Mercury Systems Inc (MRCY) 2012 Q2 法說會逐字稿

Good day, and welcome, everyone, to the Mercury Computer Systems Incorporated second quarter fiscal year 2012 conference call.

As a reminder, today's call is being recorded.

At this time, for opening remarks and introductions I would like to turn the call over to the President and Chief Executive Officer, Mr.

Mark Aslett.

Please go ahead, sir.

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

Last Monday, we announced the arrival of Mercury's new Senior Vice President and Chief Financial Officer Kevin Bisson.

Kevin comes to Mercury from SeaChange International where he served as CFO for the past five years.

With his experience at SeaChange and two prior public technology company CFO positions, Kevin was an exceptionally strong candidate for Mercury and we are delighted to welcome him to the team.

Kevin is here with us today, so I'll turn the call over to him for a brief introduction.

Kevin?

Thank you, Mark.

Based on my discussions with the Board, Mark, Bob, and others, I can say with utmost confidence that I joined Mercury at a very exciting juncture, not just in terms of the strong technology position Mercury has developed, and the critical role technology plays in our international defense, but in the clearly delineated path that the Company has laid out to drive significantly higher shareholder value.

Mercury is clearly a Company with a smart, well-defined strategy and a management team that has demonstrated its ability to not only turn around a business, but also grow a business, both organically and through acquisitions.

It's exactly the kind of environment that I want to be working in and I am looking forward to contributing to Mercury's continued success in the years ahead.

Thanks, Kevin.

Also joining me on today's call I'm pleased to say who is Bob Hult, whose official title as of last week is former CFO.

Bob was here serving as CFO four years ago when I arrived at Mercury.

At that time, we committed to the turnaround and transformation strategy for the business that Kevin just alluded to.

We've refocused Mercury on what we believe are the right parts of the defense marketplace, those being ISR, electronic warfare and missile defense.

Our success in executing on this strategy has been in no small measure to Bob's being here at my side every step of the way providing a mix of wise counsel, financial insight and hard work that the Board and I deeply appreciate.

We are very pleased that Bob has agreed to continue with us in a consulting basis for the next six months, working with Kevin, the other members of our management team, the Board and me to ensure a smooth transition as Kevin ramps up in his new role.

Bob will be playing his usual part on today's call, walking you through our Safe Harbor, discussing our Q2 financial results, and joining me in answering your questions.

So with that, I'll turn the conference over to Bob.

Thank you, Mark.

Good afternoon, everyone.

Mercury has been a big part of my life for many years now, a time that I look back on with a great deal of pride.

It is not the kind of experience you just walk away from.

So I'm actually looking forward to the next six months as a productive transition period for both Mercury and for me.

Let me echo Mark in welcoming Kevin to the team, [on a mission] that I hope you will find as rewarding as I did.

With that, let's move on to today's agenda.

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 realize the expected benefits from acquisitions and divestitures or delays in realizing such benefits, challenges in integrating acquired businesses and achieving 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 costs and other related expenses, fair value adjustments from purchase accounting, 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 of free cash flow to GAAP cash flows from operating activities are included in the press release we issued today.

With that, I'll turn the call back over to Mark.

Thanks, Bob.

First our agenda for today.

I will begin with the second quarter business update and some comments on the outlook going forward.

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

As a reminder, the operating results we reported today exclude KOR Electronics and Paragon Dynamics which will be included in continuing operations beginning in Q3.

This was another challenging quarter for the defense industry, but we continued to look deliver solid operational and financial results.

Total revenue was in the middle of our guidance range, while GAAP earnings per share and adjusted EBITDA both exceeded the high end of guidance.

Operating cash flow was also significantly stronger than in the second quarter last year.

At a consolidated Mercury level, our defense business remains solid.

Q2 defense revenues increased 42% sequentially and 46% year-over-year.

Although our defense bookings were down 12% sequentially from an exceptionally strong Q1, defense bookings were up 27% year-over-year driven by double-digit growth in both ACS and MFS.

However, our book-to-bill in defense was 0.83 and our total book-to-bill was 0.84.

Our defense backlog exiting Q2 was down 11% sequentially but up 10% year-over-year.

On the other hand, the year-over-year decline in commercial bookings and revenue continues to be a major headwind for us.

Driven by the previously announced loss of business with KLA-Tencor and ASML last fiscal year, commercial bookings were down 45% from Q2 of FY '11.

Commercial revenues were down 65% year-over-year and commercial backlog exiting Q2 is down 79% from the same period a year ago.

Our current expectation for all of FY '12 is that commercial revenue will be approximately $15 million.

In terms of our future results, we believe that the major fall-off in commercial will be behind us as we exit this fiscal year, with any potential further decline expected to be a much smaller percentage of revenue going forward.

Moving to our defense business, we are clearly seeing the impact of headwinds at the industry level.

In a climate of continued political and budget uncertainty, and with the DoD's commitment to new missions and roles with the Armed Forces, the defense industry is facing a new era going forward.

Near term, we believe that we have entered an 18-month period of transition in the industry, a period in which we believe that the procurement environment will be more difficult to forecast and navigate than it has been historically.

Both the White House and the Defense Department are on record as saying, in effect, that we are turning the page on a decade of war.

The Budget Control Act recently signed into law reduces defense spending by $489 billion over the next decade.

Along with federal defense spending generally, the defense budget is caught in the political crossfire related to the government debt and the deficit.

This could lead to a sequester beginning January 2013 that if implemented could result in roughly an additional $500 billion in cuts through 2021.

What we believe this means is that under the first phase of the Budget Control Act, defense spending will continue to grow over the long term but will grow at a slower rate.

We're currently seeing this play out in the impacts of two recent back-to-back continuing resolutions, meaning last year's CR and this year's CR, which seems to have compounded one another in the impact on defense procurement.

Just as last year's CR caused lower Q2 and Q3 bookings and backlog in our FY '11, we've seen that effect again in FY '12.

We believe this is why our book-to-bill was lower than we had anticipated.

Right now, things are moving really slowly.

In addition, our visibility and that of our customers is just not great and we are not expecting it to improve significantly in the near term.

For this reason, we anticipate moving to providing only quarterly guidance for our financial year '13.

Against this overall negative industry backdrop, we believe that our business will continue to perform well, given our areas of focus.

In terms of our results for FY '12 as a whole, we believe that we can deliver approximately 20% year-over-year organic revenue growth in our defense business.

Although this is somewhat lower than we had originally planned, it is still well in excess of the anticipated growth in government defense spending overall.

Adding the H2 results we currently expect from KOR and Paragon Dynamics to our anticipated organic growth rate, our total FY '12 defense revenue growth is now likely to be approximately 30% year-over-year.

So in summary, we now expect the acquisition of KOR will largely offset both the anticipated commercial revenue decline and the slow organic growth in defense revenue this year.

Overall, at the total Company level, we currently expect approximately 10% year-over-year revenue growth for fiscal 2012 as a whole.

However, as Bob will describe in more detail, the impact of these revenue changes will result in lower GAAP EPS.

Since the beginning of this month, President Obama, Secretary Panetta, and Chairman of the Joint Chiefs Dempsey have all stated that due to leaner budgets ahead, the priorities for our national defense have to change.

This will lead to new approaches in the way in which we address security threats and shifts in the geographic focus for both the military and intelligence community.

We believe that companies within our industry that are going to be successful in navigating both the transition period near term and the shift toward a new longer-term strategy are those that are well capitalized and have positioned themselves well from a programmatic and from a priority perspective in the right parts of the market.

We believe that Mercury will be one of these companies.

If you look at the changing roles and missions for the military announced by the Defense Department right up to New Year's, we seem to be in a good place.

Paraphrasing Secretary Panetta, our forces will be smaller, leaner, more agile and more flexible, ready to deploy quickly and technically advanced.

The DoD is making an implicit commitment to avoid hollowing out the force, stating that a smaller, ready, and well-equipped military is far preferable to a larger ill-prepared force.

We believe the JCREW counter-IED program, for example, embodies these characteristics, a technically advanced new capability that will be ready to deploy quickly in response to new and emerging threats.

In addition, while reducing the overall size of the defense budget, the DoD is committed to protecting and in some cases increasing the nation's investment in important capabilities such as ISR and electronic warfare.

The net/net, it appears that although we will have a smaller force, we'll use the dollars that have been freed up to invest in capabilities that ensure that our troops are more prepared while also using technologies of force multiplied to prevail in future wars.

At the same time, the DoD is looking to build the capacity of our international partners to more effectively defend their own territories and interests.

Where that comes into play is increasing foreign military sales, exporting our defense technology to make our allies more self-sufficient, the Patriot missile defense system and Sabre, the newly announced design win for the F-16 AESA radar replacement are good examples of this.

High among the DoD's priorities is investing to ensure that the US military has the capability to operate effectively in anti-access and area-denial environments.

This means strengthening the country's ability to project power in areas where sophisticated adversaries challenge our access and freedom to operate.

Among the challenges Secretary Panetta has specifically mentioned are electronic and cyber warfare, ballistic and cruise missiles, advanced air defenses, mines or anti-personnel explosive devices and other methods to constrain America's defense capabilities.

These are just outlines, of course, and the actual specifics at the programmatic level are not well-defined at this stage.

As I mentioned near term, we believe the industry is entering an 18-month transition period with a longer-term outlook for slower growth in defense spending overall.

We continue to feel very positive about how we've positioned the business and about the underlying strengths in our new business pipeline both near term and longer term.

Our major ongoing programs, Aegis, Global Hawk, Gorgon Stare and Patriot all appear to be well-funded at this stage.

From a new program perspective, the Navy Service Electronic Warfare Improvement Program, or SEWIP, as well as JCREW also appear to be well-funded.

From a JCREW perspective, there has not been any official new news since the government's earlier LRIP pre-solicitation.

We anticipate that the next official milestone will be when our customer, ITT Exelis, receives and responds to the final LRIP RFP.

At that point, we hope to have a better understanding as to what the rollout will look like in terms of the LRIP start date, volumes, configuration mix, and duration.

For now, and until we know more about the official start date of the LRIP we continue to model JCREW LRIP revenue beginning in our financial year '13.

The relationship we have developed with ITT Exelis demonstrates the progress we have made in developing a strong services and systems integration, or SSI, business within ACS while implementing a total refresh of our ACS product line.

We've been working to position ourselves as the premier commercial subsystem outsourcing partner to the primes as they seek more open and affordable ISR and EW solutions.

Our success in winning new designs is further proof of our achieving this position.

Design wins for the second quarter totaled 18, all of them in defense.

This compares with a total of 11 wins, all of them defense, in Q2 a year ago.

Our design wins continue to focus on radar, electronic warfare, and EO/IR applications.

Our largest wins in Q2 relate to Sabre with Northrop Grumman, IRST, an infrared seeker/tracker and upgrade program with Lockheed, and ADAS, an EO/IR 360-degree situational awareness capability upgrade for Blackhawk Helicopters with Raytheon.

The five-year (inaudible) value of our Q2 design wins is approximately $90 million.

This compares with $342 million in Q2 of last year, when we logged the $250 million design win associated with JCREW 3.3.

If you look at the companies within our industry that are going to be successful in navigating this new environment, another important factor will be the ability to make smart acquisitions.

In the past, we viewed our growth profile as being in the high-single-digit, low-double-digit range.

Looking forward, we believe the best way of thinking about our growth is at the total Company level including M&A.

We're planning for M&A to play an important ongoing role for Mercury going forward.

This is both to help smooth out potential revenue volatility associated with the timing of programs, as well as getting us into the mid-teens revenue growth rate at total Company level on our bridge and over time.

This does not include full production for JCREW which would clearly inflect this growth rate northward.

Overall, calendar 2011 was a successful year for Mercury from an M&A perspective.

We acquired LNX in January, a deal which has worked out well for us.

A month later, we completed a successful follow-on offering raising net proceeds of $94 million.

We continue building out a pipeline of promising deals, taking a very disciplined and thoughtful approach in the process, culminating in the acquisition of KOR late in the year.

We feel good about our deal pipeline going forward and our ability to capture more opportunities similar to LNX and KOR along the sensor processing chain.

Our strategy continues to focus on positioning Mercury as the key provider of end-to-end commercially developed sensor processing subsystems to the primes as well as to the intelligence community.

We're primarily prioritizing smaller private companies that are performing well, that have proven technology capabilities, and that are on the right programs and platforms.

Our M&A strategy encompasses both ACS and MFS.

In ACS we are seeing more opportunities in the [RF domain] which look particularly attractive given the growth we anticipate in the EW market going forward.

In MFS, our priorities are around multi-INT exploitation capabilities for the intelligence community.

We continue to be involved in discussions with numerous companies.

However, as with LNX and KOR we are striving to be highly disciplined in our evaluation decision-making as these discussions evolve, with an eye toward finding the right deals at what we believe to be the right price.

We are not prepared to discuss the timing of any possible future acquisitions at this point.

What we can say is that we are confident that continuing to execute on our M&A strategy over the next 18 months should enable us to navigate the defense industry transition period that we anticipate and deliver the overall mid-teens top line growth that we are now targeting.

So in summary, our commercial businesses are experiencing sharply lower revenues year-over-year and we anticipate that commercial revenue will be close to $15 million for FY '12 as a whole.

In defense, although growing less than we had initially planned, we're still looking at a very healthy organic growth rate of approximately 20% year-over-year and approximately 30% including the additional revenue for KOR and H2.

At a total Company level for FY '12 including KOR for H2 we currently expect approximately 10% revenue growth year-over-year.

Again, the impact of these revenue changes will result in lower GAAP EPS.

Our balance sheet remains strong and we've demonstrated our ability to supplement our organic growth with strategic, smart on M&A.

Overall, we believe the total Company revenue growth will be in the mid-teens on average over time which should position Mercury is one of the winners in navigating this new industry environment.

Consistent with what we have done for the past year, Bob will conclude his prepared remarks with both our guidance for Q3, as well as some directional perspective for FY '12 as a whole.

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

Bob?

Think you, Mark.

Again, as Mark noted, against a challenging defense industry backdrop Mercury solid operational and financial results for Q2.

Mercury's total revenue for the second quarter of fiscal 2012 was $68 million, at the midpoint of our guidance range of $67 million to $69 million.

This is up 22% from $55.5 million in revenue for the second quarter of fiscal 2011.

GAAP income from continuing operations for the second quarter of fiscal 2012 was $9 million, or $0.30 per diluted share, on approximately 30 million shares outstanding.

This was above our Q2 guidance of $0.24 to $0.27 per share.

For the second quarter last year, Mercury reported GAAP income from continuing operations of $5.2 million, or $0.22 per diluted share.

GAAP net income from continuing operations per diluted share includes $0.02 associated with the amortization of intangible assets for the second quarter of fiscal 2012 and $0.01 for the prior year's second quarter.

Breaking down our results by operating segment, revenue in ACS, including both defense and commercial, for the second quarter of fiscal 2012 was $66.1 million, up 24% from $53.3 million in Q2 last year.

Revenue in our services and systems integration business within ACS was $4.5 million compared with $3.8 million in Q2 last year, up 17%.

In our Mercury federal systems business, Q2 fiscal 2012 revenue was $5.2 million compared with $3.6 million a year ago, up 46%.

Please note that revenues by operating segment do not include adjustments to eliminate inter-company revenues of $3.3 million included in those operating segments.

Total defense revenue for Q2 including ACS defense and MFS was $63.9 million, up 46% from $43.9 million in Q2 of fiscal '11.

Mercury's commercial revenue for the quarter decreased 65% to $4.1 million from $11.7 million in Q2 last year.

Turning to bookings, total bookings for the second quarter of fiscal 2012 were $56.8 million, an 18% increase compared with $48.2 million in Q2 last year.

However, bookings were down 11% sequentially.

Mercury's total book-to-bill ratio for the second quarter including ACS and MFS was 0.84.

This compares with 1.30 in the sequential first quarter of fiscal 2012 and 0.87 year-over-year.

Our Q2 total backlog including deferred revenue was $122.5 million.

This compares with backlog of $101.8 million at the end of Q1 in 2012.

Included in total backlog is $31.9 million of backlog from the recent KOR Electronics and Paragon Dynamics acquisition.

Approximately 97% of our current backlog relates to defense.

In addition, 89% or $108.6 million of our total Q2 backlog relates to orders scheduled to ship within the next 12 months.

This is up by 21% or $18.7 million from Q1 2012.

In defense specifically, as Marc said, the government's continuing resolution negatively affected our bookings for the second quarter of fiscal 2012.

Including ACS and MFS, defense bookings were $53.3 million, down 12% from $60.9 million in the first quarter of fiscal 2012.

Year-over-year, however, total defense bookings were up 27% from $41.8 million in Q2 FY '11.

This was another strong quarter for MFS, which posted bookings of $6.8 million, up $4.5 million from Q2 last year.

ACS defense bookings for the second quarter of FY '12 were up 17% year-over-year.

Our defense book-to-bill for Q2 of FY '12 including ACS and MFS was 0.83.

Excuse me, 0.83, down from 1.35 in the sequential first quarter of fiscal 2012 and 0.95 in Q2 last year.

Our backlog in defense for Q2 increased to $118.7 million from $97.8 million in Q1 of fiscal 2012, and also increased from $78.9 million in Q2 of FY '11.

Again, Q2 2012 backlog includes KOR and PDI.

Mercury's adjusted EBITDA for the second quarter of fiscal 2012 was $18.8 million.

This compares with $10.7 million for the second quarter of fiscal 2011.

Adjusted EBITDA for Q2 fiscal 2012 excludes the impact of approximately $9.8 million in net expenses as follows; zero interest income and expense, a $4.8 million tax expense, $1.9 million in depreciation, $0.7 million in amortization of acquired intangible assets, $0.6 million of acquisition costs, and $1.8 million in stock-based compensation charges.

Our adjusted EBITDA margin for Q2 was 28%.

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 an effective tax rate of approximately 34.7% before discrete items for the second quarter of fiscal 2012 and expect this to be our rate for the full fiscal year.

If the federal R&D tax credit is renewed, later this year, this 34.7% effective tax rate for the full year would come down by a point or so to approximately 33.5%.

Our gross margin for the second quarter of fiscal 2012 was 60.2%, above our guidance of 59% due to a favorable program and business mix.

Operating expenses for the second quarter of fiscal 2012 were $27.4 million, compared with $25.1 million in Q2 last year and $26.4 million sequentially.

Inventory for Q2 was down sequentially to $22.8 million from $24.5 million in Q1 of FY '12.

Inventory turns for the second quarter were 4.8.

DSOs in the second quarter of fiscal 2012 were 60 days, down from 72 in the sequential first quarter, but an increase of 53 days in Q2 last year.

At the end of the second quarter, our total employee headcount, excluding contractors, was 734 compared with 604 at the end of Q1.

This includes 135 employees from the KOR/PDI acquisition.

We continue to generate cash from operations.

Free cash flow was $9.1 million in Q2, up from $2.6 million in the sequential first quarter, and $6.1 million in Q2 last year.

We closed the second quarter of 2012 with a total of $105 million in cash and cash equivalents, a decrease of $60.9 million from the first quarter of fiscal 2012.

This balance is net of both the positive cash flows in the period and the $70 million payment associated with the KOR acquisition.

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

We also have a $35 million operating line of credit and a $500 million universal shelf registration.

In short, Mercury continues to be well prepared to supplement its organic growth with additional growth from small strategic acquisitions.

Before I move on to guidance, I would like to quickly recap Mercury's acquisition of KOR Electronics.

As a reminder, our purchase accounting for this transaction is not yet finalized.

It will be filed on a preliminary basis as part of our Q2 FY '12 form 10-Q filing in early February and remains subject to adjustments for a one-year period forward.

Mercury closed the KOR Electronics acquisition on December 30, 2011 for $70 million in cash.

Our current view expects the transaction to be immediately accretive to earnings on a GAAP basis, an improvement from what we stated on our last call.

KOR's total revenue for the 12-month period ending December 29, 2011 was approximately $40 million.

As a reminder, KOR Electronics operates with a services business model.

Accordingly, their LTM gross margin as a percentage of revenue has performed in the range of 40%.

However, as we noted on our KOR acquisition conference call in late December, the EBITDA margin has performed in line with the high end of the range of Mercury's current target pro forma business model which calls for an adjusted EBITDA to be in the range of 17% to 18%.

In addition, their backlog on December 30, 2011 was $31.9 million, providing the business with good visibility and a strong foundation for continued growth.

Now moving on to guidance.

For the third quarter of fiscal 2012, we currently expect a revenue range of $65 million to $68 million.

This includes approximately $10 million of revenue from the KOR and PDI operations.

We anticipate Q3 gross margin to be approximately 51%, down sequentially from Q2 of fiscal 2012, driven by changes in program and business mix, and the inclusion of the KOR and PDI operations.

Our third quarter operating expenses, which include KOR and PDI, are currently anticipated to be about $29 million.

CapEx for Q3 of fiscal 2012 is projected to be approximately $4 million.

We expect to report third quarter GAAP income from continuing operations in the range of $0.09 to $0.11 per diluted share, which includes approximately $0.03 from the amortization of intangibles on approximately 30.2 million shares outstanding.

Turning to Mercury's adjusted EBITDA guidance for the third quarter of fiscal 2012, our estimate excludes the following approximate amounts, zero interest income and expense, depreciation of $2.2 million, $1.3 million in amortization of acquired intangible assets, and $1.4 million in stock-based compensation cost.

And as I said, an estimated FY '12 tax rate of approximately 34.7% before discrete items.

As a result, adjusted EBITDA for Q3 FY '12 is currently expected in the range of $9.1 million to $10.1 million.

On a full-year FY '12 basis, we expect a total Company revenue growth rate of approximately 10% year-over-year.

This includes approximately $20 million of KOR/PDI revenues.

We continue to expect our FY '12 adjusted EBITDA as a percentage of revenue to be in line with the high end of our target business model, 18%.

We now expect GAAP EPS for FY '12 to be in the range of $0.59 to $0.61 which includes approximately $0.09 from the amortization of intangibles.

The decrease from our previous GAAP EPS guidance, which was approximately $0.71, which included approximately $0.06 from the amortization of intangibles pre-KOR, is driven by the margin impact of lower organic revenue expectations in our ACS business of approximately $20 million which are associated with lower revenues for our commercial business and a reduction in our defense revenue expectations influenced by DoD budget uncertainties.

The inclusion of the KOR/PDI business results for H2 FY '12 only partially offsets the impact of the aforementioned lower revenues.

As we've said, the KOR acquisition is immediately accretive, adding approximately $0.03 to our H2 FY '12 GAAP earnings per share.

To further assist you in your modeling, total Company gross margin is expected to be approximately 55% for the full-year FY '12, down from our previous forecast as we've included the KOR/PDI operations for H2 FY '12.

As Mark said, beginning with our fiscal year 2013, we will move back to only providing quarterly guidance.

We believe this to be an appropriate approach to guidance going forward, given the uncertain political and budget environment that we expect the defense industry to be operating in during the next 18 months.

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

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

(Operator Instructions) We'll go first to Tyler Hojo with Sidoti & Company.

Hi, good evening, everyone.

Hi, Tyler.

Hi.

So first question, thanks for all of the detail provided, but I was just wondering, when you look at the slightly reduced organic growth expectation for the defense business, could you talk a little bit just on a program level what is driving that?

Yes, so there is really one moving part around our [name] programs which is basically we are now not anticipating receiving the bookings and revenue associated with Patriot Turkey, which is approximately $6 million or $7 million for the year.

In addition, we saw during the CR, a delay in timing associated with some of the business that we were anticipating in our services and systems integration business within ACS.

So they are really the two moving parts in defense, Tyler.

Okay, and just to follow on that, what is your expectation for the SSI piece of the business?

I know you were expecting that to be down this year.

But I guess just more broadly speaking, would you expect that to kind of return to growth after this year or just thoughts there?

It is a really important part of the business model, and I think what we saw it is that some of the programs that we were anticipating getting, definitely slowed down in this budget environment.

It looks like we are starting to see some progress and movement there.

We are hoping that we will see a pickup in bookings as we are heading into the second half, but it has clearly impacted us at this point in time.

Okay, great.

And last one for me, I understand that revenues for JCREW aren't anticipated for you guys until fiscal 2013, but maybe if you could update us just in regards to what your thinking in regards to order timing?

So as I said on the call, there is really no new news, Tyler.

I think the next official milestone, as we know it, is our customer ITT Exelis is anticipating the RFP, the final RFP from the government.

Once they have had the opportunity of basically responding to that, and gone through their negotiation, hopefully, we will be in a better position to be able to talk about the timing from a start date around our program as well as the duration, the volumes, and the configuration mix.

And so, we need to get that information to be able to, I think, forecast accurately when we expect the bookings to occur, as well as when we anticipate the revenues to occur.

So we're going to need to hold off until that RFP has been issued and responded to.

Understood, okay, great.

Thanks for the color.

Okay, thank you.

We'll go next to Michael Lewis with Lazard Capital Markets

Thank you so much.

Hey, Bob, I was wondering with regard to KOR, can you give us a split between what your expectation is between ACS and MFS on the revenue since that acquisition will add pretty significantly to the MFS side?

Right.

Mike, we actually have not done that.

I think we're going to take the KOR piece and essentially, from a segment viewpoint, move that into ACS going forward, and the PDI piece will be blended in with Mercury federal in that segment.

I think as we get rolling here, you're going to get a sense for it, but we have refrained from breaking those revenues out.

If we're looking at around $40 million in revenue over the next 12 months, we should not make any assumptions on the MFS side, just kind of -- would you suggest that we just incorporate it all right into the ACS business for now?

No, you don't want to do that, Mike.

PDI has revenues.

The KOR piece is larger than PDI.

I think I would maybe like to draw a line there in terms of trying to parse the revenue further for you.

And that $40 million, that's in LTM basis, that is looking back, essentially the calendar year FY 11, and they are modestly growing business, as we indicated on the acquisition call late December.

Okay, and when you announced the acquisition, other analysts brought up the point about the inter-Company receivables, or the revenue.

Right.

And how much, can you tell us how much of that?

Yes, we indicated that they were de minimis.

Okay.

Basically immaterial, not large.

Okay, that is fair.

And, Bob, good luck with retirement.

But, Mark, I have a quick question for you.

Just a few minutes ago Reuters announced that the Air Force may terminate the Global Hawk.

If that were to happen, what kind of implication would that have for Mercury fed?

To terminate global Hawk, did you say?

Yes.

So, I hadn't heard that.

It is not going to impact Mercury fed but we do have revenues on occasion in ACS in really two different areas on Global Hawk.

One is on the signals intelligence side of things and the other one is on the radar.

So I need to go away and look at it.

I haven't got the number off the top of my head, but we do anticipate revenue from that program going forward.

Okay.

Thank you so much.

Okay.

We'll go next to Peter Arment with Sterne, Agee.

Yes, hi, Mark, Bob, and hi, Kevin, congratulations.

Mark, can you talk about, I guess, the continuing resolution here.

You kind of had planned for that, the shortfall, do we expect that you will see some pickup here this quarter in terms of bookings?

Yes, I think we are expecting a rebound in bookings in our defense business in Q3.

As I said on the call, the visibility isn't great right now either at our level or within the customer base.

I think things are moving really slowly so, although we do anticipate a pickup, it is hard to figure out exactly how big that is going to be.

But we are expecting a bit of a rebound.

Okay, and just trying to flush out that on the visibility front, which I guess is extremely challenging, but what are those conversations, where is the hold back, is it at the program office level inside the Pentagon or are the customers just not getting the contracts being flushed out in a timely fashion?

What is it that you are seeing?

I think it is that, plus discussions around exactly how many units?

What is the timing associated with that?

So I think the challenge that we are seeing, it's really around trying to pinpoint when something will land and it is the timing that I think is what is causing the visibility issues.

Okay, and just, Bob, I guess, on margins, very strong this quarter, but was there any one-time items or program close-outs in the quarter, Bob?

No, not affecting margins.

You're referring to Q2 margins?

Yes.

They were very strong, second quarter in a row where they ran almost 60%.

Really driven, again, by in this case favorable program or business mix but no close-outs, if you were thinking that might have driven an uptick in margins.

Yes, that is what I was asking.

And I guess bridging that over to this quarter, the third quarter, is it just the program mix, the impact of KOR that we are going to see margins tail off?

We're going to see a rather dramatic tail-off in gross margins here in the third quarter.

There are two factors at play here.

First, on the ACS business, the existing business, if you will, again, program and business mix going the other way.

We have seen this before.

And then the inclusion of the KOR/PDI business, which big picture, again, services business model, actually a fairly robust one, though, running with about a 40% gross margin.

So those are the two dynamics that bring us from, literally from 60 down to 51 sequentially Q3 compared to Q2 of FY 12.

And then as we said on the -- Bob in his prepared remarks, at the year level, we're anticipating gross margins to be around about 55%, which is 100 basis points above the pro forma, but slightly down over where we produced gross margins last year, and most of that is being driven by the inclusion of KOR and PDI.

Right.

You can see, like we've said, I think we are still intending to speak to our target pro forma business model on our year-end call.

Clearly, including the KOR/PDI businesses will have an impact on that model going forward.

And also we've indicated that the CREW program would do the same.

I think we continue to believe that it will be appropriate to talk to the model here at year end.

And a quick reminder on that, we are still feeling that the innards, if you will, of the model, working your way down from revenue through gross margin, OpEx, whatever, there will be changes there but when we view the model on an adjusted EBITDA basis, you're not going to see negative change.

In all likelihood we could be modestly going the other way.

Okay, thanks, Bob.

Sure.

Hey, Mike, just to give you little perspective on your model, the question that you asked.

I think at a very high level, it's going to be roughly two-thirds of the revenue in the defense electronics piece that will go into ACS and roughly a third of the revenues will go into Paragon.

That's kind of what we see right now and just to help you out trying to get your model straight.

We'll go next to Kevin Ciabattoni with KeyBanc

Thanks, guys.

Congratulations, again, Bob, and welcome, Kevin.

Thank you.

Just looking at that KOR business and following up on Peter's last question, I know you mentioned it's a primarily a services business, and the gross margins are running around 40%, I think you said.

Do you see that improving at all, in terms of synergies, what can we expect there?

I don't think, yes, I think the gross margins are what they are.

If you think back to say what we said on the call, it's performing at the high end of our current pro forma target business model at an 18% level.

So I think that is a good way of thinking about that business going forward.

I don't think we see a dramatic shift.

Yes, and just one reminder there, again, we keep going back, I guess, to Mike Lewis's question, the model is different, PDI compared to KOR.

Right.

Okay, that is helpful.

And then looking kind of a few weeks ahead here with the release of the FY 13 budget, what programs do you guys view from your portfolios as maybe most at risk or having the most room for upside there?

Well, I think we are going to have to wait and see when that budget comes out.

I think there are a lot of things that are potentially going to change, just based upon the way in which Panetta and Obama and Dempsey came out and described the changing roles and missions, and the fact that we are going to start to see some of those effects and changes in this next budget cycle we expect sometime in mid-February.

I guess, it just got delayed a couple of weeks.

Overall, we feel that we are positioned very well.

When the president talks about operating in anti-access and providing capabilities that will allow us to project power and area-denial, a lot of our major programs play very well in those scenarios, whether it be Aegis or SEWIP, or whether it be JCREW or Patriot, I think we see them fitting in that particular segment.

But I think we're going to have to wait and see what the president comes out with because it does look like there's going to be a change.

Okay.

And then just lastly, any changes to the pace of upgrades for Aegis, or do you see any change over the next kind of 12 months here?

No, not necessarily over the next 12 months.

I think the major change that could occur is that with the AMDR program in effect being pushed out over time, what we anticipate is that the Aegis upgrades with the SPY-1 radar, of which we are a part, will likely continue for a longer period of time.

But that is not going to change anything in the short term, Kevin.

Okay, thanks.

We'll go next to Howard Rubel with Jefferies

Hi, good afternoon, gentlemen.

I hope to have a conversation with you, Kevin, at some point, and Bob, good luck.

Thank you.

Just a couple of things.

First, my understanding actually on the Global Hawk issue, it may be just one version of it that is getting terminated and they are going to consolidate some things.

So I don't see it as anything that is major.

Who knows whether it will impact you or not.

The second thing is, when you look at design wins, it seems to me that you've taken a little share, or you've done something well because this is a pretty big number, Mark.

Why is it not translating into you feeling a little bit better about business?

Well, I think we were definitely taking share and I think we do feel really good about the design win activity, and I think the fact that we got 18 design wins this year compared with 8 -- 11 in defense last year is a testament to the product portfolio as well as our sales team.

The challenges, however, in defense is how long it takes for a design win to transition into LRIP and production revenues.

In this environment, the visibility just isn't great right now.

But now that you have mentioned design wins, I would like to kind of draw out a few that we talked about on the call.

ADAS, we think, is going to be pretty significant potential longer term.

That is a 360-degree situational awareness capability upgrade for the Black Hawk helicopter.

SABR, which we talked about at our investor day, is an upgrade for the F-16 radar.

We think that plays very nicely in terms of what Dempsey and Panetta and Obama described in terms of the new roles and missions.

And we know that both Raytheon and our customer, Northrop Grumman, are pursuing opportunities with Taiwan, as well as Korea.

So that could be an important design win for us.

The design win that we got for IRST with Lockheed Martin is also an opportunity where we actually displaced a competitor in probably one of their most important accounts.

And that could get us onto the F-18, which is a platform that we have not been involved with historically.

We also won three new design wins on SEWIP.

[One] continues to strengthen our capabilities and our content on SEWIP Block 2.

But working with our customer Lockheed, we also got potential design wins or design wins on both Block 1 as well as Block 3 that our customers are pursuing.

So net/net, I think we feel really good about the design win activity.

It has been driven by the investments that we have made from an R&D perspective, and many of those design wins were services-led deals.

We feel pretty good right now.

I can relate to that.

And then related to that, though, could you sort of give us a sense of when some of these other wins are going to translate maybe into LRIP or where there is going to be an inflection in the curve because some of these items are clearly at the point where the services need them because the threat has dramatically changed.

Yes, clearly, I think the two that are probably the closest in from a timing perspective is, obviously, SEWIP which we talked about, which we believe is going to transition out of EDM or out of EMD phase, the engineering phase, and into LRIP in our financial year 2013.

And so we feel pretty good about the growth potential on that program.

As we talked about before, the SEWIP program is also targeting it upgrading a much larger portion of the overall surface fleet that say what Aegis is, so that could be a significant program.

SABR, which is the F-16 AESA radar upgrade, that also is something where we could potentially start to see some revenues in the near term, call it the next 12 to 18 months, particularly given that Northrop Grumman has just received their export license and both Northrop and Raytheon, as I mentioned, are actively pursuing business with both Taiwan to upgrade their F-16s and then potentially also F-16s in Korea.

So both of those are, from a design win perspective, relatively near-term revenue opportunities.

And then, it seemed to me that in the last month of the year, the Pentagon was busy writing contracts to the degree I had not seen in a long time, Mark.

Frankly, I think there were a number of companies that are going to show record book-to-bill in the fourth quarter as a consequence of the budget, the CR turning into an omnibus.

As you talk to your customers, and I know you alluded to this earlier on the call, why can -- why is it that you're not being more, I guess, comfortable with the outlook given, what I would say is, frankly, the elimination of a lot of uncertainty?

Well, I think, yes, we got to the CR more quickly than what we did last year.

But we are still seeing with our customers on certain programs, things move really slowly.

My concern and caution as I look at the outlook going forward is really what I described in terms of an 18-month transition period.

So if you step back and you look at it and you say what is going on?

The first is that in FY 13 we are going to see -- start to see the first phase of the budget control act reduction.

So we're going to see a reduction in defense spending overall.

The second is that with the new roles and missions, we're going to start to see those changes play out in that 18-month time period.

And the third is that we're basically going to be in an election year and so there's going to be continued political uncertainty.

So I think that our view is that we are moving into a transition period for the next 18 months.

And although we are very well-positioned, I think navigating that changing environment is going to be more challenging than what we have seen on a historic basis.

And then last on commercial, it looked like if you did -- you've done about $8 million or so on the first half of the year, is it going to be lumpy straight down, so should we expect anything in the fourth quarter for commercial or how do you see the (inaudible) wind off?

Yes, I mean it is probably going to be pro rata over Q3 and Q4, anticipating that $15 million of total commercial revenue for FY 12 as a whole.

Thank you.

We'll go next to Mark Jordan with Noble Financial

Good afternoon, gentlemen.

I would like to just try to see if I've got an understanding of sort of the kind of guidance that you seem to have offered for fiscal 2013.

Your statements for sort of an all-in growth target in the middle teens, but then it seemed that you stepped back and said that volume production of CREW would clearly throw you into a much higher level.

I guess my generic question would be looking at the 2013 type of budget and if you're looking at a mid-teens, what type of revenue assumption would you have in there for CREW, and if in fact you hit the volume, what kind of upside might you see?

Yes, so, I think the first point is that the guidance that I gave in terms of the outlook longer term, mid-teens growth rate on average over time, was not specifically targeted at financial year 2013.

I was trying to look out over time and, basically, move away from just talking about organic growth to growth at a total Company level, which we think is a better perspective on how to view us going forward.

What I also said on the call is that mid-teens growth rate obviously doesn't include full production for JCREW, but it would include a modest amount associated with JCREW LRIP.

Until we see the actual RFP, the final RFP from the government, and our customers' actually responded to it, we're not going to be really in a position to be able to articulate the exact timing of it, when it starts, the duration, the configuration mix, as well as the volumes.

That's why we are trying to look at it a little bit longer over time and talk about that growth rate at a total Company level including M&A.

Okay.

In the second, or excuse me, after the conference call in the first quarter, I think you had put forth a guidance of about $20 million in the commercial business.

It has come down to $15 million here in this quarter, specifically, where in your portfolio of commercial activities have you seen that slippage of roughly $5 million?

Well, I think the guidance that I think we have given or we have talked about historically and what many of you have modeled is the commercial business being at 10% or below.

We are clearly seeing the commercial business coming in at below what we previously anticipated, around about $15 million for the year.

It is basically coming out of the semiconductor business.

Year-over-year, we did roughly $50 million in commercial last year and we are expecting it to be $15 million and the majority of the decline is in the previously announced loss of both KLA-Tencor, as well as ASML.

Okay, thank you very much.

We'll go next to Jonathan Ho with William Blair

Hi, guys, can you hear me?

Yes, we can, Jonathan.

Just wanted to offer congratulations, as well, to Bob and a welcome on board for Kevin.

Just a quick look at, I guess, positioning for COTS-based businesses going forward.

Has there been any sort of shift or any changes around the potential for COTS to maybe play a larger role given the priorities that have been laid out?

And are you guys thinking about that from a competitive perspective shifting any of the dynamics that are out there?

I think we've positioned ourselves from four years ago, Jonathan, very well in the industry, anticipating that the defense budgets would ultimately slow down from a growth perspective, and as a result of that the [prize] would basically need to restructure their business models moving from a very high fixed cost to a more variable operating cost model.

And during the quarter, a number of our customers did some pretty significant reductions in terms of their engineering personnel, which only plays out in terms of more opportunity for Mercury going forward.

So I think we are positioned very well.

We continue to take share.

I think our business model from an R&D perspective plays extremely well in this environment and it's really -- you can see that manifest itself in terms of the number of our design wins this quarter.

So we think we are positioned well and we think it is going to continue if not accelerate.

And then another question around the environment that you guys are seeing.

Would you anticipate any of the programs that may have slipped out of your 2012 view coming back in 2013, or do you think some of these are just going to go away at this point?

No, I don't think we've lost anything.

I mean for us it feels like it is really timing.

So Turkey, as an example, with Patriot, we think it is going to happen.

But it is probably going to be more likely our FY 13 at this point.

While there are services deals that slipped as a result of largely the CR, are beginning to move again, it's just not going to be in a time scale that makes a difference from a revenue perspective for us in the second half of the year.

So I think we are taking share, not losing deals and we haven't -- I think it is basically timing.

Got it.

Thank you.

We'll go next to Brian Ruttenbur with Morgan, Keegan

Thanks for taking my call.

(audio problems) (Inaudible) First on the mid-teens growth that you have, that you are projecting in the out years, that's going to be a mix of internal and external.

How do you plan to fund the external or the acquisitions?

So we've got $105 million of cash on the balance sheet, Brian, at the end of this quarter.

That's following the $70 million that we've paid for KOR.

And as we also discussed in the call, we've got a $35 million operating line of credit, as well as a $500 million universal shelf.

So I think in the short term based upon the couple of deals that we have just done, we've got sufficient capital to go out and do at least one if not two more deals.

Okay, (inaudible) $50 million, $70 million is the number that you are thinking about, in those ranges?

Brian, I could not hear you, you broke up, Brian.

I think in terms of size of future deals, Brian --

That's correct.

LNX was $30 million, KOR has been $70 million, they are both good proxies.

It is obviously a range, but like we've been saying right along, tens of millions, or as Mark said, funding for one or two more deals depending on the size.

Okay.

And that will conclude our question-and-answer session.

I would now like to turn the call back over to Mr.

Aslett for any additional or closing remarks.

Okay, well, thank you all for joining us today, and we look forward to speaking to you again next quarter.

Thanks very much.

And, again, that does conclude today's call.

We do appreciate everyone's participation.