Mercury Systems Inc (MRCY) 2006 Q4 法說會逐字稿

Good day and welcome everyone to the Mercury Computer Systems Incorporated fourth quarter and fiscal year 2006 earnings results conference call. [OPERATOR INSTRUCTIONS] At this time for opening remarks and introductions, I would like to turn the call over to Ms. Jennifer Heizer, Investor Relations specialist.

Please go head, Ms. Heizer.

Good afternoon, everyone, and welcome to the Mercury Computer Systems fourth quarter and fiscal year 2006 earnings conference call.

With me today are Jay Bertelli, President and Chief Executive Officer, Bob Hult, Senior VIce President and Chief Executive Officer, Bob Hult, President and Chief Financial Officer, and Alex Braverman, Vice President, Comptroller and Chief Accounting Officer.

If you have 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'd like to remind you that remarks that we make during this call about future expectations, trends and plans for the Company and its business constitute forward-looking statements which involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated.

Additional information regarding forward-looking statements and risk factors is included in the press release we issued this afternoon reporting the Company's fourth quarter and fiscal year results, and in the Company's periodic reports filed with the SEC.

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

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

In addition to reporting financial results in accordance with Generally Accepted Accounting Principles, or GAAP, we will also be discussing non-GAAP financial measures adjusted to exclude certain non-cash and other specified charges, which we will specifically identified.

Management believes that these non-GAAP financial measures assist in providing a more complete understanding of the Company's underlying operational results and trends and management uses these measures, along with our corresponding GAAP financial measures, to manage the Company's business, to evaluate its performance compared to prior periods and the market place, and to establish operational goals.

However, they are not meant to be considered in isolation or as a substitute for financial information provided in accordance with GAAP.

A reconciliation of GAAP to non-GAAP financial results discussed in today's conference call is contained in the Company's fourth quarter and fiscal year earnings release.

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

Thank you, Jennifer, and thank you all for coming in on the call.

The opening remarks here -- it was for me to figure out what to do to open this up but, clearly to me, dramatically different from last year.

What a difference a year makes.

A year ago we were here looking at a $250 million revenue year, 35% growth in revenue, operating income of almost 18%, and we were operating 20% growth for FY '06, and then the wheels came off.

Well, not really on the top line, as that $236 million that we posted up there for '06 is the seconds best revenue year in Mercury's history.

As I said in the press release, the '06 performance is certainly disappointing to our faithful shareholders and also, I can assure, to you all of Mercury associates.

All of our business units failed to meet their goals.

We've been working diligently to assess the situation for the last few months.

We reduced our expenses.

We made management and organization changes.

And in some areas such as soft product development and our VistaNav group we increased our investments.

Defense program cancellations and budget reprioritization, plus some overly optimistic forecasts, caused to us miss our goal by approximately $50 million within the defense unit.

The slow adoption rate of 3D Visualization by the market place. plus some product development delays, caused us to miss our goals in Life Sciences although revenues were up year-over- year.

And the loss of some business in the semiconductor industry, coupled with a third-party supplier problem, resulted in our Advanced Solutions business unit revenues being several million dollars off their budget

Now I'm going to turn the call over to Bob for the details, and I'm come back with a more in-depth assessment, including comments on our strategies going forward.

Thanks, Jay.

Good afternoon, everyone.

I will review revenue for the fourth quarter and the full-year 2006, including details by business unit, discuss Company operating performance, balance sheet, cash flow results and finish with a discussion regarding the outlook for the first fiscal quarter and full-year 2007.

I will discuss the numbers on both a GAAP and non-GAAP basis.

Fourth quarter revenues were $62.2 million, within the guidance range of $61 to $66 million.

Non-GAAP EPS for the quarter were $0.18, exceeding the guidance range of forward to $0.16.

For the full year, revenues were $236.1 million, a decline of 6% from revenues of $250.2 million for FY 2005.

Non-GAAP earnings per share were $0.29 for the full year.

The book-to-bill ratio for the quarter was 1.05, and for the full year 0.99.

Ending the quarter, total backlog including deferred revenue stood at $105.6 million, a $2.5 million improvement over the third quarter.

Of the ending backlog, $96.2 million or about 91% is linked to shipments expected within the next 12 months.

Revenue details for the fourth quarter and full year by business unit .

Our Defense business united reported revenue of $37.9 million, or 61% of total revenues for the fourth quarter, a revenue decrease of approximately 20% versus the same period last year.

For the full year, the Defense business contributed $131.3 million, or 55% of total revenues, a decline of 11% from the prior year.

The year-over-year decline was the result of shifting priorities within the Department of Defense and several large programs being delayed, and in some instances cancelled.

Our Commercial Imaging and Visualization business unit revenue for the fourth quarter was $11.7 million, representing 19% of total revenue, slightly down against the same quarter last year.

For the full year, CIV contributed $51.8 million or 22% of revenue, which was up approximately 5% from the prior year.

Revenues from MRI and Digital X-ray [modality] were down year-over-year, due to legacy 3D products peeling off, but were offset by growth in the new 3D Visualization business.

Our Advanced Solutions business units fourth-quarter revenues were $10.1 million, were 16% of Q4 '06 revenues, a revenue decrease of approximately 2% from the same quarter last year.

For the full year revenues in Advanced Solutions were $41.7 million, or 18% of total revenues, a decline of 14% from fiscal 2005.

The year-over-year decline was primarily in the semiconductor business.

Our Marginal Products and Services business unit was up 52% in Q4, '06, from a small [bake] and contributed 4% of revenue.

This unit is starting to see up take of new products, but is still a small percentage of our total business.

For the full year revenues contributed from Marginal Products increased to $11.3 million from revenues of $4.4 million in the prior year.

Non-GAAP gross margin for the quarter were 64.7%, versus 67.9% last year.

For the full year, non-GAAP gross margin was 61.5%, versus 66.2% last year.

The full-year gross margin was primarily affected by decreased contribution from our Defense business unit.

Also, within our Defense business unit, we experienced a shift with lower margin fully configured at rack systems from historical higher margin, both [inaudible].

Finally we had a greater percentage of revenue from newer business technologies that carried in lower margin than our defense products.

Now I will detail our fourth quarter and full-year results on a non-GAAP basis.

On a non-GAAP basis we reported operating income of $4.8 million for the quarter, or 7.7% of revenues.

For the full year, operating income was $6.5 million, or 2.8% of revenues.

Non-GAAP net income for the quarter was $3.9 million.

Non-GAAP earnings per share for the fourth quarter were $0.18.

The non-GAAP net income for full year was $6.2 million.

On a non-GAAP basis for the full year, we were earned $0.29 versus $1.32 per share in the prior year.

Moving to the balance sheet, cash flow statement, operating cash flow outflow was $3.7 million in the quarter.

For the full-year 2006 we generated $22.1 million in operating cash flow.

Fourth quarter day sales outstanding, DSO, were 50.

Inventory turns were 4.4 for the quarter.

Capital expenditures were $3.0 million for the quarter, and $11.4 million for the full year.

Cash, cash equivalents and marketable securities were $162.2 million at the end of the quarter.

At the end of FY 2006, a total employee population, excluding contractors, was 836, compared to 854 at the end of the March quarter.

Now I would like to discuss the option exchange program described in the proxy statement we mailed to shareholders earlier this month.

We will hold a special meeting of our shareholders on August 7 to vote on this program, which will allow eligible employees to exchange all outstanding employee stock options with exercise prices above $23 for restricted stock, using a ratio of one share of restricted stock for every four options exchanged.

We have approximately 2.3 million stock options eligible under the program.

Members of our board of directors and our five most highly compensated executive officers will not be eligible to participate.

The purpose of this plan is two-fold.

First, it reduces the consider equity overhead resulting from outstanding out-of-the-money options.

Second, it exchanges these out-of-the-money options, which are no longer serving as performance or retention incentives for employees, with restricted stock awards priced at the market and vesting over three years for most employees.

And we believe it would better reflect the current efforts of these employees.

As an engineering-driven Company that derives much of its value from highly-skilled employees with both great innovative technology solutions, as well as understand our customers most challenging problems, we believe that tying a portion of compensation for the performance of our stock is a desirable and highly-accepted means of retaining our most talented employees.

I would now like to move to the guidance for the first quarter and full-year 2007.

For full-year fiscal 2007 we anticipate revenues of $235 to $245 million, which at the mid-point of $240 million is essentially flat with 2006.

We project a full-year revenue mix of approximately 50% defense and 50% commercial applications.

We project the non-GAAP gross margin of approximately 57% for the full-year fiscal 2007.

We expect operating expenses to approximate $131 million, which is down from fiscal year 2006 operating expenses of $139 million.

The non-GAAP tax rate will be 30%.

The diluted shares for the full year are projected to be 21 million, given Mercury's net income does not meet the threshold tor the convertible debenture adjustment.

Based on the mid-point of the revenue range, the non-GAAP earnings per share are projected to be approximately $0.29.

The impact of stock-based compensation costs for the full year will be approximately $12 million before factoring in the impact of the proposed stock option exchange program.

The amortization of acquired intangibles will be approximately $7 million.

There will be a Q1 restructuring charge of approximately $600,000.

The GAAP effective tax rate will be 30% and the GAAP shares, again, are projected to be 21 million, given Mercury's net income does not meet the threshold of the convertible debenture adjustment.

Based on the mid-point of the range, the fiscal year 2007 GAAP losses per share are projected to be approximately $0.37.

CapEx for 2007 is projected to be approximately $11 million.

Depreciation will be approximately $12 million.

For the first quarter we project revenues of $50 to $53 million.

We project a non-GAAP gross margin of approximately 57%.

Our non-GAAP tax rate is 30%, with diluted shares of 21 million.

The result of non-GAAP losses per share are in the range of a loss of $0.17 to a loss of $0.11.

The impact of the stock-based compensation cost for the quarter will be approximately $2.1 million.

The amortization of acquired intangibles will be approximately $1.7 million and the Q1 restructuring charge, again, will be $600,000.

GAAP tax rate is also 30% and the GAAP diluted shares, 21 million.

As a result, the first quarter 2007 GAAP losses per share are projected to be in the range of $0.35 to a loss of $0.29.

At this point we would like to turn the call back over to Jay for his industry comments and additional context regarding our business outlook.

Thanks, Bob.

I want to start by talking about the acquisition strategy.

We're hearing that we've been embarked on now for the last two plus year.

The acquisitions initially were targeted to support our strategies in the Defense marketplace and CIB, or Life Science markets, more specifically.

And the goal as stated was to acquire IP Intellectual property, which complemented Mercury's competencies in developing computing solutions for a range of challenging computing requirements.

You should think about Mercury's business as addressing multiple markets where there's a need for high performance computing solutions.

These markets tends to be relatively small, tens to hundreds of millions, mostly OEMs, including prime defense contractors.

When the volumes get very large, the OEMs are primes, have the incentive to do it themselves or to drive an outsourcing model, which leaves extremely thin margins and contractual liabilities that make the risk-reward ratio unacceptable to us.

So our game plan has been all along to hit singles and doubles by participating in several small to medium-size markets, where the intellectual property and core competencies that we have add a lot of value, while leveraging our R&D investments across these various markets.

Inevitably, there will be the occasional strike out and we will learn from these experiences.

Let me talk about the numbers with regards to these acquisitions, and the numbers are approximate.

In FY '05 we had done three of the acquisitions, Arch, Momentum and PGS, and the revenues from those acquisitions were approximately $14 million and the operating loss was approximately $3 million.

That's non-GAAP.

In FY '06 we added Echotek and SoHard and the revenues from the acquisitions now went up to about $25 million and the operating loss went up to $4 million, again, non-GAAP.

In FY '07 we;re projecting revenues from the acquisitions to approximate $60 million, and we expect to see a positive operating income of about $2.5 million, again, non-GAAP.

So what did we learn from these -- doing these acquisitions?

Well, we learned that extracting synergies from these small privately-held companies, while at the same time instituting public company infrastructure. is tougher and takes longer than we thought.

We underestimated the challenges in terms of cost and time to get them into SOX and 404 compliance, particularly the European acquisitions.

Different business models with existing contracts presented revenue recognition challenges.

We had to apply significant senior management attention and business controller functions to meet public company accounting standards.

We also underestimated the time to develop the products necessary to produce the revenue synergies on which the acquisitions were justified and to integrate the sales and marketing functions to bring the acquired capabilities into our traditional markets.

We're not ready to claim victory; however, in FY '07 I believe that we're going to start to see this strategy produce the results and set us up for significant growth beyond FY '07.

Our strategy is multi-fold.

In some areas we are climbing up the [battery] step.

In other areas, we are delivering more of the overall solution.

And in some areas we are expanding into adjacent markets.

For example, three to four years ago we saw the eventual decline of the 2D imagery construction business in medical diagnostic imaging.

We brought in Marcelo Lima to run the medical business and to get us into the future, which is 3D Visualization.

We developed an acquisition strategy aimed at acquiring IP that will get us into the application space, or higher up in the value stack.

The first acquisition in May of '04 was TGS, which provided us the 3D framework software called a mirror and the open inventive tool kit.

We used this software and capabilities from our SoHard acquisition as the basis to develop the application software modules which have recently been reduced for [PAX] 3D client server visualization.

Another example is our move into the oil and gas industry.

Again, the TGS software has put us here.

Several millions in software business have been booked -- several millions of dollars.

This in turn has opened up the potential to package this software with Mercury's cell-based computation engine.

In this case the revenue opportunity goes up by an order of magnitude, at least.

Another adjacent market for us now is drug design.

The TGS software is also being used in the drug industry to create 3D models of protein molecules to accelerate drug development.

Again, planning the next level of application software and combining it with cell-based computation engines has a potential to create a home run, using our baseball analogy.

One of our most interesting opportunities is for synthetic vision.

We've also used the TGS software to create our synthetic vision development market group.

The first product, VistaNav, is being sold to private pilots.

However, think of this as a market development effort and a much broader opportunity to provide synthetic vision to patrol autonomous vehicles in the air, on the ground, in and under the sea.

Processing multiple sensor inputs in real time from GSP, radar, IR or sonar, et cetera, requires computation architecture capabilities that are unique to Mercury.

As we have discussed before, the Echotek acquisition is aimed primarily at the defense market to give us more of a solution for Signet applications.

A major setback for this business in FY '06 was the cancellation of the ACS program.

However, the integration has gone relatively smoothly.

The Echotek team is intact and contributing significantly to generating the anticipated synergies, not only in defense, but also in developing data acquisition systems for the medical diagnostic imaging market.

The SoHard acquisition was done to leverage their professional services business with a major medical imaging OEM and for their rod PACS product.

PACS stands for picture archiving and communications system.

We are subsequently investing significantly in developing application software and plant server capability so as to bring a world class PACS product to market.

Evidence is building from many new design wins that our strategy is correct.

Momentum, or MPS as we now call it, was acquired to give us entry level products in markets we were not participating in, such as communications and products for the defense market to complement our high-end products.

This allows us to provide more of the overall solution.

The integration of the strategy was delayed partially because we lost the founder and principal driver of the business to a medical problem.

New management was inserted, new products are being developed for our defense markets and the sales force synergies are getting traction.

We expect to see close to 70% revenue growth in FY '07 over FY '06 in this business unit.

Now I will talk about each business units strategy and outlook.

In our Advanced Solutions Business Unit, it drives its revenues primarily from the semiconductor and the communications industries.

In FY '06 some business was lost in the semi industry to in-house designs, while a new design win from the same customer that will partially offset the loss revenue when it goes into production.

As a result of some major design wins, one based on a Cell Processor, we expect the ASBU revenues to grow by close to 30% in FY '06.

Heavy R&D investments in Cell will keep operating income as a percent of revenue in the single digits.

Mercury's software infrastructure for the Cell and its system engineering competencies have enabled ASBU to place two systems for evaluation into two different semi industry companies for a design for manufacturing and vertical instruction applications.

The DFM, or Design for Manufacturing applications has revenue potential of $15 to $25 million a year.

Another major design win that demonstrates Mercury's ability to solve the most challenging computer problems is a commercial ground-based satellite beamforming application briefly described in our July 20 press release.

ATC, not to be confused with advanced ATCA, or ancillary terrestrial component, that's what ATC stands for, promises to integrate a terrestrial and satellite components to provide high-speed, two-way voice and data services.

I am going to quote: "The seamless ability to move between terrestrial and satellite components provides for a superior consumer experience while providing public safety, first responders and emergency preparedness agencies an essential and interoperable communications systems in times of national emergencies.

This would have been greatly appreciated during Hurricane Katrina."

The quote is from Gary Parsons, who is the Chairman of the Board of mobile satellite ventures who authored the document called, "An ATC Primer: The Future of Communications."

I suggest you visit their website for a complete description of the market opportunity and the technology behind it.

You can acquire this paper, white papers at MSVLP.com.

Given the market adoption of this technology, we estimate the potential for Mercury to be somewhere between $30 and $50 million over the next three to four years in the satellite bay station part of the market place.

In FY '07 we will be delivering the first development systems.

In the defense market place, radar has been typically greater than 60% of our defense business.

And over the past four to five years, the Defense Business Unit has invested well over $40 million to produce the Powerstream 5000 and Powerstream 7000 products for these high-end radar applications.

We have achieved four design wins for these systems for programs such as MPR [inaudible], Awax and [inaudible] unclassified -- I mean classified programs.

In the FY '04, FY '05 and FY '06 timeframes, we shipped approximately $44 million worth of these systems for the development and testing phases of the program.

The LRP, or Low Rate Production phase of these programs are not scheduled to begin until our FY '08, when we expect to see $25 to $30 million a year for several years.

Our radar business has also suffered recently from reprioritization of funding for the MMA, or Multi Mission Aircraft.

If the funding had shifted to technology insertions on existing platforms, such as joint service and Awax, we could see an increase of business near term over what we are projecting.

Our Signet business in FY '06 was down significantly over FY '05, primarily because of [bullets] dictated by the primes in FY '05 and the loss of the ACS program.

We did record 28 design wins in FY '06 in various defense market segments.

Given the lengthy development and evaluation phases, significant revenues will not be realized for a few years from these design wins.

However, these design wins, when added to the FY '05 total of 35, with estimated revenue potential of approximately $150 million over a three to five-year period indicates to me that we have a very healthy Defense Business across a broad range of applications and platforms.

And we have the products and resources to compete successfully from entry level to high-end complex systems where Mercury has traditionally excelled.

Our VistaNav development activity has been placed within our Defense Business Unit, as we see significant potential for this technology within various government agencies.

Synthetic vision, combined with multi-sensor fusion, is an emerging market.

It follows the bluish in concept of defining a new space with little to no entrenched competitiveness.

It gets us into the application space in both commercial and defense markets, such as controlling UAV's to find forest fires, patrol borders, track terrorists, et cetera.

The control of autonomous vehicles and the missions they can accomplish is greatly enhanced by synthetic vision, combined with multi-sensor fusion.

And it leverages our 3D software IP and core competencies in architecting systems with various processing elements.

This year when we were exploring ways to optimize the return this the development, our estimate of the market potential is hundreds of millions of dollars four years out and growing.

This could be a double or triple in our baseball analogy.

CIV, this business consists of Life Sciences, particularly, and the TGS software business, which serves the oil and gas industry as its largest market.

Mercury has been in the medical diagnostic 2D reconstruction business for various modalities going back to 1987.

In 2003, recognizing that the future of medical imaging would be driven by an oncoming data explosion that we saw in our earlier industries, we embarked on a strategy to develop products and technologies to meet this challenge.

These include 3D Visualization of distributed images.

So we acquired TGS for the visualization tools and SoHard for their Picture Archiving System, or PACS.

Our strategy is based on the following market fundamentals.

Aging population increases the need for diagnostic imaging.

Advances in OEM sensor technology has led to the introduction of multi-slice CT and multi-channel MR scanners that generate a substantially large amount of sliced data.

Decreasing reimbursements in diagnostics modalities forces more volume reading throughout the health care system. 3D diagnostics is picking up in volume due to this data explosion.

PACS proliferation in acceptance in the U.S. and western Europe.

With PACS the diagnostic works flow changes to centralized imaging diagnosis.

Centralized reading requires speed, fit to work flow, functionality and flexibility and image quality.

These requirements do not support the current independent 3D dedicated work station.

Hence, PACS.

As a result of the acquisitions and development work done by Mercury's core medical business team, we now have the world's first fully-integrated 3D PACS system.

Additionally we have developed an innovative, enterprise-wide image distribution thin client server.

These systems were recently released for sale to OEMs in our developing dealer distributor network.

Our architect unit has also developed an MRI acquisition system that, in conjunction with software IP license from a medical college, is producing vastly superior images, while significantly improving speed of data acquisition.

It is currently undergoing clinical evaluation.

The potential for this product alone is $25 to $50 million a year in annual revenue, given that it is adopted by the OEMs.

A positive growth indicator for 3D is that the U.S. recognized the value of 3D Visualization and has approved a 30% increase in reimbursement rates starting in 2006, if a hospital diagnosis 3D from a PACS or independence 3D work station.

Excuse me while I get a drink of water here.

The [inaudible] report on worldwide 3D medical visualization market forecasts growth and presents following data..

Worldwide revenues were approximately $400 million in 2004; growing to $1.15 billion over the next couple of years which represents a 16% annual growth rate.

Of this market, Mercury estimates that approximately one-third is available to third-party providers -- that's OEMs and dealers -- and the remainder represents OEM direct end-user sales.

Therefore, we have a 2009 market opportunity of about $400 million, expect to realize up to 20% of the available market by that time.

A recent change in our distribution strategy to develop a dealer distributor network was driven by the slow adoption rate by the OEMs Moving closer to the end user will also enable us to resist margin pressure from the OEMs, get direct feedback from the market on our product development and have more control over our dent are destiny in this space.

We currently have over 1,000 web-based PACS installations worldwide through our OEM and dealer network.

In summary, CIB is in a transition year, as our traditional 2D imaging business declines and the 3D-plus image distribution offerings gain traction at a faster rate than the decline of the 2D business.

We are projecting modest growth in revenues and a return to profitability.

Our optimism is based on 17 new Life Science customer wins in FY '06 across the multiple segments we serve.

Life Sciences is truly an exciting growth market and we are investing for the long-term and we believe we are well-positioned to participate in the industry growth.

This could be a home run.

Let's talk about Cell.

Sell is very important to us, as you know from previous calls, and it's also important because it's a significant investment and it's the wave of the future.

The Cell Processor, we view it as a break-through technology, which we validated in FY '06 as an extremely good fit for several of our markets;

Defense, Life Sciences, [inaudible] inspection and new markets, such as reservoir modeling and exploitation for oil and gas, and design for manufacturing CAD tools used by the semiconductor industry.

In FY '06 we shipped evaluation systems to 13 different customers, including several defense customers.

In anticipation of the slow adoption rate for new process or architectures we are conservatively estimating low double-digit revenues for FY '07, with a pipeline building for significant revenues beyond '07.

The alliance with IBM is working very well, as both parties are motivated to drive for rapid adoption of the technology.

Mercury's low double-digit millions being invested in FY '07 are aimed at products which can be used to cross-sell markets with significant investments in the software, which is unique to Mercury, that enables our customers to extract maximum performance from the systems.

We continue to believe that Cell will drive future growth and open new markets beyond our traditional imbedded space.

In conclusion, although the trend toward standards-based hardware and traditional Mercury's market is a deep and fundamental challenge for the Company, technology changes are, at the same time, creating new opportunities.

The shifts in the market place are forcing the Company out of its traditional niches into a broader set of new markets and applications.

The key will be to make rational business decisions regarding investment areas, and then to use leverage to optimize investments in these new areas.

Mercury is becoming a horizontal solutions Company across a number of vertical markets, many of which require the same set of capabilities from Mercury.

The Company has a track record of identifying problems that can be solved by its unique set of capabilities in new markets and building businesses around these solutions.

Mercury's technology can be leveraged into many markets and addresses several large opportunities.

Driving demand across these markets is a proliferation of data and a need to process and visualize this data in a real-time, cost-effective manner.

Mercury has a unique set of skills that allow to it make the most out of off-the-shelf hardware for cost-effective solutions for OEMs.

Despite the shift in proprietary Mercury solutions to open standard hardware and software, OEMs will continue to find it more efficient to use Mercury expertise for certain design challenges.

In fact, it could be argued that the less-expensive hardware leaves budget dollars out-sourcing to Mercury to provide hardware and/or software solutions.

Mercury has been investing in new technology and domain expertise.

The Company now has the broadest array of new products and technology platforms in its history and it has reached up to the largest set of new customers in its history.

The Company has made these investments without compromising its financial position and is poised to start to grow revenues again and restore profitability by realizing design wins that are now in the sales file.

The train is back on the tracks, folks.

So in closing, I wanted to advise you of something before I open up and ask for questions and, basically, I'm volunteering the fact that I'm going to be filing a 144 tomorrow to sell approximately 75,000 shares.

Last October I acquired 106,000 shares or so.

It cost me about $1.6 million.

This, plus other events, requires that I liquidate some stock.

From my perspective, it's absolutely the worse time to be selling.

The [outtakes] are terrible.

Those of you who follow the Company know I have sold very few shares over the years, contrary to the advice from many of you managers out there.

I have no choice at this time, however.

So just a heads up that you are not surprised when you see a 144 bid tomorrow, but I can assure you that it has nothing to do with my belief in the future of this Company.

With that I am going to open up it for questions.

[OPERATOR INSTRUCTIONS] We will take our first question from Bill Benton with William Blair.

Please go ahead.

Good afternoon, guys.

Hi, Bill.

Just a question a little bit on the guidance front.

Obviously the $235 and $245 you said about half of that at the mid-point coming from Defense, $120 million.

I know your backlog traditionally has obviously been a source of that revenue and given that you have $96 million to be delivered over the next 12 months that would tend to suggest maybe a greater degree of visibility to that forecast.

Are you maybe conveying some concern about maybe some of that going away or do you just want to be conservative in light of the current environment?

Certainly not conveying any concern about some of it going away, Bill, it's pretty solid backlog.

We've got the purchase orders in house and we [bidded] the orders quite thoroughly, so no concern there.

I don't think we are trying to be conservative, either.

We are just going straight at it and stick by the guidance as I took the group through a little while along here.

Is it maybe the turns business is not as -- obviously it's not as predictable today but has that become a smaller portion of your overall Defense Business.

Which business?

Maybe you call it -- it's business that comes and gets shipped in the same quarter.

That's always a very, very small portion of the quarter.

Right.

The historical rule of thumb that we've used successfully here at Mercury for our Defense Business is to be 85%, 90% loaded going into the quarter.

We are hunting for very little of our Defense Business in the current quarter.

Okay.

And just thinking about the gross margin forecast you've got the Defense Business, obviously, mix down a bit.

Right.

That has historically carried higher margins.

Would it seem to imply maybe margins even lower than that.

Could you give us color into your thinking on the gross margin guidance?

Sure, I'd be glad to.

There has been a downward trend in our gross margins in '06 and you can see that it continues into '07.

The biggest driver here is our Defense Business Unit where, quite distinctly we have moved away from what I described as multi-computer board sets and we're moving more and more towards fully-configured systems.

Obviously systems are -- they've got our components in it and they also have buy-out components.

Having said that, they're a more complete system so there's a software side to these systems, also.

So long-term it's good news for us since we're providing more of the solution to the customer, which means we're delivering more value add.

However, the gross margin of those systems is less than the old board sets, measurably as you can see.

The other element here is that our commercial businesses have grown.

We projected a mix of 50/50 split between Defense and commercial here in '07, and it's not so long ago that we were 60/40, Defense being the 60 and commercial being the 40.

Our commercial businesses do carry a smaller gross margin than Defense.

One thing I want to bring out clearly here is our Defense gross margin is still our highest gross margin business and we expect to it remain so.

Okay.

And then could you just comment on employee -- kind of employee retention today, how that's holding in there?

I know you are doing the compensation scheme in terms of changing the compensation that's been coming out.

I just want to get a general sense on how any sort of employee turnover is going there?

Sure.

Let me hit it and I think Jay's going to want to jump in here, too, but our turnover has increased.

I don't know if that's the correct word, but I will try to call it our -- the voluntary side of the turnover.

It's increased.

It's gone from low to mid-single digits to high single-digits, so we are not at 10%.

And I think certainly as you know, Bill, and I think a lot of the others on the call, any number in technology less than 10% is low.

So we've moved up for Mercury, but against an industry standard we're still doing pretty good.

But obviously we're concerned about that, and I think, as part of your question you move towards the stock option exchange program.

That's part of what we're trying to do here.

There's nothing like growth and new exciting markets to put some fun back in the equation or more fun back into the equation.

And in the long run that's what keeps everybody here at Mercury is we're doing interesting things and having fun doing it.

Jay probably wants to jump in.

You've said it all.

Okay.

Well, guys, good luck.

I know you have a group of talented employees there, so good luck.

Thanks, Bill.

[OPERATOR INSTRUCTIONS] We will take our next question from Steve Levenson with Ryan Beck.

Please go ahead.

Good afternoon Jay and Bob.

Hi, Steve.

When we spoke not too long ago there was some discussion of upgrades and replacement work in the Defense arena.

Are you beginning to see any of that come through in contracts or orders?

I'm not sure what you're referring to specifically but if it came through it's in the backlog.

I need to know specifically what you're asking.

Some of signal intelligence and radar and precision guided munitions additional purchases.

I haven't seen anything in precision guided munitions.

I think what you're referring to in the Signet area are programs like Compass Call, maybe?

Correct.

I haven't seen anything there yet either.

Radar, I think I addressed the radar issues.

The markets or the product, the platforms that we're on today are the older platforms that were scheduled to be replaced by the MMA.

We were selected for the radar system that was going to go on the MMA and then they basically cancelled that program.

They only funded one plane for this year.

And so now it's -- what are they going to do?

Are they going to do some technology insertion on the existing platforms?

And we don't no yet.

I think that's --we are going to have to wait to see what the '07 budget looks like.

On Predator, I think there are a few Predator purchases scheduled [inaudible] aperture radar.

If you look at the budget again, they talk about buying a lot of Global Hawks and Predators.

We haven't -- I'm sure they will, but we haven't seen the results of that yet.

We'll will watch for them.

Thanks very much.

[OPERATOR INSTRUCTIONS] It appears there are no further questions.

Mr. Bertelli, I will turn the conference back over to you.

Well, thank you all for tuning in and appreciate your patience with us.

And we look forward to seeing you again on the call in October.

Good bye, now.

Ladies and gentlemen, this will conclude today's conference call.

We thank you for your participation.

You may disconnect at this time.