Mercury Systems Inc

Good day, everyone, and welcome to the Mercury Systems second 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.

Good afternoon, and thank you for joining us. I hope you've had the chance to review the press releases we issued earlier this afternoon. If not, you can find them 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. With me today is our president and chief executive officer, Mark Aslow. I'm also very pleased to welcome Michelle McCarthy to the call. Serving as Mercury's senior vice president and chief accounting officer for the past five years, Michelle has been an active and valuable member of our leadership team. I'm looking forward to working closely with Michelle in her new position as Interim Chief Financial Officer to ensure a seamless transition prior to my departure in February. Turning to slide two in the presentation, I'd 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 filing. I'd also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles or GAAP, During our call, we will also discuss several non-GAAP financial measures, specifically adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue, and acquired revenue. A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release. I'll now turn the call over to Mercury's President and CEO, Mark Aslett. Please turn to slide three.

Thanks, Mike. Good afternoon, everyone, and thanks for joining us. Typically, I'd start our prepared remarks with a review of our results for the quarter. However, given the other news we've announced today, I'll begin with key takeaways from those announcements. I'll then review the business, Mike will cover our financial results and guidance, and then we'll open it up for your questions. The Board's decision to initiate a review of strategic alternatives underscores our commitment to exploring all available avenues to enhance shareholder value. We've engaged two leading investment banks to pursue a range of options, including a potential sale. During the Board's evaluation, we'll continue to execute on our strategic plan for growth and value creation. As you know, we need to let this process play out, and as such, we won't have further comment on it today. I want to emphasize that there can be no assurance that a transaction will resolve from the review. We also don't intend to disclose developments relating to this process unless and until the board has approved a specific agreement or transaction or has terminated its review. Now, let me say a few words about Mike. As you saw from our announcement, Mike has decided to step down from Mercury to accept an opportunity at a privately held company headquartered in Virginia, where he and his family reside. Mike has been a great partner for the past eight years. He's made significant contributions to Mercury, including helping drive our M&A strategy and many acquisitions. Mike, on behalf of myself and the entire Mercury team, we wish you all the best in your new role. We've initiated a search for a permanent successor with the assistance of a leading executive search firm. We're fortunate to have a deep bench of talent on our finance team during this transition period. In addition to Michelle McCarthy's appointment as interim CFO, Nelson Erickson, Senior Vice President, Strategy and Corporate Development, will formally assume responsibility for investor relations. Last week, we also announced that Vivek Upadhyay has joined Mercury as our vice president of financial planning and analysis, further bolstering our team. Over the coming weeks, Mike will work closely with Michelle, Nelson, Vivek, and I to ensure a seamless handoff. With that, let's discuss our second quarter results. Turning to slide four, Mercury's second quarter revenue was in line with our guidance, growing 4% year over year. More importantly, we returned to organic growth and generated positive cash flow in the quarter. Gap net loss and loss per share, as well as adjusted EBITDA and adjusted earnings per share fell short of guidance. This was primarily due to an unforeseen delay in funding to our customer for a large FMS program. After this delay, which reduced Q2 revenue and margin by $10 million and $7 million respectively, Our results would have been at or above the high end of our Q2 guidance. The delay resulted in lower Q3 guidance also, as an additional $10 million of revenue and $7 million margin moved to fiscal 24. We're obviously disappointed with the delay in the short-term impacts anticipated for this fiscal year. This is a large program, and the timing is outside of our immediate control. That said, our customer is confident that their funding issues will ultimately be resolved, allowing us to recognize the entire $20 million in revenue and $14 million of margin early in Mercury's new fiscal year. Working with the customer, we've rotated in other related opportunities that we expect will partially offset the impact of this delay in the second half of fiscal 23. As we consider the back half in our full fiscal year guidance, we're shifting our outlook to incorporate this program timing and the prolonged supply chain impacts resulting in program delays and inefficiencies, which are temporarily affecting margins. On the plus side, we believe that revenue is currently trending above the midpoint of our fiscal 23 guidance, while net income and adjusted EBITDA are now expected to be toward the low end. Within our fourth fiscal year dealing with these impacts, In addition to program delays and related inefficiencies, we continue to face long semiconductor lead times, tight labor market, and inflation. These challenges, however, are not related to end market demand, which remains strong. They're largely timing-related, they're short-term, and they're not unique to Mercury. We continue to execute on our plan to control what we can in this environment, and we're optimistic about the future given our current positioning. Mercury's bookings for Q2 increased 14% year-over-year, the largest being F35, F18, L-TAN for the classified C2 program. At nearly $60 million, the F35 order for advanced microelectronics capabilities was the largest booking in the company's history. Driven by the growth in bookings, our book to bill was 1.18 in the quarter and 1.16 over the last 12 months. Backlog grew 17% year-over-year to a record $1.12 billion, which positions us well for future growth. Despite the SMS customer funding delay, our Q2 revenue increased 4% year-over-year. Organic revenue turned positive, growing 1%, versus a 13% decline in Q2 of fiscal 22. We expect to return to organic growth for the year as a whole, as expected. Our largest readiness programs in the quarter were F-35, F-16, NDSA trans-tracking layer, P-8, and SAAD. Q2 Gatman income was negative and adjusted EBITDA decline year-over-year. Both were below guidance, primarily due to the FMS customer funding delay. Although revenue is trending above our fiscal 2023 guidance midpoint, other financial measures, including adjusted EBITDA, are trending toward the low end, as I said, largely due to program delays and related inefficiencies. We believe these impacts are temporary in nature. We expect margins to increase as supply chain conditions begin to improve, and as we realize further benefits from impact and the continued shift in our program mix from development to production. Operating in free cash flow for Q2 were positive, a substantial improvement sequentially. We expect to deliver a break-even to slightly positive free cash flow for FY23, including the impact of the R&D tax legislation. Turning to slide five, the Defense Appropriations Bill was approved after the midterm elections as expected, resulting in substantial spending increases in response to national security threats. That said, the House GOP rules package adopted this month and the reported deal between Speaker McCarthy and the Freedom Caucus create risk to government FY24 discretionary spending, including defense. An extended budget continuing resolution appears to be the base case scenario for GFY24, including the potential for a full year of CRR. However, although risk does exist, we don't expect Congress to approve a reduction in DOD appropriations. Given the geopolitical challenges we face, there appears to be strong underlying bipartisan support for increased defense spending. Looking ahead longer term, we believe the defense spending outlook remains positive both domestically and internationally, and that mercury is well positioned to benefit in this environment, The growth in demand for the compute capability onboard military platform shows no sign of slowing. We also stand to benefit from the ongoing push for platform electronification. We believe that we're well positioned to continue to benefit from long-term industry trends. These include supply chain de-layering and reshoring, as well as increased outsourcing at the subsystem level. Our adjustable market has increased substantially, largely driven 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. Turning to slide six, the industry environment continues to be challenging in the short term. Despite incremental improvement in the second quarter, supply chains and strengths continue to affect program timing and efficiency. Mercury's sophisticated end-to-end processing platform passed some of the most critical A&D missions. High-end processing represents about 70% of the business. This is where Mercury likely has the largest opportunity to grow over the next five years. Prior to the pandemic, semiconductor cost of lead times were 10 to 12 weeks. They increased rapidly in the second half of fiscal 21 and now range from 36 to 72 weeks. Although current lead times on average are slightly shorter than in Q1, we don't expect to see a significant improvement until the second half of fiscal 24.