Mercury Systems Inc (MRCY) 2003 Q3 法說會逐字稿

Good day and welcome everyone to the Mercury Computer Systems, Inc.

Third Quarter Fiscal 2003 Earnings Result Conference Call.

Today's call is being recorded.

At this time, I'd like to turn the call over to the President and Chief Executive Officer, Mr. Jay Bertelli.

Please go ahead sir.

Thank you and good morning everyone.

Welcome to our third quarter conference call.

Before we go any further, I'd like to remind all of you today's conference call is being recorded and it is also our obligation to let you know the risks associated with any forward-looking comments that we might make during the call.

So, I am going to ask Jack to read the obligatory Safe Harbor statement and I'll give you a brief overview of the quarter.

Jack will review the details and review our current outlook and then we'll have some final comments and we’ll take your questions.

Jack.

Thanks Jay.

Various remarks that we may make during this call about future expectations, trends, plans, prospects and performance for the company and its business constitute forward-looking statements for purposes of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements merely reflect our current beliefs, expectations and estimates and we cannot assure the future results or outcomes of these matters described in any of these statements.

Actual results could differ materially from those projected or anticipated in the forward-looking statements.

As a result, there are certain risks and uncertainties.

Such risks and uncertainties include but are not limited to general economic and business conditions, competition, changes in technology and methods of marketing, delays in completing various engineering and manufacturing programs, changes in customer order patterns, changes in product mix, continued success and technological advances, delivering technological innovations, shortages and components, production delays, performance quality issues and various other factors beyond the company's control.

These risks and uncertainties include such additional factors as are described in the company's recently filed reports with the Securities and Exchange Commission.

The company does caution listeners, in today's conference call not to place undue reliance upon any forward-looking statements, would speak only as the date of this call.

The company undertakes no obligations to update any forward-looking statements made during the call to reflect events or circumstances that may arise after the call.

Thanks Jack.

I'll give you an overview of the Q3 financial performance as was reported in the press release for those of you who may not have seen the press release.

We are very pleased with the results of the quarter.

It was a very strong performance in nearly all respects.

Revenues were 48.7 million, an increase of 40% over the prior years third quarter.

This was our 49th consecutive quarter of profitable performance and the fourth successive quarter of meeting or exceeding our guidance.

Operating income was 8.6 million representing 18% of revenues and a significant increase over the last year's Q3 with 1 million in operating income.

Non-operating income was 2.8 million.

This includes the 12th and final $1.6 million quarterly payment for the sale of Mercury's share storage business unit as well as the $1 million payment held in escrow.

You may recall that we had indicated previously the escrow payment was expected to be recorded in Q4, but we received it in Q3.

So, there will be no additional non-operating income from the SSBU, or Shared Storage Business Unit, going forward.

Net income was 7.9 million representing a 197% growth over the prior year's third quarter net income of 2.7 million.

Our earnings per share on a diluted basis were 35 cents.

This is an increase of 192% over the prior year's third quarter EPS of 12 cents.

The SSBU escrow payment accounted for 3 cents of the EPS.

We had a solid quarter in working capital management resulting in another strong quarter of cash generation.

Jack will say more about the financials in details in his comments.

The one weakness in an otherwise very strong quarterly performance was our order rates; bookings in both our defense electronics and our medical imaging business units were lower than we had anticipated.

In our defense business, we're seeing some what is delayed and reduction in the size of some orders reflecting reduced program funding for the most part.

We've seen one program canceled not having to do with our performance in any way and we are not losing business to competition.

To some extent this is the same sort of market conditions we saw with our defense business after September 11 and the beginning of the Afghanistan campaign.

I'll say a bit more about this just in a moment but let's have Jack review the details of the quarter and our outlook.

Jack.

Thank you Jay, good morning all.

Before we review the financial performance and outlook, I want to take a minute to thank all of you who participated in the recent investor's survey we conducted to share with all of our associates.

We did receive a lot of good input and one of the key takeaways from the survey was forced to continue to provide more insight into the growth drivers and visibility in the key trends for each of the businesses.

As a result of your input on many fronts, we'll continue to provide additional information in this conference call.

We did indeed have a strong quarter on all key measures the one exception, however, as Jay described was order rates particularly in defense and the result in reduction and backlog.

We'll provide a summary of revenue by Business Unit, discuss operating performance, review the balance sheet and cash flow highlights and then discuss the performance in the context of the value driver's framework.

All comparisons I'll be making will be to the comparable period last year unless otherwise stated.

In defense electronics, revenues were 34.4 million and in recognition of the continued recovery from the last year's depressed levels increasing about 95% over last year's third quarter performance of 17.6 million.

Organic growth here within defense of about 75%, occurred across each of the three application markets within defense, including RADAR, signals intelligence and emerging applications.

The balance of the growth 20% is due to the inclusion of the I/O Center of Excellence, which we acquired on April 1, 2002.

For the quarter in medical imaging revenues, there was a decrease of 43% to 8.2 million, which represented 17% of total revenues during the quarter.

The decrease in revenue was primarily due to a $ 3.5 million reduction in CT Systems and to a lesser extent to lower average selling prices in other modalities.

We expect little or no revenue contribution from the CT modality after Q4 of fiscal 2003.

In OEM Solutions, revenue doubled from a small base last year to about $ 6 million, representing 12% of our total revenues in the quarter.

The increase in revenues was due primarily to increased shipments for inclusion in Explosive Detection Systems (EDS) and to semiconductor imaging OEMs for development and testing of new semiconductor imaging systems.

Growth in this segment continues to be constrained by the continuing depressed state of the semiconductor market.

Order rates for the quarter were low within the defense electronics and medical imaging segments and resulted in a book-to-bill ratio below 1.

Our total backlog decreased to 59.8 million at the end of March from 78.4 million at the beginning of this year, but it is comparable to about 59 million dollars at this time last year.

Of this total backlog, 54.2 relates to shipments expected in the next 12 months.

Reduced order rate and backlog position has resulted in a sequential decrease in projected revenue for Q4.

Gross margin percent was 65.5 for the quarter consistent with recent experience.

Compared to Q3 of last year, margins were up 4.1 points due to increased sales volume and a higher percentage of the DEG revenue, which carries higher margins in the commercial businesses.

Selling general and administrative expenses increased to 13.4 million for the quarter compared to 11.7 last year.

The increase was due to the acquisition of IOCE, including amortization of intangibles increased head count and also to a lesser extent to cost related to the elimination of a few mid-level positions and the termination of the distributor within the quarter.

SG&A expenses decreased a 0.5 million from Q2 levels which you recall included charge related to an arbitration settlement.

R&D expenses increased 13% from a year ago to 9.9 million representing 20% of revenues for the quarter.

The increase in Q3 of last year resulted from higher prototype and development cost associated with several programs, the inclusion of IOCE as well as additional head count.

R&D expenses increased $200,000 in the preceding quarter.

Operating income of 8.6 million represented 17.6% of revenue for the quarter.

Non-operating income for the quarter increased by half a million from last year and as Jay mentioned includes the final 1.6 million payment related to sale of SSBU as well as the $1 million escrow payment, which we had expected in Q4.

And again, we want to emphasize that we will not be receiving any additional payments from the sale of SSBU going forward.

The total SSBU in coming Q3 accounted for approximately 8 cents.

Earnings per share for the quarter increased to 35 cents from 12 cents in Q3 '02.

Turning to the balance sheet and cash flow highlights, we continue to post strong performance in managing working capital during the quarter.

Our day sales outstanding were 39 for the third quarter.

This compares favorably to our target range in the mid 40s and DSOs of 53 in Q3 '02.

The primary drivers of this strong performance include sustained improvements in revenue process management as well as the linearity in shipments.

The receivable balance actually increased from what we had characterized as a very low and unsustainable level on 12/31 of 16.4 million in 31 days.

Inventory decreased to 12.1 million during the quarter that compares to 12.8 million last quarter and is down from 15 million a year ago.

Inventory turns increased to 5.6 from 3.6 turns reported a year ago and 5.2 reported last quarter.

A number of factors continue to contribute to the improvements in inventory including improved revenue linearity and continued progress of our inventory and supply chain initiatives.

We're pleased with our initial progress but still seeing an opportunity for further improvement.

Our intermediate target for inventory turns is 6 times per year.

Cash and investments increase 3.5 million during the quarter to 111 million as on March 31st.

In order to ensure compliance with regulation G we'll be discussing cash provider by operating activities rather than free cash flow in this and future calls.

We have also included a condensed statement of cash flows in the earnings release to highlight this very strong element of Mercury's performance.

In the third quarter, we generated 6.3 million in cash flow from operating activities brining a total for year to approximately 43 million.

Some repeat components of cash flow provided from the operating activities for the third quarter is as follows: Net income was $ 7.9 million, depreciation and amortization of 2.1 million, the accounts receivable balance increase as I mentioned before was 4.7 and represents a cash outflow.

We did reduce inventories by 700 thousand.

We had a decrease in other assets and liabilities, which represents the pre-paids and accruals of about 2 million and then there were other non-cash items in that of minus 1.7 million, which is the 6.3 million in cash flow from operating activities for the quarter.

Not included in that measurement is capital expenditures, which were 1.7 million for the quarter.

Also, during the quarter, we repurchased 136 thousand shares for a total cost of 4.2 million.

We do expect to make additional purchases under the program through December 2003, unless that program would be curtailed or extended by the directors.

Our head count during the quarter increased to 616 up from 561 a year ago and nine from the preceding quarter.

This increase over the last year includes 30 associates from the IOCE acquisition and the remainder of the increase is primarily R&D and selling personnel.

In terms of value drivers, we continue to make progress in our initiative to drive and monitor our performance using the framework based on value creation.

The framework focuses our attention on the key drivers of share value including sales growth, operating effectiveness, capital management and the predictability and consistency of operating performance.

This framework allows us to monitor, communicate and present our performance with a focus on the drivers of shareholder value.

Various programs have been established to improve on our performance in each of these areas.

In addition, we've established a system of dashboards and reports to monitor our performance on both leading and lagging indicators on each of these drivers throughout the quarter.

I'm pleased to report progress across each of these in Q3 in the first nine months of FY '03.

On revenue growth, we recorded a significant gain of 40% compared to a very low level last year.

Our organic growth rate was 30% with the balance being contributed by the acquisition of IOCE.

However, our order rates and other leading indicators including the book-to-bill and backlog have declined within the quarter.

Recognizing the current limited visibility to the revenue growth, we'll continue to closely monitor market trends, order rates and leading indicators.

In terms of operating effectiveness, we sustained our improvements in key drivers such as revenue linearity.

In addition, attention to key areas in supply chain and inventory management have contributed to the overall improvements in gross margin and profitability.

In capital management, as we mentioned, we continue to have strong performance in working capital management.

Our key internal metric in this area operating cash flow is the sum of DSOs and days in inventory and it was 107 at the end Q3 that compares to our historical range of 150 to 160 days.

In terms of predictability and consistency of operating performance, our efforts to improve our forecasting process, execution, and visibility in the operating performance have resulted in our four consecutive quarter of meeting or exceeding our guidance range.

We continue to work in this area to expand our visibility into the midterm.

Before I move onto our business outlook, I want to highlight a few key points from the first nine months compared to the same period last year.

Our revenues for the nine-month period were $135.8 million, that's a 27% increase from last year.

Our book-to-bill for the first nine months of this year was under one, resulted in the decrease of total backlog from 78.4 million at June 30th to 59.8 million at March 31st.

Operating income for the first nine months more than doubled to 20 million that represents 15% of revenues.

EPS for the first nine months of FY '03 was 84 cents compared to 45 last year.

A very solid working capital performance and strong cash flow, we generated 42.9 million in cash flow from operating activities in the first nine months and that's a level significantly higher than typical for the company.

Looking ahead to the fourth quarter of 2003, as a result of the book-to-bill ratio less than one for both quarter and year-to-date and the related decrease in backlog, we now expect revenues in the range of 43 to 46 million in Q4.

The midpoint of this range would represent just 3% growth over Q4 '02.

At these revenue levels operating income will approximate 12% and we estimate EPS in the range of 16 to 20 cents per share.

Again, in the fourth quarter, we will not add any contribution from the SSBU as the escrow payment was collected earlier then expected and reported in Q3.

In terms of total FY '03 performance, if you choose the midpoint of the ranges for Q4, the company expects the complete FY '03 at the low end of our previous guidance for revenues between 180 million and 185 and EPS of $1 to $1.5.

There is significant uncertainty in all of our markets due to a combination of the current geopolitical environment and a continued weakness in the worldwide economies.

Faced with this level of uncertainty, the company is not ready at this time to provide specific guidance beyond the fourth quarter.

However, we will attempt to share our insights in the trends and drivers that are likely to impact the business over the next several quarters.

Currently, the company expects FY '03 medical imaging revenues to be approximately 35 to 36 million.

This includes approximately 7 million of revenues related to the final shipments for CT systems containing Mercury content.

The company expects limited growth potential in medical imaging revenues over the near term reflecting growth and other modalities offset by the laws of CT related revenues.

From a historical perspective, it is noteworthy to recognize that shipments for CT systems reach the peak revenue level of 21 million in FY '01.

Work in other modalities since that time have offset a substantial part of this declining CT revenue.

MRI revenues are now expected to approach 60% of total medical revenues as we exit FY '03.

Within OEM solutions, the company currently expects FY '03 revenues to be approximately 20 million.

OEM solutions include three principal application areas, semiconductor imaging equipment, explosive detection systems, and other which includes digital video.

Within the companies OEM solutions group semiconductor imaging applications experienced significant growth this year due to shipments to support customer developing efforts.

In addition shipments for explosive detection systems increased as our customers responded to the increased demand for high-end systems following September 11th.

The company anticipates that the revenue breakdown for FY '03 within OEM solutions segment would approximately the following.

Semiconductor imaging about 70%, explosive detection systems about 15%, and all other about 15%.

Growth in this segment of the business will depend on the timing and magnitude of the semiconductor manufacturing equipment recovery and the timing level of our successive customers.

Our customers new products in this market.

Demand for the high-end explosive detection systems in which Mercury has designed, is expected to be down over the next several quarters from a record levels experienced in FY '03.

The company currently expects FY '03 defense electronic revenues to be approximately 125 million for the year.

Revenue growth in the defense segment will be driven by design wins on new platforms, and on new programs upgrades on existing platforms and programs successfully penetrating new emerging applications and in general increase defense funding.

As the company has previously announced, the defense electronics business unit was reorganized to provide more focus on major application markets specifically RADAR, signals intelligence, and emerging applications, which include SONAR, data exploitation, and smart tactical weapons.

The company anticipates that the FY '03 defense revenue breaks down for the following application markets.

RADAR would be about 50%, Sig.

Int. 25, and emerging would be the balance of 25%.

Within the defense electronic segments significant uncertainty exists relative to the growth drivers in the business over the next several months.

This is due to a more small part of the current war in Iraq and the uncertainty regarding its length of continued level of US involvement and related cost.

Jay will discuss this market in more detail in his closing remarks.

Again, we want to point out that we will have significant reduction in non-operating income going forward in FY04 compared to the FY03 levels as a result of the absence of any additional income from the sale of SSBU.

For the full year 2003, SSBU accounted for a total of 5.8 million in non-operating income equating to approximately 18 cents in earnings.

Recognizing the current limited visibility to revenue growth, the company will closely monitor market trends, leading indicators, and order rates as it develops its fiscal 2004 operating plan.

At this point, the planning process of the company does anticipate modest growth in revenue in fiscal 2004.

Thanks Jack.

Let me just make a couple of comments about the situation in Iraq and how we view that from a long-term prospective.

I believe that the war's progress that we've all been watching on CNN coupled with the current economic forecast are likely to have a significant implications for the Congress’ appeals with the administration's 2004 defense appropriation's request as well as future year defense program funding.

Defense platform and program funding priorities could be significantly influenced by the experience of the war.

As the DOD assesses the pros and cons of its strategy in Iraq and the effectiveness of all the systems deployed, we can anticipate continued emphasis on network centric warfare.

At the heart of this concept is the signal and image intelligence data, that must be processed and delivered to the war fighter at all levels between the various combat elements of our services in the army, navy, air force and marines, and between our allies.

Today, Mercury provides some of the computing resources and a number of these systems.

Looking forward, we are making investments in technology to meet the next generation system requirements and investments in marketing to penetrate these adjacent application areas that could significantly expand our available market.

Our management team is in the midst of its annual strategic review and operational planning activities.

In the coming weeks and months we will closely monitor the overall business environment as well as staffing expense levels as we refine our organization to better align ourselves with requirements.

As we move forward, we are determined to keep the long view in mind, to invest in our future, both people and products and to focus those investments through the wants of our customers.

With that we will take your questions.

Thank you sir.

If you will like to ask a question on today's call, you may do so by pressing "*" "1" on your touchtone telephone.

Again to ask a question you may do so by pressing "*" "1" on your touchtone telephone.

If you are on the speaker phone, please make sure your mute function is turned off to allow your signal to reach our equipment.

Once again that is "*" "1" if you would like to ask a question.

We will pause a moment to assemble our roster.

We will take our first question from Rob Stone with SG Cowen Securities.

Mr. Stone your line is open.

Please check the mute button.

Hi guys, sorry I was trying to make sure my request went through.

Jay I wonder that you could comment a little bit more, and I recognize you’re limited and your ability to address specific programs related to what customers and the ultimate customer will let you say, but in the prepared remarks you said that order rates did not develop as expected and one program was canceled, can you help us understand a little bit more what changed and when?

Well, in some instances what we saw was a delay in acquiring the equipment because the platforms that they were due to be installed in were for another activities if you will of higher priority.

They were obviously deployed over in Iraq.

So they delayed the purchasing of the equipment until such time as they knew when the platforms will be back for the upgrade of the electronics.

It does not take but a few of those to have an impact as will know on our bookings and therefore on our shipments because most of these orders or many of these orders for production systems, when we get them there substantial measured in the hundreds of thousands if not millions, so when one or two of those slip out, it causes a significant perturbation in the performance.

So, going along that line of thinking we heard the last couple of days a couple of the carriers for example have been sent back to the US.

Is it logical to assume that as equipment is taken back out of active service over there and rotated back to base that these -- these things would get back on track?

It’s logical to assume that and that's what we are -- we'll be closely monitoring and that's why we're cautious in the guidance that we provided because we wanted to be totally open with you all so that you see things almost as clearly as we do.

Okay.

Are you able to share any more light on the -- on the cancellation if you're allowed to?

Let me -- I have to go to think about that Rob.

I don't want to answer that right now.

Okay.

Question then for Jack.

The operating margins and expense control where quite impressive in the quarter you just reported, did better than I expected even though the revenue was a little bit below my model, yet the operating margins you are looking for in Q4 are quite a bit lower.

Can you give us any sense of a target range of margins that you would like to try and drive the business to -- on a full-year basis, I recognize this is going to be vary from quarter to quarter depending on the timing of revenues but as your planning between 12% or so in Q4 and more than 17, which you just reported in Q3 is a wide range, so can you help us at all there on your thinking?

Yes, first of all as you pointed out that towards the end of your comments there the operating margins or operating model contains a lot of fixed cost, so we're just very sensitive to changes in revenue level.

So, the cost management or the improved margins was really a function of the increased revenue in Q3 rather than any reductions in cost or in the quarters you recognized.

Going forward, we'll be closely monitoring the market conditions and our views of what is going to happen to the topline.

We are in the midst of our developing our FY '04 operating plans and strategic plans right now and so we will be reevaluating the operating model on that basis.

We are making no decisions on that basis.

I think we do recognize the trade off that we need to make in terms of current financial performance and also continuing to invest in the long term.

So, the 12% in fourth quarter, we would hope to improve on.

There was not a lot of runway for us there to adjust to the revenue levels, but we look to improve on that in future.

Great.

Thank you.

Again to ask a question you may do so by pressing "*" "1" on your touchtone telephone.

Paul Ventz with Capital Flows.

Jay, relative to the CT area are there are any design wins or activity in that area which might suggest that later on next year that you can eventually recapture some of that business?

We do not have any designs wins to report Paul but you can be assured that we're making the investments in the technology that is required to get back into that market space and we are -- in fact we have begun a program to actively pursue it both again from the standpoint of developing the products and also getting back into the accounts themselves.

We had, probably about a year ago now, demonstrated a back projection system utilizing few programmable gate arrays as part of a total system.

In the past several months we have been -- and answering that and in bringing it more to our product status and that's part of what we expect to use to get back into that market space.

Thank you.

Again to ask a question you may do so by pressing "*" "1" on your touchtone telephone.

Tony Hippel with Lord Abbott.

Hi, I am Tony in for Tom[indiscernible] since he’s gone.

Can you mainly help me understand a little bit more on the 12-month backlog, if the war makes things harder to get those contracts done or is this sort of a declining backlog, I mean, I missed the earlier part of the call, is there a chance for that to improve in FY ’04, and either what makes that happen or doesn't happen and if you just add more color to that?

Well the backlog is going to be a function of order rates and shipment levels of course.

So, what we experienced throughout FY03 was a very strong backlog position as we exited FY02 and as we progressed throughout FY03, particularly in the third quarter with the order rates being low, we drove the backlog down to the level that you're looking at right now.

This ties in to the point that both Jay and I have mentioned that we will be watching very closely the market conditions, funding issues, availability of assets to upgrade, etc., here in the fourth quarter to see what the order rates will be and then that will in turn predict or drive the backlog levels on forward.

Maybe in other way to characterize this, since the DOD is fighting a war in Iraq, or since a lot of that is going on, does that help push some orders or some contracts out from this quarter or not?

It's hard to -- Tony it's hard to answer that very specifically.

There are quarters, I mean, orders that move in and out of quarters that don't have anything to do with the war.

It was a significant order for example that did not come in Q3 because those are government order that was being done on the process with nothing to do with our customers delaying things.

It was the customer's customer or the auditing agency I should say that get‘s involved.

So things like that happened and that affects the backlogs in quarter to quarter.

And I guess just in closing -- how long does an audit takes since I am not inside the beltway?

Actually, that audit is done at our customer's location and delayed the funding that they would get which in turn would release the order to us, so we are not actually in that loop.

We sell through our customers on a commercial basis.

Okay.

Thank you.

Again to ask a question you may do so by pressing "*" "1" on your touchtone telephone.

Bill Benton with William Blair.

Just a quick question.

I know you said there is a significant model uncertainty in the end markets but if you could just provide a little bit more color on what you’re seeing on the semiconductor end markets?

If there has been any improvements in the visibility there, anything happening notable?

There is no improvement in the visibility in those markets that we can see.

Again, we've done well this year, but it wasn't supportive development programs and our customers as opposed to growth or recovery in the fundamental market.

Okay.

Would it be development activity you think continue at the same levels or do you think that it would require kind of a pick up at the end market to have much improvement there?

We expect to see some improvement in that market space over the next several quarters as they move from prototyping systems-- to the development systems to some early stage of production.

There obviously are new fabs being built and retrofitting of some of the existing fabs in order to get into the next generation products, so some of that is being done.

The -- our ability to see a dramatic increase in the growth rate there is a function of the semiconductor industry turning on and growing that -- at more than the current rate.

So, I think we're well positioned and we do expect some growth there.

It's not going to be as dramatic as we had anticipated 12 months to 18 months ago.

And if you could just clarify again, did you say that there was 7 million in CT shipments and 35 million or 36 million projected on the medical side?

Yes, for fiscal '03.

Okay.

So we can assume that this quarter that was a decreased amount from the first two quarters and that it’s a relatively modest drop off to the 4Q.

You can assume that, that's decreasing each quarter and will line down in Q4 or Q3.

Okay.

Thank you very much guys.

Again to ask a question you may do so by pressing "*" "1" on your touchtone telephone.

Bob Minarik with Arbor Capital.

Good morning gentleman.

Hi Bob.

A question regarding the defense revenues.

Due to late authorization, do you anticipate any budget flush or accelerated spending in the remainder of the fiscal year?

Bob there was some static on the line.

I didn't get all of that question.

Would you mind repeating it?

Sure, sorry.

Due to the late authorization of funding in the DOD, would you anticipate any budget flush in the remaining two quarters of the government's fiscal year before the yearend or you think to hold on those funds?

I can't answer that Bob one way or the other.

I am not sure whether we'll see any spending at the end of September here just because it's in the budget or not.

Time will tell.

I can't answer that.

All right.

Again to ask a question you may do so by pressing "*" "1" on your touchtone telephone.

Gentlemen, there appears to be no further questions at this time.

Okay.

Thank you very much.

Thank you all.

This does conclude today's conference call.

At this time, you may disconnect.