Mercury Systems Inc (MRCY) 2004 Q3 法說會逐字稿

Good day, everyone.

Welcome to the Mercury Computer Systems, Inc. third-quarter fiscal 2004 earnings results conference call.

Today's call is being recorded.

At this time for opening remarks and introductions I would like to turn the call over to the VP of Investor Relations, Diane Basile, please go ahead ma'am.

Thank you.

Good morning everyone and welcome to the Mercury Computer Systems third-quarter 2004 earnings conference call.

If you've not received a copy of the earnings release, you can find it on our website www.MC.com or on the First Call network.

We would like to remind you that the remarks we may make during this call about future expectations, trends and plans for the Company and its business constitute forward-looking statements for the purposes of the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated.

For a discussion of these risks and uncertainties we refer you to the Company's reports filed with the Securities and Exchange Commission, including the Company's quarterly report on form 10-K for the year ended June 30, 2003.

Further information regarding forward-looking statements and risk factors is included in the press release we issued today reporting the company's third-quarter results.

We caution listeners of today's conference call not to place undue reliance upon any forward-looking statements which speak only as of the date of this call.

We undertake no obligation to update any forward-looking statements.

I am now pleased to turn the call over to Mercury's President and Chief Executive Officer, Jay Bertelli.

Good morning everybody, and thank you for joining Mercury Computer Systems third-quarter earnings conference call.

We have not changed our VP of Investor Relations.

We do still have Diane Basile with us as opposed to the spice basil.

Also with me on the call today is Bob Hult, our Chief Financial Officer and Joe Hartnett, our Corporate Controller.

At this point I would like to briefly review the third quarter results and then turn the call over to Bob to provide the additional financial details for the quarter.

I will then come back and summarize before we open the call to your questions.

First a few comments on an acquisition announced earlier this week.

On Monday, Mercury announced an agreement to purchase the TGS Group, a leading supplier of three-dimensional i.e. 3-D image processing and visualization software to diverse end markets including life sciences, which for us means medical imaging and biotechnology.

Geosciences, which means oil and gas exploration; and simulation, both for commercial and defense purposes.

The purchase price is approximately $18.5 million consisting of $6 million in Mercury common stock and the remainder in cash.

We expect to complete it in the fourth quarter of our fiscal 2004.

This acquisition will enable Mercury to enter high-growth 3-D imaging markets, particularly in the life sciences arena far more rapidly than we could have if we developed these capabilities internally.

TGS also gives us inroads into new applications in defense and medical imaging, such as simulation, (indiscernible) rendering and micro CT.

And it is an enabler in new markets such as geosciences, which is oil and gas, biotechnology, genomics and molecular dynamics.

This acquisition is also the catalyst for changes in our current organization.

Because 3-D imaging is quickly becoming the accepted standard for many medical procedures, we are uniting our capabilities and medical imaging and visualization under a common umbrella organization that we are calling the Imaging and Visualization Solutions Division.

Now Mercury has a bigger story to tell in our existing markets where we can offer a broader integrated solution in areas such as medical imaging and data exploitation, and more to offer in new business areas where we don't sell hardware today.

The imaging and visualization solution team continue to sell current Mercury products, as well as TGS software solutions to our medical imaging customers.

They will also continue serving current TGS customers.

IVS will also develop new products based on Mercury's and TGS' combined resources.

So to sum up this topic we believe that our acquisition of TGS will quickly lead to benefits for our customers and help us expand our offerings into markets where TGS is already active.

We can assure you that we are already hard at work in developing the potential revenue synergies.

Also as soon as the deal is completed we will implement the organization changes and process improvements that have been developed.

We will also begin the development of products resulting from the product planning efforts have already taken place by the combined teams.

The acquisition of TGS fits in with the overall acquisition strategy that we have talked about where we are not necessarily looking for top line revenue growth, not that this won't add to it, but rather looking for intellectual property that when combined with Mercury's core capabilities will enable us to deliver a superior integrated solution for our customers.

I believe these efforts will enable the IVS division to grow at a rate greater than the overall company growth rate.

As you can see from the press release we issued this morning, we marked our 53rd consecutive profitable quarter.

I am also pleased to report that backlog increased to $82 million, marking the third consecutive quarter of backlog growth.

And the book-to-bill for the quarter was greater than one.

Revenues came in within the guidance range of 45.4 million and operating income was strong at 8.3 million or 18.3 percent of revenues.

Earnings per share were 29 cents.

The end of the quarter with a balance of cash and marketable securities of $129 million.

We made good progress against our strategic objectives, continuing to be a leading innovator, operational effectiveness and organizational development.

Relative to the organization I am pleased today to introduce the newest senior member of the Mercury team, Bob Hult joined the organization during this quarter as our Chief Financial Officer, and he will discuss our third-quarter results in additional detail.

I will now turn the call over to Bob.

Thank you, Jay.

Good morning, everyone.

As you heard from Jay I have recently joined the Mercury team as Chief Financial Officer.

I look forward to working with Jay and the team and certainly excited to be a part of Mercury.

Before I get started, I just wanted to thank Joe Hartnett, our corporate controller who is here with us this morning.

It is solely I think due to his efforts that I am able to get on the call here this morning and share with you the results.

Joe has been great getting me up to speed.

Thanks, Joe.

This morning I will be reviewing our third-quarter performance and our business outlook for the fourth quarter of 2004, which ends on June 30.

After an overview of total company third-quarter financial performance, I will discuss revenues by business unit and then detail total company operating performance.

I will then follow with the balance sheet cash flow results for the third quarter.

Finally, I will also give you some guidance relative to the fourth quarter and more generally, our preliminary thoughts on the 2005 fiscal year.

As you may be aware, we are now in the process of building the 2005 operating plan.

We expect to provide much more granularity as is our practice during the year end earnings call to be held during July.

However, we want to be responsive to your request for high-level contents prior to that call.

To begin let me summarize our third-quarter results as reported earlier this morning.

Third quarter 2004 revenues were $45.4 million, which was at the lower end of the range of expectations for the quarter.

Operating income for the third quarter was $8.3 million or 18.3 percent of revenues.

Relative to the previous quarter these operating results reflect the flow-through of almost $5 million of incremental revenue at consistent gross margins while maintaining flat operating expenses.

Earnings per share for the third quarter were 29 cents, which is at the upper end of our guidance range provided on the last quarterly call.

Two points regarding the earnings per share.

The third-quarter earnings results reflect the impact of a 27 percent tax rate for the third quarter, primarily as a result of our ongoing tax planning efforts.

We expect the tax rate for the fourth quarter and full fiscal year to approximate 29 percent.

And secondly, as you may recall, the third-quarter results of last year included $2.6 million in gain on the prior sale of a division.

For the third quarter we reported operating cash flow of $2.7 million, bringing year-to-date operating cash flow to $20.6 million.

This solid cash flow performance reflects the continuation of our operating effectiveness initiatives and process efficiencies, which I will describe in greater detail later on the call today.

Turning to the third-quarter specifics, I will now review revenue by business unit.

Please note that all comparisons are to the third quarter of fiscal 2003.

Our Defense Electronics Group reported revenues of $26.7 million or 59 percent of total revenues for the third quarter.

This represented a decrease of approximately 22.5 percent from the same period last year, primarily as a result of customer order patterns and program delivery dates.

In contrast, and as a data point which confirms the lumpiness of customer order patterns, I would note that our defense business again experienced a strong bookings quarter.

Our medical imaging revenues were $9.4 million, representing 21 percent of total revenues in the current quarter.

This represented 15 percent growth relative to the same quarter last year and was driven by increased business in digital x-ray applications and shipments of our magnetic resonance imaging MRI modalities.

Our OEM Solutions Group reported record revenues of $9.3 million or 20 percent of total revenues.

This was up $3.2 million over the third quarter last year.

This increase was driven primarily by growth in applications serving the semiconductor market, offset by slight declines in applications serving the high-end baggage scanning market.

For the third-quarter revenues related to customers utilizing semiconductor applications represented approximately 88 percent of total OEM revenue.

Total book-to-bill ratio was greater than one for the company.

Total backlog at the end of the third quarter was $81.6 million, up 6.9 million from 74.7 million reported at the end of last quarter and up 24.3 million since the beginning of our fiscal year.

Significantly, this represents our third consecutive quarter of reported backlog growth.

Backlog is one of the more important leading indicators of future revenues.

As we regularly point out, specific quarterization (ph) of related revenues is subject to customer funding patterns, but the ending backlog, $69.5 million relates to shipments expected within the next twelve months.

Gross margins.

Gross margins, gross margin was 66.0 percent for the quarter up 50 basis points from the same quarter last year.

These strong results reflect a favorable program mix within the defense business despite the lower expense revenue contribution.

In general the defense business generates higher margins than our commercial businesses.

Year-to-date gross margins are 65.5 percent.

Operating expenses were $21.7 million for the quarter, reflecting a decrease of 1.7 million from the same quarter last year and essentially flat with the previous quarter.

We continue to monitor key metrics in order to maintain an appropriate operating expense cost structure relative to revenue growth expectations.

During the quarter operating expenses were comprised of SG&A expenses of $12.5 million and R&D expenses of $9.2 million.

Our associate population at the end of the third-quarter was 575 or essentially unchanged from the beginning of the year.

Operating income of $8.3 million represented 18.3 percent of revenue for the quarter, an expansion of 540 basis points from the previous quarter.

Relative to the same quarter last year, operating income expansion was driven by the previously mentioned operating cost initiatives coupled with gross margin expansion.

Net income of $6.3 million was 13.9 percent of revenue, down from 7.9 million in the third quarter of last year.

Please note that last year's net income included approximately $2.6 million of non operating income related to the sale of the SSBU (ph).

Turning to the operational cash flow and balance sheet performance, Mercury ended the third quarter with approximately $129 million in cash and investments.

This reflects an increase of almost 2 million over the previous quarter and an increase of 18 million over the same quarter last year.

Third-quarter capital expenditures were approximately $1.4 million.

During the quarter cash flow from operating activities was $2.7 million, bringing the year-to-date cash flow from operating activities to 20.6 million.

Third-quarter cash flow from operations was comprised of $6.3 million in net income and 2.7 million of depreciation, amortization and other non-cash items offset by a $6.3 million increase in working capital, resulting primarily from an increase in accounts receivable.

Third quarter days sales outstanding or DSO were 56.

This metric reflects heavy shipments in the final months of the quarter.

The increase in DSO was partially offset by continued progress on inventory and other supply chain initiatives.

Inventory turns were 8.1, up from 6.5 in the previous quarter and significantly up from 5.6 in the third quarter of last year.

In summary, we again delivered solid financial results during the third-quarter operating expense controls allowed gross margin to flow directly to operating margins, and we continued to post positive cash flow.

Before I turn now to the outlook section of my presentation, before I discuss the total company outlook, which includes the impact of the TGS acquisition let me take a minute to address the anticipated impact of TGS specifically.

We have included the impact of the TGS group in our company projections for both the fourth quarter and 2005.

The TGS revenue run rate is approximately $2 million per quarter.

We expect to complete the acquisition later during this fourth quarter, and depending on the timing of the deal close we expect that TGS would contribute approximately $1 million to the fourth quarter top line, with little to no impact to the bottom line.

Relative to fiscal 2005 we expect the deal to be accretive for both the second half and the full fiscal year.

Now I will turn to our business outlook for the fourth quarter of fiscal 2004.

For the fourth quarter of fiscal 2004 we project revenues to be in the range of 54 to 57 million; at these revenue levels we expect fourth-quarter earnings per share to range from 39 to 43 cents per share.

This earnings projection assumes a 29 percent tax rate for the fourth quarter and for the full year.

We expect gross margins of 66 percent for the year and full-year operating expenses are expected to be approximately $90 million.

Note that the fourth quarter operating expenses are anticipated to be higher than the third quarter due to projected seasonal charges primarily related to compensation.

Regarding fourth-quarter working capital metrics we project that DSO will be in the low 50s and inventory turns will remain in the range of eight times.

We expect CAPEX to be consistent with previous spending levels which would approximate $1.5 million for the quarter.

Looking ahead for the fiscal 2005 year we expect revenue to be in the range of 220 to $230 million.

At these revenue levels we anticipate fiscal 2005 gross margins in the range of 64 percent, primarily due to projected revenue mix.

We expect operating income of approximately 16 percent, and a tax rate of 30 percent for the year.

As we have indicated, we are currently in the process of building out our 2005 operating plans.

We will provide additional granularity at our year end conference call.

I would now like to turn the call back to Jay for his additional remarks.

Over the third quarter Mercury has delivered on its premise of technology leadership and innovation for our customers.

Mercury introduced the RapidIO based power stream 7000 system, which provides up to a (indiscernible) processing power and 75 GB per second of data bandwidth in a military deployable form factor.

We are on track to ship the first of these new systems within the next few months.

And we can report strong interest in them from multiple high-end airborne radar programs.

All these systems will ultimately fly on several different aircraft types; the common denominator is the need for extreme processing and data handling capabilities in a small, rugged form factor that fits in the small spaces available in different aircraft and can survive the environmental extremes ranging from desert heat to Arctic cold that these aircraft must operate in.

We have also seen great interest in our other RapidIO based system, the ImpactRT 3100.

This system is designed for commercial environments, and in addition to sales for semiconductor inspection applications, we announced in March that Micronic's has selected the ImpactRT 3100 for use in designing flat-panel displays.

There can be no doubt about the size of the flat-panel market.

As everything that once used capital grade tubes is migrating to this technology.

But while the opportunity in this space is significant, the bigger news is how our OEM applications business unit continues to cultivate new market areas where Mercury products add value.

Micronic's sale is one more demonstration of how Mercury's innovation in this case extreme performance, I/O capacity and data bandwidth, grows out of the medical and defense spaces to satisfy the needs of many emerging opportunities.

As products grow in complexity and decrease in size, the demand for real-time generation and inspection of high-precision components will increase, building additional demand for the real-time image and signal processing solutions that Mercury delivers.

Our focus on packaging and solving customers' problems is also the force driving our new future combat systems technology office.

The Army's future combat systems program started as a replacement for the Abrams Battle Tank that has grown into an overall vision of how land combat will be conducted in the future.

The backbone of the FCS program is using information as a force multiplier that allows smaller, more agile and lightly equipped forces to overwhelm much larger but less sophisticated forces.

This data intensive strategy relies heavily on real-time processing, fusion and communications of high-resolution sensor information, areas which are core capabilities for Mercury but not for most of the 300 plus companies participating in the FCS program.

Our strategy here is to reach out to these companies with our innovative product and service portfolio and form relationships that may range from (indiscernible) product sales to system integration solutions.

The FCS technology office was announced in early March and has received enthusiastic responses from several FCS bidders.

In our business we focus more on capabilities than platforms.

In this sense the capability is the solution for the customer.

In the case of the military the solution may be a radar signal processing system and our customer might be a prime contractor such as Northrop Grumman or BAE Systems.

Ultimately the customers product is installed into a military platform which is a truck, a ship or an aircraft such as an F-16 fighter, class of Navy frigates, or a future combat systems vehicle.

So as Mercury continues to deliver new opportunities in the defense market, we are constantly looking for opportunities to leverage our core competencies across new markets.

For example, I fully expect that the 3-D rendering capability of the TGS software will be applicable in defense surveillance applications when deployed on a real-time heterogeneous multicomputer from Mercury across a wide range of military vehicles.

As we continue to diversify our portfolio of applications in markets, and grow our commercial businesses to be a greater percent of our total business, we will do so by continuing to leverage our unique capabilities across these various markets.

Our FY '05 projections of 220 million to 230 million takes into account some of the revenue synergies we expect to realize from the TGS acquisition, plus more robust expectations for growth in the semiconductor and specialty market and also growth in our defense business.

That concludes the prepared remarks.

I will now open up the call for questions.

(OPERATOR INSTRUCTIONS) Sasmit Dwivedi with Sterling Financial.

Good afternoon, everyone and welcome to the call, Bob.

Great job for your first call.

Let me start off with a quick clarification first and then I have a couple of questions, on the tax rate side obviously the (indiscernible) this quarter came in significantly lower than what I was modeling.

And I guess even for the year slightly lower and it seems to go back up slightly from 29 to 30 next year.

Can you help us understand what is going on in that side?

This is Joe.

I am going to take that question.

We did some tax planning throughout the year, and we feel that the effective rates for the full year is going to be 29 percent; as a result in the third quarter we recorded 27 percent to get the full nine months up to that 29 percent.

Going forward we don't feel that is the effective rate in FY '05.

We feel it's more appropriate 30 percent.

If you look at the last couple of years the tax rate of Mercury has fluctuated between 29 and 31 percent, so we do not view that as unusual but we did take the benefit of some onetime tax planning opportunities.

That's fair.

I guess longer-term and maybe this is more appropriate for Jay to comment on, I guess if you're thinking about planning the business longer-term obviously there's an element of diversification that you need to be sensitive to in terms of wanting OEM solutions and medical imaging life sciences side businesses to be a source of strength, just as much as defense has been in the past and yet obviously there's a margin played off there in terms of, for example your guidance for fiscal '05 would imply higher growth in those lower margin businesses.

So I guess what I am trying to get at is as you think about those trade-offs, diversification say versus gross margins, where do you think ideally you would like to see Mercury say a couple of years out?

Well, I think we need to shift the focus on the gross margins to the net margin.

And we really believe that as a result of the business opportunities that we're seeing in commercial while they may have a lower gross margin, which we know because we've been experiencing that all along, the increase in the commercial business will have some impact on lowering the overall company gross margin.

But the goal obviously is to work on the net margin, and we firmly believe that as a result of the ability to address larger volume opportunities in the commercial markets, with a relatively small sales force if you will, and to leverage the R&D investments that we are making across the various markets that we will be able to produce the net margins that are important.

That's fair.

I guess on the same note looking forward to fiscal '05 guidance if I just do a quick back of the envelope based on what you said today, and I know you are still in the build up process for '05 operating plan, it would imply operating expenses roughly at 48 percent, at a revenue level of about 225 I would say at the midpoint of the revenue range, right?

So then if I do the math right it would imply your operating expenses are growing roughly at the same rate as your revenues for the year.

So in other words am I reading this right, that you're being conservative because you are early in the operating plan, or is their lesser operating leverage as you start growing revenues because there are some other elements that you haven't discussed yet?

Let me jump in there, it is Bob.

I do not think we are necessarily being conservative, but you are very accurate when you say that we're still early in the planning process.

We complete the planning process at the end of the quarter.

I am not dodging the question but I think we can get at that in a lot more detail when we share our plans by business unit here in the July time frame.

But I wouldn't label it conservative.

I would say its what we are looking at early in the process, and it is primarily mix when you focus on gross margin.

But I really want to reinforce Jay's comment that we tried to bring it altogether at the bottom line.

I guess that's what I was trying to drive more at also, is that relative to say 17 percent roughly which is where you will fall out in '04 -- I guess 16 percent would be a decline relative to some very robust top line growth you are looking at.

So I was just hoping for a little more clarity but I guess we could probably get that at the next quarter earnings call.

Absolutely.

All right, thanks a lot.

Bill Benton with William Blair.

Just a couple of questions.

On the defense side obviously it was a little lighter than you thought it might be.

I know you talked about some shifts there.

Could you give maybe a little bit more granularity into what may be happening there and similarly on the OSG side, obviously much stronger?

Maybe if you could provide some granularity into how many design wins are currently in production and at what stage, just to give us some sense of how that is progressing.

On the defense side, as you know, it is not easy for us to forecast when the business is going to come in for various reasons.

And last quarter was no exception in that there were some major opportunities that we have been working on for several months that we certainly had expected to be in by now, and that we would have realized some revenue in the last quarter from it.

They slipped out, and we certainly believe that we're going to bring it in this quarter.

One of the reasons why you see the revenues up to where they are 54 to 57 million for Q4.

So it is the lumpiness of the business, if you will.

But there were no losses in that defense space.

As far as the OEM business is concerned, I don't believe that there are any additional design wins that have gone into production.

It is simply the ramping up of the design wins we already have as a result of the increased demand in the semiconductor space.

Okay, I think last time we checked in there were something like four, I think you may have mentioned last quarter that were in production.

Does that sound about right, of the 13 or so that you had?

Bill, I'm not sure.

I can't respond to that number.

I do not have it here in front of me.

Maybe to go back a little bit to that question before, I know you said that the expectations in terms of operating margin might not be -- you wouldn't view them as necessarily conservative.

I guess you are probably looking for some defense revenue growth obviously next year and I understand that the margins in the other businesses are a little bit lower, at least on the gross margin line.

But I think you are a little over 18 percent this quarter and the fourth quarter seems to suggest a number that is greater than 20 percent in the operating margin line.

Probably.

And so are you planning on any significant change in terms of the investment line?

I know at the inoperating (ph) expenses that you might offer a little color on.

The operating model that we use and have used for some time has a 15 to 17 percent operating income range as a percent of revenue.

That is the model.

Sometimes we do better than that, sometimes much better than that for various factors.

But that is the model that we have built our plan on.

Okay, so you're not looking at any significant change in the investment structure that you want to talk about today in terms of opportunities?

No.

Okay.

Thanks a lot.

Rob Stone of SG Cowen.

Jay, on the addition of a software business which sounds intriguing in driving new business market opportunities in current and new markets, I guess it won't be that big a share of revenues this year at a couple million dollars a quarter, but is the addition of a pure software segment something that could ultimately help to lift the margin profile somewhat in your commercial business segment?

Defense is already fairly high margins, but several of the segments you mentioned for the acquisition would fall into the medical or other OEM areas.

We would certainly hope so, Rob, but given the fact that we haven't even closed the deal yet even though we have done a lot of work on it, we are not ready to project what we are going to see for margins in that business.

We see the revenue synergies but we are going to have to work on the overall synergies in order to be able to realize higher margins in that software only business as you point out.

But the real reason for buying it is not just the software revenues.

It is the synergies that we see by taking, being able to take that software and make it usable, if you will in areas that require high-performance computing so that people get the answers in minutes as opposed to hours.

So that is the basis for this is to be able to take that software and to be able to operationalize it on our multi computing platforms.

Is it fair to say that the gross margins on the software only part certainly are higher than the gross margins that you typically see in your medical and OEM solution segments?

Yes, it is.

Okay.

Second question related to the acquisition.

Do you see more opportunities during fiscal '05?

Obviously I don't assume they are baked into your preliminary guidance, but would you care to handicap the prospect for doing another acquisition sometime during the fiscal year?

We've been, I believe, reasonably active for the size Company we are in this space looking for ways to enhance our capabilities to deliver solutions across the various markets that we're in.

And so there are other opportunities that we are looking at, but we are obviously not ready to announce any deal.

But you're still actively looking?

Absolutely.

Great.

Thanks very much.

Peter Lu (ph) with Lu Capital Management.

Jay, over the long-term I have been extremely impressed with your management capability, but you and I are about the same age, and I'm just wondering how long can we have your services?

Well, Peter, I'm still having fun.

And I've got some personal objectives here.

I turned 64 today, by the way.

Today is my birthday.

Well, happy birthday.

Thank you, thank you.

I'm still having fun.

I've got some personal objectives to get this company up to 500 million, and I certainly believe that with the organizational structure that we've put in place, with the focus on external growth through acquisitions that we are going to get there before I step down.

Peter Lu That's about two years, three years?

You are not going to pin me down, Peter.

But I should also add that we started a couple years ago at the Board level to put a succession planning process in place.

It is an activity that is addressed at every Board meeting, and I believe that the Board is in sync with what we're doing here obviously, and is I believe willing to give me at least another year or two here to keep this company growing.

At the same time recognizing that we will need to bring in or promote talent that already exists here to take over.

Peter Lu When I read the language of the press release and then I saw the stock opening down $2.44 I'm saying either we investors don't understand what your company is about, or there is some kind of a message that is being skewed.

Maybe you can give us your perspective; based on my rough calculations you are going to have top line growth next year of almost 25 percent, you continue to generate cash and granted that your margins are dropping, we know that is primarily a result of a mix shift.

So how should we look at you in terms of your growth prospects going forward?

Because obviously this heavy selling suggests that there is something in the near-term very disappointing.

Well, I guess I would look to you and the other analysts out there to help us understand why, what's happening out there.

I certainly can't figure it out.

We have I think a very, very good quarter.

We've got positive news in terms of this acquisition, which I think is a fantastic addition to Mercury and yet the market reacts negatively.

So I've given up trying to project the market.

But I can tell you that I firmly believe that we have been relatively flat for the last couple years, and we are coming out of that.

The defense business people I think were expecting to see revenue growth in the defense business, probably going back even a couple years ago as a result of the increase in defense budgets.

But as I said all along it takes a couple years from the time the monies are appropriated by the Congress before it flows down into programs that we are participating in.

So I do think that we are starting to see the benefit of some of that now and that should continue for the next few years.

I guess what I am looking for -- I recognize that the margins are eroding and maybe you've probably done this calculation in your planning -- what kind of growth rate do you have to enjoy in order to offset the approximate 2 percent erosion in gross margin?

So that you can net out with a gain?

That's a good question.

I don't have the answer here at the top of my.

Peter Lu Because if you grow at, if you grow at 24 percent and your tax rate goes up by two percent and you are losing 2 percent on your gross margin, I haven't done all the calculations, but that would suggest fairly marginal net income growth.

And if you could sort of give us a sense of how much your earnings can grow, not withstanding the profit pressures then we would have a better understanding.

Maybe the market is reacting to the prospect of very modest net income growth, notwithstanding fairly respectable top line growth.

Peter, it's Bob.

Kind of jumping in here as a two-month guy.

Your point is intriguing, but I think it is as we represented and you've picked up on, our initial guidance here for '05 has got very solid top line growth coming off a period of -- if I stand back far enough from it, a few years of flatness.

The gross margins, the initial pegging of gross margins at 64 percent certainly in the range of our model 64 to 66, we are referencing some mix shift between our commercial businesses, which are doing very well of late in our defense business, which also by the way is growing here and will continue to grow in '05.

And I think on a preliminary basis we've positioned the bottom line at 16 percent with a good tax rate, one that is actually improved.

So the three of us are kind of sitting here wondering exactly what is your point because we're certainly trying to dial the growth in, not just on the top line, but get it through to the bottom line, and to me, again the (multiple speakers) --.

Are we talking about 16 percent net or 16 percent operating margin?

16 percent operating margin -- we don't have significant non-operating activity, so you would take 16 percent of the midpoint of the range is a pretty healthy number, and a 30 percent tax rate you are going to have a pretty good increase at EPS year-over-year.

That's the calculation that we've done here internally.

Right.

So where I was going, Peter, was certainly one of the early observations I made joining Mercury was the ability to get it through to the bottom line is a core competency here.

So we've got to complete our planning certainly in the next 90 days, and we'll be back on the call here at year-end diving into a bit, but I am encouraged by what we've put out here as early guidance, very encouraged actually.

You've just joined the company, but I remember about four years ago the company had a big increase in R&D and ended up with net operating margin of 17 percent.

And some people were disappointed in net operating margins of 17 percent, and most companies would kill to have a 17 percent net operating margin.

But what we've seen here is a consistent deterioration in the operating margin.

And my point is for technology investors -- and you are regarded as a technology company -- when there is over 20 percent top line growth, we expect margin expansion, not margin deterioration.

So that is the point, just in case you're missing it.

That is why your stock is going down.

So you've got to have a clearer message on why the margins are going down and how that is constraining net income growth and what you can do to offset that.

That's my point.

And I know that you think we are crazy, but the market in the long run is more right than wrong; in the short run there (inaudible) understanding.

To the contrary.

So I think what we've tried to layout here is a set of (indiscernible) numbers for '05 and I think as you understand our points, we understand yours.

Peter Lu Thank you, Bob.

Paul Meeks with Meeks & York.

I guess a lot of people are tiptoeing around the issue; the previous questioner got to it but what I see and I'm a supporter of the stock lower, what I see is a couple things.

The DSO's jumping, revenues missing and both of those things happening in the new CFO's first couple months on the job.

And the business model that just like everybody else has said, you are indicating doesn't scale, which I do not know if I want to be a $500 million company, Jay, if this is what happens.

And even with gross margin and my model very quickly from this fiscal year to next, going down almost 200 basis points, you would still have to have operating expenses go to almost $110 million from 80 some odd million to get to your 16 percent.

So hopefully there is a little sandbag or hopefully there's a little bit clarity once you actually get to the planning process.

Maybe you shouldn't put out that guidance without going through the planning process because it does show that expenses increased at the same rate of sales.

And so I don't (inaudible) not a good thing.

But that is just a comment so you guys understand what happened to your stock today.

But my question is, first of all, what do you plan to do with this almost six dollars of net cash per share, and another question I had on the cash line, because I feel like on top of everything else, in the operating cash statement or actually the finance cash statement you hit a couple of metrics.

But under other net, you have in the first nine months, a cash outflow of 3.9 million.

Can you specifically break that down for me so I can have better knowledge as to what is operating and what is free cash?

The 3.9 million was, as we described on our last call, purchase intangibles and that is an advance payment for the acquisition of TGS.

So going forward there will none of that?

Going forward there will be more of that when we complete the acquisition of TGS.

So if you go to the TGS press release we are looking at 12.5 million of cash, and 6 million of stock, so there's probably another 9 million that is going to have to go out within the quarter on that line.

What would you expect that figure to be, Joe, for fiscal '05?

That is a tough one to do because when you get into the other, that's the acquisitions.

As we said earlier, we haven't taken the acquisitions into the planning process at that this point.

So I would expect the 9 million outflow in addition to the 3.9 million year-to-date in this quarter that we are currently in?

Yes, Paul.

So I will just plan on that.

And the other stuff?

About the cash, almost six dollars net cash per share, your stock is going to be down today.

What is your plan?

Doesn't seem that you do acquisitions that are too large and too much of a cash drain.

Well, we are again continuing and have been looking at other acquisitions, and I expect that we will use some of that cash.

But how much of it, whether it's cash or stock or what the combination is will depend upon what we have to do to get the best deal.

No near-term plans to buy back stock?

We have a stock buyback plan in place that was authorized by the Board some time ago.

We have not been executing on that for the last couple of quarters.

Our stated objective with that is specifically not to try and prop up the price of the stock.

It's simply to offset dilution as a result of options being exercised and we've done that.

Okay.

I hope it didn't insult anybody, but that's exactly what the Bear is going to point out today when you guys are wondering why your stock is down.

I appreciate the input so that we can help understand it from the investor perspective.

Sure.

Good luck, guys.

Steve Levenson with Advest.

Curious about the research and development spending going forward.

Do you expect it will continue at a similar percentage level of revenue or at a similar dollar level?

And we've always said, Steve, that R&D is a cornerstone of our business, it is approximated 20 percent plus or minus a point going forward, we would expect that to be within our long-term range.

And that is what we've baked into the FY '05 preliminary guidance.

Okay, thank you.

And secondly, yesterday at the hearings relating to 9/11 there were some comments made that it is going to take another five years to have the kind of clandestine intelligence service our country needs.

With your sales into signal intelligence and signal processing equipment providers, how do you think this is going to affect you going forward?

We are currently not participating in any of the homeland, what has been called the homeland security initiatives.

We are looking at opportunities there, but there is none of our business that we either currently have or projected to have that is coming out of that budget, if you will.

This more relates to the NSA budget which is part of DOD.

Yes.

Well, it's hard to tell where all of the intelligence dollars are coming from.

They are all over the place.

We are growing our Signals Intelligence business at a rate greater than other business within the defense space.

And I think that some of that is as a result of what has happened over the last few years.

So we see continued good growth opportunities for the SIGINT space.

Thanks very much.

Duncan Stewart (ph) with (indiscernible) capital corporation.

Just a little more color if possible, on the defense side.

You commented that it was late, a little light due to a couple of orders that slid.

Where these orders that were perhaps sort of at the normal quarter end kind of thing and you're trying to close them by the 31st and they slipped.

Or is it more that it was perhaps a couple of customers that you thought were going to show up earlier who showed up later, and if so can you quantify?

Was this one single order, or was this 10 or 15 spread across?

It was more than one, but it wasn't 10 or 15.

And their orders which it was not like we expected them to come in at the end of the quarter.

There has been some extensive contract negotiations going on between our customer and the government, which resulted in the delay of a major program for us and for our customer, which we hopefully will be able to announce this quarter.

And there was another one in there, too, that resulted in our not being able to take credit for at the last quarter and ship revenue last quarter because of delays in the contracting process.

Simply contracting process delays.

None of this was due to price or product shift that we were not meeting technical specifications, not anything like that?

No.

Thank you.

Bill Benton with William Blair.

Just a couple of follow-ups.

First Jay, I presume that your birthday wish may have something to do with the Red Sox.

You are not going to let me forget about that Red Sox thing.

I had a question I guess on the -- I know it's early in your forecast.

Historically you've relied on commercial forecasts for the OSG and the medical side.

Do you have those available now to rely on them in terms of kind of what you provided as kind of a preliminary estimate?

We certainly have our view of all three markets being the medical or the new IBS, as we're calling it, the OEM Solutions Group and defense.

So they have all been factored into the projections that we've provided.

Okay, and you are projecting defense growth, and is that at all I guess as you look at the defense growth -- I know you do not want to talk about specifically next year, but can you provide any context as to kind of where you expect that segment to grow kind of a longer-term basis?

Is there any target you kind of shoot for there?

Well, if you go back to the investor conference Bill that we held last November, I think we probably provided some reasonable numbers at that point in terms of what we saw for the available market.

And I believe that what we were looking at then was roughly a $400 million available market growing over the next three to four years as a result of some of these new programs, such as this future combat system or FCS program to somewhere closer to $1 billion.

So there are new opportunities that are opening up for us as a result of new optics if you will, we are putting on what kind of business we want to go after, not just the high-end synthetic aperture radar platforms, but other business opportunities that don't require maybe as much processing power, but are higher volume.

If you look at it from a platform standpoint there is only so many aircraft that are using synthetic aperture radar flying around.

There is a limited number of them, but there is a lot more vehicles, so whether they be Humvees or other ground vehicles that could utilize our equipment as a result of the FCS activities and also in the software radio space.

So we are much more bullish longer-term on opportunities in defense than we are over the next year or so.

Okay, around the merger, the subject to certain closing conditions, is there anything there that is of significance or is it pretty standard?

And then you talked about obviously harnessing some of the benefits of the merger product development time shrinking.

Could you talk about maybe if you could provide some color around that?

And then also where you may look on the defense side in terms of exploiting this technology?

The closing issues?

There are none.

(multiple speakers)Okay.

A catchall comment.

I am familiar with those.

And the other part of the question Bill had to do with are we going to be able to leverage this capability into the defense space.

Is that what it was?

I guess, a couple of things you talked about reducing product development times as somewhat of a key advantages in terms of taking the software platform and hardware, if you could provide some quantification of that?

Presumably you're referring mostly to the commercial side of the business, on a medical side.

And then today at least.

And then defense side you talked about opportunities there in terms of even though today it is more about the medical side, where do you see kind of the defensive side playing and where do you see the bigger picture there?

Let me turn that around a little bit.

The initial thrust and the primary reason for going into that 3-D imaging space, if you will, is for the life sciences, what we are calling life sciences, which includes the medical plus some other market opportunities that we haven't been in before.

The medical industry has been talking about medical diagnostic imaging, has been talking about the 3-D for a long time, and it hasn't happened.

And I think that one of the reasons why it hasn't happened is because the right combination of those right solution, if you will, the combination of hardware and software hasn't been delivered.

We believe we had the hardware all along, but we didn't have the software.

And now by marrying this 3-D reconstruction capability, along with the ability to do this in real-time, we think we are going to make a significant impact in the medical market space and enable this market to develop.

So we are very, very positive about that and getting our medical business back on a rapid growth path here.

In terms of how that's going to translate over to the defense business, well TGS already has some customers in the defense space that are using the software for simulation.

We are in the early stages of I am just trying to understand how that applies and what we can do to again add Mercury's traditional values and also to take advantage of that and figure out where else we can take that capability in the simulation space.

So it's a little bit early for us to identify specifically where in the defense space and how much it is going to result in the growth in the defense business.

But when you look at what we do, which is the visualization of being able to see what's on the ground as a result of taking sensor data from multiple types of sensors and creating an image, I believe that this software is going to create provide the ability to create more of an image that is understandable, and at some point we are going to see some significant business coming out of the defense space for this also.

One quick one on the SG&A, you guys have shown actually quite a bit of leverage in that line over the last several quarters here, specifically at the SG&A line.

And obviously this quarter you had a sequential bump in sales.

Was there anything unusual in that line this quarter in terms of expenses that were maybe onetime in prior quarter that went away, or is this pretty kind of a consistent, been a consistent level, there's nothing unusual activity in there this quarter?

I'm not sure I understand your question.

When we take a look at the SG&A line, it was 12.7 million in Q2 and 12.5 million this quarter.

That is relatively consistent (multiple speakers) operating expenses consistent.

That's exactly what I am referring to but obviously there is not a lot of variability to it, even though sales have increased since last quarter and it is down significantly from over 13 and 14 million last year.

Is down significantly year-over-year.

Those (indiscernible) cost-cutting initiatives we instituted in Q4 and as you well now that we have been looking at the operating cost structure heavily, and that's a result of what you see in the third quarter.

And to repeat that earlier what Bob said as part of his script, that we have certain seasonal compensation charges that we expect to pickup in the fourth quarter also.

So hopefully that hangs together for you.

Okay, but there was nothing that came out this -- cause it actually dropped on an increase in revenue, its just the expense control there?

Yes.

Okay.

Thanks a lot.

Bill, let me go back to the question that I think you asked anyway.

We didn't acquire TGS for what it can do in the defense space, specifically.

We were focusing in on the life sciences.

Once we get to understand it better, we will also have a better understanding of how to leverage that capability in defense.

But when I look at the opportunities for growth in this life sciences area, just let me share some numbers with you relative to what we see as the available market sizes.

In the diagnostic medical imaging market we are looking at where we think is about a $600 million market opportunity.

In the image guided surgical market that needs 3-D imaging in real-time, it's about a $200 million market over the next couple of years.

And then the biotech, which is drug development OEMs, for example that we have not participated in, we see that as about a $400 million available market.

So we have dramatically expanded our view of how we are going to grow this life sciences business from where we were over the last few years in just looking at the 2G (ph) imagery construction for medical diagnostic imaging.

Great, Jay.

Thanks a lot.

(indiscernible) Lotus Investment Management.

You've made several comments on each of the last calls with respect to the uncertainty on defense spending.

Jay, I'm wondering if you feel better or worse about this process now versus say six months ago.

Separately, with respect to the inventory turns, do you think the 8 level is sustainable going forward?

It strikes me it might be a little bit thin.

I might be wrong on that.

Thank you.

I think I will take the inventory turns question and then we will loop back on the other one with Jay.

I believe certainly sustainable at 8, and what I would like to do is communicate a little bit more on the next call in terms of where we can take it and how we can improve it.

It's great performance, 8, whether we look at year-over-year or even competitively.

I am hoping we can do better, and to put it into a business context I think even at 8 we've created a tremendous competitive advantage for Mercury here in terms of the capability.

Customer facing capabilities that our supply chain management is capable of delivering here.

So we will maintain it, probably extend it.

With regards to the defense budget, clearly over the last couple of years the budget has grown especially in the areas that we are participating in RDT&E (ph).

And so as I said, it's just a matter of time before those monies are appropriated flow down to the programs that we are involved in.

These programs are multi-year programs going out 10, 20 years sometimes even longer.

And you just don't come up with a program like that overnight and define the requirements.

So it just takes time.

We are starting to see some of the results of the budget increases that occurred starting a few years ago.

Okay.

Thank you.

Glen (indiscernible) Broadview Advisers.

Just wondering what the headcount is today and where do you see that going into '05?

I think we mentioned it was 575 today.

Okay, and the acquisition, where do you see the headcount?

As a result of the acquisition?

Without the acquisition or --.

It is 575 preacquisition, and the acquisition brings 65 more associates to Mercury in multiple locations.

Okay.

There are no further questions at this time, Mr. Bertelli.

I will turn the conference back over to you for any closing remarks.

Thank you very much.

Appreciate your participating with us today, and there were some good questions.

You've given us some food for thought, if you will.

And we will certainly try to address these more in the coming months and looking forward to the year end call towards the first week in August.

Thank you all, and goodbye.

That does conclude today's conference.

Again thank you for your participation.