Mercury Systems Inc (MRCY) 2012 Q4 法說會逐字稿

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

Today's call is being recorded.

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

Please go ahead, sir.

Good afternoon, and thank you for joining us.

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

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

We would 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, forecast, 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 continuing geo-political 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 in 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, challenging 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 would also like to mention that in addition to reporting financial results in accordance with Generally Accepted Accounting Principals 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 our free cash flow to GAAP cash flows from operating activities are included in the press release we issued this afternoon.

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

Mark?

Thanks, Kevin.

Good afternoon, everyone, and thanks for joining us.

I will begin with a review of our accomplishments in our fiscal year '12, followed by a fourth quarter update, and finally a perspective on our business outlook.

Kevin will then review the financial and guidance, and then we will open it up for your questions.

During FY '12, we delivered total Company bookings and revenue growth of 14% and 7%, respectively year-over-year.

Strong organic revenue growth in defense and the addition of KOR more than offset a $33 million decline in our commercial business.

We delivered record defense revenues in FY '12.

Defense revenues grew 27% year-over-year including KOR, and on an organic basis, we grew defense revenues 16%.

Defense bookings and backlog also have exhibited very strong growth at 24% and 25%, respectively.

We grew operating income 21% for the year as a whole, and our adjusted EBITDA grew 20%.

At 20% of total revenue, our adjusted EBITDA ended 200 basis points above the high-end of our current target model.

Given this over-achievement, Kevin will discuss improvements to our long-term target model, which now seeks to deliver 18% to 22% on an adjusted EBITDA basis over the coming years.

Obviously, this assumes that the industry returns to a more normal funding and contracting environment.

Fiscal 2012 was a strong year for our Mercury Federal Systems business.

Driven by Gorgon Stare and the addition of PDI, revenues were up 150% year-over-year, and bookings were up 315%.

Excluding PDI, bookings and revenue were up 201% and 82%, respectively.

As we expected, MFS went from an operating loss in FY '11 to a significant operating profit for FY '12.

At the market segment levels for FY '12, revenues in our Radar business were up 14% year-over-year, and electronic warfare revenues were up 20%.

Revenues in [DYR] were up 97%, and finally, C4I revenues were up over 500%.

And also in FY '12, we successfully completed phase one of our M&A agenda through the acquisitions of KOR, PDI and soon to be Micronetics.

What we have created is a truly unique asset in the non-prime defense electronics industry.

We believe that we are the only commercial item Company that has end-to-end capabilities along the entire sensor processing chain.

We are very pleased with how our integration efforts are proceeding, and how the acquired businesses are performing and projected to perform.

We had a great year from a design win perspective.

Design wins are an important forward-looking indicator of the health and long-term growth potential in our Business.

For the fiscal year as a whole, we had 50 design wins, 47 were in defense with a five-year probable value of approximately $293 million.

Excluding JCREW from the comparison as deals of this potential size do not typically repeat every year, in FY '12 the five-year probable value of our defense design wins increased 33% year-over-year.

This is a testament we believe to three things.

First, is the very successful product portfolio refresh we undertook several years ago, which is nearing completion.

We believe we have the industry's leading intel and GPU product line, that has a significant differentiation with respect to processing density and embedded security.

The second is our services-led business model.

Thirdly, Mercury is a systems-oriented Company.

All three are proving to be major differentiators versus the competition, as the primes outsource more sensor processing subsystems to best-of-breed commercializing companies such as Mercury.

Finally, late in the year, Mercury's headquarter facility was awarded a Superior security rating by the US Defense Security Services, which places us in the top 4% of all facilities reviewed.

So, in summary, we conclude a very strong fiscal year for Mercury, in an increasingly challenging environment.

Moving to Q4, conditions in the industry did begin to take a toll on our defense revenues and bookings.

However, despite a challenging top line, we continue to execute well on the areas that we could affect, and as a result our comparable Q4 GAAP earning per share and adjusted EBITDA both came in at, or near the high end of guidance.

We said for the last six months, that budgetary constraints on defense spending, coupled with the DoD's commitment to new roles and missions for the Armed Forces are likely to lead to a period of transition and reduced visibility for the defense industry that could last for a year or more.

On our last earnings call, we also talked about the potential adverse impact of a budget sequester beginning in January 2013.

We believe these impacts have in effect, already begun to materialize within the defense industrial base.

It appears to us, that the defense industry is already operating under a form of self-sequestration.

From our level, the uncertainty surrounding the defense budget and the potential for major cuts and disruptions later in the year appear to be causing a pronounced slowdown in commitments and associated program funding levels, the timing of funding, and the overall contracting environment.

These effects were apparent in our weaker than expected defense bookings during Q4, as well as in our Q1 forecast.

We responded to these challenges during the fourth quarter by focusing on areas that we could control.

We continue to tightly constrain operating expenses, and completed a sizable restructuring action expected to result in approximately $5 million of annualized savings.

As a result of these efforts, Q4 organic operating expenses were lower than in the fourth quarter last year, and despite lower revenues, we delivered strong EPS.

Now, looking at the business from a programmatic perspective for the full-year, our major ongoing programs all performed well in FY '12.

Although bookings from Lockheed Martin and Aegis were down year-over-year, revenues were up 24%.

Revenues from the Patriot program with Raytheon were roughly flat for the year, largely due to the pushout of Patriot Turkey during FY '12.

Overall bookings for Patriot grew 89% year-over-year.

During the fourth quarter, we were very pleased to record a design win for the US Army Patriot, which could have important bookings and revenue implications for FY '13 if the timing holds.

Raytheon is also pursuing multiple additional opportunities in the Middle East.

However, as we have discussed previously, the timing of FMS sales is notoriously difficult to predict.

Gorgon Stare was also an important driver in fiscal '12.

Revenues from the program grew 180% year-over-year, with a correspondingly strong bookings performance.

Various revenues associated with different sensor processing on Global Hawk Block for both Northrop Grumman and Raytheon were reported in FY '12.

However, the previously announced cancellation of Global Hawk Block 30 in the GFY' 13 budget was disappointing, and removed approximately $12 million for our revenue plan for FY '13.

Finally, although not currently one of our recurring top programs, business with Raytheon and JFS was up substantially year-over-year.

However, due to the timing and nature of the revenues, we do not expect JFS to be a significant contributor in FY '13.

Likewise, for the classified airborne radar program we benefited from last fiscal year.

This program update is effectively complete for now, and we do not anticipate recurring revenues during FY '13.

We have two major new programs on the horizon that I would also like to touch upon.

The first is JCREW I1B1, formerly known as JCREW 3.3.

As expected and discussed last quarter, we did not receive the PO for the long-lead time materials in Q4.

This timing issue in itself triggered a reversal of the earn-out for the LNX acquisition earmarked for December of this calendar year.

Kevin will discuss this in more detail in his prepared remarks.

Based upon what we know about an ongoing government program replanning, we believe the program will remain in development longer than the previously planned milestone C highlighted in the GFY '13 budget request.

As a result, we have decided to push all JCREW LRIP bookings and revenue into our FY '14.

We remain positive about the programs status overall.

Our execution on the program has been very good, with Exelis commenting that we are the best performing sub.

JCREW I1B1 is the program of record for CID.

The Marine Corps from what we are hearing like the capability, and as we have discussed, they requested significant funding for JCREW in the GFY '13 budget.

Our second major new program, the Navy Surface Electronic Warfare Improvement Program or CWIP continues to move forward, but the progress has been slower than we had anticipated.

We didn't receive either the large PO from Lockheed Martin, or the revenue from CWIP Block 2 LRIP shipments that we had expected in the fourth quarter.

However, we currently expect to receive the PO late in the current quarter, based upon the current timing of government LRIP funding.

CWIP is shaping up to be a significant bookings and revenue driver, as we move through the fiscal year.

Our Services and Systems Integration or SSI business within ACS continued to produce a significant portion of our overall design wins in Q4.

As we expected, Q4 was a strong conclusion to a strong year for design wins.

For the fourth quarter, we had a total of 15 design wins, all of them in defense.

This compares with the total of 10 wins, 8 of them in defense in Q4 last year.

The five-year probable value of our Q4 design wins was approximately $129 million, compared with $34 million in Q4 last year, a growth of 278%.

Our most significant design win this quarter was as previously mentioned with Raytheon for the US Army Patriot.

Our other design wins include one that could designate us as the next-generation standard for radar processing for a division of one of the major primes.

We also received a radar processing design win with Lockheed Martin for a wide bodied airborne platform that could become an important revenue driver over the longer term.

As I said earlier, we continue to be successful in supplementing our organic growth with strategic M&A.

The deal to acquire Micronetics that we announced in June is just one of three such milestones over the past 18 months, the others being KOR and LNX.

The primes are responding to the funding and contracting uncertainties by downsizing their organizations, consolidating their supply chains, and actively looking to outsource at the subsystem rather than the component level.

This leaves the subsystems integration to best-of-breed commercial companies like Mercury.

With two quarters of integration behind us, KOR and PDI are performing well and shaping up to be great assets, fully aligned to our strategy as we expected.

LNX has been crucial to our success in design wins this past year.

These include another important naval SIGINT design win with Argon, as well as another large design win for CWIP Block 2 with Lockheed Martin.

Similar to the LNX and KOR transactions, acquiring Micronetics should move us closer to building out a scalable RF and Microwave business that complements our long-standing capabilities in digital signal processing.

We are making good progress towards closing the transaction during the first quarter of FY '13.

At the same time, we continue to be involved in discussions with numerous companies, that like KOR, LNX and Micronetics represent possible opportunities along the sensor processing chain.

These are companies that fit our previously stated parameters, proven technology and capabilities, strong management, participation on the right programs and platforms.

We have also been talking with some of the major banks to discuss debt refinancing to facilitate future M&A, and Kevin will discuss this more in detail later.

So with that as a background, I will conclude with some thoughts about the business outlook.

We believe that FY '13 is going to be a challenging year for Mercury and for the defense industry as a whole, given the high likelihood of another CR, and the potential for sequestration.

We are expecting reduced forecast visibility, and greater bookings and revenue volatility.

Our biggest risks during this transition period I believe, are potential delays in new program starts, potential delays to programs transitioning between phases, as well as risks to the timing and level of program funding.

In turn, these risks could impact the number and value of our design wins, as well as our bookings, revenue, profits and cash flow.

We're going to take it one quarter at a time, focusing on executing well on the things that are within our control, and remaining agile to adapt to the things that are outside of our control, as and when they occur.

Over the longer term, we feel very positive about our prospects, and the fact that we have and will continue to build intrinsic value in our defense.

We are in the sweet part of the defence market, that being ISR, EW and missile defense.

And now with the addition of PDI, we are also doing business in the intelligence community for the first time.

We are on, or have won many of the right programs, some of which are to expected to transition to low rate initial production.

We have built or acquired capabilities that are aligned with the new DoD roles and missions.

We have a contemporary, differentiated industry-leading product portfolio.

We are winning a large number of high volume new designs.

Our services-led business model is aligned to the outsourcing need of the primes.

We are successfully executing on our M&A strategy to build capabilities along the sensor processing chain, as well as to grow revenues and adjusted EBITDA.

The timing of our M&A activity has and we expect will continue, to help address potential program funding delays, and other issues during this industry transition period.

Finally, and probably most importantly, we have the smart dynamic management team, and a very talented and hard-working employee base.

We have proven over the last five years, that we cannot only restructure and turn around a business, but also we have consistently delivered profitable organic revenue growth in our KOR Defense business, that we are now scaling with solid execution on the M&A front.

We are confident, given all of this, that we have the wherewithal to navigate this industry transition period, ultimately emerging on the other side, with a potential for accelerated growth and improved profitability.

We continue to expect 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 the defense industry of the future.

With that, I would like to hand it over to Kevin.

Kevin?

Thank you, Mark and good afternoon again, everyone.

Turning to the financial results, revenue for the fourth quarter of $60.9 million was essentially flat with the revenue of $61.2 million for the fourth quarter of last year, and was within our stated guidance of $60 million to $66 million.

GAAP earnings from continuing operations of $0.19 per share, were $0.05 per share higher than $0.14 per share in last year's fourth quarter, and significantly exceeded the Company's stated EPS guidance of $0.04 to $0.10 per share.

However, GAAP earnings for fiscal 2012's fourth quarter benefited from the reversal of an earn-out liability related to the LNX acquisition which was partially offset by incremental expenses related to restructuring actions initiated in the fourth quarter and Micronetics-related transaction costs.

On a combined basis, these items contributed a net $0.09 per share in earnings for the fourth quarter, which placed the Company's fourth quarter EPS absent these items at the high end of our quarterly guidance.

I will discuss these items in more depth, later in my remarks.

Adjusted EBITDA for the fourth quarter of fiscal 2012 of $9.3 million was $800,000 lower than adjusted EBITDA of $10.1 million for the fourth quarter of last year, and was at the high end of the Company's stated guidance of $7 million to $9.5 million.

The Company ended the fourth quarter and fiscal year with $116 million of cash and investments and with no debt, and generated $1.2 million of free cash flow in this year's fourth quarter.

Reviewing fourth quarter performance in more detail, total revenue for our largest operating segment, Advanced Computing Solutions or ACS, was $54.3 million which was $6.1 million lower than the $60.4 million of ACS revenue generated in last year's fourth quarter.

The year-over-year decrease was due to a $3.8 million decrease in commercial revenue, and a $2.3 million decrease in ACS defense revenue.

The decline in ACS defense revenue related to lower program revenue from a Northrop Grumman classified airborne program, that was partially offset by the revenue derived from the Company's acquisition of KOR in December of 2011.

Revenue from our Mercury Federal Systems or MFS operating segment for the fourth quarter was $10.5 million, which was $7.9 million higher than the $2.6 million of MFS revenue for the fourth quarter of fiscal 2011.

Consistent with last quarter, this exceptionally strong revenue growth was driven by higher revenue from the Gorgon Stare program, as well as the inclusion of revenue from Paragon Dynamics, or PDI, which was acquired as part of KOR.

It should be noted that operating segment revenue for the fourth quarter of fiscal 2012 does not include adjustments to eliminate $3.9 million of intercompany revenue.

Total defense revenue, including ACS and MFS for the fourth quarter of $57 million was $3.5 million or 6% higher than defense revenue of $53.5 million for the fourth quarter of last year.

Excluding the addition of KOR and PDI revenue, fourth quarter defense revenue declined $5.9 million year-over-year, reflecting the slowdown in current defense procurement in light of the threat of sequestration.

Defense bookings for the fourth quarter of $55.5 million were $2.8 million lower than the $58.3 million of defense bookings in the fourth quarter of last year.

As Mark alluded to in his remarks, the Company's bookings performance in the fourth quarter is mainly attributable to a more discernible slowdown in purchase order activity from our customers due to the lack of clarity relative to defense spending.

Mercury's total book-to-bill ratio for the fourth quarter of fiscal 2012 was 1.0, which matches the 1.0 for the fourth quarter of last year.

Defense book-to-bill of 1.0 for this year's fourth quarter was slightly below the 1.1 ratio generated in the fourth quarter of last year.

The Company ended fiscal 2012 with $104.6 million of total backlog, which was $17.7 million, or 20% higher than the $86.9 million of backlog at the end of last year's fourth quarter.

Of the total ending backlog in the fourth quarter, $91.9 million, or 88% is expected to be shipped within the next 12 months.

$101.5 million of the ending fourth quarter backlog relates to defense, which is $20 million, or 25% higher than last year's defense backlog.

From a bottom line perspective, GAAP earnings from continuing operations of $5.7 million was $1.4 million higher than the $4.3 million of comparable earnings in last year's fourth quarter.

Lower gross margin due to the inclusion of KOR and PDI revenue that carried lower than historical Mercury margin, was more than offset by lower year-over-year operating expenses.

The reduction in operating expenses was due to the reversal of an earn-out liability related to the LNX acquisition, and significantly lower base operating expenses that were partially offset by a restructuring charge incurred in this year's fourth quarter, Micronetics-related transaction costs, and the inclusion of KOR and PDI operating expenses.

I will talk about several of these separately.

First, the $4.9 million reversal of the earn-out liability stemmed from the Company's assessment at year-end that it was probable that the earn-out related to the January 2011 LNX acquisition would not be achieved.

The reversal of this liability resulted in a corresponding reduction to operating expenses for this year's fourth quarter.

While the earn-out was not achieved, we continue to be pleased with the performance of the RF product line acquired from LNX, as it ramps up production and revenue for several important programs.

Second, the Company recorded a $2.8 million restructuring charge related to severance costs, in connection with the reduction of 41 employees in the fourth quarter primarily in engineering and manufacturing functions.

The charge was taken to proactively address the slowing defense procurement environment by reducing headcount expenses as well as manufacturing costs, via outsourcing a portion of the Company's manufacturing of digital products to a third-party.

The Company expects to generate annual pretax savings of $5 million from this cost-cutting action.

However, these projected savings exclude incremental costs associated with the pending absorption of Micronetics, which I will discuss later in my remarks.

Third, the Company incurred in the fourth quarter approximately $0.5 million of transaction costs in connection with the previously announced Micronetics acquisition.

We expect this transaction to close within the next two weeks.

Finally, when excluding the above-mentioned operating expense items, base operating expenses declined $2.5 million between this year's fourth quarter, and the fourth quarter of last year.

This decline was achieved despite absorbing $2.6 million of KOR and PDI operating expenses in this year's fourth quarter.

Base operating expense reductions, excluding the KOR and PDI impact were the result of increased customer-funded R&D and lower headcount-related expenses.

The Company has done an admirable job of proactively managing operating expenses, as a means to counteract the difficult current top line environment.

While reported earnings in this year's fourth quarter were higher than last year's fourth quarter, adjusted EBITDA of $9.3 million for the fourth quarter was $800,000 lower compared to the fourth quarter of fiscal 2012.

The exclusion of the earn-out reversal and a lower add-back of income taxes more than offset higher year-over-year add backs for restructuring, amortization and Micronetics transaction-related expenses.

Despite a very challenging fourth quarter, the Company's financial performance for all of fiscal 2012 was extremely impressive.

Our total revenue of $244.9 million was $16.2 million or 7% higher than fiscal 2011.

Defense revenue of $229.9 million was $49.5 million or 27% higher in comparable revenue from last year.

Despite total organic revenue declining by 2% in fiscal 2012, defense revenue excluding KOR and PDI was up 16% for fiscal 2012 relative to fiscal 2011, based on strong revenue growth in the significant programs that Mark mentioned, such as Aegis and Gorgon Stare.

Similarly, defense bookings of $215.9 million were 24% higher than in fiscal 2011 driven by the addition of KOR and PDI, as well as strong bookings from the Patriot and Gorgon Stare programs.

Bottom line performance for fiscal 2012 was equally impressive.

Net income from continuing operations of $22.6 million was 22% higher than fiscal 2011 earnings of $18.5 million.

In a similar fashion, adjusted EBITDA for all of fiscal 2012 of $48.9 million was 20% higher than adjusted EBITDA for the prior fiscal year.

Adjusted EBITDA as a percentage of sales was 20% for fiscal 2012, well above our 17% to18% target business model.

All in all, fiscal 2012's operating results made for an extremely successful year.

Turning to the balance sheet, the Company ended fiscal 2012 with cash and investments of $116 million and no debt, which was $1.1 million higher than the $114.9 million of cash and investments at the end of fiscal 2012's third quarter.

The increase in cash and investments for the fourth quarter was driven by $4.2 million of operating cash flow derived from GAAP earnings performance for the quarter, adding back non-cash depreciation, amortization and stock compensation expense.

Partial offsetting operating cash flow for the quarter was nearly $3 million of capital expenditures in the fourth quarter.

As Mark mentioned in his remarks, due to the lack of clarity within overall defense funding and contracting, largely due to the sequestration threat, the Company will only be providing quarterly financial guidance.

In addition, since we have not closed the Micronetics transaction, we will be providing first quarter financial guidance excluding Micronetics.

I will then provide general commentary on the anticipated impact of Micronetics on the Company's financial guidance for the quarter.

With that, for the first quarter of fiscal 2013, we are targeting total revenue in the range of $51 million to $57 million, which assumes continued challenges in order activity that we saw in the fourth quarter.

Consistent with prior quarters, we expect the split in first quarter revenue to be 92% defense and 8% commercial.

At the mid point of our guided revenue range, we expect first quarter defense revenue to generate low double digit year-over-year growth for the quarter, driven by the inclusion of KOR and PDI and increased Gorgon Stare revenue, that are partially offset by lower AFS revenue.

Within our stated revenue guidance, we are projecting gross margin to approximate 48% for the first quarter, reflecting a higher proportion of our revenue deriving from KOR, PDI, and our RF products which carry gross margins lower than those generated by the Company in previous quarters.

Operating expenses are estimated to be $27 million in the quarter, which is up slightly from the $26 million of operating expenses in the first quarter of last year.

Increased operating expenses from the inclusion of KOR and PDI, restructuring costs related to the completion of actions initiated in the fourth quarter, and Micronetics transaction expenses are forecasted to be largely offset by headcount savings from the fourth quarter restructuring action.

As we have done over the last several quarters, we will continue to judicially manage operating expenses as a means to address the uncertain revenue environment.

From a bottom line perspective, we are targeting GAAP EPS at breakeven to a loss of $0.05 per share for the first quarter based on an estimated weighted average share count of 30.7 million shares.

Within this GAAP EPS range, we are projecting a $0.04 per share impact from the combination of amortization of acquired intangibles, restructuring and acquisition-related costs.

Adjusted EBITDA is estimated to be between $4 million and $6.7 million for the first quarter of fiscal 2013.

With regards to the impact of Micronetics on first quarter financial guidance, we anticipate the acquisition to close on or about August 8, which based on this timing, would include approximately half a quarter of Micronetics' financial results.

Under this assumption, the Company would anticipate it's first quarter revenue to increase $4 million to $5 million with the inclusion of Micronetics.

At this assumed revenue, we would tentatively assess Micronetics' bottom line results to be dilutive to the Company's first quarter earnings forecast by $0.02 to $0.03 per share, largely the result of forecasted purchase accounting adjustments for the quarter.

These are obviously high level assumptions, which we will have more clarity once the transaction is completed.

Also consistent with prior statements, the acquisition of Micronetics is expected to be accretive on a GAAP basis within12 months of the closing date.

With the onset of a new fiscal year, the completion of two acquisitions, and a third pending within the last two years, and the fact that we exceeded our adjusted EBITDA target business model for fiscal 2012, we thought it would be appropriate to update the Company's target business model.

Of most importance, the new model increases our target adjusted EBITDA as a percentage of sales, from a range of 17% to 18% to a new range of 18% to 22%.

As Mark noted in his remarks, this target range assumes that the industry returns to a more normal funding and contracting environment.

However, some individual income statement components have changed, to arrive at the new adjusted EBITDA range.

Most notably, as we have discussed, we have lowered our target business model gross margin from 54%, to a range of 45% to 50%.

This reduction reflects the buildout of our RF business via the acquisition of LNX and the pending acquisition of Micronetics, and the growing importance of our services-led businesses which include SSI, KOR and PDI, which carry gross margins that are lower than the historic norm for Mercury.

This decline in gross margin is being more than offset by R&D as a percentage of revenue decreasing from a high teens percentage of revenue business model, to our new model which pegs R&D between 11% and 13% of revenue.

This reduction in R&D as a percentage of revenue stems from future top line growth deriving from the RF and services-led businesses that attract significant customer-funded R&D.

This serves to lower R&D for these businesses, by shifting these costs into cost of sales, ultimately, of course, finding reduction to gross margin.

From a GAAP perspective, our target business model for operating income remains at 12% to13%, as the 2 percentage point net benefit of lowering the R&D target, compared to the new gross margin target is largely absorbed by increased amortization expense related to the Company's recent acquisitions.

This 2- to 3-percentage point impact from amortization is essentially added back to our previously adjusted EBITDA target of 17% to18% of revenue to arrive at the new range of 18% to 22%.

As a final point, with the closing of the Micronetics transaction expected within the next two weeks, the Company's available cash will be lowered by approximately $75 million.

While we believe there is sufficient liquidity to operate the business after the completion of the Micronetics acquisition, there is insufficient liquidity to pursue the Company's M&A agenda, which as Mark has pointed out many times, is a critical aspect of the Company's strategy.

Therefore, we have actively investigated financing alternatives to support the Company's M&A objectives, and are proceeding towards replacing our $35 million revolving credit facility with a significantly larger one.

We expect to finalize this new credit facility shortly, which we believe will put the Company in a position to sufficiently finance it's next acquisition, if and when that time arrives.

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

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

Thank you.

(Operator Instructions).

And we'll go first to Peter Arment with Stern Agee.

Hi, good afternoon, Mark and Kevin.

Hi Peter, how are you doing?

I'm doing well.

The first question, I guess, Mark, is on the -- whatever you can discuss regarding the first quarter guidance range.

And I guess I'm just particularly talking about the defense portion, I guess the 92%, kind of what you outlined within that $51 million to $57 million guidance.

What are the kind of puts and takes there, or what are you seeing, given what you have in backlog and what you need to close to kind of fill out that range?

Sure.

So we did have some deals that basically moved out of Q4, a portion of which basically moved into Q1.

Probably the most notable is CWIP, where we didn't receive the PO during Q4, and hence we didn't recognize the revenues.

We are currently expecting to receive the PO late -- later in Q1, and so we do anticipate some revenues from that program.

So there is a number of puts and takes, but that is probably the most important one.

We are also expecting a certain level of booked shipment, as we do -- as we have seen in other quarters.

Peter, I would also remind you too, that historically the first quarter has been a -- been one of the lighter quarters within the year.

And I think that that is probably true in terms of our assessment for the quarter this year as well.

Okay.

And then question, Mark, just talking I guess in big picture on capital deployment, but also your M&A strategy.

So you indicated in this -- and I guess this includes the Micronetics transaction, that phase one is essentially complete of building out the end-to-end capabilities.

So how do we think about phase two?

Is it just building up more critical mass, or what kind of color you can give us there?

Yes, sure.

It's a good question.

So we feel really good about the assets that we've acquired in terms of the capabilities and the work that we've done on integrating them and their performance to date, and as well as their expected performance.

Phase two for us is going to continue with the theme, around the sensor processing chain, but it is really about scaling the platform here on out.

So that's really the goal going forward.

Okay.

And just I guess against that, as a capital deployment strategy, you are currently, when you look at your own valuation, and what you have to -- out there in the M&A, you are still seeing some decent multiples.

So how do you weigh that against deploying that capital now, and kind of the uncertainty versus when you look at your own valuation?

Yes.

No, that's a good question.

We still think M&A is a really important part of the strategy.

I think as we have looked at other downturns in the defense industry, as well as other industries that have gone through a period of significant transition, the companies that have continued to acquire and build scale, when the industry transition is ended have been the ones that have basically had a slingshot effect out of that.

We do anticipate that, as the industry goes through this transition period, the multiples are going to start to contract.

And we hope that there is going to be some interesting assets that become available.

And hence, as Kevin discussed, in our discussions with some of the banks in terms of putting in place a large revolving debt facility.

So we do think the prices are basically going to come down during this period.

Okay.

And then just one last one.

Regarding the outsourcing, I think Kevin you mentioned the 41 employees, Mark, what do you -- was that something that you had been looking at?

Or it just accelerated because of the weaker environment, or are there other opportunities going forward?

So it is a little bit of both.

The primary driver as I said in my prepared remarks, we do anticipate that FY '13 is going to be a tough year, not only for Mercury but also for the industry as a whole, largely due to what is a very high likelihood of a Continuing Resolution as well as the potential for sequestration.

So we took the opportunity of basically lowering the capital intensity of the business.

We outsourced a small digital manufacturing capability that we hide in our Huntsville facility, to our current contract manufacturing partner who is Benchmark Electronics, as well as taking out additional expenses across the business.

So I think, in overall we did a really good job at managing our expenses during FY '12, and we proactively took out costs in the end of the fourth quarter.

Okay.

And then just the last one, just regarding your adjusted EBITDA.

You finished the year at $48 million, thinking through all of the moving parts and the incremental impact from Micronetics, is your belief that you will be able to still grow adjusted EBITDA in fiscal '13?

So we are actually only in the, one quarter in the guidance, on quarter at a time guidance right now.

So we have given you the guidance for the first quarter.

And as Kevin discussed, in terms of the update to the new pro forma target business model, we do anticipate, once we get back to a more normalized environment, being able to actually expand our adjusted EBITDA over the long-term in the 18% to 22% range.

But that is a longer-term target model.

Got it.

Thanks, Mark.

Okay.

Thank you.

We'll go next to Brian Ruttenbur with CRT Capital.

Yes.

Thank you very much.

A couple of questions.

First of all, if I take your $4 million to $5 million of revenue from acquisitions this quarter.

And that's for 50% of the quarter roughly, can I then annualize and say that is about $35 million for this fiscal year?

Is that the right way to look at it?

So we're not giving guidance again on a annualized basis, Brian.

We kind of laid out what is our guidance for the first quarter.

Brian, we do not even own the company yet.

It would be not appropriate to even talk about what their forecast is, beyond just the color we gave for the quarter until we close this deal.

It is just inappropriate.

Okay.

The other question I had then on -- you have mentioned Mark, several times, about the normalized environment.

That normalized environment, you are saying is what?

That there is no sequestration and the KOR defense grows at 2% or 3% a year?

Is that a normalized environment?

What is a normalized environment?

So, certainly not the environment that we are currently in.

If you look at -- we believe that there is going to be a clearly Continuing Resolution in FY '13.

I think the expectation is probably a 6-month CR.

We'll see what happens with the sequestration itself, which obviously could have a pretty damaging impact on the defense industry and the defense industrial base.

So I think it -- we are hoping that once the new administration is in, that we kind of move back to something that we have seen prior to, say the last few years.

Okay.

Thank you very much.

Thank you.

We'll take our next question from Michael Ciarmoli with Keybanc Capital Markets.

Thanks for taking the question.

Good afternoon.

Mark, I know you're not in the business I guess, of providing an outlook for the full year.

But you have got this mid teen growth target out there, combination organic and acquired, safe to say, given this industry in transition, does that not apply to this current year?

So that growth rate and target that we talked about, was really on our ridge and over time.

It is a longer term number.

I think if you look back, Mike, we basically delivered 15% compounded annual growth rate in our defense business from FY '08 through FY '12.

Last year, we grew 27% year-over-year including KOR, and 16% on an organic basis.

We are excited about the Micronetics acquisition which should close in August.

We think that the timing of this deal and the addition of Micronetics books and revenue couldn't be better, as we head into the transition period itself.

So however, that is offset by the challenges that we see with respect to the potential for a Continuing Resolution as well as the sequestration.

So that mid-teens revenue growth rate on our bridge over time including M&A is really a long-term target.

We are not specifically pushing that into our FY '13 numbers.

Okay.

And I'm assuming then, on an organic basis for '13 you guys are probably going to remain under pressure.

So again, probably the importance of Micronetics?

So again, we are not going to talk about or -- our organic growth rate at the year level.

We do believe that as a business we positioned ourselves extremely well, given some of the programs that we have, as well as the timing of the certain acquisitions that we have done of late.

But we are in an industry environment where the visibility from a forecast perspective is somewhat murky right now.

And I think we're seeing, and clearly saw, in our fourth quarter and it is reflected in our Q1 guidance.

Some of the charges that we've seen with respect to funding delays.

So we're going to basically take it one quarter at a time.

We're going to focus on executing well the things that are within our control.

And yes, we're going to be agile enough to react to the things we may need to react to as the year unfolds.

Okay.

How about the growth trends in KOR?

I mean, you bought that, it was high single-digit and double digits, is that on track?

KOR is actually performing pretty well.

We are pleased with that performance to date.

The bookings as an example in Q4 were close to $9 million.

So they are doing well.

I think we are very, very pleased with that business, and the potential going forward.

Okay.

And then last one, and I'm sorry for asking this again on '13, but can you even give us a sense, in terms of those major programs?

You kind of did a good job outlining for us, how they trended for the year.

And I'm thinking Gorgon Stare, Patriot, Aegis, can you give us a sense of whether or not those programs, how they track in the coming year?

Do you expect growth in all of those programs, some of the programs?

We obviously -- you have talked to us about what to expect with the JCREW program.

Any other color you can give us?

Sure.

So programs that we expect to do well from a revenue perspective this year include various programs in KOR, associated with both electronic warfare as well as radar simulation business.

We anticipate the Lockheed Martin CWIP as well as Lockheed Martin Aegis is going to be important programs.

We are expecting good progress with Gorgon Stare with Sierra Nevada.

Raytheon Patriot is another program, that we are expecting good growth in.

And then there is a couple of our new ones.

The first is a dismount radar with Northrop Grumman, as well as additional upgrades to both the Predator and the Reaper.

So beyond that, I think as Bill Swanson talked about on the Raytheon earnings call, there is clearly a lot happening with Raytheon Patriot, particularly in the Middle East with countries such as Kuwait and Turkey, which does appear to be delayed a little again.

However, there is also Oman, Qatar and Kuwait.

And as I mentioned in my prepared remarks, we also booked or recorded the design win for the US Army Patriot this quarter.

I think beyond that, we would say that we are pretty excited about the potential for the F-16 radar upgrades, for both Taiwan, as well as potentially North Korea.

Clearly, this potential opportunity is a very competitive scenario, where it is Northrop Grumman's Saber versus Raytheon's Saber -- sorry, Raytheon's Racer program.

But if Northrop is successful and the timing is right, these could also be important opportunities for us.

Great.

That is very helpful.

Thanks.

(Operator Instructions).

We will go next to Michael Lewis with Lazard Capital Markets.

Hey, thanks.

Where can I start?

First and foremost, I want to ask you about the 10% tax rate in the quarter.

What is your full expectation for the year, Kevin?

And, shoot, I guess the question is, did the restructuring and the reversal on LNX have that implication on the lower tax rate?

Definitely the earn-out, because there was no tax impact associated with that, so we got the full benefit dropping to the bottom line.

Also, most of the acquisition costs, related to Micronetics are not tax deductible, so they are not factored in as well.

But essentially it is the earn-out.

It is a one quarter impact.

I think you can assume our tax rate will revert back to a more normalized level, going forward.

Okay, that is fair.

And then on the restructuring, was there any specific facility that was reduced, or was it headquarters, or one of the other outside facilities?

Can you give us more detail there?

Sure, Mike.

The largest part of the restructuring was with respect to our Huntsville facility.

And it was as I described, where we decided to outsource, what was in effect a vertically integrated manufacturing capability to contract manufacture at Benchmark Electronics.

We also took out heads in both in engineering, as well as other G&A across the business.

Okay.

And then I wanted to circle back on the debt.

What are the pros and cons of using a revolver, versus some type of note structure?

And how large do you think you would like to go on that debt, Mark?

Sure.

So I'll give you my perspective, and then I will throw it over to Kevin.

We think it is the most appropriate form of capital at this point in time for us.

It gives us the most flexibility from a capital structure perspective, with the least negative carrying cost associated with the debt.

So I will hand it over to Kevin for his perspective, in terms of where we are at, and why we decided to go with that, beyond what I just said.

Yes, obviously, Mike, you know the debt markets well, fairly attractive in terms of rate, and in terms of structure.

So obviously debt was the primary alternative that we looked at.

In terms of why a revolver again, cost and flexibility were the two parameters that we value the most.

And obviously cost is -- is best from a revolver perspective, versus a high-yield or a institutional term loan, And obviously flexibility from the standpoint of allowing -- a revolver allows us to use the money when we need it, as opposed to placing it on the balance sheet immediately, and then having the interest cost impact the both earnings and cash flow, while waiting for the next deal to be financed.

So from that standpoint, that was really the two parameters that we value the most, and got us to the revolver.

That's fair.

And let me just ask you an additional question there.

Part -- I guess part of the mandate, when you did the secondary was to use those proceeds for acquisitions.

And we are almost through those proceeds, so that mandate could possibly kind of move away.

Now if you have a low-cost debt-type structuring in the portfolio, or in the fire power here, dry powder, would you consider doing things like buybacks for example, considering that the EPS hasn't had such significant lift, especially as we progress into a fiscal year '13, uncertainty on the budgets?

Well obviously that's -- a Board decision, number one.

But I think that we will, as part of any financing package, we will preserve enough flexibility to allow for things like that.

But there are no plans at this point, with regards to a buyback.

And I think our primary agenda remains to basically continue to grow and scale the Company, in terms of capabilities, as well as our EBITDA.

And to take advantage of what we think is going to be a depressed pricing environment for when the industry returns to a more normalized structure.

Okay.

And then I apologize to my peers, but one more question.

Did you say that KOR PDI added about $9.5 million in the quarter?

I said roughly $9 million of bookings in the fourth quarter.

Do you have a revenue number?

Well, I do.

But --

Yes.

The 6 months since we have had them is about $20 million, so roughly about $10 million per quarter.

Okay, great.

Thank you.

Yes.

And with that, we have no further questioners in the queue.

I would like to turn the program back over to Mr. Mark Aslett for any additional or closing comments.

Okay.

Well, thanks very much for listening.

We look forward to speaking with you all again next quarter.

Thank you.

And that does conclude today's call.

Thank you for your participation.