Mercury Systems Inc (MRCY) 2012 Q3 法說會逐字稿

Welcome to today's Mercury Computer Systems Incorporated third quarter 2012 conference call.

Just a quick reminder, today's call is being recorded, and at this time for opening remarks and introductions, I would like to turn the call over to the Senior Vice-President and Chief Financial Officer, Mr.

Kevin Bisson.

Mr.

Bisson, please go ahead.

Thank you.

Good afternoon, and thank you everyone 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 we issued earlier this afternoon, you can find it on our website at www.mc.com.

We'd like to remind you that remarks that we make during this call about future expectations, trends, and plans for the Company and its business constitute forward-looking statements, 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, believe, 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 cost 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 to Mercury's President and CEO, Mark Aslett.

Mark?

Thanks Kevin.

Good afternoon everyone, and thank you for joining us.

First, our agenda for today.

I will begin with the third quarter business update and some comments on the outlook for Q4.

Kevin will review the financials and guidance, and then we'll open it up to your questions.

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

Driven by strong organic growth in our defense bookings, as well as bookings and revenue from the KOR, PDI, and LNX acquisitions over the last year, Mercury once again delivered solid operational and financial results in the quarter.

Total revenue for Q3 was near the high end of our guidance range.

GAAP earnings per share and adjusted EBITDA both came in substantially above the high end of guidance, and operating cash flow more than doubled from the third quarter of last year.

For the third quarter of FY12, total defense bookings and revenues both increased 41% year-over-year.

Although this growth primarily reflects the addition of KOR, excluding KOR's contribution, Q3 defense bookings were up 12% and defense revenues were up 18%, which is strong organic growth in this environment.

Our book-to-bill in defense for the third quarter was north 0.72, and our total book-to-bill was north 0.74.

Our defense backlog exiting Q3 is up 39% year-over-year.

As we expected, our commercial bookings and revenue continue to decline following the drop in our semiconductor business.

We continue to forecast total commercial revenue $14 million to $15 million for the full-year FY12, compared with approximately $48 million in FY11.

As I said last quarter, we believe the major falloff in commercial will be behind us as we close FY12, with any potential further decline expected to be a much smaller percentage of revenue going forward.

As we discussed in our last earnings call, because of the political and budgetary constraints of defense spending, combined with the DOD's commitment to new missions and roles for the Armed Forces, the defense industry has entered a period of transition that we believe could last for a year or more.

We anticipate this being a period of reduced visibility and procurement charges, but we also believe that Mercury is well-position to be successful in this environment.

[With the] defense budget on the horizon, there will be new approaches in the way our nation addresses security threats, as well as shifts in the geographic focus of both the military and the intelligence community.

While planning for a smaller, leaner, and more agile Armed Forces, the Defense Department is also committed to protecting, and in some cases increasing, the nation's investments in key capabilities such as ISR and electronic warfare.

Another goal is to export our defense technology through foreign military sales, in order to make our allies more self-sufficient.

The DOD is also strategically focused on projecting [par] to defend against adversaries who are charging our military's access and freedom to operate by deploying electronic insider warfare, ballistic and cruise missiles, advanced air defenses, or antipersonnel explosive devices.

Mercury's well-aligned with these priorities from a programmatic perspective.

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

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

Funding for Global Hawk Block 30 remains in place for the government FY12 for now.

However, the cancellation of Block 30, announced in January, is creating more uncertainty on the associated bookings and revenue for this program looking forward.

Gorgon Stare, on the other hand, is driving a great year for our Mercury Federal Systems business.

We've seen good successes on Gorgon Stare Increment Two, and we're expecting an additional booking in Q4 as well.

We expect MFS bookings and revenue, excluding PDI, to be up substantially from FY11, and we're expecting MFS to go from an operating loss to a significant operating profit for the year.

The integration of PDI into MFS is strengthening MFS as a whole, and we feel good about the future opportunities in this part of our business.

In terms of our new programs, looking first at JCREW, as a result of what appears to be a government program [replying], the potential exists for us not to receive the PO for long lead time materials during Q4 of FY12 that we had previously anticipated.

Despite this possibility, we still feel good about the program status overall, given JCREW I1B1 remains the program of record for CID, coupled with the robust FY13 funding request.

Meanwhile, the Navy Surface Electronic Warfare Improvement Program, or SEWIP, is starting to become a major bookings and revenue driver for us.

SEWIP was our largest single booking in Q3, and we currently expect to receive an even larger PO associated with the program in the fourth quarter.

In addition, we expect to generate significant revenue in the fourth quarter, as Block Two long lead time shipments commence.

Our positioning on SEWIP demonstrates the progress we've made in developing a strong service and systems integration, or SSI business, within ACS.

Our success in driving services led design wins is further evidence of this, as the SSI business generated more than half of our wins in Q3.

Design wins for the third quarter total eight, six in and defense and two in commercial.

This compares with a total of 11 wins, 8 of them in defense, in Q3 a year ago.

The five-year probable volume of our Q3 design wins was approximately $21 million, compared with $59 million in Q3 of last year.

As with our Q3 bookings, the lower number this quarter reflects the slowdown in activity following this year's CR.

We currently anticipate a strong quarter in Q4 for defense design wins.

Our design wins this quarter will focus on radar, electronic warfare, [euyr] and C4I.

An example is our partnership with ITT Exelis to move imagery exploitation on board tactical UAVs.

In addition, Corgis announced a partnership with Textron's AAI to provide the signal's intelligence payload capability.

The positive results from KOR and our success in smoothing and rapidly integrating the business reinforce our plan for M&A to play an important role for Mercury in the future, both as a way to help smooth out potential lumpiness in revenue due to program timing and funding delays, as well as getting us into the mid-teens revenue growth range for the total company level on average and over time.

We've built out a pipeline of promising deals, focused on opportunities like KOR and LNX, along the sense of processing chain.

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

We're primarily looking at smaller companies that are performing well, companies that have proven technology and capabilities, strong management and that are on the right programs and platforms.

In ACS, given the growth that we anticipate in the EW market going forward, we're mainly targeting opportunities in the RF domain.

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

We continue to be involved in exploratory discussions with numerous companies, taking a highly disciplined approach as these discussions evolve.

Our policy is not to discuss the timing of any possible future acquisitions in advance, other than to say that we expect that executing on our M&A strategy should enable us to navigate the defense industry transition period that I mentioned earlier.

Looking ahead to the fourth quarter, we're currently expecting a solid rebound in both bookings and design wins sequentially and year-over-year as we had in the fourth quarters of 2010 and 2011.

In addition to a large booking for SEWIP and continued progress with Gorgon Stare, several service deals that were pushed to the right last quarter are expected to result in the PO's by the end of the fourth quarter.

However, due to the potential for a sequester, the contracting environment is currently more challenging, and possibly different than we've seen in the past.

So this does add additional risk and uncertainties to the outlook with respect to program timing and funding.

For FY12 as a whole, we continue to expect that the acquisition of KOR will largely offset both the commercial revenue decline and the slower organic revenue growth in defense, resulting in total FY12 defense revenue growth of approximately 30% year-over-year.

Overall, at a total company level, we currently expect approximately 7% to 9% year-over-year revenue growth for the full 2012 fiscal year, with GAAP EPS exceeding our prior forecast.

Rounding out another very strong year for Mercury, our bond sheet remains healthy, and we have demonstrated our ability to supplement our organic growth with strategic, smart M&A.

Longer term, we believe that our total company revenue growth, including M&A, will be in the mid-teens on average over time, which should position Mercury as one of the winners in navigating this new defense industry environment.

Kevin will conclude his prepared remarks with our guidance for Q4.

As we announced in our Q2 call, given our limited visibility right now, we do anticipate moving to providing only quarterly guidance for our financial year '13.

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

Kevin?

Thank you Mark, and good afternoon again everyone.

As Mark noted in his remarks, Mercury generated solid financial performance in this year's third quarter, in spite of significant industry headwinds that we anticipated when we spoke at last quarter's earnings call.

Turning to the numbers, revenue for the third quarter of $67 million was $7.1 million, or 12% higher than revenue of $59.9 million in the third quarter of last year.

This year's third quarter revenue was within our stated guidance of $65 million to $68 million.

GAAP earnings from continuing operations of $0.17 per share were $0.03 per share lower then comparable EPS of $0.20 per share in last year's third quarter.

However, it should be noted that the increased number of shares issued in connection with the February 2011 follow-on stock offering reduced this quarter's GAAP EPS by $0.02 per share, compared with GAAP EPS reported in the third quarter of last year.

Our third quarter GAAP EPS included $0.02 per share related to the amortization of acquired intangibles, which is comparable to the impact from last year's third quarter EPS.

Third quarter EPS of $0.17 per share significantly exceeded the Company's stated guidance of $0.09 to $0.11 per share for the quarter, was driven by better than expected gross margins and lower operating expenses.

Adjusted EBITDA for the third quarter fiscal 2012 of $12 million was $700,000 higher than adjusted EBITDA of $11.3 million for the third quarter of last year.

Adjusted EBITDA for this year's third quarter comfortably exceeded the Company's guidance of $9.1 million to $10.1 million.

Adjusted EBITDA as a percentage of revenue of 18% for the third quarter was within our target business model of 17% to 18%.

Now reviewing third quarter performance in more detail, total revenue for our largest operating segment, Advanced Computing Solutions, or ACS, was $60.4 million, which was $2.3 million higher than the $58.1 million of ACS revenue generated in last year's third quarter.

The year-over-year increase was due primarily to a $13.9 million, or 32% increase in ACS defense revenue, driven by the increased Aegis and Patriot program related revenue, and the inclusion of KOR Electronics revenue.

As Mark said, this year's third quarter was the first quarter that included financial results from the recent acquisition of KOR, including in the financial results from Paragon Dynamics, or PDI.

This strong defense revenue growth was offset partially by the continuing year-over-year decline in our commercial business.

Commercial revenue of $2.9 million in this year's third quarter was $11.6 million lower than commercial revenue of $14.5 million in the third quarter of last year.

Revenue from our Mercury Federal Systems, or MFS, operating segment for the third quarter was $8.8 million, which was $5.4 million higher than the $3.5 million MFS revenue for the third quarter fiscal 2011.

This growth was driven by higher revenues from the Gorgon Stare program and the inclusion of revenue from PDI.

It should be noted that operating segment revenue for the third quarter fiscal 2012 does not include adjustments to eliminate $2.2 million of inter-company revenue.

Total defense revenue, including ACS and MFS, for the third quarter of $64.1 million was $18.7 million, or 41% higher than defense revenue of $45.4 million for the third quarter of last year.

Excluding the addition of total KOR revenue, third-quarter defense revenue grew 18% year-over-year, reflecting the strength of our defense business, despite the difficulties within the current procurement environment.

As mentioned earlier, strong revenue from the Aegis, Patriot, and Gorgon Stare programs contributed significantly to this growth.

From a bookings perspective, Mercury generated bookings of $49.6 million in the third quarter of fiscal 2012, which was $9.8 million higher than the $39.8 million of bookings recorded in the third quarter of last year.

The inclusion of KOR bookings in this year's third quarter, and increase bookings tied to the Gorgon Stare and SEWIP programs, were partially offset by a year-over-year decline in commercial bookings.

Defense bookings for the third quarter of $46.2 million was $13.5 million, or 41% higher than the $32.7 million of defense bookings in the third quarter of last year.

Excluding the impact of the KOR acquisition, defense bookings increased 12% year-over-year, which was fueled by the previously mentioned bookings increase related to the Gorgon Stare and SEWIP programs.

The Company's double-digit increase in bookings between years excluding KOR, reflected its emphasis on programs that are expected to thrive, despite the macro challenges within the defense sector.

Mercury's total book-to-bill ratio for the third quarter of this fiscal year was 0.74 as compared to 0.67 for the third quarter of last year.

Defense book-to-bill of 0.72 for this year's third quarter was essentially flat with the third quarter of last year.

The Company ended the third quarter with $105.2 million of total backlog, which was $19.7 million, or 23% higher than the $85.5 million of backlog in the third quarter of last year.

Of the total ending backlog in the third quarter, 98%, or $95.1 million is expected to be shipped within the next 12 months.

$99.5 million, or 95% of the ending third quarter backlog relates to defense, which is $27.6 million, or 39% higher than last year's defense backlog.

This growth reflects continued defense program strength as we entered the fourth quarter.

From a bottom line perspective, GAAP earnings from continuing operations of $5.2 million was slightly below comparable earnings of $5.4 million in last year's third quarter, as higher sales volume related gross margin was more than offset by a higher KOR related operating expenses.

It should be noted, however, that excluding KOR operating expenses for this year's third quarter, operating expenses were lower than the third quarter of last year, as the Company reduced year-over-year discretionary expenses, principally in SG&A, in light of the uncertain defense procurement environment we expect moving forward.

Despite the lower net earnings in this year's third quarter compared to the third quarter of last year, adjusted EBITDA of $12 million for the third quarter increased $700,000 compared to the third quarter of fiscal 2011.

Higher add-backs of income taxes due to this year's higher effective tax rate and amortization expense due to the KOR acquisition drove the year-over-year improvement in adjusted EBITDA.

The Company's financial metrics on a nine-month basis through March of 2012 were even more impressive.

Total revenue of $184.1 million was $16.6 million, or 10% higher than the $167.5 million of revenue generated in the first nine months of last year.

More significantly, defense revenue of $172.9 million was $46 million, or 36% higher than comparable revenue from last year.

Excluding KOR, defense revenue was up 28% through the first nine months of this year.

Again, a testament to Mercury's favorable program position within the defense space.

The Company converted solid top line growth for the first nine months of this fiscal year to increase bottom line performance.

Earnings from continuing operations of nearly $17 million were approximately 20% higher than the first nine months of last year.

Similarly, adjusted EBITDA through the first three quarters of this fiscal year of $39.6 million was 29% higher than adjusted EBITDA in the same period last year.

Adjusted EBITDA as a percentage of sales was 21.5% for the first nine months of fiscal 2012, well above our 17% to 18% target business model.

Now turning to the balance sheet, the company ended the third quarter with cash and investments at $114.8 million and no debt, which was $9.8 million higher than the $105 million of cash and investments at the end of this year's second quarter.

The increase in cash and investments for the third quarter was the result of $12.4 million of cash flow from operations generated in the quarter, driven by the GAAP earnings performance for the quarter, and adding back non-cash depreciation, amortization, and stock compensation expense.

Partially offsetting operating cash flow for the third quarter was $2.8 million of capital expenditures, resulting in $9.6 million of free cash flow for the quarter.

As we have mentioned in prior earnings calls, Mercury's favorable liquidity position is supplemented by an untapped $35 million bank credit facility and a $500 million universal shelf registration.

This position affords the Company significant financial flexibility to pursue its growth strategy, both organically and through potential M&A transactions.

For the fourth quarter of fiscal 2012, we are targeting total revenue in the range of $60 million to $66 million.

Similar to the third quarter, we expect the split in fourth quarter revenue to be 95% defense and 5% commercial.

At the midpoint of our guided revenue range, we expect fourth quarter defense revenue to generate double-digit year-over-year growth for the quarter, driven by increased revenue from the SEWIP and Gorgon Stare programs, as well as the inclusion of KOR revenue.

Within our stated revenue guidance, we are projecting gross margin to approximate 49% for the fourth quarter, reflecting a program mix shift to more RF related revenue in the fourth quarter compared to previous quarters.

Projected fourth quarter revenue also reflects the inclusion of another quarter of KOR revenue, which carries approximately 40% gross margins.

Operating expenses are anticipated to be largely flat with the third quarter, as the Company continues to carefully manage operating expenses in light of the defense industry challenges.

From a bottom line perspective, we are targeting GAAP earnings from continuing operations of $0.04 to $0.10 per share, based on an estimated weighted average share count of 30.3 million shares.

Within this GAAP EPS range, we are projecting an approximate $0.02 per share impact from the amortization of acquired intangibles.

Adjusted EBITDA is estimated to be between $7 million and $9.5 million for the fourth quarter of fiscal 2012.

At current fourth quarter financial guidance, we are projecting full-year fiscal 2012 revenues of $244 million to $250 million, which represents an annual top line growth rate of 7% to 9%.

Full-year GAAP earnings per share are projected to be the range of $0.60 to $0.66 per share.

The midpoint is above the $0.59 to $0.61 per share guidance that we provided in the second quarter, as we continue to focus on minimizing cost growth in this environment.

We anticipate that full-year adjusted EBITDA as a percentage of revenue will exceed our target business model of 17% to 18%.

In summary, our third-quarter financial performance exceeded our bottom-line expectations, as Mercury continued to enjoy significant year-over-year defense revenue growth, despite difficult macro trends.

We are projecting fourth quarter financial performance to produce annual earnings above our previous guidance for the fiscal year.

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

Operator, proceed with the Q&A session now, please.

Thank you very much, sir.

(Operator Instructions)

Peter Arment, Sterne, Agee & Leach

Thanks for all the details.

Mark, maybe you could just highlight some of the bigger drivers.

You did mention the SEWIP in the PO.

I mean, I guess between Aegis and Patriot, SEWIP, Gorgon Stare you've kind of highlighted a couple of the big drivers going forward.

How do we think about those in this budget environment?

You talk about the funding levels?

Yes, we feel pretty good about the programs that we mentioned.

The big ones this quarter, as Kevin outlined, were Patriot, Aegis, Gorgon Stare, as well as various programs with General Atomics.

We think we're pretty well positioned with those going forward, and they're going to be significant drivers of continued performance in our defense business.

Okay, and then you did mention regarding JCREW, what's the latest there?

I mean, are we just not expecting any long-lead awards until officially we get into the government fiscal year '13?

Yes, it's a little murky right now, to be quite honest.

I think we had been anticipating getting the PO for the long-lead time materials in Q4.

It's now looking like that that's not going to happen, due to a government, or a potential government program, replanning.

We don't necessarily know what that means.

However, I think we still feel pretty good about the program.

I was down at Exelis kind of midpoint in the quarter, and they still feel really good about the program itself in terms of its capabilities.

We know it's the program of record, and the funding in the FY ‘13 budget was pretty robust.

So I think we're just going to need to wait and see how things develop over the next quarter or so.

Okay, and what's the typical lead time, though, for you before you begin to ship?

It depends upon the technology, because we're actually both on the RF side of things as well as on the processing, but it's on the order of quarters.

Okay.

So within a six-month period?

Yes.

Okay.

and then just quickly on the fourth quarter.

Is it just a higher mix of the RF, is that the reason that we could see EPS, a wider range on the EPS front that you've given us, which is, I guess, $0.06 to $0.12 if you exclude the $0.02 of amortization?

I think vis-a-vis what we've done in the past, I think we have widened slightly the guidance on the top line, just based upon some of the slowdown in the activity that we've seen.

So it's largely that just falling through, Peter.

Okay, and just one more.

You mentioned the M&A and you kind of have targeted.

You said that the RF category continues to be an area that you're focused on.

Is there something in particular there, I mean, that you want to continue to build out externally there?

I mean, it seems like you have some good internal capabilities already in the RF.

We do, but we think that there's still opportunity for us to continue to pick up more capability, more program access, and more scale in that part of our business.

It's particularly important as we see the growth in the electronic warfare and signals intelligence part of the market, as well as the shift from radars moving from mechanically rotating type radars to a ether type radars, which have also got a high RF content.

So I think we see the potential for upgrades and more opportunity on the RF side, and it's an area that we're going to continue to focus on.

Okay, thanks very much.

I'll get back in queue.

Michael Lewis, Lazard Capital Markets.

Two quick questions for Kevin and then, Mark, a quick follow-up from Peter's question on JCREW, but Kevin, can you give us the EBITDA results for ACS and MFS in Q3?

While you're digging for that, you had $21 million five-year value on design wins.

Was that for the eight wins or is that for the defense's six wins?

Can you break that out for us?

Yes.

So the five-year probable value in total, $13 million was in defense and $8 million was in commercial this quarter, Mike.

Okay, and then, Mark, if I can follow up on Peter's question about the long-lead list.

I think the expectation out there in the investment community is a Q1 '13 start for production, and if you were to get, say, the order early in your fiscal year Q1 '13, would you be able to ship product by the end of that quarter?

I don't think that there's an issue on our end, Mike.

I think it's going to come down to, when is the program going to start in light of what appears to be a replanning effort, but we don't have any details so it is very hard for us to kind of give you a perspective on how things are changing.

We just don't have that detail right now.

Okay.

Do you have any update on where the Army still is positioning themselves?

Do you think that they will add onto the program, or are they still trying to define their own requirement?

I think that our customer remains in discussion with the Army.

I think, as you probably know, that at some point in the future, the Army is going to pick up the CID activities from the Navy as the executive agent.

When that occurs, I don't think anyone quite knows right now, but that is expected to occur.

I think the Army, from what we can gather, appears to be impressed with some of the capabilities on I1B1, but I think it's just too early to posit a guess, or hazardous a guess, as to if they're going to pick it up and when.

Got you, and Kevin, would you happen to have those EBITDA numbers?

Yes.

Mike, for the breakout of adjusted EBITDA, I think we reported $12 million.

Of that about $10.5 million is ACS and about $1.5 million is MFS.

Thank you sir.

Tyler Hojo, Sidoti & Company

Just to go to the bookings side of the equation here.

You talked about some expectations in Q4 on a program level, but just kind of curious.

In aggregate would you expect your book-to-bill to be north of 1 in Q4?

I'll look.

So book-to-bill, yes.

We currently anticipate that book-to-bill will be above 1 for the quarter.

Clearly it'll be above 1 in our defense business, if things hold the way in which we currently anticipate.

Okay great.

That doesn't include any bookings from JCREW.

Which are now expected to slip, right?

Right.

Okay, got it.

Just in regards to SSI revenues, I'm not sure if you spoke to them, but if you did, I didn't catch it.

So could you maybe talk about how those tracked in the quarter and maybe some updated expectations?

Sure, Tyler.

We have actually had a good quarter and our SSI revenues were up 160% on a year-over-year basis.

We did $7.2 million of revenue in our SSI business in Q3.

Okay, and what about expectations over the next, call it four quarters?

Well, we're in the one quarter at a time guidance business right now.

Okay, that's fair.

Well, it's nice to see the improvement there.

Just kind of lastly, a week or so ago you announced what seemed like a pretty nice win with AAI, I guess related to the Shadow.

Could you talk a little bit about, maybe the outlook on that?

Yes.

So we're pretty excited about it.

KOR Electronics, which is the division that's based in Cypress, California, is obviously very strong in DRFM technology, which is a pretty key capability required as part of modern electronic warfare applications, but based upon their expertise, they've also been working on pulling together a next-generation SIGNET capability and so the announcement that we made was actually an alliance with Textron's AAI business unit that obviously, as you know, produce the Shadow.

And we're working to pull together a multi-mission payload capability that's kind of plug-and-play in the first instance with the Shadow.

It's all about shortening the time to actionable intelligence to be able to actually combine SIGNET information with imagery to be able to give you a better perspective on what's going on.

So we're still in the engineering phase.

The work that we're doing initially is with PMUAS, which is the Army's executive agent, or executive office, for all unmanned aerial vehicle activities.

The work that we're doing with AAI is really around integrating that capability onto the Shadow.

As you probably know, there are a lot of Shadows that are out there.

So it's hard to project at this point just how big that could be, but it's a pretty exciting new capability, we think.

Okay, and just for clarification.

Was that included in the five-year probable value on the design win side?

It actually was not, no.

Okay, great.

Thanks a lot.

Mark Jordan, Noble Financial.

A question relative to SEWIP.

Could you talk about how consistent that program will be quarter-on-quarter, and how variable it might occur?

Is the rollout for that new platform going onto new combatants, and/or what is the plan relative to the retrofit of the surface combatant fleet inventory?

Sure.

So I think in the first instance, Mark, it's probably going to be relatively lumpy, largely because right now the bookings and the revenue that we're anticipating is largely to do with funding for long-lead time materials.

The LRIP doesn't occur until FY ‘13, and the production in FY ‘14.

So that's when we start to get some predictability in terms of the number of ship sets that's going to be, or ships that's going to be upgraded on an annual basis.

When it hits production, we're anticipating something like 14 ships will be upgraded annually.

So it's pretty well funded.

We're obviously a part of Block One as well as Block Two today.

I think, as we said on the call last quarter, I think the fact that Lockheed are partnering with Raytheon to compete for Block Three, could bode well for us getting additional content on that program, should they be down selected as part of that competition.

So it was our top bookings program this quarter.

We anticipated it being our top bookings program next quarter, and we're going to start to see some early revenues from it flowing shortly.

Okay.

Could you give us some range as to what is your content with SEWIP per unit, per ship?

No, not at this stage.

Okay.

With the JCREW program, I think in aggregate you've quantified your potential full program exposure.

Do you see that there is any change in terms of the aggregate program size, or do you have any visibility on that, or do think there it's logical to assume that where you would have said a five-year opportunity, that the dollars are the same, but you might be talking a longer period of time?

From what we know right now, I think we feel pretty good about the numbers still.

As you look at the FY ‘13 budget, the aggregate number of units for what is, in effect, the first phase of LRIP look to be very healthy in terms of both unit volume as well as translation into actual dollars.

So we still feel good about the program itself in terms of the order of magnitude.

I think the timing right, or the question right now is the timing of when our program will move into that LRIP phase, and that's the thing that we need additional clarification on.

Okay, thank you very much.

Michael Ciarmoli, KeyBanc Capital Markets.

Mark, maybe just to stay on that topic while I'm thinking of it, can JCREW actually start if we go into a continuing resolution on the fiscal '13 budget, which will probably be the case ahead of the election?

I mean, do you guys envision a scenario to which it gets further pushed out?

Well I think we believe the answer is yes, because if you look at it from an LRIP perspective, the early LRIP funding was actually in the FY '12 budget, not the FY '13 budget, but we do anticipate, I think, given everything that's going on in Washington, another continuing resolution in our FY '13.

Okay, and then if I were to just maybe parse through your comments in the release about you're kind of targeting that mid-teens percentage growth on average, what sort of are you baking in on JCREW when you're looking out at that kind of long-term on average growth?

So I think what we said last quarter is that it did include some revenues associated with LRIP, but it obviously didn't include the program going into full production, which would have inflected that growth rate northwards from that kind of mid-teens number.

Okay.

So then I can assume it's more on the conservative side with just the LRIP in there, then?

That's correct.

Okay, and then just on the, if my math is right and I'm looking at your fourth quarter here, you've obviously got the addition of KOR.

It seems like from an organic standpoint the defense revenue growth is going to really take a hit.

I mean, the comps get, I guess, a little easier in terms of the commercial revenue declines, but is that just a function of the challenging environment right now?

Yes, I mean largely.

We're still expecting, looking at Q4, we're still expecting growth in our defense business on an organic basis.

Okay, and then the last one, if sequestration does go into effect, I mean, how do you think that impacts your revenue streams?

It's very hard to predict, Mike.

I mean, I think we're going to try and pull together a budget scenario, and we're kind of in the middle of planning our FY '13 right now.

So it'd be hard to give you an exact number, but I think you know the numbers as well as I do.

125 goes down to something in the 478, 470 range, which is a $50 billion reduction -- sorry, $50 million reduction, which equates to approximately a 9% reduction.

So at the highest level you can say well, it could be 9%, but we don't know how that's going to flow through from a programmatic perspective.

So that's what we're going to try and model in this next quarter.

Hard to tell.

Okay, fair enough.

Thanks guys.

Brian Ruttenbur, CRT.

A couple questions.

First of all, assuming delays with JCREW, where can you cut your expenses to?

Just to try and understand your model, how flexible are you on your SG&A expense, R&D expenses, can you cut that by 10%, 20%, 30%?

Where do you get to the bone on those?

So we've been managing our expenses very, very carefully.

I think the fact that JCREW could potentially move out on us, based on what's happening with this long lead time to PO, doesn't necessarily require us to address our cost structure.

I mean, that's something that we would normally do as part of our annual budgeting cycle, but I wouldn't connect the two, Brian.

Okay, and let's just say that JCREW gets delayed indefinitely, or more than two years, your contingency plan on SG&A and R&D, is there room to cut?

I'm trying to figure out how much is already built in there, because you've had to have some buildup in advance of JCREW, thinking that you that you're going to be getting JCREW in the next six months or so, right?

Partially, although we still believe that we can grow at a significant rate on the top line and still be in line with our target business model absent JCREW.

That doesn't require us to take out significant expense.

Okay.

A simple one here, tax rate.

In the fourth quarter, where is it going to be?

It was 31%, which was lower than I anticipated this quarter.

We're projecting for the full year about 34%.

So the tax rate's going to be a tad higher in the fourth quarter.

Okay, and your acquisitions that you're talking about, are those going to be in the defense, your core defense electronics area, or do you want to diversify like some other defense contractors out there are looking to diversify?

Are you wanting to stay in your core?

Our M&A strategy is largely focused, as we have said in the past, building out our sensor processing chain capabilities.

So we're going to stick with that strategy.

Great, thank you very much.

(Operator Instructions)

Howard Rubel, Jefferies

You talked a little bit about some of the challenges, and there's probably some opportunities.

Any way for you to bracket FY '13?

Not at this point.

We're still in the midst of our planning process.

Can you address, maybe, sort of the bid and proposal opportunities you've been seeing?

How might you be able to characterize them year on year?

I mean, clearly your recent acquisition looks like it's opened up the aperture a bit, Mark.

It has.

I think the capabilities that KOR brings to the table, we definitely see opportunities in our customer base for their DRFM capability, and we know just based on some of the activity level around EW, that's certainly an area that's going to see increased investment.

We, from a design-win activity perspective this quarter, things were a little light compared to what we've seen historically, but we're seeing very strong activity in Q4 with some really nice potential design wins.

So we are expecting a pretty strong rebound here in the fourth quarter, just based upon what we're looking at right now.

So, Kevin, you're allowing Mark to go on the road for every day in order to win the business, to push it forward?

He's pushing me out the door.

Well, absolutely.

You've got to make sure he's -- you're the chief salesman and he's allowing your expense account to go travel where you need to, to get the most opportunities, right?

(laughter) backpack.

It's true.

I'm going to hit the road.

No, but in all seriousness, can you sort of talk about the potential aperture that you've seen in terms of market size?

I mean, clearly there's a few things that are new and different, and you highlighted some of them in the release.

Yes.

So, I mean, I think we feel pretty good about, obviously, the programs that we're involved with.

I mean, Aegis is going to continue.

SEWIP, we've built more potential, particularly with Block Three if Raytheon and Lockheed are a successful.

We're pursuing with our customer Northrop Grumman the upgrades of the F-16 ether radars, which we think could be an important opportunity for us.

We know that, just based on what's happening with Meads, that the Patriot is probably going to be the chosen system for the US Army upgrades going forward, and then Gorgon Stare just continues to go from strength to strength.

That's even before we start to look at penetrating our customer base with the recent capabilities that we have coming from KOR.

So we feel pretty good right now in terms of just the things that we're pursuing, the design win opportunities.

The challenge a little bit is that nothing happens quickly in defense, and unfortunately things are moving even more slowly in this environment then what we've seen in the past, we believe largely due to the potential now for a sequester as we get closer towards the back end of the year.

Just two final questions.

One is on JCREW, as you look at it, how would you characterize the performance of the system relative to customer expectations?

I think very positive, very positive.

I mean, I think the capabilities that Exelis has pulled together clearly addresses some of the shortfall capabilities of prior generations, and that's what it was set out to do.

So I think it's working pretty well.

Then last, I mean, I would have never bet you would've gotten another commercial opportunity.

What happened there, and is there further light at the end of the tunnel that sort of stabilizes the business?

So I don't think our commercial business is going to be much of a growth driver.

I think it's going to kind of bob along at around the levels that we're currently seeing in FY '12.

Could be up a little bit, could be down a little bit, but it's not really where we're focusing our time, energies and efforts, because I think the growth is largely going to continue to come from the defense business.

Thank you Mark and Kevin.

Gentlemen, it appears we have no further questions this afternoon.

Mr.

Aslett, I'd like to hand the conference back to you for any closing comments, sir.

Okay.

Well, thanks very much for joining the call today.

We look forward to speaking to you again next quarter.

Thank you.

Thank you, sir.

Again, ladies and gentlemen, that does conclude today's conference call.

We'd like to thank you for joining us, and wish you all a great afternoon.

Goodbye.