Mercury Systems Inc (MRCY) 2010 Q3 法說會逐字稿

Good day and welcome everyone to the Mercury Computer Systems, Incorporated third quarter fiscal year 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.

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 press release, you can find it on our website at www.mc.com.

We would like to remind you that the remarks 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 than those projected or anticipated.

Additional information regarding forward-looking statements and risk factors is included in the earnings press release we issued this afternoon reporting the Company's third quarter fiscal year 2010 results, and in the Company's periodic reports filed with 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 would also like to mention that in addition to reporting financial results in accordance with Generally Accepted Accounting Principles, or GAAP, we will discuss a nonGAAP financial measure, specifically adjusted EBITDA.

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

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

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

Thanks Bob.

Good afternoon, and thank you for joining us.

I will begin with an update on our business for the third quarter.

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

We have refocused Mercury's business to benefit from the fundamental changes taking place in Defense Electronics technology and procurement, as evidenced by our results for the third quarter.

Total revenue exceeds the high end of our guidance range by $0.6 million.

We reported GAAP earnings from continuing operations of $0.16 per share, compared with guidance of an $0.11 to $0.15 loss.

We did not record any revenue from the $27 million missile defense radar order that we received in Q2.

However, the GAAP earnings upside this quarter did reflect high defense revenue from other programs.

Earnings were also driven by higher gross margin associated with favorable changes in our business mix.

Adjusted EBITDA for the third quarter fiscal 2010 came in at $4.2 million, compared with our guidance of a negative $1.1 million to a positive $100,000.

Operating cash flow grew to $4.5 million from $2.5 million in Q3 last year.

Total books were $49.9 million, down 11% sequentially because of an over-achievement last quarter relating to the large missile defense radar order we received.

Bookings in our ACS commercial business more than doubled sequentially, driven by a strong performance in semi.

On a year-over-year basis, total bookings for the third quarter were down 14% from the unusually strong Q3 of fiscal 2009, when we booked a large defense order and ACS, and had stronger bookings in our Mercury federal systems business.

Our total book to bill for Q3 was 1.14.

Total backlog is up 42% year-over-year, and our 12-month backlog is up 44%.

Looking specifically at our defense business, total defense revenue in the third quarter including ACS and Mercury Federal declined 1% sequentially, and by 9% year-over-year to $34.2 million.

Defense bookings for Q3 were $29.4 million.

Whereas bookings and revenue this quarter reflect the top sequential and year-over-year comparisons I just mentioned.

Our book to billing defense for the third quarter fiscal 2010 including ACS and MFS was 0.86, down from 1.38 in the sequential second quarter, and 1.25 in Q3 of fiscal 2009.

Our backlog in defense for Q3 decreased 4% sequentially, but increased 33% from the same quarter last year.

Looking at our defense bookings from a broader perspective, last fiscal year the second half was stronger than the first.

This trend reversed in fiscal 2010, as we had a very strong first half and anticipate a weaker second half.

For fiscal 2010 we currently anticipate reporting a book to bill of approximately 1 to 1, and we expect defense bookings to be down from last year.

This is largely due to the near term trends we are seeing in our services and systems integration business and ACS, as well as in MFS.

I will speak to those trends in a moment.

Overall, we expect to return Mercury to growth, and to report solid defense revenue growth for the full year, fiscal year 2010.

This reflects the progress we have made in restructuring, refocusing and strengthening our core business.

First a quick update on our strategic positioning in defense electronics.

We have refocused our business in specific markets where funding should continue to grow over the next several years.

Airborne intelligence surveillance and reconnaissance, or ISR, is the largest of these markets, and represents about 50% of total defense electronic spending.

One particular area we have targeted is airborne persistent ISR, which we believe to be an important segment going forward.

Looking ahead, we are strengthening our product road map for this segment to include EO/IR processing for full motion video applications.

Anti-ballistic missile defense is the second of the key markets we have targeted, and Mercury is providing crucial radar signal processing technology for two key BMD programs.

With the military's emphasis on improving and expanding the nation's mobile BMD capabilities, we believe these programs will continue to be a defense department priority into the foreseeable future.

The Navy's Aegis ballistic missile defense capability has become our largest single program.

Our bookings in Q3 included an additional $3 million in Aegis orders.

As anticipated previously, we do expect to see significant revenue from this program in Q4, which is reflected in our current guidance.

Our second major BMD program is Patriot.

The mobile ground-based missile defense platform.

We expect to see continued growth in Patriot foreign military sales through Raytheon over the next several years.

In total, revenues in our radar business for the first nine months of fiscal 2010 grew 17% year-over-year, and bookings were up 40%.

Our third growth market is electronic warfare or EW.

This market comes electronic, signal and communications intelligence processing on ground-based, naval and aerial platforms.

And we are working hard to penetrate a number of emerging EW opportunities.

One of them, counter-IED has become large enough to be considered a growth market in its own right.

The DoD has challenged the defense electronics community to deliver technology that can effectively detect and counter roadside bombs that Mercury is engaged in this effort.

We have been downselected by two primes to work on the next-generation counter-IED program of record.

While still in the early phase, this program could generate significant revenue for us long-term, if the program is funded and if it ultimately moves into production.

In addition to funding levels, there are two other key factors to consider in the defense procurement environment, and both represent advantages for Mercury.

First, as part of a long-term reprioritization, the DoD is shifting its emphasis from major new weapons systems development, to upgrades of existing programs and platforms.

These upgrades focus on four key areas.

Improved censors, more advanced signal processing and computing, enhanced algorithms, and better communications on and off the platform.

These are all areas of strength for Mercury.

Second, the DoD is deeply committed to long-term broad-based procurement reform, shifting more emphasis toward quick reaction capabilities, or QRC, as well as more firm fixed-price contract awards.

Fixed price elevates risk for the primes.

To mitigate this risk, they are outsourcing some of their capabilities or technologies to Best-of-Breed companies in those particular areas.

We create our service and systems integration business within ACS, and our MFS business to capitalize on these opportunities.

Given these market dynamics there are five factors that we believe will drive our growth over the next several years.

One is the potential for regrowth in ACS commercial.

I will start there.

In the third quarter of fiscal 2010, revenue from our commercial business was down 28% year-over-year, and 10% sequentially.

Through the third quarter, the decline was in part related to the overall weakness in the semiconductor industry, but the largest decline in revenue came from our end of life medical business, which we do not expect to recover.

On the other hand, bookings in commercial rebounded strongly in Q3 an were up 147% sequentially, and more than 90% year-over-year.

The bookings growth was driven largely by a sharp increase in semiconductor ware sales to KLA-Tencor, grew due to an increase in product lead times and product transition, as well as stronger overall demand.

At KLA-Tencor we are roughly halfway through their current product cycle, and expect the related production revenues to continue into fiscal 2011.

Our visibility, however, with respect to our involvement in the next generation system is less clear at this point.

At ASML our opportunities are primarily related to a major design win that occurred in fiscal 2009 on their next generation platform.

Although we have begun receiving production revenues from ASML it is still in the early phase of their new product introduction cycle.

Our business with them will take time to accelerate.

Especially it seems since it seems most of that growth to date is in their lower end, existing product line, of which Mercury is not a part.

As a result, we don't expect to see the same level of commercial bookings growth sequentially in Q4 that we saw in Q3.

Given the underlying volatility we continue to see in our commercial business, we remain cautious in the near term, and are modelling roughly flat commercial revenue year-over-year for financial year '11.

The outlook for growth in our defense business however couldn't be more different.

This brings us to the second of our five growth drivers.

Increasing the number and value of our design wins in defense.

Mercury won 14 new designs in the third quarter of 2010.

Ten in defense and four in commercial.

This compares with a total of nine design wins, all of them in defense in Q3 last year.

Probably the most significant win was for another system on the Aegis BMD platform, which could potentially result in tens more millions of dollars for us in the years ahead.

For the first nine months of fiscal 2010, the total five-year probably value of our design wins decline 11% from the same period last year to $140 million.

In defense specifically, fiscal year-to-date, the five-year probable value is up 13% year-over-year to $121 million.

Our success in winning new designs reflects the impact of the restructuring and refocusing of our business over the past two years.

We dramatically improved our R&D leverage, first in hardware and now moving on to software.

As a result, we have refreshed both our signal processing and multicomputer product lines, while increasing our product velocity.

Faster product velocity aligns us with the government's demands on the price for QRC.

By shortening our product development times, we have been able to quickly launch the great products we need to win new designs in the primes, and ultimately drive bookings and revenue.

The DoD is also putting more emphasis on rapid product customization using open standards.

This is another area where we have aligned Mercury with the evolving needs of the primes.

Mercury led the industry working group developing the next generation embedded systems standard called OpenVPX, and we have positioned ourselves as first to market, by developing a broad range of OpenVPX solutions.

OpenVPX is important because it enables the primes to obtain both high performance and highly customized solutions using open standards for the first time.

With the government driving the primes towards open systems, QRC and fixed pricing, we believe the industry is heading towards more commercial items, architectures like OpenVPX, and more complete value-added signaling processing subsystems instead of boards.

This is our third growth opportunity and the reason why we developed our services and systems integration business within ACS.

In the third quarter, services and systems integration revenue more than doubled year-over-year to $7.2 million.

On a sequential basis, revenue for Q3 grew 6%.

For the first nine months of fiscal 2010, service and systems integration revenue grew over 200% versus the same period last year.

However, this is still a startup business for us, comparatively bookings and services in systems integration for fiscal 2010 will likely be lower than planned.

This is due to a very strong year in fiscal 2009, and a number of programs that are pushed out due to the timing and availability of funding.

As a result, we are likely to be heading into fiscal 2011 with a lower backlog in this business than we had going into fiscal 2010, and this is likely to be reflected in lower fiscal 2011 revenues.

That said we remain very confident that our services and systems integration business, as well as MFS are very important parts of our business model, and have positioned us as the ideal partner for the primes going forward.

That is, as a Best-of-Breed provider of open, application-ready multi and sub-systems and services for the ISR market.

MFS is the fourth on our list of five business opportunities.

The hybrid business model that we have created with Mercury Federal, enables us to leverage our domain expertise in high-end embedded computing, by providing services directly to the end customer, the front end of the design and development process.

This can open the door to design win opportunities for our ACS business, in areas beyond the commercial item defense electronics market, that historically we wouldn't have been able to address.

The capabilities we are building in MFS clearly differentiate us from our competitors.

They better position us to serve as the architects for advanced signal, image and sensor processing subsystems on next generation ISR programs and platforms.

Q3 bookings at MFS grew sequentially to $2.7 million from $400,000 in Q2, but declined year-over-year from the record quarterly bookings of $5 million we reported for Q3 at fiscal 2009.

Our major program in MFS is for the image processing subsystem of a next generation persistent ISR capability on a tactical unmanned aerial vehicle.

This platform will collect and transmit wide area motion imagery directly to the analysts and soldiers who need it on the ground,and tie in to the information provided by those images to be actionable.

In the near term, MFS bookings and revenue are likely to remain highly concentrated, and will continue to be driven by the single large program, whose timing and funding, particularly for fiscal 2011, are still being determined.

Under the leadership of Dave Martinez, who joined us early last month as President of MFS, we are optimistic about the prospects of this new business.

We expect long-term it will become an increasingly important part of our overall revenues.

However, growth in FY '11 may be challenging given our short term books outlook, and likely year-end backlog for MFS.

Business opportunity number five is growth through acquisitions.

We are continuing to look for opportunities in three areas.

First opportunities to strengthen our ISR domain expertise in MFS.

Second increased access to the most promising next generation ISR platforms and programs.

And thirdly, technology and products that can expand our platform content footprint.

So to sum up, we have restructured, strengthened and refocused Mercury, in ways that will align the business with key trends and defense procurement.

As a result, we have created solid momentum in our core ACS defense business, where we expect further strong growth in financial year '11.

Our commercial business, on the other hand, will likely continue to face challenges.

Longer term we see the potential for additional growth in our new services and systems integration and MFS businesses.

We look forward to capitalizing the opportunities we have created in defense, and continuing to achieve our growth and profitability goals in fiscal 2010 and beyond.

With that, I will turn it over to you.

Bob?

Thank you, Mark.

As a reminder, I will be discussing our results on a GAAP basis.

Please note that commencing with FY '2010 our nonGAAP 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 have divested all of our non core businesses, and treated them as discontinued operations, the numbers I will be discussing relate only to continuing operations.

Total revenue for the third quarter of fiscal 2010 was $43.6 million,above the high end of our guidance range of $41 million to $43 million.

This compares with $50.6 million in revenue for the third quarter of fiscal 2009.

Please note that in Q1 of fiscal 2010, 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 of fiscal 2011, we elected to early adopt, as the Company feels this guidance allows for the recognition of revenue for an arrangement with multiple deliverables, to more closely mirror the economics of the arrangement.

As a result of this adoption, in Q1 of fiscal 2010 Mercury recognized $2 million that would have been deferred under the previous guidance EITF 0021 with local element arrangements.

In Q2 and Q3 we recognized a net $2.3 million and $3.2 million respectively for an FY '10 year-to-date incremental revenue amount of $7.5 million.

GAAP income from continuing operations for the third quarter of fiscal 2010 was $3.7 million, or $0.16 per diluted share, on approximately 22.2 million shares outstanding.

The upside from our Q3 guidance of negative $0.15 to negative $0.11reflected three factors,higher revenue, higher gross margin driven by product mix, and reduced other cost of goods sold, and discrete tax items leading to a lower estimated tax rate for FY10.

For last year's third quarter, Mercury reported GAAP income from continuing operations of $4.7 million, or $0.21 per diluted share.

Looking at our revenues by operating unit, revenue in ACS including both defense and commercial, for the third quarter of fiscal 2010 was $42.2 million, down by $7.3 million from $49.4 million in Q3 last year.

Year-to-date ACS revenue is $131.2 million, compared with $138 million of the comparable period in fiscal 2009.

Our services and systems integration business within ACS posted another quarter of strong growth year-over-year delivering $7.2 million in revenue, compared with $3.3 million in Q3 last year.

Our Mercury Federal Systems business again performed well, as revenue increased to $2.3 million from $2.0 million a year ago.

On a sequential basis, MFS revenue declined from $3.3 million in Q2.

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

Total defense revenue for the third quarter, including ACS defense and MFS declined 9% year-over-year to $34.2 million from $37.5 million in the third quarter of fiscal 2009.

Sequentially, defense revenue is down by 1%.

However, for the nine months year-to-date, defense revenue totalled $109.7 million, up 5% from $104.9 million for the comparable period last year.

Commercial revenue for the third quarter of fiscal 2010 was $9.4 million, down 28% from the $13 million reported in Q3 last year.

Sequentially commercial revenue declined 10% from the $10.5 million we reported for Q2.

Mercury's total book to bill ratio for the third quarter, including ACS and Mercury Federal was 1.14, compared with 1.24 in the sequential second quarter, and 1.14 in Q3 last year.

Mercury's Q3 total backlog including deferred revenue was $116.6 million.

This compares with backlog of $110.4 million for the sequential second quarter, and $82.3 million in Q3 of fiscal 2009.

Approximately 85% of our current backlog relates to defense.

In addition, $94.4 million, approximately 81% of our total Q3 backlog relates to shipment schedules within the next 12 months.

This is up by $6.2 million from Q2, and by $29 million year-over-year.

As our backlog continues to grow, not only does our near-term revenue visibility improve, but our ability to execute future quarters, in a more linear shipment fashion should also improve.

Mercury's adjusted EBITDA for the third quarter of fiscal 2010 was $4.2 million.

This compares with $8.4 million for the third quarter of fiscal 2009.

Please be reminded that third quarter fiscal 2010 results include a $2.2 million tax benefit compared to $0.1million of tax expense in the third quarter of fiscal 2009.

I will discuss the drivers of the tax benefit shortly.

Adjusted EBITDA for Q3 2010 excludes the impact of approximately $0.5 million in charges, as follows.

$0.2 million in interest income, $0.2 million in interest expense, a $2.2 million tax benefit, $1.3 million in depreciation, $0.9 million in stock-based compensation charges, $0.4 million in amortization of acquired intangible assets, and $0.1 million in impairment charges.

Our adjusted EBITDA margin remains strong at 10%.

This compares with 12% in the sequential second quarter and 17% in Q3 of '09.

For the first nine months of fiscal 2010, our adjusted EBITDA margin improved from $16.9 million, or 12%, in the comparable period last year, to $17.4 million, or 13% against a longer term pro-forma target of 17% to 18%.

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

As I mentioned, we had a $2.2 million tax benefit for the third quarter including certain discrete items.

We expect our estimated tax rate to be approximately 7% for the full fiscal year FY.10.

This estimate reflects our latest view with regard to maintaining the valuation allowance on our deferred tax assets, and our ability to utilize the DTAs in future periods.

If, based on information available to us at the end of this fiscal year, we believe that we can utilize our deferred tax assets, the valuation allowance would be reversed.

Subsequently we would then expect to evidence a more normalized estimated tax rate in the range of 35% to 37% for FY '11.

Our Q3 results again demonstrated the leverage in our business model.

Gross margin was 56.9%,significantly better than our guidance range of 50% to 51%.

Our favorable gross margin continues to be driven by three factors.

First, the higher revenue.

Second, a favorable product mix.

And third, lower fixed manufacturing costs and other costs of goods sold.

In addition, as I mentioned last quarter, our investments in engineering methodologies and supply chain capabilities continue to drive product quality, and time to market benefits.

As a result, we are continuing to see declines in R&D costs, inventory provisions, and scrap.

Operating expenses for the third quarter of fiscal 2010 were $23.7 million, down modestly from $24.4 million in Q3 last year, and $24 million last quarter,and below guidance of approximately $25 million.

We are continuing to make good progress improving the underlying operations of the business, in terms of our supply chain infrastructure and our working capital, and in our ability to generate cash from operations.

We continue to believe we are well-positioned to close in on our target business model, as we grow Mercury's revenues.

Inventory was up sequentially to $20.1 million from $16.9 million in Q2.

The increase was entirely related to our pre-positioning of material to support the large Aegis radar shipments we are expecting to make in Q4.

Inventory turns for the third quarter were 3.7.

DSOs were 63 days up from 62 in the sequential second quarter.

Mercury generated $2.4 million in positive free cash flow in 2003, compared with $3.2 million in Q2, and $1.5 million in Q3 last year.

For the fiscal year-to-date, free cash flow totalled $7.4 million, compared with $4.6 million for the first nine months of FY '09.

Turning to the balance sheet-cash equivalents and marketable securities at the end of the third quarter of FY '10 totalled $92.9 million.

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

During Q3 we experienced $11.3 million of early calls on our auction rate securities at par.

This leaves us with a $38 million balance that will be redeemed at par on June 30th, and subsequently settled for cash one day later on July 1, 2010.

In the interim, we have a $25 million zero cost loan from UBS.

At the end of the third quarter, our total employee head count excluding contractors was 540, compared with 525 at the end of Q2.

Moving on to guidance, for the fourth quarter of fiscal 2010, we currently expect a revenue range of $58 million to $60 million, delivering the midpoint of this range would be consistent with the full year FY '10 revenue guidance we provided last quarter of $195 million.

As a reminder, we provided this full year revenue guidance last quarter, due to the timing of shipments for the Aegis radar order.

We do not expect to continue the practice on a regular basis going forward.

Turning to the other guidance metrics, we anticipate reporting Q4 gross margin of approximately 55%.

Our fourth quarter operating expenses are currently anticipated to be approximately $26 million.

CapEx for the fourth quarter of fiscal 2010 is projected to be approximately $2.8 million.

We expect to report Q4 GAAP income from continuing operations in the range of $0.25 to $0.28 on approximately 23.3 million shares outstanding.

Turning to Mercury's adjusted EBITDA for the fourth quarter of fiscal 2010, our estimate excludes the following approximate amounts.

Depreciation of $1.5 million, $1.2 million in stock-based compensation costs, $0.4 million in amortization of acquired intangible assets, interest income of $0.2 million, and interest expense of $0.1 million.

As I said, our estimated tax rate for fiscal 2010 is expected to be approximately 7%.

As a result, adjusted EBITDA for Q4 FY 10 is currently expected to be in the range of $9.3 million to $9.9 million.

That said, I have one closing comment.

At this point in the year, the focus is increasingly turning to FY '11.

Although we are not making it a practice to provide annual guidance, I would like to remind you that we do have a target business model that we believe remains relevant to our planning horizon over the next two or three years.

We are clearly having a strong FY '10 driven by elevated gross margins due to a favorable product and business mix, and the benefits of our focus on quality resulting in lower other costs of goods sold.

However our target model for gross margin remains in the 54-plus% range over the planning period.

We have also been very successful in holding down operating expenses in FY '10.

We continue to expect operating expenses to grow at a slower rate than our revenue will.

Although our budget for FY '11 is not complete at this point in time, we do anticipate upward pressure on OpEx for FY '11.

This is mainly related to cost of living and merit pay increases, and selective hiring.

So again, we would point to our target model as an accurate indication of where we see Mercury's business trending going forward.

With that, we will be happy to take your questions.

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

(Operator Instructions ).

We will go to our first questioner now.

Tyler Hojo of Sidoti and Company.

Good evening.

Hey, Tyler.

How are you?

I am well, thank you.

Yourself?

Pretty good

Just on the $28 million Aegis order, has any of that shipped so far in the fourth quarter?

No, it hasn't.

We expect to ship approximately $20 million of the $28 million or $27 million in Q4, split over two shipments, one in May and one likely in June.

Okay.

And has that expectation gone down a little bit for the fourth quarter?

No, it has not.

It is pretty in line with what we were anticipating in Q3.

Okay.

Very good.

And then maybe if you could just talk about, I mean, what is the risk here that that gets pushed out?

I mean how much confidence do you have in that stuff shipping in the quarter?

At this point we feel pretty comfortable.

We are in constant dialogue with our customer.

They are in the final processes of negotiation and documenting their contract with the government.

And so, we expect it to occur, as I just described in Q4 and hence it is in our guidance for the fourth quarter.

That is fair.

You guys commented in the prepared remarks just about seeing some perhaps incremental strength in some of your other defense programs in the quarter.

I was just wondering if you could perhaps elaborate on that at all?

So, well, I think longer term, I mean, as I said in my prepared remarks, I mean, we believe that the Patriot program is going to be an important driver of growth for us longer term.

I think to date we have received a single PO for a single country from Raytheon, and Swanson said on the Raytheon call, they're obviously pursuing countries, such as Saudi, Turkey, Japan, et cetera.

As we know, Congress recently approved the sale of our major new weapons systems including the Patriot to Taiwan.

So, I think overall, we do expect Patriot FMS sales through Raytheon to be an important growth driver for us going forward.

So Aegis and Patriot will be important ones for us, Tyler.

Right, right.

I was just getting at in the quarter.

You exceeded the high end of the guidance range and --

Yes.

Go ahead, I'm sorry

So.

No, clearly we did.

I think we saw strength in [global work this quarter.

And it was one of the major ones

Okay.

That's fair enough.

And then, just one last quick housekeeping question for me.

Was Merc Fed profitable again this quarter?

No.

Merc Fed lost several hundred thousand dollars in the quarter

And the guidance for 4Q what is the expectation for performance in that segment?

We don't typically forecast at a segment level on a go forward basis

Understood.

I mean maybe if you could just directionally comment on trends in either sales, or where the business is currently running?

Yes.

I mean, it is hovering around breakeven to losing a little bit of money.

It is highly sensitive on the revenue given the fixed expense that we have got.

So it could be up a little, it could be down a little

Okay, great.

Thank you

Okay.

Our next question comes from Steve Levenson of Stifel.

Thanks.

Good afternoon

Hey, Steve.

How are you?

Good, thank you.

And you?

Good.

I would think so.

Just a question.

How many 10% customers did you have this quarter and were they all in defense?

Steve, it is Bob.

We had one, and it was in defense.

Year-to-date we actually have three, and they are also all in defense

Okay.

Thanks.

And one of the things I was curious about, with the focus on airborne, one of Mercury advantages in the past has been form factoring heat dissipation.

How does that play into what your plans are now in going forward?

Form factoring.

I didn't hear the second part of the question Steve.

Heat dissipation.

Clearly we believe that size, weight and power are still very, very important factors in not only the airborne, but pretty much all mobile defense applications.

And I think what we have tried to do is lead the industry going forward, by actually authoring the next generation embedded systems standard, which is OpenVPX.

Where we are going is kind of heading up market to focus more on application-ready subsystems that are size, weight and power constrained.

We think that those, the space and thermal dissipation, et cetera, are still pretty important for us.

Okay.

Thanks.

There is recently some talk about the platforms that are planned that include everything from big jets like J Stars, down to the Project Liberty planes, and then UAVs.

Based on what you are hearing, are those potentially common, I know it is not a common platform, but will it be a common payload that if you are in one, you are likely to be in all?

It very much depends, if you look at, say, on the radar side, the Air Force has got the MP-RTIP program, which is a multiplatform, radar capability.

If you look on the [Siggins] size, there are payloads such as ACIP that span across different platforms.

We believe that we are pretty well-positioned on some of the more important ones going forward, Steve.

But I don't think you can make a truly broad statement to say that everything is going to be around one or two standards

Got it.

Thanks very much

Okay.

Our next question comes from Jonathan Ho of William Blair.

Great quarter, guys

Thank you.

Just a quick question.

I didn't know if I heard this correctly or not, but did you say you expected bookings in the back half of the year to be a 1 to 1 ratio, implying down in the fourth quarter?

So we are expecting for the year our book to bill to be approximately 1 to 1.

I think in the prepared remarks, I suggested that we had a stronger first half than what we are seeing in the second half.

And we don't think there is anything particularly happening there.

It is just the way in which the business laid out this year

Great.

And can you talk maybe a little bit about the supplemental and the 2011 budget, and some of the good things that you are seeing there, and maybe give us sort of your high level thoughts on how that would translate into sort of a benefit for Mercury's programs?

Yes.

So, I mean, I think overall, if you look at the budget on a year-over-year basis, it's going to be up, base budget up roughly 3%.

We kind of see those levels looking forward out over a five-year time horizon.

When you step back, and you look at the recently completed [qui-drennial] defense review, we definitely believe that we are well-positioned within the areas that are going to continue to see growth and good funding from a government perspective, like airborne ISR, BMD, counter-ied, et cetera.

So just some of the things that we picked up from a budget perspective is clearly, we are expecting pretty good growth in terms of tactical UAVs, in particular [Protor and Reaper] the dollars associated with those on an 11 basis versus 10 were up 58%.

We are seeing additional funding from a dollar perspective with Globalvoc, with those numbers expected to go up on a dollar basis 7% year-over-year.

Of course, I think when you look at the budget overall, Aegis continues to be well-funded.

I think they are looking at adding additional ships in the '11 budget.

So overall, I think we feel that we are in the right spots from a defense budget perspective looking at the base budget, as well as the overseas contingency

Great.

And just one final question on the commercial side of things.

Can you give us a little bit more color on exactly what is happening with KLA.

I know you said that you are on the current system and the next generation system competition.

What are your thoughts there in terms of being able to keep that program, and approximate timing in terms of when that is going to be decided?

Okay.

So I mean if you look at our semi business was obviously very strong from a bookings perspective this quarter.

Bookings were up around about $13.6 million in semi, we were up 162% year-over-year, and up 187% sequentially.

That was very much driven by a very strong quarter with KT.

The strength was really driven by a couple of different things.

The first was obviously increased demand.

However we did see additional orders associated with increased product lead times, as well as the product transition.

The latter two, which we don't expect to occur on a go-forward basis, looking forward, kind of projecting into FY '11, we are probably are halfway through their existing current product cycle, and we expect the revenues associated with that to continue into financial year '11.

At this point, we are still kind of determining how far into the year our best guess at this point is probably nine months.

So that is kind of a planning assumption that we've got.

As our budgeting cycle improves, and the visibility hopefully will go up.

With respect to our involvement in the next generation system, again things are a little unclear at this point.

And as such, we are basically modelling KT to be down in financial year '11

Great.

Thank you.

Our next question comes from Jim McIlree of Merriman.

Thanks.

Good evening

Hey, Jim.

Hi.

Can you help me understand why gross margins would be down quarter-to-quarter when you have such a large revenue increase quarter-to-quarter?

Good question, Jim.

It is Bob.

The big driver there, it is pretty much the way it has been the past few quarters.

It is going to come down to product mix within the quarter.

We have driven our O COGS down quite well.

I think that is your point.

We get more volume across items that behave at least in the short term as fixed costs.

So that is a plus up for us, no doubt about that.

But our current view on the mix for the fourth quarter would indicate to us that our guidance around 55% is more or less correct

Just the math on it implies that the Aegis orders have a lower mix, excuse me, have a lower margin than the corporate average, is that correct?

I wouldn't go there.

Aegis certainly as a program certainly does not have a lower margin than our overall.

Don't forget we just had a great bookings quarter with commercial, and that is a precursor to a pretty strong revenue rebound for commercial, particularly semi in Q4.

We had a lower margin than we experienced typically on our defense programs.

All right.

And then on the OpEx side, what is the driver for the increased OpEx quarter-to-quarter?

It is mostly engineering, we do keep working on our product road maps.

We do have some external spending associated with new product development, specifically prototype spending.

So that is a driver

It is really timing.

If you look, we were down a little bit this quarter and things can move either side of the quarterly boundary.

So it is more timing than anything, Jim, in Q4.

Okay.

And lastly, I just want to make sure I understand your comments on commercial.

You said that fiscal '11 commercial is likely to be flattish with fiscal '10, is that correct?

Yes.

How much of the end of life medical did you book in fiscal, or do you expect to have in fiscal '10 that you won't have in fiscal '11?

I will give you the numbers on a kind of on a year-over-year basis.

So in fiscal year '09 through the first three quarters we did approximately $7.2 million in revenue, in the first three quarters of financial year '10 we have done approximately 1.4.

So we have seen a pretty substantial dropoff in terms of our medical business.

So if you step back and you look at it, the reason that we are saying we are sort of cautious in both the short term and modelling roughly flat revenues in '11, KLA as I mentioned, we are roughly halfway through there as the existing current product cycle, and so there is still not a huge amount of visibility, in terms of how far that product cycle is going to continue into '11, and then the uncertainty around their next generation.

With ASML, we feel good, but we are at the start of their new product introduction cycle.

And to date, most of the growth that they have seen has been in relation to their lower existing product line, which Mercury is not a part.

So we do expect longer term growth.

In fact, we are modelling good growth for ASML in '11.

But kind of a balance there.

Looking at the other segment, we are expecting declines in certain commercial communications and other legacy customers, and then clearly in the end of life legacy business,Medical business.

So kind of given that, we are cautious and that is why we are modelling roughly flat revenues in commercial in '11.

Okay.

That makes sense.

I'm sorry, can I ask one more?

Certainly.

Absolutely

Great.

So this Aegis order that you have, that you are expecting I think you said $20 million in Q4?

Correct.

You don't have POs yet from Lockheed?

That May/June delivery is when you are kind of expecting them to happen, is that correct?

No, that is not correct.

We actually received a $27 million PO in Q2.

And it is our expectation that we will ship 20 of that in the fourth quarter.

So, we really are waiting for ship signals from Lockheed at this point.

Okay.

So I misspoke.

You have the PO but you don't have the delivery timetable yet?

That is correct.

Okay.

Okay.

Great.

Thank you very much.

(Operator Instructions).

Our next question comes from Mark Jordan of Noble Financial

Good afternoon, everyone.

First question, if you were to in the end of the fourth quarter flow through all of the valuation allowance on deferred tax assets, how big a number would that be?

The flow through that is not currently reflected in our forecast and our ETR, is that what you are asking Mark?

If the accountants were to say eliminate all of the valuation allowance this quarter, what kind of number would that be flowing through?

So we have got about $14 million in deferred tax assets on the books, with a $13 million valuation allowance against it.

So essentially a full valuation allowance.

If it gets flipped at the end of the year, about $6 million of that is going to flip.

The remaining $7 million or so is associated with mass R&D tax credits that we are never going to be able to use.

Okay.

So the $6 million would be what you would see flowing through?

Incremental to what we forecasted, yes, sir.

That is correct.

Yes, excuse me.

Semantics.

But yes.

And then subsequent to that then you would normally see just a normalized tax rate obviously as you have benefits?

Yes.

We are estimating that to be in the range of 35% to 37%.

Pretty much right out of the gate for FY '11.

Okay.

Thank you.

Mark, if I may, I think you do raise a good point.

Obviously, we are going to have a very low rate currently estimating 7% for FY '10, and if we stay on track here and do what you are suggesting, we are going to have a 35% to 37% rate next year.

That is going to have to be normalized when we do the comps next year year-over-year.

Absolutely.

Yes.

So that if you can have a 7% rate then that implies that your guidance again exclusive of any singular tax benefits that may be realized, you are talking 25% to 30% tax rate in the fourth quarter?

Just going the 7% for the full year

Yes.

If you are asking is there the potential for other discrete items to hit in the fourth quarter, other than the flip of the Val allowance, we do not see any at this point in time.

Okay.

I missed the nine-month commercial revenue number.

Could I get that, please?

The revenue for commercial through the present, or were you talking about for legacy medical?

No, no.

The commercial revenues for nine months.

I got --

$26.5 million through the first three quarters of financial year '10, and $35.6 million through the first three quarters of financial year '09

Okay.

And then a final question relative to Aegis deliveries.

Obviously, you are having a big surge here primarily in the fourth fiscal quarter expected.

If you just step back and say Aegis and the Navy programs are scheduled out and are growing, but should one assume just looking at 2011, and say that Aegis should be up year-over-year, and do you have any sense as to how lumpy that should be in 2011, fiscal '11, where it is obviously skewed to the fourth quarter here in fiscal '10?

Yes.

I don't think Aegis revenues are going to be up in '11 over '10.

We are having a very good year in financial year '10.

So I think the way in which we are currently thinking about, it is going to be roughly 10% of our revenues this financial year, the number is going to be higher than that.

And we are still kind of putting the budget together and working with Lockheed on figuring out what the calandarization of those shipments an revenues will look like.

At this point it is probably a little bit too early to tell you.

Okay.

Thank you very much.

At this time, we have one question left in queue.

That comes from Michael Ciarmoli of Boenning and Scattergood.

Hey.

Good evening, guys.

Thanks for taking my questions

Hey, Mike.

Most of mine have been asked.

With regard to the backlog on the defense side, obviously Aegis is a big contributor.

Are there any other major programs making up the balance of that backlog?

Patriot is still in there, to a degree.

We haven't shipped all of that

So if I think about it, Aegis is probably 20% to 25%, is there anything else--?

With that $27 million booking in December that is the biggest single item in backlog.

It is.

Yes There is nothing that, nothing comes even close

Okay.

Fair enough.

And then I may have missed this.

Did you disclose an operating margin number for ACS?

No.

Would you be able to do that?

What period are you talking about?

Current quarter

We can dig it out for you, I think.

Then maybe while you are digging that up Mark, you talked about ten design wins.

Can you elaborate where some of those wins are?

Are they from kind of just a scope expansion on some of your current programs?

Are they entirely new platforms for you?

Yes.

We got ten design wins in the fourth quarter.

Four in commercial, ten were in defense.

We got a design win in semiconductor wafer inspection for a company over in Japan.

It is not huge, but it is kind of in the same space.

We got another design win in next gen baggage scanning in commercial.

So they were probably the two main ones in commercial.

In defense, I would say the most significant for us was the fact that we are likely to get over time another system within Aegis, utilizing the same technology that we are providing as part of the signal processing system for the radar.

So that has got pretty good upside potential over the planned period.

So we were really pleased about that.

Another important one that I think we won was with another customer for the next generation Siggins platform.

Kind of an architecture that it is their next generation architecture that we are kind of baked into.

So I think we have some nice ones this quarter.

I felt pretty good about the results, Mike

Okay.

Great.

Thanks a lot, guys

It is Bob.

I am back.

Repeat your question, please

Operating margins for the ACS segment in the current quarter?

Yes.

So I am looking at our detailed backup sheets and we have not disclosed that at this point in time

Okay

You will pick it up when we file the Q.

It has typically not been ready right now for this call

Great.

Thanks a lot, guys

Yes.

And at this time, there are no further questions.

I will turn the call back to our moderators

I just wanted to come back quickly to the question that you asked.

I mean, the major programs that drove revenue for us this quarter were JSF, Patriot, Aegis, and F-16.

So operator, thanks very much.

And thank you all for listening.

We would like to close down the call, and we will speak to you again next quarter.

Thank you very much.

Bye-bye.

This does conclude today's conference call.

We thank you for your participation, and have a wonderful day.