Mercury Systems Inc

Bill Ballhouse. 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 Bill 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 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, Bill Ballhouse. Please turn to slide three. Thanks, Dave.

Good afternoon, everyone, and thank you for joining us. In this call, I'll cover three topics. First, introductory comments on recent changes, actions taken at the company, and my initial impressions. Second, our priorities and focus going forward. And third, expectations for our performance, both for FY24 and longer term. I'll then turn it over to Dave to discuss our results and look forward to wrapping up with Q&A. Before diving in, I wanted to take a moment to recognize the efforts of the Mercury team. Their demonstrated resilience over time, and their dedication and commitment to serving our clients and their important missions. As we've discussed throughout the company, with our recent announcements, we are on a very clear path to unlock the intrinsic value of Mercury for our customers, shareholders, and employees through enhanced operational focus. As a team, we realize that what we need to do is within our control, and we all recognize that's a great place to be. Please turn to slide four. Let me start by summarizing some of the recent changes at the company. At the end of Q4, the Board concluded its review of strategic alternatives and implemented several important changes to put Mercury on a path of enhanced execution of our strategy. Over the past two months, the Board has made positive governance changes, appointing Roger Krohn and Jerry DeMuro to the Board, both well-respected industry veterans with CEO experience. and appointing Scott Ostfeld to the board, who brings an important shareholder perspective. I have known these three individuals for a number of years and am delighted to have them on the board. In addition, the board effected a smooth leadership transition with the valuable addition of Dave Farnsworth, a seasoned defense technology leader as chief financial officer. And with today's announcement, I am humbled and excited that the board has placed its faith in me to lead Mercury through its next phase of value creation. We have significant work ahead of us, and I'm confident based on what I've seen over the last year as a board member and more recently as interim CEO, that we can and will make tangible progress toward predictable, profitable, organic growth with improved cash conversion in fiscal 24 and beyond. I also want to take a moment to thank Bill O'Brien for his 15 years of service to Mercury and for his significant leadership in navigating through this recent transition period as chairman of the board. Before I go too far, I'll give you a little background on myself. I began my career as an aerospace engineer, designing and building high-powered communication satellites for government and commercial applications around the world, supporting demanding missions and delivering very complex satellite systems. One of my key takeaways from that experience was that as a young engineer, I didn't need to worry about things outside of my control. I realized that if I just came to work every day, focused on solving the customer's hard technical problems better than anybody else, being a good teammate, doing the right thing, and delivering programs on cost and schedule, everything else would take care of itself. Customers would be happy. shareholders would be happy, and as employees, we would have a lot of fun outperforming our competitors. That was about the first decade of my career, and over the last 20 years, I've led a number of aerospace defense and technology businesses. Like Mercury, many of these businesses had great fundamentals but needed renewed focus to restore and drive strong shareholder returns. In each of these situations, I've worked with high-performing teams to drive a culture of relentless focus on enhanced execution that led to significant value creation and returns for shareholders. This experience, combined with my knowledge of this leadership team and Mercury's superb positioning in the market, gives me the utmost confidence that we will be successful in realizing the inherent growth, profitability, cash flow, and ultimately value of this national asset. Since taking on an interim CEO role on June 26, I spent significant time with the team digging into the details of the business and forming an assessment of Mercury and its value creation potential. Specifically, I have visited our major centers of operation and personally led reviews of our challenge programs and expanded those reviews to include 100% of our current development programs, their estimated cost to complete, and any roadblocks or risks to completion. I've engaged with the growth organization to review the health of our new business pipeline and our approach to accelerate organic growth. The leadership team and I have rapidly assessed our cost structure, taking initial actions to right-size our organization and improve margins in fiscal 24 and beyond. And as a leadership team, we have reviewed our major unbilled receivables balances by program, and our inventory in detail to establish burndown plans and drive improved free cash flow conversion. Please turn to slide five. Based on the last year plus that I served on the board and my work recently with the team, here are my initial impressions and takeaways. First impression, Mercury's strategy is sound. We are a national asset in the defense industrial base. At a macro level, we are positioned in an attractive growth market, defense electronics, and more importantly, we are situated in the right parts of that market that are experiencing spending growth. At a micro level, we are designed in with sole source positions on critical defense programs poised for significant electronic modernization. And finally, with enhanced customer focus and execution excellence, Mercury will continue to benefit from increased outsourcing by our defense prime customers. All these factors give me confidence in our ability to grow faster than the market. Second impression, over the past several years, the company grew inorganically into strategically attractive areas, but didn't fully integrate some of the businesses and mature processes and management systems to align with Mercury's evolving business portfolio. In my experience, this is not uncommon in businesses that grow rapidly via acquisitions. At Mercury, though, the immaturity and lack of full integration of key functional areas have led to the serious challenges the company experienced forecasting business performance over the past several quarters. That said, maturing in these areas is doable within our control and underway. My third and most important takeaway is that while our recent results are disappointing, the majority of our business is performing well, delivering predictable and profitable growth. However, this solid performance has been masked by approximately 20 programs that are experiencing unique and outsized costs, primarily temporary cost growth related to initial development challenges. In fiscal 23, these few programs impacted our financial performance by approximately $56 million. Said differently, our reported margin in 2023 does not at all reflect a structural shift in our margin profile. It is the composite of a very predictable and profitable core business obscured by an atypically large mix of development programs and cost challenges on a subset of programs that are resolvable and temporary in nature. And looking beyond our recent results, I'm encouraged by three factors. First, the majority of our business is performing very well. Second, the temporary execution challenges that are masking this performance are occurring on a small subset of programs, most of which are development in nature and are all solvable. And third, the current larger than normal mix of development programs reflects the potential for increased highly predictable and profitable business as the programs transition into production. With those introductory comments, I'd like to now transition to our priorities and focus going forward. So please turn to slide six. Our enhanced focus on execution includes four priority areas. First, delivering predictable results through improved execution on challenge programs. Second, building a thriving organic growth engine that leverages our unique strategic positioning. Third, expanding margins through a rationalized cost structure and improved program gross margins. And fourth, driving improved free cash flow conversion and near-term cash release. These priorities are central to unlocking the intrinsic value in the business. Let me provide some additional color on how we're approaching each of them. First, on delivering predictable results. In assessing our program portfolio, Our core business consisting of franchise production programs as well as a large portfolio of performing development programs is healthy and delivers solid gross margins, which gives me a lot of confidence in our long-term business model. Currently, there are two factors that have pressured and added variability to our recent results. First, as discussed in Q3, We have been successful winning a number of development programs that has led to a shift in our program mix from 20% development programs in FY21 to 40% development programs in FY23. We know this mix shift is temporary in nature and a positive leading indicator of future growth as our development programs are a precursor to higher margin, long-term production contracts. Given that our development programs typically run at approximately 1,000 basis points lower gross margin than our production programs, we have experienced near-term margin pressure tied to this mixed shift. Second, as I mentioned earlier, because our management systems and processes have not matured at the same pace as our growth over the last several years to address the complexities inherent in many of these development programs, a small number of programs have become challenged, leading to unanticipated and temporary impacts on our overall performance. In FY23, execution challenges on approximately 20 programs, a majority of which are development in nature, drove approximately 56 million of impact or approximately 580 basis points of margin contraction. We are squarely focused on mitigating the effects from the challenge programs. completing them, and transitioning them into production. We have strengthened our program reviews on development programs with increased frequency and internal rigor, and tightened program management accountability to drive better performance. Two of these programs moved into production in Q4. Five more have or are expected to transition in H1, with the majority completing throughout FY24. While I can't promise we are done seeing the impacts from the challenge programs on our results, I can say that these execution challenges are resolvable, temporary in nature, and the full force of the organization is focused on overcoming them. As we make progress through the year and as we return toward a more typical program mix, I believe the profitability of the core business will begin to become visible as we progress through FY24. And finally, Even at the increased levels of investment associated with the challenge programs, I'm confident that we'll see a high return on those programs as they transition from one-time development to ongoing, long-term, profitable production runs. Our second focus area, delivering consistent industry-leading organic growth. requires a tuned growth engine that is bidding and winning new contracts at an appropriate level given our scale after years of inorganic growth. Our book-to-bill is averaged slightly above 1.0 over the past eight quarters, which isn't adequate to meet our growth aspirations. Going forward, we are focused on driving a higher book-to-bill, which will help meet our long-term growth objectives and above-market growth rates reflecting our attractive market positioning. Sizing up our growth engine will take some time, but the good news is that we aren't opportunity constrained given our market position. I've had the opportunity to successfully work through similar growth scaling exercises several times in my career to accelerate organic growth. There is a consistent progression associated with targeting pipeline and levels of bid activity as leading indicators to revenue growth. We are beginning that work today led by our growth organization, and while it will take time to translate into revenue, I am confident that a healthy growth engine combined with Mercury's strong positioning will lead to industry-leading organic growth. Our third area of focus is margin expansion through targeted improvements to both our operating expense and gross margin. As mentioned earlier, we have taken initial actions to simplify our organizational structure facilitate clearer accountability, and align to our priorities, including embedding impact processes and execution into the business, streamlining our organizational structure and removing areas of redundancy between corporate and divisional organizations, and reducing SG&A headcount and rebalancing discretionary and third-party spend. This first set of actions will generate approximately $24 million in annual run rate cost savings. including approximately 20 to 22 million of net benefit to FY24. These savings are reflected in our FY24 outlook, which Dave will discuss shortly. In the near term, we are evaluating additional efforts to drive further efficiencies in SG&A, R&D investment, and manufacturing footprint, among others. Our fourth focus area is driving improved free cash flow conversion and cash release. Over the past two fiscal years, Mercury has delivered $333 million of adjusted EBITDA, but generated negative $107 million in free cash flow, which is clearly unacceptable. Since FY20, working capital has grown from approximately 35% of revenue to approximately 65% of revenue in FY23. This growth has primarily been driven by increases in unbilled receivables and inventory, and is a direct result of the temporary execution challenges previously discussed. Our focus in this area is as follows. First, resolve execution challenges and ship and bill against legacy program unbilled balances. Second, continue to improve asset efficiency in our new overtime revenue programs through cash neutral or positive terms and tighter alignment of manufacturing cycles with customer deliveries. And third, better align the receipt of inventory with our manufacturing execution cycles, and pursue advanced funding for material where possible. We believe these actions will help return the company to historic levels of networking capital, representing a future cash release opportunity of approximately $300 million or more over time. With that description of our focus going forward, I'd now like to discuss our expectations for both our long-term business model and guidance for FY24. Please turn to slide seven, looking at our model and focusing on margins considering recent history. With 2023 as a reference point, as we improve our program execution and resolve our challenge programs, we will remove approximately 580 basis points of headwind in our margins, which is partially offset on a go-forward basis by approximately 22 million or 230 basis points related to annual incentive plan bonus that was not paid in FY23 due to underperformance. Based on recent actions to improve our cost structure, we see another 250 basis points of benefit. We also expect a return to a more normal mix of production versus development programs over time, which will have a natural margin uplift given the 1,000 basis points lower average gross margins on development programs. Assuming we return to our historical 80-20 mix of production versus development programs, we could experience an additional 200 basis points of margin expansion, demonstrating a clear path to 22% adjusted EBITDA margins over time. Beyond that, we have several additional levers to drive margins. We will continue to focus on program execution, not only on our development programs, but on our already profitable production programs to drive gross margin improvement. We're looking at IRAD efficiency through prioritization and return thresholds. And given our unique strategic positioning and focus on growing faster than the market, we should see operating leverage with accelerated organic growth. Netting all of that together, While we have more work to do prior to communicating specific long-term targets for mercury, I do see a clear path back to predictable organic growth that delivers mid-20% adjusted EBITDA margins and strong free cash flow conversion. I look forward to coming back to investors later in the fiscal year to review our progress to date and provide more insight into our long-term financial targets. Turning now to our outlook for FY24 on slide eight. While we have taken and will continue to take actions to improve predictability, organic growth, margin, and cash flow, fiscal 24 will be a transition year. Consistent with our go-forward philosophy to deliver on our financial commitments, build credibility, and drive long-term shareholder value, we're taking a more conservative approach to guidance for the year. Dave will discuss our guidance in detail, but at a high level, we expect flat revenue at the midpoint with margin improvements throughout the year. While we're not providing quarterly guidance, I will say that Q1, which is a seasonally low quarter, is expected to be below Q1 last year's revenue and adjusted EBITDA with negative cash flow. As we continue to work through execution challenges and enhance our visibility through management system and process improvements, we anticipate improved profitability in the second half and positive cash flow for the year. While we are taking a cautious approach to guidance, I want to reiterate that our business model is sound and I have not seen any challenges that are not resolvable with proper focus and execution mindset and ultimately enhanced management processes and systems. With that, I'll turn it over to Dave to walk through the financial results for the quarter and the year, and I look forward to taking your questions. Dave?

Thank you, Bill. I'll start with a brief introduction, then present our fourth quarter and fiscal 23 results, as well as our fiscal 24 guidance. First and foremost, I'd like to thank Michelle McCarthy for serving as the interim CFO for the last six months. I look forward to working closely with her as she steps back into her role as our Chief Accounting Officer. The majority of my career spanning the last four decades was at Raytheon where I served in numerous finance roles up through Vice President and CFO of Integrated Defense Systems and prior to that as Vice President and CFO of its Intelligence Information and Services segment. The main focus in those roles was on operational finance. managing programs, developing financial plans and forecasts, as well as maximizing return on invested capital with a particular focus on networking capital improvement. It was at Raytheon that I worked with Mercury as a supplier. I gained firsthand knowledge of the unique capabilities the company brings, which are critical to mission success. The ability to design and develop affordable, open architecture defense electronic solutions reduces risk and accelerates time to market, aligning with the drive toward outsourcing in the defense industry. In my initial weeks here, I've been impressed by the agility and drive of the Mercury team. I would also echo Bill's view regarding the strength of Mercury's long-term business model. and the ability to return to above average market growth and profitability with an enhanced operational focus. As Bill mentioned, our results for the quarter and the fiscal year were disappointing. Our financial performance throughout fiscal 23, and especially the fourth quarter, obscures the underlying strength of our core business. In fact, The majority of the more than 300 active programs we are managing are performing well and generating margins in line with historical trends of above 40% across production programs and low to mid-30s across development programs. Our financial performance for the quarter and the year is masked by approximately 20 programs that have experienced unique and outsized cost growth, primarily related to development challenges. Specifically, our financial results were impacted by approximately $29 million in the fourth quarter and $56 million in the fiscal year across these challenge programs. We continue to experience minimal net changes across the rest of our program portfolio. As discussed in Q3, our proportion of development programs and execution has nearly doubled from approximately 20% in fiscal 21 to approximately 40% in fiscal 23. We have realized risks as certain of these programs have entered final stages of test and qualification in the fiscal year. Given nearly 90% of our program portfolio is firm fixed price contracts, incremental labor and material costs result in negative impacts to revenues and margin in the period recognized. Outside of this small population of challenge programs, we continue to experience predictable and profitable performance across the remainder of the program portfolio. We have taken aggressive and immediate actions to ensure enhanced execution and operational focus across programs to mitigate further risk. With that as background, please turn to slide nine, which details the Q4 results. Demand remains strong as evidenced by bookings of 294 million with a book to bill of 1.16 in the quarter, yielding backlog of 1.1 billion and up 10% year over year. Revenues for the fourth quarter were 253 million, down 37 million or 13% on a total and organic basis as compared to the prior year of 290 million. Revenue was below expectations primarily as a result of cost growth on the challenge programs. As total program costs increase on firm fixed price contracts that are recognized over time, the measure of progress on those programs decreases. This results in a delay and or reversal of revenues in the period that the costs are recorded. To a lesser extent, award and material timing also impacted program execution in the quarter. Gross margin for the fourth quarter decreased to 26.6% from 41.3% in Q4 22. Gross margin contracted primarily as a result of over 1150 basis points or approximately 29 million of impact from challenge programs in the quarter. This reflects the reduction in revenues coupled with incremental charges associated with loss accruals as well as deferred program cost recognition. The remaining contraction in gross margin is a result of the higher than historical mix of lower margin development programs as well as unfavorable manufacturing variances and reserves. GAAP net loss and loss per share in the fourth quarter was 8.2 million and 15 cents respectively as compared to gap net income and earnings per share of 16.9 million and 30 cents respectively in the prior year. The year-over-year decrease was a result of approximately 29 million of impact from challenge programs. The fourth quarter operating expenses also included a reduction of approximately 7 million for the forfeiture of stock-based compensation related to the departure of our former CEO. Adjusted EBITDA for the fourth quarter was 21.9 million compared with 71.6 million in the prior year. The decrease was primarily due to lower gross margins resulting from the impact of challenge programs as well as reduced operating leverage. Free cash flow for the fourth quarter was approximately 4 million, including the second payment of 7 million related to the R&D tax legislation and better than our view of breakeven entering the quarter. Turning to our full year results from slide 10. Fiscal 23 was a solid year for bookings. Our book to bill was 1.10 compared to 1.08 in fiscal 22, yielding backlog of over 1.1 billion. This backlog supports a high level of visibility as we enter fiscal 24. Fiscal 23 revenues were 974 million, down 1% in total and 3% organically. Our fiscal year revenue decline was primarily a result of production award delays due to execution challenges across several development programs. In addition, incremental cost growth delayed progress and therefore revenue recognition on certain programs. Gross margin for the fiscal year decreased to 32.5% from 40% in the prior year. Gross margin contracted by approximately 580 basis points as a result of approximately 56 million of impact from challenge programs incurred in the year. The remaining contraction in gross margin is a result of the higher mix of lower margin development programs as well as unfavorable manufacturing variances and reserves. Gap net loss and loss per share in fiscal 23 was 28.3 million and 50 cents respectively as compared to GAAP net income and earnings per share of 11.3 million and 20 cents respectively in the prior year. The year-over-year decrease was a result of approximately 56 million of impact from challenge programs. Adjusted EBITDA for fiscal 23 was 132.3 million compared with 200.5 million in the prior year. The decrease was primarily related to lower gross margin and reduced operating leverage. Free cash flow for the fiscal year was an outflow of approximately $60 million, including payments of $26 million related to the R&D tax legislation. The remaining outflow is reflective of growth in both unbilled receivables and inventory as a result of execution delays across our challenge program. Slide 11 presents Mercury's balance sheet for the last five quarters. We ended fiscal 23 with cash and cash equivalents of $72 million. We have $511.5 million of funded debt under our $1.1 billion revolver, which provides us with significant financial flexibility. Turning to cash flow on slide 12. Our billed receivables remained flat while unbilled receivables increased approximately 6 million quarter over quarter. During the quarter, we successfully resolved the critical technical challenge dramatically improving our yields on a product platform common across many of our programs. We began final shipments and converted approximately 20 million of longstanding unbilled receivables to billed receivables on these programs during the quarter. This reduction was more than offset by new unbilled balances recorded in the quarter. More importantly, the resolution on this common product platform will enable the conversion of an additional 50 million of longstanding unbilled receivables over the course of fiscal 24. We also leveraged our receivables factoring arrangement at levels similar to the prior quarter. Inventory decreased for the first time in eight quarters as we improved our processes and management systems to better align procurement of materials with manufacturing cycles. Other non-cash items, net and other operating assets and liabilities, primarily reflect the activity within our tax accounts related to the R&D tax legislation. Working capital continued to grow as a percentage of sales, largely driven by increased unbilled receivables and inventory. We expect continued progress towards the completion of challenge programs to serve as a catalyst for the start of a significant reduction of unbilled receivables. The following production awards associated with these programs will consume inventory, resulting in improved asset efficiency and cash flows beginning in fiscal 24. I'll now turn to our financial guidance for the full year fiscal 24 on slide 13. We have shifted our guidance approach in fiscal 24 to guide annually rather than quarterly. While we have taken steps to improve predictability, fiscal 24 will be a transition year. As such, we're taking a more conservative approach to guidance for the year. Given our attractive positioning within the defense technology market, our existing franchise production programs, and the sole source nature of approximately two-thirds of our portfolio, we expect the demand environment to continue to support strong bookings. As a result, we expect a positive book to bill in fiscal 24. Our fiscal 24 guidance for total company revenues is $950 million to $1 billion. This represents flat growth at the midpoint. Our backlog entering fiscal 24 supports a high level of revenue visibility, providing more than 70% forward coverage over our revenue range. This exceeds historical levels of forward coverage entering a fiscal year. We expect improved revenue linearity between the first and second half of the year as compared to prior years. Gross margins in the first half of the fiscal year will approximate those of fiscal 23 as we transition through the challenge programs and balance the potential for unknown risks that may materialize through final stages of completion. Gross margins will increase throughout the year as we receive and execute on the expected follow-on production awards and begin to shift from the higher mix of lower margin development programs. GAAP results are expected to be a net loss for fiscal 24 in the range of 13.7 to 5.9 million, with GAAP loss per share of 24 cents to 10 cents. GAAP results include approximately $9 million of restructuring charges related to the cost savings efforts announced today. We expect fiscal 24 adjusted EBITDA in the range of 160 to 185 million of 30% at the midpoint from fiscal 23 and reflecting adjusted EBITDA margins of 16.8% to 18.5%. Adjusted EPS is expected to be in the range of $1.14 to $1.48 per share. Adjusted EBITDA and adjusted EBITDA margins reflect the marked improvement in gross margins Although not a full recovery to historical levels, reflecting the potential for unknown risks materializing as we transition through the final stages of execution on our challenge programs, specifically in the first half of the year. As such, our adjusted EBITDA and adjusted EBITDA margins in the first half will be below the comparative period in fiscal 23. In addition, adjusted EBITDA and adjusted EBITDA margins reflect net cost savings of 20 to 22 million associated with the workforce reduction, as well as reductions in discretionary and third-party spend announced today. These cost-saving actions will result in annualized net savings of approximately 24 million. We expect positive cash flow for the fiscal year inclusive of a full year of cash outflows related to R&D tax legislation. Cash flow will be second half weighted as we complete a majority of our challenge programs, ship and build final product, and convert unbilled receivables to billed receivables and then to cash. We expect improvement in networking capital by the end of the year as we begin to see reductions in unbilled receivables and inventory with more meaningful reductions over the longer term. Looking beyond fiscal 24, Mercury is well positioned for stronger growth, margin expansion, and improved working capital. We expect our current backlog and strong slate of existing programs coupled with increased defense spending to drive a return to above industry average revenue growth. On the bottom line, as we complete our challenge programs and our mixed transitions from the current weighting of development programs to higher margin production programs, we expect to see a natural uplift in gross margins beginning in fiscal 24. In closing, our strategy remains sound. The organization is centered around four priorities, enhancing execution to deliver predictable performance, building a thriving organic growth engine, addressing our cost structure to improve margin expansion, and driving free cash flow release and improved conversion. Executing on those priorities will not only enable a return to historical revenue growth and profitability, but will also drive further margin expansion and cash conversion, demonstrating the full potential of our business model. With that, I'll now turn the call back over to Bill. Thanks, Dave.