Mercury Systems Inc (MRCY) 2013 Q1 法說會逐字稿

Good day and welcome everyone to the Mercury Computer Systems Incorporated first quarter fiscal year 2013 conference call.

Today's conference is being recorded.

At this time for opening remarks and introductions, I would like to turn the call over to 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, could, should, would, plans, expects, anticipates, continue, estimate, project, intend, likely, forecast, probable, and similar expressions.

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

Such risks and uncertainties include but are not limited to, continued funding of defense programs, timing of such funding, 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 technology logical advances and delivering technological innovations, 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 and quality issues with outsourced components, inability to fully realize the expected benefits from acquisitions, divestitures, and restructurings, and delays in realizing such benefits, challenges in integrating acquired businesses and achieving anticipated synergies, changes in export regulations, increases in tax rates, changes to Generally Accepted Accounting Principles, difficulties in retaining key employees and customers, unanticipated costs under fixed-price service and system integration engagements, and various other factors beyond our control.

These risks and uncertainties also include such additional Risk Factors as are discussed in the Company's filings with the US Securities and Exchange Commission, including its Annual Report on Form 10-K for the fiscal year-ended June 30th, 2012.

The Company cautions readers not to place undue reliance upon any such forward-looking statements which speak only as of the date made.

The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances after the date on which such statement is made.

I would 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 and 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 operating activities.

Reconciliation of adjusted EBITDA to GAAP net income from continuing operations and 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 today's call with the first quarter update.

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

The results we announced this afternoon were in line with the revised guidance we announced on October the fourth.

Total revenue for the quarter was flat year-over-year at $49 million, including a partial quarter of Micronetics, which we acquired on August the eighth.

Our GAAP net loss from continuing operations was $7.2 million, or $0.24 per share compared with GAAP net income of $0.09 per share for Q1 last year.

The increased loss largely reflects SEWIP revenue delays and a fiscal first quarter restructuring action we previously announced.

Adjusted EBITDA was down 81% year-over-year and below our current target business model.

We said for the past nine months that government financial year 2013 would likely be a year of transition leading to reduced visibility and heightened risk for the defense industry.

Along with the approaching sequester, budgeting constraints of defense spending, coupled with political gridlock in Washington, have led the industry to operate in what currently appears to be a [sultan] sequestration environment.

This we believe has resulted in a slowdown in defense program funding and contracting, that could continue to affect our financial results and visibility for the next six to 12 months.

The funding and contracting environment had a more significant impact on our first quarter business than we initially anticipated.

The main factor being delayed orders associated with SEWIP Block 2, which is beginning the transition from the engineering phase to low range initial production.

Total defense revenues were down 1% from Q1 of FY 2012 and total defense bookings were down 41%.

Our book-to-bill in defense for the first quarter was 0.81 and our total book to bill was 0.83.

Our defense backlog exiting Q1 benefited from the recent addition of Micronetics and was up 10% year-over-year.

We see delays in reductions across our defense business, from ongoing programs to new programs transitioning between phases, like SEWIP to smaller run rate deals and new defense design wins.

We are experiencing a broad slowdown across several of our large ongoing programs, such as AEGIS, Global Hawk, Patriot, ACIP, F16, and Predator/Reaper.

These are not programs or platforms that we believe are at risk, nor are they indicative of Mercury performance issues, but they are currently producing at lower levels than they have in the past, largely we believe due to the slow funding and contracting environment.

The same is true for the smaller run rate deals that we get each and every quarter.

These deals typically relate to spare parts, maintenance and repair, and are not necessarily associated with named programs.

Although these run rates deals have been steady revenue drivers for us over the years, this is another area where we are being impacted.

We are also seeing a fall-off in new services led design wins.

This reflects the fewer dollars associated with new programs sought under the current continuing resolution.

It also reflects the primes cutting back on their internal research and development spending because of the potential for sequestration.

There is a total of six design wins for the first quarter, five of them in defense.

From compares with nine wins, eight of them in defense in Q1 last year.

The five year probable value of our Q1 fiscal 2013 design wins was approximately $143 million, compared with $39 million in the first quarter last year.

The increase in value reflects two major design wins related to cause DRFM, or Digital Radio Frequency Memory subsystems, which are integral to modern electronic warfare applications.

Another reported design win this quarter was associated with greater content on SEWIP Block 2. We feel very good about the relationships we have built with Lockheed around SEWIP, and continue to expect that SEWIP will be an important bookings and revenue driver for Mercury going forward.

So this is clearly a challenging environment for Mercury and the defense industry as a whole.

Our plan for the near-term is to focus on controlling what we can control, taking it one quarter at a time and staying ahead of the curve by being as proactive as possible.

In

the fourth quarter of FY 2012 we implemented a restructuring action that is expected to result in approximately $5 million of recurring annualized savings.

Seeing further deterioration in the industry environment as the first quarter unfolded, we implemented a second round of cost-reduction actions.

These actions reduced the size of our workforce by 142 positions, and is expected to lower annualized expenses by an additional $20 million beginning in the second quarter of FY 2013.

At a total Company level, 107 of the Q1 headcount reductions were centered in the ACS, Engineering, and administrative functions in our headquarters.

These actions were taken for two reasons.

First, to deal the with the bookings and revenue slowdown we are experiencing in the core computer part of our ACS business.

Second is that in the first fiscal quarter, we successfully completed the new product introduction cycle we embarked upon five years ago, and we no longer need to invest at the same level.

When I joined Mercury, our products were behind the competition.

Since then we have invested approximately $225 million in R&D, and it has produced and industry leading an state-of-the-art and embedded processing portfolio.

We have pioneered new capabilities such as developing Teraflop GPU based multi computers, for sensor and big data processing applications.

We have created an industry-leading embedded Intel server class product line.

We have introduced important security capabilities across our products, we lead in the packaging dimension with important new innovations, such as [air flow by], our next-generation cooling technology, which is leading to a dramatic improvement in processing density, and last but not least, our embedded software is second to none in the industry and is a key enabler to our customers being rapidly able to port their applications onto a truly open sensor processing subsystem.

These are the products and solutions that have and will continue to lead to new design wins and future growth in our business.

Turning to Micronetics, 35 positions were eliminated during Q1 relating to the first phase of our integration activities.

This phase focused on reorganizing Micronetics from five independent businesses built through acquisitions over time, into two business units focused on RF components and RF subsystems, as well as streamlining some redundant corporate and overhead functions.

Reducing headcount is never easy, and we have parted with many talented and hard-working former colleagues.

However, we have been careful during these reductions to focus on retaining key engineering talent and middle management to preserve both our unique capabilities and our ability to scale-up, once we get through this period of industry uncertainty.

As a result we believe we have preserved the intrinsic value of the business, while significantly and quickly reducing our overall expense levels.

From a strategic perspective we are now forecasting and managing the business differently than in the past given the end market conditions.

Knowing that we can't control the timing of order flows or revenues at this juncture, the team is working hard to maximize our results during these difficult times in the defense industry.

We are focused on managing all of the things that are within our control, chief among them operating expenses, working capital investments, CapEx and cash flow.

Our management of the business for the next several quarters is now less about driving to deliver revenue upside, and more around managing to a more conservative revenue plan, built around shippable backlog and high probability book ship orders.

Wanted to stay away from making large future bets from an inventory perspective, as deals continue to move to the right.

We have also slowed down or in some cases ceased purchasing long lead time materials ahead of order receipt for programs where the orders timing is questionable.

Avoiding the related working capital investment will help us manage cash flow in the short-term, and should help us rebuild backlog as the year progresses.

Overall we believe that we have been very proactive under really tough circumstances.

We have accelerated the Micronetics integration, and completed the first phase in less than two months.

We executed on an aggressive restructuring in the core business, it has aligned our cost structure with the lower revenue environment.

With the product portfolio refresh and improved operating leverage in the business, we should be well-positioned when the industry returns to more normal conditions.

At the same time we have insured that we have sufficient liquidity and financial flexibility not only to manage the ongoing needs of the business, but also for future M&A purposes, when our end markets are more favorable.

As we announced last week, we have closed on a $200 million unsecured revolving credit facility with very favorable terms.

This facility is available for general corporate purposes but primarily future M&A.

That said right now we are focused on integrating Micronetics, and don't wish to lever up any financial risk to the industry risk we are currently experiencing.

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

Despite multiple previous CRs and budget turbulence, we have delivered 15% impounded growth organically in our defense business since 2008 with improved profitability.

We are confident that given our lower cost structure, Mercury will not only quickly recover when the industry returns to a more normal environment, but also be positioned for accelerated growth, and improved profitability for the long-term.

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

Kevin.

Thank you, Mark, and good afternoon again everyone.

Turning to our financial results for the first quarter, revenue for the quarter of $49.4 million was largely flat with revenue of $49.1 million in the first quarter of last year, and was within our revised guidance of $48 million to $50 million as provided earlier this month.

The Company incurred a GAAP loss from continuing operations of $0.24 per share in this year's first quarter, compared to GAAP earnings from continuing operations of $0.09 per share in the first quarter of fiscal 2012.

This year's first quarter loss per share was on the favorable end of the Company's revised guidance of a net loss of $0.24 to $0.28 per share for the quarter.

Included in the Company's GAAP loss per share for the first quarter of fiscal 2013 was a significant restructuring charge that contributed approximately $0.11 per share to the reported $0.24 per share loss for the quarter.

In addition, the delay in the receipt of the SEWIP program order that was cited in our early October announcement of revised financial guidance contributed an additional estimated $0.10 per share to the first quarter loss.

Finally, the inclusion of Micronetics in financial results for the quarter excluding restructuring costs added $0.03 per share to the first quarter's loss largely due to purchase accounting adjustments.

Adjusted EBITDA for the first quarter of fiscal 2013 of $1.6 million was $7.1 million lower than the adjusted EBITDA of $8.7 million for the first quarter of last year.

But was at the high end of our revised guidance of negative $1 million to a positive $2 million for the quarter.

The Company ended the first quarter with $30.6 million of cash and investments and with no debt but incurred a free cash flow burn of $10.9 million in this year's first quarter.

Reviewing first quarter performance in greater detail, total revenue for our largest segment Advanced Computing Solutions, or ACS was $42.7 million, which was $4.6 million lower than the $47.3 million of ACS revenue generated in last year's first quarter.

The year-over-year decrease was due to a $5.4 million decrease in ACS defense revenue that was partially offset by an $800,000 increase in commercial revenue.

The decline in ACS defense revenue stemmed largely from unusually high JSF related revenue in last year's first quarter and lower year-over-year Global Hawk program revenue.

That were partially offset by revenue derived from the acquisitions of KOR Electronics and Micronetics.

Revenue from the Company's Mercury Federal Systems, or MFS operating segment for the first quarter was $9.9 million, which was $5.7 million higher than the $4.2 million of MFS revenue for the first quarter of fiscal 2012.

Similar to the last two quarters this significant increase in revenue between the years was due primarily to 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 Electronics.

It should be noted that operating segment revenue for the first quarter of fiscal 2013 does not include adjustments to eliminate $3.2 million of intercompany revenue.

Total defense revenue including ACS and MFS for the first quarter were $44.5 million, and was $500,000 lower than defense revenue of $45 million in the first quarter of last year.

Excluding the addition of KOR, PDI and Micronetics first quarter defense revenue declined $13.5 million, or approximately 30% year-over-year, reflecting the considerable slowdown in defense procurement in light of the threat of sequestration, as Mark referenced in his remarks.

Defense bookings for the first quarter of $36.1 million were $24.8 million or 41% lower than the $60.9 million of defense bookings in the first quarter of last year.

Excluding an unusually large JSF related booking in last year's first quarter, defense bookings declined by approximately 11% between years.

The Company's first quarter bookings performance is a direct result of a more pronounced slowdown in purchase order activity fundamentally affected by the lack of clarity regarding a defense budget for the current government fiscal year.

Mercury's total book-to-bill ratio for the first quarter of fiscal 2013 was 0.8 which was below the 1.3 book-to-bill ratio in the first quarter of last year.

Defense book-to-bill of 0.8 for this year's first quarter was similarly below the 1.3 ratio generated in the first quarter of last year.

Again last year's first quarter JSF booking had a significant impact on the high book-to-bill ratio in the first quarter of last year.

The Company ended the first quarter of fiscal 2013 with $120.2 million in total backlog which was $18.4 million, or 18% higher than the $101.8 million of backlog at the end of the last year's first quarter.

Of the total ending backlog in the first quarter $102.7 million, or 85% is expected to be shipped within the next 12-months.

$107.9 million of the ending first quarter backlog relates to defense which is $10.1 million, or 10% higher than last year's defense backlog.

From a bottom-line perspective the Company incurred a GAAP loss from continuing operations of $7.2 million in this year's first quarter, compared to GAAP earnings of $2.7 million in last year's first quarter.

The difference in bottom-line performance between years was primarily due to lower gross margin, resulting from an unfavorable product mix.

As such lower organic defense revenue which carry higher gross margin was largely offset by acquisition-related RF and services related revenue that carry comparably lower gross margin.

In addition, year-over-year operating expense growth derived mainly from the $5 million of restructuring charges incurred in this year's first quarter as $4.5 million of incremental core PDI and Micronetics operating expenses were essentially offset by lower base operating expenses.

As we mentioned publicly earlier this month the Company completed a sizeable headcount reduction at the end of the first quarter, resulting in a significant restructuring charge at quarter-end.

Of the 142 positions eliminated, approximately 75% involved engineering and administrative functions at the Company's headquarters facility, to address the rapid slowdown in bookings and revenue in our core computer business, and as Mark noted earlier, the completion of our core compute product refresh that the Company undertook five years ago.

The remainder of the headcount reductions pertain to additional integration efforts related to the Micronetics acquisition.

All told we expect that this action and other cost reduction initiatives will yield approximately $20 million of annualized savings beginning in the current fiscal quarter.

Consistent with our comments last quarter, the Company has been aggressive in managing operating expenses in light of the difficult industry dynamics.

Adjusted EBITDA of $1.6 million for the first quarter of fiscal 2013 was $7.1 million lower than the $8.7 million of adjusted EBITDA generated in the first quarter of last year.

The reduction in adjusted EBITDA between years is mainly attributable to the pre-tax loss generated in this year's first quarter, that was partially offset by higher year-over-year add-back of purchase accounting adjustments due to the recent acquisitions, and this year's restructuring charge add-back.

Turning to the balance sheet the Company ended the first quarter of fiscal 2013 with cash and investments of $30.6 million and no debt which was $85.4 million lower than the $116 million of cash and investments at the end of the fourth quarter of fiscal 2012.

The decrease in cash and investments for the first quarter was driven by $74.3 million of cash used to acquire Micronetics during the quarter, combined with a $10.9 million free cash flow burn for the quarter.

This free cash flow burn was driven by $9.9 million of operating cash flow burn largely the result of a loss incurred in the first quarter, combined with higher organic inventory related to the SEWIP order delay and lower accruals.

Capital expenditures were $1 million in this year's first quarter.

With regards to forward-looking guidance the Company will be providing only quarterly financial guidance due to the lack of clarity within current defense contracting and funding.

With that as a backdrop, we are targeting second quarter total revenue to be in the range of $43 million to $49 million.

This range assumes procurement challenges persisting within the defense sector.

In addition, as Mark referred to in his comments, this forecasted revenue range also reflects a much higher reliance on revenue derived from orders in backlog, and less on orders to be booked and shipped in the second quarter.

We believe that in these unprecedented times whee defense procurement has slowed so historically low levels, it is prudent to prepare operational plans forecasting revenue where customer commitments are more readily identifiable and reliable.

While perhaps sacrificing some revenue upside potential, it minimizes the build-up of working capital, and hence preserves our available cash on hand.

Consistent with prior quarters we expect the split in second quarter revenue to be approximately 90% defense and 10% commercial.

At the mid-point of our guided revenue range, we expect second quarter defense revenue to approximate this year's first quarter defense revenue, as increased revenue from a full quarter's impact from Micronetics is forecasted to be largely offset by lower organic defense program revenue.

We want to emphasize that our revenue guidance does not include any revenue associated with the current SEWIP program, due to the unplanned delays the Company has experienced relative to this program over the last two quarters.

Within our stated revenue guidance we are projecting gross margins of approximately 35% for the second quarter, which reflects a higher proportion of revenue deriving from Micronetics, whose gross margin is lower than the Company's organic defense business.

Operating expenses are forecasted to be $26 million for the second quarter, which is nearly $6 million lower than the first quarter operating expenses.

The sequentially lower operating expenses expected for the second quarter reflects savings associated with the cost-reduction actions completed in the first quarter, and lower restructuring charges that are partially offset by a full quarter's effect of Micronetics operating expenses, including increased amortization expense related to that acquisition.

Bottom-line perspective we are targeting a GAAP loss per share in the range of $0.17 to $0.24 per share for the second quarter, based on an estimated weighted average share count of 30.1 million shares.

Within this loss per share range, we project a $0.06 per share impact from the combination of intangibles amortization and trailing restructuring costs.

Adjusted EBITDA for the second quarter is estimated to be between negative $2.1 million and positive $700,000.

With regards to liquidity we anticipate ending the second quarter with approximately $30 million of cash and investments and no debt, which is essentially flat with our cash position at the end of the first quarter.

We expect to generate a small amount of operating cash flow during the second quarter that will be largely offset by forecasted capital expenditures.

As a final note on liquidity, you may have noticed that the Company announced a weak and a half ago that it had replaced its existing $35 million secured revolving credit facility with a $200 million unsecured revolving credit facility.

As we mentioned at last quarter's earnings call we entered into this larger facility to provide financing capabilities that would allow the Company to continue its M&A strategy in light of its current cash on hand following the closing of the Micronetics acquisition in the first quarter.

Furthermore, this new facility affords the Company additional financing flexibility in view of the challenging industry dynamics, while taking advantage of an attractive borrowing environment.

It should be noted that the facility is currently undrawn, with no plans to currently utilize it.

With that we will be happy to take your questions.

Operator, you can proceed with the Q&A.

Thank you.

(Operator Instructions).

We will take our first question from Peter Arment.

Yes.

Sterne, Agee.

Hi Mark and Kevin.

A question regarding, could you go over just first, more detailed question on the expenses for the operating expenses.

You mentioned $24 million.

What is the break up that you are looking at for those for the second quarter?

Basically from an operating expense standpoint we have got three things going on here.

Number one is, and I am just comparing between Q1 and Q2, on the increasing operating expenses you have got a full quarter's worth of Micronetics operating expenses in Q2 compared to Q1.

So you are going to have an increase relative to that, but more than offsetting that increase is two takedowns.

Number one is obviously we have got a big restructuring charge in the first quarter that we obviously are not going to have in the second quarter.

So there is going to be a significant reduction from that perspective.

And then secondly you are also seeing as we mentioned the savings in the, I will call it the base business associated with the restructuring actions that we took in Q1 coming to bear in Q2.

So the combination of the lack of a restructuring charge and base savings associated with that restructuring are the real causes for the reduction sequentially quarter to quarter.

Okay.

That is helpful.

And then, Mark, I think we have a pretty good understanding on the details you have given us on SEWIP and some of the other programs, but Patriot was one that I thought that we would see the potential for we would begin to see some movement here with the US Army.

What is going on there?

Maybe you could just give us an update there.

Okay.

Sure.

So obviously there is a lot of opportunity particularly in the Middle East according to Raytheon's public statements, with countries such as Kuwait, Turkey which has been delayed a couple of times now, the decision on that is expected in the latter part of calendar Q4, or early calendar Q1 of 2013.

Over and above that Raytheon is pursuing Aman, Qatar, and Kuwait, so there is a fair amount of opportunity.

As it relates to the US Army we did book that design win in the fourth quarter of financial year 2012, but there is really no news on that at this point in time.

So our bookings this quarter were down pretty substantially versus the first quarter of last year.

That is largely due to the fact that in the first quarter of 2012 we booked an over $9 million deal with Saudi Arabia.

So net/net we think that Patriot is a pretty important program, it is a growth oriented program.

The challenge is ever on the program itself is predicting the timing of the order flow, given that most of the sales are largely FMS related, which are both lumpy and basically notoriously difficult to predict, so we think it is solid, it is a growth oriented program, but FMS sales are slow.

Okay.

And then I guess just one high level also just regarding your interaction with the primes.

I mean you talk about the primes cutting back on their internal R&D budgets, but it doesn't sound like you are getting the flow-through either regarding any outsourcing opportunities right now.

When do you think, or how do you think, what is going on there?

So I think as I said in my prepared remarks, I mean we have basically seen slowdowns in really four major areas.

One of them is to do with services led design wins.

So on a dollar basis, we actually had a great quarter for design wins with the five year probable value being $143 million, which is substantially up year-over-year.

Two of those design wins were to do with KOR, where we got basically two design wins, one with their existing DRFM system, and one for their next-generation, but on top we had a large design win for SEWIP Block 2.

But in essence I think what is happening is that under a continuing resolution there are no new program starts, so we kind of saw a slowdown of sorts associated with that, and then I think right now our customers are just very reticent to spend money in light of the potential for sequestration.

So we don't think it is anything to do with our competitiveness or our products.

We think that we are very well-positioned there.

It is just a general, what is going on in the environment.

Okay.

I will jump back in queue.

Thanks.

Okay.

Thanks, Peter.

Thanks, Peter.

And we will take our next question from Tyler Hojo with Sidoti & Company.

Yes.

Hi.

Good evening guys.

Hi Tyler.

I just wanted to ask you about just kind of acquisitions, some of the acquisitions that you made.

It sounds like your outlook for Micronetics hasn't really changed since you made the acquisition.

Is that a fair statement?

So I think that is fair.

We think that the Micronetics is going to be a good acquisition, it has got some great customers, great management Team, great technology, good programs that they are involved with so yes, we feel good about Micronetics.

Okay.

So if the outlook for Micronetics hasn't changed, I am just trying to understand a little bit better why your kind of legacy, the legacy Mercury business would be much more impacted than Micronetics.

Is it possible that there is some concern that maybe we will see some of this impact of the business that you just acquired?

So we think basically what we are seeing in the core of the ACS compute business right now.

we are really seeing four different phenomena.

The first is that we are seeing a broad slowdown in programs that have generally produced at a higher level in prior periods.

We think that again it is basically due to what is going on in the environment given the potential for sequestration.

That has also been manifested in kind of the run rate deals.

These are maintenance spares and repairs, that aren't necessarily associated with named programs, but we saw a pretty substantial slowdown there.

That we believe is due to the fact that under the current continuing resolution, I guess they admitted to actually include the OCO funding, so they are actually currently using O&M funds to actually fund some of the war efforts, so it is obviously having an impact on that part of our business.

The third area is in relation to the design win activity that I mentioned,that we basically just went through.

So in essence I mean we are literally seeing an impact across-the-board, and with the fourth one being programs, transitioning between phases such as SEWIP.

We do think there is a difference between the compute part of the business and RF.

As we look at the RF business, typically what we are seeing there is that the RF and the microwave part of the business has gotten much longer lead times than what we typically see in the compute part of our business.

So I think that is part of what we are seeing also.

Finally, as it relates to Micronetics, they came into Mercury with a very, very strong backlog and outlook, and so it is a bit of an apple and a pear from a comparison perspective.

Okay.

Very helpful.

And just lastly for me, Mark, we have gone through the entire call to this point without discussing JCREW, and I guess it wouldn't seem right if I didn't ask you a question on that one.

Any changes in regards to kind of how you are viewing the program?

Obviously it has slipped a bit here but just your comments there would be helpful.

Yes.

Sure.

So there is basically still no official new news on the status of the fate of the program.

As you know all program funding has being exhausted at this point, and our customers basically stopped work.

As you know also, we actually removed all JCREW I-1B1 LRIP bookings and revenue from our FY 2013 plan, due to the delays that we are currently experiencing.

So we still believe that the program itself is the program of record, or remains the program of record, and that the Marine Corps has still absolutely got an ongoing and urgent need as evidenced by their funding requests in the recent GFY 2013 budget submission, but there is basically no new news at this time.

Okay.

Great.

Thanks for all of the color, Mark.

Okay.

And we will take a question from Michael Ciarmoli with KeyBanc Capital Markets.

Hey.

Good afternoon guys.

Thanks for taking my questions.

Hey Mike.

Just maybe to stay on Tyler's path of thinking, Mark, can we assume that KOR is still tracking as well, according to plan?

Yes.

Okay.

And I know you guys probably don't want to disclose it, but it would seem like the organic business is probably down 30% or so, give or take, is that a fair assumption?

That is correct.

Yes.

It is as in the remarks.

Okay, alright, I just have missed it.

Do you guys think, obviously the sequestration, and maybe I know the answer to this, the war is winding down, how much of the funding pressure might just be primes finally realizing how much of some of the funds they have been realizing over the past couple of years coming from the supplementals, and they are now just starting to just, maybe it is paralysis, maybe that are just sifting through available funding, but do you think that there is more of an up tempo slowdown risk that is hitting the business, I mean certainly it could be applicable to JCREW not having deployed.

I mean is that factored into the analysis at all?

I don't think it is related to that Mike, I think it is related to the fear of sequestration, basically they don't want to spend money that they are not sure that is going to be available under that scenario, so we know that the depos are basically hoarding money, that has impacted those small run rate deals, we know that under the sequestration scenario, there is concern about programs transitioning between phases in SEWIP, and that anti-deficiency legislation that we have talked about in the past is also coming into play.

So from our perspective and what we can see, and from what we are hearing from our customers is very much due to the macroeconomic environment, and not due to the up tempo.

Okay.

What are you guys getting, what is the latest you are getting from the Hill on sequestration, I know Obama threw everybody a curve ball last night saying it will not happen, but what is sort of your internal planning, I mean do you think it is actually going to happen, or do you think we will get some sort of deal, what are your kind of contacts or experts saying?

Well, I thought that it was interesting that President Obama said that it will not happen last night, I think his advisors after the fact in the spin room were saying that it should not happen, so I don't know whether there was a proverbial slip there or not, I think there is a range of different scenarios that may or may not occur with respect to sequestration.

I think the view right now is that there is a form of sequestration that the budget ends up in the roundabout $500 billion level, how we get to that point in terms of the process, it is still unclear.

Because there is a lot of work to be done to get to that piece of legislation being approved by Congress and also approved by the President.

So we feel that we are already feeling the effects of sequestration, maybe because we are a smaller defense company, whose business model is different than that of the large primes, they have got multi-billion dollar, multi-year backlogs, they recognize a lot of their revenue on a percent of completion type contracting, whereas we have got a 6 month backlog on average, and our order flow is somewhat lumpy due to the fact that we are shipping systems for revenue.

So it is hard to tell, Mike, exactly what is going to happen, because there is not a lot of guidance, but we already feel that we are seeing the impacts.

Got it.

Fair enough.

Last one, what are you thinking about in terms of the portfolio, in terms of any additional kind of needs here or desires to sort of round out the defense chain as you guys kind of elaborated on?

So as we said, with the recent acquisition of Micronetics, we really did complete the first phase as a result of that acquisition, we think that we have got a strong RF and microwave portfolio, and as we alluded to on the call, we have just recently refreshed at the end of Q1 our embedded processing portfolio, so we have got a lot of capabilities, and right now we are very much focused on integrating Micronetics, we completed the first phase of that integration within a two month period, which is very, very rapid, and the next phase will be complete by the end of the year, so we are pretty happy with what we have got we are pursuing opportunities in the customer base, and we will continue to look for opportunities going forward, but for right now we are focused on the integration.

Got you, alright.

Perfect, thanks guys I will jump back in the queue.

And we will take a question from Jonathan Ho with William Blair and Associates.

Good afternoon guys, just wanted to understand a little bit better, some of the comments here that you gave about looking at the business differently and now having maybe more reliance on backlog driven business versus book to ship, I just want to understand how much more conservative you are being here, and if you can give us any color around sort of how you are changing your FP&A, or how you are changing about how you look at the business from that perspective?

Sure.

So I think as Kevin said in his prepared remarks, we are taking a more conservative stance in terms of our forecasts, and it is largely around deals that are shippable from our backlog, as well as high probability book ship orders, where the deals are likely in purchasing and where we know what year the funding monies are coming from.

We are doing that because obviously is you look at what has happened with SEWIP, we forecast that for the last two quarters in Q4 from a bookings perspective and in Q1 from both a bookings and revenue perspective, and it didn't happen two quarters in a row.

So we took that deal out of our guidance this quarter, it is still and upside, but we didn't guide it as part of our guidance, just given the environment that we are currently operating in.

Got it.

And if we can just talk a little bit about the SEWIP program in particular, do you still anticipate that it comes in at some point in the future?

Is there a cascade effect maybe in terms of, if it gets delayed by a quarter then a few shipments also get delayed, I just want to understand, is there a catch-up effect where once the money starts flowing, then everything within the fiscal year still takes place, but maybe in a more concentrated manner?

Sure.

Look we are going to take it one quarter at a time.

Again SEWIP is outside of our guidance at this point, given the delays that we have experienced in the last two quarters.

What is happening at the program generally is that Lockheed is currently integrating and testing the SEWIP Block 2 solution.

We do believe at this point the Navy is actually signed up on Milestone C, which is a very, very positive step forward, given that the sign up on Milestone C is what allows the program to transition into that LRIP phase.

On the contractual side, our customer is meeting with the Navy again in early November to try and resolve the open Ts and Cs related to the LRIP production contract, but again, just given the delays that we have experienced in the last two quarters we haven't included that in our revenue guidance.

Fair enough.

Thank you.

And we will take our next question from Michael Lewis with Lazard Capital Markets.

Thank you.

Hey Mark and Kevin.

So I just wanted to look at ACS a little deeper.

Is there a way for you to tell us the proportion of the shorter cycle versus longer cycle revenue within that business?

Not really, Mike.

No.

Okay.

So should we assume that it is a long recycle, Mark?

No.

It is a mix of both.

So I think we have really got one issue in the business right now, which has been the delays that we are seeing across the patch in the ACS core compute part of our business.

We feel that we size the Company's expense structure in line with the current revenue run rate, or the run rate that we see in the business today.

So we think that we have been taking appropriate action there.

Okay.

That is fair.

That is fair.

Okay.

Then just after you closed out Q1, and you continue to see progression in bookings as we look into where we are in Q2 right now, are they on plan, below, above plan?

Could you give us some idea how that is coming in right now?

So we feel it is that we are going to be positive book-to-billing in Q2.

So we will hopefully deliver that, but that is what we are currently forecasting.

Okay.

And then just one more, and I will get out of the way here.

Kevin, I was wondering for your new facility could you give us what your under used facility fee is, and then also the rate for the funds once you would actually do an acquisition and use those funds?

Yes.

Basically it is in determination of the borrowing rates, it is essentially either based you have of a base rate that is akin to a prime rate, or it is a LIBOR rate, but essentially a spread based on the leverage ratio that we have at the time that we take out the debt, so it could range anywhere from 50 basis points to higher amounts, depending on the leverage, a lot of this Mike is filed as an exhibit, we filed our 8-K I think it was about 1.5 weeks ago, the commitment fees I think I will just say all-in the fees were well less than $1 million.

Okay.

Thank you so much.

Yes.

And we will take a question from James [Natari], Neuberger Berman.

Hey Mark, Kevin.

I just had a couple of quick things, kind of following up on some of the previous questions, and you might have talked about this, I may have missed it, but the gross margin in the quarter on the $49.5 million of revenue, looks like eyeballing it about 41%.

Was there something in the mix, that caused such a big margin change?

So it is largely what we said earlier, which is basically the slowdown in the core compute part of our business, which typically carries a much higher gross margin than some of the acquired businesses in the RF and the services domain, so when part of our business gets impacted, then you see it basically flow through the gross margin line.

Yes.

Yes.

Okay.

I thought that is what you said.

I just wanted to make sure.

And then in terms of having the business, the restructuring that you have undertaken the idea there is to say run at current revenues at cash flow breakeven?

Is that the idea of the restructuring at this point?

Exactly.

Yes.

Alright.

Okay.

Alright.

Great.

Thank you.

Yes.

And we have a question from Howard Rubel with Jefferies.

Thank you very much.

I have a couple.

First to follow-on with the last question, at what level do you think you will be able to become profitable again, Mark?

So we are not going to predict that, Howard.

It is basically we are taking one quarter at a time from a guidance perspective, a lot depends on the top line and the mix of revenues, so we have given our guidance for Q2.

No, I understand that, but you have sized the business not to make money at current levels, is that correct?

Cash flow breakeven at the current revenue run rate, yes.

Just you had a very nice order for KOR for $58 million a basis ordering agreement from the Navy.

Yes.

How much of that was funded in the current quarter?

Or will be fund when you sign the a treatment, there is typically a certain amount?

No.

Basically it's a bow, which is a form of agreement that really covers the Ts and Cs of potential future orders, so the agreement itself is valid for five years, and can be up to $58 million of orders.

Each order, however, will come out really as an RFP, and will be subject to specific negotiations around the amounts that they want to order.

So it is not a funded contract per se, but it is the ability of the government to be able to order from it over time.

Did you include that in the five year potential dollars?

From a design win perspective, yes.

Yes.

Okay.

And then what was the backlog that you acquired with Micronetics?

Roughly about $24 million.

It was actually $30 million.

After the end of the quarter.

Sorry.

When we acquired it.

I'm sorry?

When we acquired the business, Howard, is that what you are saying?

Yes.

At the time of the--?

At the time of the acquisition we had about $24 million of backlog from Micronetics.

And so you said it grew during the quarter so you're now at $30 million from what happened?

Yes, it did.

Yes.

That is correct.

So they had a 2.38 book-to-bill for the quarter, Micronetics.

And what were the top two or three programs there?

So the major program was related to an EW fighter upgrade, would be and unfortunately at this point we are not at liberty to kind of disclose the platform.

They also experienced bookings for another EW program more on the rotary side of the house with Excelis.

So they were the two major ones in the defense domain.

In the commercial domain, the largest booking that they had was for a commercial aerospace satellite communications application.

Oh, so that was the major commercial business in the quarter as well?

Yes.

Yes.

Yes.

Yes.

Thank you, gentlemen, very much.

Okay.

Thanks, Howard.

Not a problem, Howard.

And our next question is from Brian Ruttenbur with CRT Capital.

Thank you for taking my question.

The question has been asked, but I am not sure if I understand the answer.

If sequestration hits, can you remain cash flow positive?

We believe that we are going to remain cash flow positive.

We sized the business based on what we think is going to happen from a revenue perspective.

However, we are going to end up taking it one quarter at a time, as we said earlier.

Okay.

And then the second question is a harder question, and you may not have an answer at this point.

What about selling the Company, what does the Board think about that?

Is there any kind of thoughts in your mind from a macro standpoint when is the right time to exit, if it is in fact the right time in the near-term or not?

So obviously that is not something that we would comment on externally.

I mean clearly the Board understands what is going on in the industry, as well as their fiduciary responsibilities, and that is always an option that is open to the Company, but it is not an option that we are pursuing at this time.

Great.

Thank you very much.

We have a question from Mark Jordan with Noble Financial.

Hi.

This is [Eric Sharif] in for Mark Jordan.

Just a quick question relative to gross margins.

Now that Micronetics is integrated, is it reasonable for the Q2 gross margin guidance to reflect a normalized run rate for the balance of the year?

We are basically providing one quarter at a time guidance, so clearly Micronetics is integrated into our current Q2 guidance, but we will be updating Q3 guidance when we report Q2.

Got it.

Mark pointed out as well we have only completed phase one of the integration, so we do have additional integration activities going on, but to his earlier point, we are going one quarter at a time at this point.

Okay.

That is it.

Thank you.

And there are no further questions at this time.

I would like to turn the call back over to Mark Aslett.

Alright.

Well, thank you all very much for listening.

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

Thanks a lot.

And this does conclude today's conference.

Thank you for your participation.