Mercury Systems Inc (MRCY) 2014 Q2 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems' second-quarter fiscal 2014 earnings conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the Company's 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 we issued earlier this afternoon, you can find it on our website at www.mrcy.com.

We'd like to remind you that remarks that we make during this call about future expectations, trends, and plans for the Company and its business, constitute forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. You can identify these statements by the use of the words may, will, could, should, would, plans, expects, anticipates, continue, estimate, project, intend, likely, forecast, probable, potential, 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, as well as the timing and amounts 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 and restructurings, or delays in realizing such benefits; challenges in integrating 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 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, 2013. 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 statement 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.

With that, I'll turn the call over to Mercury's President and CEO, Mark Aslett. Mark?

Thanks, Kevin. Good afternoon, everyone, and thanks for joining us. I'll begin today's call with a business update. Kevin will review the financials and guidance, and then we'll open it up for your questions.

Despite challenging conditions in the industry, Mercury performed well in the second quarter. Total revenue for the quarter was $53 million versus our guidance of $48 million to $54 million. Our GAAP loss from continuing operations was $0.03 per share, favorable to our guidance of a loss of $0.12 to $0.06, and much improved both sequentially and year-over-year. Adjusted EBITDA was 10% of revenue, up substantially from last quarter and Q2 last year, and well above the high end of our guidance. Cash flow also exceeded our plan, due to higher-than-expected collections at quarter-end.

We continue to make good progress on our most important programs. Total revenues in our defense business for the second quarter increased 10% sequentially from Q1 to $50.8 million, and were up 12% versus the second quarter last year. Total defense bookings increased 10% sequentially to $47.9 million. Our total book-to-bill was 0.9 compared with 1.3 in Q2 last year. Our book-to-bill in defense was 0.9, flat sequentially, and down from 1.2 a year ago. Defense backlog and total backlog exiting the second quarter were both down 2% sequentially.

From a bookings perspective, our largest programs this quarter were for F-15 EW upgrades with BAE, Aegis with Lockheed Martin, as well as ASIP, the Airborne Signals Intelligence Program, and a classified airborne program, both with Northrop. International defense bookings, including foreign multi-sales, were 49% of total defense bookings compared with 17% in the sequential first-quarter. From a revenue perspective, Aegis, ASIP, Gorgon Stare, and Predator/Reaper, were important contributors during Q2. International defense revenues, including FMS, were 16% of total defense revenue compared with 23% in Q1.

Moving to the operations. Over the past two quarters, we successfully laid the groundwork for the second and final phase of our acquisition integration strategy, which begins in Q3. Our goal over the next 18 months is to create a fully integrated business that we can continue to profitably grow organically and scale through potential acquisitions.

I'll start with some background. Over the past several years, our top priority has been to leverage our relationships with the primes, and drive bookings and revenue from existing programs as well as new programs and platforms. We've collectively and successfully built up Mercury's portfolio with best-in-class products and capabilities across the entire sensor processing chain. We achieved this through a combination of ongoing work in our existing businesses and strategic acquisitions in RF, microwave, and electronic warfare. These acquisitions, which we think of as Phase I, were all about aligning our business with the needs of our customers, as well as positioning ourselves for sustainable growth in the long-term. This phase culminated with the acquisition of Micronetics. And through a lot of hard work, we've created a commercial company that I believe is second to none in the defense electronics industry.

The second phase integration which is underway consists of three key initiatives. First, facilities consolidation around our two advanced microelectronics sensors. Second, standardizing business processes and systems across the enterprise; and third, realignment of our engineering resources. Successful execution of these Phase II initiatives over the next 18 months should result in approximately $16 million of annualized expense reductions when complete. Kevin will discuss the financial aspects of the restructuring in his prepared remarks.

Looking at the plan in more detail, the first of our priorities is to take full advantage of the investments we've made in our advanced microelectronics sensors. These facilities position us as a world-class player in the RF and microwave industry. With the AMC Centers of Excellence concept in place, and with the New Hampshire AMC up and running in Q2, we can now begin to consolidate, where appropriate, other non-core facilities in New Hampshire. This consolidation will enable us to further reduce our facility footprint and expense base over time. It will also help make us more efficient and more effective in driving advanced microelectronics solutions into the marketplace. In addition, we expect it to drive margin improvement, as certain programs move into full rate production.

The second element of Phase II involves standardizing our common set of core business processes and systems across the Mercury enterprise. Three acquisitions since 2011 have left us with a disparate array of processes and systems, and have increased our costs and reduced efficiencies. This is something that happens at virtually all companies engaged in acquisition-driven growth, and is something that we planned for in our M&A strategy.

For the past six months, we've been working methodically to address this issue. The result is a blueprint for a common set of core business processes and IT systems that will allow us to centralize, wherever possible, Mercury's administrative functions and manufacturing operations. We believe these initiatives, which are well underway, and proceeding on time and on budget, will also make Mercury an easier company to do business with. At the same time, the resulting savings in time and resources should significantly lower our G&A expense and improve gross margins.

The third and final integration plan component is to align and rebalance our engineering resources. Our goal is to create sustainable, repeatable engineering safe model, based on what we're calling advanced development centers, or ADCs. We began implementing the ADC model internally last year by outsourcing our remaining digital manufacturing. This allowed that particular facility to focus exclusively on engineering development and low-volume new product introduction. Going forward, Mercury's high-volume digital production will continue to be performed by our contract manufacturing partners and, in the case of RF and microwave, in one of our own AMCs.

We see the AMC and ADC concepts as models that we can sustain and replicate as we continue to grow and scale our business. The realignment of engineering resources is designed to sustain our lead over the competition and processing, while strengthening high-growth areas such as RF and microwave. Overall, the realignment will result in a very modest net reduction to our engineering headcount. Said another way, the plan I just outlined is not about scaling back on R&D. It's about leveraging our acquisitions to make the business more efficient, and taking out costs to improve margins and reducing operating expenses.

In effect, we are positioning ourselves to achieve our target business model earlier and under more conservative revenue growth assumptions, reflecting the prevailing industry conditions. Assuming approximately 10% annual revenue growth next year, the normal program mix, and reduce operating expenses from our Phase II integration, we currently expect to achieve our target business model for fiscal 2015.

Moving to the industry. We are encouraged by the recently-enacted two-year federal budget, which we believe will reduce the short-term impact of sequestration. We were also pleased to see the approval of the government's FY14 Defense Appropriations deal earlier than last year. These should help solidify the growth in bookings, revenue, and EBITDA we have forecast for the second half of FY14, and should also position us well for fiscal 2015. With this in mind, the guidance that Kevin will discuss today includes our expectations for both the third quarter and the fourth full fiscal year. We are anticipating mid-single digit to low-double digit revenue growth in the second half, driven largely by Aegis, SEWIP Block 2, LRIP, Patriot and JSF.

I said in the past that RF and microwave, as it relates to next-generation EW and radar subsystems, will likely become the fastest-growing part of our business. The investments in our RF and microwave capabilities that we've made over the past two years are clearly bearing fruit.

Our second half guidance suggests an improvement in topline growth compared to the industry, with the potential to accelerate this growth in fiscal 2015. We invested significantly during the good times, and now we're reaping the benefits of that. Mercury's strategy, technology, capabilities, and ongoing programs and platforms, align well with the DoD's new roles and missions. As a result, we are positioned to win new business and to take share from the competition in next-generation processing opportunities.

These opportunities include the Pacific Pivot, the upgrade of aging military platforms, as well as growth in foreign military and international sales. In addition, as a leading outsourcing partner to the primes, we have the potential to capture significant upside from defense procurement reform. Looking ahead, SEWIP is the largest of a group of programs that we believe will be important to Mercury longer-term. These other programs include Aegis and Patriot; upgrades to the Predator/Reaper, F-15 and F-16; Surfit; JSF; E-2D Hawkeye, as well as Filthy Badger and Buzzard. These are a franchise set of programs for Mercury that, in aggregate, could represent hundreds of millions in revenue potential over their lives.

If we can continue to deliver growth despite the prevailing industry conditions, while continuing to execute on the second and final phase of our integration plan, we should benefit from the substantial operating leverage that exists and that we continue to drive in our business. This leverage should further strengthen Mercury's position to deliver significantly improved profitability, cash flow generation, and shareholder value as we move forward.

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

Thank you, Mark, and good afternoon again, everyone. Turning now to our financial results, revenue for the second quarter of fiscal 2014 of $53.1 million was $3.3 million or 7% higher than revenue of $49.8 million for the second quarter of last year, and was at the upper end of our stated guidance of $48 million to $54 million. The Company generated a GAAP net loss of $0.03 per share in this year's second quarter, which was substantially smaller than the GAAP net loss of $0.16 per share in the second quarter of fiscal 2013. This year's second-quarter loss per share was smaller than the Company's guidance of a net loss of $0.06 to $0.12 per share for the quarter.

Adjusted EBITDA for the second quarter of fiscal 2014 of $5.1 million was $4.1 million higher than the adjusted EBITDA of $1 million for the second quarter of last year, and exceeded our stated guidance of $400,000 to $3.5 million. The Company generated free cash flow of $4.5 million in this year's second quarter, and ended the second quarter with $44.5 million of cash and cash equivalents, and with no debt.

Reviewing second-quarter performance in greater detail, total revenue for our largest operating segment, Mercury Commercial Electronics, or MCE, was $45 million, which was $4.5 million or 11% higher than the $40.5 million of MCE revenue generated in the second quarter of last year. The year-over-year increase in second-quarter revenue derived mainly from significantly higher Aegis program revenue, and was partially offset by lower RF components and UAV program-related revenue.

Revenue from the Company's Mercury Defense and Intelligence Systems, or MDIS, operating segment for the second quarter was $10.6 million, which was $3.5 million lower than the $14.1 million of MDIS revenue for the second quarter of last year. The lower revenue between years was primarily due to lower Digital Radio Frequency Memory, or DRFM, Jammer program revenue, and lower MIS revenue resulting from delays in customer funding. It should be noted that operating segment revenue for the second quarter of fiscal 2014 does not include adjustments to eliminate $2.5 million of intercompany revenue.

Total defense revenue, including MCE and MDIS of $50.8 million for the second quarter, was $5.3 million or 12% higher than defense revenue of $45.5 million for the second quarter of last year. As mentioned previously, the year-over-year increase in defense revenue stems from higher Aegis program revenue that was partially offset by lower revenue at MDIS. Of the total defense revenue in the second quarter, $8.4 million or 17% derived from international customers compared to $9.3 million or 20% in the second quarter of last year.

Revenue from international customers includes foreign military sales to our prime customers, as well as direct sales to non-US-based customers. The key programs driving international revenue in this year's second-quarter were the Aegis and F-15 Electronic Warfare, or EW programs, as well as direct sales to a customer in the Asia-Pacific region.

Commercial revenue for the second quarter of $2.3 million was lower than the $4.3 million of commercial revenue generated in the second quarter of last year. The year-over-year decrease in commercial revenue was principally the result of lower product shipments to customers in the Telecommunications Equipment and Security sectors.

Defense bookings for the second quarter of $47.9 million were lower than the unusually strong defense bookings of $55.7 million in the second quarter of last year. However, second-quarter defense bookings were $4.3 million or 10% higher sequentially from the first-quarter defense bookings of $43.6 million, as higher F-15 EW and F-35 program bookings were partially offset by lower Aegis program bookings. It should also be noted that second-quarter defense bookings included the Company's first order for the Sabre program that was recently awarded by the US Air Force to our customer, Northrop Grumman. Lower year-over-year defense bookings were primarily due to decreased SEWIP, B-1 Bomber, and Aegis program bookings that were partially offset by higher F-15 EW program bookings.

Mercury's total book-to-bill ratio for the second quarter of fiscal 2014 was 0.9, which was below the 1.3 book-to-bill ratio for the second quarter of last year, but matched this year's first quarter. Defense book-to-bill of 0.9 was similarly below the 1.2 book-to-bill ratio generated in the second quarter of last year, but matched this year's first quarter.

The Company ended the second quarter of fiscal 2014 with $130.5 million of total backlog, which was $2.7 million lower than the $133.2 million of total backlog at the end of last year's second quarter. Of the total ending backlog in the second quarter, $101.4 million or 78% is expected to be shipped within the next 12 months. $112.6 million of the ending second-quarter total backlog related to defense, which was $1.7 million lower than last year's second-quarter defense backlog. From a bottom-line perspective, the Company incurred a GAAP net loss of $1 million in this year's second-quarter that was substantially smaller than the GAAP net loss of $4.8 million in last year's second-quarter. The stronger financial performance between years was mainly due to a 12 point improvement in gross margin, driven by a recovery in the Company's higher-margin digital signal processing business.

Fueling this recovery was year-over-year revenue improvement from the Aegis, F-35, and various UAV-related programs, which carry gross margins accretive to the Company's overall gross margin this quarter. Partially offsetting the increased gross margin were higher operating expenses compared to last year's second-quarter, due principally to lower customer-funded development work and higher prototype expenses.

It should be noted that the Company's gross margin of a 47% in the second quarter was 3 to 4 points higher than the stated guidance for the quarter. This increase in gross margin compared to guidance is attributable to previously forecasted RF and microwave program revenue, which carries lower than historical margins, slipping to the third quarter, and being replaced by digital signal processing program revenue, which carries higher margins, that was originally forecasted for the third quarter of this year.

Adjusted EBITDA of $5.1 million from the second quarter of fiscal 2014 was considerably higher than the $1 million of adjusted EBITDA generated in the second quarter of last year, due largely to the overall improved operating performance between years. Relative to our stated financial guidance for the second quarter, we are pleased to report that the Company was at or above the high end of its guidance in all the key financial measures. Second-quarter revenue of $53.1 million was at the high end of our guidance of revenue between $48 million and $54 million. Reported GAAP loss per share of $0.03 for the second quarter was favorable to our guidance range for a net loss of between $0.06 and $0.12 per share. And finally, adjusted EBITDA of $5.1 million for the second quarter comfortably exceeded guidance of $400,000 to $3.5 million.

Turning now to the balance sheet, the Company ended the second quarter of fiscal 2014 with cash and cash equivalents of $44.5 million and no debt, which was $4.4 million higher than the $40.1 million of cash and cash equivalents at the end of the first quarter of fiscal 2014. The Company generated $4.5 million of free cash flow during the second quarter, as $7.4 million of operating cash flow driven by the quarter's cash earnings, and lower working capital due to improved receivables collections, were partially offset by $2.8 million of capital expenditures.

Before providing financial guidance for the third quarter, I want to spend a few moments discussing the financial implications of the Phase II integration efforts that were outlined in this afternoon's earnings release and Mark's earlier comments. The Phase II integration plan encompasses actions that began this quarter, with further actions to be completed over the next 18 months or by the end of fiscal 2015. Upon completion of Phase II, the Company anticipates generating annualized gross savings of $16 million. Third-quarter actions that were recently completed are estimated to achieve $9 million of the $16 million of gross annualized expense savings. This development further demonstrates that the savings associated with the Company's Phase II integration plan are heavily front-end loaded.

Forecasted gross savings for the third quarter resulting from the third-quarter actions are estimated to be $1.6 million, with $400,000 relating to manufacturing, and the remainder split evenly between SG&A and R&D. Total restructuring charges for the third quarter are expected to amount to $3.4 million.

For the second half of fiscal 2014, Phase II actions are forecasted to generate $4.3 million of gross savings as compared to first-half expense run rates, with $1.2 million related to manufacturing, $1.6 million related to SG&A, and $1.5 million related to R&D. Total restructuring charges for the second-half of fiscal 2014 are expected to be $4.9 million. For fiscal 2015, integration actions for Phase II are estimated to produce an additional $9 million of gross savings as compared to total forecasted expenses for fiscal 2014.

The breakout of these savings includes $4 million related to SG&A, $3 million related to manufacturing, and $2 million related to R&D. The Company anticipates incurring $4.2 million of restructuring charges in fiscal 2015. With the anticipated completion of Phase II integration actions by the end of fiscal 2015, the full $16 million of gross annualized savings, as compared to current expense run rates, is expected to be realized in fiscal 2016.

Now, turning to third-quarter financial guidance, we are forecasting total revenue to be in the range of $50 million to $56 million, which is higher than the revenue guidance the Company has provided over the last several quarters. As Mark alluded to in his remarks, the passage of the Bipartisan Budget Act in December by Congress and signed by the President provides better defense spending clarity for government fiscal years 2014 and 2015. In addition with the enactment of a Defense Appropriations bill for the remainder of government fiscal 2014, the Company is seeing some loosening of procurement activity from its prime customers, leading us to raise our revenue guidance this quarter as compared to previous quarters.

The estimated revenue range for the quarter assumes continued strength from the Aegis, SEWIP, and UAV-related programs, as well as a classified Northrop Grumman program. We expect the split in the third-quarter revenue to revert to the more normal 90% defense and 10% commercial split, as compared to the 95% defense, 5% commercial split seen in the second quarter.

Within our stated revenue guidance, we are providing gross margins of between 38% and 40% for the third quarter, which is below the 47% gross margin generated in this year's second quarter. The reduction in gross margin is mainly due to product mix, as the second quarter is described earlier, included a greater proportion of higher-margin digital signal processing revenue that had not been previously anticipated. The third quarter is now expected to include a greater proportion of RF microwave and commercial revenue that carry gross margins lower than the digital signal processing business.

Operating expenses are forecasted to be $28 million for the third quarter, which is slightly higher than the second-quarter operating expenses. Excluding the restructuring charges, operating expenses for the third quarter are forecasted to be $24 million, which is $3 million lower than the second quarter, due to savings from the integration actions and higher customer funded development.

From a bottom-line perspective, we anticipate a reported GAAP loss per share in the range of $0.09 to $0.15 per share for the third quarter, based on an estimated weighted average share count of 31 million shares. Excluding restructuring charges, the loss per share for the third quarter is estimated to be in the range of $0.03 to $0.09 per share. The loss per share forecast assumes an income tax benefit of approximately 36% for the third quarter, which is comparable to the second quarter. This forecasted tax rate assumes no benefit for the remainder of fiscal 2014 from the Federal Research and Development tax credit, which expired on December 31, 2013. Consistent with the second-quarter, the loss per share range forecasted for the third quarter includes an approximate $0.04 per share impact from the amortization of intangible assets.

Adjusted EBITDA for the third quarter is estimated to be between $1 million and $4.1 million, which is slightly higher than the forecasted range the Company provided for the second quarter. Relative to liquidity, we anticipate ending the third quarter with cash and cash equivalents between $43 million and $45 million, which is slightly lower than cash and cash equivalents as compared to the end of the second fiscal quarter. Operating cash flow from cash earnings is expected to be offset by higher receivables-related working capital, due to the unusually high second-quarter collections, and capital expenditure levels that are estimated to be comparable to the second quarter.

With improving topline visibility from our customers stemming from the Bipartisan Budget Act, in 2014, Defense Appropriations bill, the Company will now be providing full-year financial guidance. For all fiscal 2014, the Company is forecasting revenue in the range of $215 million to $225 million. At the midpoint of this range, fiscal 2014 revenue would represent an approximate 5% growth rate from a year ago. In addition, we expect gross margin to be between 42% and 43%, which is slightly below the first-half gross margin, due to a more favorable product mix in the second quarter, and its adverse impact on forecasted third-quarter gross margin.

Operating expenses are forecasted to be approximately $107 million for fiscal 2014. Excluding restructuring charges, fiscal 2014 operating expenses are expected to amount to $102 million. Forecasted GAAP loss per share for fiscal 2014 is in the range of $20.34 per share. Excluding restructuring charges, the loss per share is anticipated to be between $0.10 and $0.24 per share. Achieving the favorable end of the latter loss per share range would result in profitability, excluding restructuring charges, for the second half of fiscal 2014. Adjusted EBITDA for all of fiscal 2014 is projected to be between $14 million and $20 million. At the high end of this range, the Company would generate adjusted EBITDA of nearly 10% of revenue for fiscal 2014.

With that, we'll be happy to take your questions. Sayeed, you can proceed with the Q&A now.

Kevin Ciabattoni, KeyBanc Capital.

Just looking at the target model. You say you hope to achieve it by 2015. Is that something you expect to be able to achieve on a full-year basis? Or is it something we're more likely to see at the tail end of the year? Just trying to kind of figure out the ramp there.

Yes, so we anticipate achieving it for fiscal 2015, Kevin.

Okay, great. Any color you can give us on amortization for next year? I know you gave the restructuring number, Kevin. That was helpful.

Yes. I think similar to the quarterly rate we're seeing right now, somewhere between $1.9 million and $2 million a quarter.

Okay. And then some reports are out there that the F-16 upgrade program is in doubt with the 2015 budget. Just any thoughts on what you're seeing there and how that might impact the business going forward?

Sure. So I saw the article earlier today. To me, when I read it, it looked more like propaganda. I think it's still speculative as to what's actually going to happen from a funding perspective for the US piece. But from what we know right now, Taiwan looks like it's in great shape. It's going ahead, and we received our first order for the Sabre program during Q2. So, I guess we're going to have to wait and see more information around capes, see whether or not the radar upgrades are going to be done as part of that or separately. So, I haven't heard anything official, Kevin.

Okay, thanks. And then just one last one for me. Just wondering if you could give us any color on what you're seeing in terms of the level of outsourcing from the primes? And whether you've seen any change since you've been able to get the New Hampshire -- the new New Hampshire facility kind of up and running, just in terms of overall outsourcing?

Sure. Yes, I'd love to. So we feel very excited about the opportunity in RF and microwave. You know, I think as we said on the last call, we spent a tremendous amount of time looking at the industry structure. And the way in which I described it at Investor Day was, basically said it was an hourglass.

Net-net, what we see as our customers are looking for a better alternative than either the companies that are their traditional suppliers on the high-end or the small companies that they are working with. And what we've done through the acquisitions that we've made in the space that -- the most recent one was Micronetics -- and now the investments in the AMC, we are providing an alternative. So, a couple of different data points.

During the quarter, I was down with one of our customers in -- that provides a lot of capabilities in the EW space. And literally as a direct result of bringing the new AMC facility online, the investments that we've made in our existing AMC, as well as the additions that we've made to the engineering team in RF and microwave, they're going to outsource substantially more work to us than what they were previously planning on doing, which I think is great.

We've hired pretty much all of our major customers. Two are the new AMC facility in Hudson, New Hampshire. The feedback has been overwhelmingly positive, to the extent that at least two of them are actually approving us as a strategic supplier in RF and microwave for more advanced RF and microwave subsystems. And one of the other customers that we are dealing with today, where we're not actually doing much at all in RF, has given me a verbal commitment that we're going to get some business for them, and they see us as a strategic partner going forward.

So, I couldn't be happier with the progress that we're making. And I think it's a substantial opportunity for growth for us going forward, Kevin.

Great, thanks. That's good color. That's all the questions I had.

Thank you.

Thanks, Kevin.

Jonathan Ho, William Blair.

I just wanted to see if you'd give us a little bit more color on how each of the components that you outlined in your cost savings plan is going to contribute to that $16 million in aggregate savings? And maybe a little bit more color in terms of how we should be modeling those savings to come in to the model over time?

Yes, I think we were -- Jonathan, I think we were fairly explicit about that. I think we -- in terms of the second half of this year, we outlined that we would expect roughly $4.3 million in savings. And I think the if you do the numbers, I think it's about $1.2 million for manufacturing, $1.5 million R&D, $1.6 million for SG&A; another $9 million in fiscal 2015 over -- compared to fiscal 2014's expense levels.

And again, I think the splits there are roughly $4 million SG&A, $3 million in cost of sales or manufacturing and the rest in R&D. And then because we have actions planned probably towards the end of 2015, where the savings won't be achieved until 2016, the remaining $2 million -- $2.5 million of savings, we would expect to be in 2016. So I think -- you add those three together and I think it comes pretty close to $16 million of savings. Again (multiple speakers) --

Got it, got it (multiple speakers)

From my level, Jonathan, it's roughly 40% of the savings are in manufacturing; 40% are in SG&A; and 20%, about $16 million in R&D. But just to put a fine point on it, this is not about a reduction in our research and development. When you look at the number of heads that we've reduced this quarter, it was 17. And we're done with that action.

Most of the activities that we're talking about going forward are really about the fact that now that we've got the new AMC up and running, we can consolidate more of our -- or other non-core facilities over time. And given that we've got an operating model in place for the business, we can standardize on a common set of core business processes and systems that, in particular, will allow us to actually centralize our manufacturing operations as well as our general and administrative functions. And that's really where you see the big overall savings.

Got it. And just as a second question, just want to understand from a confidence perspective, now that you guys have offered sort of the 10% perspective on 2015, can you remind us which of the programs you expect to sort of support that visibility? Are there any potentially at risk? Or with the budget visibility that's there now, do you feel pretty good about sort of the potential for those programs to happen?

Sure. So the numbers that we gave you are not necessarily guidance, per say. We're trying to put the context of the integration plan that we announced and the potential impacts that we see in the business model. Net-net, I think, as a result of the activities that we've taken, in essence, what it does is it brings in the attainment of the target business model, and allows us to attain that target business model range at a lower revenue run rate than what we previously anticipated.

So, in essence, what supports from a programmatic perspective, the fiscal 2015 kind of outlook, as it were, we'll give more firm guidance on the fourth quarter call for fiscal 2014. It's really around SEWIP Block 2, the LRIP, as well as some production, as well as increased content on the SEWIP Block 2 that we talked about at Investor Day. I think Patriot has the potential to see increased revenues in fiscal 2015 associated with both foreign military sales, as well as the fact that the U.S. Army Patriot upgrades, particularly for the radar, they got very good funding in the overall budget.

We expect Aegis to be an important revenue contributor, not necessarily a growth program but a -- an important contributor overall. And then I think I would -- finally, I would say Filthy Badger and Buzzard in our Mercury Defense and Intelligence systems operating segment as well as JSF. So, programmatically, those are the drivers. From a business model perspective, I think I would kind of boil it down to really two things. We are anticipating continued strong rebound in the more traditional processing part of our business, and continued strength in RF and microwave.

And Jonathan, I would add too, to put some numbers behind it -- if you took the high end of our revenue guidance for the second half of the year and annualized that, you're probably looking at a 70% growth rate year-over-year. So, kind of puts into perspective what a 10% year-over-year growth rate would mean for us.

Got it, got it. And just one final question on the environment. Now that we've got sort of the budget passage and some of the visibility towards 2014 and 2015, I mean, do you feel sort of a normalization in terms of your contacts with the prime contractors? You know, their confidence level and visibility, order flow? Just want to get a sense for you how the environment feels at this point.

Yes, I think overall, people feel much better than, say, where we were during fiscal 2013. In essence, the budget deal eliminated sequestration and traded that for reduced spending levels. But the spending levels for fiscal 2014 and 2015 are somewhat baked at this point -- you know, flat to what was enacted in fiscal 2013 at $500 billion a year. So to take it away that uncertainty surrounding sequestration, which, in our mind, was one of the big issues that were causing the delays in funding and contracting to occur.

So, I think it's really positive overall. I think people feel better about that we've got at least some short-term clarity from the overall budget environment, and the 2014 Defense Appropriations bill was signed earlier than it was last year. So, we're not out of the woods, but I think things are heading in the right direction and we generally feel better about it.

Great. Thank you.

Tyler Hojo, Sidoti & Company.

Just a follow-up on the last question. When you talk about seeing kind of business normalize, what you had been talking to us about was being really conservative in terms of how you had been running the business, really running it for cash, and kind of stepping away from some of the book and ship opportunities that you've traditionally gotten. So, in context with what you've said about seeing some normalization, do you get a little bit more aggressive?

And then maybe as a follow-on to that, do you need to get more aggressive in order to get kind of to that 10% growth bogie?

So, if you look at, say, the high end of guidance range to -- that would suggest a 10% revenue growth rate. And given the integration plans and the reduction of operating expenses, that would lead to a huge improvement in terms of adjusted EBITDA over the first half of the year. And that's somewhat consistent in terms of what we saw during fiscal 2013, if you can remember back that far, Tyler.

When the Defense Appropriations bill was actually approved in the second half of our fiscal 2013, we actually saw a 12% increase in bookings and a 10% increase in revenues. And, in essence, at the high end of the range, we're kind of forecasting that to occur again. At the four-year level, [the gain] at the high end of the guidance range, we're basically delivering revenue growth, or forecasting to deliver revenue growth, that's in the high-single digits.

So, as you project forward really into fiscal 2015, it's not too much of a stretch to see how we can achieve the target business model, given the integration plan that we've just outlined, given the growth rates that we're potentially forecasting for fiscal 2014, and given some of the things they talk about from a program perspective. So, look. We're trying to give you some perspective on the -- what we see, the outlook for the business being going forward in the context of the integration plans. And obviously, as we exit this fiscal year, we'll give firmer guidance for fiscal 2015. But we're just trying to put in context what we see and the net result of the actions that we're taking.

Yes -- no. And it's definitely appreciated to kind of lay something out for us as we start thinking about fiscal 2015. But you know, when you think about your comfort level, I mean, do you still run the business pretty conservatively today until you see maybe a little bit more improvement? Or are you at the point where you think you can be a little bit more aggressive going after those book-and-ship type orders?

Well, we must be feeling somewhat better, because we're kind of returning back to full-year guidance. And the guidance that we're giving for Q3 is higher than the guidance that we've given for probably the last three or four quarters. So, yes, I mean, I think we do anticipate that we're going to see higher growth in revenues and substantially higher bookings in the second half.

Are we going to let that all flow through to the top line? Probably not. We still want to continue to grow the backlog. But we're probably prepared to take a little bit more risk than what we have done over the past several quarters.

Got it. Okay. Well, I do appreciate that commentary. And maybe just moving to one other item. If you look at the R&D spend this quarter, it was up a bit, quite a bit on a year-on-year basis and up sequentially. And if we look at achieving the target business model in 2015, it's going to grow quite a bit next year as well. So, how do we think about that in context with the kind of some of your commentary in regards to the reduction in R&D?

Yes. So we're not going to get into the specifics at a line item detail level, Tyler, for fiscal 2015. Because again, what we're trying to do is really provide more context around how it is that we can get back to the target business model, not necessarily give you guidance on each and every line item.

I think net-net, we feel like we've made a very small reduction on a net basis to the hedge in engineering. What we are going to do is actually add back in certain areas where we see the potential for growth. And I think much of that is in the RF and micro space; whereas -- where we see the potential for our customers transitioning to a better alternative supplier, which is the way in which we positioned the Company. So, we feel can we get back to the target business model? We believe that we can under a reasonable set of growth assumptions, given the actions that we've taken. But I don't want to get into too much detail regarding the specific expense line items.

Makes sense. Well, that's all I had. So thanks a lot.

Peter Arment, Sterne, Agee.

Hey, Mark, I hate to circle back on this 10% growth kind of number that you put out there, but I just want to -- another way of looking at it is that -- does it seem like you're getting -- you're just going to get better lift from some of these core programs you outlined? And we haven't really -- that's not really even factoring in kind of the -- ultimately, the share gains that you're going to get from this new -- the new AMC centers and all the efforts that you're putting out there for longer-term.

Yes, so it's a continued rebound in the core processing part of our business, which was somewhat depressed during fiscal 2013. And clearly, we've started to see a rebound there and some pretty good growth. But, in particular, as I outlined earlier, we have got some programmatic drivers as well, with various programs at different stages that are transitioning, as well as different funding profiles of programs that we think can have an impact next year.

So, yes, so I think it's a mix of different things. But when you look at the growth rates at the high end of our H2 forecast, which is 10% -- which is really what we delivered in H2 of fiscal 2013; or for full-year fiscal 2014 being in the high-single digits, it's really not too much of a stretch to look out an additional 10% as we move into fiscal 2015. So, again, directionally, we are trying to give you a perspective on how and when we might achieve that target business model, versus what it potentially could have looked like prior to the second and final phase of our integration activities.

Okay, that's appreciated very much. Kevin, did you mention the -- what the international sales were in the second quarter? I thought I wrote down 16%. Was that the right number?

Yes, correct.

Yes. So bookings were actually -- bookings this quarter were 48%. International and defense bookings were 48% of total defense bookings in the quarter. And international and defense revenues were 16%, as Kevin said, of defense revenues.

Yes, Mark, how do you see the international sales mix transitioning for the full-year 2014?

Well, so we haven't broken it down in terms of giving guidance, but I think we are seeing strength in foreign military sales. Internationally, in this quarter, it was being driven by the F-15 EW upgrades. It was driven by Aegis. I think going forward, we think that Patriot is going to be a strong contributor in foreign military sales.

The only challenge that we see there is that they're actually notoriously difficult to predict the timing of them. So, I think they're going to continue to grow, because I think we are well-aligned with our customers as they're pursuing growth overseas. But I'm not going to go out on a limb and forecast fiscal 2014 from an international and defense perspective at this time.

Okay. That's all I had. Thanks for all the color.

All right, thanks.

Mark Jordan, Noble Financial.

A question relative to your guidance on 2015. Does the obtaining the business model, does that include or exclude the restructuring charges that you will flow through in 2015?

Mark, that would exclude them.

Okay. And if I'm looking at the right presentation, is the business model for operating income 12% to 13%?

Correct.

Yes, I think we are more thinking along the adjusted EBITDA lines, which is kind of the metric that we are using.

Okay. And that was -- if I'm looking at the right target, 18%-plus?

Correct.

Right.

Okay. Looking at the -- your guidance for this quarter, I guess for -- or last quarter, you had about a $6 million spread, given a lot of the contractual nature of your business. Is that wider range a function of the incremental book-and-ship business that can come? Or is that dependent upon last-minute adjustments of delivery schedules by your customers?

So, it's more the latter, but the range hasn't actually changed. We've kept with the same spread, as you called it. And it's been that way for probably four quarters now?

Yes.

-- or more. The guidance range is consistent, Mark.

Okay. And looking at the savings that you expect to be able to realize in 2015 with the restructuring, will those be spread equally through the year? Or weighted in one period or another?

They are spread out throughout the year according to the actions that take place. So, at this point, we're not going to get into the specifics of what actions in what quarter. We'll really -- we feel it will guide that on a quarter-by-quarter basis. But we've given you the high level savings on a per year basis for you to kind of put your models together.

And also, as we mentioned earlier, Mark, the actions we took in Q3 of the $16 million of annualized savings, $9 million of it has already been achieved from the actions we took in Q3. So we've got a good chunk of it done right away. And as Mark said, we've got a phased approach going forward in terms of the remaining actions and the associated savings.

Thank you very much.

Brian Ruttenbur, CRT Capital.

Very encouraging. A couple of quick questions. In fourth quarter 2014, what were the level of charges that you stated? Were there any?

Yes, we had -- we said -- well, you can kind of -- it's $1.5 million we are anticipating in Q4 for a total of (multiple speakers) --

Okay. That was perfect. I just wanted to make sure there was a lot of numbers getting turned around. And then the charges in fiscal 2015, what were the total on that? What was the total on that -- excuse me?

It's estimated to be about $4.2 million.

And how is that? By first-quarter, second quarter or is there equal? Or is it all front-end weighted?

Yes, we're not going to -- Brian, we're not going to get into that level of detail at this point. I think it's -- as we get closer to the end of this fiscal year, we'll get into 2015 -- fiscal 2015 guidance with more clarity.

Okay. So as I understand fiscal 2015, what you stated is, high-single digit growth, charges of around $4 million; gross margins should go back to ideal, which is in the high 40s. SG&A should drop by how much in 2015? I heard 2016 but I didn't -- it was a little confusing how much 2015 was going to drop by.

So, the gross savings in fiscal 2015, approximately $9 million. So -- but again, what we're not doing here is kind of guiding exactly what our expense structure is going to be, because we are going to have some potential add-backs between now and then. So, net-net. if you look at the -- what we are assuming on the top line, and then what we said is we feel like we can achieve our target business model for fiscal 2015. So, we're not going to guide the individual line items, Brian, because we're trying to give a framework and context of the integration plan, not specifically give 2015 guidance on this call.

Great. Thank you very much.

Sheila Kahyaoglu, Jefferies.

Nice progress and clearly some productivity. How are you ensuring that you're keeping the cost savings and you're not giving it back to the customer?

So, we actually feel pretty good about that, Sheila. I think, as we've talked about in the past, a measure of the value that we deliver to our customers is really in the gross margin line. And I think we've historically, in the processing part of the business, had very strong gross margins.

We're not seeing a ton of pressure there, largely because I think the economic benefit to our customers is where they outsource more work to us as an engineering level, and we can do it much more quickly and much more cost-effectively. And so, in essence, we are a commercializing company. We're selling off a commercial pricelist, and we are investing heavily in the R&D. And our customers are getting the benefit of it.

Great, thanks. And can you provide us an update on timing of SEWIP Block 3? And perhaps a reminder of what your current content is on the Block -- on Block 2? And if you're expecting any additional content there?

Yes. So, Block 3, I think the timing at this point is that the award is likely going to be made in the second half of this fiscal year for us. So, over the next six months. And from a content perspective on SEWIP Block 2 and Block 3, we kind of laid that out in detail in our Investor Day presentation in November. And things haven't changed since then, Sheila.

Are you bidding on any additional content there? Or is that -- it's sort of it?

So, we -- I mean, we are always looking for new business. And -- but I think the content expansion opportunities that we've been pursuing are laid out in the investor presentation in November.

Sounds good. Thank you very much.

Okay. Thanks, Sheila.

All right, Sheila. Thanks.

Thank you. And Mr. Aslett, it appears that there are no further questions. Therefore, I'd like to turn the conference back over to you for any closing remarks.

Okay. Well, thank you for your interest in Mercury. We enjoyed the call. Look forward to speaking to you next quarter. Bye bye.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect and have a wonderful day.