Mercury Systems Inc (MRCY) 2018 Q2 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems Second 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.

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

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

If you've 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 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, seek, 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 any U.S. government shutdown or extended continuing resolution; effects of continuing 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 U.S. 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; changes in tax rates or tax regulations; changes to generally accepted accounting principles; difficulties in retaining key employees and customers; and 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 on 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 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'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 continue to deliver strong results in the second quarter of fiscal 2018, organically and in our acquired businesses.

We came in at or above the high end of our guidance in all of our metrics, achieving record revenue, bookings and backlog.

Design win activity was strong and our key programs are doing well.

We're seeing more opportunities in marketplace and we'll continue to execute successfully on our M&A market penetration and market expansion strategies.

We made solid progress from an operational perspective thanks to another great effort by the Mercury team.

We continue the consolidation of our RF manufacturing locations associated with the integration of Delta Microwave.

We completed the Richland Technologies systems integration.

We also continued the insourcing activity at our world-class trusted digital and microelectronics manufacturing facility in Phoenix.

Finally, we announced the acquisition of Themis Computer, which is expected to close in early February.

Looking quickly at some of the numbers, total revenues for Q2 including the acquired businesses, were up 20% year-over-year.

Our largest revenue programs in the quarter were Aegis, SEWIP, F-35, E-2D Hawkeye and Filthy Buzzard.

Total bookings were up 24% from Q2 last year and our book-to-bill was a strong 1.14.

Our largest bookings programs were F-35, DEWS, Aegis, Paveway and Patriot.

Adjusted EBITDA for Q2 on a consolidated basis was up 17% year-over-year and a 23% of revenue within our target model.

With the business firing on all cylinders, the main uncertainty we face relates to the defense budget, which was not approved at the end of calendar 2017, as we and others have anticipated.

The government is still operating under a continuing resolution, which given the current political climate could be extended.

The consensus view however is that there will be an FY '18, FY '19 budget deal.

This eliminates the budget caps followed by an FY '18 defense appropriation by mid-February.

Given that, we still expect Mercury's second half of fiscal '18 will be stronger than the first.

We expect to continue to deliver above industry average growth in revenue and profitability for the full fiscal year.

Our confidence in the outlook reflects Mercury's strong market position and positive momentum as we begin Q3.

The underlying industry growth drivers are alive and well.

As I mentioned, we exited the second quarter with record backlog.

The level of new business pursuits and design activity remains the highest I've seen since joining the company.

Our win rate is strong and we are continuing to take share.

Finally, we believe that we are at the beginning of a multi-year increase in defense spending.

We're targeting the most rapidly growing parts of the aerospace and defense electronics market and expanding our offerings to customers.

The acquisitions that we've done have dramatically increased the size of our total addressable market.

They've also allowed us to move up substantially higher in the value chain.

Our design wins and growth reflect our continued success in broadening and deepening our relationships with key customers and our position on major programs.

Our top line performance also reflects the substantial investments that we've made in internally funded R&D for critical and differentiated technology for use onboard military platforms.

As well, it reflects the trusted domestic manufacturing capabilities we've created in the RF, digital and custom microelectronics domains.

In executing on our strategy, we've closely aligned to Mercury with the DoD's most important investment priorities.

We participate in 2 major markets, sensor and effector mission systems and C4I, and we're seeing strong growth in both of those areas.

In sensor and effector mission systems, this growth is being driven by a wave of sensor modernization, affecting a broad range of platforms.

In the radar domain, the industry is shifting to AESA, or actively electronically scanned arrays.

We are seeing significant activity associated with upgrades in electronic warfare.

We're beginning to see increased modernization activity in EO/IR in response to the new threats that are developing around the world.

As well, we are seeing growing investment in readiness and modernization in the weapon systems domain, primarily associated with replenishment of stocks in that space.

Long-term, we anticipate seeing continued weapon systems growth driven by modernization activity related to new security, safety and EW requirements.

Sensor and effector mission systems is the market in which we've participated in the longest.

Revenue from this portion of the market has grown 22% over the past 12 months, and it now amounts to 72% of total company revenue.

In Q2, revenue for the sensor and effector market was up 20% versus the same period last year.

We're also seeing a wave of modernization in C4I, those other types of computers onboard the platform that aren't related to sensor processing.

This is now the fastest-growing part of our business, reflecting that C4I is a market that we just recently entered.

Mercury C4I revenues have grown 290% over the past 12 months compared with the prior period and now represent 12% of total company revenue.

In Q2, our C4I revenues grew 105% year-over-year.

Our growth in both the sensor and effector in C4I markets reflects the impact of 3 industry trends we've discussed for some time.

The first is outsourcing.

Our prime -- our defense prime customers are outsourcing more at a higher level than they have in the past.

As a result of our investments in R&D and our focus on pre-integrated subsystems, Mercury's ideally positioned to provide them with high-quality lower-cost solutions than they can deliver internally.

Second, we continue to see a flight to quality in both RF and secure processing.

We're taking share in these domains as a result.

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.

At the same time, the primes are seeking partners that like Mercury, has scalable and trusted capabilities in manufacturing assets that combined to deliver innovations with high quality faster and more affordably.

Trend number 3 relates to both the government as well as the primes seeking to delayer their supply chains.

Some of the major platform integrators are working to make their solutions more affordable.

They're doing this by reaching deeper down into the industrial base to partner with companies at the Tier 2 level.

The companies that are funding innovation.

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

With our commercial business model, we positioned ourselves as an ideal partner as the delayering trend evolves.

Our strategic acquisitions over the past several years have allowed us 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.

In the past 24 months, we've completed or announced 6 acquisitions putting a total of $575 million of capital into highly strategic deals of various sizes.

These transactions all share a common strategic rationale.

They've expanded our addressable market and customer offerings, while generating cost and revenue synergies over time.

In line with this strategic rationale, acquiring Themis Computer will provide us with the platform for accelerating our growth through further penetration of the C4I market.

Themis is a large installed base and is designed in as a provider of rugged rackmount servers to some of the largest army and navy server programs.

As a result, Themis strongly complements Mercury's presence in this area as well as in the sub-surface market.

As we focus our efforts on C4I, we believe we can offer additional capabilities to Themis' customers, most notably through our industry-leading security IP portfolio.

This will help them meet their unique requirements and growing demand for secure and trusted computing.

We look forward to the Themis team becoming part of the Mercury family.

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'll 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 this scale of technology platform that we've built.

We'll remain focused on assembling critical and differentiated solutions for secure sensor and mission processing.

We plan to continue acquiring smaller capability-led tuck-ins, while seeking to capitalize on larger opportunities as and when they present themselves.

In summary, we believe Mercury is on track for another great year in fiscal '18.

We are pioneering a next-generation defense electronics business model and it's working very well.

We have unique and differentiated technologies.

We substantially increase the size of our addressable market.

Our low-risk content expansion growth strategy is producing great results.

We're targeting the largest secular growth opportunity in defense, which is outsourcing.

We're taking share and we're seeing high levels of activity based on our investment and capability set.

Mercury is delivering well above industry average growth and we've built a platform that we can continue to grow organically, as well as scale through additional acquisitions.

At the same time, our planned integration and manufacturing synergies are materializing as anticipated.

Given our results in Q2, our record backlog, our current business and defense budget outlook, we're anticipating continued strong performance for the remainder of the year.

As a result, we're increasing the midpoint of our full year fiscal '18 guidance for both revenue and adjusted EBITDA.

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

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 company's financial results, I'll note that unless otherwise stated, we'll be discussing those 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.

Collectively, the contributions of these businesses comprise what we will refer to as acquired revenue for purposes of this call.

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

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

I'll turn now to Mercury's second quarter results, which were strong on both a consolidated basis and organically, highlighted by record revenue, bookings and backlog as well as progress on yet another strategic acquisition.

Total revenue increased 20% from Q2 last year to a record $117.9 million exceeding our guidance range of $112.5 million to $116.5 million.

Organic revenue for Q2 increased 12% year-over-year to $104.9 million, up substantially from the 7% organic growth rate recorded in the first quarter of fiscal '18.

Acquired revenue was $13 million, which is not comparable to Q2 of fiscal '17 due to the inclusion this year of Delta Microwave and RTL, which were not a part of Mercury in Q2 of last year.

Our customers are seeking growth through foreign military and international sales and we are successfully leveraging this trend.

For Q2 of fiscal '18, international revenue, including foreign military sales, was $27.9 million or 23.7% of total revenue.

This compares with 15.3% of revenue in Q2 of fiscal '17 and is up 87% over last year.

At our Investor Day, we talked about the business in terms of 3 industry tiers where Mercury participates: components, modules and subassemblies and integrated subsystems.

On the last 12 months basis, components revenue has grown 109%, while modules and subassemblies revenue has grown 21%, both driven primarily by our acquisition activity.

Integrated subsystems revenues, which are largely driven through the organic business have grown 7% on an LTM basis, providing a rough indicator of what we see as growth in the overall rate of outsourcing.

At the end of Q2, components represented 34% and modules and subassemblies and represented 35% of Mercury's total revenues, respectively, while integrated subsystems represented nearly 1/3 of total revenues.

These percentages reflect the fact that we are acquiring businesses at the Tier 3 or component, module and subassembly levels.

We then seek to move those businesses up the value chain by progressively integrating more components into modules and subassemblies, and over time, to migrate these lower tier elements into our integrated subsystems capabilities and offerings.

These percentage of total revenues numbers will move around depending on the sizes and frequency of our acquisitions and how we're doing with respect to our strategy.

That said, we're very pleased with the progress that we're making with this aspect of our strategy and the opportunities it creates with and for our customers.

Turning now to bookings.

Total bookings for the second quarter were up 24% year-over-year, driving a 1.14 book-to-bill ratio.

We ended the quarter with record total backlog of $376 million, up 18% from $319 million a year ago.

Approximately $310.4 million or 82% of our Q2 backlog is expected to ship within the next 12 months.

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

We anticipated slightly lower gross margins and slightly higher operating expenses for Q2, and adjusted EBITDA landed squarely at the midpoint of our percentage guidance range for the quarter.

Our gross margin for Q2 was approximately 46% compared with 48.3% a year ago, driven by product mix.

This is slightly below our Q2 guidance, but still well within our target business model.

The outcome was driven primarily by a large last-time component buy on behalf of a customer, which carried a low margin, while Q2 of '17 had a proportionately larger amount of high-margin royalty revenue.

Total Q2 operating expenses were $43.3 million versus our guidance of $41.7 million to $42.8 million and $38.4 million for the same period last year.

OpEx was slightly higher than anticipated, primarily due to transaction expenses related to our acquisition activities and modest restructuring costs associated with our ongoing facilities realignment and consolidation in California, neither of which are included in guidance.

We're continuing to make good progress in realizing the expected integration synergies associated with our recent acquisitions as well as capturing the benefits of our in-house U.S. manufacturing operation in Phoenix.

GAAP net income for the second quarter of fiscal 2018 was $9.1 million or $0.19 a share, up 76% from $5.2 million or $0.13 a share for Q2 last year and well above the top end of our Q2 guidance.

This is based on approximately $47.4 million -- 47.4 million weighted average diluted shares outstanding for the quarter.

The increase year-over-year and the outperformance versus guidance largely reflect revenue growth that continued to outpace growth and operating expenses as well as tax benefits associated with the federal tax reform legislation signed into law this December.

Q2 GAAP net income reflected an aggregate tax benefit of approximately $1.6 million related to the new tax law.

Looking ahead to full year fiscal '18, we expect to see an overall tax benefit of about 2% compared with the prior tax regime, reflecting a partial benefit from the new law in the second half after being blended with our prior tax rate in the first half.

Looking farther ahead to fiscal '19, our estimated tax rate for planning and guidance purposes will be 30%, reflecting an estimated benefit of approximately 5 points compared to Mercury's prior 35% estimated tax rate.

Although the new corporate rate is 21% or 14 points lower than our prior estimated rate of 35%, 3 primary items related to deductions are expected to offset about 9 points of this rate differential.

First, the deduction for state taxes provides less of a benefit due to the lower federal rate.

Second, the limitation on executive compensation deductions has been expanded to apply to a broader group of individuals, and also to capture forms of compensation that were previously not limited by the cap on deductibility, namely performance-based compensation.

Third, we've historically benefited from the Section 199 manufacturing deduction, which has been eliminated for tax years beginning after December 31 of 2017.

These factors combined with various other tax changes create the upward impact on the effective rate.

While Mercury benefited in Q2 from a GAAP perspective, tax reform had a slightly negative impact of approximately $0.03 per share on Mercury's adjusted EPS for the second quarter, which still came in at $0.28 per share.

This represents the low end of our guidance range of $0.28 to $0.30 per share and compares with adjusted EPS of $0.30 a share in Q2 of fiscal '17.

This is primarily because the favorable Q2 impact of the tax reform legislation reduced the value of deferred tax liabilities primarily intangibles, which are add backs to adjusted EPS, meaning the total value of the add backs is somewhat smaller and adjusted EPS is therefore somewhat lower.

Driven by Mercury's strong growth and solid profitability, adjusted EBITDA for Q2 of fiscal '18 increased 17% to $26.9 million from $23 million in Q2 of last year.

This is slightly above the high end of our Q2 guidance of $25.3 million to $26.8 million and represents 22.8% of revenue.

As expected, for the first 6 months of the year, adjusted EBITDA was 23% of revenue, well within the long-term target range of 22% to 26%.

Turning to the balance sheet.

Mercury ended the second quarter of fiscal '18 with cash and cash equivalents of $32 million compared with $46.2 million a year earlier.

As anticipated, inventory increased in Q2 as we continue to migrate production to our Phoenix U.S. manufacturing operations.

In the process, we're internalizing an additional layer of what formally was part of our supply chain, adding into our inventory the materials and labor associated with conversion of those materials at the later stages of production.

The lead times and transformation steps associated with converting that additional layer of inventory into finished goods also lengthens inventory cycle times.

Managing this important manufacturing shift, which is ongoing, has also led us to increase the amount of buffer stocks that we keep on hand as we continue transitioning more products in-house.

Over time, we expect this buffering to diminish as we move to more steady state production and begin realizing more production efficiencies.

Mercury's operating cash flow for Q2 of fiscal '18 was $8.8 million compared with $14.2 million last year.

Our cash flow reflects the buildup of inventory associated with our expanded in-house manufacturing capabilities, offset in part by a 9-day decrease in days sales outstanding in Q2 compared to Q1.

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

Cash flow from operations in Q2 was partially offset by $4 million of net capital spending.

As anticipated, capital expenditures were substantially lower than the $7.7 million incurred in Q2 of last year.

Net of CapEx, free cash flow for Q2 was $4.8 million compared with $6.5 million a year ago.

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

We concluded Q2 well positioned to continue executing on our capital deployment strategy supporting future growth both organically and through acquisitions.

The estimated benefits of tax reform further support this deployment strategy.

Entering Q3, we've maintained flexibility in our capital structure and good access to capital with an untapped $400 million revolving credit facility and an unused universal shelf registration filed in Q1.

The revolver will fund our anticipated $180 million acquisition of Themis Computer, which is subject to net working capital and net debt adjustments.

As Mark said, Themis is an extremely good strategic fit with Mercury, aligning very well with our target model and creating an excellent platform for continued penetration into the C4I market.

Themis has a record of strong organic growth driven by established positions and well-funded programs, delivering an estimated $57 million of revenue in calendar 2017 with an adjusted EBITDA margin approaching 23%.

In addition to potential revenue synergies, we anticipate realizing about $1 million of run rate cost synergies over time.

Consistent with our past practice, there will likely be some modest initial investment in order to realize run rate synergies and align R&D spending, which would be slightly dilutive to the bottom line margin ratio at the outset.

However, the deal is expected to be immediately accretive to Mercury's adjusted EPS and adjusted EBITDA.

Again, echoing Mark's comments, we see this as an important and exciting opportunity and we look forward to having the Themis team onboard and helping us drive Mercury's future growth as we continue penetrating the C4I market.

I'll turn now to our financial guidance for the third quarter and full fiscal year 2018.

For purposes of modeling and guidance, we've assumed no restructuring and no acquisition or nonrecurring financing related expenses, an effective tax rate of 33% in the periods discussed, which includes the impact of tax reform.

The guidance also assumes weighted average fully diluted shares outstanding of approximately 47.5 million shares for Q3, and 47.7 million shares for the full fiscal year.

Finally, our guidance does not include Themis because the acquisition has not yet closed.

As the transaction is expected to close during Q3, we anticipate providing updated guidance that includes Themis when we report our Q3 earnings.

Our guidance for Q3 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 our major product lines and across many of our programs as well as by our enhanced manufacturing capabilities.

We're planning that R&D internal investment will remain at or near the high end of 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 expect to see improvement in our free cash flow for the year as we continue to grow and our CapEx has reduced versus fiscal '17.

We continue to 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 of 5% of revenue or less.

With that as background for the third quarter of fiscal 2018, on a consolidated basis, we're forecasting total revenue in the range of $116 million to $120 million, an increase of 8.1% to 11.8% over Q3 of fiscal '17.

Gross margin for Q3 is expected to be approximately 46.6% to 47%.

Q3 GAAP net income is expected to be in the range of $7.8 million to $9 million or $0.16 to $0.19 per share.

Adjusted EPS for Q3 is expected to be in the range of $0.33 to $0.35.

per share.

This estimate assumes approximately $4.2 million of depreciation, $5.7 million of amortization of intangible assets, no fair value adjustments from purchase accounting and $4.7 million of stock-based and other noncash compensation expense.

Adjusted EBITDA for the third quarter of fiscal '18 is expected to be in the range of $26.3 million to $28 million, representing approximately 22.7% to 23.3% of revenue at the forecasted revenue range.

For the full fiscal year 2018, we now expect Mercury's total revenue to increase to between $460 million and $468 million, an increase from our prior guidance.

Currently, gross margins for the year are expected to be between 46.5% and 46.8% and operating expenses are expected to be in the range of $167.3 million and $169.7 million for the year.

Total GAAP net income for fiscal '18 is expected to be in the range of $38.4 million to $40.4 million or $0.81 to $0.85 a share.

Adjusted EPS is expected to be in the range of $1.33 to $1.37 per share.

We currently expect total adjusted EBITDA for fiscal '18 of approximately $106 million to $109 million and at approximately 23% of revenue, well within the range established by our current target business model.

As Mark said, although the federal government has continue to operate under a CR, we still expect that in fiscal 2018, as in the past several years, our second half will be stronger than the first half and Mercury will deliver another year of strong growth and financial performance.

With that, we'll 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 Jonathan Ho of William Blair.

I just wanted to start out with maybe a few clarifications around your organic growth this quarter.

Were you guys satisfied with the organic growth rate and are you seeing sort of the translation from some of the acquisitions that you've made over the past couple of years show up in terms of those numbers?

So yes, we were very happy with it this quarter, Jonathan.

So in Q2, the organic revenue grew 12% year-over-year versus 7% last quarter.

I think as we've said in prior calls, we've actually been very successful, taking the acquisitions that we've done previously, and through the investments that we've made in the business and the channel that we have, being able to inflect the growth rate of those business northwards versus what they would do on a stand-alone basis.

So yes, we're pretty happy with the results.

Got it.

And then just in terms of the Themis business, I think you said in the press release that this was growing pretty quickly, but is there any sort of metric you can give us in terms of how quickly that business is growing?

So we actually haven't disclosed the growth rates, and obviously, we don't yet own the company since the deal hasn't closed.

We're estimating that they're doing roughly $57 million of revenue for calendar year '17 with an EBITDA that is roughly in line with ours at 23%.

So we'll have more to say about it on the call next quarter.

Our recommendation would be to hold off trying to include any of the revenues from that acquisition given that we'll have more to say about it on the Q3 call.

Got it.

And then just one final one in terms of the impact from the government shutdown and lack of budget clarity.

I mean, you guys have executed through CRs in the past, is there anything different about this time?

Or any sort of impact that you're seeing that maybe changed from last quarter?

Well, so I think if you look at what I said in my prepared remarks, I think last quarter, we were anticipating that there would be a defense budget appropriation by the end of the calendar year.

Obviously, that didn't happen.

It's bled over into the new calendar year.

We were operating under another continuing resolution following a short shutdown of the government.

So it's clearly more challenging than what we've seen.

Our expectation right now based upon the consensus view is that there will be an FY '18, '19 budget deal that removes the prior budget caps associated with sequestration followed by an FY '18 defense appropriations by mid-February.

So that's what we've based our guidance on.

And yes, we certainly hope that, that happens.

Our next question comes from Seth Seifman of JP Morgan.

I guess, in looking at the strong bookings and the backlog growth that you guys had during the quarter, if you could talk a little bit about how much of it came from sort of positions that you have on existing programs that are growing versus maybe how much of it came from share gain and you've talked in the past a little bit about how you're gaining share and kind of whether you see that share gain accelerating from where it was 3 months ago or whether it's at the same pace or starting to level off?

Sure.

So I think overall we continue to perform extremely well.

Yes, as we talked about on the call, if you look at our 2 major market segments in Q2, sensor and effector, which is the more traditional part of our business was up 20%.

If you kind of go down the level inside of that market segment, really what is driving the growth is a couple of different areas.

The first is EW, and the EW business increased 38% in Q2 of fiscal year '18 versus the prior year.

So clearly, that is well above the growth rates in the industry, which suggests that we continue to do well, meaning taking share as well.

We've obviously got some programs that are in production.

The weapon systems arena is also an area that we continue to benefit from.

That particular market segment was up nearly threefold versus the prior period.

And then as I said in my prepared remarks, we're also beginning to see some modernization activities in the EO/IR space, which for us is a relatively small percentage of our revenue today, but we believe it's going to be larger going forward as some of the programs that we're winning and our customers are pursuing hopefully move into production.

So we're very pleased with how the business is performing and Gerry, I don't know if you want to add anything?

Yes.

So one other dimension that I mentioned on the prepared remarks section is this transition that we're seeing to the integrated subsystems.

So I noted the 7% year-over-year increase, but the important factor is that, that's on the back of a 26% increase year-over-year of last year.

So you can really see the way we're executing that strategy and that cuts across those dimensions that Mark was talking about, and so it in effect, protects both the organic and the acquired businesses as we assemble those capabilities together.

And we do think that we're unique in that regard.

And so we're extremely happy to see that happening because those unique capabilities we think also leave us very well positioned with those customers as we look forward.

So -- thanks for that, Gerry.

So if you kind of take it from a more of a technology level.

There's really 2 areas that we've talked about in the past that we're taking share.

One is in the RF domain.

And I think we've mentioned that there is a couple of different industry participants that are really struggling right now and we continue to take share from them primarily in EW, but also we've seen some opportunities in the radar domain from an RF perspective.

The other is in secure processing and as you know, this has been a theme for us for many years and in fact, we're now on our fourth generation of embedding critical security technology into the processing infrastructure and at a time when our customers need it both domestically as well as to enable foreign military sales and we've clearly taken share in that domain as well.

So we're extremely pleased with how we're positioned and the progress inside of the business there.

Great.

And then just as a follow-up, if you look at the National Defense Strategy that the Pentagon released last week, and what they say in the business section talks about looking to do faster development, more iterative development, more frequent upgrades.

I would imagine that that's something that works to your benefit, but at the same time, it's probably something that's very easy to put in a strategy document and much more difficult to translate into the real world, and so I guess, whether you've picked up on any movement in this direction at the department already, and how focused do you see the customer being on this item and the degree to which you think your customers, the defense primes, sees this as something that would drive further outsourcing?

Yes.

It's a great point.

And obviously, I think, we believe that we're extremely well aligned with the National Defense Strategy as laid out by Secretary Mattis.

I mean the themes for us when you kind of look at that is the fact that we're moving into a period where we're focusing on what he describes as the great power competition with really more strategic competitors and specifically, targeting China and Russia.

As we know, both of those countries have got much more sophisticated technology and capabilities than some of the terrorist threats that we faced historically.

And a lot of that is leading to this wave of modernization that we see occurring in really the core of our business on the sensor side as well as C4I modernization.

From a business model perspective, I think, you also hit the nail on the head and we've seen under Under Secretary Lord, a real focus on trying to not only improve -- continue to improve the affordability, which has been an ongoing theme.

But also speed up the rate at which new technology is introduced downrange largely because the threats are moving very rapidly and the military needs to be able to keep up with the pace at which these threats are occurring.

And so the fact that we've got a business model that produces technology much more quickly, much more affordably at lower risk than the older way of doing it, we think bodes extremely well for Mercury in the longer term.

So it's -- we're very pleased with what Secretary Mattis said and our positioning with respect to that.

Our next question comes from the line of Jon Raviv of Citi.

Jumping back to some of the budgets ups and downs right now, can you just describe the -- almost the mechanism by which an extended CR and/or shutdown impact your financials.

I mean, are you seeing your customers slow their spending in reaction to that?

So not that we can identify specifically, but clearly, I'm sure that there is concern with the very short shutdown and the fact that we are in an extended CR compared to what we've had in the past.

In the impact of any future shutdown or an extended CR, obviously will really depend upon the duration of any potential shutdown and how the DoD and our customers respond.

And can you just review some of the things that you've done, I sort of got the impression that between larger backlogs and your market penetration strategy, no one is immune from these sorts of things.

But if things have to be purchased, if things have to be done especially in the context of you guys being a lot smaller than the total defense budget.

Just what have you done to almost derisk or minimize risk or mitigate risk around these sorts of things and that weren't in place, say 5 years ago?

Yes, it's a great point, Jon.

So we've, obviously, worked extremely diligently since fiscal 2013 to reduce our dependency on what we would describe as book ship revenue and the way in which we've done that is by really building up our backlog.

And so we've ended Q2 with a record backlog and we've had multiple records in a row and it's totally now $376 million.

And we've got a very strong 12-month forward revenue coverage.

So in essence what we've been doing is we've been focusing on reducing the amount of book ship is really buying down the amount of risk in the business period-to-period.

So to put this in perspective and to put a finer point on it, if we went back to say, fiscal Q2 of fiscal '13, the book ship in the core of the business, which is our MCE operating segment at that time was around about 45%.

If you look on an LTM basis, the amount of book ship revenue that we have it's around about 15% of total revenue.

So there's been a dramatic reduction in terms of the risk that we've had as we focus on building the backlog.

Our next question comes from the line of Michael Ciarmoli of SunTrust.

Maybe just to stay on that line of a question with the continuing resolution.

Mark, I mean, the guidance for the remainder of the year, had we had a budget in place, would that have changed your outlook at all?

I'm just trying to maybe if you can specifically quantify if there's been an impact at all, did it prompt you guys to maybe introduce a little bit more conservatism in the forecast, given the unknown?

And I'm sure, we're going to have shutdown talks 3 weeks from now as well.

Yes.

Well, yes, I mean, it's hard to say specifically, Mike.

I mean, what we're trying to do is take into account a multitude of factors when we guide, and obviously, if we look at where we are at with the budget, we do anticipate that there have been a budget deal, a multi-year budget deal with an appropriation.

So we think that we have taken that into account into the guidance and that's the numbers that Gerry went through.

Got it.

What about on the -- I think in the prepared remarks, you guys mentioned the electro-optic/infrared, saying you plan to grow it and it will be bigger, what -- can you walk us through that, I mean, if I envision your kind of Investor Day slide, you've shown all the mission kind of silos there, and you didn't really have a major presence in EO/IR.

So what's the strategy there to grow that business?

Is it organic growth?

Are you going to target more specific M&A in that capability to drive growth?

Do you have enough internally with design wins to drive a meaningful amount of growth there?

Maybe just elaborate a little bit.

Sure.

So the chart that you're talking about is the market segmentation chart and that chart specifically is really more focused on demonstrating how it is that we're executing from an M&A.

Mercury is already participating in EO/IR and if you go back, we're on a program called Gorgon Stare, which is the preeminent wide-area motion inventory platform.

We are seeing a different type of requirement in EO/IR and I'm not going to go specifically into detail because I think it's a relatively sensitive area.

But we do think that, that we've got the processing capability to go after that market opportunity that's going to require a tremendous amount of compute horsepower.

So although it's a small percentage of the business today, it's roughly 3% of total revenue.

We are seeing double-digit growth rates and these are in early stage, call it, tech demonstrated programs.

But if any of these programs kind of go into production over the longer-term, we think it could be another important driver of growth, combined with the other sensor upgrades that we're involved with.

Got it.

And then last one, maybe Gerry just housekeeping.

Funding Themis on the revolver, what should be expect?

Will interest expense, probably not so much in the third quarter, fourth quarter, will that have a meaningful impact on financials that we should be thinking about at all in fiscal '18?

So you should start thinking about it as soon as we do issue some guidance and we actually have taken down the debt.

As we said, we expect to fund it through the revolver.

So assuming that all goes to plan, we would see some interest expense in Q3, and then we'd see a full quarter's load in Q4.

It's going to still be a pretty modest debt level at about 1.5 turns, a little under that, net of our cash.

So -- and it's a very good rate in terms of the -- in terms of the revolver.

So it is what it is.

But we haven't updated any of the numbers yet to reflect that.

Our next question comes from the line of Greg Konrad of Jefferies.

I just wanted to go back to the CR for a minute.

You talked about how you've kind of derisked your own business, but I think some of the businesses that you target on the M&A front are maybe a little bit more susceptible to the issues of having these extended budget negotiations.

Can you maybe talk about how that's impacted the M&A market?

And then the on top of that with tax reform, have you seen any change in seller's expectations?

So certainly for the business that we've recently acquired as well as the one that is pending, we don't think that there are any significant impacts that we can identify at this time that is different than what I previously described.

With respect to tax reform and the change in rates, yes, I think it probably does have a longer-term impact in terms of seller's expectations with the higher potential cash flow associated with the lower tax rate.

And then you talked about revenue synergies a couple of times in the prepared remarks.

Is there any way to kind of quantify what you look for when looking at targets in terms of upside from generating those revenue synergies?

Yes.

So a big part of what we focused on is that content expansion strategies that we talked about previously.

Mercury has built out a very strong strategic account sales model where we're dealing with the highest level of our customers on down and you know, that's important because when our customers are actually outsourcing, they're entrusting us with a very important part, a critical technology element of their overall system.

So when we are looking to acquire a business, we are looking for ways in which we can insert that technology to create a better solution for the customer in the short and longer term.

And I think we've been doing that very, very successfully, given the growth rates that we've been experiencing.

The other thing is, we clearly look as we are evaluating what we can do with an acquisition and how might it change as a business once it's a part of Mercury.

The technology point that Mark made is very important and is one of our key considerations, but we also look at our ability to leverage a channel, which is very strong.

So we are looking at the overlap from a customer's standpoint, from a program standpoint as well as the technologies that are either something that we're very familiar with, or is very closely adjacent to what we're already doing, which is what gives us the ability to introduce those capabilities to the customer and also integrates those capabilities with the more highly integrated offerings that we set out to bring to our customers.

And Themis is a great example of that.

So if you think about, it's really very complementary from a position perspective with respect to both companies customers as well as the programs, and we do think there's a strong ability for them to leverage the channel that we've created.

Now they've already got a strong position in the rugged server markets, and I think one of the potential synergies there is the fact that Mercury has got an industry-leading security IP portfolio that many of Themis' customers and programs, we believe, will benefit from.

So it's really a highly complementary, in the case of Themis, a highly complementary acquisition.

We also view it as a platform, right.

So we are in the early stages of penetrating the C4I space.

It's already over 10% of the total company revenues, it's the fastest-growing market segment in which we are participating and we think that we're at the early stages of the growth in this particular sector.

Our next question comes from the line of Peter Arment of Baird.

Quick one on Mark, I guess, thinking about your discussion around Tier 3 to Tier 2 kind of moving into that integrated subsystems.

I think you mentioned roughly 32% or 33% of your revenue mix.

As you continue to grow the capabilities, I mean, how quickly does that continue to increase, I mean, will this eventually be 50% of the mix?

How should we think about that?

Do you want to add?

Yes.

So the way I would think about it, Peter, it's a little hard to prognosticate what portion of the mix, but what we want to see is what we have seen, and I think I've mentioned it in an earlier response, which is that we are selling more of those subsystems.

Now if we go out and do another acquisition similar to those that we've done in the past, what it does is dilute that percentage because we are acquiring entities that are down at the lower level, and then what we're trying to do is, again, incorporate their capabilities into the portfolio of offerings.

But also into the specific solutions that we're offering so that we begin to leg up through to higher levels of integration in terms of what we are offering the customer.

That does a couple of nice things for us.

One is, obviously, it gives us the optimal ability to leverage our channel.

It also protects our positioning in those program because we're more and more comprehensively, and therefore, tightly anchored into those as we capture content and that's what's helping to drive program values up and order values, which is a trend that we've seen pretty persistently in the business in recent years.

So again, our goal is to keep building that up and then diluting it by acquiring more capabilities other companies and building them up as we go and creating kind of virtuous cycle to it.

I can tell you, Peter, it's by far the majority of all of the new design win activity is actually at the subsystem level.

So it's consistent with the theme of our customers actually outsourcing at a higher level, seeking to deal with companies such as Mercury that are able to provide more affordable solutions more quickly with lower risk.

But not only the companies that are able to lean in from an R&D, but also the companies that can actually manufacture and the capabilities that we've built in the trusted manufacturing, domestic manufacturing is turning out to be a very significant competitive advantage for us.

And that's one of the reasons, by the way, we're managing that transition so carefully is that it's a really important element of what we do and what we do for the customers, and we do not want to disrupt that at all.

Yes, no, I was thinking indirectionally that it would have a high correlation if you continued to build record backlog.

So that's what it sounds like, certainly.

That's great.

Just -- and then just regarding the kind of the pipeline, Themis closing here in early February.

What's your, I guess, your comfort level around historically leverage of just whether those opportunities are still out there to do larger deals or you still that there is plenty of kind of tuck-in deals?

So, yes, I think, as I said in my prepared remarks, right, we're focused on the smaller capability-led tuck-ins as well as the larger opportunities as and when they present themselves.

You know that we've got an in-house M&A team that has built very strong relationships, both on the larger side as well as on the smaller side and we're pretty much getting a look at everything that is out there.

We are pretty disciplined in our approach where we're not just looking to gain scale for the sake of it, where we're seeking to do deals that are very strategically aligned with the strategy that we laid out in Investor Day and we are going to continue to do that.

The -- I would say that right now that there is a fair number of -- yes, the market is quite active, let's put it that way.

Our next question comes from the line of Brian Ruttenbur of Drexel Hamilton.

Just one quick question on tax.

Your given guidance for 30% in fiscal '19, do you anticipate that tax rate could go down into the 20s, the high 20s at least in 2020 or 2021, and what can you do to adjust that?

And is there anything that you can do to get your overall tax rate down into those ranges?

Yes.

So we aren't looking at something that would cause us to change our view as yet.

There are probably a handful of nuances around things like the compensation deductions and as the -- as the company grows in size, that becomes probably a smaller overall percentage, and therefore, has less of an adverse impact in terms of the now lost portion of deductibility and so on.

So it's more of a proportionality issue than anything else.

And then the other thing is that our guidance does not include any discrete items.

So that's the major element that we will see from time to time, but as we've said in the past, because that will vary and can vary pretty considerably from period-to-period, we don't build that into the general rate forecast.

Okay.

And then are any of your acquisitions that you're looking at or that you're currently in the process of doing?

Will that NOLs or something like that help you in the future to lower that tax rate?

No, we don't really see any continuing benefit from an NOL standpoint.

I'd love it if we had it.

Sometimes, we have an opportunity to pick up some of that through an acquisition, which has happened in the past.

So it's certainly something that we consider at the time as we are evaluating the acquisitions.

The other thing and I don't think I called this out specifically, but we don't see on the tax front, any adverse consequence associated with deemed repatriation from overseas earnings and so on.

So anything that we do it because, of course, we now do own some overseas operations, will certainly take the new tax regime into effect, which is overall favorable.

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 all very much for listening.

We look forward to speaking to you again, next quarter.

Thank you.

This concludes today's conference.

Thank you for your participation.

And have a wonderful day.