Mercury Systems Inc (MRCY) 2018 Q1 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems First Quarter Fiscal 2018 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.

Thank you, operator, and 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'd like to remind you that remarks that we may make during the call -- 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 and technological advances in delivering technological innovations; changes in or in the U.S. government's interpretation of federal procurement regulations and rules; market acceptance of the company's products; shortages in components; production delays or anticipated expenses -- 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 U.S. Securities and Exchange Commission, including in our annual report on Form 10-K for the fiscal year ended June 30, 2017.

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

Adjusted income excludes the following items from GAAP net income: 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 income and expense and stock-based and other noncash compensation expenses, 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'll 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 is off to a great start in fiscal 2018.

Our acquired and organic businesses continue to deliver solid results in the first quarter.

We came in just into the high-end of our guidance for revenue and exceeded guidance on adjusted EBITDA and adjusted EPS.

Bookings for the first quarter was strong, and we had several important new design wins.

Thanks to good execution by the team, it was also a successful quarter from an operational perspective.

We completed the RTL acquisition and made solid progress on the Delta Microwave integration.

Last week, we opened our world-class trusted digital and microelectronics manufacturing facility in Phoenix.

And during Q1, we delivered important new capabilities in RF as well as safe and secure processing.

Taking a quick look at the numbers.

Total revenue for Q1, including the acquired businesses, was up 21% year-over-year.

Our largest revenue programs in the quarter was SEWIP, F-35, Aegis, F-16 SABR and Filthy Buzzard.

Total bookings were also up substantially from Q1 last year.

Our largest bookings programs were F-35, Aegis, Predator, APG-79 and DEWS.

Adjusted EBITDA for Q1 on a consolidated basis was up 37% year-over-year and a 24% of revenue well within our target model.

The growth drivers we've discussed over the past couple of quarters are even more relevant today.

We began our fiscal year with another budget continuing resolution as anticipated, and we currently expect that the CR could continue through the end of this calendar year.

Nonetheless, we believe Mercury will continue to deliver above industry average growth in revenue and profitability in FY '18.

This reflects the positive underlying industry trends, our record backlog and the significant investments that we've made in our technologies and manufacturing assets.

It also reflects the continued success we have achieved in broadening and deepening our relationship with key customers and on key programs.

The level of new business pursuits and design activity remains the highest I've seen since joining Mercury, and our win rate is strong.

These opportunities fall in 2 broad areas: The first area is sense of processing on traditional strength, where we continue to see growing demand in radar, EW, EO/IR as well as weapon systems.

The second category focused on computing beyond the sensor, including mission computing, comps processing, command-and-control, combat systems and platform management.

These are new markets and long-term opportunities for Mercury and ones that we're excited about.

In this category, we recently introduced an industry-leading secure rack-mount blade server and completed the acquisitions of RTL and prior to that, CES.

From a platform perspective, our positioning in these markets translates into a broad opportunity set, ranging from the naval service fleet to fighter jets, wide-bodied signals intelligence, unmanned aerial vehicles and ground stations.

We're currently involved in a number of high-value pursuits in both sensor and non-sensor computing.

Most important, we're continuing to convert a high percentage of these pursuits into new design wins.

The primes are transforming the way they're dealing with their supply chains, moving from procuring to partnering.

Mercury's win rate demonstrate that we've positioned ourselves as an important facilitator and partner in this transformation.

On previous calls, I've described the prime's new supply chain strategy in terms of 3 underlying trends.

First is outsourcing, which appears to be accelerating as our customers wrestle with a number of challenges.

One such challenge is the volume of internal hiring required to keep pace with their recent awards and expected growth.

Another is the prime's need to increase their level of internal R&D spend and to focus this investment as they can no longer do everything in-house.

At the same time, the need to keep pace with the new and emerging threats continues unabated, requiring them to leverage and deploy commercial technology more rapidly than ever before.

We're ideally positioned to provide our customers with high-quality, lower-cost solutions than they can deliver internally.

We're doing this through a significant investment in R&D and by focusing on pre-integrated subsystems using the latest open standards and architectures.

The second underlying trend is what appears to be an active focus by the government and the primes to delay their supply chains with the goal of making their solutions more affordable.

They're doing this by dealing directly with the companies that are actually funding and developing the innovations.

Supply chain delayering creates the potential for larger deals and likely faster growth for us over the longer term.

Our strategic acquisitions over the past several years have allowed Mercury to move up the value chain to the mid-Tier 2 level.

This, in turn, has expanded and improved our ability to provide affordable subsystems.

With our commercial business model, we've positioned ourselves as an ideal partner as this trend evolves.

The third trend is what we call a flight to quality.

The price is seeking to deal with fewer, more capable suppliers, suppliers who are willing and have the capacity to co-invest significant internal R&D dollars.

They're seeking partners that have scalable and trusted capabilities and manufacturing assets that, combined, deliver innovations with high quality, faster and more affordably.

Mercury measures up well on these dimensions of quality.

We continue to increase our R&D investments on a dollar basis over the past few years to one of the highest internal R&D spend-to-revenue ratios in the defense industry.

At the same time, we substantially expanded and strengthened our trusted manufacturing capabilities.

As proof, in the past quarter, we received 2 upper echelon supply quality awards from customers.

And just last week, I was in Phoenix to host the grand opening of our world-class trusted manufacturing facility with many of our top customers and other dignitaries.

Moving to our acquisition integration activities, we continue to make progress in consolidating our 3 small RF facilities on the West Coast.

Ultimately, we'll create a state-of-the-art, larger and scalable RF manufacturing location, similar to what we did in Hudson, New Hampshire.

The activities are underway and on track to completion early next fiscal year.

The strong position we developed as a partner to the primes is also reflected in our design wins.

We're capitalizing on increased outsourcing at the subsystem level in radar and EW modernization and in secure processing, among others.

For instance, during the first quarter, we displaced a competitor as the outsourced supplier on an important radar due to our superior security solution.

We also received an initial award for a tactical airborne EW program that exemplifies the delayering that we see happening.

We're winning new content in the weapon systems arena as the industry works to replenish supplies in the near term and invest in new capabilities in the long term.

In addition, we're seeing growing opportunities driven by the increase in modernization activity related to C4I and other non-sensor-related computing onboard the platforms.

On our Q4 call, I talked about design win pursuits related to 2 large secure airborne processing opportunities.

One pursuit recently resulted in a purchase order for our secure rack-mount server, and we expect additional awards as the year progresses.

In the other pursuit, we were selected by a third-party, meaning we're now on multiple teams to varying degrees.

So overall, we're seeing great opportunities in sensor processing and weapons systems.

We're now also moving into C4I, including executing on growth strategies and mission computing, C2I, platform management and safety certifiable avionics.

With the business model we've created and the capabilities we've developed, both organically and through acquisitions, we believe that we are strongly positioned for continued growth across our core markets.

Going forward, we intend to remain active and disciplined in our approach to M&A as we work to extend our record of growth above the industry average.

We continue to look for deals that are strategically aligned, have the potential to be accretive in the short term and promise to drive long-term shareholder value.

We'll continue to target acquisitions that expand our addressable market in aerospace and defense electronics domestically and internationally and the scale of technology platform that we built.

We remain focused on the key pillars of the business, RF and secure processing, while also continuing to assemble critical and differentiated solutions to secure sensor and mission processing.

We plan to continue acquiring smaller capability-led tuck-ins, such as RTL most recently, while capitalizing on larger opportunities as they present themselves.

In summary, Mercury is on track for another great year in fiscal 2018.

Our business model is working very well, we're taking share and we're seeing high levels of activity based on the investments that we've made and the capability set that we've created.

In addition, our planned integration in manufacturing synergies are materializing as anticipated.

Given our results in Q1, our record backlog and our current business outlook, we're anticipating continued strong performance in the second quarter and we're raising our full year guidance for fiscal '18.

Gerry will take you through the guidance in just a minute.

Finally, as a reminder, we'll be discussing our strategy and plans for growth in depth at our Investor Day in New York City on November 7. We sincerely hope that you can join us.

With that, I'd like to turn the call over to Gerry.

Gerry?

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

Before we go through the financial results, I'll note that, unless otherwise stated, we'll be discussing the company's financial results, comparisons to prior periods and guidance on a consolidated basis.

These consolidated results include the CES and Delta Microwave businesses we acquired in the second and fourth quarters of fiscal 2017, respectively, and Richland Technologies or RTL, which we acquired during the first quarter of fiscal '18.

As a reminder, we're now reporting 2 categories of revenue breakdown, organic and acquired.

Organic revenue is defined as revenue attributed to businesses that have been a part of Mercury for more than 4 full quarters.

Acquired revenue is revenue defined as associated with acquired businesses that have been part of Mercury for 4 full quarters or less.

After the completion of 4 full quarters, acquired businesses will be treated as organic for both current and comparable historical periods.

For Q1 of fiscal '18, acquired revenue includes the contributions associated with the former CES, Delta Microwave and RTL businesses.

Turning now to our first quarter results.

Mercury delivered a solid start to fiscal 2018 on a consolidated basis and organically.

Total revenue increased 21% from Q1 last year to $106.1 million near the top of our guidance range of $102 million to $107 million.

Organic revenue increased 7% year-over-year to $93.5 million, ticking up from the 4% organic growth rate recorded in Q4 of fiscal '17.

Acquired revenue was $12.6 million, which is not comparable to Q1 of fiscal '17 due to the inclusion this year of Delta Microwave and RTL, which were not a part of Mercury in Q1 of last year.

International revenue, including foreign military sales, was 15.4% of total revenue compared with 16.1% in Q1 of fiscal '17.

The decrease percentage of total revenue is largely a phenomenon of the expanded and more diverse overall revenue base offsetting a 16% year-over-year increase in the dollar volume of international revenue.

Radar revenue for Q1 of fiscal '18 was down 3% year-over-year, while electronic warfare revenue increased 34%.

Revenue from radar and electronic warfare together accounted for 60% of consolidated total revenue compared with 67% in Q1 last year.

As with the international split, the lower proportion of total revenue year-over-year, once again, reflects Mercury's overall larger and more diverse revenue base.

As expected, the new businesses we've acquired over the past 1.5 years have substantially expanded both our addressable market and our revenue base.

Total bookings for the first quarter were up 11% year-over-year, driving a 1.01 book-to-bill ratio.

We ended the quarter with a record total backlog of $360.7 million, up 22% from $296.4 million a year ago.

Approximately $281.7 million or 78% of our Q1 backlog is expected to shift within the next 12 months.

Mercury's bookings and revenue growth continue to translate into solid profitability, organically and in our acquired businesses.

Our product sales mix for the first quarter of fiscal '18 was stronger than originally anticipated, producing somewhat higher gross margins than what we expect for the fiscal year as a whole.

That said, we're continuing to realize the expected production cost efficiencies and acquisition integration synergies as well as benefits from the continuing ramp-up of our in-sourced U.S. manufacturing operations.

Our gross margin for Q1 of fiscal '18 was 47.8%, up from 45% a year ago.

This is nearly 1 percentage point above the top end of our Q1 guidance due to product mix.

It is also up about 1 percentage point on a sequential basis and close to the midpoint of our target business model.

Our bottom line this quarter also reflected solid performance in cost containment even though we've acquired several businesses and have continued to steadily increase our R&D investments over the past year.

In addition, we continue to see modest restructuring costs associated with our ongoing facilities realignment and consolidation in California.

Nonetheless, total Q1 operating expenses continued to increase at a lower rate than our revenue growth rate.

Operating expenses in Q1 rose 13% to $40.3 million from $35.7 million in Q1 of fiscal '17.

GAAP net income for the first quarter of fiscal 2018 was $18 million or $0.38 a share.

This compares with $3.8 million or $0.10 per share for Q1 of last year.

The GAAP increases year-over-year, and the outperformance versus guidance largely reflect the impact of discrete tax items benefiting the most recent quarter.

These include a $7.9 million tax benefit related to stock-based compensation and a $4.1 million benefit related to net operating loss carryforwards associated with previously acquired businesses, while Q1 of last year included a $2.2 million tax benefit related to stock-based compensation.

Excluding the impact of the discrete items, GAAP EPS for Q1 of fiscal '18 would have been $0.13 a share, also exceeding our guidance.

Adjusted EPS for the first quarter increased to $0.37 a share from $0.22 a share in Q1 of fiscal '17.

This was substantially above our Q1 guidance range of $0.24 to $0.26 a share.

Adjusted EBITDA for Q1 of fiscal '18 increased 37% to $25 million from $18.2 million a year ago.

This also exceeds our Q1 guidance of $21.4 million to $23.5 million and at 23.6% of revenue is well into our long-term target range of 22% to 26%.

Turning to the balance sheet.

Mercury ended the first quarter of fiscal '18 with cash and cash equivalents of $26.1 million compared with $41.6 million a year earlier.

Mercury's operating cash flow for Q1 of fiscal '18 was $8 million compared with $10.3 million last year.

As in the sequential fourth quarter, our cash flow reflects the continuing buildup of inventory associated with our expanding in-house manufacturing capabilities and the timing of invoicing and collections for certain program activities.

This shift is occurring as highly integrated subsystems become a more significant part of our overall revenue mix.

Overall, we expect fiscal 2018 to yield stronger cash flows compared to fiscal '17 as cash flow strengthened through the second half of the year.

Our cash flow from operations in Q1 was partially offset by $3.6 million of net capital spending, primarily associated with the continued build-out of our trusted manufacturing operation in Phoenix.

As anticipated, capital expenditures were substantially lower than in Q4.

Net of CapEx, free cash flow for Q1 was $4.4 million compared with $4.2 million a year ago.

In terms of Mercury's financial position, we continue to maintain a conservative approach to the balance sheet.

In Q1, we filed a new universal shelf registration, which remains unused to date.

This replaced our previous shelf registration, which was scheduled to expire in early September.

Overall, we remain 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 second quarter and full fiscal year 2018.

For purposes of modeling and guidance, we have assumed no restructuring and no acquisition or nonrecurring financing-related expenses and an effective tax rate of 35% in the periods discussed.

The guidance also assumes weighted average fully diluted shares outstanding of approximately 47.5 million shares for Q2 and 47.8 million shares for the full fiscal year.

Our guidance for Q2 and fiscal '18 reflects the outlook that Mark discussed, highlighted by continuing strong performance, both organically and in our acquired businesses.

We expect to continue delivering growth and profitability at rates higher than the industry average.

We expect this performance to be driven by our record backlog, growth in major product lines and across many of our programs as well as our enhanced manufacturing capabilities.

We're planning that internal R&D investments will remain elevated versus our target model as we continue to align the R&D levels of our newly acquired businesses with that of the organic business.

At the same time, we continue to invest incremental R&D dollars to capture new design wins.

Even with the incremental investment in R&D, we also expect to see improvement in our free cash flow for the years our CapEx has reduced versus fiscal '17.

We expect CapEx to be modestly higher in the back half of fiscal '18 based on our integration plans, but for the full year to be consistent with our goal in the vicinity of 5% of revenue or less.

As Mark said, the federal government had entered its new fiscal year, operating under another CR, which is likely to continue through the end of calendar 2017.

Against that backdrop, we, once again, expect that for fiscal 2018, as in the past several years, our second half will be stronger than the first half.

As a result, we expect Mercury to deliver another year of strong growth and solid financial performance.

With that as background, for the second quarter of fiscal 2018, on a consolidated basis, we're forecasting total revenue in the range of $112.5 million to $116.5 million, an increase of 15% to 19% over Q2 of fiscal '17.

Gross margin for Q2 is expected to be approximately 46.1% to 46.7%.

Q2 GAAP net income is expected to be in the range of $6.1 million to $7.1 million or $0.13 to $0.15 per share.

Adjusted EPS for Q2 is expected to be in the range of $0.28 to $0.30 a share.

Our estimates assume approximately $4.2 million of depreciation, $5.7 million of amortization of intangible assets, $0.1 million of fair value adjustments from purchase accounting and $5.2 million of stock-based and other noncash compensation expense.

Adjusted EBITDA for the second quarter of fiscal '18 is expected to be in the range of $25.3 million to $26.8 million, representing approximately 22.5% to 23% of revenue at the forecasted revenue range.

For the full fiscal year 2018, we now expect Mercury's total revenue to increase to between $457 million and $468 million or approximately 12% to 15% year-over-year.

Currently, gross margins for the year are expected to be between $46.8 million and 47.3%.

And operating expenses are expected to be in the range of $167.7 million and $171.2 million for the year.

Total GAAP net income for fiscal '18 is expected to be in the range of $37.8 million to $40.7 million or $0.79 to $0.85 per share.

Adjusted EPS is expected to be in the range of $1.29 to $1.35 per share.

We currently expect total adjusted EBITDA for fiscal '18 to be approximately $105 million to $109 million and at approximately 23% to 23.3% of revenue for the year, well within the range established by our current target business model.

With that, we'd be happy to take your questions.

Operator, you can proceed with the Q&A now.

(Operator Instructions) Our first question comes from the line of Peter Arment with Baird.

Gerry, just, first, as a clarification on that 12% to 15% top line guidance number for revenue for this year, are we -- what's the organic number?

Is there a way to arrive at that?

Or do we have to kind of true that up at the end of the year?

Yes.

You have to true that up at the end of the year.

We don't guide on the organic versus inorganic split.

We only report it back on an historic basis.

What I can tell you is that on a pro forma basis, we still continue to target organic growth in the neighborhood of about 10%.

Okay.

That's helpful.

Just -- and then just, Mark, if you could just give us a little more color on how you're doing in terms of progressing into the kind of the weapons category.

You don't guide ammunitions.

I know that it's been a big part of kind of the carve-out acquisition.

And how are things progressing there?

Yes.

So it's actually progressing pretty nicely, Peter.

If you look in our Q1 results on a year-over-year basis, our business in weapon systems space increased greater than 250%.

So we're clearly seeing our ability to take share as well as seeking road to the -- the DoD seeks to actually replenish stocks.

On an LTM basis, the -- we've seen very substantial growth as well in the business over the last 12 months is up greater than ninefold.

So we're quite pleased with the results.

Okay.

And if I can just squeeze in one more.

Gerry, what is the assumption for kind of what we should assume for the tax rate for the year?

So we just use the flat 35% rate, Peter, because we don't guide on the discrete items.

We will see, over time, the stock-based compensation moves, but Q1 is, far and away, the largest.

We had a particularly large one this quarter, and that was really driven by the ramp-up in the stock price over the period, and we get the benefit of the investing day price.

Most of our equity investing happens in the quarter; that's why that was a little outsized this period.

But as we have in the past, we'll see that roll through on a quarterly basis.

Again, provide those updates, what we guided 35%, which you can sort of think of as a marginal rate.

Peter, just as a follow-up as well.

I think at a year level, we're expecting that actually the weapons systems segment will likely be the fastest growth in the markets that we're currently participating in.

And our next question comes from the line of Seth Seifman with JPMorgan.

Mark, I wonder, maybe you could shed a little more color.

You made the distinction between the sensor-associated products and the computing outside of sensors, which is kind of a new market for the company.

And sort of what some of the challenges are in terms of penetrating that new market, kind of the relative growth of those 2 markets?

How?

Is the outsourcing dynamic kind of the same at your customers in both the traditional sensing and the non-sensing piece?

And just how you see those 2 pieces evolving within the company?

Yes.

So I think overall, we're actually really pleased with the progress that we're making there.

So I'll move into C4I.

It's really comprised both on organic investments and our secure rack-mount blade server, where we're already beginning to see business in both enable as well as the airborne domain.

We think that's going to continue going forward.

We already received an initial purchase order for an airborne opportunity, where we expect additional business as the year progresses.

The idea around moving into that segment actually came from one of our customers in discussion some time ago.

And they basically said, "Look, we love what you're doing in the -- on the secure sensor side of things.

If you could do the same in the other non-sensor-related computing, we'd love to buy that from you." So we've obviously done a couple of acquisitions in the space now in Q1.

It actually was one of the strongest-growth market segments that we had.

And we're expecting pretty strong growth going forward as well.

So with respect to challenges, we really don't see many right now.

I think the technology that we have, some of the recent releases, the press releases that we've made, customers are really pretty excited about what we're doing.

Great.

And then maybe as a quick follow-up, if you can sort of address what the M&A environment looks like these days.

So I think it's pretty active.

I mean, obviously, there's been a couple of really big deals in the space that we think has probably got some long-term implications.

As we've seen in the past, we remain active in the markets in which we're participating.

I think our reputation as an acquirer is very, very strong, so we're tending to see pretty much all of the deals that are out there in our target space.

Mike and the M&A team is doing a pretty good job.

So we're -- we continue to look at smaller and larger deals in the space.

And our next question comes from the line of Jason Gursky with Citi.

I was wondering if you could maybe just give us your perspective on the consolidation that we've seen amongst some of your customers and whether this creates further opportunities for you.

Or is there -- or if this puts anything at risk or if it's just a continuing neutral event.

Yes.

I don't think it puts us at risk, from what we can gather.

I think, if anything, it provides more opportunity.

As I said in my prepared remarks, I think there's really 3 major trends that's going on.

The first is outsourcing at a higher level than what the primes have done previously, which is largely being at the module.

We continue to see more outsourcing at the subsystem level.

The other trends around the flight to quality, I think, represents an opportunity for us as larger companies combine and seek to rationalize their -- the number of suppliers.

They seek -- clearly seeking to deal with fewer numbers but suppliers that are able to lean in and invest more in R&D but then also build out the manufacturing assets that's required as programs transition from (inaudible) into production.

And we've clearly done that.

I mean, the -- we just opened up the new facility in Phoenix last week.

It was very well attended in the political arena but also from our major customers.

And the feedback that we got was extremely positive.

The other trend that I think is also positive for us, just given the capabilities and the manufacturing assets that we have, is with respect to the delayering.

Customers are clearly seeking to deal with those companies that are truly innovating.

And I think, as Gerry said in his prepared remarks, we continue to increase our R&D spend on a dollar basis.

But then you've also got to be able to manufacture those products, and we're investing there as well.

So if anything, I would kind of summarize to say that our customers are continuing to rationalize their supply chain.

It's moving from procuring to partnering.

And we believe that we're very well positioned.

Right.

And then maybe just a quick follow-up on a bigger-picture question.

I mean, you guys have talked about kind of a target financial model over the last several years.

Can you maybe just kind of update us to get some current thoughts on kind of the size that the company needs to be at from a revenue perspective to put you on a path to sustainably achieving those financial targets?

And then maybe what are some of the hurdles that you've got to get over between now and get into that sustainable financial model?

Well, so if you think about we updated the target model when we did the acquisition of Microsemi and we added 400 basis points on adjusted EBITDA to the bottom line, we actually achieved the -- or inside of that model, in fiscal year '17, a full year ahead of where we thought we were going to be.

And we're actually expecting, just based upon the guidance that we've just given, to actually extend that during fiscal year '18.

So we're already inside the model.

I think as we continue to grow and demonstrate operating leverage in the business, then hopefully, it was successful.

We'll increase towards the higher end of the EBITDA range.

I don't know if you want to add anything, Gerry?

Yes.

And I think, it's -- you kind of asked, is there a certain size or a sort of critical mass that we need to achieve to make us sustainable.

I'd point out 2 things.

One is that we've sustained it now for over a year.

So we racked up a full 23% adjusted EBITDA for the year last year.

And obviously, we've shown it again this year, and we currently expect it for the full year based on our just-updated guidance.

But as much as anything, I would say, it depends on the execution against the strategy, not just a size question.

If you look -- Mark mentioned a moment ago that we moved into more and more subsystems.

The top customers that we have these deep relationships with are using us more and more for that.

If you look at it on an LTM basis, our growth in subsystems has actually outstripped our growth in the base revenue.

So it shows that, that strategy is paying dividends and that we've added the right kinds of capabilities to facilitate not only our ability to deliver those solutions but the ability of our customers to tap into us for them.

So I think that's really where the heart of the matter lies.

And our next question comes from the line of Jonathan Ho with William Blair.

Just wanted to start out with the Phoenix facility and some of the consolidations that you talked about on the West Coast, and maybe what sort of margin impact we should expect and potentially the time frame for that margin impact.

So we don't guide on anticipated margin increases other than to say, we think, as we said in my prepared remarks, that we think this year, we can do as well or maybe even slightly better from an adjusted EBITDA margin standpoint than we did last year.

Obviously, we're not yet enjoying the full benefits of all that.

We just did the ribbon-cutting last week, and we're continuing to invest.

So we built some room in our model for good reason, and we want to harvest that over time and even through subsequent acquisitions.

Mark?

Yes.

So I think it's a good point, Gerry.

I think going back to the question that Seth asked, as we continue to see growth on the top line and as we complete our facilities consolidation in RF as well as complete our activities around our trusted manufacturing facility and bringing some of that secure processing work in-house, then we'll see some of the margin expansion.

But it's a multiyear journey.

It doesn't happen in one quarter.

With respect to the timing, so as I said in my prepared remarks, we're already underway in terms of the activities on the West Coast with respect to the integration post the Delta Microwave acquisition.

We expect to have those facilities combined and consolidated and fully integrated by early next fiscal year.

The U.S. manufacturing operations, which is the facility in Phoenix, as you -- as I said in my prepared remarks, we literally just opened up last week.

So work is already underway there, and we've got additional work that we'll move into that facility as the year progresses.

So we're actually quite pleased with the progress that we're making.

And we're on track, and good progress overall.

Got it.

And then just on a separate topic.

Given the situation in North Korea, can you give us a sense of where maybe you're seeing some incremental opportunities?

Again, maybe over what type of time frame those opportunities can be recognized?

Well, it's hard to say specifically with respect to North Korea because I'm not sure that we've got specific insights with respect to what is happening there.

But if you look at overall, from a market segmentation perspective, which is kind of how we tend to view things, we're seeing really strong growth across our major markets.

So talked a little bit about the growth that we're seeing in the C4I space.

C4I is obviously those other types of computers that are not related to the sensor.

That business is growing rapidly as a result of some organic investments as well as acquisition.

The EW business is growing extremely well as well.

That, I think, is due to a lot of modernization activity and recapitalization of EW assets.

What that translates into for Mercury is significant growth in the RF business.

And when I talk about flight to quality, we're clearly benefiting from a couple of different suppliers kind of shortfalls in that space, and we continue to take share.

In the weapon systems arena, I think that is also an area that we're seeing substantial growth.

As you may remember, we wanted to enter that marketplace, and that was one of the major reasons that we did the acquisition of Microsemi.

And then in the radar business, which has been a mainstay for Mercury, we're also expecting and seeing good growth, and that is still a large part of the business.

So probably the best way of viewing it is really through the lens of what we see happening in the market, Jonathan.

And our next question comes from the line of Ron Epstein with Bank of America.

This is Caitlin Dullanty on for Ron tonight.

Mark, you've mentioned that you've won market share.

Can you discuss the competitive environment and your overall strategy to continue gaining that market share?

And more specifically, as you brought in your capabilities, how are your competitors responding?

Yes.

So I would say that we're really gaining share in a couple of different areas.

First is clearly in the RF domain.

As I mentioned, our EW market segment is growing very rapidly.

We're continuing to take share across a number of different programs that we weren't a part of previously.

That, in particular, is I think because of the 2 particular suppliers that seem to be struggling.

They are not investing in the level of R&D that we are.

And clearly, they don't have the sorts of scalable high-quality trusted manufacturing that Mercury built out really during the period of sequestration, which was a particularly different period in the industry.

So we expect that to continue going forward.

We've been at kind of building out our RF capability for the last 5 years now, and we feel like we've got a significant lead.

The other area where we feel that we are also taking share is in the secure processing domain.

And this is an area that we have invested significantly in.

We're actually moving into our fourth generation of embedded security, which is critically important.

Just this past quarter, we won an important radar program displacing a competitor.

And this is particularly nice for us because the program is soon to transition into production.

So those will be 2 that I would point out directly.

Beyond that, I think there are opportunities for us to gain share through the outsourcing that's occurring in the subsystem level as our customers are seeking to purchase more complete subsystems with multiple technologies.

And Mercury is actually in a unique position to be able to do that.

There really is no other supplier that we know of operating at our level that's got the capabilities in RF and in digital as well as processing combined with security and the advance software that we have.

So we think that our model is working extremely well.

And I think you can see that in our above industry average growth.

All right.

That's very helpful.

And since you brought up R&D, if I could just ask a little bit about that.

When you look about -- look at R&D, how do you measure your return on that investment?

Can you talk a little bit about that?

Sure.

Well, I think you can look at it in a couple of different ways.

I mean, ultimately, we're seeking to generate high returns.

We have been very successful not only at growing the level of our EBITDA as measured in absolute dollars, but we have very systematically increased the EBITDA as a percentage of revenue over the last 4 or 5 years.

And we have, as you know, about 1.5 years ago, we reset the model, and we're already inside that.

So that is one.

The other is, obviously, we look at over the longer term and we try to assess the lifetime value of the programs that we're involved with as it relates to the content that we believe that we have selected for, and that has also seen a very substantial increase.

So we feel that we're doing a very good job increasing our R&D but generating a significant opportunity for prolonged growth.

Yes, and I think I'd kind of add to that and say that we also see it in our win rates because we're very focused.

I think I mentioned in the remarks portion that we're adding into our R&D efforts for pursuit of specific opportunities.

Our win rates have been very strong.

That, in turn, adds to the pipeline, and we've seen good, steady increases in bookings and backlog, et cetera.

So we see the very sort of systematic logical translation of the investment in R&D leading to a rich set of pursuits and a high win rate that we're translating, we think, very effectively, and that's driving both our above-average growth rate as well as the above-average overall profitability over time.

So...

And our next question comes from the line of Brian Ruttenbur with Drexel Hamilton.

Yes.

Quick question on the budget.

It hasn't been brought up.

Are we still expecting in your guidance timing of a passage by December or January?

What are you anticipating in your guidance?

Yes.

So I think we anticipate a budget resolution by the end of this calendar year, Brian.

Okay.

All right.

And if there is a 90-day delay, what does that do to your numbers?

Is it significant or not?

Well, we don't believe so, but it's always hard to tell.

We are sitting here with record backlog.

So we feel like we've got pretty good coverage.

So time will tell.

Okay.

And then just one follow-up on M&A and the environment right now.

What I've seen is whenever there's this big M&A push, there's also big fallout.

People have to divest in small pieces.

Is that something that you're looking at as possibly moving into adjacent areas by picking up pieces that are available?

So I would say that we're going to remain disciplined in our approach to M&A in terms of the target areas.

I do, however, agree with you that as a result of some of the larger acquisitions that are currently underway and maybe additional acquisitions going forward, there could be some select divestitures associated with that.

And clearly, if it was in line with our strategy, we'd be interested in having a look at them.

And our next question comes from the line of Michael Ciarmoli with SunTrust.

Maybe on the -- just on the topic of R&D.

It's actually -- in absolute dollar terms, it's actually declined now for 3 straight quarters.

And I know you've been talking about the elevated R&D investment.

Should we be expecting a material uptick?

Or I know previously, you guys have said, it'll probably run at the high end of that 11% to 13% target.

I mean, is it still expected to be as high up to that 13% level or a bit higher, which that seemingly implies a pretty big step-up?

I mean, do you guys have that in the budget?

Do you see that spend flowing through here?

Yes.

So Mike, I'm not sure I'd agree with you on the numbers.

So it was about flat Q4 to Q1.

It was, I think, 13.9% in Q1, 13.7% in Q1.

Q1 had somewhat lower revenue, so the percentage was actually higher.

And both of those numbers are higher than Q1 of the prior year.

So we're up about $1 million Q1-over-Q1.

So that's point number one.

Point number two is we're right at about 13% of revenue in the most recent quarter.

We, as I said, expect it to certainly hang at the high end of our target model, maybe even step outside of it a little bit.

We have done that in the past, so it would not be the first time.

But those are typically aimed at pursuits that we feel we have a good chance of hitting on.

And the -- so it's a targeted effort, but again, one where, as we look at an opportunity, we typically aren't thinking of it as a one and done.

We're looking at more franchise opportunities, where are we going to apply those investments across a few different opportunities.

So...

Yes.

If you look at it on an LTM basis, Mike, it's up close to $14.5 million, 36% year-over-year, which is less than the 43% growth on an LTM basis that we saw on the top line.

So we're continuing to invest in -- as we said in the prepared remarks and as Gerry has just said, we expect to continue to invest in that space.

It's a really important part of the business model, and it's an area that the customers really like.

Got it.

And then just Mark as well, we often get asked on this outsourcing opportunity.

It's pretty sizable out there as you guys laid out, I think, the last Investor Day.

I mean, can you provide us with any quantifiable metrics in terms of how far penetrated you are into that market right now?

I mean, where you are in terms of outsourcing wins.

Is there any tangible hard metrics you can provide us with kind of execution against that market opportunity?

Not on a quarter-by-quarter basis, Mike.

Because again, I think the data isn't readily available.

What we see however is that, I think, in at least 2 of our major customers, by now, the majority of the new pursuits and the design wins are really outsourced at the subsystem level.

We have seen growth, I think, as Gerry said, in terms of our overall product lines, and that we're seeing pretty substantial growth in terms of the subsystem revenues, particularly on an LTM basis.

But there's nothing specifically at this point in time that I would point to with respect to market data that is hard to get a hold of.

We will have more to talk about, though, at our Investor Day that's coming up in November.

Okay.

And then just the last one from me.

I know you're not going to guide to it.

But the bookings outlook, you guys continue to put north of onetime book-to-bills up here.

You've got challenged suppliers.

You're taking share.

It seems like the pipeline's pretty attractive.

Can you guys -- or are you forecasting?

Do you expect this book-to-bill in the bookings level to remain strong here as you continue to work through the year?

And maybe even does this continuing resolution pose a near-term threat for bookings?

Should we maybe temper expectations this quarter?

Or you do you feel as confident enough as ever?

We feel, actually, pretty good about bookings potential.

I think, as I said, the activity level is probably the highest I've seen since I joined Mercury.

We feel that we're winning more than our fair share.

And I think that's a direct result of the fact that our strategy is working extremely well.

So I would say that we do expect, overall, positive book-to-bill for the year.

Okay.

And I think, as we've said in the past, Mike, bookings tend to be a little chunkier and, therefore, a little choppier quarter-to-quarter.

So as Mark said, we feel pretty good about the year.

I think the hardest challenge is always bringing new entities in and helping to drive their growth rates, and I think we've demonstrated very successfully that we can do that and it manifests in not only the overall growth rates, but the ability to keep those booking levels solidly positive, as we have.

So again, overall, we feel pretty good about it.

And our next question comes from the line of Ben Klieve with Noble Capital Markets.

All right.

Just a couple of quick questions here.

So first, I'm looking at free cash flow.

I'm wondering if you can elaborate a bit on the working capital build over the last couple of quarters, particularly in regards to inventory.

Can you kind of discuss the function of that increase?

Was it really just a matter of timing?

Or was it additions to the acquisitions?

Or investments ahead of production?

Kind of how can we think about that build over the last couple of quarters?

Yes.

So it's a good question, Ben.

So the answer is, yes.

You kind of hit a couple of the main points.

So first of all, we have brought in additional inventory as a result of doing multiple acquisitions.

It's worth remembering, when you do an acquisition also, you bring that inventory in at a stepped-up basis.

So it comes in a little bit high, and then it takes some time to work that off at normal levels.

But in addition to just the step-up overall, because of the acquisitions and being a bigger company, we've shifted to -- or actually in the process of still shifting to our U.S. manufacturing operations, which we dedicated last week.

That has lead us to build inventory over time.

And included in that is also some safety stock because we don't want to put risk in the business unnecessarily as we manage through some of those transitions.

And then it's also a point of note that as we shift to in-house manufacturing, we're stepping down one level in our own supply chain, so that inherently carries slightly larger amounts of inventory with it.

And then, I guess, the final point that I would make is, I mentioned we do more and more of these more complex, more sophisticated subsystems than we have in the past.

Those tend to be bigger, as I said, more complicated, more expensive, which is nice for us.

And as we do that, they inherently involve not only more physical inventory but also more labor.

And then often, some of those large subsystems are actually scoring revenue on a percentage of completion basis.

And there can be timing issues around when we're recognizing the revenue as we're working through it and when we actually convert that revenue into cash over time.

So those larger programs will tend to build either inventory or unbilled and then ultimately regular build receivables over time.

And then, over time, they convert out so that kind of normalizes.

So those, I think, are the main things that are going on in addition to just us being bigger.

Got you.

And one final quick question from me.

A follow-up on an earlier question regarding areas of international attention.

I'm wondering if you can just elaborate specifically on foreign military sales, how that has evolved recently kind of from a geographic perspective?

Within foreign military sales, does that mean your order flows accelerate in any particular region?

Are you able to elaborate on that at all?

So in Q1, I think as Gerry said in his prepared remarks, international defense revenue, including FMS, was actually up 16% year-over-year.

On an LTM basis, it's actually up 24% year-over-year.

So we are seeing pretty good growth.

It's hard to specifically tie it back to a region because I don't think we've necessarily got that insight because some of the programs that we're involved with, we sell to our customers here domestically that they're selling overseas that they're encompassing that number.

But many of our programs that we're involved with have got FMS components.

(Operator Instructions) Our next question comes from the line of Greg Konrad with Jefferies.

Just really only -- I just have one question.

Most of my questions have been answered.

But is there any way to quantify your win rate?

And as the primes have become a little bit more comfortable with their growth forecast, the way they kind of splice your growth based on higher build rates for the programs you're on versus kind of new content wins or upsize in terms of your content on key programs?

Not specifically the win rate, Greg.

I mean, obviously, that's something that we keep a close eye on and is definitely trended northwards as we continue to take share in both RF, particularly as it relates to EW, the modernization activities as well as in the processing domain as it relates to secure processing.

But that's not a number that we publish.

At Investor Day, we will give an update on just some of the lifetime values of the different pursuits that we're going after related to the different platforms and market segments.

And you'll see, we hope, the increases that we've seen year-over-year.

So -- but not specifically win rates.

And Mr. Aslett, it appears there are no further questions.

Therefore, I'd like to turn the call back over to you for any closing remarks.

Okay.

Well, thank you very much for listening today's call.

We hope to see you at Investor Day in New York City on November 7. Thank you very much.

Take care.

Ladies and gentlemen, thank you for participating in today's call.

This does conclude the program, and you may all disconnect.

Everyone, have a great day.