Mercury Systems Inc (MRCY) 2011 Q1 法說會逐字稿

Good day and welcome, everyone, to the Mercury Computer Systems First Quarter Fiscal Year 2011 Conference Call.

Today's call is being recorded.

At this time, for opening remarks and introductions, I'd like to turn the call over to the Senior Vice President and Chief Financial Officer, Mr.

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

We'd like to remind you that remarks that we may make during this call about future expectations, trends and plans for the Company and its business constitute forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995.

You can identify these statements by the use of the words may, will, should, would, plans, expects, anticipates, continue, estimate, project, intend, and similar expressions.

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

These risks include, but are not limited to, general economic and business conditions, including unforeseen weakness in the Company's markets, effects of continued geopolitical unrest and regional conflicts, competition, changes in technology and methods of marketing, delays in completing engineering and manufacturing programs, changes in customer order patterns, changes in product mix, continued success in technological advances, and delivering technological innovations, continued funding of defense programs, the timing of such funding, changes in the US government's interpretation of federal procurement rules and regulations, market acceptance of the Company's products, shortages in components, production delays due to performance, quality issues with outsourced components, inability to fully utilize the expected benefits from acquisitions and divestitures or delays in realizing such benefits, challenges in integrating acquired businesses and achieving the anticipated synergies, and difficulties in retaining key customers.

Additional information regarding forward-looking statements and risk factors is included 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 several non-GAAP financial measures, specifically adjusted EBITDA and free cash flow.

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

Free cash flow excludes capital expenditures from cash flows from operating activities.

A reconciliation of adjusted EBITDA to GAAP net income from continuing operations and the free cash flow to GAAP cash flows from operating activities are 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, Bob.

Good afternoon, everyone, and thanks for joining us.

I'll begin with an update on our business for the first quarter, Bob will review the financials and discuss our guidance, and then we'll open it up for your questions.

Mercury continued to perform well in Q1.

Revenue and GAAP EPS both exceeded the high end of our guidance range.

Bookings and 12-month backlog were up 6% and 45% year-over-year respectively.

Adjusted EBITDA for Q1 increased 13% year-over-year and was well above our guidance.

Finally, operating cash flow grew to $9.4 million, an increase of 259% year-over-year.

Looking at our defense business, total defense revenue, including ACS and Mercury Federal, was in line with our expectations at $37.7 million, down 7.6% from Q1 of last year.

Our commercial business more than made up the difference, however, as revenue grew nearly 120% year-over-year to $14.4 million.

Defense bookings for the first quarter were up 9% year-over-year.

Our book-to-bill in defense was 1.09, up substantially from Q1 of fiscal 2010.

And with 45% growth year-over-year in our 12-month backlog, Mercury is on track to deliver solid organic growth on the top and bottom lines in fiscal 2011.

Our major defense bookings this quarter included an order for the Taiwan Patriot System through Raytheon, continued business on the Aegis platform through Lockheed Martin, and additional orders for the ASIP, Airborne Signals Intelligence Package, with Northrop Grumman.

Q1 bookings in our commercial business were roughly flat with Q1 last year.

Although backlog-driven revenue from KLA Tencor will be winding down during the year, Q1 was our fourth consecutive quarter of increased revenue from ASML.

Overall, we still expect roughly flat revenue in commercial for fiscal 2011 as compared with FY '10.

In our defense business, we focused Mercury on key markets that continue to look promising in terms of DOD funding, as well as foreign military sales.

These include ISR, ballistic missile defense, and electronic warfare.

At the same time, we have and continue to position Mercury to succeed in a defense market driven by budget constraints and procurement reform.

We've evolved our business model to align with the needs of the primes in an increasingly challenging environment.

At a macro level, the major change is that Mercury is transitioning to being a best-of-breed commercial item ISR subsystem company.

This means getting involved in programs earlier with an eye toward winning services-lead engagements that will generate long-term production-based revenue annuity streams through the sale of ISR subsystems to the primes.

The Service and Systems Integration business we've developed within ACS has been a major step in this direction.

SSI has successfully positioned Mercury as a trusted outsourcing partner for the primes as they seek more affordable commercially-developed application-ready subsystems for their markets.

These subsystems are enabling us to win new, higher value designs on important, well-funded programs.

Our Mercury Federal Systems business will enable us to make our next transition.

This is to build upon our commercially-developed application-ready subsystems to provide the primes with affordable ISR subsystems that deliver even greater value.

In terms of demonstrating growth-driven results in defense, the key leading indicators is design wins.

Q1 was Mercury's strongest quarter for defense design wins since I joined the Company in calendar 2007.

We won 13 new designs in the first quarter of 2011, all of them in defense.

This compares with a total of seven wins, six in defense and one in commercial, in Q1 of last year.

In total, the five-year probable value of our Q1 design wins grew 242% year-over-year to $56.8 million.

In defense, the five-year probable value is up 318% year-over-year.

Our three most significant design wins this quarter were in electronic warfare and EO/IR.

One was for a technology refresh associated with a major naval [sigand] program.

The second was for a digital storage subsystem associated with a new wide area optical sensor with BAE.

The third major win was for a refresh of the processing architecture for the ASIP, Airborne [sigand] system, with Northrop Grumman.

This new architecture was particularly important from a technology perspective.

It was one of the first programs to trial our new virtual application-ready subsystem design capability that allows for concurrent engineering with our customers.

The refresh will also utilize our new generation of Intel-based products.

Together, the design wins this quarter are significant and provide good growth potential for Mercury in the years ahead.

Our success in growing defense bookings and design wins is not just a function of offering best-of-breed technology and services.

We're also focusing the sales organization to sell higher, to sell earlier in the cycle, and to engage our customers with our services-lead value proposition as we continue to capitalize on the trend towards outsourcing by the primes.

That said, SSI is still an emerging and somewhat lumpy business.

Bookings were up 46% in Q1 year-over-year, but revenue declined.

We still expect SSI revenue for the full year to be down in fiscal 2011 coming off a strong FY '10.

Looking farther ahead, it appears our business model is gaining traction, evidenced by a substantial increase in our 18-month pipeline of opportunities.

In addition, deals previously won in SSI are likely to continue to generate annuity streams for ACS that extend well beyond the year in which the initial services were delivered.

The proof can be seen in terms of our involvement in major programs that are ramping or that are already in production today.

Our presence on the Patriot Missile Program was driven by our SSI business where, in effect, Mercury was paid to do the upfront work that is now producing subsystem annuity revenues.

As I mentioned, we received our second foreign military sales purchase order for Patriot systems in Q1 for Taiwan as anticipated.

We continue to expect additional Patriot bookings and revenue in fiscal 2011, in large part driven by Raytheon's announced goals with sales to Saudi Arabia and Turkey.

In addition to Patriot, we expect our involvement on existing programs and platforms to continue driving organic growth for Mercury over the next several years.

The Navy's Aegis Ballistic Missile Defense System was our largest single program in FY '10.

We expect that Aegis shipments and revenues through Lockheed Martin will continue to be an important revenue driver in FY '11 and beyond.

As I mentioned last quarter, electronic warfare, specifically counter ID technology, could be a game-changing opportunity for Mercury.

We've been down selected by two primes to work on the next generation counter ID program of record, which focuses on ground vehicles.

Protecting military vehicles from roadside bombs is a top DOD priority, and we expect the contract to be awarded to one of these primes in the fall.

Mercury's content is greater with one of the primes than the other.

If the contract is awarded to the right prime, if the program is fully funded, and if it goes into full production as we believe it may, the organic revenue implications for Mercury, beginning as early as 2013, could significantly alter the growth trajectory of our business.

Mercury Federal Systems, or MFS, could also positively impact our business as we transition toward becoming an ISR subsystems company.

Adding the capabilities of MFS to our ACS core business enables us to work on classified projects and work directly with the customers earlier in the process.

This will open the door to ISR design wins for ACS that wouldn't otherwise be available to us.

Bookings at MFS for Q1 of FY '11 declined by slightly over $600,000, or 22%, from the first quarter of FY '10.

In the near term, our bookings and revenue in MFS will continue to be driven primarily by one large program, a next generation persistent ISR image processing subsystem on a tactical UAV.

We expect FY '11 to be essentially flat with the prior year in terms of our results in this business.

That said, if phase II of this program is awarded and development moves ahead this year, MFS bookings could begin ramping to higher levels sooner than we previously anticipated.

We believe the Pentagon considers this persistent ISR system to be an extremely important war-fighting capability, and phase I of the program appears to be producing impressive results.

However, the program still needs to get through the House and Senate's budgeting process, so funding for phase II and its timing are not yet certain.

I'll conclude some thoughts on the potential for both ACS and MFS to supplement our organic growth through acquisitions.

We're continuing to look for bolt-on or tuck-in opportunities in a couple of key areas - first, performing businesses with technologies or products that can help ACS expand its core business and, second, ISR companies that we can build around in MFS.

Given the shape of the current landscape in our space, we'll most likely be focusing on smaller private companies that are closely adjacent to our existing business.

In short, we won't be swinging for the fences.

We have considerable resources at our disposal, including the $82 million of cash that Mercury has on hand, as well as the cash we expect to generate.

Our free cash flow for the first quarter grew to $7.8 million from $1.8 million in Q1 last year, and we feel good about how FY '11 is shaping up from a cash flow perspective.

In addition, we've assembled a new corporate development team that adds significantly to our expertise and bandwidth in this area.

We're also continuing to add depth to our board.

At last week's annual meeting, as you probably know, Mercury shareholders selected two new directors, Jim Bass, the former CEO and President of Piper Aircraft, and Mike Daniels, the former Chairman and CEO of Network Solutions, both of whom have significant experience running and growing businesses organically and through acquisitions.

We welcome Jim and Mike to Mercury and look forward to benefiting from their counsel in the years ahead.

Before I turn it over to Bob, I'd like to thank those of you who participated in our shareholder's survey this month, for providing us with a tremendous amount of feedback and insight.

I'm also looking forward to seeing many of you at our 11th Annual Investor Day, which will be held in New York City on the morning of Wednesday, November the 10th.

We expect this to be an informative half-day of presentations from our senior team as well as from Edmond Giambastiani, former Vice Chair of the US Joint Chiefs of Staff, who will share his thoughts on the defense budget in the ISR market as well as acquisition reform.

Summing up, we have pretty good visibility into our business right now, but like everyone else in this industry, we hope that the approval of the defense budget is resolved quickly.

We also feel good about the positive leading indicators we're seeing, largely driven by the government's push on reforming defense procurement.

Our pipeline is growing, and we're doing well on increasing the number and the value of our design wins.

We're in a strong position on important, established, and well-funded programs.

Our ACS service and systems integration business and MFS have effectively aligned Mercury with the future needs of the primes.

Finally, we're engaged in a thoughtful, measured exploration and pursuit of opportunities to supplement the Company's organic growth through acquisitions.

We expect fiscal 2011 to be another year of solid top and bottom line growth for Mercury and for our defense business.

We also anticipate reporting continued progress toward reaching Mercury's long-term operating model as the business expands.

With that, I'd like to turn it over to Bob.

Bob?

Thank you, Mark.

This was another solid quarter and a good start to our fiscal year.

Mercury's total revenue for the first quarter of fiscal 2011 was $52.1 million, exceeding the top end of our guidance range of $48 million to $50 million.

This compares with $47.4 million in revenue for the first quarter of fiscal 2010.

GAAP income from continuing operations for the first quarter of fiscal 2011 was $3.7 million, or $0.16 per diluted share, on approximately 23.4 million shares outstanding.

This was well above our Q1 guidance of $0.03 to $0.06 per share.

For the first quarter last year, Mercury reported GAAP income from continuing operations of $4.4 million, or $0.19 per diluted share.

The upside from guidance was due to three factors - first, higher revenues, second, higher gross margins due to favorable product mix and lower other cost of goods sold, and third, a modest under-spend in operating expenses.

Breaking it down by operating segment, revenue in ACS, including both defense and commercial for the first quarter of fiscal 2011 was $51.9 million, up 15% from $45.3 million in Q1 last year.

Revenue in our services and systems integration business within ACS for the first quarter of 2011 was $3.9 million compared with $5.1 million in Q1 last year.

As we have said, SSI is still a new business and somewhat lumpy in terms of bookings.

We enter FY '11 with a lower backlog than in FY '10, and we continue to expect SSI's revenues to be lower year-over-year.

In our Mercury Federal Systems business, Q1 fiscal 2011 revenue was $1.9 million, down from $3.1 million a year ago.

As Mark said, our bookings and revenue in MFS are likely to be concentrated on a single large customer in the near term, and we're modeling flat revenue for full-year FY '11.

Note that revenues by operating segment do not include adjustments to eliminate intercompany revenues of $1.7 million included in those operating segments.

Total defense revenue for Q1, including ACS, defense and MFS, was $37.7 million, down 8% from $40.8 million in Q1 of fiscal 2010.

More than offsetting the decrease in defense, Mercury's commercial revenue for the quarter increased 118% to $14.4 million from $6.6 million in Q1 last year.

This growth was driven by semiconductor sales where our business with ASML has been ramping.

And although KLA Tencor is still drawing material from us, we expect their product to go end-of-life at some point this year.

So, as Mark said, we do expect to see flat revenue in commercial for FY '11 as compared with FY '10.

Turning to bookings, total bookings for the first quarter of fiscal 2011 were $51.6 million, a 6% increase compared with $48.6 million in Q1 last year and flat sequentially.

Mercury's total book-to-bill ratio for the first quarter, including ACS and MFS, was 0.99.

This compares with 0.81 in the sequential fourth quarter of fiscal 2010, and 1.03 for full-year FY '10.

Our Q1 total backlog, including deferred revenue, was $104.1 million.

This compares with backlog of $104.6 million at the end of fiscal 2010 and $99.4 million for Q1 of 2010.

Approximately 78% of our current backlog relates to defense.

In addition, 87%, or $90.8 million, of our total Q1 backlog relates to shipment scheduled within the next 12 months.

This is up by $2.4 million from Q4 2010 and $28.4 million, or 45%, from the first quarter of fiscal 2010.

Given the year-over-year growth in our backlog, we should see continued improvement in our near term revenue visibility and in our ability to execute future quarters in a more linear shipment fashion.

In defense specifically, bookings for the first quarter of fiscal 2011, including ACS and MFS, were $41.3 million.

This is up 52% compared with defense bookings of $27.1 million in the sequential fourth quarter of fiscal 2010, and up 9% compared with $37.9 million in Q1 last year.

Our defense book-to-bill for Q1, including ACS and MFS, was 1.09, up from 0.57 in the sequential fourth quarter of fiscal 2010, and 0.93 in Q1 last year.

Our backlog in defense for Q1 increased to $81.1 million from $76.8 million in Q4 of fiscal 2010, but decreased from $90.5 million in Q1 of FY '10.

Mercury's adjusted EBITDA for the first quarter of fiscal 2011 was $8.8 million.

This compares with $7.8 million for the first quarter of fiscal 2010.

Adjusted EBITDA for Q1 fiscal 2011 excludes the impact of approximately $5.1 million in net benefits as follows - zero interest income and expense, a $2.1 million tax expense, $1.4 million in depreciation, $0.3 million in amortization of acquired intangible assets, and $1.3 million in stock-based compensation charges.

Our adjusted EBITDA margin for Q1 was 17%.

This is the low end of our long-term pro forma target of 17% to 18%.

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

We used a tax rate of approximately 36% for the first quarter of fiscal 2011, and we expect this to be our rate for the full fiscal year.

If the federal R&D tax credit is renewed, this 36% rate for the full year would come down by one to two points.

Our gross margin for the first quarter of fiscal 2011 was 58.8%, above the high end of our guidance of approximately 57%, due to favorable product mix, material cost improvements, and lower other costs of goods sold.

Operating expenses for the first quarter of fiscal 2011 were $25.4 million compared with $22.2 million in Q1 last year, and flat sequentially.

With the outlook for strong operating leverage as the business scales, we expect that operating expenses for FY '11 will grow at approximately 50% of the rate at which our revenue grows.

We're continuing to make good progress improving the underlying operations of the business in terms of our engineering methodologies and supply chain capabilities.

As I've mentioned on prior calls, these investments continue to drive product quality and time-to-market benefits.

We're also continuing to improve in terms of working capital and in our ability to generate cash from operations.

Inventory for Q1 was up sequentially to $18.9 million from $17.6 million in Q4 of FY '10 as we preposition material for Q2.

Inventory turns for the first quarter were 4.5.

DSOs in the first quarter of fiscal 2011 were 68 days, up from 62 in the sequential fourth quarter, and a slight increase from 67 in Q1 last year.

At the end of the first quarter, our total employee headcount, excluding contractors, was 531 compared with 523 at the end of Q4 of FY '10.

Mercury performed well in generating cash this quarter.

Free cash flow increased to $7.8 million in Q1 from $1 million in the sequential fourth quarter and $1.8 million in Q1 last year.

We closed the first quarter of 2011 with a total of $82.2 million in cash and cash equivalence, an increase of $8 million from the fourth quarter of fiscal 2010.

Looking further down the balance sheet, we have zero short and long-term debt.

We also have a $15 million operating line of credit, a $20 million acquisition line of credit, and a $100 million universal shelf registration that remains effective.

In short, Mercury is well-prepared to supplement its organic growth with growth through acquisitions.

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

Shareholders voted in favor of all three matters on the agenda, including the reelection of Lee Steele and the election of Jim Bass and Mike Daniels as directors.

And echoing Mark's comments, let me extend to you our invitation to attend Mercury's 11th Annual Investor Day in New York City on Wednesday morning, November 10th.

We hope to see you all there.

Now moving on to guidance, for the second quarter of fiscal 2011, we currently expect a revenue range of $54 million to $55 million.

We anticipate Q2 gross margin to be approximately 55%.

Our second quarter operating expenses are currently anticipated to be about $26 million.

CapEx for Q2 of fiscal 2011 is projected to be approximately $3 million.

We expect to report second quarter GAAP income from continuing operations in the range of $0.10 to $0.12 per diluted share on approximately 23.9 million shares outstanding.

Turning to Mercury's adjusted EBITDA guidance for the second quarter of fiscal 2011, our estimate excludes the following approximate amounts - zero interest income and expense, depreciation of $1.6 million, $0.4 million in amortization of acquired intangible assets, $1.3 million in stock-based compensation costs and, as I said, an estimated FY '11 tax rate of approximately 36%.

As a result, adjusted EBITDA for Q2 FY '11 is currently expected to be in the range of $7.1 million to $7.7 million.

Mercury's results this quarter reflect further strengthening of our operating leverage and progress towards achieving our target business model.

With enhanced working capital efficiencies, healthy cash flows from operations, and a strong balance sheet with no debt, Mercury is positioned to accelerate its growth and capitalize on new opportunities.

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

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

(Operator Instructions.)

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

Good morning, or good afternoon, everyone.

I guess one of my first questions would be relative to the first quarter's performance.

You obviously were ahead of your expectations.

Specifically, was the higher level of revenue derived out of the commercial side?

And could you give us a sense of what kind of visibility you traditionally or typically have on commercial revenue as you enter the quarter?

Yes.

So, we actually did well in both commercial and defense this quarter, Mark.

From a visibility perspective, with commercial, we -- if you reflect back to the end of last year Q3 and Q4, we had really good bookings in those past two quarters, which meant that the backlog for commercial coming into this year was pretty high which gives us the confidence and the visibility that we need to kind of continue to predict what we've said for the last couple of quarters, which is modeling roughly flat commercial revenues year-over-year.

All right.

What percent of your business is booked and shipped in the same quarter?

Roughly 20%.

Not even.

Not even that, yes.

We--.

--It varies.

I mean, we'd like to target 100% to have in the backlog, Mark.

I think our comfort range is when we're hunting, booking and shipping 15% or lower, we get a high degree of confidence, and it tends to run that way.

Okay.

While you don't give any guidance beyond the first quarter, I mean, last year, you had a real anomaly with relatively weaker earlier quarters, a weak third quarter and a very strong fourth.

Is this your -- should we just assume that there should be just modest sequential improvement as each quarter evolves, or is there any unique pattern that might occur this year?

Yes.

I mean, typically the way in which the business has evolved is that Q1 has been our seasonally weak quarter and Q2 has been progressively stronger, Q3's been better than Q2 and, in a couple of years in a row, I think we had a fallback in the fourth quarter.

That's typically the way in which the business has evolved and that's the way in which we expect it to play out this year based on what we know today.

All right.

A final question, just relative to the share count - your guidance for the first quarter was, for share count, 23.7.

It came in at 23.4.

You're now at 23.9 for the second quarter, which would be 0.5 million increase in the share base.

It seems a bit high to assume that type of sequential growth.

Well, I think -- well, I mean, don't forget, we still had some options underwater, so there's a complexity factor to this.

I think your best option is to go with the guidance.

I don't think we'll be higher than that certainly, Mark, but I wouldn't shave it on the downside second-guessing us.

It's our best effort.

Okay.

Thank you very much.

Yes.

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

Hey, good evening, everyone.

First question, just in regards to the defense business - I think last quarter, you guys indicated that the defense business in fiscal '11 would be up high single digit, low double digit.

I heard you kind of talk about commentary for SSI and Merc Fed, but just didn't hear just a commentary on the overall defense business.

We typically don't give guidance in total, but nothing's changed from what we said last quarter.

We still believe that at a total company level, we're going to demonstrate good growth at a total company level, as well as in defense.

So, we feel pretty good about where we're at right now, Tyler.

Okay, that sounds good.

And then, just to dig a little bit deeper on the commercial side of the business, so what exactly happened this quarter for the sales to come in so much stronger and then kind of still have the flat expectation in the year?

So, if you go back to -- really what's happening, so semi bookings were up 19% year-over-year, but were down 71% sequentially.

Semi revenue at $10.9 million was up 152% year-over-year, but down 9% sequentially.

So, big picture, if you look at what's going on, there's really two things.

From a revenue perspective, we had very strong bookings with KLA Tencor in the third and fourth quarter of last year.

We're basically burning off that backlog.

At the same time, ASML is continuing its ramp, and we saw a 40% sequential increase in the revenues from ASML and more than a fivefold increase in the revenues from ASML year-over-year.

We expect that the revenue from KLA Tencor is going to start to decline in line with kind of what we've described historically on previous calls.

So, you kind of net out all of the moving parts in the commercial business.

We're still sticking with that we believe that our commercial business is going to be roughly flat on a year-over-year basis.

So, we've just got a lot of moving parts.

Okay.

And I guess some of the uncertainties on the budgetary side of things isn't concerning you too much?

I mean, was that the correct read?

Yes.

I think from a -- right now, we feel pretty good.

We've got decent visibility.

As I said, though, we, like everyone else in the industry, are waiting with bated breath for the defense budget to be passed post the elections.

So, we've got pretty good visibility from a revenue.

If there's any concern that we have, it may be around the timing of bookings associated with the approval, but we feel good about where we're at.

Okay.

And then, just lastly from me, on the federal side of the business, you mentioned your one key program there.

I was just wondering if you had any sort of timing in terms of when that program could take kind of the next step.

So, we think that we're in a pretty good position from the work that we've done and that we believe that, frankly, to be the company that's down-selected to work on the new system for phase II.

Right now, the whole program itself is held up in the budget cycle, so -- between the House and the Senate.

So, we're not going to really know any more until the budget is approved, which is going to be hopefully some time in the fall.

But, that's what we know at this point.

But, I mean, is it correct to assume that you think it could perhaps be a fiscal '11 event for you guys?

Yes.

We -- if it's likely to happen, if the House and the Senate agree on that it is an important program, and if it's funded, we think it's going to happen this year.

But, there's elements outside of our control at this point.

Okay, understood.

All right.

Great, thanks.

Thanks, Tyler.

We'll go next to Jonathan Ho with William Blair.

Good afternoon.

Great quarter, guys.

Thanks, Jonathan.

So, my first question is on the JCREW 3.3 program.

You guys talked a little bit about sort of your expectations around that.

Given that we're already pretty far into October, do you think the award is imminent?

And what should we think about in terms of the approximate magnitude between the two sides here?

Yes.

So, at this point, there's really no new information.

We're still waiting for the government to make an award to warrant the prize.

We think it is going to be a single down-select.

As we've said, we've got more content with one of the primes than the other.

We haven't been specific in terms of the amount or the magnitude difference.

And so, at this point, I think we'd prefer to just kind of wait until the government makes their selection and the announcement is made, at which point we can start to be a little bit more forthcoming with additional information.

Okay.

And on the commercial side, do you guys have any more clarity in terms of KLA's next gen system and whether you have a chance to get onto that platform?

Yes.

Not really.

We still believe that, overall, it's doubtful that we're going to be involved, just given the way in which things played out.

That is baked into our numbers.

We're assuming that we're not involved.

And as a result of that, our commercial revenues will be roughly flat year-over-year.

So, we should know shortly.

But, I would just stick with what we're saying and -- at this point, assuming that it's unlikely.

Got it, got it.

And final question is on just your Patriot expectations with Saudi Arabia and Turkey.

If you were to receive sort of the bookings order for that, would that substantially change your outlook for the year, or is that already sort of baked into your expectations for defense, or would this be more of a multi year contract to begin with?

Yes.

So, we -- it's partially baked into our expectations.

So, a lot depends on the timing of it.

So, I think if you listen to what Raytheon is saying, they're pursuing both Saudi and Turkey.

We're just going to have to wait and see.

But, we did get Taiwan this quarter, which is what we're anticipating, which was a good thing for us.

Great.

Thank you.

We'll go next to Steve Levenson with Stifel Nicolaus.

Thanks.

Good afternoon, everybody.

Hey, Steve.

Just in relation to some recent transactions, I think one of your customers was acquired by Boeing and another one has retained a banker.

Would a change of ownership in either case have any impact on Mercury one way or the other?

Well, if you look at the Argon, Argon's been a great customer for Mercury.

We continue to provide them with what we believe to be important technology.

We continue to win new design wins with them, including one this quarter.

If anything, I think the acquisition by Boeing of Argon, we see upside potential longer term, particularly given Argon's strength in the [sigand] domain and Boeing's expertise in the airborne domain.

Those two things together could be a pretty powerful combo.

So, we're continuing to work with them.

We think there's more opportunity.

As it relates to the other announcement that was made, given the amount of business that we're doing, it really -- we don't see any meaningful impact there.

Okay, great.

Thank you.

And just in terms of big picture looking forwards, with new contracting rules and acquisition reform, obviously, that's something that should help you.

Could you give us a little detail on your opinion there please?

Sure, yes.

I mean, we feel that the whole shift of improving defense acquisition is going to be a really important thing for Mercury going forward.

We've been talking about this for a -- really, since 2008.

And we set up our business model in light of what we thought was going to occur that is now absolutely occurring.

So, the ACS SSI business is critically important.

We set it up to capitalize on the outsourcing trends by the primes that we believe will be driven by defense procurement reform.

And then, Mercury Federal Systems we set up as being much more of an ISR business to add even greater value to the primes through more value added subsystem solutions.

So, we think that the defense procurement reform will be a good thing for Mercury and provide more opportunity.

And we're actually seeing that in terms of the growth in our pipeline.

So, it's a good thing.

Thank you very much.

(Operator Instructions.)

We'll go next to Jim McIlree with Merriman.

Thank you, and good evening.

Hey, Jim.

Hey.

The -- Bob, can you talk a little bit about the gross margin levers for Q2?

So, what goes up or down that makes the gross margin decline quarter to quarter?

It's almost completely mix, Jim.

In terms of the [OCOG] elements of gross margin, the earlier investments in, as I've noted, in engineering methodologies and supply chain infrastructure, I believe we've trapped those on a sustainable basis.

So, we're not losing any ground on that front.

So, the movement that you'll see -- and you're going to see it quarter to quarter -- it's simply product mix or business unit mix could play a factor there, too.

But, with regards to Q2 specifically, it's a product mix.

It's not that much movement.

It's only a few hundred basis points.

Is there a big movement because of the change -- or, is there a movement because of a shift from commercial to defense?

That's part of it.

I mean, if you look at the mix changes that Bob's talking about, so commercial and defense is one, ACS MFS is another.

You've got all the new product, which is a third.

And then, you've got specific programs within ACS.

So, we really have got a number of different moving parts at the gross margin line.

And to date, we've managed it pretty effectively from a guidance perspective.

Yes.

We've been running substantially above our target model of 54% plus.

But, just to give you a little bit of an assurance there, we drop right down to the order/program level in the products in services that we're planned and forecasted to deliver for the next quarter.

So, I don't want to make it sound like a big spreadsheet, but it actually is.

So, we've got a fair amount of detail there.

And again, I think I'd caution people to second guess us on that line.

It's our best estimate.

But then, you'll hear us on occasion talk about orders that we thought were going to go in a quarter get moved to the following quarter.

And equally, orders that we thought were in the following quarter, customers are asking us to pull those in for the quarter.

So, the mix shift continues right through the better part of the quarter.

It's a little bit of a changing landscape.

I think it's a good estimate.

We've managed it pretty effectively, though.

I mean, I think we -- if you look at our guidance, we believe our process works.

Well, I ask you this question every time I speak to you, so I didn't want to disappoint you.

And the -- Mark, I think Mark Jordan asked a question about the progression of results throughout the year by quarter.

Yes.

And you responded Q2 better than Q1, Q3 better than Q2 and Q4 dropping off.

What were you referring to - total company or ACS or defense or what?

Total company.

So, we've typically had a bit of a sore tooth in the business, and that's the way in which we expect it to play out this year.

Total company.

Okay.

So, this will be a pretty dramatic change from last year in that you had a big skewing into Q4 last year because of the Aegis delivery.

Yes--.

--Does that imply that the Aegis deliveries are more evenly spaced this year?

Well, we would certainly hope so.

If you -- last year really was -- Q3 and Q4 was an anomaly.

And the way in which we kind of look at it is really 9 of $10 million that we delivered in Q4 should have been delivered in Q3 had we not had the challenges from a funding perspective or had our customer not had the challenges from a funding perspective.

So, strength in Q1 through Q3, dropping back a little bit in Q4 is I think what we've seen on a historic basis.

And that's what we anticipate at this point based upon what we see as we look forward.

And the commercial progression, it was a very strong September quarter.

Is it reasonable to think that that just kind of glides downward or do you have a big drop off in a quarter as that transition between KLA and ASML takes place?

It's probably going to be a slower progression.

We're not expecting a cliff.

Okay.

And then, I think my last one - so, when I think of the revenue buckets, you have commercial, which you've said is probably flat for the year, SSI, which is probably down for the year, MFS, I think you've indicated is flat for the year.

So, that big all else is -- sounds like -- and that would include Aegis, Patriot, ASIP, etc.

I mean, that is expected to be a nice solid growth business this year.

Is that a fair assessment?

I think you've hit the nail on the head.

We expect good performance in the ACS defense business in FY '11.

We've got a couple of things that may change the color, in particular in MFS, if that large program that we're involved with is funded as part of the budget cycle, the President's budget cycle.

But, at this point, we're not going to know.

They're roughly flat to slightly down, though we're expecting an MFS is kind of baked into our numbers.

If that other program happens the way in which it may, then that might give us a little upside potential.

And do you need -- in order to get that ACS defense business you characterize as solid, do you need something special?

Do you need the budget to get passed?

Do you need Saudi Arabia to buy the Patriots?

I mean, do you need something really big to happen in order to make that, or is it kind of a normal business thing where it's you just need your normal share of good stuff offset by your normal share of bad stuff to happen?

It's the latter.

We -- it's kind of business as usual.

We feel we've got pretty good visibility right now, certainly from a revenue perspective.

The bookings is more of a challenge, just given everything that's gone on with the defense budget.

But, we think that's just really a timing issue, that we're on the right programs, we're on the right platforms.

I think from a business model perspective, we set ourselves up very, very well in light of what's happening at a macro level with procurement reform.

And if you look at our performance on design wins this quarter, just as an example, it was the strongest that it's been since I joined the Company in 2007.

We had 13 defense design wins, and the five year value of those design wins was up over 300% on a year-over-year basis.

So, we feel actually pretty good about the business right now.

I think things are going well, they're clicking, and we're involved in some nice things, okay.

Okay.

I'll requeue up.

Thank you.

Okay.

(Operator Instructions.)

And we'll take a follow up from Jim McIlree with Merriman.

Hey, Jim, that was quick.

Mr.

McIlree, your line is open.

I'm sorry.

I put it on mute temporarily.

Yes.

That was quick.

So, when you look at -- so, when you're -- when I'm thinking about the year, I'm thinking, okay, if you get lucky with MFS and the big program gets funded and that's a nice bit of upside, and I kind of know where my downside is.

Maybe it just gets pushed to the right or Saudi Arabia doesn't buy, something like that.

But, is there something else within ACS defense that could be a big game-changer, either -- no game-changer, but a solid change to your expectations either up or down?

Like ASIP - does ASIP have a chance of getting pulled in and doing a lot more business this year, or is it possible that (inaudible) actually has an impact this year, something like that?

Yes.

I mean, we're on a lot of programs.

I wouldn't say there's one silver bullet.

It's the ups and the downs.

So, I think we do expect good growth in the ACS defense business.

We do expect good growth in the business in total.

I wouldn't single anything out in particular.

We certainly don't think it'd be the JCREW thing, as an example.

Okay.

And given that you have a very strong balance sheet right now and a lot of capacity to do deals, where are you in that process in terms of evaluating deals and potentially putting out offers?

Yes, we're pretty active.

We've been talking to a lot of companies.

I think there's some pretty interesting assets that are out there.

We are staying away from auctions.

We don't they are the right thing for us.

So, we're finding companies that are under-banked, not over-banked.

And we're in discussions with a number of different companies.

I'm not going to kind of throw out any timelines as to when it is that we may or may not close something, but we're pretty active.

And I think the new corp.

debt team that we brought on board is making a difference.

Is it -- is there anything about the tax law change, potential tax law changes that would happen -- that might not happen before year-end that would suggest that you might do a -- you might have something completed by the end of this calendar year?

Yes, I'm not going to be specific in terms of timing.

I mean, some of the potential sellers are more sophisticated than others in terms of what a potential change in the tax rates may mean.

I wouldn't say that is a -- the only factor that they're considering, but it's certainly something that is on their mind.

Okay.

That sounds great.

Thanks a lot, guys.

Appreciate it.

Okay.

Thanks, Jim.

(Operator Instructions.)

At this time, we have no further questions.

I'd like to turn the conference back over to Mr.

Mark Aslett for any additional or closing remarks.

Okay.

Thanks, Jay, and thanks to you all for listening.

We look forward to speaking to you again next quarter.

Operator, this concludes our call.

That does conclude today's conference.

Thank you for your participation.