Mercury Systems Inc (MRCY) 2019 Q3 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems Third Quarter Fiscal 2019 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 Executive Vice President and Chief Financial Officer Mike Ruppert.

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 mrcy.com.

The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations.

Please turn to Slide 2 in the presentation.

Before we get started, I would like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's financial outlook, future plans, objectives, business prospects and anticipated financial performance.

These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially.

All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2, in the earnings press release and the risk factors included in Mercury's SEC filings.

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 also discuss several non-GAAP financial measures; specifically, adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue and acquired revenue.

A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release.

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

Please turn to Slide 3.

Thanks, Mike.

Good afternoon, everyone, and thanks for joining us.

I'll begin by providing a business update.

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

Mercury delivered strong results in the third quarter of fiscal 2019, including record bookings, backlog, revenue, adjusted EBITDA and adjusted EPS.

We continue to execute strategically by building new capabilities, growing organically and supplementing organic growth with strategic M&A.

We closed on the acquisition of GECO Avionics early in Q3, and on April 18, we completed the acquisitions of Syntonic Microwave and the Athena Group, which expand our capabilities in electronic warfare as well as embedded security.

Mercury has been successful delivering high single-digit to lower double-digit organic revenue growth which we supplemented with M&A.

Over the past 3 1/2 years alone, we've completed 10 acquisitions, deploying nearly $700 million of capital.

As a result, over the last 4 fiscal years, we've grown total company revenue and adjusted EBITDA at compound annual growth rates of 24% and 51%, respectively.

This model of strong margins and high organic revenue growth supplement with disciplined M&A and full integration is the embodiment of our strategy.

We believe this strategy will continue to generate significant value for shareholders over the longer term.

Looking at fiscal '19, we are raising our full year revenue and adjusted EBITDA guidance and now expect 10% to 11% organic growth for the year, 3 to 4 percentage points higher than fiscal '18.

Turning to our Q3 results on Slide 4. We produced record revenue, which increased 50% in total and 31% organically year-over-year.

Our largest revenue programs in the quarter were for next-generation missile system, WIN-T, SEWIP, F-35 and Filthy Buzzard.

Our bookings momentum remains strong.

Total bookings for Q3 increased 26% year-over-year, leading to a record backlog, which was up 30%.

Our largest bookings this quarter was a $41 million order for an advanced weapons application, another example of how weapon systems replenishment and modernization are adding to our growth.

Our RF and digital product lines continue to do well.

We received a $25 million booking for SEWIP, the next production order for that program.

We also booked orders [Aegis], Filthy Buzzard, Reaper and CPS.

Mercury is continuing to deliver strong levels of profitability, with adjusted EBITDA up 55% from Q3 of fiscal '18.

Free cash flow also increased substantially, coming in at 49% of adjusted EBITDA.

Turning to Slide 5. We're in the most favorable defense funding and industry growth environment I've seen since joining Mercury.

This is leading to a high level of new program starts and design win activity.

Since fiscal 2013, we've seen the estimated lifetime value of our top 30 programs and pursuits grow more than 4.5x.

This growth reflects our M&A strategy and the impacts of three industry trends that we discussed in the past.

These trends include supply chain delayering by the government and the primes, the flight to quality suppliers by the primes and, most important, increased outsourcing by our customers at the subsystem level.

We continue to see outsourcing as the largest secular growth opportunity in defense.

Mercury is also strongly positioned in well-funded defense budget priorities.

These include radar and EW modernization, avionics and mission computing upgrades, and weapon systems as well as C4I.

We're beginning to see significant design win opportunities in the missile defense domain with upgrades of ground-based radars.

We're seeing EO/IR system upgrades associated with new A2AD capabilities.

We're seeing opportunities in C4I related to rugged servers and avionics.

That's significant activity in EW associated with emerging threats.

We're also seeing more opportunity in the smart munitions and space domains.

We've been investing in these areas for several years now.

Our customers are now responding in kind, and they're supplementing our own internally funded R&D with R&D of their own.

As a result of the substantial combined investment, we've been able to rapidly adapt our commercially developed technologies to these new and emerging opportunities.

The trends we are seeing are supported by recent increases in defense appropriations, authorizations and outlays.

We clearly see an increase in investment account spending that prioritizes modernization and next-generation technologies and capabilities, which, in turn, favor Mercury.

We continue to take share from competitors for multiple reasons.

First and foremost is the uniqueness and strength of our high-tech business model.

Mercury is rapidly becoming the leading conduit for commercially developed technologies for use inside of the defense industry.

We're also taking share because of the strength and uniqueness of the channel we created and the partnerships we're developing with our customers and other technology companies.

Both our target markets, Sensor and Effector Mission systems and C4I, continue to grow faster than the defense market overall.

Sensor and Effector revenue accounted for 60% of total revenue in Q3, increasing 48% from the third quarter last year.

In C4I, revenue increased 74% year-over-year to 26% of total revenue.

As you can see on Slide 6, we make solid progress on our strategic plan during the third quarter thanks to an outstanding effort by the Mercury team.

From an operations perspective, we've been strategically focused over the past 5 years on building out our own domestic manufacturing capabilities.

We're now on a multiyear journey to optimize these assets, which include our trusted digital SMT manufacturing facility in Phoenix.

Our goal is to improve both working capital efficiencies and the manufacturing operations themselves over time.

We're still in the early stages, and with Amir Allahverdi leading this effort, we're beginning to make progress.

The build-out of our West Coast RF manufacturing location is progressing and we expect to complete the consolidation activity early in the new fiscal year.

We continue to make good progress integrating Themis and Germane and migrating both businesses to Mercury Systems and processes.

The full integration is on track to be completed by fiscal year-end, and the new leadership team is doing an outstanding job.

From an operations and financial perspective, the performance of the combined business is solid.

The GECO Avionics integration is underway and on track as well.

The team is happy to be part of Mercury, and the combined business has already generated some interesting new growth opportunities.

Turning to our R&D strategy.

We believe that more of the technology that goes into U.S. military platforms will need to be designed and produced in the U.S. We're pursuing this opportunity by investing significant R&D to develop secure hardware and software technologies domestically.

Looking forward, our business outlook remains strong, driven by high levels of new design win activity and opportunities for future growth.

Over the longer term, our baseline forecast is for overall defense spending to increase at low single-digit rates.

Mercury's goal is to continue delivering organic revenue growth at a rate that exceeds this industry average.

We're also well positioned to continue supplementing a high level of organic growth with smart, strategic M&A.

The M&A pipeline is very robust right now.

We continue to see interesting opportunities of varying sizes that are consistent with our strategy.

In line with that strategy, the recent Athena Group and Syntonic Microwave acquisitions will further strengthen our customer offerings.

The all-cash total purchase price for the 2 transactions was $46 million, funded through our existing revolving credit facility.

As outlined on Slide 7, the Athena Group is based in Gainesville, Florida, and specializes in cryptographic and countermeasures IP vital to securing defense computing.

They're a world leader in differential power analysis, or DPA, with a broad portfolio of solutions designed to mitigate reverse engineering attempts on mission-critical systems.

We have a long history of collaboration with Athena in protecting these systems on surface, subsurface, ground and airborne platforms.

Adding Athena's strong capabilities will expand Mercury's security IP portfolio and extend our leadership in secure embedded computing.

Syntonic Microwave is based in Campbell, California.

They specialize in advanced synthesizers, wideband tuners and microwave converters for EW applications.

Syntonic delivers a unique combination of modularity, configurability and rapid prototyping.

This makes their portfolio well suited to address the industry's rapidly evolving needs.

We believe Syntonic's [deep] domain expertise and agile RF technology will strengthen Mercury's position as a leading supplier of high-performance EW subsystems while enabling us to penetrate other markets.

We're very pleased to welcome the Athena and Syntonic teams to the Mercury family.

Looking forward, we intend to remain active and disciplined in our approach to M&A, focusing on the Sensor and Effector Mission Systems and C4I markets as we have in the past.

We'll continue to look for deals that are strategically aligned, have the potential to be accretive in the short term and promise to create long-term shareholder value.

Turning to Slide 8. Mercury remains on track for another year of strong performance in fiscal 2019.

Our strategy and business model are working extremely well.

We're growing the business substantially faster than the industry overall.

Our plant manufacturing and M&A integration synergies are materializing.

We're expecting another year of double-digit growth in revenue and adjusted EBITDA as well as strong cash flow generation.

We remain confident that we can achieve the high end of our model over time by continuing to execute our plans in five areas.

First is to drive high single digit low double-digit organic revenue growth supplemented by acquisitions.

This is consistent with a 20%-plus compound annual growth in total company revenue we've delivered over the last 4 fiscal years.

The second is to invest in new technologies, our facilities, manufacturing assets and business systems.

We'll also continue to invest heavily in our people.

Mercury's become a destination employer and an acquirer of choice.

Our ability to attract and retain the talent we need to support our growth has never been better.

Third is manufacturing insourcing as well as driving stronger operating performance across our manufacturing locations.

The goal here is to enhance margin and on-time delivery while improving working capital efficiencies over time.

Four.

We're seeking to grow operating expenses more slowly than revenue, creating stronger operating leverage in the business.

And finally, we're fully integrating the businesses we acquire to generate cost and revenue synergies.

These synergies, combined with the other areas of the plan, should continue to produce attractive rates of return for our shareholders.

During the third quarter we also strengthened the leadership team.

[Stephanie Georges] has joined Mercury as our new chief marketing officer.

Stephanie brings a wealth of experience in all marketing disciplines as well as corporate strategy, and I'm thrilled to have her aboard.

In summary, given our top and bottom line results in Q3, our record backlog and our current business outlook, we expect to report continued strong performance in the fourth quarter.

We're again raising our full year fiscal '19 guidance, and Mike will take you through those numbers in detail.

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

Mike?

Thank you, Mark, and good afternoon again, everyone.

Q3 was a record quarter for Mercury in terms of bookings, revenue, adjusted EBITDA and adjusted EPS.

Operating cash flow and free cash flow were strong.

We concluded the quarter with a book-to-bill of 1.09 and record backlog.

Organic revenue for Q3 was up 31% year-over-year.

We now expect organic revenue growth for fiscal '19 of 10% to 11%, up from our previous guidance of 9% to 10%.

We're anticipating strong financial performance in the fourth quarter, and increasing our fiscal '19 guidance for revenue, adjusted EBITDA and adjusted EPS.

In addition to organic growth, our focus on acquiring businesses that fit with our strategy and integrating them into Mercury is delivering results as planned.

As Mark said, Germane and Themis are performing well on the top and bottom lines as we continue to integrate both acquisitions.

The GECO Avionics integration is also on track.

The acquisitions we announced on April 18, Athena and Syntonic, are further examples of our ability to identify strategic companies that differentiate Mercury and to work efficiently with owners to complete transactions.

We believe this capability has created and will continue to create significant value.

The pipeline of new opportunities that fit with our strategy is robust, and we anticipate continued M&A activity going forward.

Turning now to Slide 9, and our Q3 results.

Mercury's total bookings increased 26% year-over-year to a record $189.7 million, driving a 1.09 book-to-bill ratio.

Year-to-date, our book-to-bill is 1.13.

We ended the quarter with record backlog of $558.2 million, up 30% from Q3 fiscal '18.

Backlog expected to ship within the next 12 months increased to $367.3 million.

Q3 was another strong quarter for revenue growth.

Total revenue increased 50% year-over-year to a record $174.6 million, exceeding the top end of our guidance of $162.7 million to $167.7 million.

This out-performance reflects the continued acceleration in new program starts as well as increased customer-funded R&D, or CRAD.

Gross margin for the third quarter was 42.3%.

This compares with our guidance of 43.6% to 44.1% and gross margin of 45.4% in Q3 last year.

The decrease from last year is largely due to the inclusion of Germane Systems, program mix and increased CRAD.

As we've discussed on previous calls, new programs and CRAD tend to have lower gross margins than the rest of our business, but they accelerate our revenue near term and bode well for sustainable future growth.

They are the precursor to the high margin annuity revenue streams we will see as these programs transition into low rate and then full rate production over time.

Internal R&D expense was $17.4 million in Q3, or 10% of sales.

This compares to 12.9% for the same quarter last year, again driven primarily by the impact of CRAD, where we are getting paid by our customers to customize solutions.

On a dollar basis, IRAD was up sequentially by $1.2 million from Q2.

In the fourth quarter, we expect IRAD spending to increase from 10% of sales in Q3 to the low end of our target business model range of 11% to 13% of sales.

SG&A for Q3 increased 29.7% to $27.4 million from $21.1 million last year, driven by the inclusion of Themis, Germane and GECO as well as the organic growth in the business.

As a percentage of sales, SG&A was 15.7%, down from 18.2% in Q3 fiscal '18.

This decrease highlights the operating leverage we're creating as we continue to grow sales faster than expenses.

In the fourth quarter, we expect SG&A to increase from 15.7% of sales to near the midpoint of our target business model of 16% to 18% of sales as we continue to invest in growing the business.

GAAP net income and GAAP EPS in the third quarter increased by 282% and 263% year-over-year, respectively.

Adjusted EPS for the third quarter was $0.50 per share, up 67% from $0.30 per share for Q3 last year.

Adjusted EBITDA for Q3 increased 55% year-over-year, to a record $38.8 million, exceeding our guidance of $34.8 million to $36.8 million.

Adjusted EBITDA margin was 22.2% for the quarter.

This compares to 21.6% in Q3 fiscal '18, and exceeds our guidance of 21.4% to 21.9%.

Finally, free cash flow, which we define as cash flow from operations less capital expenditures, was $19.2 million, an increase of $21.8 million from Q3 last year.

Slide 10 presents Mercury's balance sheet for the last 5 quarters.

We concluded Q3 well positioned to continue executing on our capital deployment strategy, supporting future growth organically and through acquisitions.

Driven primarily by Mercury's strong free cash flow, cash and cash equivalents at the end of Q3 totaled $112.5 million, up $18.6 million from $93.9 million at the end of Q2, and up $68.3 million from $44.2 million in Q3 last year.

Inventory in Q3 increased by $5.3 million quarter-over-quarter, and inventory turns were up.

Accounts receivable increased by $2.4 million quarter-over-quarter, and DSOs improved.

As Mark said, with the completion of the Athena and Syntonic acquisitions, we've now completed 10 transactions, deploying nearly $700 million of capital in the past 3 1/2 years.

At the same time, we've maintained flexibility and good access to capital.

Prior to this month's 2 acquisitions, at the close of Q3, we had $276.5 million of debt.

Post the transactions, which we funded under our revolver, Mercury now has $324.5 million of debt, or approximately 1.5x net debt to adjusted EBITDA.

Turning to cash flow on Slide 11.

Free cash flow for Q3 was $19.2 million, representing 49% of adjusted EBITDA.

For the first 3 quarters of fiscal '19, free cash flow was at 50% of adjusted EBITDA and up 712% from the same period in fiscal '18.

Operating cash flow for the third quarter increased to a record $26.2 million from $0.9 million in Q3 last year.

Working capital was a $5.8 million use of cash compared with a $3.4 million use of cash in Q2, and a $17.5 million use of cash in Q3 last year.

Working capital as a percentage of sales decreased year-over-year, reflecting operational improvements and acquisition integration.

Capital expenditures in Q3 were $7.1 million or 4% of revenue, and $17.9 million or 3.7% of revenue for the first 3 quarters of fiscal '19.

We expect CapEx to increase in Q4 as we continue to integrate recently acquired businesses.

I'll now turn to our financial guidance for Q4 and the full 2019 fiscal year.

This guidance includes the impact of Syntonic and Athena as well as GECO Avionics.

Starting with fiscal '19 on Slide 12.

Our guidance reflects both strong organic growth and recent acquisitions.

For the full fiscal year, we now expect revenue of $642 million to $651 million, representing growth of 30% to 32% from fiscal '18.

The increase from our previous guidance reflects our outlook for 10% to 11% organic growth.

Consolidated gross margin for fiscal '19 is currently expected to be 43.3% to 43.5%, reflecting new design win activity, more new program starts in the mix and recent acquisitions.

Looking ahead as I said earlier, this higher level of new development activity sets the stage for growing annuity revenue streams as these programs move toward full rate production.

Consolidated operating expenses for fiscal '19 are expected to be $203.4 million to $205.9 million, including an estimated $27.2 million of amortization expense.

As mentioned on our call last quarter, we continue to invest in the business for the rapid growth that we are experiencing.

In Q4, we expect to increase R&D and SG&A spend to position the business to take advantage of the growth opportunities that Mark discussed.

In Q3, we exceeded the high end of our adjusted EBITDA guidance by $2 million.

Our strong financial results through the first 3 quarters allow us to invest for the future while still raising our full year guidance for adjusted EBITDA.

Interest expense for fiscal '19 is now expected to be approximately $9.1 million.

This reflects the estimated additional debt associated with GECO for 5 months and Syntonic and Athena for approximately 2 months.

Total GAAP net income on a consolidated basis for fiscal '19 is expected to be $45.2 million to $47.4 million or $0.95 to $0.99 per share.

Adjusted EPS is expected to be in the range of $1.79 to $1.83 per share, an increase of 26% to 29% compared to fiscal '18 results.

Our fiscal '19 guidance for adjusted EBITDA is $141.5 million to $144.5 million on a consolidated basis or 22% to 22.2% of revenue.

This is an increase of 24% to 26% from fiscal '18, and up from our previous guidance.

We expect adjusted EBITDA margins to increase over time as we integrate our recent acquisitions and recognize the anticipated synergies.

In addition, we expect to gain further operational efficiencies and we anticipate continued improvement in operational leverage as revenues grow.

Finally, we expect CapEx or fiscal '19 to be approximately 5% of revenue.

This is up from approximately 3% last year, primarily driven by continued investment in the consolidation of our West Coast RF manufacturing locations.

I'll now turn to our fourth quarter guidance on Slide 13.

Doing the math based on our actual results for the first 3 quarters, we're forecasting consolidated total revenue in the range of $164.2 million to $173.2 million, an increase of 7% to 13% compared with Q4 last year.

Q4 gross margins are expected to be 43.6% to 44.5%.

The decrease from Q4 this year is primarily driven by lower margin revenues from our Germane and GECO acquisitions.

Q4 GAAP net income is expected to be $11.3 million to $13.4 million or $0.23 to $0.28 per share.

Adjusted EPS is expected to be $0.42 to $0.47 per share.

Finally, adjusted EBITDA for Q4 is expected to be $34.1 million to $37.1 million, representing approximately 20.8% to 21.4% of revenue.

Turning to Slide 14.

In summary, Mercury's Q3 was another excellent quarter with great operating results across the board.

We delivered record bookings, backlog and revenue, and our organic growth was strong.

We've completed 3 strategic acquisitions in the last 3 months.

And our M&A pipeline continues to be robust.

As a result, we expect strong Q4 and fiscal '19 performance, and we're raising our full year guidance.

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

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

(Operator Instructions) And our first question is from Pete Skibitski from Alembic Global.

Nice quarter.

On the West Coast consolidation, you mentioned it'll end soon.

Can you reemphasize, that's largely a margin expansion play?

And then when it is done, can we expect CapEx to decelerate pretty meaningfully next year?

So the consolidation that we're doing is really part of our full integration strategy.

We did something very similar on the East Coast when we completed a number of acquisitions there, also.

And so what we seek to do is to try and consolidate our footprint and then invest in the facilities to create more scalable automated manufacturing capabilities.

So that's the plan.

We're seeking to actually complete the consolidation or the build-out and then the consolidation of the facilities early in the new fiscal year and, after which, CapEx for that specific acquisition integration should go down.

However, we've got other acquisition integration activities underway as well.

Okay.

Yes.

And, Pete, I would just add that we've said historically that our maintenance CapEx is about 3% to 4% of revenues.

We've talked about 5% for this year.

And as Mark said, what really drives the expansion CapEx is the integration of our acquisitions.

Got it.

Understood.

Okay.

And then last question.

We're approaching your fiscal '20.

And I'm just wondering how much you guys are concerned if we get a CR for DoD into maybe calendar 2020, should we think about that having any impact to your fiscal '20?

Or is the backlog so good and the trend so good that, that maybe would be more of a fiscal '21 impact for you guys?

So hard to tell exactly what might happen.

I think our operating assumption right now is that it's likely going to be a 3-month CR.

We've heard that it may go longer than that; so a little too early to tell.

We are obviously very pleased with the bookings performance.

We've got another record backlog that was up 30% this quarter.

So we are in a good position.

But we're not really going to talk about fiscal '20 from a guidance perspective.

We're going to wait until our Q4 quarter to do that.

Our next question is from Greg Konrad from Jefferies.

I was just hoping, seeing if you could maybe quantify the contribution from Athena and Syntonic or at least from a run rate perspective and how that kind of equates to the expected Q4 organic growth rate.

Yes.

So in terms of Athena and Syntonic, we did not announce the amount of the revenue or contribution for the fiscal year or for Q4.

What we did say when we announced the transactions is that we don't expect them to be material to either Q4 or fiscal '19.

We've only owned them for about 2 months, and they are smaller acquisitions.

We think they fit incredibly well.

And as Mark went through in his prepared remarks, we think there's a large opportunity to create value.

But from a financial perspective this year, it's minimal.

And then just from the financing, I mean I think you said in the release that it would be paid for with existing credit facility.

And I think you ended the quarter with maybe $112 million in cash.

I mean how should we think about debt to end the year versus kind of that cash buildup at least from the beginning of the year?

Yes.

So right now, following the acquisitions of Syntonic and Athena, we have $324.5 million of debt on our balance sheet up from where we were at the end of the quarter.

And you're right, we have $112.5 million of cash.

One of the things we talked about in our prepared remarks was the pipeline we have around M&A.

And we see a lot of opportunities in front of us.

So we'll evaluate our capital structure, what we do with our cash as we go forward.

But we're always trying to keep an eye on the flexibility to take advantage of the M&A pipeline that we see.

I'm just going to sneak one more in there.

In terms of CRAD, you mentioned growth year-over-year.

Maybe can you talk about where you're seeing the largest customer investments?

And when we think about the development timeline on the CRAD, maybe how quickly that kind of materializes into maybe more sustainable programs?

Thank you.

Yes.

So CRAD was actually up 46% in the third quarter.

So we continue to see some pretty substantial growth there.

And as we talked about, that is supplementing the significant investments that we're making.

In terms of the market segments where we're seeing opportunities to work with our customers, it's really related to I would say three major areas.

The first is in EW modernization.

The second is in radar modernization.

And the third is in the weapons system arena.

Our next question's from Seth Seifman from JPMorgan.

Good quarter, and good afternoon.

Just wanted to ask, I think maybe two kind of quick questions.

First, certainly appreciate the growth in CRAD and kind of how it feeds the future.

The gross margin guide for the fourth quarter is for a kickoff.

Is that due to some of that CRAD work starting to move toward production?

Or would you say that there's a reasonable opportunity that you'll continue to see maybe more of that come than expected?

And what's kind of the timeframe over which that moves toward production?

Yes.

So my take just based upon the environment is that we're going to continue to see increased CRAD from the customers.

The RDT&E line in the budget was up quite substantially.

They're clearly trying to focus on next-generation technology investments.

And we're seeing the same thing for the customers.

So I think that trend towards new capabilities will continue.

It's hard to predict exactly what that will be kind of as we look forward to next fiscal year.

But I do think the trend is towards more activity rather than less.

From a timing perspective, with respect to some of these programs, they're all at very different stages with respect to as they transition from the prototype or EMD phase into LRIP.

But we do think that when those programs do transition, that the margin profile of those annuities will be higher than the margin associated with the engineering efforts today.

Yes.

And Seth, I would just add, we have program mix every quarter that causes up and downs.

And you're right, our Q4 guidance is an uptick from where we were this quarter.

But if you look back at the last couple of quarters, you see our gross margins fluctuate a bit; they were 44.6% in Q2.

So it's really just program mix that you're seeing; whereas, over time our gross margins have been relatively consistent.

Great.

Thanks.

And then I don't know if there's any additional color that you guys can give about the M&A pipeline in terms of where you're seeing the most opportunities and whether there are some larger opportunities as well as kind of smaller ones?

Yes.

So I would say it's extremely active right now.

It's probably the busiest that we've seen it for quite some time.

I think the opportunities that we're looking at play very much into the themes that we've discussed in the past.

We've got a number of those kind of going on in parallel.

The first is in the C4I domain where we continue to see opportunities around rugged servers.

We've got an active theme around avionics processing and capabilities in mission computing where we see some opportunities.

And then we're also continuing to see opportunities in the security and the RF domain.

So those are the areas that we're continuing to look at.

And there's obviously a lot of other things that we get to see just given how inquisitive we are.

We pretty much get to see most of the opportunities that are out there today.

So we're quite pleased with how we're positioned and our ability to execute, Seth.

Our next question's from Michael Ciarmoli from SunTrust.

Real nice quarter.

Just to pick on the gross margins a little bit.

I mean the level they were at, a multiyear low, I mean you've got the target model out there 45 to 50.

And I get investing in the annuity programs.

But clearly as you alluded to, Mark, and the DoD is investing, the R&D budget was up significantly, the big primes are kind of feeling the pressure of new verse legacy mix.

Is there any danger that on top of taking more CRAD for a maybe longer sustained environment, does the pricing environment get any more challenging for you?

I mean did your customers try to slide any of that downhill as they look to shore up their margins?

Or how should we be thinking about that?

Yes.

Look.

I mean we always work with our customers to try and be as competitive as we can and to help them as they're trying to win more business.

One of the big things that we're doing, as you know, is really leaning in on the IRAD side.

And we're kind of partnering with our customers on these next-generation programs.

And they're, in effect, supplementing our R&D or high levels of R&D with moneys of their own to try and position themselves well to win new programs.

So I think it's a very positive environment right now.

I mean you can kind of see that in the level of growth that we're delivering organically as well as a total company.

And as I said in the prior answer, I don't really see that slowing down in the short term.

Mike, I don't know if you want to add anything there?

Yes.

Mike, I would just add that as I look at the business, I start by looking at the EBITDA margins because the CRAD increases that we've seen cause shifts between COGS and IRAD that impact the gross margin, and we've discussed that.

But they're offset at the EBITDA line.

And so at the EBITDA level, we've been relatively consistent over the last couple of years.

We were 23% in '17, 23% order of magnitude in '18.

This year, the midpoint of our guidance is a little over 22%.

And the primary driver of that reduction is our acquisitions of Germane and GECO; that's about 1%.

So if you exclude those, our acquisitions, we'd be about 23% EBITDA margin, so in line with fiscal '17 and fiscal '18.

And as Mark said in his prepared remarks, as we look at EBITDA, we see the opportunity over time to achieve the high end of our target business model for all the reasons that he mentioned.

And so specifically on gross margins, we are seeing, because you see that offset at the EBITDA level, it really is the acquisitions, Germane and GECO, are about 1.5% impact on gross margins, but then the rest of it is CRAD.

And because of the offset to R&D, we're still in our target range on the EBITDA margin line.

Got it.

That's helpful.

And then maybe just on the program side, maybe one on a big one for you guys, just how do you think about the F-35?

Seems clearly the DoD doesn't one to procure as many.

I know that's been a big program for you.

And then on the flipside, maybe new pursuits, sensor is what could be a very big radar program with [Spadoc] and Hypersonics and perhaps a new kill chain.

Are some of these booking awards or design wins that you're seeing related to some of those new opportunities?

So the answer is yes.

So I think our position on the F-35 is pretty strong.

We continue to win more content on the program overall, particularly in the RF domain where we won additional content for radar as well as this quarter we actually took additional share for RF, for EW applications.

As I step back and kind of look at the marketplace, I do think there is significant opportunities associated with radar upgrades in really two different areas.

The first is associated with missile defense.

And there are, I think there some significant opportunities for either new ground-based radars or upgrades to existing ground-based radars that we are participating in.

The other is obviously the shift towards more [ether] radars for both airborne-ground and naval applications.

And there's at least four, five, maybe six opportunities that we see right now that are well underway.

And so that is definitely a driver of some of the CRAD activity.

And we do think it bodes well just given our capability set.

The other areas that I would say are important in terms of modernization activity, is around EW.

We're kind of beginning to see that shift towards more cognitive and adaptive capabilities.

In EO/IR, we're seeing new advanced processing architectures starting to income online to be able to add more machine learning capability.

In C2I, we're participating in processing architectures associated with adding AI capabilities.

So we really like the positioning that we have as this modernization activity continues across multiple different sensor domains.

Got it.

And then, are you guys on or working with Lockheed and Raytheon SENSR, the Spectrum Efficient National Surveillance Radar program, which could be the largest radar program ever?

I mean are you guys working on that one?

So I'm not going to speak specifically to that, Mike.

It's in the early stage and is obviously still competitive.

But we do think that our technology suite, particularly given the very high performance, server class products that we brought out, and now with the rackmount rugged servers that we have with Themis and Germane, we're very well positioned for future upgrades.

(Operator Instructions) And our next question's from Jonathan Ho from William Blair and Company.

This is John Weidemoyer for Jonathan Ho.

Just wondering, to the extent you're at liberty to discuss, when you mentioned in your presentation the new growth opportunities with GECO Avionics that you identified, could you speak to any of that?

Yes.

I won't mention the specific platform.

But I think we've had multiple conversations with customers that are interested in their capability set technologies that combined with Mercury.

And it's largely targeted at airborne upgrades, John.

Okay.

Great.

And I'm wondering, you mentioned that you have your robust pipeline for acquisition activity and you mention it looks like multiple percentage points of growth augmentation in your outlook going forward to achieve like 20% total growth, including acquisitions.

I'm wondering what kind of a run rate do you kind of view that as?

Is that like the next year or two?

Could it be even longer than that?

Just trying to get a sense as you guys grow from your prior activity, and you've done quite well, just wondering if it's robust enough to go even out into 3 to 5 years, that kind of thing.

Yes.

We believe so.

I think if you look at over the last 4 fiscal years, we've grown total company revenue at a compound annual growth rate of 24%, and that includes high single-digit, low double-digit organic growth.

As you mentioned, we supplemented with M&A.

The M&A pipeline's pretty robust.

I think the market size, our addressable market is large enough for us to continue what we've been doing for the last 4 or 5 years where we've created a tremendous amount of volume.

So that's really the strategy that we have laid out and that we're executing against, and that we're going to seek to continue to do.

Mr. Aslett, it appears there are no further questions, therefore, I would like to turn the call back over to you for any closing remarks.

Okay.

Well, thanks very much everyone for listening.

We look forward to speaking to you again next quarter.

Take care.

Ladies and gentlemen, thank you for your participation in today's conference.

This concludes the program.

You may now disconnect.