Mercury Systems Inc (MRCY) 2017 Q2 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems second-quarter FY17 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 www.mrcy.com.

We'd 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 rate; 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, 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 statements to reflect events or circumstances arising after the date on which such statement is made.

I'd also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles, or GAAP, during our call, we will also discuss several non-GAAP financial measures, specifically adjusted EBITDA, adjusted income, adjusted earnings per share, or EPS, and free cash flow.

Adjusted income excludes several items from GAAP net income. 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 settlement -- and settlement income and expense, and stock-based compensation expense, along with the tax impact of those items. This yields adjusted income, which is expressed on a per share basis as adjusted EPS, calculated using weighted average diluted shares outstanding.

Adjusted EBITDA excludes interest income and expense, income taxes and depreciation, in addition to the exclusions for adjusted income. 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.

I will now 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 continued to deliver strong results in the second quarter of FY17. Industry trends appear to be improving and our strategy is working. Our acquired and organic businesses performed extremely well, and we came in at or above the high end of our guidance on all of our metrics, setting several records along the way.

Mercury's total revenues for Q2 grew 62% year-over-year, to a record $98 million, and we continue to deliver strong growth organically. Excluding the recently acquired CES business, revenues were up nearly 56% from Q2 last year. Our largest revenue programs in the quarter were F-35, Aegis, SEWIP, Filthy Buzzard and Reaper. Adjusted EBITDA was a record, up 83% year-over-year, and at 23% of revenue, well within our recently updated target financial model.

This was also a record second quarter for total bookings and backlog, and our 12-month forward revenue coverage continues to be strong. Our largest bookings in Q2 were SEWIP, Filthy Buzzard, F-35, PGK, which is the precision guidance kit for artillery shells, and Aegis. International defense bookings, including foreign military sales, were 10.1% of total bookings versus 9.6% in Q2 last year.

As we begin the second half, we are expecting FY17 to be another year of solid revenue growth both organically and at a total company level. Our content and market expansion growth strategies are working well. We're targeting what we believe to be the largest secular growth opportunity in the defense industry, outsourcing by the major defense primes for work that was previously done in-house.

We're actually seeing an acceleration in outsourcing demand across the customer base, including locations that historically have been more inclined to do the work themselves. At the same time, our customers are continuing their flight to affordable, higher quality, innovative suppliers. As a result, we continue to take share from less capable competitors.

The strategic deals that we've completed since FY11 have substantially expanded our capability set and our total addressable market. These transactions have enabled us to provide a broad range of affordable pre-integrated secure processing sub systems. We're leveraging the new capabilities we have acquired and developed organically to drive above industry average growth. We're involved in franchise programs that appear to be well funded and are currently in or moving into production. We're also winning important new designs. As a result, we continue to expand and diversify our basic programs and content on those programs, great examples being Aegis and SEWIP.

If you look at our top 10 revenue programs so far in FY17, only four of them were in the top 10 in FY13; and if you look at this year's top 30 programs, less than half were in the top 30 four years ago. The new entrants in the top 30 now comprise 42% of our top 30 program revenue through the first half of this fiscal year. This broader portfolio means lower programmatic risk and additional opportunities for growth.

Over the past few years, we've successfully leveraged internal R&D investments and acquisitions to build a best-in-class portfolio of products and capabilities. We've demonstrated significant value creation through our M&A approach. We have a strong track record of successful acquisitions and integration, and our scalable platform targets a significantly expanded addressable market.

Our vision is to be the leading commercial provider of secure sensor and mission processing sub systems. Overall, the level of activity in secure processing upgrades, RF content and expansion, and EW remains very high. Our new design win pipeline for this fiscal year is likely the largest I've seen since joining Mercury.

Our big news on the M&A front this quarter was successfully closing the acquisition of CES, which is now doing business as Mercury Mission Systems International, or MMSI. Strategically, MMSI has important and complementary capabilities in mission computing, affordable safety critical avionics and platform management that are in demand from our customers. These new capabilities will further expand our addressable market, markets that are aligned to Mercury's existing focus.

Like Mercury, MMSI has exceptional technology, solid engineering talent and strong leadership. We believe there is an excellent fit, strategically, culturally and operationally, between this business and Mercury. The business fits very well with both our market and content expansion growth strategies and exemplifies our long-term approach to M&A, that is, entering a new market in a relatively low-risk way, learning how to succeed there over time, and then scaling the new business, as we did in RF last year with the Microsemi carve-out transaction.

It's been approximately eight months since we closed that transaction, and everything continues to go extremely well. The businesses are delivering good financial results in terms of improved growth and strong profitability, the teams are working seamlessly and are well integrated, the security and networking infrastructure has been fully migrated. We continue to accelerate our manufacturing efficiency initiatives and are ahead of our original plan. The migration to Mercury's existing ERP applications is progressing well and is expected to be completed in the second half of this fiscal year, as planned. In total, we're on track to deliver the planned synergies and to complete the integration activities on time and on budget. All in all, we couldn't be happier with the team, how the acquired business is performing, and the success of our integration efforts to date.

We also continue to make good progress on our headquarters move from Chelmsford to Andover, Massachusetts, which we expect to complete in early March. In addition to upgrading our headquarters facility, relocating to Andover provides an opportunity to modernize our engineering tools and development methodologies to a more agile approach. We'll also improve how we collaborate and communicate with one another across the Company and how we provide cutting edge solutions for our customers.

During FY16, we demonstrated our ability to complete a large acquisition and an extensive set of financing transactions quickly and with great results. Going forward, we intend to remain active and disciplined in our approach to M&A, as we work to extend our record of organic and acquisition-driven growth. We will continue to look for deals that are strategically aligned, have the potential to be accretive in the short term, and drive long-term shareholder volume.

As we do so, we'll continue to target acquisitions that expand our addressable market in aerospace and defense electronics and that scale the technology platform that we've built. We will remain focused on the key pillars of the business, RF and secure processing, while working to assemble critical and differentiated solutions for sensor and mission processing. We'll remain focused on smaller capability-led tuck-in acquisitions, while continuing to build a pipeline of larger opportunities.

Moving to the industry conditions, as anticipated, we began government FY17 with another budget continuing resolution that will continue through March. On balance, however, the industry conditions appear to be improving and our pipeline of opportunity continues to grow. The strategy we're pursuing is increasing the size of our addressable market and expanding our capabilities. It's clearly resonating with our customers and it's consistent with the government's defense priorities and goals for a procurement reform.

In light of Mercury's strong results in Q2 and the first half of FY17, the continued success of our integration activities, and our strong backlog, we are again raising our full-year guidance. Gerry will take you through the outlook in more detail.

In summary, we are anticipating continued strong performance, both organically and in our acquired businesses, in the second half of FY17, driven by growth in our major product lines and across many of our programs. As a result, we believe that Mercury is heading towards another strong year in FY17 in total, as we continue to grow revenue, GAAP income, and adjusted EBITDA above the industry average. With that, I'd like to turn the call over to Gerry. Gerry?

Thank you, Mark, and good afternoon again, everyone. Before I go through the financial results, I'll note that, unless otherwise stated, we will be discussing the Company's financial results, comparisons to prior periods and guidance on a consolidated basis. This includes the CES business we acquired in Q2 of this fiscal year, as well as the LIT and Microsemi carve-out businesses we acquired in FY16.

Turning to our financials, Mercury delivered another very strong performance in the second quarter of FY17, as bookings, backlog, revenue and adjusted EBITDA all grew to record levels. At the same time, we completed yet another acquisition aimed at expanding our addressable market and capability set. Overall, it's been a great first half on a consolidated basis and organically.

Total revenue for the second quarter increased $37.6 million, to $98 million, up 62% from Q2 last year and exceeding the top end of our guidance of $91 million to $95 million. Excluding the impact of CES, which we acquired on November 4, 2016, organic revenues would have been $94.1 million, an increase of $33.7 million, or 55.8% year-over-year.

International revenue, including foreign military sales, was 15.3% of total revenue, compared with 21% in Q2 of last year. Revenue from Radar and Electronic Warfare together accounted for 67% of consolidated total revenue, compared with 82% a year ago. The lower proportion reflects the larger and more diverse revenue mix for the quarter resulting from the addition of several new businesses and the associated expansion of our addressable market and revenue base. Radar revenue was up 51% year-over-year, while Electronic Warfare revenue grew 6%.

Mercury's total bookings for the second quarter were $108.5 million, up 140% from $45.2 million in Q2 last year, yielding a strong book-to-bill ratio of 1.11. We ended the second quarter with an all-time record total backlog of $319 million, which is up $114 million, or 56% from the $205 million of a year ago. Approximately $279 million, or 87% of this total backlog, is expected to ship within the next 12 months. Our backlog demonstrates the continued growth we're seeing in our franchise program portfolio and additions to that portfolio through continued design wins, content expansion, and new market opportunities.

We continue to translate our bookings and revenue growth into solid profitability. Mercury's gross margin for the second quarter of FY17 was approximately 48%, above our Q2 guidance and within our target business model. Gross margin was up 3 points from the prior quarter, as we benefited from high royalty revenues in our Q2 sales mix, as we did in last year's Q2, when gross margin was 49%. Our Q2 FY17 gross margin also included a $0.7 million negative impact from the step-up of inventory valuations due to purchase accounting, which we discussed last quarter.

Total Q2 operating expenses were $38.4 million, versus our guidance of $36.3 million to $36.6 million, and $23.4 million for the same period last year. The year-over-year change reflects the inclusion of CES acquisition expenses and two months of CES operating results in this year's Q2, which were not included in our guidance for the quarter, plus the incremental year-over-year addition of the businesses acquired from Microsemi, as well as higher overall compensation expenses resulting from the Company's annual compensation adjustments that went into effect in October.

The most recent quarter's operating expenses also reflect our ongoing investments to realize planned manufacturing efficiencies and increased R&D investment in our newly acquired businesses, as we boost spending to align with our organic level of R&D investment.

OpEx in the second quarter also included approximately $0.4 million of non-cash rent expense attributable to the lease of our new headquarters, driven by GAAP lease accounting. This duplicative non-cash expense is expected to total $1.1 million, approximately, for the full fiscal year and will end in May of 2017, when actual cash rent payments for the new facility commence and the lease of our current headquarters site expires.

GAAP net income for the second quarter of FY17 was $5.2 million, or $0.13 a share. This compares with $5.0 million, or $0.15 a share, in Q2 last year. Excluding the impact of CES, Q2 net income would have been $5.0 million, or $0.13 a share.

Adjusted EPS for the second quarter increased to $0.30 per share, up 30.4% from $0.23 a share in Q2 of FY16 and above the high end of our guidance range of $0.22 to $0.27 a share. Excluding the impact of CES, adjusted EPS would have been $0.28 a share. This is based on approximately 40.0 million weighted average diluted shares outstanding for the quarter.

Mercury's Q2 FY17 adjusted EBITDA increased 83%, to $23 million from $12.6 million a year ago, representing 23% of revenue and well above our guidance range of $18 million to $21 million for the quarter.

Turning to the balance sheet, reflecting the CES acquisition and anticipated higher capital expenditures, Mercury ended the second quarter of FY17 with cash and cash equivalents of $46.2 million, compared with $81.6 million a year earlier and $81.7 million at the beginning of this fiscal year.

The balance sheet also reflects a non-cash liability of $7.7 million associated with estimated, but as yet unearned, future potential benefits under the Swiss statutory employee pension plan for CES. This is simply a result of accounting for the plan under US GAAP. The plan is fully funded for all current benefit obligations.

From a cash flow perspective, Mercury's operating cash flow of $14.2 million for Q2 of FY17 was partially offset by $7.7 million of capital expenditures. This yielded $6.5 million of free cash flow, compared with $11 million in Q2 of FY16.

Net capital expenditures this quarter were lower than we anticipated, due to modest delays in the timing of certain spending and earlier than anticipated reimbursements for tenant improvements in our new headquarters location. This reflects only the timing of expenditures and reimbursements and we're pleased that the project remains on time and on plan.

As we begin the second half of FY17, Mercury's financial position remains strong. We've maintained flexibility in our capital structure and good access to capital, with a moderate level of debt, an untapped $100 million revolving credit facility, and $400 million of remaining capacity on our universal shelf registration. As a result, we are well positioned to continue executing on our capital deployment strategy supporting future growth, both organically and through acquisitions.

I'll turn now to our financial guidance for the third quarter and full FY17. For purposes of modeling and guidance, we have assumed no restructuring and no acquisition or financing-related expenses, and an effective tax rate of 35% in the periods discussed.

Once again, we expect the second half of the fiscal year to be stronger than the first half, based on the strength of our bookings and backlog and the results of our accelerated acquisition integration efforts, which should begin yielding planned savings and increased operating leverage as the year progresses. As a result, we are once again raising our revenue and adjusted EBITDA guidance for the full year, even before the inclusion of CES.

We also expect strong positive operating cash flow for the balance of the fiscal year. Partially offsetting that, we now anticipate that Q3 will be our peak quarter for CapEx in FY17, with capital expenditures expected to be approximately $15 million to $16 million. This reflects the incremental addition of the acquired businesses, completion of our new headquarters, and the acceleration of our acquisition integration activities.

Even with the elevated level of CapEx expected for Q3, we expect free cash flow to be stronger in the second half of the year than in the first half, as capital spending tapers down in H2 and we begin seeing the benefit of the operating leverage associated with a more highly integrated business. Our integration plan remains on track and we anticipate realizing the estimated $10 million of originally projected run rate synergies well within the timeframe laid out in our initial plans, with approximately two-thirds of those run rate synergies being realized within the first two years.

With that as background, for the third quarter of FY17 we're forecasting total revenue, which includes CES, to be in the range of $103 million to $107 million. Gross margin for Q3 is expected to be approximately 47%. This reflects a lower impact from purchase accounting inventory valuation step-ups, more than offset by lower royalty revenues and other more modest changes in our Q3 sales mix.

Q3 GAAP net income is expected to be in the range of $5.6 million to $6.8 million, or $0.14 to $0.17 per share. Adjusted EPS for Q3 is expected to be in the range of $0.29 to $0.32 per share. This estimate assumes approximately $4.7 million of amortization of intangible assets, $0.3 million of fair value adjustments from purchase accounting, and $3.8 million of stock-based compensation expense.

Adjusted EBITDA for the third quarter is expected to be in the range of $22.8 million to $24.7 million, representing approximately 22% to 23% of revenue at the forecasted revenue range. This includes $0.3 million of non-cash rent expense attributable to the lease of our new headquarters, as well as modestly increased operating expenses associated with our integration and R&D spending plans.

As I said, we are also raising our guidance for the full year. Before the addition of CES, we now expect our base revenue for the full fiscal year to increase to between $377 million and $384 million, up from our prior guidance of $370 million to $380 million which also excluded CES. Including CES, we now expect Mercury's total revenue to be in the range of $393 million to $400 million for all of FY17.

Total GAAP net income for FY17, including CES, is expected to be in the range of $19.4 million to $21.4 million, or $0.49 to $0.54 a share. We currently expect total adjusted EBITDA for all of 2017 to be approximately $87.5 million to $90.5 million, an increase of 53% to 58% year-over-year and, at approximately 22% to 23% of revenue for the year, well within the range established by our updated current target business model. Adjusted EPS for FY17 is now expected to be approximately $1.09 to $1.14 per share.

In summary, we have concluded the first half of FY17 with record performance across multiple dimensions, including forward indicators, such as bookings and backlog growth. Our content and market expansion growth strategies position us well in today's defense industry environments. Our program base is becoming larger and more diversified, and we've proven our ability to expand our addressable market and drive profitable growth through disciplined M&A. Reflecting these positive dynamics, we believe that Mercury is on track for a year of strong growth and solid financial performance in FY17.

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

Thank you, sir.

(Operator Instructions)

Jason Gursky, Citi.

Good afternoon, everyone.

Hello, Jason.

Mark, can I start with a question for you? As you've had an opportunity here to reflect on the new administration, can you talk a little bit about the potential for policy reform or procurement reform that might be coming down the horizon? And what would be good for Mercury and what would be a bad outcome, if we were to see some procurement reform?

Sure. So I don't think we expect a significant change overall in terms of the focus on improving the affordability of the goods and services that the DOD procures. I think that is going to endure, just based upon what we've heard from President Trump. And that ends up, as we have said previously, ends up actually be a catalyst for increased outsourcing, because, given our model, we're able to do things more quickly and more affordably than many of our customers are able to do things in-house. So I think that is by far the primary driver. What could be a negative is if they decided not to focus on improving the overall affordability levels.

Okay. That's great. And then Gerry, I was wondering, given the recent acquisition, whether you could update us on some relative ship set values for Mercury. Specifically, I'd love to hear some updated thoughts on F-35 ship set content relative to F-18, and then ship set value on the varying Navy ships, just rank order where you've got the most content after the recent acquisition.

Sure. We don't typically comment, Jason, in terms of the ship set values on any particular program or platform. But I think as we laid out at our investor day, we've been very successful, not only expanding our addressable market, which has gone from approximately $3.8 billion when we were simply a processing product provider at the Tier 3 level, to today, as we kind of moved into the RF marketplace and most recently, with the acquisition of CES, moving into more mission computing, avionics, as well as platform management. That market, on a global basis, for just what we do is over $30 billion.

If you go back to some of the examples that we gave at Investor Day, I think we've a really good job taking either the investments that we've made internally in organic R&D or the acquired businesses and turning that into expanded content on different programs. So we talked at Investor Day about the Naval surface fleet and how we have gone from literally just providing the processing associated with the radar, largely for domestic applications, to now we are also providing capabilities for FMS. With SEWIP, we moved into the electronic warfare suite. We are now providing capabilities for the signals intelligence on board those platforms. We're involved in the [C4I] on programs such as the NMT, which is the Navy multi-band terminal. And we continue to see opportunities, as we've made investments in our server class, blade server architecture, to moving to other parts of the computer architectures on board.

So I didn't directly answer your question in terms of the ship set volume, but the reason that our revenues are growing much faster than the overall industry average is because our strategy is working.

Okay. That's fair. Thanks, guys.

Sure.

Thank you. Jonathan Ho, William Blair.

Hello, guys. Congratulations on the strong quarter. I just wanted to start out with the CES acquisition. And is there any way that you could maybe help us with thinking in terms of the growth rate for that business and whether there's any seasonality, either in the bookings, expenses or revenue for that business that may be different from your current business?

So, we obviously didn't give a ton of detail. It's a relatively small acquisition, so we don't expect it to move the needle meaningfully through the year, Jonathan. I guess a couple of high points. CES is a profitable business. It's a growing business. We think it aligns pretty well with our overall financial profile. As we said at the time of the acquisition, it's slightly dilutive on an as acquired basis to our adjusted EBITDA, but we also expect that there will be realizable synergies that will bring it into line with our operating model in a relatively short period of time. We generally look for things like that happen within about the first year of ownership.

So we've taken all of that, by the way, into account in issuing our guidance for the quarter and for the year. So that's why I was careful to highlight that where I was including CES and then distinguishing the changes in guidance both pre-and post the acquisition. Does that help?

Yes. Perfect. And then just in terms of the operating leverage that you're seeing in the model, can you maybe break it down for us a little bit more in terms of how much of this is coming from the cost synergies from prior acquisitions, how much from the mix changes and the royalties? And then, also thoughts in terms of how much additional leverage we can look for throughout the course of the year?

Sure. So I think Gerry talked about the gross margins and just the impact that mix has had and will continue to have on that in any particular period. We still think that the range that we've given in terms of our updated target business model is fine, but it can move around period to period.

I think the benefits that we're getting for an operating leverage perspective is as a result of our integration efforts, which continue to go extremely well. As you know, we're not a holding company; we are deeply integrating the businesses that we acquire from a channel and from a process and from a systems perspective. And it's really that, that is yielding the leverage that we've seen. And I think our belief is that we will continue to be able to grow our expenses at a rate that is slightly less than the overall top line.

So we'll continue to see some of that operating leverage manifest itself. And as Gerry said in his prepared remarks, the integration activities is going well, which is why we think that the second half will be stronger than the first.

And to illustrate that just a little bit, you'll recall that at the beginning of the year, we said we thought we could touch our updated, i.e. stepped up 400 basis point target operating model. As you heard from the guidance update that we just gave, we think we're going to get into that model, i.e., not just hit the 22%, but somewhere in the 22% to 23% range for the year. And that's reflecting exactly what Mark talked about.

Got it. And just one final one, just qualitatively. When we think about the new administration and some of the commentary that they've had specifically for prime contractors, are you starting to see those primes come to you more often? Is there a tipping point which could maybe drive an acceleration in that interest level?

Yes, I'm not sure whether it's directly related to the new administration, because I think that is still obviously very early days. But as I said in my prepared remarks, I think there are two really, trends that are clearly more pronounced. The one is that we are seeing more outsourcing occurring, and even in parts of our customer base that historically have tended to do more of the work in-house, which is a very encouraging sign overall.

The second is what I describe as really a flight to quality. And our customers are really seeking to do business with a smaller number of more capable suppliers who really focus in on affordability, higher quality, as well as innovation, and Mercury is clearly one of those. I think it's that old adage, never waste a good downturn. We leaned into the period post-sequestration and invested significantly in the business. And I think that's one of the reasons that we're seeing the heightened activity level that I described in my prepared remarks.

Thank you.

Thank you. Peter Arment, Baird Equity Research.

Yes. Good evening, guys. Nice results. Mark, can I just call out, on the gross margin side specifically, really nice results this quarter. But we've seen a lot of volatility, if I think back, over the last several quarters. I know it's tied to a lot of the acquisitions and the mix, but what's the right way to think about margins in the second half of the year?

I'll take that one, Peter. As we've said sometimes in the past, the gross margin will tend to move around a little bit within the range we've established of 45% to 50%. And that's really driven largely by mix, some of which is offset in that mix by other changes down the OpEx line. So for example, higher and lower levels of customer funded R&D, which will shift some of our costs up into the revenue and cost of goods sold line.

So we really think that it may not be the best way to look at the business, tracking at the gross margin level, and look more into the operating and adjusted EBITDA margins. And there, we've seen very steady progressive upticks over time, and of course, the step function upward in our target model. And that's the reason for that. We do see mix shifts. But even with those mix shifts and the little bit of spikiness by things like royalty revenues, which obviously would carry very high margin, those tend to normalize over time. Often the way I like to say it is, if you think of our range as 45% to 50%, that we, on average, will tend to hover around the middle of that, plus or minus 1 point or 2 any quarter, which is not as noteworthy as it might seem on its face.

No, that's very helpful. And just a follow-up on CapEx. So this year, particularly the step up, is there a way to think about what's the maintenance CapEx for the business? Because we've seen a lot of changes with the Microsemi carve-out, and now CES.

So we haven't forecasted CapEx, except obviously to say what we thought it was going to be in Q3, which I did just update. But as we've noted, the spike, or the uptick, has been driven by several fairly distinct things. Obviously, we've had some significant incremental addition through the various acquired businesses, each of which brings a little bit of CapEx with it. Generally speaking, I would say the profile is similar to what we have done historically at Mercury, on a proportionate basis. But then we're seeing separate upticks caused by investment in the acquisition synergies and the program that we initiated. And then we've accelerated some of that investment, which has stacked it up. And then of course, we've mentioned the build out of the headquarters.

So those are the three factors: acquired businesses, build out of the headquarters, and acceleration on the synergies program, that are really driving it. But nothing in the basic profile of the business has really increased its overall capital intensity.

Got it. And one last one, Mark, one for you, just on the overall CR that's in place, it looks like expectations are that we're going to see that hopefully resolve in early April or the end of March. If it lingers materially beyond that, how is that affecting what you've allocated in terms of your outlook?

Yes, we've got pretty good visibility. I think we've got strong forward revenue coverage, had a great bookings quarter, backlog's at record levels. So we feel pretty comfortable with the increased guidance that we gave, Peter.

Great. Thanks. Nice results.

Thank you.

Thank you. Michael Ciarmoli, SunTrust.

Good evening, guys. Thanks for taking the questions. Real nice results. Mark, you talked about the design wins, you talked about this hit list, I guess, being the largest ever. Can you give us a sense of maybe what specific markets you're seeing those design wins in? Are you starting to see maybe more of a penetration into that missile market, which is going to be new and obviously an expansion for you, on the Microsemi deal?

Sure. So it's a number of things, Mike. Our two largest market segments today are Radar, as well as EW. We're seeing increased investments in both of those areas. So seeing that shift from the older type radars to the more [Esa-type] radars. We've done a pretty good job capturing the secure processing content, as that shift occurs. We're also capturing more RF content on those radars, which historically we haven't done. We're seeing a significant uptick in EW, which is driving growth in what was formerly the Mercury Defense Systems segment, which is the former core acquisition on the West Coast, as well as significant growth in our RF businesses. And that, we anticipate continuing going forward.

The third area, I think as you alluded to, is also in the guided missile and precision munition domain. Obviously, we're expending a lot of weapons based upon what's happening in theater right now. So I think where the stockpile has been depleted. At the same time, we're seeing opportunities to insert new technologies and capabilities to deal with some of the more advanced threats that we see occurring. And we believe that we're very well-positioned there, whether it be adding secure processing to some of those missile systems, whether it be adding some miniaturized EW capabilities or just more general RF capabilities. So those are the three major trends that we're seeing. And the design win pipeline is very, very healthy right now.

Got it. Given that pipeline, given what you just said, should we expect this backlog to continue to grow through the second half of this year?

Well, backlog is not something that we typically forecast, Mike, but we're certainly hoping it will.

Got it. And then just if we were to look out at some of these big programs within the industry, [JStars], the trainer, ground-based deterrent, [3DELRR], you guys clearly have a lot of opportunities out there, a lot of radar needs. Should we expect, or how are you guys looking at some of those programs? Are they on that hit list that you just referenced?

Yes, some of the ones are that you mentioned, for sure. We think we're well positioned with JStars, just given some of the investments that we've made in the very high performance processing that was recently tested at one of the government labs, where we got very, very high marks. There are other programs that maybe are less well known, that again, are going through a tech refresh, whether it be in radar or EW, that potentially significant opportunities for Mercury that we're also pursuing. Just this past week, we were notified of three new design wins in the RF dimension that are great wins, one of which is an outsourcing and two of which are competitive displacements. So we feel, actually, really good about how we're positioned for a capabilities perspective. The investments that we've made in manufacturing infrastructure and the automation is making us more affordable. And I think we feel pretty good about how we're located right now, Mike.

Got it. And then just, Gerry, corporate tax reform. You guys are at a 35% tax rate. I would imagine that anything would be very beneficial to you guys. Can you give us any color on how you're thinking about that?

Well, I think you kind of hit it. We're a corporate taxpayer. We're mostly US-based revenue. So we pay a pretty hefty load. So any discussion that I've heard about tax rates is that if it moves, it's going to move down, which would certainly be a benefit to us. But we're not going to model that in. Hope is not a strategy. We'll hope for it. And if we get it, that will just be a good thing.

Sounds good, guys. Thanks a lot for taking the questions.

Sure.

Thanks, Mike.

Brian Ruttenbur, Drexel Hamilton.

Thank you very much. Couple questions. I hear that the growth is going to come initially maybe in readiness programs, and then we've also had conversations about FMS orders and growth happening there. Can you address both of those and what you're seeing on that front, and if there's been any pick up as of yet?

Are you talking about potentially where President Trump will put any increase in defense spending? Is that the question, Brian?

The question is, do you have any indications that you're going to have increased spending on the FMS orders or there's going to be an easement? I know it's only a couple days into the administration, but I didn't know if you've seen anything, I think you've run -- what is your normal percentage for FMS?

So it's changed over the last year or so. It was in the high teens, maybe even the low 20s. But as we have acquired a great diversity of programs, as an overall percentage, that number has come down. I would say it's too early to tell in terms of the new administration but as we have seen, or as we have said previously, a lot of our major programs have got FMS sales associated with it. So as our customers succeed, as they're seeking to penetrate those marketplaces, so we get dragged along. And one of the things that you are probably aware of is that there is an enhanced intensity on making sure that as we export our technologies overseas, or also refresh our systems here domestically, that security is part of those refresh. And so the emphasis and the investment that we've made on our next-generation secure processing product portfolio, we think bodes well to help enable those sales to occur in a timely manner.

Okay. And then in terms of readiness, do you have any exposure in there? And would you anticipate to see any increase in spending or orders because of maybe increased troop levels on the readiness side?

Not really, Brian. I think the readiness side is not an area that we, as a company, have really participated in historically. From what I'm reading, it sounds like that maybe one of the beneficiaries of increased spending could be the Navy and the Air Force, and that counts for the majority of where our revenues are coming from today, and we're obviously involved in some great programs there and are well positioned.

Great. Thank you very much.

Thank you. Ron Epstein, Bank of America.

Hello. Good evening, guys. Just following up on one of the topics you were talking about, you mentioned the increased outsourcing that you're seeing from the defense primes. On the contracts that have been up for bid, can you give us a feel for what your win rate's been?

That's a good question. It's hard to specifically say what our win rate is. I can tell you that literally, as I said just a minute ago, on three awards that we received last week, we haven't actually received the PO yet but we've been notified, two of those were actually competitive displacements in the RF microwave domain into pretty important programs.

So I think the way in which we're being viewed is that, is one of those more capable suppliers. We've got a very high R&D spend, which is critically important to our customers as they're seeking more technology. We've invested in the infrastructure in terms of the manufacturing assets to make us more affordable and to produce high quality. And then if I step back, part of the business model that we have is because we are actually at the Tier 3 level and because we're emerging supplier. We're actually, in many instances, able to bid concurrently with multiple primes as they are competing for the government's business. Now it doesn't always work out that way, but wherever we can, that's certainly a strategy that we like to pursue.

And it seems like there's some momentum gaining in this outsourcing space. Are you seeing any new competitors coming to the market?

No, we're not. I think if anything, we are seeing in the RF domain, a shift from the primes doing business purely on the basis of trying to get a better price, to recognizing that, that strategy is not the best way of improving affordability in the long term. And so there's a move in the other direction, a shift from simply trying to procure, through the procurement process, better terms, to partnering for success in the long term which requires investment and it requires a much earlier level of engagement. And that's really what we're seeing. So we are seeing a shift in terms of just the supply chain strategies, but we clearly feel that's actually benefiting Mercury, based upon the strategy that we've been pursuing.

Okay. And then maybe just a more technical question for Gerry. When you think about the prospects of this changing tax code, if you can no longer deduct interest, does that change how you think about doing M&A?

Well, I suppose it could, as a theoretical matter, you'd have to consider what the impact is. As you know, we are not operating like a traditional private equity shop, turning extremely high levels of debt. I think there are, frankly, a lot of things to consider there not only debt levels or relative debt levels -- turns. What are the effective interest rates, how do you balance that against the anticipated growth rates and what you think you can do with the business, and then the deductibility of the interest. So I'd say it's a multi-faceted equation that is not susceptible to an easy answer. But you have to consider all the factors.

Okay. Fair enough. Thanks, guys.

Thank you.

(Operator Instructions)

Sheila Kahyaoglu, Jefferies.

Good afternoon, guys.

Hello, Sheila.

With CES, I don't know if I missed it, but can you talk about the growth outlook for that business? And maybe if you could give us some color on if there were particular platforms that were attractive with the acquisition or does it just add to your international portfolio?

So the business itself has actually got, I'm not going to name the specific programs, because unfortunately, I think it's not something that we can do at this time, but they have got some broad exposure to some wide body platforms. The heart of their business is that they are providing the computing elements for many of the tactical communications systems on platforms for a large communications defense electronics company based here domestically in the US. So they've actually got a very broad exposure with that particular focus area.

So it puts you in the cockpit a little bit further, is that where it's seeming to add again?

So in the [C-Fly] mission systems segment is where they primarily play.

Okay. And you had a fairly large contract in October on the precision munitions side. And I'm assuming that is a legacy Microsemi business. Is there an opportunity there to, I don't know how much you can disclose, but to add on to your legacy Mercury business in terms new potential customer, anything you could disclose on that order?

Yes, sure. The business that we acquired from Microsemi has got a strong position in the guided missile and precision munitions marketplace. So they're on programs such as Small Diameter Bomb II, which, as you know, is going to be one of the missiles that goes onto the F-35. They're on the Paveway, which is obviously seeing increased growth, just given the up tempo.

But they've also got other pursuits, as well. And literally, just in the last few weeks, we have introduced them, given the strength of our channel, into one of our major customer's missile systems divisions, where they haven't historically done any business. And we've already uncovered a number of opportunities. So I do think that given the capabilities of the combined companies and the strength of our channel, this will continue to be an important area. It was certainly one of the things that attracted us to the business that we acquired.

Great. Thank you. And then just the last one, if you could give us any color on the blade server opportunity in terms of what you're seeing in your bookings or design wins.

So the blade server opportunity, we're pretty excited about. We've seen some pretty significant growth in the C-Fly market segment, as well as actually in our processing product line. It's still very early days. We just announced it at one of the major trade shows. But because it's a very unique product targeting a specific application, we do think it's a part of the business that's going to grow in the long term. We've already won some specific business with it. A number of customers have requested access to the product to test in their various facilities, and we think it's got some good growth potential longer term. And it's very much in line with the trend that we've seen in the more embedded applications, where high performance, secure embedded processing is really what our customers are looking for. And we've come up with a pretty unique set of technologies and capabilities there.

Sure. Thank you very much.

You're welcome.

Thank you. Keith Curtis, Brant Point Capital.

Hello. Just wanted to ask about the EBITDA contribution from CES. And you broke it out for this quarter, but I didn't notice any breakout on the contribution and the updated guidance for the year.

That's correct. We didn't break it out, because, as you probably know, we're an integrator and we integrate the businesses relatively rapidly. And once we start to collapse channel and collapse sales force, as well as some of the internal support operations, the distinctions very quickly go away and it becomes rather difficult to figure out where and how to measure a specific contribution. So that's why. And we don't expect that we'll be breaking it out in the future.

Okay. And just to follow-up on that, earlier in your prepared remarks, I think you said something about the EBITDA being dilutive pre-synergy. So just looking for a clarification on that.

Yes. The EBITDA percentage that it brings in the door is little bit lower than where the organic business is on day one. But we expect, and we said this at the time of the acquisition, as well, that we would be able to lift them into alignment with ours in the relatively short term.

Got it. Thanks for that.

Sure.

Thank you. Mark Jordan, Noble Financial.

Thank you. A question relative to R&D. Obviously, with acquisitions, our quarterly R&D spend has increased pretty significantly here. And with the addition of CES for a full quarter, probably you would expect some growth. Looking out as a normalized run rate, say, moving towards FY18, are there synergies in that number or should we assume that, that R&D as a percent of revenue is going to stay around that 12% range of revenue?

Yes. So we expect, over the long term, that we'll maintain a run rate of the 11% to 13% spend annually that we call for in our target business model. If you look back in recent periods, we have sometimes been a bit higher than that. But we continue to invest and what's happening is that the revenue is growing at a faster rate than the spend on the R&D overall. So we expect to settle right into that range. And frankly, would seek to maintain it, because we see it as a significant competitive advantage for us.

We have differentiated ourselves through a variety of technologies. It's one of the reasons that, as we've acquired businesses, we've taken a close look at what their spend is. And in some cases, and we highlighted this in the prepared remarks, we've set up spending plans that actually bring them into alignment with our overall rate of spend. Because again, we want to be at the edge of those technology capabilities, particularly as we seek to integrate them into more subsystem integrated solutions that we're providing to our customers. So it's played out very well for us and we look to continue doing that as we go forward.

A final question for me, with the CES being acquired, obviously a Swiss company, you mentioned that they sell significantly into the United States. Is there any export issues that you might have, where their customer base might be restricted, given the fact that they're now part of a US corporation?

No, we don't think that there's anything negative in terms of our ownership of them. We think, if anything, we can potentially open some market opportunities, particularly over time. And that's why we focus on what the addressable market is, not just what business they're doing today.

Okay. Thank you.

Sure.

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

Okay. Well, thank you, everyone, for joining the call this evening. We're very pleased with the results this quarter and we look forward to speaking to you again next quarter. Thank you.

Ladies and gentlemen, thank you for your participation on today's conference. This does conclude the program and you may all disconnect. Everybody, have a wonderful day.