Mercury Systems Inc (MRCY) 2013 Q2 法說會逐字稿

Good day and welcome everyone to the Mercury Systems, Inc, second quarter fiscal year, 2013 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 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 at our website at, www.MRCY.com.

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

You can identify these statements by the use of the words may, will, 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, the 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 technological 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 quality issues with outsourced components, inability to fully realize the expected benefits from acquisitions, divestitures and restructuring, or delays in realizing such benefits.

Challenges in integrated acquired businesses, and achieving anticipated synergies, changes to export regulations, increases in tax rates, changes to generally accepted accounting principles.

Difficulties in retaining key employees and customers, unanticipated -- 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 30, 2012.

The Company cautions readers not to place undo 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'd also like to mention that in addition to reporting financial results in accordance with Generally Accepted Accounting Principles, or GAAP, during our call, we will discuss several non-GAAP financial measures, specifically, adjusted EBITDA and free cash flow.

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

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

Reconciliation of adjusted EBITDA to GAAP net income, and free cash flow to GAAP cash flows from operations, 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 thank you for joining us.

I'll begin today's call with the business update.

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

Our focus right now is to maximize the results in a difficult environment.

And Q2 was successful from that perspective.

Total revenue for the quarter of $49.8 million, exceeded the high end of our guidance range.

Our net loss narrowed to $4.8 million or $0.16 per share, versus our guidance of a loss of $0.17 to $0.24 per share.

Adjusted EBITDA came in slightly above the high end of our guidance and we were cash flow positive for the quarter.

Probably the highlight of the quarter is that bookings were up substantially from Q1, resulting in a total book-to-bill of 1.3.

That said, conditions in the defense industry remain challenging, and promise to remain so for the foreseeable future.

We face two key issues in the short term.

First, is the increased likelihood that the current CR will be extended for the full government fiscal year.

And second, there is the possibility that the recently modified sequester will actually take affect.

At the Mercury level our biggest risks, poor visibility, potential delays to expected orders and increased uncertainty on the timing of associated revenue, delays to the timing of new program stocks and programs transitioning between phases, slower foreign military sales, risks that funds from the DOD investment accounts are reprogrammed, and the risks to the timing and level of program funding.

In turn, these risks are and could continue to impact the number and value of our design wins, as well as result in lower bookings, revenues, profits and cash flow, for at least the remainder of our fiscal 2013.

As Washington continues to avoid dealing with sequestration and approving a defense budget for this government fiscal year, and now with the potential for FY 2014 presidential budget submission to be delayed, our results could be further affected.

Based on the challenging industry conditions and the risks that we face, we made some tough decisions in Q1 that in retrospect were absolutely right.

Although total Company revenues were down in Q2 year-over-year, our bookings actually grew 11%.

In an environment so radically changed from FY '12, the relevant question now is, are we beginning to make progress on the sequential basis.

During the second quarter I believe that we did.

We were pleased to see growth in both total Company revenues and bookings, as compared with Q1.

Turning to defense, total defense revenues grew 2% sequentially to $45.5 million, while total defense bookings increased 52%, to nearly $56 million.

Our book-to-bill in defense improved to 1.2 from 0.8 in Q1.

And as I said, our total book-to-bill was 1.3.

This compares favorably with 0.8 in Q1.

Our defense backlog exiting the second quarter was up 8% sequentially.

The part of our business that was hit hardest in Q1, the ACS core business, had a really good bookings quarter on a sequential basis in Q2, as did Micronetics, the business we recently acquired and reorganized.

Although defense revenue in the ACS core was up just 1 point sequentially, defense bookings were up 63%, and defense backlog increased 7%.

We are obviously very pleased with this progress.

The two major ACS core defense bookings we received during Q2 were for Aegis and SEWIP Block 2. The Aegis order is the largest booking for that program that we received since fiscal 2011.

Also during the quarter, it is our understanding that Lockheed received the official SEWIP Block 2 Milestone C sign-off, which is great news.

We believe it's now likely that the program will begin the transition to low rate initial production.

This sign- off and what appear to be near final contract negotiations between the Navy and our customer, are what likely triggered our receipt of the SEWIP order during Q2.

Although Lockheed has not formally provided a ship date, the indication from our customer, based upon the recent progress, is that we will finally be able to ship and recognize our first SEWIP [Lrip] revenue, during our first fiscal quarter Q3, following several quarters of delays.

Looking farther ahead we continue to feel very good about the relationship we've built with Lockheed around Aegis, SEWIP, and several other potentially major program pursuits.

We continue to expect that both Aegis and SEWIP will be important bookings and revenue drivers for Mercury over the longer term.

Commercial bookings in the ACS core business also increased this quarter, growing 42% sequentially, and our commercial backlog was up 45%.

This growth was driven by a large booking for a complex networked RF subsystem for security applications.

In addition to the substantial improvement from a bookings perspective in the ACS core business, Micronetics delivered very strong performance in Q2, its first full quarter as part of Mercury.

Revenue was up 94% sequentially, bookings were up 48%, and backlog exiting Q2 was up 25%.

This booking and backlog growth was largely driven by the single largest booking Mercury received during the quarter, for EW system upgrades on the B-1 bomber.

In terms of our other large ongoing programs and platforms, they continue to produce at lower levels than they have in the past.

However, we see this as a reflection of the slowdown in activity related to the ongoing budget negotiations in Washington, and don't currently see any of them as being specifically at risk.

The smaller run rate deals related to spares, maintenance and repair, that we typically receive each quarter, also being negatively affected in this environment.

However, we were encouraged that bookings for these deals were also up sequentially, growing nearly 50% from the first quarter.

Unfortunately, we didn't see comparable strength in our design wins in Q2.

The ongoing slowdown in defense design wins reflects two factors.

First, under a continuing resolution, there are no new program starts.

Secondly, we believe that the primes have continued to reduce their internal R&D spending because of the potential for sequestration.

Looking at the second quarter specifically, we have a total of seven design wins, six of them in defense.

This compares with six wins, five of them in defense, in the immediately preceding quarter.

Our design wins continue to focus on radar, electronic warfare, and electro optical infrared.

The five year probably value of our design wins in Q2 was approximately $43 million, compared with approximately $143 million in Q1.

As we said last quarter, knowing that we can't control the timing of specific deals, order flows, or revenues in this environment, we're managing the business differently than in the past, focusing only on the things that are within our control.

Overall, we're managing to a more conservative forecast and revenue plan, given the industry conditions.

We also believe that managing for cash in this environment is the most prudent thing to do.

For example, to minimize working capital, we've slowed down or in some cases ceased purchasing long lead time materials, ahead of order receipt, for programs where the order timing is questionable.

We continue to take it one quarter at a time, staying ahead of the curve by being as proactive as possible.

With two major restructurings since Q4 of fiscal 2012 under our belts, we're confident that we have achieved our goals in reducing our overall expense levels, while preserving Mercury's intrinsic enterprise value.

At the same time, we have ensured 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 visibility and conditions in our end markets are more favorable.

During the second quarter, we closed on a $200 million, unsecured revolving credit facility with excellent terms.

This facility is available for general corporate purposes, but it was intended primarily for future M&A.

Our current focus, however, is on integrating Micronetics.

We take a very cautious view of leverage in this environment, looking to avoid adding financial risk to the high level of industry risk, that we're facing.

So, in summary, Mercury performed well in the second quarter, and we were pleased with our progress.

Looking ahead near term, it appears that the industry is assuming a full year CR.

And in light of the March sequester deadline, the armed services are now actively planning for sequestration, and have begun to implement pre sequestration spending cuts.

We believe the Company's key programs align well with the DOD's new roles and missions, and should survive these potential cuts.

However, the slowdown in defense procurement that we have seen for the last several quarters, is expected to continue until Washington resolves the DOD's future spending authority.

We currently expect to make continued progress in Q3, and longer term our outlook for Mercury remains positive.

With the product portfolio refreshly implemented over the past five years, the programs we have won, coupled with the improvements in our operating leverage, we believe we have built intrinsic value in our business.

We have done this despite historic levels of volatility in defense budgeting and contracting, and we expect to continue doing so.

During those same five years, we have established and secured a competitive standing as the premier commercial ISR subsystem outsourcing partner, to the defense primes.

When the industry returns to more normal conditions, we believe that pressure to outsource to Company like ours will only increase.

Mercury is well positioned to capture a significant share of this potential opportunity.

We're confident that given our cash management focus and recent expense reductions, this recovery will generate substantial operating leverage, and this will lead to a significant improvement in profitability and cash flow generation over time.

With that I'd like to turn the call over to Kevin.

Kevin?

Thank you, Mark and good afternoon again everyone.

Turning to our financial results, revenue for the second quarter of fiscal 2013 of $49.8 million, was lower than revenue at $68 million for the second quarter of last year, but exceeded our stated guidance of $43 million to $49 million.

The Company incurred a GAAP net loss of $0.16 per share in this years second quarter, compared to GAAP earnings of $0.30 per diluted share in the second quarter of fiscal 2012.

This year's second quarter loss per share was smaller than the Company's guidance of a net loss of $0.17 to $0.24 per share for the quarter.

Adjusted EBITDA for the second quarter of fiscal 2013 of $1 million, was lower than the $18.8 million of adjusted EBITDA for the second quarter of last year, but exceeded our stated guidance of negative $2.1 million to a positive $700,000 for the quarter.

The Company generated free cash flow of $800,000 in this year's second quarter, and ended the second quarter with $33.9 million of cash and investments and with no debt.

Taking a look at the second quarter in greater detail, total revenue for our largest segment, advanced computing solutions or ACS, was $46.7 million, which was $19.4 million lower than the $66.1 million of ACS revenue generated in the second quarter of last year.

The year-over-year decrease was due to a $19.6 million decrease in ACS defense revenue, that was partially offset by a $200,000 increase in commercial revenue.

The lower ACS defense revenue was due primarily to unusually high revenue in last year's second quarter, from a classified program with Northrop Grumman, and the JSF program, that were partially offset by revenue derived in this year's second quarter from acquisitions of KOR Electronics and Micronetics.

On a sequential basis, ACS revenue in this year's second quarter was $4 million, or 9% higher than the first quarter revenue of $42.7 million, due mainly to higher Micronetics related shipments driven by the B-1 bomber program, and a full quarter's impact of Micronetics revenue, compared to a partial quarter's impact in the first quarter.

Revenue from the Company's Mercury Federal Systems or MFS operating segment, for the second quarter was $7.9 million, which was $2.7 million higher than the $5.2 million of the MFS revenue for the second quarter of fiscal 2012.

The increase in revenue year-over-year, was due primarily to the inclusion of revenue from Paragon Dynamics or PDI, which was acquired as part of KOR Electronics.

Compared to this year's first quarter, second quarter MFS revenue declined by $2 million, principally due to lower revenue from the Gorgon Stare program.

It should be noted that operating segment revenue for the second quarter of fiscal 2013 does not include adjustments to eliminate $4.8 million of inter company revenue.

Total defense revenue, including ACS and MFS for the second quarter of $45.5 million, was lower than the $63.9 million of defense revenue for the second quarter of last year.

The year-over-year reduction in defense revenue as mentioned earlier, stemmed principally from a significant decline in the Company's organic defense revenue related to JSF and a classified Northrop Grumman program, offset in part by the impact of acquisition related revenue.

On a positive note, defense revenue for the second quarter increased $1 million from the first quarter, reflecting increased Micronetics related revenue that was partially offset by lower Gorgon Stare program revenue.

Defense bookings for the second quarter of $55.7 million, were $2.4 million or 5% higher than the $53.3 million of defense bookings in the second quarter of last year.

More impressively though, second quarter defense bookings were $19 million or 52% higher than defense bookings of $36.7 million generated in this year's first quarter.

The substantial increase in sequential bookings was driven by orders received in the quarter related to the B-1 bomber, Aegis, and SEWIP programs, offset partially by the absence of the large F-15-DW upgrade booking, received in the first quarter.

Mercury's total book-to-bill ratio for the second quarter of fiscal 2013 was 1.3, which was significantly above the 0.8 book-to-bill ratio, for both the second quarter of last year, and this year's first quarter.

Defense book-to-bill of 1.2 for this year's second quarter, was similarly above the 0.8 book-to-bill ratio generated in the second quarter of last year, and the first quarter of this year.

The Company ended the second quarter of fiscal 2013 with $133.2 million of total backlog, which was $10.7 million or 9% higher than the $122.5 million of backlog at the end of last year's second quarter.

Of the total ending backlog in the second quarter, $109.4 million or 82%, is expected to be shipped within the next 12 months.

$116.2 million of the ending second quarter total backlog related to defense, which was $2.5 million lower than last year's second quarter defense backlog, was $8.3 million or 8% higher than defense backlog in this year's first quarter.

From a bottom line perspective the Company incurred a GAAP net loss of $4.8 million in this year's second quarter, compared to GAAP earnings of $9 million in last year's second quarter.

The reduced bottom line performance year-over-year was mainly due to lower gross margin, resulting from lower revenue, and an unfavorable product mix.

Impacting product mix was lower organic defense revenue in this year's second quarter, which carried higher gross margin, which was partially offset by acquisition related RF, microwave, and services related revenue, that carry comparably lower gross margin.

Partially offsetting this year-over-year reduction in gross margin, were lower operating expenses, as the benefits of the restructuring actions completed in last year's fourth quarter and this year's first quarter, were partially offset by incremental KOR, PDI and Micronetics operating expenses.

On a sequential basis, the second quarter net loss of $4.8 million was $2.4 million favorable to the first quarter net loss of $7.2 million.

Lowered sequential gross margin due to a higher mix of RF and microwave related revenue, was more than offset by the restructuring benefits and the absence of this year's first quarter restructuring charge.

Adjusted EBITDA of $1 million for the second quarter of fiscal 2013, was significantly lower than the $18.8 million of adjusted EBITDA generated in the second quarter of last year.

The reduction in adjusted EBITDA between years, is mainly attributable to lower earnings offset partially by a higher year-over-year add back of amortization expense, and purchase accounting adjustments, related to the Company's recent acquisition.

Relative to our stated financial guidance for the second quarter, we are pleased to report that the Company exceeded the high end of its guidance in all key measures.

Second quarter revenue of $49.8 million, exceeded our guidance of revenue between $43 million and $49 million.

Loss per share of $0.16 for the second quarter, was favorable to guidance of $0.17 to $0.24 per share.

And finally, adjusted EBITDA of $1 million for the second quarter, exceeded our guidance of negative $2.1 million, to a positive $700,000.

Now turning to the balance sheet, the Company ended the second quarter of fiscal 2013, with cash and investments of $33.9 million and no debt.

This was $3.3 million higher than the $30.6 million of cash and investments at the end of the first quarter of fiscal 2013.

The increase in cash and investments for the second quarter, stem from the release of restrictions on the Company's restricted cash, due to the renegotiation of certain Company real estate leases.

We generated $800,000 of free cash flow for the second quarter, as $1.6 million of operating cash flow due to improved receivables collections was partially offset by $700,000 of capital expenditures.

Consistent with the prior two quarters, the Company will be providing only quarterly financial guidance, due to the continued lack of clarity relative to defense procurement in the looming threat of sequestration.

With that in mind we are forecasting third quarter total revenue to be in the range of $44 million to $50 million.

As Mark pointed out in his remarks, this forecasted revenue range continues our recent policy of placing much great reliance on revenue sourced from existing backlog, and less reliance on revenue required to be booked and shipped in the same quarter.

We believe that in these unprecedented times of defense industry uncertainty, the appropriate course of action for the time being is to minimize the buildup of working capital, and preserve liquidity, at the expense of potential revenue upside.

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

The Company's third quarter revenue forecast also reflects defense revenue, that is largely in line with second quarter defense revenue.

With the receipt of the SEWIP purchase order in the second quarter, and favorable indications from our customer that it will authorize shipment of product shortly, we have included revenue from the SEWIP program in our revenue guidance for the third quarter.

Within our stated revenue guidance we are projecting gross margin to approximate 35% for the third quarter, which is largely consistent with the second quarter.

The mix of forecasted third quarter revenue between the base defense business, and the RF and microwave businesses, is expected to approximate the second quarter product mix.

Operating expenses are forecasted to be $26 million for the third quarter, little changed from operating expenses in the second quarter.

From a bottom line perspective, we anticipate a GAAP loss per share in the range of $0.02 to $0.08 per share for the third quarter, based on an estimated weighted average share count of 30.2 million shares.

Included in this loss per share range is an unusually high income tax benefit, driven by the extension of the federal research and development tax credit, retroactive to January 1 of 2012.

As part of the fiscal cliff legislation signed in early January.

In effect, our estimated tax benefit for the third quarter will include the cumulative impact of four quarters of R&D tax credits.

The loss per share range forecasted for the third quarter also includes an approximate $0.06 per share impact, from the combination of intangibles amortization and trailing restructuring costs.

Adjusted EBITDA for the third quarter is estimated to be between negative $2.5 million and positive $1 million which is large -- which largely tracks our second quarter guidance.

Relative to liquidity, we anticipate ending the third quarter with cash and investments between $32 million and $33 million, which is slightly lower than cash and investments at the end of the second quarter, as slightly positive operating cash flow is forecasted to be offset by capital expenditures.

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

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

(Operator Instructions)

Peter Arment, Sterne Agee.

Question, I guess, Mark, the previous cost reductions that you addressed really last quarter, and a lot of that was primarily related to integration of Micronetics, maybe you can just give us an update on how you anticipate some of those savings flowing through, and where things stand there, and any additional actions you're taking now that, you know, the CR is going to extend and we have this additional uncertainty with sequester?

Sure.

So the -- we've basically done two restructurings to date, one in the fourth quarter and then one in the first quarter.

The majority of the actions that we took in the first quarter were actually expense reductions in the ACS core business, which is where we've seen the majority of the slowdown.

So we did see a significant amount of the benefits this quarter, however, we've also added in a full quarter of expense from the recently acquired Micronetics, which has provided a partial offset there.

We believe that the expense reductions that we have taken to date is sufficient for the environment that we see right now, and obviously we're taking things one quarter at a time, Peter.

Okay.

And then just regarding -- just your comments about potential reprogrammed funds.

Could you just give us maybe, without all of the details, but the kind of qualitative like monies that have been obligated but not ultimately released to you, and what the risks are for some of the -- what that is in terms of reprogrammed funding?

Yes, we -- we haven't got it at that level, Peter.

I think it is more just an industry macro level.

What we hear occurring, if you look at and read with what Secretary Mavis has said and the Secretary of the Army, I think both of them are very concerned around the shortfall that they see in particularly in the O&M budget.

Now right now I think that under the CR they have little flexibility of moving monies across and between accounts, but that is a potential going forward depending upon what happens with both sequestration, as well as the CR.

So it's more a risk that we see, as opposed to something that is very specific right now.

Okay.

And then you also mentioned potentially slowing MFS funds.

What do you equate to your total international mix as of today?

Could you maybe look that up, Kevin?

Why don't I give you sort of more of a qualitative perspective on that and I think really there I was pointing at one specific program, which is -- which is Patriot.

So if you go back and you kind of listen to what -- what Raytheon said on their last earnings call, there is clearly a lot of opportunity in the Middle East, and specifically around Kuwait, Qatar and Turkey.

However, if you look at what we've booked and recognize from a revenue perspective through the first half of fiscal 2013, it is basically zero.

So, that program is not producing the way in which we would have hoped.

Raytheon did expect a decision on Kuwait in their Q4, but it slipped, and they now expect a decision either this quarter or maybe next.

Qatar award is currently targeted in late calendar 2013, so it is really outside of our current fiscal year.

And I think everyone knows what's happened with Turkey, which is basically loaning Patriot systems from NATO at this point.

So, Patriot's a really important program, but we have seen delays on it.

Okay.

That is helpful.

Just one last one.

Just the R&D tick down, it's the lowest I've seen it in a while.

Was that just proactively, was that just timing, just being additionally cautious just given the back drop is that kind of a new run rate or how should we think of that?

I didn't hear the question Peter, could you just repeat the --?

On the R&D, it was certainly one of the lower levels that we've seen on an absolute and a percentage basis.

Is it just your cautiousness or was it just timing?

Is that kind of the expected new run rate?

Or how should we think of it?

So that's part of the major cost reduction actions that we've taken.

If you remember what I said last quarter, in Q1 we really completed a very significant new product portfolio refresh cycle.

And so as a result of that, but also the weakness that we're seeing in the ACS defense core, we did take the opportunity of reducing our R&D expenditure in that part of the business.

Okay.

So it's a good run rate from this point in time.

Okay.

That is helpful.

Thanks, I'll get back in queue.

Tyler Hojo, Sidoti & Company.

Just the first question, just to follow on Peter's line on the R&D side, I was hoping that maybe you could talk a little bit about the affect on design wins?

We're down a little bit this quarter, and I think that was expected, but maybe you could talk about what your expectations are over the next several quarters in light of the kind of declining R&D budget?

Sure.

I don't believe that the reductions that we made in the R&D budget impacted our design win activity during the quarter.

I think, as I said in my prepared remarks, really what is impacted our design wins, is the fact that under a continuing resolution there are no new program starts, and in addition, what we're seeing in this environment, particularly given the potential for sequestration, the primes themselves are actually lowering their internal R&D budget.

So I think those are the items that in effect have actually impacted the both the quantity, as well as the dollar value of our design win activities in the second quarter.

So I think we're going to be sticking it -- we're going to be at this level until there is clarity around what is happening with the defense spending environment.

But to reiterate again, I don't believe it is related to our reductions in R&D spending, because we believe that we've probably got the industry's most up-to-date product portfolio, given the new product introduction cycle.

Okay.

Great.

Thanks for that clarification, and moving on to something else.

You mentioned that the guidance includes some sort of SEWIP shipment in Q3.

Two questions on that.

First, is that the same order that's been pushed out here over the last several quarters?

And how big is that?

So, yes, that is the order that has been pushed out for the past several quarters.

Obviously, we feel really good that we finally received that.

And as I intimated in my prepared remarks, I think the reason that we received it during this quarter, is the fact that Lockheed finally received the official notification of the milestone C, which signifies the transition to the Lrip production.

In addition, I think they have made pretty good progress in terms of narrowing the gap as it relates to the remaining contractual items that they're working on.

So, they send us the PO and we're pleased to get it.

As it relates to the specific magnitude of the order itself, we're not going to break that out, but it is obviously encompassed in the guidance that we've provided.

Okay, that's fair.

Just lastly on free cash flow.

Obviously it was nice to see the cash generation this quarter.

Could you maybe expand on -- I think you mentioned in the prepared remarks that CapEx was going to lift a little bit in Q3, could you maybe quantify that and just talk about longer term where you think free cash flow is going to go?

So if you look at -- in the second quarter Tyler, CapEx levels were historically low.

It's $700,000 that's been the lowest that we've had for a while.

Now clearly we are managing that in this environment.

It is one of the things that we mentioned that is within our control, so we don't see that up ticking materially, but there is timing issues, and we do see a slight increase quarter-over-quarter, so we don't expect it to grow substantially as the year progresses.

Great.

Thanks so much.

Brian Ruttenbur, CRT Capital.

Couple of questions, first of all, JCREW 3.3, I may have missed this, but what is the status, is it pushed off, what is the timing, the visibility, maybe you can give me a little program update on that?

Sure, so good evening, Brian, there is really no official new news on the status or the fate of the program at this time.

So it is pretty much a status quo.

As we said last quarter, all the program funding that our customer received has been exhausted, and our customer has actually stopped work on the program.

You may recall, also, that previously we actually removed all JCREW I1B1 Lrip bookings and revenue from our financial year '13 plan due to the delays.

So, at this point we still believe that the Marine Corps has a need, but it is unclear as to how it is that the program is going to proceed at this point.

Okay.

The other question I have is on the gross margin in this period.

You expect a dramatic uptick in gross margin from second quarter to third quarter, is that how the earnings are being driven, assuming that you said operating expenses are being held essentially flat, so it is a gross margin increase, is that right?

So in the --.

Brian, this is Kevin, no we had said in our prepared remarks that gross margin is going to be roughly flat between Q2 and Q3 at roughly 35%.

The uptick on the bottom line, a lot of it has to do with an unusually high tax benefit that we're going to be benefiting from in the quarter, largely because of the extension of the R&D tax credit, retroactive to January of 2012.

So you are effectively going to get four quarters worth of R&D tax benefits baked into the third quarter.

But in terms of the gross margin, it is going to be roughly flat quarter-to-quarter.

Okay.

Then thank you, I missed that.

I dialed in late, I apologize.

So then in the fourth quarter, assuming things don't change, then gross margins should be maintained in this level kind of going forward as we all have to project the ongoing quarter unfortunately, just thinking on terms of gross margin, what would impact it to get higher again or back to historical levels?

So, I mean, the -- what is going to drive that is really the program mix, but right now, as we said, in Kevin's remarks, we're really sticking with the one quarter at a time guidance, Brian.

Okay.

And the tax benefit is only for the third quarter, or would you automatically carry that out for the fourth quarter as you think about tax benefit?

I'm not asking for specific guidance for the quarter, I'm just thinking about taxes.

No, I think -- I think the large benefit will be this -- will be this quarter because of the cumulative impact of the R&D tax credits.

But moving beyond that, we will certainly get a benefit from R&D tax credits, but only the usual quarter-to-quarter, not a cumulative benefit.

So in essence it will be a lower benefit in future quarters based on the lack of the cumulative feature this quarter.

Right.

And then you expect to in the -- well, I'm asking for more guidance.

I was going to ask about cash.

Can you tell us about cash on the year?

Do you expect to maintain no matter what, maintain $30 million of cash, is that the goal, or something like that, long term?

So, we're only providing one quarter at a time, Brian, of guidance.

I appreciate the color.

Thanks.

Michael Ciarmoli, KeyBanc Capital Markets.

Follow-up, Mark, maybe on Peter and Tyler's questioning on SEWIP.

You've got the one quarter of guidance laid out, I guess the midpoint $47 million, it includes SEWIP now.

So it's still down, I guess.

What I'm looking at is why is the guidance trending lower, if SEWIP is coming into the fold, is there anything in the current quarter that weakens or that is lumpy, and I'm just thinking to how you stated that you're managing the business from backlog in hand, and not the book ship business?

Is there anything to read into there?

No, I don't think there is, Mike.

The defense business, as you know, is notoriously lumpy and we're taking a conservative view in terms of what is included in our guidance.

So I wouldn't kind of read it as because this is in something else moved out and there is a problem elsewhere.

That is not the way in which we're -- we constructed the guidance.

Okay.

No, that is fair.

And then just the only other one I had, if you can as I remember at your Analyst Day, you showed, I think, two pages of kind of your key programs in production, and I'm trying to get a gauge out of the programs in your portfolio, what type of risk is there or that you would associate with any IDIQ contracts?

I tend to think in this budget environment if you're going to see cost cuts, the easiest area to cut on some of the contracts would be on IDIQs where there is no termination clauses or anything.

Do you foresee any risk in terms of your IDIQ portfolio in the coming months here?

We have only really got one program that is technically classified as an IDIQ, and that is a program called Filthy Badger.

And we didn't name it.

It is a Naval program inside of the acquired company KOR Electronics.

And if you remember, we actually had a press release in actually this quarter that outlined a new IDIQ that is being put in place by the Navy.

From what we can tell right now, this is a -- it is a needed capability, it is obviously in the EWEA space, which is high priority.

So we don't see any potential risk at this point in time.

However, as we discussed on the call, there is still a tremendous amount of uncertainty given the potential of now a full year CR and the fact that sequestration is still looming.

But that is the only IDIQ that we have in our portfolio.

Okay.

Perfect.

That's helpful.

Thanks a lot guys, that's all I have.

Howard Rubel, Jeffries.

A couple things.

Could you, Mark, just give us a sense of headcount, where did you end the quarter, and where -- and where do you think you'll be at the end of the next quarter?

So we -- we ended Q2 at 769 heads, and we are expecting, I guess, a small increase in heads going forward.

But we've got a pretty tight grip on expenses right now.

You talked about the second quarter kind of being maybe -- or the third quarter, rather, being in the range of $50 million and if we assume SEWIP's material, maybe you could give us a little more granularity as to how you constructed the guidance for the next quarter, because it would appear that something is either down or soft or lumpy?

Yes, as we said, we have a portfolio of programs not each of them produces at the same level each and every quarter or even each and every year.

And so, you know, the SEWIP is in our guidance.

We're pleased that it is in the guidance, and I think we haven't, as I said to Mike, we don't see anything specifically that is at risk.

We're just taking a more conservative approach given everything that's going on down in DC.

Believe me, I get that.

The other thing is, you kind of look at where you are with headcount and you are trying to manage that, and you have clearly resized R&D and CapEx and all of that, what level of volume -- you know, I'm sure you've done the scenarios, what level of volume do you think you need to get to break-even?

So we size the business to basically to be break-even roughly on a cash flow basis, that was our goal.

We believe that what is happening in the industry right now is temporary.

And that we are at some point going to see a rebound in some of our major programs that have produced for us well in the past.

So, it is a balance between how far do you cut when you think it is only temporary, and we believe that we've made the right decisions in light of that.

We should -- I mean, you still have GAAP losses but cash flow plus or minus you feel pretty comfortable that you've found that level where there's equal puts and takes?

That is basically the way in which we went through the exercise of the reductions, yes.

Just two more.

One is, when -- you had nice backlog numbers, how did you sort of evaluate or how would you sort of stack up your bids versus your proposals?

So the overall contracting environment is as you can see from our design -- our design win activity, right, there wasn't a lot going on there compared to what we've seen in prior quarters, or even in prior years.

And that, again, I believe is largely due to the CR, no new starts and the primes reducing their internal R&D budget given the potential for sequestration.

We had three major bookings in the quarter that I think Kevin talked about.

The largest of which was in Micronetics, which was a very significant booking, to do with upgrades on the B-1 bomber relating to electronic warfare.

The other two were in the ACS core, which was great.

The first was Aegis, and that was the largest single booking that we've had from Aegis since -- excuse me -- since 2011.

And then clearly we were pleased to get the SEWIP order, which has been delayed, as you know, for several quarters.

So, I think we were pleased to see the progress in bookings.

We had a very substantial book-to-bill of 1.3.

The core, the ACS core, which was impacted last quarter, clearly did much better.

But we're still hesitant and cautious in this environment, given everything that is going on down in Washington.

Last thing is to go back to SEWIP one more time, my guess is most of it is sitting in inventory today, and so one would expect that you would actually have a reasonably decent cash flow quarter because all you have to do is just ship it at this point?

And collect the cash.

Well, you know, Lockheed is a pretty good payer the last time I check.

So, I think most of the product is sitting in inventory and we do expect to be able to ship it for revenue this quarter.

The collection of the cash is anticipated in the cash flow forecast that Kevin described in his prepared remarks.

Thanks, gentlemen.

Jonathan Ho, William Blair.

Hey, guys, just wanted to get a sense at this point looking forward from a visibility standpoint, when do you think things start to normalize, and how do you see that playing out?

I guess I'm just trying to wonder whether you guys are seeing a light at the end of the tunnel yet, or whether we could be in this for a while longer?

Well, I think the visibility has probably gotten incrementally worse quarter-over-quarter, Jonathan.

Largely because, I think, the industry is currently anticipating that it is likely that we're going to have a full year CR, and the budget control of the sequester that got basically pushed two months, to now being triggered on March 1, even the services are beginning to undertake some pre sequestration cuts as well as planning, that sequestration may actually occur.

So, until there is actually clarity around what's happening with the defense budget itself in terms of the dollar volume, as well as improvements in the way in which they're currently budgeting, meaning the process, I don't think things are going to improve materially.

So, we've kind of -- we're taking it one quarter at a time, and hopefully being as practical as we possibly can, as we see things occur down in DC.

Got it, that is helpful.

Can you talk a little bit about how some of the acquisitions have performed now that you've had some of these for an extended period of time, relative to your expectations and just taking into account what's happened with the environment?

Can you maybe grade some of the performance that you've seen?

I think we're seeing good performance literally across the entire portfolio that we've acquired.

Going way back when, the L&X business that we acquired is right in the heart of delivering against our SEWIP program, which is, as you know, probably one of the largest single programs that we've won as a Company to date.

If you look at core defense including Micronetics, that business continues to perform well.

They just recently in this past quarter received a $58 million IDIQ for their existing generation of systems, and they anticipate getting another IDIQ for the next generation, probably within the next six month period.

So they're doing well, also.

Micronetics, which is the business that we just recently acquired, had another really strong quarter, the second in a row.

Bookings were up 48% quarter-over-quarter, the backlog was up 25% sequentially, and revenue was up 94%.

So all in all we feel pretty good about the businesses that we have acquired, in terms of their strategic fit, the way in which we've integrated them, as well as their financial performance to date.

Great.

Thank you.

And it appears there are no further questions at this time.

Mr. Aslett I'd like to turn the conference back over to you for any additional or closing remarks.

Okay, well thank you all very much for listening.

We're pleased with the progress that we've made in the second quarter, and w look forward to speaking with you all next quarter.

Goodbye.

Ladies and gentlemen that concludes today's conference call.

We thank you for your participation.