Mercury Systems Inc

Good day everyone and welcome to the Mercury Systems third 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 Senior Vice President and Interim Chief Financial Officer, Michelle McCarthy. Please go ahead, Ms. McCarthy.

Good afternoon and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Adlett. If you have 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. 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 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 will now turn the call over to Mercury's President and CEO, Mark Adlett. Please turn to slide three.

Thanks, Michelle. Good afternoon, everyone, and thanks for joining us. I'll begin with a business update. Michelle will discuss the financials and guidance, and then we'll open it up for your questions. First, a quick note about the review of strategic alternatives we announced last quarter. The review is continuing, and we don't intend to disclose any new developments on the call today. As Michelle and I will discuss, we're running the business in the ordinary course as this process unfolds and continue to execute on our strategic plan. With that, let's turn to the third quarter. Revenue was above the high end and adjusted EBITDA came in at the midpoint of guidance for Q3. Bookings were in line with our expectations and our book to bill was 0.93. This follows 1.18 in the first half and 1.1 over the last 12 months. Q3 backlog grew 10% year-over-year. Our largest bookings programs in the quarter were V22, EF16, Aegis, AH64, and a classified CPI program. We're positioned for strong bookings growth sequentially in Q4 as planned, given the timing of awards. Q3 total revenue increased 4% year-over-year, as did organic revenue. Our largest revenue programs were LTAMs, EGIS, F-16, F-35, and a classified C4I program. GAAP net income and GAAP earnings per share for the third quarter exceeded our guidance due to a higher than expected tax benefit. JustDPS and JustDebitDA declined year-over-year as expected. Free cash flow was positive, excluding the R&D tax impact. Looking forward to our results at the year level, we expect to deliver record bookings for fiscal 23 and a positive book to bill. Revenue is now expected to be flat to slightly up year-over-year, $30 million below the midpoint of prior fiscal 23 guidance due to award and supply chain delays. Organic revenue is expected to be approximately flat year-over-year versus a 5% decline in fiscal 22. On the bottom line, we're lowering the range for gap net income and adjusted EBITDA by $34 million and $44 million at the midpoint. Free cash flow is expected to be around break even in Q4 and negative for fiscal 23. We expect lower cash outflows year over year, excluding the R&D tax. Turn to slide four. We're in our fourth fiscal year dealing with the derivative effects of the pandemic on the business. We've seen impacts in prior years on bookings and organic revenue. This year we've seen the bottom line impact, primarily driven by lower margins. We're experiencing temporary margin degradation for two reasons. The first is a significant shift toward development programs in our business mix. And the second is the pandemic-related impacts on product and program execution, especially as related to certain development programs. Over the last several years, we've won a significant amount of new business, both organically and through acquisitions. These wins decreased the ratio of production to development stage programs from approximately 80-20 to approximately 60-40 in fiscal 23, corresponding with a doubling in customer-funded R&D revenues. Our typical period of performance on programs pre-pandemic was, on average, approximately 18 months. far shorter than many of our customers, given where we sit in the value chain. Over the course of the pandemic, this period increased to an average of approximately 30 months, driven in part by delays in development programs. In the initial phase, development programs typically carry gross margins in the low to mid 30s on average. In comparison, more mature production programs' gross margins are above 40% on average. Although this elevated ratio of development stage programs has pressured margins over the past couple of years, and more significantly in fiscal 23, these programs will drive Mercury's future growth as they transition into production. We expect to see a meaningful margin expansion also as they transition and our mixed returns to pre-pandemic levels. The second contributor to margin degradation, as I mentioned, is the pandemic-related impacts on execution. Supply chain delays and inefficiencies, long semiconductor lead times, tight labor markets, and inflation have resulted in cost growth impacting both direct costs and R&D. In terms of R&D, Mercury is a leveraged commercial investment model focused on developing sophisticated new technologies and products. These highly differentiated capabilities are then used across multiple DoD programs. The cost growth we're experiencing is associated with certain new technology developments that are nearing completion and new product introductions, which are taking longer than planned. The higher costs are related to both labor as well as materials, driven by labor and supply chain inefficiencies, manufacturing constraints, and inflation. Approximately a dozen or so of our 300-plus active programs have been affected, and all but two of the affected programs are more than 90% complete, in terms of the total expected costs incurred. The good news is that once we complete the development and new product introduction activities, multiple programs will quickly benefit due to our product program leverage model. We expect these programs to complete over the next two to three quarters and transition to production-based contracts thereafter. This transition should lead to stronger fiscal 24 results not only improve gross margins and adjusted EBITDA as cost pressures diminish, but also lower working capital as we quickly relieve unbilled receivables through shipment, invoicing, and cash collections. As I said previously, our challenges are not related to end market demand, which remains strong. They're largely timing and cost related, they're short term, and they're not unique to Mercury. We're focused on controlling what we can in this environment, given the technologies that we've developed and the programs that we've won. Structurally, our business model and financial outlook are sound, and we're very optimistic about the future. We expect margins to naturally return to pre-pandemic levels as we overcome current execution challenges and as the supply chain conditions continue to normalize. Further margin expansion will follow as the late stage development programs transition to production and as we return to a more normal 80-20 business mix over time. Turning to slide five, we now have Alan Couture on board as head of execution excellence, Mitch Stevenson now leading our mission systems business, and Roger Wells continuing to lead microelectronics. Under their leadership, we're driving continuous improvements in new product development, supply chain, operations, and program execution. New leadership was instrumental in clarifying the magnitude and timing of our late stage development challenges. We're making progress on the engineering development challenges and manufacturing yields began to improve by the end of the third quarter. We expect this progress to continue in Q4 and fiscal 24 allowing for final program execution. In addition, we're through the first phase of our business systems integration in Torrance, California, the former POC. This was delayed largely due to COVID-related travel restrictions and is on track to be completed in the fourth quarter. Completing these integration activities will increase our visibility across the business, especially with respect to program execution and related labor and material costs, as well as working capital. The platform systems business we built through a series of acquisitions over time, of which Torrance is the largest part, has some amazing capabilities. In addition to the work that we've done around our secure processing and trusted microelectronics, we expect it to deliver long-term growth in the business. Although we made progress on the income statement in Q3, we still have more work to improve our balance sheet and cash flow. We expect that our impact program, together with improved execution, will lead to increased margins, a reduction in inventory and unbilled receivables, resulting in improved cash flow. Turn to slide six on the industry operating environment, which continues to improve incrementally. Employee hiring at Mercury continued to outpace attrition in Q3, and the supply chain is beginning to flow more smoothly. We saw fewer supply decommits this quarter, with some suppliers delivering ahead of plan. Semiconductors are still affecting program timing and efficiency, although to a lesser extent. Semiconductor processor lead times peaked in Q1 of fiscal 23 at 52 to 99 weeks, and now range from 13 to 78 weeks. Prior to the pandemic, the average 10 to 12. Although current lead times on average are getting shorter, Constraints in certain areas are still affecting new product development and program execution. We don't expect a significant improvement in lead times until the second half of fiscal 24. Semiconductor inflationary pressures remain a challenge also. In the third quarter, for example, we made approximately $10 million of end-of-life related semiconductor purchases, where the prices increased nearly 9x. Our impact program launched in early fiscal 22 is continue to evolve and deliver positive results. We've streamlined our organizational structure and significantly strengthened our leadership team. We've pushed margin expansion and working capital efficiency initiatives deeper into the business. In this inflationary environment, we're passing on higher costs wherever we can, and we've raised prices across the board on the commercial microelectronics side of the business. We're improving R&D investment effectiveness and consolidating our manufacturing facility footprint. Our digital transformation efforts in engineering operations in the back office should also help improve our cost structure over time. Turning to slide seven, we believe the defense spending outlook remains positive. The Defense Appropriations Bill approved last year, as well as the President's budget request, targets substantial spending growth related to national security issues, as well as continued support for Ukraine. An extended budget continuing resolution appears to be the base case scenario for government fiscal 24, including the potential for a full year CR. However, given the geopolitical environment, there appears to be strong bipartisan support for increased defense spending. Domestic and international defense spending is expected to grow in both the short and longer term, and we believe that mercury is well positioned to benefit from secular industry trends. We've seen continued growth in demand for compute capability on board military platforms and an ongoing push for platform electronification. We also stand to benefit from supply chain de-layering and reshoring, as well as increased outsourcing by our customers at the subsystem level. Our addressable market has increased substantially, largely driven by our strategic move into platform 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. As we announced in March, Christine Fox Harbison has joined us as Chief Growth Officer to help capture these opportunities. Christine has an impressive track record of driving growth, developing new markets, and building successful partnerships in defense and commercial technology businesses. We're very pleased to welcome Christine to the Mercury team. With that, I'd like to turn the call over to Michelle. Michelle?