Mercury Systems Inc (MRCY) 2016 Q2 法說會逐字稿

Good day, everyone, and welcome to Mercury Systems second-quarter fiscal 2016 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 Executive Vice President and Chief Financial Officer, Gerry Haines.

Please go ahead, sir.

Thank you, operator.

Good afternoon, everyone, and thank you for joining us.

With me today is our President and Chief Executive Officer, Mark Aslett.

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.

We would like to remind you that remarks that we may make during this call about future expectations, trends and plans for the Company and its business constitute forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995.

You can identify these statements by the use of the words may, will, could, should, would, plans, expects, anticipates, continue, estimate, project, intend, likely, forecast, probable, possible, potential, assumes and other similar expressions.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated.

Such risks and uncertainties include, but are not limited to: continued funding of defense programs; the timing of such funding; general economic and business conditions, including unforeseen weakness in the Company's markets; effects of continued geopolitical unrest and regional conflicts; competition; changes in technology and methods of marketing; delays in completing engineering and manufacturing programs; changes in customer order patterns; changes in product mix; continued success in technological advances and delivering technological innovations; changes and or in the US government's interpretation of federal procurement rules and regulations; market acceptance of the Company's products; shortages in components; production delays or unanticipated expenses due to performance quality issues with outsourced components; inability to fully realize the expected benefits from acquisitions and restructurings or delays in realizing such benefits; challenges in integrating acquired businesses and achieving anticipated synergies; changes to export regulations; increases in tax rates; changes to generally accepted accounting principles; difficulties in retaining key employees and customers; unanticipated costs under fixed-price product, service and system integration engagements and various other factors beyond our control.

These risks and uncertainties also include such additional risk factors as are discussed in the Company's filings with the US Securities and Exchange Commission including in our recent annual report on Form 10-K for the fiscal year ended June 30, 2015.

The Company cautions readers not to place undue reliance upon any such forward-looking statements which speak only as of the date made.

The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances arising after the date on which such statement is made.

I would 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 discuss several non-GAAP financial measures, specifically, adjusted income from continuing operations, adjusted EBITDA, adjusted earnings per share, or EPS, and free cash flow.

Adjusted income from continuing operations excludes several items from GAAP income from continuing operations.

The excluded items are: amortization of intangible assets; restructuring and other charges; impairment of long lived assets; acquisition and financing costs; fair value adjustments from purchase accounting; litigation and settlement expenses; and stock-based compensation expense as well as the tax impact of those items.

This yields adjusted income from continuing operations, which is expressed on a per share basis as adjusted EPS calculated using weighted average diluted shares outstanding.

Adjusted EBITDA excludes the same items as adjusted income from continuing operations as well as depreciation, interest income and expense, and income taxes.

Free cash flow excludes capital expenditures from cash flows from operating activities.

A reconciliation of these non-GAAP metrics to their nearest GAAP equivalence is included and the earnings press release we issued earlier this afternoon.

With that I will turn the call over to Mercury's President and CEO, Mark Aslett.

Thanks, Gerry; good afternoon, everyone, and thanks for joining us.

I will begin today's call with a business update; Gerry will review the financials and guidance and then we will open it up for your questions.

Mercury's business is performing well and we continue to deliver strong results in the second quarter of fiscal 2016.

The capabilities that we have developed and acquired are very much aligned with the needs of our customers.

We are pioneering a next-generation defense electronics business model, which aligns well with the industry conditions today and what we expect to occur in the future.

We are also continuing to deliver important new program wins along with above industry average revenue and EBITDA growth.

Our total revenue for Q2 was up 6% year over year and near the top end of our guidance.

Reflecting favorable mix and improved operating leverage in the business, adjusted EBITDA for Q2 came in well above the high end of our guidance, increasing by $1.9 million or nearly 18% year-over-year on $3.3 million of incremental revenue.

GAAP profit from continuing operations increased 66% from Q2 last year and cash flow from operations was also up substantially.

We are successfully leveraging our relationships with the primes to drive bookings and revenue from existing programs as well as new programs and platforms.

We have established strong positions for Mercury on critical production programs in the right segments of the market.

These programs appear to be well-funded, are currently in or moving into production and are precisely aligned with the DOD's roles and missions.

As we expected, our fiscal 2016 bookings and revenue are coming from a broader set of key programs than in the past couple of years.

This is primarily due to strong demand related to radar and EW modernization activities.

Secondly, we continue to see an insatiable appetite for more high-performance processing onboard military platforms.

As well, the DOD is mandating program protection security requirements for domestic and foreign military sales.

These trends are driving our above industry average growth.

In terms of revenue, our largest programs in defense in Q2 were SEWIP Block 2, F-35, Patriot and Aegis.

Bookings for the second quarter were up 3% year-over-year, coming in a little lighter than we expected, and our total book to bill was approximately 0.75.

This was due to some temporary order delays and we expect to make up for the shortfall in Q3.

Total backlog exiting Q2 grew nearly 7% year-over-year.

Our 12-month forward revenue coverage remained strong positioning us well for the fiscal second half.

At our recent Investor Day we announced that Mercury was notified by Northrop Grumman that it will be a part of their SEWIP Block 3 team.

And in Q2 we received an $11 million order.

We booked the EMD portion of this order in the second quarter and expect to recognize the remainder as the LRIP options firm up.

As a result of our strategy, our strategic relationships and our ability to provide multiple technologies and capabilities, we have gone from not being part of the Northrop team prior to the award to winning an important position on SEWIP Block 3 in a very short period of time.

We also received large bookings in Q2 for the F-35, Aegis and Reaper.

In addition, as we said on our call last quarter, our customer Lockheed won the long range discrimination radar program.

We received an initial small order associated with that program in Q2 and we expect a much larger booking in Q3.

We were also awarded a $42 million IDIQ for additional budget EW systems in MDS during the quarter.

Although our policy is not to count IDIQ wins towards our reported bookings number, this is still an important contract award for us.

We expect to begin recording the associated bookings over time as we receive individual task orders.

Wrapping up the bookings review -- international defense bookings for Q2, including foreign military sales, were 10% of total bookings compared with 15% in the second quarter last year.

As I just mentioned, we are seeing significant growth driven by DOD program protection security requirements.

Our industry-leading secure Intel server class product line positions us to capitalize on this opportunity set.

We also have the potential to capitalize on demand for secure server class computing applications beyond the sensor.

These include other mission-critical computer applications where we haven't participated in the past.

The acquisition of LIT, which we announced at the end of Q2, expands our security capabilities.

They have developed an impressive set of services and intellectual property that enable advanced security for embedded processing applications.

We have been working very closely with the team at LIT for the past several years.

Bringing their capabilities in-house moves us another step forward in our strategy to become the industry's most advanced secure processing Company.

Q2 was also an important quarter for us in the Radar and EW modernization space, highlighted by the booking for SEWIP Block 3. Winning a position on Block 3 demonstrates the strategic relationships and competitive advantages we have created for Mercury in RF, microwave, digital and processing.

Our Advanced Microelectronics Center, or AMC, in New Hampshire is the centerpiece for our RF activities.

The AMC has world-class scalable RF and microwave manufacturing and subsystems integration capabilities.

This differentiates us from our competitors as a provider of industry-leading pre-integrated sensor processing subsystems.

At the same time the integrated business systems we have installed at the AMC have been crucial to improving the operating leverage in our business.

Over the past two years we have leveraged our sales strategies, internal R&D investments and acquisitions to build a best-in-class portfolio of products and capabilities.

We are also targeting the right segments of the market and, as a result, we are strongly positioned on a great set of franchise programs.

At the same time, Mercury's balance sheet remains pristine and our capital allocation strategy continues to focus on growing the Company's enterprise value and capabilities.

We are primarily targeting acquisitions that scale the technology platform that we have built, focusing on the key pillars of the business, RF, microwave and secure processing.

In addition, as evidenced by LIT, we will also continue to look at capability led acquisitions.

Our goal is to assemble critical and differentiated capabilities across the entire sensor processing chain.

This will allow us to provide our customers with more complete and more affordable solutions.

We remain active as well as disciplined in our approach to M&A, focusing on opportunities for both revenue and cost synergies.

We continue to develop a solid pipeline of potential deals that have the potential to be accretive in the short-term and drive long-term shareholder value.

Now for some thoughts on the industry conditions.

Overall the contracting environment remains challenging with new awards still experiencing protracted delays and intense competition.

However, we were pleased to see the passage of the government fiscal year 2016 Defense Appropriations Bill and the removal of the sequester.

This means a return to growth in base defense spending.

The fact that we now have greater clarity around the budget is positive for the industry as a whole and for Mercury.

In summary, the business delivered a strong performance in Q2 in the first half.

We remain on track for another strong performance in fiscal 2016 as a whole given our strong backlog, expected bookings, broader mix of programs and the benefits of integrating our acquisitions.

We believe we are well-positioned to continue delivering above industry average revenue and EBITDA growth.

As we said last quarter, we expect gross margins to be slightly lower in the second half due to program and product mix.

Nonetheless, we are raising our fiscal 2016 guidance with the expectation of solid revenue and adjusted EBITDA growth versus fiscal 2015.

Gerry will discuss these expectations in more detail.

So with that I would like to turn the call over to Gerry.

Gerry?

Thank you, Mark, and good afternoon again, everyone.

before we go through the financial result I just want to remind everyone that, unless otherwise noted, I will be discussing the Company's financial results, comparisons to prior periods, and guidance on a continuing operations basis.

However, in accordance with GAAP, Mercury Intelligence Systems is reflected in our statement of cash flows for periods prior to our sale of that business in January of 2015.

Turning to our results for Q2, Mercury delivered solid performance across the board, consistent with our expectations.

Total revenue increased $3.3 million or 6% from Q2 last year to $60.4 million, near the top end of our guidance of $58 million to $61 million.

International revenue, including foreign military sales, was 21% of total revenue compared with 26% in Q2 last year.

Revenue from Radar and Electronic Warfare again accounted for 82% of total revenue, the same as a year ago.

Radar revenue was down 14% year-over-year while Electronic Warfare revenue grew 59%.

Net of $1.3 million of intercompany eliminations revenue in our largest reporting segment, Mercury Commercial Electronics or MCE, was $53 million, an increase of $1.2 million or 2.3% from net revenue in Q2 of last year.

In our Mercury Defense Systems, or MDS, reporting segment net revenue was $7.9 million, up $3.2 million or 67% from the second quarter last year.

These segment revenues are adjusted for revenues of negative $0.5 million in Q2 of fiscal 2016 and positive $0.5 million in Q2 of fiscal 2015 that are included in our consolidated results for those quarters.

This revenue difference is attributable to development programs where the revenue is recognized in both segments under contract accounting and reflects the reconciliation to our consolidated results.

Turning now to bookings, Mercury's total bookings for the second quarter were $45.2 million yielding a book to bill of approximately 0.75.

As Mark said, we experienced some shifts in order activity during the quarter and as a result we expect strong bookings in Q3.

We ended Q2 with total backlog of $205 million, which was up $13 million or 6.6% from $192 million of backlog a year earlier.

Approximately $152 million, or 74%, of this total backlog is expected to ship within the next 12 months.

Mercury's gross margin for Q2 was a solid 47%, roughly the same as Q2 of last year, remaining at the midpoint of our target business model and in line with our guidance as we continue to benefit from favorable program and product sales mix.

In addition to our solid gross margin, we continue to realize the benefits of improved operating leverage from our prior restructuring and integration efforts.

Q2 operating expenses were $22.2 million compared with $23.5 million for the same period last year.

Adjusted EBITDA for the second quarter of fiscal 2016 increased 18% to $12.8 million -- I'm sorry $12.6 million from $10.7 million in Q2 of last year.

This exceeded the high end of our guidance range of $10 million to $11.5 million and, at nearly 21% of revenue, was above the midpoint of our target business model.

Mercury continued to perform well on the bottom line as well this quarter with GAAP income from continuing operations increasing to $4.8 million or $0.14 a share from $2.9 million or $0.09 per share and the second quarter last year.

Adjusted EPS for the second quarter increased to $0.23 per share from $0.20 a share in Q2 of fiscal 2015.

The results for Q2 of 2016 include the impact of discrete net tax benefit of approximately $0.5 million associated with the renewal in late December of the federal R&D tax credit.

Again these numbers are fully reconciled to GAAP EPS from continuing operations in our earnings press release issued earlier today.

Looking quickly at the balance sheet, Mercury ended the second quarter of fiscal 2016 with cash and cash equivalents of $81.6 million compared with $57 million a year earlier.

We generated $10.6 million of free cash flow during the quarter compared with $7 million in Q2 last year, with operating cash flow of $11.9 million driven by cash earnings being partially offset by $1.3 million of capital expenditures.

In addition, we used $9.8 million of cash for the acquisition of LIT in the second fiscal quarter, but still increased our ending cash balance from the end of Q1 thanks to the strong operating cash flows in the quarter.

Also, based on a 338(h)(10) tax election applicable to the LIT transaction, we expect an aggregate tax benefit of approximately $4 million making the net after-tax cost of the acquisition closer to $6 million.

As we said, LIT is not expected to have a material impact on our operating results for fiscal 2016.

That said we believe that the acquisition provides critical enhancement to our capabilities in the product security domain, which is an area of increasing emphasis and importance in our key markets.

I will turn now to our financial guidance.

We believe that Mercury's growth opportunities and robust backlog position us to continue delivering solid revenue growth in the second half of fiscal 2016.

The operating leverage gained from our acquisition integration continues to serve us well, coupled with our ongoing focus on operational efficiencies.

We expect to continue translating this revenue growth into strong operating and earnings performance and once again achieve our target business model for the full fiscal year.

For the third quarter of fiscal 2016 we are forecasting revenue to be in the range of $63 million to $67 million.

We expect gross margin for Q3 to be approximately 45% based on the expected revenue mix for the quarter.

Consistent with our comments from last quarter, we expect gross margins to remain at approximately that level for the remainder of the fiscal year, again based on the anticipated mix of program activities and product sales.

Operating expenses for the third quarter are expected to be approximately $23 million to $24 million.

Adjusted EPS for Q3 is expected to be in the range of $0.19 to $0.22 per share.

This forecast assumes approximately $1.7 million of amortization of intangible assets and approximately $2.3 million of stock-based compensation expense in the quarter.

It also assumes an effective tax rate of approximately 36% for the quarter.

Adjusted EBITDA for the third quarter is estimated to be in the range of $11.3 million to $12.6 million, representing approximately 18% to 19% of revenue at the forecasted revenue range.

Looking at the full fiscal year, after a solid first half and with the recently approved defense budget, we remain on track to achieve our objectives while we continue investing in the business to drive future growth.

We currently anticipate fiscal 2016 revenues to be up in the range of 6% to 8% year-over-year.

And, based on our current revenue mix and associated gross margin expectations for the second half, we expect adjusted EBITDA growth of approximately 9% to 13% year over year.

In terms of the balance sheet, we expect to continue building our cash balance through positive cash flow for the remainder of fiscal 2016, driven primarily by cash earnings and offset in part by a modest increase in capital expenditures compared with last year.

Finally, Mercury's balance sheet remains pristine with zero debt.

In summary, we believe that our participation on important high-priority DOD programs positions us well to continue growing our bookings, backlog, revenue, adjusted EBITDA and adjusted EPS.

We look forward to the prospect of another year of solid revenue growth, higher operating income and stronger profitability overall in fiscal 2016.

With that we will be happy to now take your questions.

Operator, you can proceed with the Q&A.

(Operator Instructions).

Michael French, Drexel Hamilton.

Congratulations on the strong results here.

The first question -- you mentioned Northrup selected you for the Block 3 SEWIP program.

Maybe you can walk us through what the chain of events was, because, as I understand it, you weren't originally on their team.

So why is it they turned and selected you?

Sure.

So, we have had a long-standing relationship with Northrup and I would characterize it as being a strategic relationship.

We weren't part of their team prior to award mainly because I think we were working extremely closely with both Lockheed and Raytheon who were competing against Northrup for the SEWIP Block 3 business.

However, since they were awarded the business we have engaged or reengaged with them and we obviously know the SEWIP program well.

And we have got multiple sets of technologies and capabilities that are applicable for Block 3. And so, I think it is a result of our capabilities, our relationships, our knowledge of the program that allowed us to basically win a pretty significant piece of business on the program going forward.

Okay, yes, that is great.

Congratulations.

Thank you.

Just to shift gears, you mentioned that there were some temporary order delays during the period.

Can you tell us where those delays came -- was it a result of the CR or just something having to do with the program?

Or what was the underlying cause?

Yes, I don't think it is anything that is material in nature; it was just really just some short-term timing delays in terms of getting the POs from our customers.

And as I mentioned in my prepared remarks, we do anticipate that those bookings will occur in Q3.

And in fact, we expect a very strong bookings quarter this quarter.

Okay.

And what was the magnitude of the delays?

Or in other words, what do you think the book to bill would have been had the delays not happened?

Yes, it is not something that we are going to talk about per se, but we do expect a strong bookings quarter in Q3, Mike.

Okay, fair enough.

And then the last one, on the taxes -- and I think Gerry answered this in his comments.

But the tax rate came down during the quarter.

Was that solely a result of the LIT adjustment?

No, it wasn't so much LIT because we only had them for a very short span at the end of the quarter.

It was really a combination of two things.

One is the catch-up for the tax year of 2015 where -- so we had a few quarters of catching up to do.

So that is that one time (multiple speakers).

The R&D.

(Multiple speakers) the R&D tax credit that was reenacted.

And then of course there is the regular slug of it that would have applied to the quarter and which will apply on a go-forward basis and that is what is lowering our rate a few points.

All right, very well.

Thank you.

Sheila Kahyaoglu, Jefferies.

I guess just a follow on the order comment.

It seems like you will recover that in the third quarter.

Maybe could you elaborate on your revised outlook a bit and what the expected contribution is from the LIT acquisition and how much of that is being -- is contributing to it?

So, as we said, we don't expect LIT to have a material impact on either the quarter or for the year.

The capabilities -- that is a capabilities lead acquisition, it is obviously very small.

So essentially what we are doing is absorbing a little more on the OpEx front which is dominated by engineering.

So it is going to drive some of the R&D expense, a piece of which is money that we would likely have spent internally, but for the fact that we now own the capability through LIT.

So it kind of gets lost in the results; we don't see it making a big contribution to the year.

But we see it as a capability that we can leverage very effectively as we move forward.

And as we are seeing the market take shape in the future, we think that is an increasingly important capability and one that we have spent a lot of time working on, as has LIT.

And so it just made a lot of sense for us to acquire it.

So, put another way, really the increase in our guidance from 5% growth to now 6% to 8% in revenues and from 10% growth in adjusted EBITDA to now 9% to 13% is largely a result of the strong performance in the first half, as well as the improved government year fiscal 2016 budget outlook.

Understood.

That clarifies it, thank you.

And then I guess are you sort of -- you do expect a big Q3.

But I guess just in ongoing discussions can you give us an idea of what the environment is like for short cycle demand for your products?

And also maybe on the international side, if you have seen that move along or what kind of discussions you are having with your primes?

Sure.

So as I said in my prepared remarks, I think we are extremely well-positioned.

We are deeply entrenched in some very important production programs.

What is driving the growth is really Radar and EW modernization; the fact that we talked about the long-term trend of requiring more processing onboard military platforms to deal with the big data issue that is present.

As well relating to the LIT acquisition, we believe that we have a leadership position in embedded security for high-performance processing for defense and intelligence applications.

And with the wave of flow downs from DOD relating to program protection security requirements, we are exceptionally well-positioned there.

And that becomes a driver of growth in not only domestic sales but also for foreign military sales where, as our customers are looking to export their capabilities overseas, that technology needs to be protected.

And so, we're kind of right in the middle of that particular trend.

So, overall we feel that we are well-positioned.

Many of our programs, I think as we've talked about historically, have got FMS sales associated with them whether it be Aegis or Patriot or the F-35.

So again, we think that is going to continue to be an important part of the business, Sheila.

Thank you.

Michael Ciarmoli, KeyBanc Capital.

Congratulations, real nice quarter.

Mark, just to go back maybe to SEWIP Block 3. Are you guys ready to sort of quantify the long-term probable and possible impact there?

Yes, so right now based upon our (inaudible) assumptions we believe that the Block 3 value to Mercury is approximately $58 million to $144 million.

It could change over time as the ship set assumptions; the number of platforms that are going to be upgraded is either increased or decreased.

But that is our expectation right now, Mike.

Okay.

And then obviously given the success getting back in Block 3, how should we think about AMDR?

Is there going to be an opportunity for you guys to claw your way back onto that program?

Well, we will see.

It is an area that -- the naval service fleet is an area that we are very focused on.

We believe we have got a set of capabilities that is broadly applicable to a number of different programs of which AMDR may be one.

It is too early to say anything specific about that, but it is certainly something that we would like to be a part of.

Got it.

And then just on the -- you mentioned the facility in New Hampshire.

Can you guys give us a sense of sort of what the utilization is up there now?

I know for quite some time you've been talking about customer visits, a lot of positive feedback.

Can you give us any sense how that facility is performing right now from a volume standpoint?

Yes, so again, talking about a specific utilization rate is not something that we'd discuss, other than to say that we are still running one shift and we have got plenty of capacity to meet both our forward revenue projections as well as potential future M&A.

The facility is performing extremely well, it is critically important as obviously programs such as Filthy Buzzard moves into full rate production later this year, as well as programs such as SEWIP, which you may recall received our first full rate production order for Block 2 last quarter.

So volumes are increasing, but we have still got plenty of capacity.

Got it.

Thanks a lot, guys.

I will jump back in the queue.

(Operator Instructions).

Peter Arment, Sterne Agee.

Mark, just maybe a verification back on SEWIP Block 3. You mentioned I think it was an $11 million contract.

Is that just the EMD portion and how long does that last roughly?

Sure.

So, we actually received an $11 million order of which we recognized slightly less than half from a bookings perspective associated with the EMD phase during Q2.

The other or the remainder we'll recognize as LRIP orders once the options for the LRIP firms up.

Got it.

And then the mention on the $58 million to $144 million kind of probable value, is that just a differential between the current relationship with Northrup versus the previous expectation with Lockheed and kind of on the mix or is it just being conservative on the units?

No, it is actually I think since what we thought was going to happen with -- when we were part of the Lockheed and Raytheon team; it really isn't to do with the content per se.

It is more around the assumptions of the number of ships that is going to be upgraded with the Block 3 capability.

Previously the assumption was much higher.

Our latest information is the number of ships that is going to be upgraded has gone down.

Now that is the current assumption, it may change over time.

But that is the assumption right now.

So it is more to do with number of ships than it is to do with the content.

Got it, that is helpful.

And then just lastly, Mark, on the -- kind of the blade server opportunity, some of the things that you are seeing there.

I mean what kind of conversations you're having, are you seeing any more pickup in kind of the interest there?

Yes.

So I think the answer is, yes, this is going to play out over the long term, but we have already won several applications in the naval domain for the technology that we provided.

At our Investor Day recently we talked about not only being able to provide server class capability in an ATCA format, but we're also exploring the opportunity of providing it in a two use stackable form factor which again opens up other potential opportunities for us.

The nice thing about this opportunity is that it is basically all leveraged R&D.

We design a processing complex once and we can relay that out very cost-effectively and very quickly into different form factors.

So, we think that it's going to put us in an interesting position, particularly when you tie that highest performance processing with the source of embedded security capabilities that we are now delivering.

Got it, appreciate it.

Nice quarter, guys.

All right, thanks, Peter.

Thank you.

And Mr. Aslett, it appears there will be no further questions.

Therefore I will turn the call back over to you for any closing remarks.

Okay, well thank you all for listening.

We look forward to speaking to you again next quarter.

Good evening.

Ladies and gentlemen, that does conclude the program and you may all disconnect.

Everyone have a great evening.