Mercury Systems Inc (MRCY) 2018 Q4 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems Fourth 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 early this afternoon, you can find it on our website at mrcy.com.

The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations.

Please turn to Slide 2 in the presentation.

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.

All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2 and in the earnings press 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 as an appendix to today's slide presentation and in the earnings press release.

I'll now turn the call over to Mercury's President and CEO, Mark Aslett.

Please turn to Slide 3.

Thanks, Mike.

Good afternoon, everyone, and thanks for joining us.

I'll begin today's call with the business update.

Mike will review the financials and guidance and then we'll open it up for your questions.

Mercury finished the fiscal year with strong momentum in the fourth quarter as expected.

Total bookings for Q4 were up 30% year-over-year hitting an all-time record.

Our largest bookings programs in the quarter were Filthy Buzzard, Triton, F-35, the ground-based Radar and Aegis.

Total revenue for the fourth quarter increased 32% year-over-year and organic revenue was up 16%.

Our largest revenue programs in the quarter were SEWIP, Aegis, F-35, Patriot and (inaudible).

On the bottom line, GAAP net income increased 15% from Q4 last year and adjusted EBITDA was up 36%.

Working capital and cash flow improved substantially and H2 free cash flow increased 106% from H1, in each case as we have expected and previously discussed.

We delivered great results for the fiscal year as well.

Total bookings and revenue were up 27% and 21% from FY '17, respectively, both hitting all-time records.

Organic revenue was up 7% year-over-year, and we currently expect faster growth organically in FY '19.

GAAP net income increased 64% year-over-year and adjusted EBITDA was up 23%, breaking $100 million for the first time.

Our year-end backlog increased 25% to a record $447 million.

Our 12-month forward revenue coverage remains strong, positioning us well for fiscal '19.

Turning to Slide 4. From operational perspective, Q4 was a strong finish to a year of strategic achievement.

Our integration of recent acquisitions is progressing well and we are very pleased with their performance.

We continue to build-out new manufacturing capabilities in the USMO.

We added a second production shift in Q4 to support the increased demand, while completing our AS9100 [rev D] certification with no major findings.

We wrapped up external audits during the quarter with praise from key customers for our capabilities, processes and quality.

We also won the prestigious manufacturing leadership award from Frost & Sullivan.

Our insource production ramp is progressing and delivering substantial savings.

We should triple the number of boards across the business in FY '18 compared with the prior year, while achieving insourcing-related cost reduction benefits, which Mike will discuss.

While we're still not finishing insourcing our digital manufacturing, our customers really like what we're doing.

This capability, along with Mercury's other world-class manufacturing assets, is strategically important in terms of our ability to continue growing the business.

Our customers and their customers continue to focus on trusted domestic manufacturing in their supply chains.

It's very clear that we wouldn't have been able to compete with certain large opportunities without building this internal capability.

These opportunities are both in our traditional sensor processing market and increasingly in C4I, which we'll continue to penetrate organically and through our recently acquired RTL and Themis businesses amongst others.

Over the past 31 months, we completed 7 acquisitions, including the transaction we announced today.

Total $620 million of capital and deals of various sizes.

These transactions share a common strategic rationale.

They've expanded our addressable market domestically and internationally, broadened our customer offerings, while generating cost and revenue synergies.

Because we're full integrators, we also expect to realize manufacturing and operating expense synergies from acquisitions over time.

The acquisition of Germane Systems, outlined on Slide 5, is a great example of our strategy in action.

It's another important step forward in our plan to target opportunities in the C4I market.

Germane is a leading provider of rugged servers with C2I applications similar to Themis.

Our intention is to combine Germane and Themis, creating a leading rugged server business serving the defense industry.

We will inject our industry-leading security IP into their products where it makes sense to create highly differentiated secure rugged computing solutions.

Combination is also highly complementary from a program perspective in strategically important markets.

80% of Germane's business is naval subsurface and airborne, while 80% of the Themis program portfolio is surface navy and ground.

So in essence, with Themis and Germane, we cover the full C4I market in 2 acquisitions, creating over $100 million rugged server business in less than 6 months.

The purchase price of $45 million funded with our existing revolver is about 10x Germane's 12-month trailing adjusted EBITDA.

Net of the present value of the tax benefit and expected cost savings, it's approximately 4x.

We paid 13x adjusted EBITDA for Themis, knowing it was a platform on which we can continue to acquire and integrate subsequent acquisitions.

Looking at Germane and Themis as a combined business, with a substantial cost synergies plus the tax benefits, the total net purchase price is approximately 9x adjusted EBITDA, which is a phenomenal outcome.

Both businesses valuations were supported by their respective stand-alone discounted cash flows, and combined, we expect the platform to generate a healthy ROI over time.

That said, with a partial integration cost synergies this fiscal year, Germane will be dilutive to our gross margin and adjusted EBITDA margin in FY '19, but accretive to fiscal '19 adjusted EPS.

Reflecting the full synergies, we expect the combined Germane and Themis platform to achieve the midpoint of our adjusted EBITDA target in fiscal 2020.

Turning now to Slide 6. The business outlook remains strong.

I continue to believe that we're in a unique time in the industry from an investment and modernization perspective.

We've made substantial growth investments over the past several years, including most notably funding high levels of R&D as well as creating trusted domestic manufacturing capabilities.

These investments have dramatically expanded our addressable market.

Our ability to strategically win new business has never been stronger.

As a result, the level of pursuit and design win activity continues to be the highest I have seen since joining Mercury.

The defense budget has increased and is expected to continue growing at a low single-digit rate.

As well, Mercury is strongly positioned to capitalize on the 3 industry trends we've discussed in the past: Increased outsourcing at the subsystem level; the flight to quality and supply chain delayering.

We're also continuing to take share.

In targeting Sensor and Effector Mission Systems, as well as C4I, we're focused on 2 of the most important market segments in the aerospace and defense electronics industry.

Driven by acquisitions and new design win activity, we grew C4I revenue 176% year-over-year in FY '18.

Sensor and Effector Mission Systems revenue was up 13%.

Our high-tech business model is working extremely well.

We invested 12% of our revenue this past fiscal year on IRAD, one of the highest in the defense industry.

In addition, as you will hear from Mike, our customers are supplementing this IRAD with more of their own R&D funding.

In essence, we're partnering with our customers and creating significant combined R&D operating leverage, which helps them win new business.

We've been a significant beneficiary of this customer-funded R&D over the past few years.

The CRAD has a lower gross margin [than our goal] as do some of the early-stage prototypical subsystems we're developing and this has weighed on gross margin.

That said, this investment and it is an investment is laying a solid foundation for future organic growth.

Stepping back a little, in FY '18, we saw a substantial increase in the lifetime value of our top programs and pursuits, given our ability to capture more subsystem level business.

Since fiscal 2013, we've seen the value of our top programs and pursuits grow over 4.5x, and we'll say more about this at our Investor Day in November.

Our outlook for growth, both organic and M&A driven, remains strong.

For FY '19, we currently expect organic growth in the range of 8% to 9%.

Turning to Slide 7. In summary, we believe we can continue to expand in our core C4I and Sensor and Effector Mission Systems markets, growing the business organically at high single-digit to low double-digit rates on average over time.

At the same time, we believe we can supplement our high levels of organic growth with smart, strategic M&A.

Our M&A pipeline is strong and we continue to see a number of interesting opportunities of varying sizes.

They're all aligned with our strategy with Germane being the most recent example.

Going forward, we intend to remain active and disciplined in our approach to M&A.

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 remain confident that we can achieve the high-end of our adjusted EBITDA target model over time, by continuing to execute our plans in 4 areas.

The first is revenue growth, continue to grow the business organically, while supplementing this organic growth with acquisitions.

Second, we'll focus on manufacturing insourcing where it makes sense strategically, operationally and financially as well as driving operating efficiencies in our existing manufacturing facilities to improve margins.

Third, we expect to grow our organic operating expenses at a rate lower than our revenue growth.

And finally, we're thoughtfully and fully integrating acquired businesses, the goal being to generate cost and revenue synergies that combined with these other elements produce attractive rates of returns for our shareholders.

We'll continue to execute on this model that has been so successful over the past 5 years.

Nothing fundamentally has changed.

We're anticipating another year of double-digit growth in revenue and profitability in fiscal 2019 as well as continued improvement in cash flow generation.

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.

Mercury concluded a great fiscal year with a strong Q4.

Revenue, adjusted EBITDA and adjusted EPS hit record highs.

Working capital and cash flow improved substantially.

We delivered record bookings and concluded the quarter with record backlog and a book-to-bill of 1.12.

As I go through the slides, I'll provide more insight into our financial results, focusing on 4 areas.

The first is the trend in gross margins.

Second, Mark just discussed the strategic importance of our insourcing initiative.

So I'll talk about the investments that we have made and the benefits we are seeing in the financial results.

Third, is free cash flow and working capital.

Finally, the Germane acquisition and its impact on our fiscal '19 guidance.

So turning now to the metrics on Slide 8. Mercury's revenue and bookings growth continued to translate into solid profitability in Q4.

As expected, it was also a great quarter for cash generation, and we believe this trend will continue.

Total revenue increased 32% from Q4 last year to a record $152.9 million, exceeding our guidance of $146.7 million to $151.7 million.

Organic revenue for Q4 increased 16% year-over-year.

Gross margin for Q4 was 44.7% compared with 46.6% a year ago.

Gross margin was affected by product mix, including an increase in customer-funded R&D and early-stage programs, the inclusion of Themis, which has lower gross margins as well as an inventory step-up associated with the Themis purchase accounting.

Q4 operating expenses were up 21% year-over-year, largely due to the Themis acquisition and growth in SG&A as we continued to scale the business.

Q4 R&D, as a percentage of sales, was lower year-over-year, reflecting an increase in customer-funded R&D or CRAD.

CRAD revenues tend to have lower gross margins than the hardware annuities they help create when the program goes into full rate production.

This investment lowers gross margins in the near-term, but is critical to future organic growth and an offset to internally-funded R&D expense.

GAAP income in the fourth quarter increased 15%, and GAAP EPS was up 11% year-over-year.

Adjusted EPS for the fourth quarter was $0.47, up 47% from $0.32 for Q4 last year.

Adjusted EBITDA for Q4 increased 36% year-over-year to a record $37.7 million, exceeding our guidance of $33.2 million to $35.7 million.

Adjusted EBITDA margin was 24.6%, well above the high-end of our guidance, demonstrating the operating leverage we have in the business.

Finally, free cash flow, which we define as cash flow from operations, less capital expenditures, increased 487% year-over-year to $21.6 million.

Turning to our full year results on Slide 9. You can see that fiscal '18 was another excellent year for Mercury.

With record bookings and backlog and a book-to-bill of 1.14, we concluded fiscal '18 well positioned for future growth.

Total revenue grew 21% year-over-year to a record $493 million.

Mercury's organic growth was 7% year-over-year.

And as Mark said, we're expecting the growth rate to increase in fiscal '19.

Gross margins were 45.8% compared to 46.9% in fiscal '17, reflecting the dynamics I discussed earlier.

Excluding Themis, gross margins for fiscal '18 would have been 46.2%.

Mark talked about the strategic benefits of insourcing.

From a financial perspective, fiscal '18 gross margins benefited from approximately $4 million of savings due to our insourcing efforts.

We expect another $2 million to $3 million of benefit in fiscal '19, getting us to the target run rate of around $6 million to $7 million we expected when we acquired the Microsemi Carve-Out assets.

This annual benefit compares to an investment of approximately $18 million to $20 million.

This includes $10 million to $12 million of inventory as well as $8 million in capital expenditures in fiscal '17 and '18.

We're also seeing the benefits of our new manufacturing capability from a revenue perspective as the USMO has helped us win new programs.

Fiscal '18 R&D increased by $4.7 million over fiscal '17, but decreased as a percentage of sales from 13.2% in fiscal '17 to 11.9% in fiscal '18.

This percentage decline was a result of increased CRAD as well as the inclusion of Themis.

Adjusted EBITDA increased 23% year-over-year to $115.4 million.

At 23.4% of revenue, this was above the high-end of our guidance and we continue to see strong profitability in the business.

Adjusted EPS increased 23% to $1.42 per share and as expected, free cash flow increased.

Slide 10 presents the balance sheet for the last 5 quarters.

As a reminder, these numbers do not include the impact of the Germane acquisition, which we closed today.

Mercury ended fiscal '18 with cash and cash equivalents of $66.5 million, up $22.3 million from $44.2 million at the end of Q3, driven by the strong cash flow we saw in the fourth quarter.

Accounts receivable increased by $2.2 million from Q3, while revenue increased by approximately $37 million, resulting in lower day sales outstanding.

In Q4, inventory declined by $8.5 million.

Inventory turns improved, and we expect continued improvement in fiscal '19.

From a capital structure perspective, we maintain flexibility and good access to capital.

As Mark said, we've seen an increase in M&A opportunities and companies that fit extremely well with Mercury and our strategy.

In addition to $66.5 million of cash on the balance sheet, we have $160 million remaining on our line of credit, post the acquisition of Germane.

Following the acquisition, we now have $240 million outstanding on our revolver.

On a pro forma basis, including Themis and Germane for full year, our balance sheet remains conservatively levered at less than 1.5x net debt-to-adjusted EBITDA.

Turning to cash flow on Slide 11.

Free cash flow was very strong in Q4 as expected, increasing to $21.6 million, reflecting lower inventory and improved collections.

Q4 operating cash flow was $25.6 million.

As we discussed on our call in April, we believe the build up in inventory due to insourcing is now behind us.

In Q4, inventory turns increased and DSOs improved from Q3.

Overall, working capital for Q4 was a $1.6 million use of cash.

Capital expenditures in Q4 were $4 million.

Free cash flow as a percentage of adjusted EBITDA was 57% in Q4.

Over time, the target we expect to achieve on average, is approximately 50%, although this will vary from quarter-to-quarter.

In Q1 of fiscal '19, free cash flow to adjusted EBITDA will likely be below 50% due to year-end bonus payments and higher CapEx.

For full year fiscal '19, even though we're forecasting higher CapEx, we think that 50% free cash flow to adjusted EBITDA is a reasonable target.

Looking now at fiscal '18 as a whole, free cash flow was $28.2 million compared to $26.3 million in fiscal '17, an increase of 7%.

Operating cash flow for fiscal '18 was $43.3 million compared to $59.1 million in fiscal '17.

Capital expenditures were $15.1 million compared to $32.8 million in fiscal '17, a decrease of $17.7 million year-over-year.

The higher CapEx in fiscal '17 was primarily a result of the investments we have made in our new headquarters in Andover as well as the build-out of our facility in Phoenix as we insourced our manufacturing.

As a percentage of sales, capital expenditures were approximately 3%.

We believe that this level of capital expenditures is at the lower end of our maintenance CapEx levels, which we estimate at 3% to 4%.

I'll now turn to our financial guidance, starting with the full 2019 fiscal year on Slide 12.

This guidance includes 11 months of Germane.

For purposes of modeling and guidance, we have assumed no restructuring and no acquisition or nonrecurring financing-related expenses.

We've assumed an effective tax rate of 27%, excluding discrete items, which is lower than our previous estimate of 30%.

For the full 2019 fiscal year on a consolidated basis, including Germane, we expect revenue of $602 million to $624 million.

This guidance represents growth of 22% to 27% from fiscal '18.

Consolidated gross margin is currently expected to be 43.7% to 44.4%, which is 2.1 to 1.4 percentage points lower than fiscal '18.

The primary reason is the inclusion of Germane in the forecast as well as continued growth in CRAD and early-stage programs.

Consolidated operating expenses are expected to be $202.2 million to $204.3 million.

This guidance assumes an estimated $26.9 million of the amortization expense.

We expect interest expense of approximately $9.5 million on $240 million of funded debt.

Total GAAP net income on a consolidated basis is expected to be $36.1 million to $44.5 million or $0.75 to $0.93 per share.

Consolidated adjusted EPS is expected to be in the range of $1.58 to $1.76 per share, an increase of 11% to 24% compared to fiscal '18 results.

Our guidance for adjusted EBITDA is $130.5 million to $142 million on a consolidated basis, or 21.7% to 22.8% of revenue.

At the high-end, this is within the range established by our target business model.

We expect adjusted EBITDA margins to increase over time as we integrate Germane and recognize the anticipated synergies.

In fiscal '19, we expect CapEx to be approximately 5% of revenue weighted to the first half, reflecting integration activities and ongoing investment in the business.

Slide 13 shows the impact of Germane on guidance.

The left-hand column is the fiscal '19 consolidated guidance I just outlined, which includes Germane.

The right-hand column is Mercury without Germane.

As Mark discussed, we believe that Germane is a great acquisition, strategically and financially.

The 4x purchase price multiple, net of tax benefits and full run rate cost synergies provides us with a tremendous value creation opportunity.

Net of Germane's estimated $43 million revenue contribution, we're estimating Mercury's revenue for fiscal '19 to be $559 million to $581 million with a midpoint of $570 million.

This range represents 13% to 18% growth over fiscal '18.

Moving down the slide, you can see that Germane's gross margin is dilutive to Mercury's stand-alone gross margin.

Net of Germane's 23% expected gross margin, our estimated gross margin is 45.3% to 46%, with the high-end 20 basis points above the 45.8% we reported for fiscal '18.

As I mentioned, fiscal '19 is likely to be another strong year for new design wins and increased CRAD.

That said, we do expect gross margins to expand over time as these early-stage programs move into production, and we expect to get back to our current gross margin target of 45% to 50%.

In terms of profitability, net of Germane's estimated $5 million adjusted EBITDA contribution, Mercury's adjusted EBITDA for fiscal '19 would be in the range of $125.5 million to $137 million with a midpoint of $131 million.

Adjusted EBITDA margins, excluding Germane, are forecast to be 22.5% to 23.6%.

This compares with 23.4% in fiscal '18.

We expect gross margins of 45.3% to 46% as insourced manufacturing margin improvement is offset by increased CRAD and early-stage programs and product mix.

Turning now to Q1 guidance on Slide 14.

We're forecasting consolidated total revenue, including Germane, to be $135 million to $141 million.

Q1 gross margins are expected to be 43.1% to 43.6%.

This includes lower Germane gross margins as well as an estimated $0.8 million for the inventory step-up associated with the Germane acquisition.

Q1 GAAP net income is expected to be $4.9 million to $7 million or $0.10 to $0.15 per share.

The decline from fiscal '18 is the result of the tax benefit in Q1 '18 that is not expected to recur in Q1 '19.

Adjusted EPS is expected to be $0.32 to $0.36 per share.

Finally, adjusted EBITDA is expected to be $27 million to $30 million, representing approximately 20% to 21% of revenue.

Turning to Slide 15 in summary, Mercury concluded a great fiscal '18 with a strong fourth quarter.

We delivered record backlog, bookings, revenue and adjusted EBITDA as well as solid free cash flow.

Our insourcing investments are driving strategic and financial benefits.

Our acquisition integrations are on track, and we have a large and growing pipeline of new design wins.

As a result, we are expecting another year of strong performance in fiscal '19.

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

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

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

On the organic growth, Mike, you just confirmed -- I know you're talking about 8% to 9% organic growth outlook for FY '19.

Curious as what would it take to see something even higher than your typical high single-digit, low double-digit target, especially as we see some of your -- well, I would say all of our customers raising their expectations based in part on technologies, I would assume Mercury contributes to.

Sure.

So we are seeing a lot of design win activity, new design win activity, Jon.

And as you know, we did 7% this year and we already in our guidance have raised it to 8% to 9%.

I think -- and we feel good with that number.

We do expect that in fiscal years '20 and '21, I think we get back to that double-digit range.

So it's simply a matter of timing of the programs that we believe that we're a part of.

Okay.

And then on the margin, certainly understand and acknowledge the sort of the mix issue.

But on the CRAD item specifically, I understand that CRAD hits the gross margin line, but it somewhat offsets IRAD.

Right now, the gross margin is, sort of, overall [will be] IRAD.

So I guess, wrapping all that up together, when does that dynamic get more balanced?

Essentially, when do we start to see margin -- underlying margin head more in the -- in the upward direction rather than seeing a sort of some -- a little bit of softness there?

Yes.

So Jon, if you look back over time and you look at our gross margins, you know they fluctuate quarter-to-quarter.

But on an annual basis, they're pretty consistent.

We were 47% in fiscal '16, 47% in fiscal '17.

And then, as you saw, we are 46% this year.

And every year has its puts and takes, but overall, we've been pretty consistent.

Now what we saw this year was a decline from 46.9% in fiscal '17 to 45.8%.

Now some of that was driven by the inclusion of Themis in the numbers.

And without Themis, as I mentioned, gross margins would have been 46.2%.

So a decline of 0.7%.

Now one thing I want to throw into the mix is USMO as well.

So our insourcing provided a benefit of $4 million and we estimate that as a positive to gross margins of about 0.9% of sales.

But that benefit, as you mentioned, was offset by the margin impact that we saw because of the CRAD, which we estimate to be about 0.8%.

So the 2 about offset each other during the year.

Now it's important to remember as you said, that offsetting the gross margin decline is the benefit that we see in internal R&D.

And so while gross margins were 1% lower, what you also saw was R&D drop from 13.2% last year down to about 12% this year, 11.9%.

And so when you put it all together and you look at the gross margins decline, we actually saw adjusted EBITDA grew from 23% to 23.4%.

And so we have adjusted EBITDA increasing from fiscal '17 to fiscal '18.

But we also have a number of new programs, which bodes well for future growth.

And as Mark just mentioned, we expect accelerated growth in the out years.

And then, if you look at our guidance, excluding Germane, so we put a page in the presentation that excludes Germane, you will see that the financial profile for fiscal '19 is going to be a lot like fiscal '18 was, i.e., the gross margins are pretty similar, but so is IRAD as a percentage of sales.

So once we move beyond fiscal '19 and some of the early-stage programs ramp up, we believe gross margins will start to expand, but we'll still have the operating leverage in the business, and it's really that dynamic that's going to allow us to get to the high-end of our adjusted EBITDA range over the next few years.

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

Maybe just a follow-up on that point about the customer-funded development.

When you think about going into production and moving into the next phase on those programs, does that affect -- how does that affect the returns that you get in the more mature phases of production, when it's the customer who has been funding the development?

So I think it's important to note what the funding is for, Seth.

So if you go back to our business model with typically spending between 11% to 13% of our revenue on Advanced Technology, modular products and capabilities that can be combined together into different subsystem capability.

What the customer funding is typically doing is paying for the customization of the individual products into a specific subsystem for a platform.

And the reason that they do that is because we -- because of the specific nature of the subsystem, we wouldn't be able to generate a return on that customization effort because we couldn't use that specific subsystem elsewhere.

And so we still get to -- because of the investments that we made, we own the IP.

We own the underlying technology.

They are paying for the packaging of it for their specific needs.

So as the program transitions from the EMD phase into LRIP, and then, ultimately, full rate production, that's when we start to see the margin improvement for the hardware annuities that we're creating.

Right.

And we should think of that process as kind of a typical program process that we see at one of the primes where it takes a bit of time to move through the development phase and into the production phase.

And I guess, over time, as you layer these things on top of each other, there will always be stuff moving into production, but for now it will take a little bit of time?

Yes.

I think that's a fair comment.

So we do expect to achieve our adjusted EBITDA target model high-end of that over time.

I think as Mike described, when some of these earlier-stage programs move into production, we'll see gross margin kind of move back into the range.

But we are viewing the increase in design win activity and the additional CRAD that we're getting from our investment -- from our customers, sorry, is really an investment in future growth.

And I think some of our customers have already talked about the [slowdown] that they are seeing from some of their customers.

So I think it's a positive.

The level of new design win activity is the highest I've seen.

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

Mike, on the free cash flow, just if I could dig into that a little bit on the guidance, and I'm sorry if you stated this, but you said the target is 50% of adjusted EBITDA for -- over time, is that the best benchmark that you said?

Yes, it is.

So we're not specifically guiding free cash flow numbers, but we are looking to provide a conversion target and that's 50% of adjusted EBITDA.

Okay.

Is there -- how do you expect, I guess, thinking about working capital dynamics this year versus as we know there was a lot of working capital buildup this past year?

How are we thinking about when you think about fiscal '19 the way that rolls out?

So I think from my perspective, as Mike said, in his prepared remarks, I think we've seen the significant buildup associated with the insourcing of manufacturing.

I think working capital as a percent right now we think it's going to come down as a percent of revenue over time because there's clearly an opportunity for us to continue to optimize that inside of the business.

Okay.

And then just lastly, Mark, you mentioned some of the large opportunities that you're benefiting from the kind of the insourcing efforts that you've done.

Is that kind of what you were alluding to that the growth really -- the design wins are starting to flow through, but we're really not going to see that upper end of the growth until you get out into 2020 and beyond?

That we believe is true, yes.

So we're seeing a tremendous amount of new design win activity really across the patch.

So literally in the last quarter, we've seen a significant, I think, uptick in both modernization associated with radar.

We're selected by a customer literally on 3 separate radar processes for both ground, naval and airborne applications.

We've seen multiple new starts associated with EW.

We're continuing to penetrate in different missiles and munitions, which we think is important as well as seeing some early-stage growth in EO/IR.

So I really do believe that we're actually in a pretty unique period in terms of modernization.

And with the products, technologies and capabilities that we developed organically as well as what we've added through M&A, I think our relevance to our customers has never been higher.

And our next question comes from the line of Sheila Kahyaoglu of Jefferies.

Just on that last point to a degree.

Your backlog conversion is almost now 50% within the next 12 months.

That figure used to be much higher.

So given these design wins and longer-term visibility, does that change the structure of contracts that you work on in any way or any insights on that?

Yes, Sheila, it's Mike.

One thing just to make sure we're looking at the same numbers on 12 months backlog as a percentage of total backlog was about 73%.

If you look at our forward coverage, I think it's up closer to 60%.

But when you look at what has gone on, we do think we have good forward coverage and visibility.

We had a good book-to-bill.

Now one of the things that we are seeing is as we move to more subsystems and bigger programs, we are getting some more backlog that goes out beyond 12 months, which is a good thing.

So backlog coverage is still good.

When you look at Themis, they had lower forward coverage than Mercury historically did.

So that brings it down a bit.

But overall, we feel pretty good about the visibility we have going into fiscal '19.

And then on Themis and Germane, did they -- can you give us an idea of like their product overlap and customer overlap?

Or is it just -- it broadens the customer scope and you could -- there is significant cost savings opportunity with that?

Yes.

So it's providing generally similar capabilities, but in different market segments and clearly different portfolios from a program perspective.

So I think, as I mentioned, if you look at Themis, 80% of that business is in the naval surface fleet on programs such as [KEDS and KEPS], which is associated with Aegis as well as in the ground domain on program such as JLTV.

If you look at Germane, 80% of their business is targeting the subsurface.

So they're pretty much in every U.S.-based submarine that is out there as well they've got a growing business in airborne on program such as the P-8 as well as KC-46.

So there's very little overlap from a programmatic perspective, but we do see the opportunity, obviously, of combining the 2 businesses together, which will generate pretty significant savings.

And when you look at the cost savings as well as the tax benefits, we see the combination of those 2 businesses together getting to the midpoint of our target adjusted EBITDA next fiscal year.

So we think it's a great combination, and we created a rugged server business that is well over $100 million in less than 6 months, pretty phenomenal.

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

Congrats on the strong quarter.

I just wanted to maybe dig a little bit deeper into the competitive landscape around Germane and Themis, and can you give us a sense of why -- what your scale is relative to competitors in that space?

Yes.

So we believe that from what we can -- from what we can tell in the marketplace that we're probably one of the largest suppliers with the combination of these 2 assets together with some of the work that we've been doing organically.

And it's -- we see there's a pretty significant opportunity.

I think as we've talked about, the C4I marketplace is actually larger than Mercury's traditional sensor and effector mission marketplace.

So it provides the opportunity for continued growth.

We've already created -- if you look at the lifetime value of our Top 30 programs, over $1 billion of potential opportunity in this space with the deals that we've done and the investments that we've made.

So we're pretty excited about the opportunity, Jonathan.

Got it.

And then just as a follow-up.

And I know you've talked about becoming more strategic and relevant to your customers, but can you talk about maybe how that's translated in terms of win rates and in terms of content as you kind of broaden and deepen your capability set?

Yes.

So we don't typically talk about our win rates, but we continue to take share really in a number of different dimensions.

The first is in the RF domain.

I think we've talked about in the past a flight to quality where there are at least 2 of our, call it, competitors in the RF space that are struggling to meet the customer's demands and we are taking share from both of those.

In addition, I think the other major trend that we see occurring is the shift from regular processing to [quality care] processing.

And Mercury has invested significantly in an industry-leading set of embedded security capabilities and we'll continue to take share in that domain.

So I think overall, we feel really good about the position that we have and our ability to continue to grow in C4I, in radar and in EW as well as the other markets in which we're participating.

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

Mike, I guess, you guys have provided a lot of color on '19.

Any thoughts on, sort of, the bookings outlook?

I mean, it sounds like the design win activity has never been better.

I mean, should we, sort of, calibrate expectations for this above one time book-to-bill to continue, or any maybe color you can give on the bookings environment?

Yes.

So clearly, we had a very strong book-to-bill, again, for the quarter as well as for the year and we do expect the positive book-to-bill next year as well, Mike, but I'm not going to go beyond that.

Got it.

Just on the Germane acquisition, what was the -- the EBITDA looks fairly low given the multiple you paid.

What's the driver there for their low EBITDA generation of margins relative to their sales?

So I think in large part, the business in our opinion is really not been set up to produce the products in an optimal way.

So if you look at Themis and Germane, very similar businesses with quite a different financial profile.

If you think about what we said when we did the Themis acquisition, we view Themis as a platform on which we could continue to acquire and integrate other businesses and we're doing exactly that with this acquisition.

So if you look at the combined purchase price, net of the -- both the acquisitions, net of the tax benefit and the expected cost synergies, which we wouldn't get had we not had the Themis platform.

Both deals on the net purchase price basis is 9x, which is pretty phenomenal in this environment.

So we're pretty excited about the opportunity of being able to combine these together to inject Mercury's embedded security capability.

And then do what we have in the past, which is to leverage the very strong channel that Mercury has with its customers to inflect the growth rates in the business over time.

So we think that next fiscal year, as I have mentioned previously, we can get the combined entity at the midpoint of our target business model from an adjusted EBITDA perspective.

So all round, we're pretty excited about it.

Got it.

That's helpful.

And then, just one more on the strong design wins.

Can you just give any color?

Are you seeing -- I mean, I know you talked about new starts with EW and an uptick in radars, but are you seeing certain pieces or components or subsystems of already in production platforms being re-competed by some of the larger primes in an effort to lower pricing or lower the overall cost of those platforms?

Is that where you're seeing some of this activity as well?

No.

I mean, it may be, that's -- I think that's not necessarily where we're necessarily participating.

I think what we see is that with the DoD's focus on increasing the rate of tech insertion to deal with the emerging threats that we see with our near peers or the peer threats, that's where kind of Mercury is being really brought into play because the significant level of investment that we're making in R&D and the fact that we got the trusted domestic manufacturing is exactly what they're looking for.

So now it could result in efficiencies and savings, particularly if some of the work was being previously done in-house because we tend to be much more affordable than that.

But I think in the main, we're seeing a wave of modernization to deal with the threats that are out there.

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

So the first question I have, can you mention, again, it's a housekeeping amortization of intangibles in 2019.

So that's a easy one.

I got a harder one.

It should be in the press release I believe it was 26.9, hold on one second.

Okay.

For 2019?

Yes, 2019 guidance.

Okay.

That (inaudible) so that was the lay-up of you've got the soft fall here we come to pick it up the pace.

So with this acquisition, is the flow of revenue the same as the rest of your company?

Is there choppiness in any specific quarter?

I'm just trying to figure out the flow of revenue.

And why did you pick the timing of -- to do this acquisition?

Was there something that was just so compelling that you want to do it right like it just happen to be on the market.

It was filling this need that you had to fill right now?

Or is it just part of your bigger strategy of acquiring along the way?

Sure.

So I don't think there is necessarily a change from a revenue flow perspective or seasonality that is any different than kind of Mercury's existing business because we're largely participating in the same end-markets with the same customers.

From a timing perspective, we obviously completed the acquisition of Themis approximately 6 months ago.

And as we said, growing our business in C4I is a part of the strategy of the company.

We announced when we did the Themis deal that we saw that as a platform acquisition that we would continue to acquire and integrate into and we've done basically just that.

We've known Themis -- sorry, we've known Germane for quite a while and we approached them following the acquisition of Themis, and we did a proprietary negotiated transaction with them.

And we thought the timing was right given our new fiscal year.

And so we closed the deal today and we're pretty excited about that.

(Operator Instructions) Our next question comes from the line of Jon Raviv of Citi.

Mark and Mike, on the M&A pipeline, how would you characterize that pipeline, is it more establishing new platforms?

Or is it -- Microsemi type insourcing plays?

Just trying to get a sense of the character of what you're seeing in the market.

And also, from a margin perspective, it seems like some things you acquire raise the target margins, some are dilutive at first and they are more of the cost synergy play over time.

So it's kind of like where is the M&A focus right now?

Sure.

Why don't I hit on the pipeline and some of the things we're seeing and then maybe Mark can talk a little bit about the different areas in the markets that we're looking.

But as we've said in the past, the M&A market continues to be very active and our pipeline is good as well, and we're seeing deals of all sizes, Jon, that fit with our strategy, small, medium and large.

As you know, from M&A perspective, it all starts with strategy for us.

And the other thing we're doing is we're very active in terms of sourcing new deals on a proprietary basis and Germane is another great example of that.

So the pipeline is robust, it's small, medium and large.

We've looked at all of them, and we're going to continue to be active.

Yes.

And I think from my perspective, Jon, I think, as you know, a critical element of our M&A strategy is the fact that we're full integrators.

And so the Microsemi deal had margins that were accretive to ours, Germane is slightly dilutive in the short-term until we recognize the cost synergies.

We'll do that very rapidly.

We're integrating these kind of midsize acquisitions in approximately 6 months now.

So we're getting really good at it.

And we end up dollar cost averaging down.

And so when you look at the net multiples that we're paying just on a cost basis, they're pretty good.

And then you start to inject the power of Mercury's channel and we even take that net purchase price multiple down even further.

So that's the key part of the strategy.

We're going to continue to do that.

And then just on the pipeline, how are you thinking about funding sources at this point?

I know a couple of months ago, equity was not so attractive.

How are you thinking about equity versus debt right now?

Sure.

Jon, it's going to depend obviously on the deal.

Right now, we still have good capacity under our current revolver.

So $160 million post the Germane acquisition.

We also have an accordion feature with it, that gives us additional capacity.

And so it's going to depend on the transaction depending on the size.

I think we're -- we've shown that we're pretty prudent and good stewards of capital in terms of how we examine the different financing alternatives.

But right now, we're focused on integrating Germane with Themis and then continuing to build the pipeline of M&A opportunities.

And when the right one comes across we'll figure out how we finance it.

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

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

Okay.

Well, thank you all very much for listening.

We look forward to speaking to you again next quarter.

Take care.

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

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

Everyone, have a great day.