. uh you know right now with the the great resignation and you know i think we've done a good job you know retaining our employees as well as being able to hire uh you know the people that we need to continue to grow the business we've also made substantial progress uh you know looking at our facility footprint you know i rattled off just a few of the uh you know the reductions in terms of the number of facilities that we've already done over the course of the last 12 months. And we've got several others that we expect to complete by the end of this fiscal year. Over and above that, I would say that we've done a tremendous amount of work on the digital transformation. We're just completing the rollout of a new digital manufacturing execution system. We are in the process of migrating our engineering tools to the Amazon Gulf High Cloud, which is going to give us better productivity, you know, and scalability and efficiency over time. And so, you know, so we've actually done a lot. Unfortunately, you know, I think we're not really seeing the benefits of what we've done just given the, you know, the challenges that we've seen around, you know, productivity and the supply chain, you know, which are linked. But over the course of the next five years, we do believe that we're going to see substantial margin expansion as well as substantially improved cash flow generation and yield.
spk05: Thank you.
spk00: Your next question comes from the line of Michael Chermoli with Truist Securities. Your line is now open.
spk02: Hey, good evening, guys. Thanks for taking the question. Nice results. Mark, I know you've spent a ton of time here on the free cash flow, but can you just, I mean, you've got customers holding back payments. And I mean, when I hear customers, I mean, are we thinking the prime contractors? I mean, I'm just trying to better understand what that dynamic is like. They're holding back payment and simultaneously you're investing in in inventory and working capital to support these programs, yet you're taking all the risk on your balance sheet with your cash flow while they're all basically buying back stock? I mean, how is that dynamic working among the customers?
spk08: Yeah, it's a good question. Let me kind of maybe touch on it at a high level, and I'm sure Mike will contribute. So we did see some holdbacks at the end of the quarter. So to give you an example, one particular customer paid us for two things, and then the third, which was also due, we got paid on the first day of the new quarter. So it's not like they're withholding for long periods of time, but we definitely saw some holdbacks at the end of the quarter. The other thing that affected us, Mike, was also just the timing of specific orders. And in particular, our three largest orders in the first quarter all ended up moving to the right and taking the revenue and the cash associated with those outside of the cash window. So it's a number of things that's going on. But look, I think the last two quarters at an industry level, Mike, in terms of revenue and top and bottom line, have been challenging overall. And I think we're seeing some changes in behaviors associated with that. So Mike, I don't know if you would like to maybe add to that.
spk06: Yeah, no, I think you hit on it. I mean, Mike, the only thing I would add is that The business models, and Mark has spent a good bit of time going through it, between us and our prime customers are different. And he just talked about that. We are doing things to change the dynamic, especially around unbilled receivables. So we're negotiating with customers now to get more favorable milestones and progress payments on new and existing programs. We've got updated processes internally. So we're trying to change the way we contract with customers so it's not all of our balance sheet being used to support these programs. And so that's why we think we're going to see some unwinding of the working capital here going forward.
spk08: Yeah, if you think of what we've done from a cash thing, there's five things that we're focused on, right? We're obviously looking to drive the cash conversion, burning down the unbilled receivables and inventory, but doing it in a way in which it doesn't put revenue execution and on-time delivery at risk. So for every action, there's usually a reaction. We have absolutely enhanced our demand planning processes. As part of impact, we put in place leverageable and scalable tools to drive the demand signal accuracy and much earlier identification of the commitments that we need to make on materials or to focus in on those part shortages given the unprecedented lead times. The third thing that we've got a major focus on is on negotiating milestones with customers. And, you know, it's part of the issue that we've had, you know, in some of the legacy contracts is when we've shifted towards the subsystems revenue, we didn't necessarily have milestone or performance, you know, or progress payments. We're now going back and making sure that we got those all, you know, in the commercial side of the business, we're actually getting cash up front. We're also prioritizing the labor resources to make sure that, you know, we can actually liquidate those unbuilt balances as well. Labor is critically important, right? So I think we're very much, as I mentioned, as part of the impact conversation, you know, focused on retention and resourcing, you know, to ensure that we're actually mitigating any execution challenges, you know, related to shortages and staffing. And then finally, I think over the longer term, you know, as we're moving up, you know, the, the industry and the value chain, uh, and going after much larger proposals that we've, that we've done in the past, we're very much focused on strengthening our bid proposal and capture processes, uh, to dry, you know, better terms and protections from mercury in the future. So we're all over it. Um, and, you know, I think as Mike said, you know, we think that the, the, uh, The cash flow is bottoming in Q1. It should improve in Q2 as the year progresses.
spk02: Got it. That's helpful. And just one quick follow-up on related. On the budget dynamic and the continuing resolution, do you guys, your kind of internal planning, do you think we get a full bill before year-end or based on midterms if we see a complete turnover, either red wave or blue wave, do you think you know, any signing of the bill will have to wait for new Congress to get seated. So we run through maybe end of January, February timeframe.
spk08: I think our operative assumption right now is that we get, you know, the bill before year end, but, you know, your guess is as good as mine, Mike, right on the, you know, what the election, you know, results are going to be and how that might affect things.
spk00: So,
spk08: Yeah, we're expecting a relatively short CR, which we've obviously taken into account in terms of our guidance. Got it. Helpful. Thanks, guys. Thanks.
spk00: Your next question comes from the line of Austin Muller with Canaccord. Your line is now open.
spk05: Hi, good afternoon. Hi, Austin.
spk04: Just my first question here. Do you expect that pressure on some of the NATO European allies due to the economy and inflation could delay new orders for modernization programs by maybe a year or more relative to the US?
spk05: It's a good question.
spk08: I think my gut would say probably not. you know, the, you know, clearly, you know, with what's happening over in the Ukraine, you know, it's the threat environment that usually kind of dictates both the altitude and the timing, you know, of defense spending. And clearly, you know, nine months into this, the situation is not great. So, you know, so my gossip is that we're going to continue to see increased spending in Europe. And, you know, whether it, immediate or, you know, takes a little bit longer, time will tell. But, you know, I think they're acting with a sense of urgency, Austin.
spk04: Okay, that makes sense. And can you call out any specific key program deliveries in the second half that you anticipate will support the step up in free cash flow?
spk08: So in the second half, I think we've got some pretty significant programs just kind of rattling through a few off the top of my head. We've got Filthy Buzzard. That is beginning to ramp again. We're expecting a very large IDIQ this quarter, as well as delivery orders ramping up as the year progresses. I think F-16 will be a significant contributor, the large new EOIR program, the large microelectronics program. So there's a number of programs that we expect to ramp in the second half of the year.
spk06: Yeah, and Austin, the only thing I would add on that, too, is from a working capital release perspective, while there's orders that we need to drive revenue and bookings, there's other things that we're working on from a release of working capital perspective. And we've seen unbills and programs being delayed because of supply chain delays, because of contract definitization. And as we work through those in the second half, that will also help the working capital in addition to the growth programs that Marcus described.
spk05: Okay, awesome. Thank you for all the details.
spk00: 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.
spk08: Okay. Well, thank you very much, everyone, for joining us here this evening. We look forward to speaking to you again next quarter. Thank you.
spk00: This concludes today's conference call. Thank you for attending. You may now disconnect.
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