Mercury Systems Inc (MRCY) 2018 Q3 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems Third 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, Mike Ruppert. Please go ahead, sir.

Good afternoon, and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you have not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com.

Before we get started, I would like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's financial outlook, future plans, objectives, business prospects and anticipated financial performance. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. Our forward-looking statements should be considered in conjunction with the cautionary statements in today's earnings release and the Risk Factors included in Mercury's SEC filings.

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, adjusted EBITDA and free cash flow. 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, Mike. Good afternoon, everyone, and thanks for joining us. Before we dive in, I'd like to say how happy I am to have Mike Ruppert with us today in his new role as CFO. Our acquisition-related growth since Mike joined Mercury 3 years ago is a testament to both his industry experience and capabilities as a leader.

Mike has been running our combined finance and M&A teams as CFO since mid-Q3 and he is off to a great start. As expected, we're already seeing a high level of integration in our corporate development, finance and accounting team activities. So Mike, welcome aboard.

With that, I'll turn now to the business update. Mike will review the financials and guidance and then we'll open it up for your questions. Q3 was more challenging than we had originally anticipated as a result of the prolonged continuing resolution. But despite this brief setback, which I'll talk about in a moment, we are reaffirming our prior guidance for the full fiscal year and raising the range, including Themis.

At the midpoint, our updated consolidated guidance would result in approximately 20% growth in both revenue and adjusted EBITDA year-over-year, substantially faster growth than the industry as a whole. Big picture, nothing has changed. Mercury's growth engine continued to perform strongly in Q3 as did the business overall.

As we said in the past, we expect to continue growing at high single-digit low-double digit rates organically supplemented by strategic and accretive acquisitions.

For fiscal '18, we're currently expecting 7% organic growth. Looking back over the past 5 years, and assuming the midpoint of consolidated guidance, we'll deliver 20% total revenue and over 60% adjusted EBITDA compounded annual growth. We've made substantial investments to achieve results at this level, including above industry average internal R&D funding, CapEx to build out our insourced manufacturing capabilities as well as working capital to support overall growth in the business.

We believe our strategy is working extremely well and we expect to extend Mercury's record of above average performance in fiscal '18.

Turning to Q3. Because of the funding delays, the quarter became progressively more backend loaded compared to our plan. Ultimately, $11 million of revenue moved from Q3 to Q4. The largest impact was in SEWIP Block 2, where, although we booked an order for $16.8 million, $8 million of associated revenue moved to Q4.

At this point in Q4, we've already shipped the majority of the delayed SEWIP Block 2 revenue. And with the budget now approved, we do not expect budget-related revenue delays to impact Mercury this quarter. We delivered record bookings of $150 million, which resulted in a 1.3 book-to-bill and we ended the quarter with another record backlog totaling $429 million.

The design win activity remains high with several important new wins across the customer base during the quarter. Our design win pipeline is robust with significant opportunities in C4I, radar, EW, EO/IR and weapon systems.

Our key programs continue to do well. We're seeing excellent organic growth opportunities in the marketplace. We continue to execute successfully in our market penetration and market expansion strategies. All in all, the opportunity set and the levels of new business and design win activity remain the highest I've seen since joining Mercury. Our win rate is strong and we continue to take share.

It appears that M&A activity within the industry is picking up speed. Our long-term team member, Nelson Erickson, is now running this part of the business reporting to Mike. Nelson has led or been involved with all of our transactions and is well respected within the business and industry.

Our M&A pipeline is likely the largest and most actionable it has been. We're seeing a number of interesting opportunities of varying sizes, all of which are aligned with our strategy. This was another good quarter for Mercury from an operational perspective. We closed the Themis acquisition and the integration is off to a good start. Bookings, revenue and margin for the acquired business were in line with our plan and we're excited about the team. We're also enthusiastic about the Themis platform, which presents us with new opportunities to grow organically and make further acquisitions in the C4I space.

During the quarter, we continued the consolidation of our 3 West Coast RF manufacturing locations. We signed a lease for a building adjacent to our existing Oxnard, California plant, where we plan to take occupancy in early FY '19.

Once the buildout is finished, moving the remaining West Coast microwave facility to the new location will complete the consolidation and acquisition integration of Delta Microwave. The buildout of our Phoenix operation and the associated insourcing of our digital manufacturing continues. The team introduced new capabilities during Q3, while growing throughput 50% versus the prior quarter. The forecast synergies and timeline remain on track.

Taking a quick look at our Q3 financial results, total revenues increased 8% year-over-year to $116.3 million. Our largest revenue programs in the quarter were Aegis, F-35, Filthy Buzzard, E-2D Hawkeye and Patriot.

Adjusted EBITDA for Q3 on a consolidated basis was up 3% year-over-year. Total bookings were more than $150 million, up 41% from Q3 last year. And as I mentioned, our book-to-bill was a strong 1.3.

Our largest bookings programs in the quarter were SEWIP Block 2, EGNOS, ELTA, APG-79 and Reaper. Exiting Q3 with an approved fiscal 2018 defense budget, record backlog and having shipped the majority of the delayed revenue, sets us up for strong growth in Q4 and for the fiscal year.

With the capabilities we've acquired and built internally, we believe that we are also well positioned to benefit from an improving defense budget environment over the longer term. Our design wins are above industry average growth reflects our continued success in broadening and deepening our relationships with key customers and our position on major programs. The substantial growth investments that we've made over the past several years have strengthened our performance in winning new business. These include most notably, in funding high levels of R&D for commercially developed and highly differentiated military technologies as well we're creating trusted domestic manufacturing capabilities in the RF, digital and custom microelectronics domains. At the same time, the acquisitions that we completed have dramatically increased the size of our total addressable market.

We're targeting 2 of the most important and growing areas in aerospace and defense electronics, sensor and effector mission systems and C4I. Our growth in the first area is being driven by a wave of sensor modernization on a broad range of platforms. In the radar domain, the industry is shifting to AESA or Actively Electronically Scanned Arrays and there were significant activity associated with the upgrades in electronic warfare.

We're also beginning to see increased modernization activity in EO/IR, along with growing investment in readiness and modernization in the weapon systems domain. Sensor and effector mission systems is the market in which we've participated the longest. This part of the business has grown 12% over the last 12 months to 61% of total revenue. In large part, driven by a 269% increase in weapon systems.

In Q3, reflecting the delayed shipments, our sensor and effector revenue decreased 7% versus the same period last year. We're also seeing increased modernization activity in C4I. Those are the types of computers on-board platforms that aren't related to sensor processing.

Our C4I revenues have grown 192% over the past 12 months compared with the prior period and now, represent 23% of total company revenue. In Q3, C4I revenues grew 160% year-over-year.

As we've discussed previously, our growth in both the sensor and effector and C4I markets reflects the impact of 3 industry trends: Outsourcing, the flight to quality and supply chain delayering. Our defense prime customers are outsourcing more at a higher level than they have in the past. By investing in R&D and focusing on preintegrated subsystems, we've ideally positioned Mercury to provide them with high-quality, lower-cost solutions than they can deliver internally. At the same time, the prime's are seeking to deal with fewer, more capable suppliers, suppliers who are prepared to co-invest in the internal R&D and have scalable and trusted manufacturing capabilities and assets in both RF and secure processing. We're taking share in both domains as a result of this flight to quality.

And finally, the government and the primes are seeking to delay their supply chains. In response, some of the major platform integrators are working to make their solutions more affordable. They're partnering with companies at the Tier 2 level, the ones that are funding the innovation. Mercury has transformed itself into a Tier 2 company over the past several years, positioning us as the ideal partner as the delayering trends evolves.

We've accomplished this transformation through strategic M&A. Over the past 27 months, we've completed 6 acquisitions totaling $575 million of capital in deals of various sizes. These transactions all share a common strategic rationale. They've expanded our addressable market and range of customer offerings, while generating cost and revenue synergies over time.

Going forward, we intend to remain active and disciplined in our approach to M&A. We're continuing 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 domestically and internationally and its scale the technology platform that we built. We will remain focused on assembling, critical and differentiated solutions to secure sensor and mission processing. We plan to continue acquiring smaller capability-led tuck-ins, while capitalizing on larger opportunities as they present themselves.

In summary, Mercury is on track for another great year in fiscal 2018. Our strategy, technology, capabilities and ongoing programs and platforms are well aligned with the DoD's roles and missions. Our business model is working extremely well. We substantially increased the size of our addressable markets and our growth strategy is producing great results. We build a platform that we can continue to expand organically as well as scale through acquisitions. Our M&A pipeline is healthier than ever before and our planned integration manufacturing synergies are materializing as anticipated. We are anticipating a strong performance in the fourth quarter and above industry average growth in revenue and profitability for the full fiscal year.

Mike will take you through the guidance in detail. And with that, I'd like to turn the call over to Mike. Mike?

Thank you, Mark, and good afternoon, again, everyone. Before I go through the financial results, I want to provide a couple of personal thoughts.

Serving as Mercury CFO is an honor and a great opportunity. Based on my experience here over the past 3 years, I can say with the utmost confidence that I'm stepping into this new role at an exciting time for Mercury. Our prospects for growth have never been brighter. We've invested in the business over the last few quarters as we've insourced our manufacturing, we've upgraded our facilities and integrated our acquisitions. And the M&A pipeline is as robust as I've seen it since starting in Mercury.

So as I take on this role, I believe we are well positioned to continue to create value through strong organic growth as well as strategic, synergistic and financially-accretive acquisitions.

Equally as important, our team is strong. In addition to having Nelson Erickson heading up M&A, as Mark mentioned, Michelle McCarthy recently joined Mercury as our new Chief Accounting Officer. Since taking on this role, I have been very impressed with the talent and professionalism of our entire finance and accounting team. I'm looking forward to working with Nelson, Michelle and everyone on our M&A, finance and accounting teams to deliver value for all our stakeholders in the years ahead.

Now to the financial review. As a reminder, our consolidated results include 2 categories of revenue, organic and acquired. Acquired revenue is revenue associated with the businesses that have been part of Mercury for 4 full quarters or less. After the completion of 4 full quarters, revenue from acquired businesses is treated as organic for current and comparable historical periods.

On this call, acquired revenue includes the contributions of Delta Microwave, which we acquired in Q4 of fiscal '17, as well as RTL and Themis acquired during the first and third quarters of fiscal '18, respectively.

I'll turn now to Mercury's third quarter results. As Mark said, the government funding delays led to shifts in the timing of revenues and related billings that couldn't fully be mitigated by quarter's end. Nonetheless, Mercury's business remained fundamentally strong. We continue to deliver solid organic growth with high profitability, supplemented by strategic and accretive M&A. Bookings were up 41% year-over-year to a record $150 million and we ended the quarter with record backlog.

Our revenue increased 8% from Q3 last year to $116.3 million. Excluding Themis, which we owned for 2 months in the quarter, revenue would have been $106.8 million. This is roughly flat compared to Q3 a year ago. On an organic basis, revenue for Q3 decreased 6% year-over-year to $100.6 million versus the 12% organic growth rate recorded in the second quarter of fiscal '18. This decrease was driven by the approximately $11 million of SEWIP Block 2 and other revenue, which shifted from Q3 to Q4. Absent the delayed revenue, organic growth would have increased 4% and we currently expect 7% organic growth for fiscal '18.

Acquired revenue for Q3 was $15.7 million, which again reflects contributions from Delta Microwave, RTL and Themis. International revenue for Q3, including foreign military sales was $22 million or 19% of total revenue. This compares with $19.5 million of revenue in Q3 of fiscal '17, representing a 13% increase year-over-year.

Radar revenue for Q3 was up 13% year-over-year and continues to be a strong market for us. Electronic warfare revenue decreased 46% year-over-year driven by the movement of SEWIP Block 2 from Q3 into Q4. Electronic warfare bookings increased to 41% year-over-year showing the continued strength of this end market. Revenue from radar and electronic warfare together accounted for 49% of consolidated total revenue compared with 64% in Q3 last year.

I'll turn now to the 3 industry tiers where Mercury participates: Components, modules and subassemblies and integrated subsystems. Components revenue for Q3 was up 21% year-over-year, while modules and subassemblies revenue declined by 7%. The decline in modules and subassemblies was primarily a result of the SEWIP Block 2 revenues slipping into Q4. Integrated subsystems revenue was up 19% year-over-year. At the end of Q3, components represented 26% of Mercury's total revenue, modules and subassemblies 36% and integrated subsystems represented 38%.

Turning now to bookings. Total bookings for the third quarter were up 41% year-over-year, driving a strong 1.3 book-to-bill ratio. We ended Q3 with record total backlog of $429.3 million, up 35% from $318 million a year ago. Approximately $321 million or 75% of this backlog is expected to

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Moving down the income statement, our gross margin for Q3 was 45.4% compared with 47.3% a year ago. This decline was driven by program mix as well as the inventory step-up related to the Themis acquisition. Q3 operating expenses were $45.9 million compared with $39.1 million for the same period last year. The $6.8 million increase was largely a result of increased operating expenses from the acquired businesses, higher amortization expense and acquisition, restructuring impairment costs. Taxes for Q3 were $2.2 million, resulting in a tax rate of 37.4%. The tax rate was impacted by approximately $0.2 million of discrete items. We expect our effective tax rate to decrease to 34% in Q4.

GAAP net income for the third quarter was $3.7 million or $0.08 per share, down 47.6% from $7 million or $0.16 per share in Q3 last year. This is based on approximately $47.5 million weighted average diluted shares outstanding for the quarter.

Adjusted earnings per share was $0.30, up 3% from $0.29 for Q3 last year. And finally, our adjusted EBITDA for Q3 increased 3% to $25.8 million from $25 million a year ago.

Turning to the balance sheet. We ended the third quarter of fiscal '18 with cash and cash equivalents of $44.2 million. Operating cash flow for Q3 was $0.9 million compared with $24.9 million for Q3 last year and $8.8 million in the second quarter of fiscal '18.

Free cash flow, defined as cash flow from operating activities less capital expenditures, was negative $2.6 million in Q3 compared to a positive $11.9 million in Q3 fiscal '17. The lower cash flow in the quarter was primarily driven by lower net income due to the extended CR as well as higher net working capital. Trade Accounts Receivable increased by $14.1 million from last quarter. This reflected approximately $6 million from the Themis acquisition and approximately $8 million associated with a higher volume of shipments at the end of the quarter.

Inventory was up $11.2 million from Q2, reflecting approximately $8 million of acquired Themis inventory as well as inventory associated with SEWIP Block 2 and other revenue, which shifted out of the quarter. Excluding these 2 impacts, inventory would have decreased as anticipated. We expect to see continued improvement in our inventory metrics over the next few quarters.

The other major driver of net working capital this quarter was Accounts Payable. Accounts Payable decreased by $4.8 million from Q2 as the payables associated with inventory purchased in the second quarter came due. This was partially offset by the acquired Themis payables of $4.5 million.

In Q3, we had $3.5 million of capital expenditures. As anticipated, capital expenditures were substantially lower than the $13 million incurred in Q3 of last year.

From a capital structure perspective, we continue to maintain flexibility and good access to capital. In addition to $44 million of cash on the balance sheet, we have $205 million of remaining revolving credit subsequent to the $195 million we tapped for the acquisition of Themis. Our Q3 results reflected 2 months of Themis-related interest expense totaling $1 million, and we will see a full quarter's impact in Q4.

On a pro forma basis, including Themis for the full year, our balance sheet remains conservatively levered at under 1.5x net debt to pro forma EBITDA. Given the strength of our M&A pipeline, we want to make sure we maintain that flexible capital structure. We've seen an increase in M&A opportunities in companies that fit extremely well with Mercury and our strategy.

In addition to organic growth, we see the continued ability to create value through the acquisition strategy we followed over the last few years.

I'll now turn to our financial guidance starting with the full fiscal 2018 year and then for the fourth quarter. For purposes of modeling and guidance, we've assumed no restructuring and no acquisition or nonrecurring financing-related expenses in the fourth quarter. We've assumed an effective tax rate of approximately 34% for the fourth quarter, excluding discrete items. The following guidance also assumes weighted average fully diluted shares outstanding of approximately 47.6 million and 47.5 million for Q4 and the fiscal year, respectively.

Our guidance reflects the outlook that Mark discussed. We've already booked, shipped and recorded a majority of the revenues associated with the orders that were delayed in Q3. We've entered the fourth quarter with record backlog. We're continuing to see strong growth in design wins in our major product lines and across many of our programs. Our acquisition, integration and manufacturing initiatives are tracking according to plan. As a result, we anticipate that Mercury will deliver strong growth and solid financial performance for both Q4 and fiscal '18.

With that as background, for the full 2018 fiscal year, we expect revenue, excluding the Themis Computer business, in a range of $464 million to $468 million. This compares with our prior guidance of $460 million to $468 million. So we are raising the bottom end and increasing the midpoint. This guidance represents growth of 14% to 15% from fiscal '17.

Including Themis, we expect Mercury's total consolidated revenue for fiscal '18 to increase to between $487 million and $492 million, up 19% to 20% year-over-year. Gross margin for the year on a consolidated basis is currently expected to be between 45.7% and 45.8%.

Consolidated operating expenses are expected to be in the range of $177.9 million and $178.4 million for the year. Total GAAP net income on a consolidated basis for fiscal '18 is expected to be in the range of $40.2 million to $41.8 million or $0.85 to $0.88 per share.

Consolidated adjusted EPS is expected to be in the range of $1.35 to $1.38 per share. We currently expect total adjusted EBITDA for fiscal '18 of approximately $111 million to $113.5 million on a consolidated basis and at approximately 23% of revenue within the range established by our current target business model.

Turning now to Q4 and doing the math based on our actual results for the first 3 quarters, we're forecasting consolidated total revenue in the range of $146.7 million to $151.7 million. Q4 GAAP net income is expected to be in the range of $9.4 million to $11 million or $0.20 to $0.23 per share.

Adjusted EPS for Q4 is expected to be in the range of $0.40 to $0.43 per share. This estimate assumes approximately $4.3 million of depreciation, $7.6 million of amortization of intangibles, $0.3 million of fair value adjustments from purchase accounting and $4.5 million of stock-based and other noncash compensation expense. Adjusted EBITDA for the fourth quarter is expected to be in the range of $33.2 million to $35.7 million, representing approximately 22.6% to 23.5% of revenue at the forecasted revenue range.

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

(Operator Instructions) And our first question comes from the line of Jon Raviv with Citi.

I was wondering if you could just talk a little bit about the 7% organic growth this year. I realize that the target you've typically talked about is relatively broad, but just, why 7% this year? And what the confidence is in getting that to accelerate, or the possibility of that accelerating into FY '19?

Yes. So we did basically say that we think that the growth rate is approximately 7% for this fiscal year. That will obviously lead to a much higher growth rate of 17% organically in Q4. If you step back, some years are going to be a little higher organic growth rate, some a little less. And so we still feel that, that high single-digit, low double-digit is a good number for us. The primary reason, however, if you look at the organic growth rate isn't higher this fiscal year is due to the fact that we actually completed a very large Homeland Defense Radar program in fiscal '17, which total $20 million. So the delta between fiscal '18 and fiscal '17 is approximately $18.5 million. So if you exclude that revenue on a period-over-period basis, our organic growth rate would actually be greater than 12%. So it really just depends on what's happening programmatically, Jon.

Got it. And then, on gross margins, just seem to be a little bit low again in this quarter and we certainly have the guidance into next year, but how do you see that trending going into FY '19? You mentioned mix being an issue. I know there's some reality there. And I guess, more broadly, can we get off the 23% adjusted EBITDA margin, assuming you don't make any more deals?

So big picture, I think, the guidance range that we have from a pro forma target model perspective is still good, that 45% to 50%. As we've said, it really depends on what is happening from a program mix perspective that largely dictate any variability. This quarter, we'd obviously acquired Themis. And as Mike said in his prepared remarks, there were some inventory step-up that affected gross margins during the fourth quarter. So we think that the gross margin range that we have in the model is good. How it is that we increase the adjusted EBITDA from the current forecast of roundabout 23% to the higher end of the range is basically operating leverage. As we continue to grow the top line and benefit from the insourcing of manufacturing and the fact that expenses should continue to grow at a rate that is slower than the overall top line will eventually grow into that 22% to 26% model.

Just last one, can we expect to see that benefit starts to accrue in the first quarter of '19 on the op leverage?

We're not going to talk about specifically '19 at this point, Jon, because we only are guiding for Q4.

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

You spoke a little bit earlier about more opportunities for M&A. I wonder if you could highlight in the various end markets that you guys call out, whether it's the sensors or C4I, where you see more opportunity? And then also, you talked about wanting to maintain financial flexibility and how the current balance sheet structure gives you that, but sort of what should we think about as being adequate flexibility?

So why don't I take the first part of that question and then Mike can take the balance sheet part. So the M&A pipeline is likely the largest and most actionable that we've seen since we really started our M&A program and I think Mike feels the same way too. There is a lot of opportunity in the areas that we've kind of laid out. So we continue to see more opportunity in the C4I market, specifically around mission computing and avionics, which is a target focus for us, following the acquisition of CES that we did 18 months or so ago. And then we also see additional opportunities in the rugged-rack server space. And we just completed the acquisition of Themis. And as we said on the last call, we really see Themis as a platform in which we can continue to build out. And so, there are clearly opportunities in that regard. We see opportunities in the security space. A couple of years ago, we did a very interesting IP acquisition of a business down in Huntsville that has turned out to be extremely important as we continued to deliver trusted and more secure processing solution. So we kind of see a range of opportunities, but still, very, very much in line with the strategy that we've laid out, Seth. Mike, would you like to take the second part of that question?

Yes. And I'll also add on that I do agree that the pipeline is stronger than I have seen it since I've been here. We have a lot of opportunities, both big and small, and I think that gets to the capital structure. If you look where we are today, Seth, we consider ourselves relatively modestly leveraged. We have less than $200 million drawn on our $400 million revolver. We've got another $150 million accordion feature on that revolver. From a leverage perspective, we're under 1.5x net debt to pro forma EBITDA. So we think we've got good flexibility right now. But we're always thoughtful about our capital structure so as not to restrict optionality, both in terms of our acquisition strategy and operations. And I think we've got a pretty good track record of finding good targets that fit strategically with us and we'll evaluate those as they come along.

And our next question comes from the line of Greg Konrad with Jefferies.

Just wanted to follow-up on the last question. I mean, you mentioned that the pipeline is fuller than it's ever been. I mean, is there a catalyst for that? I mean, is that the fiscal year '18 budget? Why is that pipeline bigger than it's been in the past?

I think, I mean, from my perspective, it's a handful of things. Obviously, the budget is positive. The outlook for a lot of these companies is positive and they're seeing additional growth. And the reality as well is the valuations are high right now relative to where they've been over the last 2 and 10 years. So I think that is propelling a lot of buyers to explore their alternatives. But we're looking at small deals that are founder owned. And a lot of times, we see those are driven by personal interests. We're looking at carve-outs associated with some of the -- some bigger multi-industry companies. And those are driven I think by focusing their business as well as there are some benefits now from the tax laws where it makes it less onerous. So I think, that the pipeline and the reason it's picking up is generally because of the budget, but each deal we look at is a little different, Greg.

And then just shift to the organic side. I mean, I think, we've heard some contractors still trying to figure out how these fiscal year '18 dollars, which ended up being bigger than expected flow through. And there is probably an element of capacity constraint to maybe meet some of that funding. I mean, have you had any conversations? Or do you look at the '18 budget as maybe a catalyst for the outsource trend that you talked about in the past?

So we kind of looked at the budget and the individual programs that were part of the macro level. And we saw a, call it, a roughly 10% increase in funding of those programs in GFY '18 versus '17, an additional 3% growth the following year. However, I think, that's more directional in nature, right because we are obviously not involved in every part of a program. And clearly, there are timing differences between appropriations and outlays. But directionally, I think, we are headed into a better budget environment. And we think that we're pretty well positioned in the areas that are going to continue to see increased funding flows, specifically, around modernization in the sensor and effector mission side of things and increasingly in C4I. So we feel pretty good about how we are positioned, Greg.

And our next question comes from the line of Peter Arment with Baird.

Mark, on the Themis deal, now you've owned it for roughly, I guess, 3 months. Can you may be update us your thoughts on the integration process there? I think you once mentioned maybe $1 million or something around there for cost synergies but maybe give us your thoughts around how you're approaching the integration there for this deal?

So it's a good question, Peter. So the Themis acquisition, I think, the way in which we described it previously, we really see as a platform. So it's got a great management team. They've built a very strong set of technologies and capabilities. They're involved in some really good programs. And so, the initial acquisition of Themis is not necessarily a cost play. It's all about how it is that we're going to actually use that as a platform to continue to grow in the C4I space and to potentially acquire into and that's very much what it is that we're focused on. From an organic perspective, the feedback from customers has been tremendous. We're already seeing additional opportunities with the fact that Mercury has acquired them in terms of new pursuits. And we were actually recently informed that literally as a direct result of Mercury acquiring them, they've been selected on an important sub-surface program, which has also been an area that we have been -- that we've been targeting. So overall, we couldn't be happier with the business and the opportunity for us to continue to grow it organically as well as to add to it from an M&A perspective.

And just as a follow-up to that, on the inventory side, is there a difference the way they either outsource versus your approach on the insource side? And how should we expect that to kind of change going forward?

So not too much of a difference. I mean, we did acquire approximately $8 million of inventory with the purchase of Themis this quarter. But let me kind of step back and just talk a little bit about what's going on with inventory specifically because clearly there is some things flying around in the market that I think will be a good opportunity for us to respond to. So if you look at it on an LTM basis, inventory is up $45 million and it has been a use of cash. Now we actually see this really as an investment in the business from an organic growth perspective and it really boils down to 4 things. So the first is that as an acquisitive company, we clearly have added inventory and seen a step-up associated with that inventory over the last couple of years. And I just mentioned, we've actually acquired $8.7 million of inventory associated with Themis. Probably the most important, however, is being the fact that we're focusing on insourcing our manufacturing. And so we've added $10 million to $12 million of component level inventory associated with standing up the USMO, which is our manufacturing operation in Phoenix. And the way to think about that is that, previously, when we were outsourced, that inventory, the component level inventory would have been at our contract manufacturer. We wouldn't have owned it. But because we've now built out that facility and because we're actually ramping up production, we need to have that component stock. Now we've also as we transitioned from that contract manufacturing model to actually ramping up internal production, as I mentioned in my prepared remarks, the throughput at the USMO actually increased 50% quarter-over-quarter. We also wanted to ensure that we were able to manage the risk, both from an operational, from a financial and to ensure that we could meet our customer commitments.

And so, we've added an additional $8 million of safety stock associated with that. So the third area is that we've got very rapid organic growth in the other part of the Phoenix business. And to put it in perspective, that is a part of the business that came to us through the acquisition of Microsemi. One of the areas that we were very focused on was weapon systems. And the business in Phoenix itself has actually grown or is expected to grow 31% this fiscal year. And that in large part, that is being driven by the substantial growth in our weapon systems business and weapon systems is up 269% alone in the last 12 months.

Now to support that organic growth, we needed to invest in the inventory to support it, which we have. And so we purchased an additional $9 million of inventory in 2 areas. The first is end-of-life semiconductor and the second is we've actually purchased semiconductor component materials in parts of the semi market, where we've seen lead times increasing. And so, in essence, we're fueling the organic growth that we see in the business. So that's really what's been going on with inventory, which has been a significant investment. So having built out the facility in fiscal '17 and ramping the growth in working capital this year, next fiscal year is all about optimization. And so, think of it that we've been on a 3-year journey, '17, building out the facility, high CapEx, that's now significantly reduced. We've built out the working capital moving into fiscal '18 to support the growth. And next year, we'll get back to more normalized levels and focusing on improving efficiency.

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

Just wanted to, I guess, focus on some of your comments around design wins. Are you seeing that translate into increases in either content or maybe capturing more wallet share with some of these new wins just given the progress on the strategy?

We are, Jonathan. I mean, it was actually a pretty amazing quarter in terms of just the things that we are getting involved with. I mean, we were selected by a couple of customers on a army ground radar program that's going to go through a tech refresh. We're selected by another incumbent on a different, but other very important ground radar program where we are expecting additional content. We've been pursuing a very large classified radar for probably 10 years and had a major breakthrough this past quarter in both the RF side of things where we're displacing a company as well as actually potentially winning the processor refresh, which was previously done in house. We have won or are being selected in a number of naval C2 and other ground radar applications as a result of the Themis acquisition. So the level of design win activity and new pursuits is, as I said in my prepared remarks, probably the highest that I've seen since joining the company.

Great. And then, just to talk a little bit more about the Phoenix facility, can you give us a sense of what inning we're in in terms of capacity utilization? And what further opportunities you have in maybe just the current base that you're integrating to drive that capacity?

Yes. So go back to -- kind of go back to the journey a little bit and think about what we've been up to in the last 3 years. So if you look at fiscal '17, fiscal '17 for us was a significant year from a capital expenditure perspective. And it really was investing in 2 things. The first was investing in our new headquarters facility. As you know, the lease in our prior headquarters in Chelmsford was expiring and we needed to move to accommodate the additional space that we needed to meet our organic growth needs. The second investment was exactly what you were talking about was related to the Microsemi Carve-Out acquisition. When we bought the Microsemi businesses, we saw the opportunity of insourcing our digital manufacturing. And this was a very significant synergy of the deal. And it was really the primary reason that allowed us to raise our target financial model from what was then the 18% to 22% adjusted EBITDA to the current goal of 22% to 26%. But to do that, we needed to build out the Phoenix facility, which we basically did during 2017 and 2018. So if you look at it from a CapEx perspective, 2017 was a significant increase. And we're expecting currently that our CapEx in fiscal '18 will decrease by $18 million.

Now with that build out of that facility in place, as I just went through, fiscal '18 is all about basically insourcing the manufacturing and ramping up the production rate and we're really in the, call it, the midst of that right now. So we saw a 50% increase in throughput in the last quarter alone. But the working capital build really began at the end of fiscal '17 and this moved into fiscal '18. So this particular quarter, if you look at it from an inventory perspective, absent the acquisition of Themis and absent the inventory associated with the deals that moved to Q4, our inventory growth was basically slightly negative. So we've kind of seen that build somewhat ameliorate. And now, it's about continuing to ramp the capacity and the throughput in that facility. And as we move into fiscal '19, it's all about optimization. It's optimizing that facility to ensure that we can continue to grow.

But from my perspective, I mean, I'm extremely proud of what the team has been able to do. The Phoenix facility is state-of-the-art. It's a trusted manufacturing facility. It recently was awarded the Frost & Sullivan Manufacturing Leadership Award. The production is ramping and the facility itself is critical to both our strategy, our growth and our profitability goals, as I mentioned. So I think we've managed a very, very complex outsourcing to insourcing transition with no disruption to the business and it's supporting the growth objectives.

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

Mark, you were sort of on a roll there when you were answering Peter's question about inventory and maybe anything else that's negative in the marketplace or being miscommunicated that you want to address now, SEWIP program or anything else on your mind?

It's a great point, Mike, yes. So why don't I clear up some of the confusion on that specific program. And so SEWIP basically stands for, as you know, the Surface Electronic Warfare Improvement Program. And it's a collection of individually funded programs. And each of the programs provide distinct yet complementary capabilities over time. The individual programs themselves are actually at different life cycle stages and are run by different prime contractors. And we're actually performing work on 2 major programs: SEWIP Block 2 and SEWIP Block 3.

Block 2 is a very well-funded program. The program is currently in full rate production and is a meaningful contributor to our financial results at the year level. However, that doesn't mean that the program itself will produce ratably each quarter. It can be somewhat lumpy. Block 3 on the other hand, which I think is where some of the confusion is in the marketplace, has experienced some delays and it's in the engineering phase and it's basically immaterial to our current financials. So if we kind of give a brief update on what we see happening on Block 2 and Block 3. So late in fiscal Q3, Lockheed received $119 million Block 2 contract award modification. And in turn, on the last working day of the quarter, we received a $16.8 million full rate production award, which was actually a 16% increase versus the prior year. We currently expect the SEWIP Block 2 will be our largest -- second-largest revenue program growing 35% year-over-year and our fourth-largest bookings program.

Block 3, as I mentioned, is an important program. It's an integral part of the Navy surface EW upgrades. The program is slightly behind schedule, but we understand that it's actually performing better. And the DoD, more importantly, is very eager to get to Milestone C and to start to deploy the system. To put the materiality of Block 3 in perspective, we've completed $2.9 million of engineering work over the last 12 months. So it's basically immaterial to our financial results. And so, I think, there was some confusion as to Block 3 and Block 2. Block 3, we expect to get some long lead time funding associated with the first LRIP next fiscal year. And if you look at the GFY budget, the funding for Block 3 has increased substantially. It's up 80% in GFY '19 to $420 million. So the program is alive and well. It's an important capability and we're well positioned on both.

Got it. That's helpful. Mark, just some housekeeping. On the bookings and backlog, was there any material contribution from Themis for each of those metrics?

So the bookings, Themis had a strong bookings quarter, as did we. So both organically as well as -- and Themis had a positive book-to-bill, Mike, but we're not going to break out the bookings per se.

Got it. What about just the continuing resolution, the bookings environment for you was very strong and obviously it sounds like the bulk of those revenue miss was tied to one program, but you've dealt with continuing resolutions in the past. Was anything that different? I know we had the shut down, but usually, you kind of see it impact too on the bookings. What was different this time versus prior [resolutions]?

Yes. It's a good question, Mike. I think on the last call, we had anticipated that we'd kind of get through the CR by mid-February and it basically moved into March. And the largest impact that we had was on SEWIP Block 2. As I mentioned, there were a couple of other deals that also got impacted that totaled $11 million. But Lockheed received their SEWIP Block 2 contract modification award literally right at the last day of the quarter. So it just -- there are kind of things bunching up to the back end of the quarter because of the extended or prolonged CR is really what hit us. So we've had CRs, I think, each and every year for probably the last 7 years, but this was longer than what we've seen in the past and it was really that, that hit us.

Got it. And then just last one housekeeping. You probably had some more time to digest the tax law changes. Anymore thoughts on the long-term 30% tax rate? Or should we still be thinking about that same target?

Mike, we're not going to hit on that right now. We'll provide more guidance on that on our next call, when we provide our guidance for fiscal '19.

And our next question comes from Ronald Epstein with Bank of America Merrill Lynch.

So help me understand, Mark, operating margins like got cut in half, maybe not quite, 60% of what they were sequentially, quarter-over-quarter, year-over-year, I mean, what happened there? Like, I don't get that. I understand the top line growth, but it's not profitable. And there is no cash. So help me understand why this is good?

So, if you look at the -- actually, why don't you talk through the working capital stuff, right, in terms of Q3 because I think we hit it on the -- in the prepared remarks, Ron.

So, Ron, maybe we can start with cash because that's clearly an issue that we want to be able to explain both for the first 3 quarters and for Q3. So if you look at what happened in the first 3 quarters, the biggest use of cash was what Mark talked about, it was the inventory by far and the second was Accounts Receivable. And in Q3, we had 2 things, if you look at the balance sheet, on the accounts receivable, we see that AR increased in Q3 by $14 million. $6 million of that was from Themis, $8 million was from an organic increase. And that was really driven primarily by the back end nature of the quarter due to the extended CR, that Mark to talked about, that reduced the in-quarter collections and thereby increased AR at the quarter end. So we actually saw a cash outflow of close to $10 million in Q3 associated with AR. And what we've also seen over the last couple of quarters and as I've come in it's one of the things that I'm focused on where I think we've got good opportunity is if you look at the accounts receivable for the first 3 quarters of the year, we did see an increase in Q1 and Q2 as well as our DSOs grew disproportionately to revenue. So AR grew with revenue but DSOs grew as well. And the primary driver of that, that we saw was towards the end of the year, so our customers' fiscal year, the calendar year 12/31, our Q2, was our customers were really managing their cash and their AP at the end of the year. And if you've looked at Q1 and Q2, we saw an uptick in average days late from our customers that drove DSOs higher. So we think there is a lot of opportunity to reduce DSOs going forward. We've seen the actions of our customers in terms of late payments have already started to ameliorate somewhat. And so we expect DSOs to go down. The third thing that you saw this quarter from a cash perspective was accounts payable. And so, accounts payable went down by about $10 million. And that increase is related to the increase in inventory over the last quarter. So inventories increased significantly over the first half of the fiscal year. That slowed in Q3 as we talked about. We expect the inventory turns, as Mark said, to improve going forward. But this quarter, we reduced the AP associated with those inventory builds. So when you look at the cash flow, in our opinion, you need to take it in the whole story in terms of what has happened over the last 3 quarters plus what happened this quarter. We think we're really well positioned going forward. Working capital, the metrics associated with inventory turns, AP as a percentage of sales or AR, days sales outstanding, we think there is a lot of opportunities in each of those areas going forward. Hopefully that helps a little bit on the cash flow question.

When will you expect to see free cash flow as a percentage of net income get back to a level of 80%, something like that? Most defense companies have pretty predictable free cash flow. So when will we expect that to happen for you guys?

We expect that -- I mean, if you look at the inventory, it's already basically declined a little bit quarter-over-quarter. So what I mentioned is I was talking about the journey that we are on year 1, year 2, year 3. Year 3 is really where we are focused on the optimization, right? We're still in the build phase or the ramp phase of getting that USMO up and running. So fiscal '19, we should begin to see the improvements in EBITDA to free cash flow, Ron.

Improvements? All right. And then, you guys didn't speak to the margins. So operating margins in the quarter of 5.9%. I mean, some of your competitors in the space have operating margins of 20%. So I'm just trying to get my head around why is operating margin less than 6%?

Well, I think just a couple of housekeeping things on that. So 5.9% EBIT margins that did include $1.3 million of acquisition costs and other related expenses. We had $1.4 million of restructuring and other. And we also had $7.1 million of amortization of other intangibles associated with the acquisitions. So when you look at big picture of what happened, gross profit, as we discussed did go down. It was 45.4%. Some of that was related to the step up of the inventory associated with Themis acquisition. SG&A was 21.1%, it was relatively constant as a percentage of sales at 18.2%. And then R&D stayed consistent with our model at 12.9%. So I think, what you're seeing on the bottom line is some of those one-time costs associated with the acquisition.

The other thing as well, right, as we said, we had $10 million or $11 million of revenue basically move from period-to-period. If that had occurred, our revenues would have been in line with the guidance that we gave and our adjusted EBITDA would have actually been above the high-end of the range.

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

Just a quick wrap up. I know that you haven't given '19 yet and will probably after this quarter, but it seems like growth should be accelerating in '19 versus '18 on an internal basis and margin should be expanding? Is that correct after hearing all the Q&A and jumping in especially after the last Q&A last question (inaudible), but could you talk a little bit about that at least generally, which direction things are going if there is an acceleration, are you anticipating acceleration [of business]?

We'll have more to talk about that on the next call, Brian. I'm not going to get into discussion around fiscal '19 on this call.

And we have a follow-up question from the line of Jon Raviv with Citi.

Just on the margin question, is there some way we can [get you earning a] commercial business model somewhat? How do you guys think about incremental margins in this business?

So I think, if you look at say, well, we'll see more in Q4, let's put it that way. With the incremental revenue that we are focused on generating, both organically as well as the acquired and the revenues that moved, my belief is that you're going to start to see kind of the operating leverage at work.

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

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a wonderful day.