Mercury Systems Inc (MRCY) 2010 Q1 法說會逐字稿

Good day, and welcome, everyone, to the Mercury Computer Systems, Incorporated, first-quarter fiscal 2010 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 Company's Senior Vice President and Chief Financial Officer, Mr.

Bob Hult.

Please go ahead, sir.

Good afternoon, and thank you for joining us.

With me today is our President and Chief Executive Officer, Mark Aslett.

If you have not received a copy of the earnings release, you can find it on our website, www.mc.com.

We'd like to remind you that remarks that we make -- that we may 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 first quarter fiscal year 2010 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 statements, which speak only as of the date of this call.

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

I'd also like to mention that, in addition to reporting financial results in accordance with generally accepted accounting principles, or GAAP, during our call, we will discuss a non-GAAP financial measure -- specifically, adjusted EBITDA.

Adjusted EBITDA excludes interest income and expense, income taxes, depreciation, amortization of acquired intangible assets, stock-based compensation costs, and restructuring expense.

A reconciliation of adjusted EBITDA to GAAP net income from continuing operations is included in the press release we issued this afternoon.

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

Thanks, Paul.

Good afternoon, everyone, and thank you for joining us.

I'll begin with an update on our business for the first quarter of fiscal 2010.

Bob will review the financials and discuss our guidance for the second quarter, and then we'll open it up for your questions.

Our priority for fiscal 2010 is driving the growth and profitability in the business, and the first quarter was an excellent start in that direction.

On a continuing operations basis, revenue and GAAP earnings both exceeded the high end of our guidance range, coming in at $47.4 million and $0.19 per share, respectively.

Total defense revenue in the first quarter, including ACS and Mercury Federal, grew 2% sequentially and by 22% year over year to $40.8 million.

We're also continuing to demonstrate the operating leverage we have in the business with adjusted EBITDA margin coming in at 16% for the quarter against the longer-term pro forma target business model of 17% to 18%.

Inventory was down again, both sequentially and year over year, and Mercury is continuing to generate positive free cash flow.

Total bookings for the first quarter increased 4.8% from Q1 of fiscal 2009, to $48.6 million.

Bookings declined sequentially by 24.5% from the fourth quarter of fiscal '09, reflecting the typical seasonality we see in Q1.

Including both Mercury Federal and ACS, defense bookings were up 11% year over year, to $37.9 million.

We closed the first quarter with a book-to-bill in defense of 0.93, down from 1.49 in the sequential fourth quarter and 1.02 in Q1 of last year.

If you look at the past three fiscal years, bookings and revenue in our defense business, including both ACS and Mercury Federal, have grown at a compounded annual rate of 28% and 14%, respectively.

This growth reflects the work we've done to strengthen our core defense business while expanding our presence in emerging high potential growth areas within the overall defense electronics market.

As a result, we have a diversified install base of defense business encompassing a wide range of high priority military platforms and programs at various stages of development and deployment.

This creates a low potential risk profile for us as we pursue additional programs and platforms to drive future growth.

In reference to the government's OCI rule making, as I mentioned last quarter, we've reached two conclusions based on the federal review of the existing rules.

First, Mercury is not currently involved in any projects or planning any new business that would trigger the OCI rules as they stand today.

Secondly, we believe that the relationship between Mercury and Mercury Federal does not trigger any of the existing rules.

In terms of the legislation that may have an impact on current best practices or existing rules, the National Defense Authorization Act and the Weapons Systems Acquisition Reform Act, we anticipate that the government is likely to focus more on the large primes under the definition as well as potential conflicts associated with being classified as the lead systems integrator.

In our view, neither Mercury nor Mercury Federal would currently fall under that category.

In terms of the procurement landscape overall, we agree with the general sentiment projecting only flat to modest DOD budget growth over the next several years.

Therefore, it is important to be in the right areas.

Clearly, ISR is one such area for us.

Mercury's ACS business is also well positioned on key programs and platforms in three other areas that should see increased funding over time.

Starting with airborne ISR, this represents probably our largest market opportunity and accounts for over 50% of the military's total spend on defense electronics.

As an example, Mercury is very strong in the radar domain, providing the signal processing for a number of important airborne platforms.

A number of these platforms are expected or are in the process of being upgraded to actively electronically scanned arrays.

This type of radar enables the airborne platform to track more targets at a much greater distance while still maintaining a stealth profile.

Sticking with radar for a moment, we're also benefiting from demand for SAR, or synthetic aperture radars, driven primarily by the significant growth in the number of UAVs being deployed.

The DOD's budgets for FY'09 and FY'10 allocated $2.4 billion in procurement for an additional 137 unmanned airborne medium-altitude ISR platforms, such as the Reaper and Predator, and $2.8 billion for an additional 12 Global Hawk high altitude platforms.

Today, Mercury's providing the processing hardware and software for the radar sensors on all these platforms.

Looking specifically at the performance of our radar business in FY'09, revenues were up 21% over fiscal '08, with bookings up 27%.

Another bright spot in the market is missile defense, where the DOD's new priorities are clearly working in our favor.

The previous administration's plan was to locate a fixed, ground-based ballistics missile defense site in Czechoslovakia.

President Obama and Defense Secretary Gates changed that in favor of relying on a combination of the Aegis Naval Missile Defense System and other mobile, ground-based missile defense systems, of which we are a part.

As you are probably aware, Aegis is one of Mercury's largest single programs that should soon hit production.

Elsewhere in the world, the threats posed by the missile programs in North Korea and Iran are also causing great concern.

As a result, our prime defense contractor customers are seeing increased foreign military sales for ground-based missile defense systems.

In the fourth quarter of fiscal 2009, we received an $18-million order to provide the radar processing subsystem for a ground-based missile defense system with one of the major primes.

We believe this initial order represents only the leading edge in a significant longer-term market opportunity for Mercury in the years ahead.

Another growth market is electronic warfare that encompasses, among other things, both signals and communications intelligence.

EW is an area of growing strength and importance to Mercury.

Our EW business grew 6% in '09, and we believe that we are currently well positioned for additional airborne and naval EW platform upgrades through our prime customers.

Looking further out, another growing market opportunity is in the army's push for technology that can effectively detect and counter improvised explosive devices, or IEDs.

We are now working with a number of primes to develop technology for a next-generation counter IED system.

Finally, we're increasingly well positioned in the electro-optical infrared, or EOIR, processing space.

If you look at ISR, video has become one of the military's most important sensor technologies.

We've been making significant R&D investments on products that will enable more on-board data exploitation of full-motion video.

We believe that this will be one of the primary ways in which the current ISR architecture will evolve.

And hence, we see this as an important longer-term growth market.

Let's move now from market opportunities to business opportunities.

There are five key factors that will drive the expansion of our business on both the top and bottom lines over the next several years.

Starting with ACS commercial, in fiscal 2009 we laid the groundwork for regrowth in our commercial business with significant new semiconductor design wins.

So the question is, when will we begin seeing a rebound in the semi-cap equipment space?

As we expected, Q1 of fiscal 2010 saw further declines in commercial bookings and revenue, which were down 13% year over year to $10.7 million and by 42% to $6.6 million, respectively.

On our call last quarter, I described the signs of improvement in our commercial business as inconsistent, but they seem to be more evident now.

Although our visibility is still relatively limited, our commercial bookings in Q1 were actually stronger than we anticipated, and feedback from customers suggest that our commercial business may be stabilizing at this point.

If there is any growth in the second half of fiscal 2010, it is likely to be driven by semiconductor customers such as KLA-Tencor, whose business appears to be picking up, and by ASML, where we recently received our first production orders.

Although it is still early in the game with ASML, since they are just starting to ship their new system, we could start to see the benefit of those shipments in the second half of fiscal 2010.

It's our understanding today that the rebound in demand is being driven primarily by chip makers that are looking to buy equipment with an eye towards launching new chips rather than increasing capacity.

A more sustained increase would likely require a broader-based economic recovery.

Outside of semi, some of our customers in the commercial communications space pushed out programs during the downturn.

They now appear to be cautiously reexamining several of those opportunities.

In Q1, our commercial booking sequential increase was largely driven by one new customer win for test equipment in the 4G wireless communications space.

This sets us up for modest sequential revenue growth in Q2.

But sustained growth, if it does materialize, is not likely until the second half.

The second growth factor is increasing the number and value of our design wins.

The primes are under increasing pressure to cost effectively deliver new capabilities to their customers and, ultimately, to the war fighter.

The imperative for us in this environment is to launch new products and to help get them into theater faster than ever before.

We're in the midst of a major refresh in both our signal processing and multi-computer product lines, with a particular emphasis on increasing our product velocity.

Mercury won seven new designs in the first quarter of 2010 -- six in defense and one in commercial -- compared with a total of eight design wins in Q1 last year.

The five-year probable value this quarter was $16 million, compared with $36 million a year ago.

In defense specifically, the five-year probable value of our Q1 2010 design wins was $13 million, compared with $17 million in the first quarter last year.

In fiscal 2009, we created significant hardware design reuse and leverage in the business as the way to enhance our product velocity.

We're working to enhance velocity even further in fiscal 2010, with more design reuse and leverage in the software side of our model.

In fiscal 2009, we also led the development of the next-generation imbedded system standard, VPX, with what we called OpenVPX.

We expect OpenVPX to be ratified shortly by the standards body that supports the defense electronics industry.

In parallel, we've been working to develop the broad range of new OpenVPX products that we announced last week, which should position us as first to market when the new standard is adopted.

Defense electronics is a high-mix, low-volume business, where the key is not only product velocity but also product customization.

Historically, the primes couldn't have high performance and highly customized open standards technology.

With Mercury's newly introduced OpenVPX products, they now can.

OpenVPX will reinforce Mercury's reputation as the best of breed in high-end digital signal processing, and positions us as a key architecture partner to the primes in their performance migration to open systems.

In terms of both hardware and software, our objective is to use OpenVPX systems as the path to design reuse and standardization and, thus, deliver a more complete customized solution at less cost and with greater velocity.

This will better position us to respond to the government's increasing focus on QRC, or quick-reaction capabilities, by rapidly responding to the new design requirements and quickly meeting those requirements with new technologies.

OpenVPX also helps us as we shift to a more of a systems focus.

We see our ISR-focused Service and Systems Integration business in ACS as Mercury's third key growth driver.

Our goal for this business is to penetrate the two-thirds of the defense electronics market that, in the past, our focus on hardware alone has prevented us from addressing.

After its startup in fiscal 2008, Services and Systems Integration was the fastest growing part of our ACS business in fiscal 2009, posting year-over-year bookings and revenue increases of 106% and 157%, respectively.

This growth accelerated in the first quarter of 2010, as bookings were up nearly 200% from Q1 last year to $3.2 million, and revenue more than tripled to $4.9 million.

For both the government and the primes, the days of proprietary closed systems are over.

The primes appear to be looking to outsource more capabilities to best-of-breed companies that can deliver not only open systems but architectures that include greater use of commercial items.

Mercury has long been recognized as the best of breed in high-end digital signal processing and a leader in commercial item technologies for the defense market.

This makes us the logical choice for integrating the signal processing subsystems on new ISR programs and platforms.

The fourth in our list of five growth drivers is growth in federal services through Mercury Federal.

In creating Mercury Federal, our goal is to begin penetrating the broader defense electronics market that we haven't previously addressed.

We believe this opportunity is 10 times larger than the commercial item defense electronics market that our ACS defense business has targeted in the past.

The hybrid business model that we've created with Mercury Federal takes us beyond subsystems integration into serving as the architects for all the advanced signal, image and sensor processing on next-generation ISR programs and platforms.

After reporting $5.7 million of revenue and $11.9 million in bookings in fiscal 2009, essentially its first year in business, Mercury Federal delivered a strong first quarter of 2010, delivering revenue and bookings of $3.1 million and $2.9 million, respectively.

Similar to the Services and Systems Integration business, Mercury Federal is leveraging our new advanced processing solutions to address the DOD's principal airborne ISR challenge of closing a critical and growing gap, the gap between the huge amounts of data collected and the amount that can be analyzed and delivered to tactical users in time for it to be actionable.

Combining the hardware and software capabilities of our converged sensor network architecture, we're developing systems for wide-area, unmanned aerial surveillance that enable multiple operational assets to receive timely, relevant information over larger areas of interest.

Last quarter, I mentioned that we were awarded a contract to pull together the image processing system for the Gorgon Stare ISR system on the Reaper unmanned aircraft.

Gorgon Stare was recently named by C4ISR Magazine as one of the five finalists in the innovations category in the Big 25 C4ISR program awards for 2009.

This program represented a significant portion of Mercury Federal's Q1 bookings.

The fifth in our list of growth drivers is acquisitions, and we're continuing to explore this type of opportunity.

As we do so, we will be likely pursuing opportunities that achieve three things -- one, strengthening our ISR domain expertise; two, growing the core by improving the timing and our access to the most promising next-generation ISR platforms and programs; and finally, increasing our overall footprint through increased platform production content.

In conclusion, the defense spending environment is favorable for our business.

We're improving our product velocity and winning new designs.

Our focus on ISR with Services and Systems Integration and Mercury Federal puts us in the right places with the right business model within the overall defense market.

In our commercial business, although it feels like we may be stabilizing, one quarter doesn't yet make a trend.

Our revenue for the second quarter of fiscal 2010 will be down sequentially due to a single large radar order that pushed from Q2 to Q3.

However, we believe that Mercury is positioned for renewed growth in the second half of fiscal 2010 and for the year as a whole.

Finally, I'm looking forward to seeing many of you at our annual Investor Day, which will be held in New York City on the morning of Tuesday, November the 10th.

We expect this to be an informative half-day of presentations from a cross-section of our senior team, as well as from John J.

Young, former Under Secretary of Defense for Acquisition, Technology and Logistics, who will share his thoughts on the defense market as well as reforms in the government defense procurement process.

With that, I'll turn it over to you, Bob.

Thank you, Mark.

As a reminder, I'll be discussing our first-quarter fiscal 2010 results on a GAAP basis.

Please note that commencing with FY2010, our non-GAAP measure for reporting financial performance is adjusted EBITDA.

We believe that GAAP combined with adjusted EBITDA is consistent with practices in the defense industry.

In addition, now that we've divested all of our noncore businesses and treated them as discontinued operations, the numbers I will be discussing relate only to continuing operations.

Starting on the top line, total revenue for the first quarter of fiscal 2010 was $47.4 million, well above the high end of our guidance range of $43 million to $45 million.

This compares with $44.8 million in revenue for the first quarter of fiscal 2009.

Please note that in Q1 FY'10, Mercury elected to adopt the new EITF 08-1, Revenue Arrangements With Multiple Deliverables.

Although Mercury was not required to adopt this guidance until Q1 FY'11, we elected to early adopt, as the Company feels that this guidance allows for the recognition of revenue for an arrangement with multiple elements -- multiple deliverables to more closely mirror the economics of the arrangement.

As a result of the implementation, Mercury recognized $1.9 million that would have been deferred under the previous guidance, EITF 0021, for multiple element arrangements.

GAAP income from continuing operations for the first quarter of fiscal 2010 was $4.4 million, or $0.19 per diluted share.

This was also above the top end of our guidance range, which was $0.03 to $0.08 per share.

For the first quarter of last year, Mercury reported GAAP income from continuing operations of $1.4 million, or $0.06 per diluted share.

Looking at our revenues by operating unit, revenue in ACS, including both defense and commercial, for the first quarter of fiscal 2010 was $45.3 million, up 1.4% from $44.6 million in Q1 last year.

As Mark said, our Services and Systems Integration business within ACS posted strong growth, delivering $4.9 million in revenue for the first quarter of 2010, compared with $1.5 million in Q1 last year.

Our Mercury Federal Systems segment turned in another excellent quarter, as revenue increased to $3.1 million from $0.3 million a year ago.

We're continuing to deliver solid results in our core defense business.

Total defense revenues for the first quarter, including ACS defense and Mercury Federal, grew 22% year over year to $40.8 million, from $33.4 million in the first quarter of fiscal 2009.

Commercial revenue for the first quarter of fiscal 2010 was $6.6 million, down 42% from Q1 last year.

Mercury's total book-to-bill ratio for the first quarter, including ACS and Mercury Federal, was 1.03, compared with 1.33 in the sequential fourth quarter and 1.04 in Q1 last year.

Mercury's first-quarter total backlog, including deferred revenue, was $99.4 million.

This compares with backlog of $98.2 million for the sequential fourth quarter and $79.2 million in Q1 of fiscal 2009.

Reflecting the slowdown in our commercial business, approximately 91% of our current backlog relates to defense.

In addition, $62.4 million, or approximately 63%, of our total backlog relates to shipments scheduled within the next 12 months.

This is down from Q4 and year over year, driven by the increases in the engineering and systems integration components of our business, which tend to play out over more than a 12-month period.

Our customers are the primes, and every order we book is backed up by an executed purchase order.

So the lower percent shippable within the next 12 months speaks not as much to risk in our business as it does about the success of our growth strategy.

Mercury's adjusted EBITDA for the first quarter of fiscal 2010 was $7.8 million.

This compares with $5.1 million for the first quarter of fiscal 2009.

Adjusted EBITDA for Q1 2010 excludes the impact of approximately $3.4 million in charges as follows -- $0.1 million in interest income, $0.1 million in interest expense, $0.9 million in taxes, $1.3 million in depreciation, $0.4 million in amortization of acquired intangible assets, $0.5 million in stock-based compensation charges, and $0.3 million in restructuring charges.

A reconciliation of adjusted EBITDA to GAAP net income is included in the press release we issued this afternoon.

We used a tax rate of 17% for the first quarter of fiscal 2010, and expect this to be our rate for the full fiscal year 2010.

This reflects our latest view on the release of the valuation allowance on our deferred tax assets and our ability to utilize them in future periods.

We do expect to evidence a more normalized tax rate in the 36% range for FY '11.

Q1 results are a good demonstration of the leverage in our business model.

Gross margin for Q1 was 57.6%, or 110 basis points, above the midpoint of our guidance range of 56% to 57%.

The improvement this quarter is driven by two things.

The first is favorable product and business mix.

In addition, as our product quality improves, we're seeing declines in sustaining engineering and warranty costs.

Operating expenses for the first quarter of fiscal 2010 were $22.2 million.

This compares with $23.6 million in Q1 last year.

Operating expenses came in approximately $1 million lower than we had assumed in our Q1 guidance, primarily driven by general expense controls as well as lower stock-based compensation expenses reflecting both executive and employee departures within the quarter.

Turning to the balance sheet and cash flow statement, cash, cash equivalents and marketable securities at the end of the first quarter of fiscal 2010 totaled $94 million.

This compares with $91.9 million at the end of the sequential fourth quarter of fiscal 2009.

Mercury generated $1.7 million in positive free cash flow in Q1.

As a reminder, our auction rate security settlement with UBS entitles us to full repayment of our ARS portfolio at par on June 30, 2010.

In the interim, we continue to have a $33million, zero-cost loan from UBS.

We continue to make good progress improving the underlying operations of the business with a focus on working capital.

Inventory was down by $2.1 million in Q1 from the sequential fourth quarter, contributing to the increase in operating cash flow.

Inventory turns are now up to 5.5 from a low water mark of 3.2 turns a year and a half ago, and we've taken our more than $14 million of net inventory during this time.

First quarter DSOs were 67 days, compared to 53 in the sequential fourth quarter.

An issue we continue to address in this area is our shipment linearity within the quarter.

In Q1, this was most evident in accounts receivable, which increased to $35 million from $29 million in the sequential fourth quarter.

This type of lumpiness will always be a factor in our business to some extent, but we're working with our customers to make as much progress on shipment linearity as we can.

Overall, we feel good about the improvements we've made in our supply chain infrastructure and working capital and in our ability to generate cash from operations, and believe we are well positioned to grow into our target business model as we expand Mercury's addressable market.

At the end of the first quarter, our total employee headcount, excluding contractors, was 519, compared with 517 at the end of Q4.

Before we move on to guidance, I would like to extend our appreciation to Mercury's shareholders for their participation in our annual meeting last week.

Shareholders voted in favor of all five matters on the agenda, including the reelection of Russell Johnsen and Vincent Vitto as Directors.

And echoing Mark's comments, let me again extend our invitation to attend Mercury's Investor Day in New York City on the morning of November 10.

I hope to see you there.

Our guidance for the second quarter of fiscal 2010 reflects our view that we may have seen the bottom for Mercury's commercial revenues in Q1.

We expect our commercial business to evidence modest sequential revenue growth in Q2.

A more pronounced recovery may evidence itself in H2.

Although the underlying trends in our defense business remain strong, pushing the large radar order into Q3 will affect our revenues and profitability for the second quarter.

Given that we're not providing annual guidance, I'll just say that we expect to be back on track in the second half of the year.

For the second quarter of fiscal 2010, we currently expect a revenue range of $40 million to $42 million.

We anticipate reporting Q2 gross margins of approximately 52% to 53%, down from Q1 due to business and product mix shifts and lower volumes across our fixed manufacturing costs.

Our second-quarter operating expenses are currently anticipated to be in the range of $23 million to $24 million.

This increase is primarily driven by delayed expenses from Q1, modest hiring, and more normal quarterly stock-based compensation expense.

CapEx for the second quarter of fiscal 2010 is projected to be approximately $2 million.

We expect to report a second quarter GAAP loss from continuing operations in the range of negative $0.08 to negative $0.04 on approximately 22.8 million shares outstanding.

Turning to Mercury's adjusted EBITDA for the second quarter of fiscal 2010, our estimate excludes the following approximate amounts -- $1.3 million in stock-based compensation costs, interest income of $0.1 million, interest expense of $0.1 million, $0.4 million in amortization of acquired intangible assets, and depreciation of $1.4 million.

Again, our tax rate for fiscal 2010 is expected to be approximately 17%.

As a result, adjusted EBITDA for the second quarter of fiscal 2010 is currently expected to be $0.6 million to $1.9 million.

Before we go to your questions, I'd like to conclude with a reminder that coincident with preparing our FY '10 strategic operating plan, we updated our pro forma target business model to better align with our current operations.

The model consists of two segments.

The first is our Advanced Computing Solutions, or ACS, business.

ACS represents our core defense business, including Services and Systems Integration, as well as our commercial business.

The second segment consists of Mercury Federal Systems.

On the year-end call, we reset our non-GAAP target business model at the corporate consolidated level to reflect a 14% to 15% operating margin, with a gross margin of 54%-plus.

This is based on Mercury's targeted profitability within the next two to three years, excluding acquisitions.

We expect a 90/10 revenue split in that timeframe between the ACS and Mercury Federal businesses.

The ACS unit continues to drive high margins, and we are targeting a 55% gross margin and a 15% operating profit in this larger part of our business.

This gross margin target is slightly down from currently reported gross margin levels, driven by the faster growth in our Services and Systems Integration business and a commercial rebound that we expect ACS to be characterized by over the next two to three years.

Mercury Federal Systems, being a value-added service provider for the primes and federal government agencies, has targeted a more typical 20% gross margin and 10% operating profit.

In addition, we currently expect that our new target business model will deliver an adjusted EBITDA margin in the range of 17% to 18% of revenue.

Now that we've refocused ACS on high-growth defense markets and begun the development of Mercury Federal, we believe this new target model aligns well with our new and stronger positioning and provides more insight into the underlying operations of the business.

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

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

Thank you.

(Operator instructions).

And we'll go first to Steve Levenson with Stifel.

Thanks.

Good evening, Mark and Bob.

Hi, Steve.

Hey, Steve.

How are you?

Okay, thank you, and you.

Glad to see the progress.

A question about contract timing.

Have you seen anything, either directly or through the primes, being held up or slowed down?

I know you spoke about the radar contract.

I don't know if that was exclusive or if there's more.

Today, that's really the only one that we've seen, Steve.

We do believe it's just a matter of timing.

Our customer has spoken to the government, and we believe it's going to happen next quarter.

And the program itself is rock solid, so we think it's just a government first quarter timing delay.

And this is one where you're the sole source for the embedded computers, I take it?

That is correct.

Okay, thanks.

Second, did you have any 10% customers during the quarter, and are you expecting any through this current fiscal year?

We did, Steve.

We actually had four 10%-or-better customers this quarter.

Are they somebody that you name in the 10-Q or that you name, or (inaudible - multiple speakers)?

They are the usual suspects, yes.

We don't actually name them, but it's three of the big ones and one of the tier two primes.

And you expect that to continue through the year?

That's actually a large number in a given quarter.

We always seem to have two or three.

Okay.

And you talked about new chips driving the business on the semiconductor side.

Is that new chip designs, new geometries, or just --?

Yes.

Maybe you can explain it better than I can ask it.

No, I think it is basically customers looking to migrate to higher technology levels, meaning reduced line widths, to improve technology in mobile phones, DVDs and video games.

Great.

Thanks very much.

Okay.

And we'll go next to Mark Jordan with Noble Financial.

Good afternoon, everyone.

First, I'd like to just go back and review your -- the model that you just talked about in terms of adjusted EBITDA margins of 17% to 18%.

If you were to look at that on a GAAP basis backed out, could you say what would be generically, on a percentage basis, what stock comp would run and also what D&A would run if you backed those out to get kind of an op margin?

Sure.

So we believe our model is targeting 17% to 18% adjusted EBITDA, where we've got a range for depreciation in there of 2% to 3% and a range for stock comp also of 2% to 3%.

So if you work that a bit, Mark, you'll find a GAAP model of 12% to 13%.

Okay.

Next, I'd like just to -- if you could just discuss kind of the Aegis program in aggregate rather than just talking about potential shorter-term contracts.

If you were to look at Aegis in this aggregate of what is that in terms of kind of a percentage of total revs, what it might be this year?

And what -- how does that grow over the next two to three years, as you would have, I would assume, both new shipped installations and then, I think, starting, what, in 2011 you would have next-generation retrofit available?

And how would that kick in?

Yes.

So I think overall, Aegis is probably our largest program.

It's [truly] the only 10% program that we have.

We expect that is likely to going to continue, if not grow, as we start to hit production and the retrofits of the ships that you mentioned.

We haven't been specific in terms of what we expect to occur in years '11 and beyond, because we're not in the business of giving long-term guidance.

But it is an important program.

It's a 10%-plus type program, and we expect it to continue in that regard.

Well, not asking, obviously, for longer-term forecast per se, but in talking with Lockheed, what do they share with you with regards to how this program could grow given the fact that we've, in essence, canceled one of the major competitive forces on missile defense, which was the ground-based program that would have been developed for Europe and we're going to depend much more heavily on Aegis.

How does that impact this program over the next couple of years?

So I think --

And related -- yes, I guess related to that, they got a -- Lockheed got a $1 billion, five-year development program.

How did that play into your opportunity also?

Yes.

So I think if you look at big picture, as I mentioned in the prepared remarks, we believe that missile defense is going to be an important growth driver going forward.

If you step back to the Secretary Gates' budget reprioritization, I think the DDG 1000 lost out in the budget and the Aegis class cruiser on the BMD perspective definitely saw additional funds.

So we think that there's going to be an uplift there.

If you step back and look at the overall theater of missile defense, with what Gates and Obama did, originally they were going to have a fixed missile defense site over in Czechoslovakia.

That I think changed to putting more Aegis class cruisers in the North Atlantic, as well as actually increasing the number of mobile, ground-based missile defense systems, of which we're also a part.

So I think we feel that we're well positioned, whether it be from a naval BMD perspective or whether it's from a ground-based missile defense with the major booking that we showed in the fourth quarter of 2009.

So clearly, we're going to see more monies flow into the space with everything that's going on in Korea and Iran, etc.

One final, off-the-wall question.

Do you know how many ships that you have to have in aggregate to support one ship on station?

How many -- I'm not sure I understand the question.

Well, if you're going to have an Aegis ship, say, off Israel at all times --

Oh, I see what you're saying.

Yes.

-- do you need three or do you need four?

I'm not sure of the answer to that, to be honest.

It's certainly something that I could ask Lockheed, though.

To go back to -- actually, I didn't answer the second part of your question, which was on the $1 billion contract that was announced by Lockheed on the 26th.

This is the regular contract for the engineering services integration test and support for the Aegis BMD program.

So this was certainly expected from our perspective and not out of line with the current book of business that we anticipate.

Okay.

Thank you very much.

Okay.

And we'll go next to Jonathan Ho with William Blair.

Hi.

Good afternoon.

Hey, Jonathan.

Hey.

So in terms of the ACS commercial business, can you give us a little bit of additional color in terms of what you're seeing there?

And sort of do you have orders in hand at this point?

How do we think about sort of the visibility and the projections that are out there?

Okay.

So let's -- kind of let's break it down into what's happening in commercial overall, really starting to dig into a little bit in the semiconductor space, which is what we believe is going to drive the growth looking forward, and then how do we feel at an overall level.

So I think if you look at what happened in Q1, it really did play out very much as we anticipated.

The last quarter, when we had the call, we basically said that the signs of improvement were pretty inconsistent.

Since then, it seems to be -- things seem to be getting better, and there's more evidence appearing of a turnaround in the semi as well as the telecom space.

But I think if you look at the growth that may occur, it's definitely going to be a H2 phenomena.

Stepping through the semi market, semi has really seen a pretty continuous revenue decline on a sequential revenue basis throughout 2009.

Q1 was actually the first positive book to bill that we've had in semiconductor since the fourth quarter of 2008 on a financial year basis, so that's a good sign.

In terms of the performance of semi in the quarter, we saw that our revenues in semi increased by 29% sequentially, and the bookings in semiconductors were up over 48%, again on a sequential basis.

However, if you step back and look at it on a year-over-year basis, the semi business is still down pretty substantially.

So at this point, we do expect sequential bookings growth in semiconductor, and we expect the revenues to be relatively stable.

And as I say, we're expecting overall that the growth in H2 will be driven by the increases in both KLA as well as ASML, where we received our first production orders during the quarter.

So we certainly feel a little bit better in terms of where the commercial -- where the business is today versus where it's coming from.

But one quarter doesn't make a trend, and we need to see how this thing plays out.

Great.

Can you talk a little bit about sort of the faster product development cycles that you guys have been able to implement and maybe how that's factoring into some of the design wins and some of the activity that you guys are seeing?

Yes.

We think that increased product velocity is really, really important for our business.

The reason being is that if we can get more products to market more rapidly and more cost effectively, we're able to go after a broader range of design wins.

And winning new designs in the defense business could enable us to actually grow our bookings and, hence, grow our revenue.

So I think the evidence of the success that we've had to date on that is that -- if you go back in '09 and looking at the growth of the probable value of our defense design, wins just as an example, the value of those were up 51% year over year.

Much of that was driven by the fact that we've been bringing new products to market as part of our product refresh cycle.

So I think we did a really good job fixing the hardware design leverage and reuse during financial year 2009.

What we're now focused on is improving our software design leverage, which is obviously the other part of the model.

So I think the guys in engineering have done a great job.

We've got a lot of new products hitting the market.

You may have seen just this past week the announcement of a whole new range of products around the OpenVPX standard that Mercury basically helped write, and that is the new standard for the embedded defense electronics industry.

So we should be first to market with products against that new standard.

Great.

Thank you.

(Operator instructions).

And we'll go next to Tyler Hojo with Sidoti & Company.

Hey.

Good evening, guys.

Hi, Tyler.

A couple of quick questions here.

In regards to the Merc Fed business, I know you guys don't break out the operating margins, but could you just tell us if it was profitable in the quarter?

It was around about breakeven for the quarter.

Okay.

And I mean, obviously, nice improvement on the revenue front.

What are your expectations for that business as we kind of move through the rest of the year?

Understanding that you don't want to give quarterly guidance, but I mean, is it going to be a little bit bumpy, or do you just see a pretty nice trajectory up from here?

It could be a little bit of both, right?

We do expect growth overall.

I think we're relatively well positioned there.

We have one big program, which is the Gorgon Stare program, that I think we're executing very well against our contract.

We expect that to continue going forward.

So we do expect growth.

I think we've seen a pretty substantial increase here in this past quarter in terms of both backlog on a year-over-year basis as well as revenue, and the team is doing pretty well.

Okay.

And in terms of finding a permanent replacement for the business heads there?

Any comments?

Yeah.

So we are out in the marketplace searching for a successor for Terry.

I think on an interim basis, you probably saw that we appointed the for- -- Rear Admiral Mike Johnson, who is also the former CEO of Recon Optical.

And Mike was actually our guest speaker at Investor Day last year.

He's pretty much touched every form of ISR and has actually been on the Board of Merc Fed pretty much since its inception, so he's a great interim leader.

But we are, obviously, in the marketplace looking to find a suitable replacement.

Very good.

And just lastly, I just want to go back to the, I guess, delay for the radar contract that you thought you were going to get in the second quarter, but now it's third quarter.

I mean, if you could maybe just give us a little bit of an understanding of how much confidence you have that that will actually be realized in the third quarter.

Or I mean, is there a possibility that could become a 4Q event and perhaps other contracts that you're seeing starting to slip to the right, or is this really kind of a one-time thing?

I know that's a mouthful there.

Yes.

No, no, no, you're -- I mean, you're asking multiple questions, so that's fine.

First of all, I don't think we're seeing multiple programs slip to the right.

This seems to be a one-off.

Clearly, the defense industry, right, I think which we've talked about before, is lumpy, right?

And a deal either side of the quarterly boundary can make the difference between an up quarter and a down quarter.

Unfortunately, this quarter it was on the wrong side of that line.

The program itself we believe is absolutely rock solid.

It's a very important program, I think, from a government perspective.

It did see increased funding during the Gates reprioritization, and so we really truly do believe that it's simply a matter of timing.

Our customer, the prime, did actually go and speak to the government themselves, and the response that they got back is that they believe that this is a Q3 funding event.

So at this point, we do believe it's just simply a matter of timing.

Okay.

All right, great.

And just, again, to follow up on -- gosh, I can't remember who asked the question on the commercial side, but I mean, you've talked about all these opportunities, and if I've done my math right here, commercial ACS is about $6.8 million this quarter.

I mean, order of magnitude -- I mean, where can we get in the back half in terms of a quarterly run rate if everything kind of goes perfectly here?

Yes.

Well, again, we're not doing multi-quarter guidance.

I think we're -- I kind of laid out what we're seeing in the semiconductor space, which is really what we think is going to drive the growth in the second half.

So I think we're going to have to wait and see, Tyler, but we're hopeful that that part of our business is going to see some rebound.

There's definitely some positive signs there.

You've done pretty good math for Q1, though, Tyler.

Yes.

All right, great.

Well, we gave you all the numbers.

Your model's work- --

Yes, it wasn't that difficult.

Yes.

Your model is working.

All right.

Great.

Thanks, guys.

All right.

Thank you.

And we'll go next to Ran Wrighton with Barrow, Hanley.

Good evening.

I'm curious if you guys can elaborate on the counter-IED opportunity.

And I guess firstly, do you have content on the currently fielded versions?

And in terms of the next competition, is -- I mean, any brackets around the type of opportunity it is?

And are you tied to one specific competitor, or do you have content on multiple versions?

Okay, so we currently don't have content on the crew program.

We have been doing some small research type contracts within Mercury Federal.

The opportunity that I referenced in the prepared remarks is largely around [J crew 3.3], which will be a spiral upgrade to the capabilities that they're -- that's in the field today, but providing what we think to be some pretty significant new capabilities.

We are positioned with multiple primes, and so we feel that if that program comes to pass, then we'll be an important player there.

So I mean, any ballpark on full funding, what type of longer-term revenue opportunity that could be for you all?

Not at this stage.

I think the government did award, I think, a couple of contracts recently to two primes to investigate and prove out the system.

And so I think it's going to play out here in the longer-term, which is basically what I had previously mentioned.

However, if you step back, though, the counter-IED issue is probably one of the more substantial issues that the military is facing in both Iraq and Afghanistan, and it isn't going away.

I read some statistics recently that said that they're probably finding 5% of the number of IEDs that are being planted, and so continuous improvement of the technology around counteracting these devices is important.

And we recognized that early on, and we invested in it from an R&D perspective, and we expect it to be an important growth area for us going forward.

Great.

And my second question is just along the lines of international military sales.

You've seen a lot of activity on that front as it relates to foreign sales and missile defense products, but the volumes really start to ramp up the next few years.

Just curious if you can put any brackets around that opportunity for you.

Yeah, we clearly think that's an important area.

I think one of the more important programs that we have in that regard is around the ground-based mobile -- or mobile, ground-based missile defense.

So we announced a pretty major program or booking in the fourth quarter of '09 where we're providing the radar processing subsystem for one of those platforms.

The growth in that particular program is all being driven over the next five years by foreign military sales.

The $18 million that we booked in Q1, $6 million of it was for the first country.

And over the next however many years, we expect multiple countries to fall, again, from a foreign military sales perspective.

So that's clearly going to drive growth around that category.

Great.

Thank you.

And it appears we have no further questions at this time.

I would like to turn it back over to Management for any additional or closing remarks.

Okay.

Thanks, Lena, and thanks to everyone for listening here today.

We look forward to speaking with you again next quarter, or if you're attending our investor conference in New York on November the 10th, we'll see you then.

Thank you very much.

And that concludes today's conference.

Thank you for your participation.