Mercury Systems Inc

Good day, everyone, and welcome to the Mercury Systems second quarter fiscal 2025 conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the company's Vice President of Investor Relations, Tyler Hojo. Please go ahead, Mr. Hojo.

Good afternoon, and thank you for joining us. With me today is our Chairman and Chief Executive Officer, Bill Ballhouse, and our Executive Vice President and CFO, Dave Farnsworth. 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 we will be referencing 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 DAP, during our call, we will also discuss several non-DAP financial measures, specifically adjusted income, adjusted earnings per share, adjusted EBITDA, and free cash flow. 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 Chairman and CEO, Bill Ballhaus. Please turn to slide three.

Thanks, Tyler. Good afternoon. Thank you for joining our Q2 FY25 earnings call. We delivered solid results in Q2 that were once again in line with or ahead of our expectations, and I'm optimistic about our ongoing efforts to improve performance as we move through the fiscal year. Today I'd like to cover three topics. First, some introductory comments on our business and results. Second, an update on our four priorities, delivering predictable performance, building a thriving growth engine, expanding margins, and driving improved free cash flow. And third, performance expectations for FY25 and longer term. Then I'll turn it over to Dave, who will walk through our financial results in more detail. Before jumping in, I'd like to thank our customers for their collaborative partnership and the trust they put in Mercury to support the most critical programs and our Mercury team for their dedication and commitment to delivering mission-critical processing at the edge. Please turn to slide four. Our Q2 results reinforce my confidence in our strategic positioning and our expectations in delivering predictable organic growth with expanding margins and robust free cash flow. Bookings of $242 million and a trailing book-to-bill of 1.12. Revenue of $223 million. up 13% year over year. Adjusted EBITDA of $22 million and adjusted EBITDA margin of 9.9%, both up substantially year over year. And record free cash flow of $82 million, up $44 million year over year. We ended Q2 with $243 million of cash on hand. These results reflect continued progress in each of our four priority areas, with highlights that include solid execution across our broad portfolio production and development programs, a record backlog of 1.4 billion, reduced operating expense, enabling increased positive operating leverage and continued progress on free cashflow drivers with networking capital down 115 million year over year, or 19 and a half percent. Please turn to slide five. Starting now with our four priorities and priority one, delivering predictable performance. In the second quarter, our focus on predictable performance positively impacted our results primarily in three areas. First, we continue to make progress mitigating what we believe to be predominantly transitory impacts as discussed over the last several quarters. In Q2, We recognized approximately 4.4 million of net EAC change impacts across our portfolio, which is the lowest in the last few years and reflects the progress we are making in maturing our processes in program management, engineering, and operations. Second, we continue to make progress in the quarter ramping production in our common processing architecture product area. We expect to have our full capacity become available as we move through the second half of the year. This progress is enabling follow-on production awards, as we discussed last quarter, and led to a notable takeaway in Q2 from a processor board competitor that wasn't able to meet the security requirements provided by our common processing architecture. This reflects our ability to take share in this attractive market segment based on our technology leadership position. And third, our focus on accelerating customer deliveries generated a 29 million or 31% year-over-year increase in point-in-time revenue, the majority of which was driven by pull-forward deliveries and revenue from Q3. Please turn to slide six. Moving on to priority two, driving organic growth. Solid Q2 bookings of 242 million resulted in a record backlog of 1.4 billion, In line with our expectations, over 80% of trailing 12-month bookings were production in nature, which has driven a mixed shift toward production. In line with this shift, we recently announced a workforce restructuring to align our team composition with this increased production mix. Some wins in the quarter worth noting. A development contract from a U.S. defense prime contractor where we will replace and upgrade a competitor's existing processing capabilities with a solution leveraging a common processing architecture. Our additional protection features enable the system to be eligible for export to allied nations to support forward deployed operations. A $24.5 million contract to develop a data processing and storage subsystem for a U.S. Defense Department satellite program. Under this contract with an innovative Space Systems Prime contractor, we will deliver a number of subsystems that leverage our commercial products and deep expertise in data recording, data processing, and subsystem integration for defense applications. Two awards with Naval Air Systems Command, a $16.5 million delivery order for data transfer units, and a $14 million contract option for high-definition video recorders that support U.S. and allied military aircraft, and following production awards for two long-running U.S. Navy programs of record supported by multiple lines of business and two key U.S. Air Force programs of record where Mercury is the sole source provider of memory modules. These awards are important not only because of their value and impact on our growth trajectory, but also because they reflect those customers' trust in Mercury to support their most critical franchise programs. We know from engagements with our customers that our unique capabilities providing mission-critical processing at the edge align well with their priorities and what we believe is strong demand in growth markets. including sensors and effectors, electronic warfare, avionics, C4I, and space. All in all, Q2 was a good bookings quarter with multiple competitive wins where we believe we are growing share based on our technical differentiation. Please forward to slide seven. Now turning to priority three, expanding margins. As we've discussed in prior calls, in our efforts to achieve our targeted adjusted EBITDA margins in the low to mid 20% range, we are focused on the following levers, executing on our development programs in minimizing cost growth impacts, getting back toward a more historical 2080 mix of development to production programs, driving organic growth to generate positive operating leverage, and achieving cost efficiencies. Q2 adjusted EBITDA margin of 9.9% was in line with our expectations and indicative of progress on each of these levers in our effort to reach our targeted margins over time. Gross margin of 27% was in line with our expectations and largely driven by the average margin in our backlog coming into FY25. As we've discussed over the last two quarters, our backlog margin coming out of FY24 was lower than what we expect to see on a go forward basis, driven primarily by a small number of low margin development programs and programs that incurred adverse net EAC change impacts in FY24. We expect backlog margin to increase going forward as we continue to bring in new bookings, as we did once again in Q2, that we believe will be in line with our targeted margin profile and accretive to the current average margin in our backlog. Operating expenses, specifically R&D and SG&A, are down significantly year over year as a result of prior and ongoing actions to streamline and focus our operations. As expected, R&D levels increased sequentially in the quarter. Please forward to slide eight. Finally, turning to priority four, improved free cash flow. We continue to make significant progress on the drivers of free cash flow, and in particular, in reducing net working capital, which at $475 million is at the lowest level since Q3 of FY22. Combined free cash flow over the last three quarters is approximately $122 million, and net debt is down to $349 million, the lowest level since Q2 of FY22. We believe our continuous improvement related to program execution and hardware delivery, just-in-time material, and appropriately timed payment terms will lead to continued reduction in working capital and improved free cash flow performance going forward. Please turn to slide nine. Looking ahead, I am optimistic about our team, our leadership position in delivering mission critical processing at the edge, and our expected ability over time to deliver results in line with our target profile of above market top line growth, adjusted EBITDA margins in the low to mid 20% range, and free cash flow conversion of 50%. As we discussed last quarter, Although we will not be providing specific guidance for FY25, I will update the color we previously discussed. First half revenue, up 13% year over year, exceeded our expectation that the first half would be in line with last year. The overperformance was largely driven by the acceleration of about $30 million in customer deliveries and revenue into Q2 from Q3. For full year FY25, We now expect revenue growth approaching mid-single digits year over year versus our prior expectation that revenue growth would be relatively flat. As we discussed last quarter, our current backlog margin is lower than what we expect to see on a go-forward basis, driven primarily by a small number of low-margin development programs and programs that incurred adverse net EAC change impacts in FY24. Although we are encouraged that our recent quarter bookings are accretive to our overall backlog margin, we continue to expect low double-digit adjusted EBITDA margins overall for FY25 as we complete lower margin development efforts and continue to shift our mix toward production. We expect Q4 adjusted EBITDA margins to be the highest level of the fiscal year. Finally, with respect to free cash flow, we continue to expect to be cash flow positive in FY25. Given the large acceleration of cash from Q3 into the first half and first half free cash flow of $61 million, which is well ahead of our prior expectation, we expect free cash flow to be around break even in the second half. In summary, given the operational improvements over the last several quarters and our recent momentum, I expect that our performance in FY25, in particular our exit run rate, will represent a positive step toward our target profile. Given our progress in the first half and our momentum heading into the second half, I look forward to providing additional insights relative to our expectations for full-year performance as we progress through the back half of the year. With that, I'll turn it over to Dave to walk through the financial results for the second quarter, and I look forward to your questions. Dave?

Thank you, Bill. Our second quarter results reflect solid progress toward our goal of positioning the business to deliver predictable performance characterized by organic growth, expanding margins, and robust free cash flow. There is still work to be done, but we are encouraged by the progress we have made and expect the second half of fiscal 2025 revenue and adjusted EBITDA margins to improve over the first half. Our continued progress in our priority areas is highlighted by a few key milestones that we achieved during the second quarter. This includes delivering improved operating performance, making additional progress in ramping production in our common processing architecture product area, and continuing to expand our record backlog. With that, please turn to slide 10, which details our second quarter results. Our bookings for the quarter were 242 million with a book to bill of 1.09 yielding a backlog of 1.4 billion of 77 million or 6% year over year. Revenues for the first quarter were 223 million of 26 million or 13% compared to the prior year. The increase is primarily driven by higher point in time revenue of 29 million largely accelerated from Q3 as we continue to focus on delivering for our customers. Gross margin for the second quarter increased to 27.3 percent from 16 percent in the same quarter last year. The increase in gross margin during the current quarter was primarily driven by a reduction in the net EAC change impact on our programs recognized over time to 4 million as compared to 31 million in the same quarter last year. and lower inventory reserves of approximately $12 million. These improvements in gross margin were partially offset by higher manufacturing adjustments of approximately $4 million. As Bill previously noted, we expect to see an improvement in our gross margin performance over time as the average margin in our backlog improves, resulting from newer awards at targeted margins. Operating expenses decreased approximately 12 million year over year, primarily due to lower R&D and SG&A expenses. These decreases were driven by the actions taken in fiscal 2024 to improve our performance by consolidating and simplifying our operations. Gap net loss and loss per share in the second quarter were approximately 18 million and 30 cents respectively. as compared to gap net loss and loss per share of 46 million and 79 cents respectively in the same quarter last year. The improvement in year over year earnings is primarily a result of increased revenue and the associated gross margin coupled with reduced operating expenses. Adjusted EBITDA for the second quarter was approximately 22 million compared to negative 21 million in the same quarter last year. Adjusted earnings per share were 7 cents as compared to adjusted loss per share of 42 cents in the prior year. The year-over-year increase was primarily related to lower net losses in the current period as compared to the prior year period. Free cash flow for the second quarter was a record of nearly 82 million as compared to approximately 38 million prior year. The significant increased cash flow was primarily driven by the improvement in cash provided by operating activities of approximately 40 million in the current year as compared to the prior year. Slide 11 presents Mercury's balance sheet for the last five quarters. We ended the second quarter with cash and cash equivalents of approximately 243 million, driven primarily by approximately 85 million in cash provided by operations and investments of approximately $4 million in capital expenditures. Billed receivables decreased approximately $20 million or 16% sequentially. Unbilled receivables decreased year over year and sequentially by approximately $72 million or 21% and $20 million or 7% respectively. These decreases reflect the incremental progress we've made by delivering on programs to our customers, which significantly drove our cash flow performance during the current quarter. Inventory decreased slightly year over year and sequentially by approximately $10 million and $7 million, respectively. The current quarter balance also included approximately $15 million of material receipts supporting milestone invoicing, which largely drove the increase in our deferred revenue of nearly 40 million. These material receipts partially offset our decrease in inventory from accelerated point-in-time revenue. This increase in milestone invoicing activity reflects the progress we've made to better align the payment structure of our contracts to match the corresponding cash outflows of these arrangements. Accounts payable decreased approximately $10 million sequentially, driven by the timing of payments to our suppliers. Accrued expenses decreased approximately $2 million sequentially, primarily due to payments under our restructuring taken in fiscal 2024. Deferred revenues increased year over year and sequentially by approximately $55 million and $40 million, respectively, as a result of additional milestone billing events achieved during the period. Working capital decreased in the second quarter approximately 115 million year-over-year, or 20 percent, and decreased by 89 million, or 16 percent, sequentially. This demonstrates the progress we've made in reversing the multi-year trend of growth in working capital, highlighted by five quarters of sequential reductions in unbilled receivables, resulting in the lowest net working capital since Q3 fiscal 22. As a reference point, we have driven our net working capital in the last three quarters from a high of 72% of trailing 12-month revenue to under 54%. Net working capital remains a primary focus area, and we believe we can continue to deliver improvement. Turning to cash flow on slide 12. Free cash flow for the second quarter was approximately 82 million as compared to 38 million in the prior year. We believe our continuous improvement related to program execution and hardware delivery, just-in-time material, and appropriately timed payment terms will lead to continued reduction in working capital and improved free cash flow performance going forward. In closing, we are pleased with the first half performance for the fiscal year and the higher level of predictability in the business. We believe continuing to execute on our four priority focus areas will not only drive revenue growth and profitability, but will also result in further margin expansion and cash conversion, demonstrating the long-term value creation potential of our business. With that, I'll now turn the call back over to Bill.

Thanks, Dave. With that, operator, please proceed with the Q&A.

Thank you. If you would like to ask a question, please press star 1 on your telephone keypad. If you would like to withdraw your question, simply press star 1 again. We ask that you please limit yourself to one question and rejoin the queue if needed. If you are a member of the press, we ask that you submit your questions via the web. Please ensure you are not on speakerphone and that your phone is not on mute when called upon. Thank you. Your first question comes from the line of Pete Skibitsky with Alembic Global. Your line is open.

Hey, good evening, guys. Great quarter. It's... I mean, it looks like even excluding the pull forward revenue was still a strong quarter, especially on the cash flow side. So, Bill, I'll ask a question I've asked before, but maybe this is the last time I need to ask it. Just can you talk about the progress in the second quarter on the CPA kind of processes and programs in terms of the maturity there? Are there any kind of technical risks that remain at this point, or is it just a matter of slowly moving kind of ramping from LRIP to full rate production on the programs?

Yeah, Pete. Well, first of all, thanks for the comments up front. And I would characterize our progress on CPA as planned and consistent with what we discussed previously. We are ramping the full rate production. We expect to get our capacity to be fully available as we move through the back half of the year. And of course, how we use that capacity will benefit the business in a number of ways. We've already seen as we brought production online that we've received significant production awards. We talked about that in Q1. We had a really nice takeaway from a competitor based on our technical differentiation this quarter. That's been another benefit. And as we progress through the second half, we'll be able to allocate that capacity to drive revenue performance and deliver for our customers on new awards and continue to burn down unbilled balances where we have receivables on older contracts. So continued progress, all sort of normal course at this point, and very much progressing to plan and consistent with what we discussed previously.

Okay, that's great. Just one more for me. As you guys build confidence in that system, I'll call it, Can you talk about order flow? You know, backlog is kind of inched upward in the first half of the year, you know, we can say, I think. How are you expecting order flow to trend in the second half of the year? You know, should that accelerate or, you know, kind of in conjunction, you know, how's the continuing resolution been impacting order flow? Thanks.

Yeah, you know, I don't get too granular in focusing in on orders by quarter because like cash, it can be a little bit lumpy. I do think that our trailing 12 month book to bill of 1.12 is, you know, reflective of solid performance. And as we're looking forward, we still feel really confident about not only our strategic positioning, which we've talked about consistently, but also the enduring demand drivers and the need for mission critical processing at the edge. So, you know, all in all, I feel very optimistic about that outlook. Our trailing 12 month book to bill, I think it's solid at one point. one, two, and I think it positions us well for the second half of the year.

Great. Thank you very much.

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

Yeah, good afternoon, Bill, Dave, Tyler. Welcome to the call. Congrats on the quarter. Obviously, a lot of progress being made here. I guess I just want to understand the back half of the year free cash flow kind of break-even commentary because I think you've made a tremendous amount of progress of bringing the unbilled down. And, again, you saw evidence of that this quarter. But now you've also got this deferred revenue growth. And I just want to understand whether that's tied to the new contract structure and on receiving the milestones. Could you maybe just, Dave, walk us through a little bit of the dynamics of why there isn't positive still cash being generated in the second half?

Yeah, and as we said, Peter, you know, when we looked at the first half, our cash was ahead of where we were expecting, and some of that was driven by the milestones that we were able to achieve and drove, as you saw, a significant increase in our deferred revenue based on the timing of those milestones. So those milestones, as we work through the second half, will be performing effort against that cash that we've already received. So we expect to see the deferred revenue come down as we get through the back half of the year. It does not mean that unbilled won't continue to, you know, be something that we're working aggressively on. But, you know, we do expect to see materials draw down of that deferred revenue that was brought in, those milestones that were completed earlier.

Appreciate that. I'll jump back in the queue. Thanks.

Question comes from the line of Ken Herbert with RBC Capital Markets. Your line is open.

Hey, good afternoon, Bill and Dave. You know, you consistently talk now about sort of the longer-term opportunity to get adjusted EBITDA margins back into the 20%, low 20s range. Can you provide, without getting maybe too specific on timing, but How does the business look when you get to that level? I mean, is there a way we should think about that from a revenue standpoint, from an efficiency standpoint? Can you provide any more sort of parameters around how you think about that, maybe from a timing standpoint or just operationally as you think about the business moving forward?

Yeah, thanks for the question. Let me – this is Bill. I'll take it. You know, we've talked pretty consistently – for the last several quarters about the main levers that we're focused on. And we've made progress on each of the levers. And I think as we're sitting here looking forward and thinking about the path to our target margins, I think there's really two primary things that we're focused on. One is the conversion of our backlog margin that we've talked about. the fact that coming out of FY24, our backlog margin was lower than what we expect to see on a go-forward basis, impacted by a small number of low-margin development programs and a number of programs that were impacted by EAC adjustments in FY24. And as we're progressing each quarter and we're bringing in new bookings, We're really pleased to see that the margin on those bookings are coming in in line with our target margins associated with our targeted EBITDA margins that we're working to get to. So that's a dynamic that will play out over time. We haven't been specific around the timing where we expect the backlog margin to be at a place where it's consistent with our target margins. But we have a duration associated with our backlog, so you could do some thinking around how that might turn over over time. But that's the first driver. And then the second is around our operating expense so that we can get positive operating leverage as we continue to drive volumes. And I feel like at this place where we are with our operating expense, we've made significant progress over the last 18 months on that part of our cost structure. And while we said before, and it will continue to be a focus that will drive efficiencies into the business as we go forward on an ongoing basis, but I feel good about where our operating expense is relative to the positive operating leverage that we expect to see as part of our game plan to get to our targeted margins. So those are really the two pieces, and I feel like we're in a pretty good place in terms of understanding where we are and being able to see those two moving pieces work together to get us to our targeted margins.

Thanks for all the detail, Bill.

The next question comes from Steph Seifman of JP Morgan. Your line is open.

Hey, thanks very much. And good afternoon and nice quarter. I guess just in thinking about the growth rate, you know, you talk about above market, you know, maybe just to put some parameters around that when you, you know, when you think about what market is, do you think about it kind of as, you know, the defense budget, which I think, you know, a lot of people think about maybe, you know, low to mid single digit growth over time, do you think about it as a more as a certain subset of the defense market that might be growing faster. And then the second part of that question is the common processing architecture. And when you're fully ramped up there, kind of what role that plays in the mix and how that plays into your thoughts about the overall growth rate of the business as we look out over, let's say, a one to three year period.

Yeah, so as we discussed before, we're focused on delivering top-line growth that represents a growth rate above market growth rate. And specifically, the market that we're focused in on is the defense electronics, Tier 3 defense electronics market, with growth rates that are historically in the 5% to 6% range. And we believe for a number of reasons, in particular when we focus in on the sub-segments of that market where we're well positioned and we focus, and in particular that's around delivering processing power and capability to the edge, those sub-segments tend to grow a little bit faster and we feel like we're very well positioned based on our technical differentiation to deliver growth that exceeds those market growth rates. So that's really what we mean by when we talk about our targeted growth rates. With respect to the common processing architecture, as we've worked through the technical challenges in that area and gotten those behind us and then ramped to full rate production, it impacts our business in a number of different ways positively. First, it unlocks bookings because a number of customers were holding back follow-on development and production awards until we had demonstrated we got to root cause, eliminated the technical risk, and then ramped up production. So it's opened up new production awards. It also now gives us the opportunity with a capacity becoming available to allocate that capacity in the way that makes the most sense. And that could be either burning down backlog and delivering new units and revenue that goes with it, or allocating the capacity to more legacy programs that represent our unbilled balances, that when we deliver those units, there's less revenue associated with those units because the revenue has been recognized in prior periods, but it allows us to deliver the units, invoice our customers, and collect cash. So having that capacity online gives us a number of different degrees of freedom to drive performance and have it flow through our P&L into our cash flow statement and into the balance sheet. So hopefully that's helpful.

Yeah, absolutely. Thank you.

The next question comes from Jonathan Ho with William Blair. Your line is open.

Hi. Let me echo my congratulations as well. I just wanted to get some additional color on what drove the 30 million in pull-forward contract activity. You know, was this, you know, concentrated in, you know, a handful or a single program? And, you know, was there sort of a customer impetus or, you know, a government directive to drive earlier deliveries?

Thank you. Yeah, thanks, Jonathan. Thanks for the comment up front and the question. 18 months, we've been very consistent in the prioritized focus of the business with priority one being a focus on delivering predictable performance. You know, looking backward, a lot of that effort was focusing on completing the large mix of development programs in our portfolio. But it also includes a relentless focus on delivering for our customers. So a lot of what we've seen in our results for both Q1 and in Q2 is a byproduct of our team being relentless on delivering for our customers. And that shows up in two ways. It's delivering out of our backlog on new awards, delivering hardware associated with that backlog, getting it out the door, as well as working down our unbilled balances. In this quarter, really the overperformance was tied to point in time revenue and and those were on programs and for products where based on that focus on delivering for our customers we're able to pull to the left from our initial expectations and that's what really drove the shift into the quarter and jonathan i would add it it was not a single contract or a single customer it was multiple different products and customer said and again as bill said you know as we're

Improving our capacity in our operational facilities, we were able to pull some things that we thought we would not get delivery on, and as it's point in time, revenue is on delivery. We would not get revenue on and deliver in Q2. We were able to pull them forward out of Q3 and Q2, deliver them early, get them to our customers earlier than expected, and get them to our customers. So, you know, a positive all around.

And I think one of the things that was encouraging in the quarter is as we really focused our capacity, we were able to demonstrate both the pull forward of deliveries to drive revenue and at the same time finish off programs and drive down our unbilled receivables. And I think that's really a credit to our team, the improvement in our management system and our focus on delivering for our customers.

Excellent. Thank you.

The next question comes from Michael Charmoli with Truist Securities. Your line is open.

Hey, good evening, guys. Thanks for taking the question. Nice results. Bill or Dave, maybe just to stay on that topic and get some more clarity. I mean, it sounds like the pull forward was just basic blocking and tackling and delivering. I mean, because if I You know, when I hear pull forward, I probably want to strip it out and your revenues would have been down year over year and down sequentially. But, you know, that that doesn't seem like the way we should interpret this. And then and then I guess, you know, the pull forward and thinking about the back half of the year. So you've got mid single digit revenue growth kind of implies, you know, a flattish sequential trajectory here. um but but what would drive in that flattish you know uh revenue environment for the rest of the year what what drives the margins higher especially in in the fourth quarter is that kind of what you were referencing with the bookings coming in you know at that targeted margin rate yeah so let me start with the top line in the revenue movement within the period and again i don't want to get

too granular the revenue between quarters. But I do want to remind everyone that in Q1, we had some pull forward from Q2 into Q1, and then again from Q3 into Q2. Now, if you kind of normalize the volume and where it sits, It does sort of spread out the growth throughout the year to get a more balanced and consistent growth between the first half and the second half. And I think if you adjust that 30 million in your thinking, you'll see a more balanced growth rate across the full year. As far as the margin uplift in the fourth quarter, I think there's two things that are happening. the dynamics in the backlog. So we are seeing the roll forward of the lower margin backlog being replaced with the new awards that are coming in line with our target margins. But as we saw last year, in the fourth quarter we would expect to see some positive operating leverage with the increased volume. that would be additive to our margins. And that's why we're expecting the fourth quarter to be the highest margins in the year. Hopefully that makes sense.

And I think there are two things that impact that backlog margin, you know, as Bill discussed. One is, of course, the new bookings coming in and the margin rate on those bookings. And we said, you know, that it's been accretive as we've been going forward. And the other is the the level of the margin on the contracts that we're actually performing, executing on. And we've talked about some of the contracts that we're completing and moving past were some of the lower margin contracts. So those two phenomena act in concert with each other to naturally start to raise that backlog margin.

Got it. Helpful. Thanks, Gus. Thank you.

The next question comes from Brian Jesuale with Raymond James. Your line is open.

Hey, nice quarter. And thank you for taking my questions. I wanted to maybe just delve into this journey you're taking to remix the business away from, not away from, but this natural shift from development to production work. Can you talk about where we're at in that journey and then maybe give us a little bit of sensitivity

uh how the margins shift higher as development moves every you know 500 or a thousand basis points yeah we we have uh you know we've talked about this in the past kind of the difference between margin rates typically on development versus production contracts and the way we think about that model and what we've talked about in the past is the differences in the thousand basis points kind of range the difference between those two. And so we are, and we talked about that the bookings we're seeing are in line with our targeted margins. You know, as Bill talked about, when we look at our bookings for the last 12 months, they've been in the 80% range production. So we're seeing that happen. You know, it's... you know, some of that is as a consequence of finishing these development programs. You know, we had a large number of development programs that we've been working through. I want to make sure that people don't take the amount of production happening as a natural phenomenon. Finishing those development programs and getting the follow-on production awards, we still are focused on new development and the right kinds of new development, and we still... you know, are moving innovation along in the company, but this is a natural move of how we see the business proceeding. We expect, you know, this level of kind of bookings to be the case for some days, some period of time.

Great. And then maybe just a quick follow-up. So if you think about how that backlog naturally progresses towards your target margin work. Yep. How do you, how much of that margin bridge from 10 to 20% or 10 to 20 plus percent comes from this natural mix shift as opposed to some of the other levers that Bill alluded to earlier?

Yeah, I don't think we've broken out the individual components of that. So, you know, I wouldn't want to try and detail that. Okay, fair enough. Thank you.

Once again, ladies and gentlemen, if you have a question, it is star one on your telephone keypad. Your next question comes from the line of Sheila of Jefferies. Your line is open.

And great quarter, guys. Thanks for taking the time. I want to maybe start on free cash flow and just ask the $82 million of free cash flow in the quarter, I think, was your all-time high. free cash flow in a quarter, in a year, let alone a quarter. So can we talk about how we bridge that free cash flow to what true free cash flow is, given you're implying break even in the second half? There was obviously some factoring in there and some benefit from other items. So maybe if you could just talk about how we should be thinking about the second half being break even and as we head into fiscal 26.

Yeah, I think, Sheila, this is Dave. I think that the way to think about it is, you know, we were able to accelerate cash in essence into the second quarter. Largely when you look at our deferred revenue, you see our deferred revenues up around $40 million. That's milestones that we achieved that are ahead of all of the effort being completed. So, you know, as we go through the second half, we expect to be seeing that deferred revenue come down as we get the work done around those things or complete work around those things. And so we expect that we'll have, you know, it will lower the deferred revenue, resulting in an offset to the cash that we're bringing in on the other programs. So that 40-inch million dollars is almost a pull forward, a piece of that out of the second half of the year. So, you know, we're not looking at it as a pure, you know, hey, it's a break-even back half of the year. We're looking at it as running to offset that activity. We still are focused on our networking capital and bringing it down. Our networking capital is You know, the lowest it's been in several years. I mean, we're headed in the right direction. You know, obviously that's not at the exclusion of revenue or margin, but it's something we're working in concert. So I think the way we're thinking about cash is consistent with what we've said in the past. You know, we expect to be a consistent positive cash flow generator. And, you know, we expect to have, you know, positive cash as we exit the year. Obviously, we're, you know, with where we are today, a little bit ahead of where we thought we'd be through the first half.

Got it. And then maybe if we could just talk about, you know, it's been asked a few different ways of profitability profile too. Any sort of color you could give on production versus development margins? And then if you could just talk about the competitive wins you mentioned in the slides, what are those and how do we think about the profitability of those?

Yeah, I'll start and then, Bill, I'll let you talk about the wins. As we just said, I think that, you know, what we said historically is that, you know, production margins and development margins because of the different profiles, those things are roughly, you know, the targets we see for those are roughly 1,000 basis points different. You know, we've seen that consistently in our bookings that that's about right. The bookings we're bringing in are absolutely consistent, as Bill has said, with the target model that we have. And so, you know, we see the bookings that are coming in at the margins we need to step towards our ultimate business model.

And I'll just make a comment on the competitive wins. We had a number of head-to-head competitive wins in the quarter. I think a couple worth mentioning. One is on U.S. Defense Department satellite program with an innovative space systems provider. I think what's interesting about this pursuit is it was led by our advanced concepts group, which is a group we launched last year to focus on our next generation technology and position us for next generation type pursuits. came up with a very innovative solution that actually leveraged existing products and work that we had done for other customers. And so we think it's right in line with an innovative development program with the right risk profile that will lead to production runs down the road. So it's exactly what we wanted to do with the advanced concepts group and a really good success story. And then the second is the takeaway associated with our common processor architecture product line. And as we've said before, this is an area where we see emerging demand and we feel like we've got solid technical differentiation. And this takeaway was a perfect example of that. It was a relatively entrenched competitor and incumbent providing a processing capability The end customer was looking to upgrade the capability to include the functionality consistent with our common processing architecture. The incumbent couldn't meet those requirements. We could, and that was the basis of the takeaway and the development award. So I think those are very notable. They're worth mentioning, and I think they're evidence of Joseph Baeta, Supt of Schools, You know our ability to compete head to head and when based on the technical differentiation associated with the mercury processing process.

Elizabeth North , Thank you. Elizabeth North , Mr ballhouse it appears there are no further questions, therefore, I would like to turn the call back to you for closing remarks.

Joseph Baeta, Supt of Schools, Okay well thanks everybody for your participation, I would like to thank the mercury team. because it's people in teams that deliver the results that we talked through today, and the team had an outstanding quarter. We appreciate your participation, and we look forward to the update next quarter. Thank you. Thank you.

This concludes today's conference call. We thank you for joining. You may now disconnect.