Mercury Systems Inc (MRCY) 2019 Q1 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems First Quarter Fiscal 2019 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've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. 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, 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, free cash flow, organic revenue and acquired revenue. 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'd like to start the call by thanking the entire Mercury team for their continued focus on execution and delivering great results. I'll begin by providing a business update, Mike will review the financials and guidance and then we'll open it up for your questions.

Mercury delivered solid results for the first quarter of fiscal 2019, extending the momentum from Q4 and starting the New Year strong. We came in at above the high-end of our Q1 guidance for revenue, adjusted EBITDA and adjusted EPS while making good progress operationally.

Total bookings for Q1 were up 67% year-over-year, hitting an all-time record and driving a strong 1.24 book-to-bill. We ended the quarter with a record backlog of more than $0.5 billion, up 41% year-over-year. Total revenue for the first quarter increased 36%. Organic revenue was up 6%, and we continue to expect an increase of 8% to 9% for this fiscal year. Our largest revenue programs in the quarter were F- 35, [WinT], Predator, CDS and Filthy Buzzard. On the bottom line, adjusted EBITDA increased 25% from Q1 last year. Free cash flow was up 271% year-over-year and in line with our target yield at 50% of adjusted EBITDA.

Turning to Slide 4, Mercury's executed well on its strategy to become a leading provider of secure and safety-critical processing subsystems for aerospace and defense applications. We strongly believe that over time more and more of the technology that goes into U.S. military platforms will need to be designed and produced domestically. This represents an enormous opportunity for Mercury, given our strategy, capabilities and the investments we have already made. At the same time, I have no doubt that the U.S. defense industry will need to continue to leverage the investment and innovation occurring in the high-tech, commercial world. This is necessary given the speed at which the threats are evolving as well as the need for more rapid, secure and affordable modernization. The issue will be the continued globalization of supply chains, which will challenge DoD-specific needs in trust and assurance.

Mercury's pioneered and proven that a high-tech business model can operate successfully at scale within the aerospace and defense industry. There is a serious gap between the globalization of the high-tech world and the need for domestically-developed and produced products for defense applications. It is companies like Mercury, entrepreneurial and investing significantly in R&D and trusted domestic manufacturing that will help to bridge this gap.

This belief is further reinforced by the recent GAO report on improving the cyber resiliency of weapon systems. It is also reinforced by the assertions in a recent Bloomberg article which describes an alleged hack to a U.S.-based company's technology via their offshore supply chain. These assertions have since been publicly refuted by the company in a letter to its customers that was filed with the SEC on October 18.

Two of the businesses we acquired over the last 8 months use products from this company. However, we have been pursuing our own domestically-developed and manufactured secure processing technology as a core tenet of our strategy for many years. We've invested significantly in internal-funded R&D to develop our now fourth-generation of secured hardware and software technologies. These technologies offer our customers? choice and an industry-leading range of secure embedded and enterprise computing solutions.

In addition, we have funded and invested the capital dollars necessary to build out a trusted domestic SMT manufacturing facility in Phoenix, Arizona. Here, we can produce these sophisticated and important capabilities. Mercury has the secure processing technology and the trusted domestic manufacturing assets to help the defense industry as it makes this transition. It's these investments and our commitment that puts us in a position to help accelerate this shift as our customers' needs dictate.

When we acquired Themis and Germane, one of the synergies was to insert our own domestically designed and produced secure processing capabilities into their rack server solutions over time and for certain applications. And to lead the acquisitions and these efforts, we chose the general manager who was running our security products business. We view Mercury as part of the solution to these industry challenges. And we believe that we are better prepared and more strategically aligned than most other companies in this space.

With that as a backdrop and turning to Slide 5, our team continues to execute well, and Q1 was a strong quarter from an operational perspective. Our recently acquired businesses, Themis and Germane, are generating strong revenue and cost synergies. Both businesses are performing well and in line with our plan. We see no change in customer behaviors, no financial impact and no change to our current business outlook because of the allegations in the Bloomberg article.

We've also invested significantly over the years in building our best-in-class cybersecurity capabilities. These capabilities are designed to protect our own infrastructure, critical technologies and information. We're not only compliant with the DFARS 800-171 cybersecurity policies, we are complete. We've been told by our customers that Mercury's a role model for how seriously we've taken the level of cybersecurity risk, for the investments we've made and for the capabilities we've deployed.

At the same time, we've also made substantial investments in our defense industrial security program. Mercury currently has 10 locations that participate in what is known as the NISPOM, the National Industrial Security Program. All locations, while they've been partnered with the Mercury family, have received superior ratings from the Defense Security Service, or DSS. Of the 13,000-plus companies participating in the NISPOM, less than 12% achieve a superior rating. Mercury has also received the prestigious James S. Cogswell Award twice in recent years for its outstanding security program. This puts us in the top 1% of all eligible defense contractor locations.

Our IT and internal cybersecurity team is extremely capable. Jeff Eason recently assumed our CIO role following the planned retirement of our former CIO. Jeff has been with the company since 2009 and brings a wealth of knowledge and experience to the position. Jeff, our existing Chief Information Security Officer and the rest of the IT team have led the company for many years in building a best-in-class cybersecure and resilient infrastructure to address internal and external threats.

Moving to Slide 6, we further strengthened the Mercury leadership team in Q1 by recruiting Amir Allahverdi, the former Group EVP of Operations for Meggitt PLC. While at Meggitt, Amir implemented a range of centrally driven strategies to enhance operational performance. Among them were improvements in quality, delivery, cost, inventory and purchasing across 50 manufacturing locations globally. Amir was also the key architect for what is known today as the Meggitt Production System. We're pleased to have Amir join us to oversee Mercury's ongoing manufacturing and supply chain improvement initiatives.

Attracting top talent in an increasingly tight employment market is no easy task, but we're doing well. According to a D.C.-based consulting firm, Mercury has attained the highest current employee Glassdoor ratings in the defense industry. We were also recently named to Fortune Magazine's 100 Fastest Growing Public Companies for 2018, ranking 27th overall. Notably, we were the only listed company in the aerospace and defense industry.

We continue to make good progress on acquisition integration in the first quarter. The consolidation of our West Coast RF manufacturing locations is moving forward. We've taken occupancy of the leased building adjacent to our existing Oxnard, California plant. We're beginning the buildout of that facility, which when complete will allow us to consolidate our remaining West Coast microwave operation.

This will integrate as our strategy goes beyond physical and operational consolidation to include migrating the businesses we acquire to Mercury systems and processes. In Q1, we transitioned Themis to Mercury's Oracle ERP platform, and we began combining Themis and Germane.

We're on track building out our Phoenix trusted domestic SMT production capabilities for secure processing products. This capability, along with Mercury's other world-class domestic manufacturing facilities in RF and custom microelectronics packaging, are crucially important to our ongoing ability to grow the business.

Turning to Slide 7, our business outlook remains strong. We're seeing an impulse in defense spending this fiscal year that is leading to a high level of new design win activity and a strong book-to-bill. Over the longer term, our baseline forecast is for overall defense spending to increase at low single-digit rates. Mercury's goal is to continue delivering organic revenue growth at a rate that exceeds this industry average.

Our ability to win new business has never been stronger. As a result, the level of pursuit and design win activity continues to be the highest I've seen since joining Mercury. As I mentioned earlier, for FY '19 as a whole, we currently expect organic growth in the range of 8% to 9%.

Our largest bookings in the first quarter included a classified missile system, PGK, F-35, [LTams] and Predator. We also booked orders for radiation-tolerant, solid-state drives, rugged shipboard radar processing, integrated subsystems for the U.S. Navy, rugged memory for airborne computing applications as well as RF subsystems for advanced electronic protection applications.

The markets we're targeting, Sensor and Effector Mission Systems and C4I, are typically growing faster than the defense market overall. This growth has been driven by a wave of modernization across a broad range of platforms, from radar to EW to missiles and munitions, EO/IR and C4I. Sensor and Effector Mission Systems is Mercury's traditional market. This part of the business has grown 11% over the past 12 months to 62% of total revenue. In Q1, Sensor and Effector Mission Systems revenues were up 6% year-over-year.

In C4I, where we've created a leading rugged server business through M&A, our revenues have grown nearly 3x over the past 12 months and now represent 22% of total revenue. In Q1, driven by acquisitions and new design win activity, C4I revenues grew over 3x year-over-year to 31% of revenue. The C4I market is larger than the Sensor and Effector Mission Systems market. If you look at the estimated lifetime value of our top 30 programs, we've created $800 million of potential opportunity in C4I, with the deals that we've done and the investments that we've made.

Our growth in both the Sensor and Effector and C4I markets reflects the impact of 3 industry trends we've discussed in the past. The first is increased outsourcing by our customers at the subsystem level. Second is the flight to quality. The primes are seeking to deal with fewer, more capable suppliers, suppliers like Mercury, who are prepared to coinvest in internal R&D, have trusted domestic manufacturing assets and have invested in cybersecurity. Third is supply chain delayering by the government and the primes. We've transformed Mercury into a tier 2 company over the past several years, moving up the value chain and positioning ourselves to capture more content as the delayering trend evolves.

Since fiscal 2013, we've seen the estimated lifetime value of our top programs and pursuits grow close to 5x, and we'll say more about this at our Investor Day on November 6. A substantial amount of this growth is attributable to M&A. Over the past 34 months, we completed 7 acquisitions, totaling $620 million of capital in deals of various sizes. These transactions share a common strategic rationale. They're expanding our addressable market, broadening our customer offerings as well as our program base. At the same time, the cost and revenue synergies they're generating are contributing to our financial progress. Looking ahead, we are well-positioned to continue supplementing our organic growth with smart, strategic M&A. Our pipeline is strong, and we continue to see interesting opportunities of various sizes, all of them well-aligned with our strategy.

As Mike will discuss, on September 28, we signed an agreement that increased the size of our existing revolving credit facility from $400 million to $750 million while improving the terms. As a result, we have ample committed financing to support our M&A journey going forward. We intend to remain active and disciplined in our approach. We continue to look for deals that are strategically aligned, have the potential to be accretive in the short term and promise to create long-term shareholder value.

Turning to Slide 8, in summary, Mercury's on track for another year of strong performance in fiscal 2019. Our model is working extremely well. We're growing the business substantially faster than the industry overall. Our planned manufacturing and M&A integration synergies are materializing. We're expecting another year of double-digit growth in revenue and strong cash flow generation.

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. First is to drive high single-digit, low double-digit growth in the business organically, supplemented by acquisitions. This is consistent with the 20% compound annual revenue growth we've delivered over the past 5 years.

Second, we're focused on manufacturing insourcing where it makes sense strategically, operationally and financially as well as improved operating efficiencies to drive margins. Third, we're creating stronger operating leverage in the business by ensuring that organic operating expenses grow more slowly than revenue. And finally, we're fully integrating the businesses we acquire to generate cost and revenue synergies. This, combined with these other elements should produce attractive rates of return for our shareholders.

Given our results in Q1, our record backlog and our current business outlook, we expect to report continued, strong performance in the second quarter. We're raising our full year fiscal '19 guidance and Mike will take you through those numbers in detail.

Finally, as a reminder, we'll be discussing our strategy and plans for growth in depth at our Investor Day in New York City on November 6. We sincerely hope that you can join us.

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

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

Mercury's first quarter results were strong. Revenue, adjusted EBITDA, adjusted EPS and free cash flow were up substantially from Q1 last year. We delivered record bookings and concluded the quarter with record backlog. We completed the acquisition of Germane Systems and increased the size of our revolving credit facility, providing us more flexibility going forward. Given the strength of our Q1 results, we're anticipating continued strong performance for the remainder of the year. As a result, we're increasing our full year fiscal 2019 guidance for revenue, adjusted EBITDA and adjusted EPS. I'll walk through the updated guidance shortly.

Turning now to the metrics on Slide 9. Mercury's revenue and bookings growth continued to translate into solid profitability in Q1. Total bookings increased 67% year-over-year, driving a 1.24 book-to-bill ratio. We ended the quarter with record backlog of $507.9 million, which is an increase of 41% compared to Q1 fiscal '18. Backlog expected to ship within the next 12 months increased 34% from Q1 last year to $377.8 million.

Total revenue increased 36% from Q1 last year to $144.1 million exceeding our guidance of $135 million to $141 million. Organic revenue was up 6% year-over-year, and as Mark mentioned, we continue to expect 8% to 9% organic growth for fiscal '19.

We also saw strong growth in our acquired businesses during the quarter, highlighting the continued success of our M&A strategy. Our strategy of identifying businesses with good growth profiles and integrating them into Mercury to inflect growth is clearly working. As we expected, gross margin for Q1 was down year-over-year, coming in at 42.8% versus 47.8% in Q1 of fiscal '18. This decline reflected anticipated changes in program and product mix, the inclusion of Themis and Germane, which have lower gross margins, an inventory step-up associated with the acquisition of Germane, and increased customer-funded R&D or CRAD.

As we discussed last quarter, CRAD has a lower gross margin than our target model, as do some of the early stage development programs, so it reduces gross margins in the near term. CRAD for Q1 increased 79% year-over-year. The magnitude of this increase is the primary reason for gross margin coming in slightly below our guidance for the quarter. For the year, however, we expect gross margin to be unchanged from our prior guidance.

Longer term, we look at customer-funded R&D as an important driver of organic growth. CRAD is a precursor to the hardware annuities it helps generate as early-stage programs transition from the EMD phase to LRIP and ultimately into full rate production. I'll also note that CRAD has the effect of reducing operating expenses in the near term by serving as an offset to internally-funded R&D or IRAD. IRAD was $14.9 million in Q1, compared to $13.7 million a year ago. As a percentage of sales, IRAD was 10.4% in Q1, down from 13% of revenue in Q1 '18. This decline is primarily a result of the increased customer-funded R&D.

While IRAD as a percentage of sales declined slightly in Q1, Mercury still maintains one of the highest IRAD levels in the defense industry. As our customers supplement this investment with more of their own R&D funding, we're creating substantial combined R&D operating leverage for both of us. Partnering with our customers in this way helps them win new business while improving our performance in terms of both organic growth and operating expenses.

SG&A for Q1 increased 20% from $20.6 million in Q1 '18 to $24.7 million primarily driven by the inclusion of Themis and Germane. As a percentage of sales, SG&A decreased from 19.4% in Q1 '18 to 17.2% in Q1 '19, highlighting the operating leverage we're creating in the business as we continue to grow sales faster than expenses.

GAAP income and EPS in the first quarter decreased by 58% year-over-year. The declines were solely the result of a significantly lower effective tax rate last year. In Q1 '18, we had an $8.4 million tax benefit compared with a $3.1 million expense in Q1 '19, a difference of $11.5 million year-over-year. While GAAP income was impacted by this, income from operations grew 33.2% and profit before tax grew 10.8%.

Adjusted EPS for the first quarter was $0.39 per share, up 5% from $0.37 per share for Q1 last year. Adjusted EBITDA for Q1 increased 25% year-over-year to $31.6 million, exceeding our guidance of $27 million to $30 million. Adjusted EBITDA margin was 22%, above the high end of our guidance and another example of our operating leverage.

Finally, free cash flow, which we define as cash flow from operations less capital expenditures, increased 271% year-over-year to $16.3 million.

Slide 10 presents Mercury's balance sheet for the last 5 quarters. Mercury ended Q1 fiscal '19 with cash and cash equivalents of $72.9 million, up $6.4 million from $66.5 million at the end of Q4. This growth was driven by the strong free cash flow we saw in the quarter, partially offset by the repurchase of common stock associated with the settlement of employee-restricted stock awards annual vesting.

Inventory in Q1 increased by $12.6 million from Q4 '18 to $121.2 million. $7.5 million of the increase was the result of the acquisition of Germane. The other $5 million was primarily driven by program mix as well as early receipt of long lead key components. Accounts receivable increased $10.1 million, of which $5.8 million was driven by the inclusion of Germane. DSOs remained flat quarter-over-quarter.

From a capital structure perspective, we maintain flexibility and good access to capital. At the end of the quarter, we had $240 million of debt, an increase of $45 million from the end of Q4, driven by the acquisition of Germane. Our balance sheet remains conservatively levered at approximately 1.3x net debt to adjusted EBITDA.

As Mark said, we have a robust pipeline of M&A opportunities and companies that fit extremely well with Mercury's strategy. Given the strength of our pipeline and strong bank markets, we increased the size of our revolver from $400 million to $750 million this quarter. In addition to increasing the size, we were also able to reduce the interest rates. At current leverage levels, our interest rate is now [L plus] 125, a reduction of 25 basis points compared to our previous rate. We believe this increased size and lower rate positions us extremely well to continue to execute on our M&A strategy.

Turning to cash flow on Slide 11, free cash flow was $16.3 million representing 52% of adjusted EBITDA. As we mentioned on our call last quarter, we have an annual target of 50% free cash flow to adjusted EBITDA. Operating cash flow more than doubled from $8 million in Q1 ?18 to $20 million this quarter. Working capital for Q1 was a $4.5 million use of cash. Absent approximately $8 million of bonus payments made during the quarter, working capital would've been a source of cash. Capital expenditures in Q1 were $3.7 million. At 2.6% of revenue, this is lower than what we expect for the rest of the year.

I'll now turn to our financial guidance. Starting with Q2 guidance on Slide 12, you can see that we're forecasting consolidated total revenue to be $151.6 million to $156.6 million, an increase of 29% to 33% compared to Q2 fiscal '18. Q2 gross margins are expected to be 43.9% to 44.5%. The decrease from Q2 fiscal '18 is primarily driven by the inclusion of Themis and Germane, which have lower gross margins, and program mix, including higher levels of CRAD than last year.

Q2 GAAP net income is expected to be $8.3 million to $10.3 million or $0.17 to $0.22 per share. Adjusted EPS is expected to be $0.39 to $0.43 per share, up 39% to 54% compared to Q2 fiscal '18. Finally, adjusted EBITDA is expected to be $31.7 million to $34.5 million, representing approximately 20.9% to 22% of revenue.

Turning to Slide 13, our guidance for the year reflects the outlook that Mark discussed highlighted by continuing growth and profitability. For the fiscal year, we now expect revenue of $607 to $625 million, an increase from our prior guidance. This guidance represents growth of 23% to 27% from fiscal '18. Consolidated gross margin for fiscal '19 is currently expected to be 43.7% to 44.4%, which is consistent with our previous guidance.

Consolidated operating expenses are expected to be $199.2 million to $202.6 million. This guidance assumes an estimated $26.8 million of amortization expense. We expect interest expense of approximately $8.8 million on $240 million of funded debt. Total GAAP net income on a consolidated basis is expected to be $39.1 million to $45.6 million or $0.82 to $0.96 per share. Adjusted EPS is expected to be in the range of $1.65 to $1.79 per share, an increase of 16% to 26% compared to fiscal '18 results.

Our guidance for adjusted EBITDA is $133.5 million to $142.5 million on a consolidated basis or 22% to 22.8% of revenue. At the low end, this is an increase of 0.3% from our previous guidance and within our target model. As we've mentioned, we expect adjusted EBITDA margins to increase over time as we integrate Germane and recognize the anticipated synergies. We expect CapEx for fiscal '19 to be approximately 5% of revenue, reflecting our integration activities and ongoing investment in the business.

Turning to Slide 14, in summary, Mercury delivered a strong first quarter with record bookings and backlog, revenue, adjusted EBITDA and adjusted EPS above our guidance and solid operating and free cash flow. We also increased our access to capital, providing financial flexibility to support execution of our M&A strategy. As a result, we're well-positioned for 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) Jon Raviv with Citi.

Can you just talk a little about the organic growth trajectory this year coming out of the chute at 6%, still talking about 8% to 9% for the year. Just how should we expect things to rollout over the course of the year? And then I know you've talked about acceleration thereafter. So if you can just also add a little perspective on how you see that picking up FY '19.

Sure. So we're currently expecting or guiding growth to be approximately 9% in Q2, and we said overall we're remaining at about 8% to 9% for the year, and that's what we currently see right now. You look at our LTM organic growth through the end of the first quarter, it's up 11%. So beyond fiscal '19, I think we still feel extremely good about how we're positioned. I think we'll continue to be well aligned with budget and the needs for ongoing modernization in the 2 major market segments in which we're participating, those being C4I and Sensor and Effector. And I think we demonstrated our ability to continue to grow the business over a multiyear period at high-single digit, low double-digit rates and supplement that organic growth with acquisition. And if you look at over the past 5 years, we've got a 20% compounded growth rate over that same period. So I think we continue to feel good. Jon, about the business, how it's performing as well as our ability to grow organically and through M&A.

And on that organic growth, I mean, you've historically been able to kind of put some space in between you and what some of your major customers are doing in terms of organic growth. With those customers now pointing to, in some cases, up to 8% organic growth in 2019, how do you see that delta playing out over time, the delta, again, between their organic and your organic? Sorry. Go ahead, Mark.

Yes. We'll see. I mean, if you look at the DoD outlays, right, they're up 10% year-over-year and up 10% year-to-date. [RDT&E] and O&M funding typically have got a shorter spending window compared with procurement dollars, which as you know, kind of spans or can span a multilayer period. We've clearly seen a pickup in RDT&E activity, which is driving the higher bookings in the short term as well as the increased levels of CRAD funding that Mike had mentioned. So our bookings were up 67% year-over-year. We had a 1.24 book-to-bill. CRAD, I think as Mike mentioned, is up 79% and up 34% LTM. So I think we're already beginning to see the impact of some of that budget -- kind of increased budget spend kind of flow-through, and we'll have to see how that plays out going forward. But we do feel that we're pretty well positioned overall. And if you look at the 24% growth that we've delivered in last 12 months and 11% organic growth over the last 12 months, we're quite pleased with our performance.

Our next question is from Seth Seifman with JPMorgan.

I wonder if you could talk a little bit more about mix and what's expected for the rest of the year in terms of the acceleration in organic growth that you're going to see and if that comes more on the Sensor and Effector side or more in C4ISR. And then also in terms of the customer-funded research that you've seen, has that been more in one of those buckets or the other? And then in terms of where it's trending in both.

Okay. So if I kind of look at the year, there's really, I would say, 4 drivers overall of growth that we see in the business. We're expecting a strong performance in our radar processing. We'll continue to expect a strong performance in EW. We're clearly seeing fund flows into that specific area. If you look at the weapons systems arena, we've seen a very substantial uptick. Our LTM weapons systems revenues were actually up over 100% through the end of Q1. And if you look at our weapons systems bookings in Q1, it was up tenfold versus the prior period, so we're clearly seeing some monies flow there. I think beyond that, we obviously have targeted the C2I space -- the C4I space, and we are benefiting from the acquired revenues from Themis and Germane. But we've also seen a very substantial increase in the previously acquired CES business that is based over in Geneva that is targeting comms processing as well as mission computing, and we're winning some very nice design wins there. So that's kind of generally what we see. I mean, we're seeing growth really across the business. With respect to CRAD, I think it's similar. We have won 2 pretty significant awards this quarter in the classified missiles domain for rad-tolerant storage and rad-tolerant processing that we're pretty excited about. We saw 2 quite significant mission computing design wins over in our business in Geneva as well, which is supplementing, obviously, the significant IRAD investments that we're making as well. So hopefully that provides some color, sir.

Yes. Definitely.

And Seth, I would just add just from a guidance perspective, as Mark said, we're in the period of significant design wins and new program starts. When you think about guidance for the rest of the year, we do have CRAD normalizing in terms of the level at that, so if more design wins come in, that's a good thing for us. But right now in our forecast, we have it normalizing.

All right. Okay. And then just as a clarification, Mike, did you say at the end of the prepared remarks, CapEx of 5% or so of sales this year?

Yes. So we've talked before about maintenance CapEx being about 3% to 4% of revenue. This year -- and it was a little below that in Q1. For this year, we're expecting about 5%, and the 2 real drivers are associated with the buildout of our Huntsville facility as well as the integration of 2 of our facilities in California, one in Camarillo and in Oxnard, California associated with the Delta Microwave acquisition. So that's what's driving it up a little higher this year.

Yes. So most of the -- we're not really a capital-intensive business. I think as Mike said, most of the capital increases are largely associated with our integration programs. And as you know, full integration of the businesses that we're acquiring is a critically important part of our strategy going forward and has been since the outset.

Our next question is from Sheila Kahyaoglu with Jefferies.

Maybe can you provide some color on how Germane and Themis are tracking versus your expectations. You said in your prepared remarks that they're doing quite well. And just broadly speaking if you could maybe elaborate on your comments with regards to Supermicro a bit, both the risks and as an opportunity for Mercury.

Yes. So both of the businesses are performing extremely well. They're growing strongly. We are in the early stages of combining the 2 businesses together, but we've already completed a very substantial integration effort at Themis as part of Mercury. And as I mentioned on the call in my prepared remarks, this quarter, we actually transitioned Themis onto Mercury's ERP platform. So we couldn't be happier with kind of how the integration's going and how the businesses themselves are performing. I think with respect to Supermicro, I kind of hit that on the call. There's been no impact to the business financially as the result of the alleged hack. We haven't seen any change in customer behaviors or change in the outlook to the business as a result. Stepping back, however, I think if you think about the need, we do expect that, over time, more and more of the technology that goes into U.S. military platforms will need to be designed, developed and produced here domestically. And that has been a core tenet of our strategy for many years. And when we acquired Themis and Germane, one of the synergies that we saw as the result of the deal was being able to actually transition our own internally developed and manufactured products into their rack server solutions over time and as customers' needs dictate. So we think that we're probably one of the best companies in the industry from a positioning perspective to help the industry and the DoD transition to these types of capabilities here domestically.

Thanks, Mark. And then just one on free cash flow. It was particularly good in the quarter. How do we expect that to move forward for the rest of the year? Some of it is CapEx moving up from 3% to 5% of sales. Any moving pieces you could provide with regards to working capital?

Yes, Sheila. So first of all, as you know, we're not specifically guiding free cash flow numbers, but we are continuing to target the 50% number that we put out there. If you look at the rest of the year in terms of the couple things that you mentioned from a CapEx perspective, we do expect it to pick up probably in the latter half. From a working capital perspective, we think there's probably some opportunities at the end of the year, by the end of the year, in terms of DSOs and inventory. But overall, we're happy with where we are from a cash flow perspective, what we've done with the business and the outlook going forward around our cash flow.

Our next question is from Ken Herbert with Canaccord.

I appreciate the color on the facility consolidations in California and Themis and Germane, but can you provide an update on the ramp in Arizona and that facility? And I know it was a bit of a working capital headwind not too long ago. How's that facility ramping, and can you just remind us of when you expect it to be a tailwind and some of the milestones or contributions into the back half of this year?

Sure. So the buildout of the SMT facility in Phoenix, I think, is progressing well. We are -- we've completed a fair amount of the transition from our previously outsourced partner. It will continue to a lesser extent for the remainder of the year. And as we've said in the past, we're continuing to seek to make that as well as our other manufacturing locations in RF as well as the custom microelectronics packaging operationally more efficient over time, and that's an ongoing program. We were very pleased this quarter, as I mentioned in my prepared remarks, to hire Amir Allahverdi, who ran manufacturing -- the whole of the manufacturing operations for Meggitt. And so we're going to be on a similar journey there. It's an important part of our model, and we see continued opportunity.

Okay. That's great. Thank you. And then if I could, there's certainly been discussion lately about maybe different levels as part of the fiscal '20 defense budget request. And I'm not going to ask your opinion about where that exactly comes in, but under a scenario theoretically where maybe a comes in closer to the $700 billion, I'm just curious in your business model when you look at the outsourcing trends and flight to quality and supply chain delayering, how do you view, if we are under maybe more top line pressure into fiscal '20, the pros or cons relative to your business model?

Yes. It's a great question. I think if you look at it, we've really just begun to see the increases in outlays. FY '18, it was up 10%. I think the year prior to that, it was up 3%. It was up very low single digits, I think, in '16, and prior to that, it was roughly flat. Mercury, really throughout a period of very low single-digit growth or even kind of declines, has been able to grow the business at high single-digit and low double-digit rates, and it's exactly because of the trends that you mentioned. We are seeing our customers actually outsource more of the work that they previously did in-house, and the outsourcing is occurring at a subsystem level. And then we, I think, have done a pretty good job at taking share in really 2 different areas. The first is in RF, where there truly is a flight to quality, where Mercury has invested significantly in its RF development and manufacturing capability, where other companies hadn't, and as a result of that, we are a displacing them in certain areas. The second area is around secure processing, and we're now in our fourth generation of truly embedded secure processing capabilities that we're now manufacturing in our own facility domestically. And we've got capabilities that are far in advance of what the competition has. And so we're taking share in that domain as well. The final thing that I would kind of point out is that I think, as a company, we've done a pretty good job at really targeting what we believe to be the faster-growth streams in the budget overall. And you can clearly see that with the growth that we've experienced in areas like EW or also in the weapons systems arena that has grown very, very rapidly and continues to do so. So I think our business model is working well. It's driven by the investments that we're making and some of the industry trends that I just mentioned.

Our next question is from Ronald Epstein with Bank of America Merrill Lynch.

This is Kristine Liwag calling in for Ron. Mark, Mike, what's driving the $9 million cash inflow from deferred revenues and customer advances? And if book-to-bill continues to exceed 1, should we expect this to be continued tailwind to working capital?

Yes, let me touch on the deferred revenue question. So one of the things that we've been working to do as we've done more subsystems is get advance payments and milestone payments from our customers. What happened this quarter is we had a very big design win and booking. As part of that, we received a $13 million advance payment. That increased accounts receivables. It also increased deferred revenue. So that's what you're seeing around that.

I see. And generally speaking, what are the key milestones for cash collection? So when you get an order, how much cash do you get upfront versus when you receive at other milestones or at delivery?

So it varies dramatically from program to program, so I wouldn't say there's necessarily a rule of thumb, Kristine.

Our next question is from Peter Arment with Baird.

Just so I just understand the CRAD?s increase. Obviously, long term it's very favorable. What is the best way to think about how this transitioned? Is this -- eventually we're going to start to see this move into LRIPs and other forms as we get out into fiscal 2020. Or is this for efforts that go way out beyond that?

So it could be both is the answer. So we've got some that are relatively short period of performance, so the large plus site development work that we're doing for a missile system is a 2-year period of performance. It's a program that is still competitive in nature, so we'll have to see how that potentially transitions over time. Other programs can follow the traditional EMD, LRIP production cycle. But I think, as Mike said in his prepared remarks, we truly do view the incremental CRAD funding that is on top of the investments, the significant investments in IRAD that we're making, as being the forerunner of future organic growth tied to those hardware annuities which typically drive higher margin. So we've always got a mix of different programs at different stages, Peter, but we clearly are in a period of significant new design win activity.

Yes. That's helpful. And just also just regarding your program mix because you do have so many programs and you've won a lot. Do you have any headwinds though when we ? just thinking about the organic growth? 8% to 9% is very good, but do we have any programs that are rolling off when we think about '19 or going into '20?

We've always got programs that are kind of moving. As an example, if you look at Patriot this year is probably not going to be a 10% revenue program for us, yet we're expecting pretty strong bookings just given what Raytheon is seeing with orders or potential orders from Romania, Poland and Sweden as well as other companies. Aegis, I think, is going to be a little lower in our existing business than what we've seen previously as some of that backfill activity kind of slows down. That being said, we have added some pretty significant content on the Aegis platform in the form of the [KEDS] and [KEPS] program, which came to us through the acquisition of Themis. So we've always got things kind of moving around in the portfolio, but if you kind of step back and you look at the guidance, that portfolio mix change is anticipated in the guidance that we gave, Peter.

That's great. And just lastly for me just on the -- Mike, on the credit facility, obviously taking advantage of some very favorable terms and creating quite a bit of capacity, but you already had a lot of flexibility already. So is there -- opportunities in the pipeline are increasing or you just want to have the capacity available to move?

Yes. Peter, we didn't do it with a specific transaction in mind or anything like that, but we do have a robust pipeline, as we've talked about, of opportunities that fit with us strategically. We're looking at acquisitions that are small, medium and large, so we've been very active, and we had the opportunity to upsize it and reduce the rate, and we thought it was a good opportunity to get the capacity when we could.

Our next question is from Michael Ciarmoli with SunTrust.

Maybe Mark or Mike, just on the gross margin, would you be able to parse out -- I know you've talked a lot about the CRAD, but it seems like Germane and Themis each had lower gross margin profiles. Can you give us a sense of how much of the margin pressure was just from the acquired revenues alone and does that -- you've got a sort of a ramp in gross margin throughout the year. Is that a function of just better performance and integration at those companies or do we see mix or the level of CRAD kind of taper off? Just how do we think about the margin trajectory there?

Yes. So Mike, let me start with the first one. And we obviously don't break out the gross margins by acquired and organic. But last quarter, we did because it was the first quarter right after we had acquired Germane, so we provided our fiscal '19 guidance consolidated and then broke out Germane. What you could see is the impact of Germane on our gross margins was about 1.6%, and so I think that's relatively consistent. As we go through the year in terms of the increasing gross margin, it's not necessarily related to increased margins associated with the acquired businesses. It really is program and product mix. So we've got CRAD being relatively stable over the course of the year, and then we've got other programs moving in which is causing the increase. We had some accounting stuff. We had about 600k in Q1 associated with inventory step-up related to the Germane acquisition, but really what's driving it up is program and product mix.

Got it. And then just maybe one bigger picture, Mark, on this whole Supermicro and maybe the need to really sure up and secure this kind of supply chain for the DoD. I'm definitely an agreement it creates a lot of opportunities, but as you guys look at this, does it potentially layer on costs? I mean, if more work needs to shift internally, does that potentially change working capital profiles and intensity or even profitability if you guys are now being asked to make commoditized parts and components, something like a printed circuit board? Just any view there on how -- obviously, longer term, not going to impact anything soon, but how you guys might be thinking about that?

Yes. I don't believe so, Mike. I think the DoD recognizes that the prices for domestically developed and produced products are going to be different than stuff that is benefiting from huge volumes in offshore manufacturing locations. We have already invested in significant technologies associated with our embedded secure [cross-link] products. And we're going to continue to invest, and we may invest slightly more too where appropriate, replace some of the Supermicro motherboards. But we think that the cost differential -- or there will be a cost differential or price differential. So we don't really see right now any kind of margin implications nor would I expect to see any significant changes to working capital either, Mike.

Our next question is from Jonathan Ho with William Blair.

I just wanted to build on that last question, and when we think about the potential for higher secure content and manufacturing requirements and future opportunities, how does that maybe influence or impact prime willingness to outsource and potentially maybe even win rates as we start to look at whether that starts to happen or not?

Yes. So I think -- I don't think it affects the outsourcing trend per se. I think we are in a very strong position to help our customers and the industry as a whole transition to this domestically developed and produced supply chain. And we've been doing this, as you know, for many years. It's been a core tenet of the strategy. Mercury is on our fourth generation of embedded security products, and we've probably got the most contemporary embedded secure processing product portfolios in the industry. So if anything, I think it represents a significant opportunity for us to do what we've been doing, which is taking share from other folks along the way. And as I said in my prepared remarks on the call, one of the major synergies that we saw when we acquired Themis and Germane was to actually insert our capabilities into their products over time for certain applications, and that's something that we've begun to execute on.

Got it. Got it. And then just with the recent acquisition that was made by L3, I just wanted to understand. Does this create any opportunities or risks for you? Is there any potential for more competition in the M&A space? Just want to get a sense of whether industry landscape changes are having any impact?

Are you talking about the merger Jonathan?

Yes.

Yes. So, look, I think from my perspective, I mean, it seems like a pretty good combination. Two strong companies getting together to create an even stronger business. As they merge and as they in essence kind of move up a level to become that sixth prime, we actually believe that there could be even more opportunities for us to work together, especially given the increased rate of outsourcing that we see occurring elsewhere in the industry. And it may even lead to some portfolio shaping because I think some of those companies have got assets at tier 3 and tier 2 levels that may not fit with their strategy going forward. But that's purely hypothetical my part. So we'll see. I think it's an interesting combination, and we think that we could potentially benefit from it longer term.

(Operator Instructions) Our next question is from Jon Raviv with Citi.

Just a question on the M&A pipeline. What do you see more of right now: kind of adding new platforms or adding capabilities to existing platforms or are you open to both (inaudible)?

So it's a mixture, Jon. We've really got kind of 3 themes going on in parallel right now, and the way in which we think about M&A is very thematic in nature. So we obviously have built a rugged, secure server or rugged server business targeting the C2I space that we think that we can continue to grow. We've got a theme that is going on in kind of mission computing and avionics that I would say is pretty early stages, but we see some opportunities there. On the sensor processing side, we've built a pretty substantial business in the RF domain, I think we continue to see large, medium and small opportunities in that space. We've dipped our toe in the water internationally with the acquisition of CES that we did some time ago. And we see other opportunities to create potentially new themes, but still sticking with that aerospace and defense electronics focus, not straying away from kind of the core. And I think we've demonstrated our ability to enter into close adjacencies and create significant businesses and extract value. And we're going to keep doing that.

Thank you. Mr. Aslett, it appears there are no further questions, therefore I'd like to turn the call back over to you for any closing remarks.

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

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