Mercury Systems Inc (MRCY) 2016 Q3 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems third quarter fiscal 2016 conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the Company's Executive Vice President and Chief Financial Officer, Gerry Haines. Please go ahead, sir.

Good afternoon 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 in 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 annual report on Form 10-K for the fiscal year ended June 30, 2015. And in our prospectus supplement on Form 424B5 filed April 4, 2016.

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 EBITDA, adjusted income from continuing operations, 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 depreciation, interest income and expense, as well as income taxes, in addition to the exclusions for adjusted income from continuing operations. And finally, free cash flow excludes capital expenditures from cash flows from operating activities.

A reconciliation of these non-GAAP metrics is included in the earnings press release we issued 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'll begin today's call with a business update, Gerry will review the financials and guidance, and then we'll open it up for your questions.

Mercury made significant progress in the third quarter of fiscal 2016. On top of a major acquisition announcement and the related debt and equity transactions, the business performed well and we continued to deliver strong results.

Our highest priority for the near term is closing the carve-out for Microsemi and beginning the integration. As Gerry will discuss, the debt structure has been finalized and we've established an exceptional bank group that can support the Company's future M&A agenda.

The follow-on equity offering was also very strong with a greater than three times over subscription. As we discussed during our call on March 23rd, the acquisition will strengthen and help grow the core of our business.

In our secure solid-state storage to our industry-leading pre-integrated processing subsystems, it substantially expands our RF and microwave business. It provides us with new capabilities in embedded security and custom microelectronics while also giving us access to new markets, customers, and programs.

Moving now to our Q3 results, Mercury's total revenue was up 11% year-over-year and near the top end of our guidance. Our largest revenue programs were SEWIP, Aegis, F-16 [SABR], and Patriot.

Reflecting favorable mix and improved operating leverage in the business, adjusted EBITDA for Q3 came in well above the high end of our guidance, increasing by $3.1 million, or 27% year-over-year, on $6.3 million of incremental revenue.

This was a strong quarter for bookings. We're up 42% year-over-year in Q3. Our total book-to-bill was 1.23 and total backlog exiting the quarter grew 16% year-over-year to record levels. Our 12-month [forward] revenue coverage remains strong, positioning us well for Q4 of fiscal 2016 and looking forward to fiscal 2017.

Our largest order this quarter was for the long-range discrimination radar with Lockheed for $28 million. This booking is for the radar processing and will utilize our new ATCA-based blade server product line.

Following the $42 million budget EW IDIQ contract in Q2, another major award this quarter was the $15.4 million contract for next generation Filthy Buzzard EW systems. International defense bookings for Q3 including foreign military sales were 8.2% of total bookings. This compares with 21.5% in the third quarter last year.

Our bookings and revenue are coming from a broader set of key programs than in the past. We're seeing strong demand in the radar and EW modernization space, plus a growing appetite for more high-performance secure processing on board in all three platforms.

Our success in major EW programs such as SEWIP, Badger and Buzzard, demonstrates the strength of the strategic relationships and competitive advantages we've created for Mercury in RF, microwave and digital.

We've invested not only in the technology but the manufacturing assets we need to continue to profitability grow our radar and EW revenues. These assets are centered in our newest advanced microelectronic center, or AMC, in New Hampshire.

We've built world-class scalable RF and microwave manufacturing and subsystems integration capabilities at the AMC. These capabilities differentiate Mercury from our competitors as a provider of industry-leading, pre-integrated sensor processing subsystems.

At the same time, the integrated business systems we've installed at the [Hudson] AMC have been crucial to improving the Company's operating leverage. Our more diversified bookings and revenue also reflect the DOD's increasing focus on program protection security requirements for domestic and foreign military sales.

The acquisition of LIT earlier this fiscal year strengthen our capabilities in the embedded security domain. The LIT business is now fully integrated and continues to play an important role in several of our major programs.

With our industry-leading secure Intel server class product line, together with LIT and new capabilities coming from the pending acquisition, we've positioned Mercury as the defense industry's largest commercial embedded secure processing company.

Our revenue and bookings this quarter continue to demonstrate that we're strongly positioned on a great set of franchise programs. These are programs that appear to be well-funded, are currently in or moving into production, and are precisely aligned with the DOD's high priority roles and missions.

Over the past few years, we've leveraged our relationships with the primes as well as our sales strategies, internal R&D investments and acquisitions to build a best-in-class portfolio of products and capabilities targeting the right segments of the market.

We've also been active and disciplined in our approach to M&A. We're looking for deals that have the potential to be accretive in the short term and drive long-term shareholder value. This will continue to be our approach going forward.

We'll continue to look at smaller capability-led tuck-in acquisitions similar to LIT while also building our pipeline of larger opportunities, with the Microsemi carve-out being a good example.

We believe that capability-led deals and carve-outs are likely the most interesting acquisition opportunities for Mercury. We have an experienced corporate development team that continues to build strong industry relationships as well as a pipeline of these types of opportunities.

We have demonstrated our ability to execute a complex set of financing transactions quickly and with great results. We have built a strong internal integration team that is skilled at complex business separation and integration. Finally, as a buyer, we are diligent and offer sellers swift and discreet execution.

We'll continue to target acquisitions that scale the technology platform that we've built, focusing on the key pillars of the business: RF, microwave, and secure processing. And are working to assemble critical and differentiated solutions across the entire sensor processing chain.

The capabilities that we've developed and acquired are very much in line with the needs of our customers. We're pioneering a next generation defense electronics business model, one that aligns well with the industry conditions today and what we expect to occur in the future. We believe we're well-positioned to continue delivering important new program wins along with above industry average revenue and adjusted EBITDA growth.

In summary, the business delivered a strong performance in Q3. We remain on track for another strong performance for fiscal 2016 as a whole, given our strong backlog, expected bookings, broader mix of programs, and the benefits of integrating our previous acquisitions.

In light of our strong bottom line performance in Q3, we are raising our adjusted EBITDA guidance for fiscal 2016. Gerry will have more to say regarding our expectations for Q4 and the fiscal year.

This guidance excludes the Microsemi carve-out acquisition that we expect to close shortly. We expect to provide fiscal 2017 guidance for the consolidated business on our Q4 earnings conference call.

So with that, I'd like to turn the call over to Gerry. Gerry?

Thank you, Mark. And good evening again, everyone.

Before we go through the financial results, I'd like to remind everyone that unless otherwise noted, I'll 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, the third quarter was another significant milestone toward achieving our objectives for fiscal 2016. Total revenue increased $6.3 million, up 11% from Q3 last year, to $65.9 million, near the high end of our guidance of $63 million to $67 million.

International revenue, including foreign military sales, was 21% of total revenue, compared to 17% of revenue in Q3 of last year. Revenue from radar-related applications was roughly flat year-over-year, accounting for 59% of total revenue in Q3, compared with 61% a year ago.

Electronic warfare-related applications accounted for 27% of total revenue in Q3, up from 18% of revenue a year ago. Net of intercompany eliminations, revenue in our largest reporting segment, Mercury Commercial Electronics, or MCE, was $57.5 million, an increase of $4.7 million, or 9% from Q3 of last year.

And our Mercury Defense Systems, or MDS, reporting segment, net revenue was $8.6 million, up $1.9 million, or 28% from Q3 of fiscal 2015.

These segment results exclude revenues of negative $0.2 million in Q3 of fiscal 2016 and positive $0.1 million in Q3 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 to bookings, Mercury's total bookings for the third quarter grew 42% year-over-year to $80.8 million, yielding a book-to-bill of 1.23. We ended Q3 with record total backlog of $$220 million, up approximately $30 million, or 15.7% from $190 million a year earlier. Approximately $172 million, or 78% of our total backlog, is expected to shift within the next 12 months.

Mercury's gross margin for Q3 remained near the middle of our target business model at 46%, compared with our guidance of 45% and 47% in Q3 of last year.

Q3 operating expenses were in line with our guidance at $23.7 million, compared with $21.8 million for the same period last year. The most recent quarter's operating expenses include $1.6 million of acquisition-related expenses, without which operating expenses would've been roughly flat year-over-year.

We continue to realize the benefits of operating leverage as we grew the bottom line even faster than the top line once again this quarter. While revenue grew 11% in Q3, adjusted EBITDA increased 27% to $14.6 million, up from $11.5 million in Q3 of last year. This was well above the high end of our guidance range of $11.3 million to $12.6 million and at slightly more than 22% of revenue was at the top of our target business model.

GAAP income from continuing operations for the third quarter of fiscal 2016 was $4.5 million, or $0.13 a share, which includes the impact of $1.6 million, or $0.03 per share, of acquisition-related expenses. This compares with $4.7 million, or $0.14 a share, in Q3 last year, which included no acquisition-related expenses.

Adjusted EPS for the third quarter increased to $0.25 per share, up 13.6% from $0.22 a share in Q3 of fiscal 2015.

Looking quickly at the balance sheet, Mercury ended the third quarter of fiscal 2016 with cash and cash equivalents of $84.2 million, compared with $66.5 million a year earlier. We generated $2.6 million of free cash flow during the quarter, compared with $7.8 million in Q3 last year.

Operating cash flow of $4.3 million was partially offset by approximately $1.7 million of capital expenditures in the quarter. After the close of the quarter, we also completed the previously announced follow-on equity offering, adding $94.4 million of net cash to the balance sheet.

I'll turn now to our fis-- financial guidance for the fourth quarter and full fiscal 2016. We believe that Mercury's market opportunities and backlog position us to continue delivering solid revenue growth in the fourth quarter of the fiscal year. We expect to translate this growth into strong operating and earnings performance and once again achieve our target business model for the full fiscal year.

Again, the guidance we're providing today excludes the impact of the pending acquisition of the Microsemi carve-out business announced on March 23, 2016. We expect to provide combined guidance including the acquired businesses when we announce our fourth quarter fiscal 2016 results.

As Mark said, our highest priority for the near term is closing the acquisition which we currently expect to take place very early in May, and beginning the integration. The recent equity offering and the debt financing transaction associated with the pending acquisition have proceeded smoothly.

Once all the transactions are complete, we will have established a better optimized flexible capital structure and a strong banking group that should serve our needs well moving forward.

The equity offering after exercise of the over-allotment allocation option raised net proceeds of $94.4 million, which will partially fund the pending acquisition. We also expect to utilize debt financing in the form of a $200 million term loan A facility. The term loan amount is $65 million less than we previously announced due to the proceeds of the equity offering.

The lower quantum of debt also results in a more favorable interest rate on the debt, which we currently expect to be LIBOR plus 200 basis points. As part of the debt financing, we will also establish a new $100 million revolving credit facility, which will be undrawn at closing.

We're very pleased with the financing and the resulting capital structure. It will leave us well-positioned with respect to our debt service obligations and provide flexibility for potential future acquisitions once we get the current businesses substantially integrated.

With that as background, for the fourth quarter of fiscal 2016, and again excluding the carve-out acquisition, we're forecasting revenue to be in the range of $65.5 million to $68.5 million.

We expect gross margin for Q4 to remain at approximately 46% based on the anticipated mix of program activities and product sales for the quarter. Operating expenses are expected to be approximately $24 million.

Adjusted EPS for Q4 is expected to be in the range of $0.20 to $0.22 per share. This forecast assumes approximately $1.8 million of amortization of intangible assets and $2.2 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 fourth quarter is expected to be in the range of $12 million to $13.5 million, representing approximately 18% to 20% of revenue at the forecasted revenue range.

For the full fiscal year, we expect revenue in the range of $250.2 million to $253.2 million, an increase of 6.5% to 8% from fiscal 2015. Based on Mercury's strong year-to-date performance and the year-over-year revenue growth anticipated for the fourth quarter, we are raising our adjusted EBITDA guidance for the full fiscal year.

We currently expect adjusted EBITDA for fiscal 2016 of approximately $51 million to $52.5 million, an increase of 15% to 18% from fiscal 2015, and a $2.5 million increase from our prior guidance range for the year.

In terms of the balance sheet, we expect to continue building our cash balance through positive operating cash flow during the fourth quarter. Offset in part by an increase in capital expenditures compared to last year as we invest modestly in equipment and infrastructure improvements supporting the continued organic growth of the business.

In summary, we believe that our top line moment, coupled with our operating leverage, have positioned us for a solid finish to the fiscal year. We look forward to reporting another full year of revenue growth, higher operating income, and stronger profitability for the full fiscal year 2016.

With that, we'll be happy to take your questions. Operator, you can proceed with the Q&A.

Thank you. (Operator Instructions) Peter Arment, Sterne, Agee.

Hey, Mark, I know we're going to talk about MSC once the deal closes on the next quarter call. But can you talk about just kind of the -- your desire to continue to do acquisitions in terms of as we look out over the next, say, 12 months during when you're going to be integrating what will be the largest deal to date? Can you just give us a little more color on kind of the bandwidth that you guys have?

Sure. So our focus in that time period that you mention is solidly going to be on integrating the business and starting to harvest the synergies that we discussed during the equity offering. So that's going to be our primary focus.

So I don't see us going out and doing another significant acquisition in the short term, Peter. That said, the team continue to build relationships with folks and looking for opportunities because, as you know, there is a lead time associated with developing these sorts of opportunities.

Okay. That's helpful. And then just regarding, you mentioned kind of the radar revenue mix was flat year-over-year. Are you still seeing a lot of opportunities when you look out regarding the upgrades to Patriot? And maybe just a little more color there.

We are. I think it's a theme that's going to continue for some time and it's across both the airborne domain for fighters on various UAVs. Clearly missile defense radars are seeing some substantial new starts as well as upgrades there.

And probably the most significant of which is the LRDR order that we just announced this quarter, which was a very large deal for us. We're also seeing other opportunities in terms of ground-based radar.

So, yes, I think it's a theme that we expect to continue, Peter.

Okay. And just lastly, you mentioned the -- I think it was 8% of the bookings were international this quarter. Certainly lower than we've seen in the past. Are you seeing any impact from the delays from customers? Or is it just more timing and lumpiness?

It's more lumpiness than anything else. I think at the Euro level we expect that our international and FMS revenues will actually increase slightly year-over-year. But as you know, they're notoriously difficult to predict from a timing perspective.

Okay, I'll jump back in queue. Nice quarter.

Thank you, Peter.

Thanks, Peter.

Sheila Kahyaoglu, Jefferies & Company.

Hi, guys. Good evening. Thanks for taking my question. So in terms of the proceeds from the transaction, we should assume the $30 million of additional net proceeds from the stock offering and the lower term loan A is going to be cash on the balance sheet? And I guess can you just update us on your target leverage metrics?

So the -- obviously we've taken the term loan A down from 265 to 200. The equity offering at 94 plus supplements the 84 plus that's already on the balance sheet. And then the acquisition, the headline price was 300. There will be some expenses associated with that and the remainder will land on the balance sheet as we move forward.

As you gathered, we're expecting a lower interest rate because we got a lower quantum of debt on a net basis, given the cash on the balance sheet. And that's going to put us inside of two turns of debt.

Got it. And then in terms of LRDR, I think this is the first large blade server win. Can you talk about it is a new program. How you guys got on it? Was it competitive in the decision for Lockheed to outsource that portion of it?

Sure. So we've done, obviously, as you know, a tremendous amount of work with Lockheed Martin on the Aegis program. And this is some of the team that have worked on this are obviously working on Aegis as well.

We think that we've got one of the broadest and best processing product portfolios in the industry today. And I think the opportunities that has arisen as a result of the fact that IBM selling its blade server business to the Chinese company Lenovo and the DOD and our customers' desire to purchase solutions from domestic suppliers.

So we've been working with them on it for a while. They called us when the announcement was made and asked whether or not we had something that we could provide to them. Which we did very, very quickly.

And so we're thrilled to be a part of it. I can't comment on the process that they underwent in terms of whether it was competitive or not. But we are the sole source provider of the processing solution.

Perfect. Thank you.

Thanks, Sheila.

Michael Ciarmoli, KeyBanc Capital Markets.

Hey, good evening, guys. Nice quarter and thanks for taking my questions.

Sure, Mike.

Maybe just a follow up on the LRDR. I think the booking contract or award was $28 million. Can you give us a sense as to what that covers? Is that for one installation? Or how should we think about your sort of ship set content there? (multiple speakers)

Yes, so --

-- program evolves?

Sure, Mike, it's a good question. So right now there is only one radar that we know of that is going to be deployed in Alaska at a clear air force station. The order that we received is going to cover the initial systems that will be used for development and integration efforts, as well as systems that will actually be deployed up in Alaska.

I think we'll see what happens but I think there's some discussion at the government level as to whether or not we need additional installations like the Alaska in various parts or places around the world as well as domestically. But nothing is finalized there.

We do think, however, that this is an important program for us not only because of its size. But also because it is our first large blade server opportunity. And historically, most of our work has actually either been in the naval domain or the air for -- the airborne domain. And this is a very large ground contract for us as well.

So we're thrilled to be part of the team. And we do see additional opportunities going forward as the program progresses.

Got it. That's helpful. Who else are you guys competing with on these blade servers? Was any other company potentially in the running? Or are there other significant companies out there with this capability?

Yes. So there are clearly other commercial companies but I think as we've discussed in the past, part of the challenge that the DOD is facing is that the technology in many of our competitors' products are designed, developed, manufactured and supported overseas.

Which becomes increasingly more difficult for the DOD to utilize that technology, given their desire to ensure the provenance and the integrity of not only the technology but also the supply chain. And the increasing mandates that we see occurring across the DOD with respect to program protection security requirements.

So I think the opportunity is that we've really positioned ourselves extremely well with not only the broadest and probably highest performance processing product line, but the fact that we've invested significantly in embedded security capabilities both through our own internal R&D investments with the recent acquisition of LIT. And with the soon-to-be-acquired Microsemi carve-out businesses.

So we've created a very unique and differentiated set of capabilities that are increasingly important.

Got it. And then just last one for me and I'll jump off here. In terms of Microsemi, in terms of the integration, can you elaborate a little bit in terms of what we should expect? Are we going to see any facility consolidations or are you going to run these units sort of as stand-alone where they exist now? Just trying to get a sense of how you are going to proceed with layering this business into the existing.

Yes, sure. So what we talked about, this is not a head count reduction exercise. This is about the ability to be able to expand their manufacturing capability to be able to manufacture some of our existing product line, which we see as an opportunity from a margin expansion perspective.

We see the ability to generate margin by shifting what is today more of a distributor model into more of a direct sales approach, given the strength of our channel and customer relationships.

And then finally, there are purchasing synergies, just given that we're involved in somewhat similar areas. The total of the synergies that we described is approximately 10 million by 2020 with two-thirds of that by the end of the second fiscal year.

The plan that we developed is a phased approach. So as we are standing up some of these new manufacturing capabilities, we're doing that in a very thoughtful phased approach. So we don't create undue risk in the business.

Great. Thanks a lot, guys.

Okay.

Sure, Mike.

Jonathan Ho, William Blair & Company.

Just wanted to understand what's been sort of the response from your customers regarding Microsemi? And can you maybe give us a little bit more color in terms of what sort of opportunities this might open up with different groups within the primes? You know, new areas that you can potentially target. Just a general sense or what the reaction's been.

So the reaction has been extremely positive. I think not only because they know the leadership team and the capabilities of the businesses that we're acquiring. But also because I think customers clearly see the synergy and the fit with Mercury's strategy, technology, and capabilities.

I think the areas that we're focused on from a synergy perspective are around being able to actually provide more complete and integrated security capabilities. We see the opportunity in the RF and microwave domain of being able to expand our content footprint, just given some of the capabilities that they have.

As an example, they've got gun-based high-power amplifiers. They're involved in providing certain capabilities in certain next generation antennas, which would be potentially a significant market expansion opportunity for us in the RF, microwave and digital domain.

We see the opportunity of selling secure solid-state storage in -- alongside our secure processing product lines. So there are a whole host of opportunities, I think, that we're going to look to harvest from a revenue-growth perspective over the longer term.

Got it. And you guys have talked a little bit about sort of the security opportunity on the embedded side. But I just wanted to understand how is this sort of showing up in the market?

Is this additional requirements that are coming onto platforms? Is this new capabilities that people need to add? Is it software capabilities? I'm just trying to understand sort of how to think about or maybe quantify what this could do for your business.

Yes. So I think it's a number of folds. The DOD have got mandates to start to protect the electronic subsystems. And in the case of the processor, it's really the brains of the system on both existing systems domestically, new program starts.

But also protecting the critical information and the technologies that are embodied inside of these platforms also becomes critically important as these systems are actually exported overseas. So international and foreign military sales.

So we're really seeing opportunities across the patch in both airborne, naval and ground-based applications. And when you couple that not only the security but the requirements of very high performance processing, and buying that from a company that does the design, development and manufacturing domestically it really narrows down the field very rapidly.

And in essence what we've done is created a very unique business model with a very unique set of assets to be able to help our customers address those government needs.

Great. Thank you.

Michael French, Drexel Hamilton.

I'd like to go back to the blade server and the opportunities there. And you mentioned that the -- possibly some sites outside Alaska could be opportunities. And that makes sense since we know that that's not the only site.

Now, are there other markets besides ground-based missile defense where you hope to market these? And if so, what's the status of those endeavors?

Yes. So there are other opportunities. Clearly, this is the first one that we've publicly announced. Yes, we have sold additional systems into certain of our other customers for various applications, including on some large naval programs.

We see the opportunities in some of the larger wide-bodied signals intelligence platforms. So anywhere where there's more of a controlled environment where space is not necessarily at a premium like it is, say, in an aircraft or a fighter aircraft, an opportunity exists to sell those systems.

The -- one of the things that we've also talked about and I think what we're seeing as a result of us having this new capabilities is the fact that we're actually being -- we're seeing opportunities that expands our addressable market from not just providing the processing associated with the sensor.

But up into other mission-critical computer applications on board. So command and control or combat systems as an example. So it really is opening up the aperture and we've already got some other wins, albeit at an earlier stage for some development programs.

Okay. And perhaps along similar lines, the F-35 is in the news again. There's another GA (inaudible) about the ALIS system having some problems. And you've bid on the processor upgrade for F-35.

So is there possibly any connection to the issues they're having now and perhaps the skill set that you could bring to address those? I mean, does this create opportunity for you? Or (multiple speakers) just any overlap at all here?

So I'm not aware that any of our technologies or capabilities will be involved with the issues that you described. We obviously are playing a major role through the licensing of some of our intellectual properties and technologies on that program to various customers.

And longer term, we do see the opportunity just based upon some of the significant investments that we've made through our own Intel R&D efforts to intercept some of the longer term needs associated with that particular program.

So we'll see how the upgrade cycle occurs, the competition associated with that. But we're very supportive of the program as well as our customers who are pursuing that particular opportunity.

Thanks, Mark. I appreciate your response.

Thank you, Mike.

(Operator Instructions) [Maury Marcus], Sidoti & Company.

So just got two quick questions on the quarter. Number one is, what caused gross margin to be better than expected? And then number two is just on research and development, it seems like you had a lot government funded work. Is that true?

So gross margin really is ultimately driven by mix. We also continue to see the benefit of some improvements from a process standpoint as we've grown and just simply gotten a little bit better.

So we're always looking to move the dials a little bit and produce as efficiently as we can. So we saw those sort of small factors combine to just give us a little bit better margin than what we had originally thought as we were entering the quarter.

Customer-funded R&D has been progressively increasing as we've won opportunities in new programs. As we get into the design win piece and we get into bigger subsystems and things like that where we're doing more stuff.

Obviously, those systems are more complex, have literally and figuratively more moving parts. So the design work that goes into them tends to increase and we've been certainly devoting resources to that effort.

Okay. So then, so it would be fair to assume that going forward you -- they just expect a little bit more government-funded R&D? Or customer-funded R&D?

I think it's been a trend that has continued that we expect to continue. And I think Gerry hit the nail on the head. I think by far the majority of the work that we're doing now is at the subsystem level.

That's very much in line with the trends that we've discussed in terms of our customers outsourcing at a higher level of integration. We're investing in the technology building blocks that the reason that we're seeing an increase in customer funding is to do with the customization of those particular products into the subsystems that our customers need for their specific application.

So it's basically a prove point that our strategy is working well.

Okay. Got it. And then just one more question and I don't know if you guys can talk on this just because it's kind of recently announced. The navy announced that about a $800 million IDIQ to kind of the main primes just regarding electronic.

The contract is in electronic maneuver warfare command and control program. Just to design the studies, fabrication, integration and test, evaluation. This pretty much is the idea we've talked about in the past where the open RF and open modular systems just going forward.

Is that, again, it's early on, but is that something you guys are looking to get on and work with them? Because this is a lot of the clients, customers that you guys have worked on in the past.

So I can't comment specifically on that program that you mentioned. But I can say that the open -- the initiative that we have around open RF which is start -- which is seeking to add much greater modularity into what is today a very proprietary set of capabilities in RF, microwave, and digital.

Tried to open that up to speed up the rate at which new technology can be introduced. Creating standards which will help improve the affordability is something that all of our customers as well as the government is interested in.

Like you saw Mercury do in the digital world, we are seeking to kind of pioneer a set of technologies and solutions in that area. And so you will continue to see us be very active in that space.

Okay. Great. Thank you, guys.

Yes.

You're welcome.

Thank you. And Mr. Aslett, it appears there are no further questions. Therefore, I would like to turn the call back over to you for any closing remarks.

Okay. Well thank you all very much for listening. We look forward to speaking to you again next quarter.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone have a great day.