Mercury Systems Inc (MRCY) 2022 Q4 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems Fourth Quarter Fiscal 2022 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've 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 with the business update. Mike will review the financials and guidance, and then we'll open it up to your questions.

Before we begin, I'd like to recognize the entire Mercury team for a tremendous effort through the course of an exceptionally demanding year. As to your strong performance, Mercury delivered record bookings, revenue and adjusted EBITDA for the fourth quarter. That said, the quarter and the year were more challenging than we anticipated due to lingering pandemic impacts, the extended defense budget delay, continued supply chain disruption, labor market constraints and growing inflationary pressures.

Despite these charges, our bookings increased 27% year-over-year in Q4 to a record $332 million, leading to a 1.14 book-to-bill and record backlog exiting the year. We received a large Aegis FMS order that was delayed in Q1, which was larger than we had originally expected. We also received the funding associated with the F-35 TR3 Lot 16 as anticipated, among others. Our largest bookings programs in the quarter were Aegis, F-18, F-35, PGK and the SDA tranche trucking layer. Term revenue was up 16% year-over-year and 9% organically.

Our largest revenue programs in the quarter were Aegis, F-35, P-8, MH-60 and a classified radar program. We continue to see high levels of new business activity. Design wins in Q4 totaled more than $680 million in estimated lifetime value. For the year, we received 33 new design wins with an estimated lifetime value of more than $1.6 billion, up 9% from fiscal '21.

On the bottom line, we delivered adjusted EBITDA margins of nearly 25% in the fourth quarter and a record of $71.6 million in adjusted EBITDA. This is up 36% from the third quarter and up 21% from the record set in Q4 last year.

For the full year, we delivered record bookings, which grew 21% for positive book-to-bill and record backlog. Total revenue increased 7% year-over-year, while adjusted EBITDA declined 1%. Our largest revenue programs for the year were MH-60, F-35, the classified C2 program, P-8 and Aegis.

Turning to Slide 4. Notwithstanding these record results, we fell short of our guidance for Q4 and the year, primarily as the result of material and order delays that affected the timing of revenue. We continue to see in-quarter supply deep mix, long lead times for high-end semiconductors and delayed supply and deliveries. In the past, we've been better able to mitigate short-term revenue risk. That wasn't possible to the same extent this year, given the supply chain and labor market disruptions. The contracting delays also resulted in the higher accounts receivable and lower imported cash collections, which reduced free cash flow.

Inflationary pressures, in large part related to semiconductors, became more of a challenge as fiscal '22 progressed. Semiconductors equate to 38% of our external supply spend, and we're seeing double-digit price increases. We expect to see greater impacts from material inflation and, to a lesser extent, labor inflation in fiscal '23. Given the short-cycle nature of our business, however, we believe these impacts will begin to normalize over time as our future business is priced at market rates.

Clearly, these are unprecedented times. Mercury's sophisticated end-to-end processing platform powers many of the most critical A&D missions and represents about 70% of our business today. High-end processing requires high-end semiconductors, and this is where the global supply chain has been most disrupted. That said, it's also where Mercury likely has the largest opportunity to grow over the next 5 years.

Fortunately, the issues we're experiencing are not demand related. They're supply and timing related, they're temporary and they're not unique to Mercury. We have a plan to focus on what we can control, and we're very optimistic about the future given our positioning. The demand environment is strong and appears to be getting stronger. Although the defense industry is dealing with short-term headwinds, we expect to see a shift to tailwinds as defense spending grows and the supply chain conditions improve. We believe that we're well positioned to deliver results more in line with our target model in fiscal '23.

Looking ahead over the next 5 years, our plan remains intact. We believe Mercury can and will continue to grow at high single digit to low double-digit rates organically as the short-term challenges diminish. The war in Ukraine, the most challenging global threat environment since the Cold War, will likely result in a sea change in defense spending domestically and internationally. Our advisers estimate that U.S. growth, combined with increases in NATO defense spending to 2% of GDP, could drive up to $1.5 trillion of additional spending over the next decade.

This should lead to higher bookings for Mercury in the electronic systems associated with missiles and ammunitions, air and missile defense systems, unmanned systems, fixed-wing and rotorcraft, ground vehicles and electronic warfare. These set new trends benefiting Mercury remains favorable in our view. The demand environment is improving, as demonstrated by our strong bookings and design wins growth in fiscal '22. We believe that a greater percentage of the value associated with future defense platforms will be driven by Electronic Systems content when Mercury participates.

Our addressable market continues to increase, driven in large part by our strategic move into Mission Systems and potential to deliver innovative processing solutions at chip scale. Our model sitting at the intersection of high tech in defense positions us well. As a result, we expect our business to continue growing faster organically than overall defense spending over time. In addition to organic growth, our 5-year plan includes continued margin expansion, driven by our impact initiatives.

Turning to Slide 5 and our expectations for fiscal '23. The defense budget outlook is improving, and we expect to deliver another year of double-digit bookings growth and a positive book-to-bill. Despite the potential for an extended CR due to the midterm elections, the DoD top line budget submitted for FY '23 is up from FY '22. There also appears to be strong bipartisan support to increase defense spending. Labor market conditions have improved somewhat, and the primary health effects of COVID continue to subside. However, the second order COVID supply chain effects will likely continue in fiscal '23 and possibly beyond. We also expect to see greater impacts from material and labor inflation for the year.

As I said, we believe that we're well positioned to deliver results more in line with our target model in fiscal '23. We began the year with a record $1 billion in backlog and much improved forward revenue coverage versus fiscal '22. We expect double-digit growth in bookings for the year, and improved bookings linearity leading to a high backlog, better visibility and reduced risk as the year progresses. We also expect a positive book-to-bill for the year.

At the midpoint of guidance, we're expecting approximately 3.5% year-over-year growth in revenue and adjusted EBITDA versus 6% and 7% increase at the high end. We expect growth together with improved operating leverage and our impact initiatives to partially offset material and labor inflation, resulting in similar margins to fiscal '22. In addition to record adjusted EBITDA, we expect to deliver improved free cash flow.

Our fiscal '22 bookings growth largely occurred in H2, and as I've said, we've seen longer semiconductor lead times. For high-end semiconductors, lead times now range from 36 to 99 weeks, 3 to 5x pre-pandemic norms. As a result, we expect the timing of our revenue and adjusted EBITDA to be back-end loaded in fiscal '23, with Q1 being the low watermark of the year. The increased backlog we expect as the year progresses should help improve operational execution in this challenging supply chain environment and ease the recent pressure on working capital. This should result in improved cash flow over time.

Another year of expected double-digit growth in bookings and another positive book-to-bill in fiscal '23 give us the confidence that we can and will return to organic growth back in line with our model in fiscal '24, provided supply chain and labor market conditions normalize. And again, looking ahead over the next 5 years, our plan remains intact.

Turning to our impact program on Slide 6. We began the journey a little more than a year ago with the goal of amplifying the value we create as we scale the business over time. During fiscal '22, we simplified and streamlined our organizational structure and strengthened the leadership team. We also focused 1MPACT on analyzing, quantifying, developing initiatives to drive margin expansion. As we enter fiscal '23, we're taking advantage of this progress by pushing the execution of these initiatives deeper into the business. We're using the 1MPACT processes and tools that we've developed and matured to deliver on our margin expansion goals over time.

We expect 1MPACT to generate $30 million to $50 million of incremental adjusted EBITDA by fiscal '27. This is later than we originally anticipated, given the expected impact of inflation in the short term. Over the next 5 years, 1MPACT should drive significant margin expansion nonetheless. If fiscal '22 evolved and things became more challenging, we pivoted 1MPACT towards areas that could help mitigate risk and deliver the most immediate financial results. This focus will continue in fiscal '23.

Through 1MPACT, we're seeking to derisk the timing and availability of materials in our supply chain and to better manage inventory. We're implementing processes and tools to make better and more timely pricing decisions. We're also prioritizing our human capital resources to the greatest effect. To counteract the inflationary pressures, we're updating our commercial price list and proactively negotiating existing contracts where possible. On new contracts, we're introducing more favorable inflation related terms and milestones to drive improved cash conversion.

Another 1MPACT initiative for fiscal '23 is R&D investment efficiency and returns, following the progress in fiscal '22. In addition, 1MPACT was aimed at optimizing our balance sheet by improving our working capital and asset efficiency. Like many others in the industry, as a result of the environment, our unbilled receivables balances grow. We're using 1MPACT to focus on and improve the timeliness of our receivables cash conversion. Although we've made some progress, we have more work ahead to achieve our long-term cash flow objectives.

Our digital transformation initiatives in engineering and operations will help improve our cost structure and performance over the long term as well. We're also continuing to consolidate and optimize our facilities footprint. As it relates to M&A, 1MPACT is about leveraging our proven ability to integrate and grow acquired businesses but with a greater scale going forward. The M&A environment continues to be active, and we remain focused on our existing M&A themes.

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

Thank you, Mark, and good afternoon, again, everyone. I'll discuss our Q4 and full year results and then focus on our Q1 and fiscal year guidance.

Turning to Slide 7. In Q4, Mercury delivered all-time company records for bookings, revenue and adjusted EBITDA. We exited Q4 with record backlog of more than $1 billion. Our 12-month backlog was up 22% year-over-year, providing improved revenue visibility into the next 12 months. Revenue in Q4 was up 16%, and organic revenue up 9% year-over-year. During the quarter, we recognized the revenue that we expected from the large Aegis FMS sale, F-35 TR3 and other key programs that we discussed on last quarter's earnings call. We did, however, experience more supplier decommits and award delays on other programs, which had a greater than $25 million revenue impact on our Q4 results.

Acquired revenue in Q4 included Pentek, Avalex and Atlanta Micro. As a reminder, Physical Optics Corporation, which we acquired in Q2 of fiscal '21, is incorporated into organic revenue as of last quarter. Physical Optics continue to perform well, despite being impacted by contract delays, labor market and supply chain decommits, like the rest of the industry. In fiscal '22, Physical Optics had revenue in line with expectations and had a 1.27 book-to-bill. Overall, a strong performance.

The acquisition, which was our largest in history, is a critical component of our open mission systems strategy. As planned, when we bought Physical Optics, we continued to transition the business from its historical small business innovation research work to subsystem development and production contracts. We're pleased with the acquisition, its growth and its alignment with our strategy.

Q4 gross margins were up slightly year-over-year. Growth in higher margin production and licensing revenue was partially offset by increased direct allocation of engineers to customer-funded programs as well as the impact of material inflation that we were not able to pass through to our customers. As a result of the direct allocation of engineers, our internal R&D was lower as a percentage of sales compared to Q4 last year.

In Q4, we had record adjusted EBITDA, up 21% year-over-year. Compared to Q4 last year, our adjusted EBITDA margins increased 120 basis points to 24.7%, primarily as a result of improved operating leverage. Free cash flow for Q4 was an outflow, primarily as a result of working capital and onetime expenses, which I'll discuss further in a moment.

Turning to our full year results on Slide 8. Fiscal '22 was a record year for bookings. Our book-to-bill was 1.08 compared to 0.95 in fiscal '21. This rebound drove backlog higher and increases our visibility heading into fiscal '23. Fiscal '22 revenue was up 7% in total and down 5% organically. Our organic revenue was impacted by the external market conditions, including supply chain disruption, labor market constraints and contracting delays. Despite these delays in fiscal years '21 and '22, none of our major programs have been canceled.

Adjusted EBITDA for fiscal '22 was down 1% year-over-year. Our adjusted EBITDA margins were 20.3% compared to 21.9% in fiscal '21, primarily driven by program mix and inflation. Free cash flow in fiscal '22 was an outflow, primarily as a result of an increase in working capital as well as onetime expenses.

Slide 9 presents Mercury's balance sheet for the last 5 quarters. We ended Q4 with cash and cash equivalents of $66 million and approximately $452 million of debt funded under our $1.1 billion revolving credit facility. Our balance sheet is strong, and we have significant financial flexibility to continue to invest in the business organically and through acquisitions.

Accounts receivables increased in fiscal '22. This was primarily a result of unbilled receivables, which increased approximately $61 million from Q3 fiscal '22 and $140 million compared to Q4 fiscal '21. This was primarily driven by the growing proportion of overtime or a percentage of completion revenue as we execute on our content expansion strategy.

In Q4, overtime revenue increased to approximately 60% of total revenue compared to 44% a year ago. In addition, unbilled receivables were impacted by supply chain disruptions, which continued to delay delivering milestones and cash collections in the quarter. We expect unbilled receivables as a percentage of overtime revenue to return to a pre-pandemic level of approximately 35% as supply chain conditions improve and legacy contracts roll off.

Inventory increased approximately $11 million in Q4 compared to Q3 and approximately $49 million from a year ago. This was primarily due to accelerated raw material purchases to support higher demand and mitigate supply chain risk in fiscal '23. It also reflect the decisions by our suppliers to end of life more key components, requiring us to invest in raw materials. We expect to see less of this dynamic in fiscal '23.

Turning to cash flow on Slide 10. Free cash flow for Q4 was an outflow of $28 million and $47 million for the year. Last quarter, we forecast an expected free cash outflow in Q4 driven by onetime payments as well as working capital billed due to the record revenue quarter. The Q4 outflow was further impacted by supplier delays, primarily within unbilled receivables. In addition, in Q4, we had approximately $7 million of onetime cash outflows associated with our impact initiatives, acquisition expenses and shareholder settlement costs.

When the supply chain normalizes, we expect our cash conversion cycle to normalize as well and cash conversion to return to our target levels, which we have set at 50% free cash flow to adjusted EBITDA. We currently expect free cash flow to improve in the second half of fiscal '23 as net income grows and working capital metrics improve.

I'll now turn to our financial guidance, starting with the full fiscal year '23 on Slide 11. As of June fiscal year in this company, we are initiating guidance for the next 12 months in a very fluid environment. As such, our guidance incorporates to the extent we can, potential risks related to continued supply chain delays and material and labor inflation as well as the potential for another continuing resolution in a midterm election year. While these uncertainties do pose risks, they are timing-related and not related to demand, which is strong.

On a quarterly basis, our guidance is second half weighted as a result of the bookings profile and supply chain delays that we've discussed. We are entering fiscal '23 with strong backlog coverage given the record bookings in the second half of fiscal '22. We also have visibility into the key programs not currently in backlog that we believe will drive our revenue. During the year, we expect to receive bookings on programs such as F-16, F-18 Filthy Buzzard, SEWIP and others. We are designed in and have sole-sourced positions on these programs.

For fiscal '23, we're guiding revenue of $1 billion to $1.05 billion, representing 1% to 6% growth from fiscal '22. Organically, the high end of our revenue guidance represents a 4% increase year-over-year. Based on the midpoint of our revenue guidance, we have approximately 63% of our forecast revenue in backlog. This compares to approximately 52% entering fiscal '22. Over 90% of our fiscal '23 revenue guidance is either from backlog or from programs where we are designed in.

We expect fiscal '23 revenue to be H2 weighted, primarily as a result of award timing and supply chain lead times. We expect adjusted EBITDA margins to expand throughout the year as a result of program mix, 1MPACT initiatives and operating leverage. While we always tend to have years weighted towards the second half, this year, we expect that to be more pronounced as a result of the macroeconomic headwinds. As a result, we expect approximately 2/3 of our adjusted EBITDA in the second half.

Unlike the last 2 years, we expect our bookings to be spread relatively evenly throughout the year with a strong book-to-bill in H1, providing significant backlog coverage going into H2. Based on our current outlook for bookings, we expect to have nearly 80% of our H2 revenue in backlog, driven by the key bookings I mentioned. This is above historical levels of backlog coverage entering the second half of the year, supporting the strong growth we expect in H2.

Our guidance range for adjusted EBITDA for fiscal '23 is $200 million to $215 million, approximately flat to up 7% from fiscal '22. At the midpoint, adjusted EBITDA margins are 20.2%. These margins are approximately flat year-over-year as the anticipated impacts of material and labor inflation are offset by 1MPACT initiatives related to procurement and pricing. We currently expect free cash flow to adjusted EBITDA conversion of 30% to 40% in fiscal '23. This estimate assumes the current R&D capitalization tax law is delayed or repealed. We expect a free cash outflow in H1, primarily as a result of continued supply chain disruption, with free cash flow returning to target levels in H2 as working capital increases subside. For the year, we're expecting double-digit bookings growth in a book-to-bill above 1.

I'll now turn to our first quarter guidance on Slide 12. Our current revenue guidance for Q1 is $215 million to $225 million. At the high end, this is flat from last year. We expect Q1 adjusted EBITDA in the range of $27 million to $30 million. Margins are expected to be approximately 13% of revenue compared to 17% in Q1 last year. This is primarily a result of continued supply chain and labor inflation as well as program mix. We expect margins to expand as we move through the year as a result of program mix, operating leverage and 1MPACT initiatives offsetting inflation.

We expect a free cash outflow in Q1 as a result of continued supply chain disruption as well as onetime cash outflows associated with 1MPACT and shareholder settlement costs. While we don't guide bookings, we are expecting strong bookings in Q1, as I said, with a book-to-bill above 1, resulting in record backlog at the end of the quarter. So while we expect a challenging environment to continue in the first half, we believe our backlog and expected bookings in H1 will position us well heading into H2 and into fiscal '24. Over the next 5 years, we expect strong top line growth as well as margin expansion consistent with our target model.

With that, I'll now turn the call back over to Mark.

Thanks, Mike. Turning now to Slide 13. The timing challenges that we've experienced the past 2 years are likely to continue, at least through the end of fiscal '23, as we see it today. That said, the demand environment remains strong, and we believe that strategically, Mercury could not be better positioned.

We're entering fiscal '23 with record backlog and strong new business momentum as expected. We believe this positions us to deliver another year of double-digit bookings growth and a positive book-to-bill, with revenue exceeding $1 billion for the first time while maintaining strong margins. Our 5-year outlook remains intact. We expect increased defense spending through this period to positively impact the business. We're well positioned to continue benefiting from the effect of increased electronic systems content, supply chain delayering and reshoring and increased outsourcing at the subsystem level.

We believe the supply chain constraints and inflationary pressures that we're facing today are short term in nature. Mercury's fundamentals are strong, and with 1MPACT, should improve over time. Executing on our long-term strategy over the past decade, we've improved margins while growing the business organically, supplemented with disciplined M&A and full integration. As a result, we created significant value for our shareholders and expect to continue doing so. We've also added depth to the Board. Continuing in that vein, I'd like to welcome Mercury's newest Directors, Howard Lance and Bill Ballhaus, who were elected to the Board on June 24.

In closing, thanks once again to the Mercury team for your outstanding work and contributions. With that, operator, please proceed with the Q&A.

(Operator Instructions) Your first question comes from the line of Pete Skibitski with Alembic Global.

Guys, if we think about fourth quarter top line, fiscal '23 revenue guidance, can you talk maybe about quantifying what part of the headwind is labor related, what part is supply chain related? And then just maybe, are you seeing it across all of your hundreds of programs? Or are there a few key programs -- sizable programs that are being unusually impacted?

Sure. So why don't I kind of give the high level and then maybe, Mike, you can kind of fill in some of the details, Pete? So at a high level, we saw greater than $35 million impact on bookings. The 2 probably biggest impacts were around the F-18. And then we also saw that SEWIP kind of slipped out of the quarter into Q1. Revenue, I think as Mike said in his prepared remarks, it was really due to 2 things. It was largely due to some of the order delays where we were actually expecting the order and to be able to recognize some revenue. So it's a good example of that. The product was built. But then also, we absolutely saw some supply decommits. So we're expecting material that ended up not arriving as we'd anticipated. So Mike, I don't know if there's anything that you'd like to add there.

Yes. So Mark said a great -- just in terms of numbers, as we look at the impact on fiscal '22 associated with the award delays, we estimate that, that was about $22 million. And then the supplier decommits and extended lead times, about $20 million in terms of the revenue impact in fiscal '22.

Okay, and are you thinking kind of 50-50 also for fiscal '23?

So in fiscal '23, we -- when we look at those 2 things, what you'll see is that we talked about in the prepared remarks, is that it's more about timing during the year. And so what we're seeing is that the award delays that we've had this year and the supplier decommits are leading to a lower H1 from a revenue perspective and a margin perspective because of the mix of business in a bigger H2. So we're really looking at it as a fiscal '22 impact right now.

So Pete, I'd just like to add, though, I think it's an important point, right? So we clearly saw a pretty substantial ramp in bookings in the second half. We thought that was going to occur. We did get some impact, as I mentioned, just with some orders that didn't arrive. The good thing is that the actual demand environment and order flow remains pretty strong. We're actually expecting very strong growth in bookings in the first half, which should actually help improve the linearity as we head into fiscal year of '24.

So we fortunately, if you step back, we're kind of in a multiyear industry events here. And the linearity of bookings in both fiscal year '21 and fiscal year '22 hasn't helped us with respect to the timing of revenue and EBITDA. So we're trying to take that into account as we head into the new fiscal year, just given the challenges that the industry is experiencing. But overall, I think we're seeing some improvements around bookings, which we believe is going to help not only in H2, but also next year as well.

Very unusual times. And if I could ask just one last one. We've had this CHIPS Act passed, but even separate from that, are you guys able to identify additional semiconductor capacity coming online in kind of the near term that could address the shortages that you've had or at least lessen the impact?

Yes. It's a great question, Peter. Yes, I think, as I said in my prepared remarks, the -- as one of our customers said on their earnings call, right? It's [come to mouth] right now. It's pretty challenging. For high-end semiconductors, the lead times of 36 to 99 weeks, to put that in perspective, that's 3 to 5x what we saw pre-pandemic. And that's just for the semiconductor -- for the high-end semiconductors that the increases in the lead times have gone up across mechanicals, components, interconnect, I mean, literally, it's across the entire supply chain.

The CHIPS Act won't help in the short term, right? I think it's a strategically and critically important piece of legislation for the nation. But that's really about how do we actually bring back, reshore the chip manufacturing capability to make our supply chain more resilient. And it's very clear with what the industry is facing right now, that that's the right thing to do. So -- but it won't help us in the short term. So I think it's going to take some rollover in demand in the semiconductor space to really -- to loosen up the challenges around availability. I think we're already starting to see some of that in certain parts of the semiconductor market.

So memory is generally more available than what it has been in the past. You're seeing some freeing up of supply around lower-end semiconductors associated with consumer electronics. Unfortunately, that doesn't really help Mercury because we are producing very sophisticated processing subsystems, which is where we're still seeing the tightness in the very long lead times. So I think if the economy starts to slow down and as you start to see some demand soften, I do think you'll start to see some pickup in terms of availability.

What we've also seen in the past is that when there is a scarcity, a lot of companies over order because they're concerned about the ability to actually get access to the parts. And so we're hoping somewhat that as demand starts of slow, the effects of the limited supply could actually turn quite quickly. But as we see it today, we don't see that occurring and we just don't have the visibility piece.

Your next question comes from the line of Peter Arment with Baird.

Mike, just a clarifying comment first. Do you expect to be free cash flow positive this year? And then, Mark or Mike, who wants to make a comment, trying to understand just the dynamics a little bit that's going on with your unbilled receivables. You talk about 60% of kind of overtime revenue and getting back to 35%. What are some of the key things we need to see to begin to see that happen? Is it just availability of the supply chain? Maybe if you could just walk us through a little color, that would be helpful.

Yes. Peter, let me start with your first question in terms of free cash flow. So coming into the year, we weren't facing the same number of supply chain issues that we're facing today or that we did face during the year. So if you look at fiscal '22, our free cash outflow was $48 million. Now we invest in the business. We had about $27 million of onetime costs really associated with impact and some of the org redesign that we did. And I mentioned some of the other onetime costs in my prepared remarks. But the biggest impact by far has been the supplier and contracting delays, which we estimate was probably about an $80 million impact on our cash flow during the year, in addition to those onetime costs that I just mentioned.

So coming into the year, we didn't expect that working capital increase that was really driven by the supply chain and the contracting delays that I mentioned. And that really shows up in unbilled. And to answer your second question in terms of unbilled and making sure that I clarify the percentages that we've talked about. So if you look at our overtime revenue, it has increased since fiscal '20 from 27% to 55% in fiscal '22, so this year. And the 60% that you mentioned was our Q4 overtime revenue or percentage of completion revenue. And that's related to our subsystem work. And that's a natural growth as we do more subsystems consistent with our customer base.

When we look at the -- what's the right metric for unbilled, how do we size it and say what's the right amount of unbilled, because we're naturally going to have some. The way we look at that is the percentage of our overtime revenue. And so if you look back from fiscal '19 to fiscal '21, you'll see we averaged at around 35%. And in fiscal '22, that number went up to 43%. And that's what you're seeing, because of the supply chain delays, which delayed milestones, which delayed deliveries, and that's the number that as we look at normalization of our working capital, we're really going to drive down. And so that 43% that we ended the year with in '22, we think the good target is 35% over time. And we think that will unwind in fiscal -- a little bit in fiscal '23, more in the second half and then heading into fiscal '24.

Mike, you just sort of touched on, the second part of the question was around the -- do we expect positive free cash flow in '23?

Yes. I'm sorry about that. Yes, we do -- we talked about 30% to 40% free cash flow to adjusted EBITDA conversion for fiscal '23. And -- that's going to be second half weighted. As I mentioned in my prepared remarks, we are looking at an outflow in Q1, unless we were currently forecasting. But for the year, we are looking for positive free cash flow. And then that normalize even further as we go into fiscal '24.

So it's -- just to clarify, so if we get into like fiscal '24 and say the supply chain availability is much better, then it doesn't necessarily mean the top line story, but you could actually start seeing a lot of these unbilled receivables unwind, is that the right way to think about it?

Absolutely.

Yes. And it's also inventory. So if you look at our -- in general and step all the way back, we look at working capital as a percentage of sales, you'll see that before fiscal '21, and even in fiscal '21, we're around 40%. Prior to that, we were around 35%. And this year on an LTM basis, we've jumped up closer to 56%. And that's the combination of that higher unbilled as a percentage of overtime revenue, plus inventory. Because as we've talked about, we invested in inventory to defray some of the risk associated with the supply chain. And we've seen inventory increase as we've seen contracting delays. So yes, you're absolutely right. The right way to think about it is as we get through fiscal '23 and then into fiscal '24, you should see working capital as a percentage of sales come down.

Your next question comes from the line of Seth Seifman from JPMorgan.

Guys, I just wanted to ask about the expected EBITDA in the first quarter and that kind of 13-ish percent margin, which even last year, which you would have considered kind of a tough quarter for profitability, was 17% to 18% margin. I mean it would seem like that's implying something like a low 30s type of gross margin in the first quarter. Is that because of inflation? Is that because of mix? And to the extent that, that is the case, how does that improve through the year? And does that imply some kind of exit rate that's higher than usual? Or does it imply a quick step up in the second quarter?

Yes. So you're right. When we look at -- when we look at Q1, revenue, $215 million to $225 million is the guidance range. We don't guide, as you know, we don't guide gross margin. But we were 39% in Q1 of '22. We're going to be -- mix is going to shift, Seth. So don't necessarily hold me to this, but we're going to be about 300 basis points lower in Q1 this year than Q1 last year. So around 36% is what we currently expect. So your number is right.

And so what's driving that? It is 2 things. First is the result of production slips. So revenues lower and gross margins are down because of the engineering work that we're looking at the end of the first half of the year is lower margin. And the reason for that is that the production work where we're waiting for supplies has gotten pushed to the second half. So that's one part of it.

And the second part is inflation. We've tried to take into account in our guidance, some of the inflation that we won't be able to pass through. We have at least 100 basis points impact from inflation in those gross margins, but we're trying to manage that through 1MPACT and other initiatives. So yes, so gross margin is down about 300 basis points. And then EBITDA is down 400 basis points because we were at 13% at the midpoint of our Q1 guidance now. We were 17% in Q1 '22. About 300 basis points is from the gross margin that I just mentioned. And the other 100 bps is associated with the negative operating leverage. And labor inflation is the other piece of it. So that is what's driving Q1.

As you look at the year, Seth, we are going to see a gradual increase in gross margins throughout the year. So while we're -- I just mentioned 36% in -- or that's what we're estimating for Q1. We expect that to ramp up probably relatively similar, maybe a little higher in Q2. But then in the second half of the year, we have good visibility, as I said in my prepared remarks, to the programs that are going to make up the revenue in the second half and, therefore, the margins on those programs, too. So we see a nice margin mix in the second half of the year, so it's closer to 42%, 43% gross margins. Then you also benefit from operating leverage because of the higher revenue in the second half.

If you step back, Seth, it's literally what I said, big picture earlier. The bookings really the last 2 years have been heavily weighted to the second half of the year. So we have a massive ramp in H2 this year. But with that, the timing of those orders, combined with long lead times on the materials, even though we've prepurchased inventories wherever we have a strong conviction that the orders and the timing going to come in, pushed the production revenue and the EBITDA to the right. So it's not like we're losing anything. We're not. But from a timing perspective and the mix of business is skewed towards the back half of the year like it was in fiscal year '22.

Now as I mentioned in Pete's comment, the good thing is that we saw the ramp in bookings in the second half and that ramp in bookings or that strength in bookings is actually continuing in the first half of this year, unlike last. So we are expecting pretty good growth year-over-year in the first half compared to what we experienced last year. So things do seem to be moving from an order flow perspective. But right now, we are being impacted from a timing and mix.

Your next question comes from the line of Jonathan Ho with William Blair.

Can you maybe help us understand or provide a little bit more color on how quickly you can push through pricing and maybe how we should think about that margin progression over the course of that second half of 2023?

Yes. It's a good question. So the biggest area that we're probably seeing from an inflation perspective is in relation to semiconductors, which I think, as I've mentioned in my prepared remarks, account for about 38% of our external spend and not supporting the 70% of our revenue, which is coming from processing systems. So that's the biggest impact that we're seeing.

The rate at which you can pass through the inflationary pressures varies, quite honestly. So it depends upon the mix of business, how much is cost plus versus firm fixed price? How much of it you've already got in backlog when those materials come in. I can tell you, though, that we've got a major focus on it. And it's been a big part of what we're doing with 1MPACT. In multiple different areas, we're focusing on enhancing both the pricing side of things, our cost estimation, business proposal practices to ensure that we're adequately pricing the effects of inflation while looking at the commercial side of the business to make sure that we're capturing the value associated with the capabilities and the value that we're providing to customers.

So right now, we just implemented a standard commercial product price increase that was effective across our microelectronics portfolio beginning July 1. We have got pretty -- we've narrowed the (inaudible) on quotes. We are controlling discounts. We are -- we changed our contract modification authorities internally, leveraging the new pricing tools that we put in place. So as we see materials, we're able to actually immediately, wherever possible, flow those actuals into our costs. So there's a huge amount of work going on. And we're actually expecting to offset a fair amount of the inflation that we're seeing in fiscal year '23, but maybe not all.

Your next question comes from the line of Austin Moeller with Canaccord Genuity.

My first question here, just how do you view the discussions that are going on around the new $30 billion F-35 order? It's for around 375 aircraft, which is 22% lower than the last block by -- how would you expect that to impact Mercury relative to maybe what you expected? And do you think you could have higher margins on that smaller production lot?

Sure. So let me kind of step back a little bit, Austin, and kind of just give a more general update on the F-35. Because I think to some extent, it answers the question, but it's important to understand all moving parts. So we're obviously aware of just the production rebaselining and kind of what's going on. As we said in the past, we're on multiple parts of the F-35 system across different parts of our product line. And although we experienced a pretty substantial reduction in order flow in fiscal year '21 as a result of the TR3 development delays and the COVID impacts on manufacturing that resulted in the initial production rebaselining, things have improved substantially since then.

Probably one of the more important ones for us is that, as L3 Harris reported on their last call, they successfully completed all of the safety flight testing requirements and delivered the first flight chipset on what is known as the F-35 TR3 ICP. It's the core processor associated with the F-35. They previously reported that the other elements of the systems that we're a part of, which is the panoramic cockpit display and the aircraft memory system have also [well down] the path.

Lockheed clearly was able to actually reach an agreement on Lots 15 through 17. And so I think to me, there were some very important events that occurred during our fourth quarter there, I think, are not only important for Mercury, but also for the industry as a whole. Stepping back and looking at the F-35 for Mercury at a year level, we saw a very substantial rebound in orders as we've expected. So our orders on F-35 were up 123% year-over-year, with $24 million of orders in the fourth quarter. As we expected and discussed on our last call, we actually received the Lot 16 long lead time funding, as expected, following the initial award that we got in the first quarter of '22. That's important because it actually supports our revenue plan in fiscal '23. And right now, we're actually looking at a partial Lot 17 ultra-long lead time award in the first half of the new fiscal year.

Setting back to the question you asked, right, and the potential or the reduction in terms of the number of units, I think there's another couple of things that are important to understand, in particular, with Mercury. So we've been actually very successful winning new content on the program, actually expanding our content footprint with a couple of different customers in a couple of different sensor suites, both of which are moving. So following an initial award on one of them in the third quarter, we actually received additional orders in Q4 that is resulting in our substantially taking share from a competitor. And that will turn into future revenues and profits.

On the other customer capability, we've actually completed qualification testing and anticipate an initial order in fiscal '23. So some of those new design wins are actually coming online and are more than expected to offset any decline in terms of the unit count. So overall for us, I think the content and the ASP continues to grow. The other thing that I think we are obviously noting is that there's clearly some impact associated with what's just happening in the Ukraine. There's far more interest in the F-35 from our NATO allies. So the Czech Republic indicates its intent to acquire 24 aircrafts. Greece is requesting 20, and the prospective sales to Canada, Germany, Finland and Switzerland. So all of which could help actually offset some of the U.S. decline. So overall, I think we made a lot of progress, the program is playing out the way in which we anticipated, and I think there's strong demand internationally.

Great. And then just a follow-up on the tracking layer. I know you'd mentioned the SDA constellation. There's 200 satellites planned for the tracking layer, 684 satellites planned for the transport layer, 200 for the deterrence, et cetera. As some of these SDA constellations start to scale, do you foresee that this could maybe become a top 10 program or a more relevant program for Mercury?

I don't think it's going to hit the top 10 as we see it today, but we're obviously very, very pleased with the win. We're providing some of our space qualified solid-state drives. And I think there seems to be high interest in there, in that particular area. So -- we'll see how the space market evolves for Mercury. But clearly, we're thrilled to be a part of the tracking layer with one of our customers.

Your next question comes from the line of Michael Ciarmoli with Truist Securities.

Just a follow-up on Jonathan's question. Mark or Mike, can you tell us what percent of revenues are under fixed price contracts versus cost plus versus maybe the more commercial catalog book ship where you can get immediate price increases?

And if you got that, Mike?

Yes, Mike, the vast majority of our programs are either commercial terms or fixed price. So from a cost-plus perspective, that only is about $40 million to $50 million of our fiscal '22 revenues, about 5% of the overall business. Commercial still accounts for a lot of our pricing, probably 50% plus, probably around 60%. And then 35% is noncommercial firm things price.

So to go back, talk about last quarter, Mike, right, is the fact that we've actually got a relatively short sales cycle where our customers actually order capabilities from Mercury in line with our manufacturing lead times, probably the only time that the short cycle business assists with our ability to be able to pass on those inflationary pressures versus having multiyear agreements, which is really not the way in which the industry works for the sub tiers right now.

Yes. I guess that's what I'm trying to figure out that if 50% is commercial, it seems like there's more of an outsized impact then for you guys on the inflation, where you could be passing along. Or maybe I've got that wrong?

No, we are passing it through. So we're seeing bigger effects internally than I think than what we actually experienced last year in terms of the margin degradation. And I think it's due to the fact that we're able to pass the prices on where appropriate as a commercial company or just given the short cycle nature of the business. So it doesn't mean that we're immune. Again, 38% of our external spend is related to semiconductors. And we're seeing 10% to 20% price increases across the board in the different categories. So then ultimately becomes a matter of timing when do you absorb those costs and how quickly can you pass them through. We do believe it's tempering.

Got it. And then just on 1MPACT, I think you guys had already recognized $27 million of incremental kind of savings, but now you're pushing (inaudible) it seems like you're already at that low end. Anything really changing on that incremental adjusted EBITDA there?

So no. I mean I think the 30 to 50 we believe, is still a good number. I think if anything, the pipeline of opportunities associated with 1MPACT is increasing. We did push out the achievement as the goal year, largely because I think we're seeing the impact of inflation at the back end of fiscal '22 and more so in fiscal year '23. But overall, I think, 1MPACT should drive substantial margin expansion over the course of the next 5 years. I don't know if you want to add anything, Mike?

No. I mean I think you hit on it. The only thing I would say is the fact that we launched 1MPACT slightly over 12 months ago, it means we're really well positioned to face the headwinds that we've got. So while we're delaying things, I think we're in a good position to offset some of the headwinds that we're seeing.

Your next question comes from the line of Sheila Kahyaoglu with Jefferies.

Maybe if we could just summarize some of the comments from prior, whether it was a question or Mike just now. When we think about the fiscal '23 margins, how much of that comes from inflation? I think you said 100 bps earlier versus volume inefficiencies and then development programs. And Mark, last time I saw you at a facility, your facilities are pretty good. So how much of the impact comes from those development programs? And what are those programs? And when do they transition into production?

Yes. So Sheila, let me take a cut at that. In terms of inflation and how we've positioned that into our guidance, we have put some inflation headwinds into the guidance that we have. I mean one thing to remember is we're guiding right now in a very fluid environment with the macroeconomic headwinds. And we're trying to predict what's going to happen not just over the next 6 months, but over the next 12 months. So we're trying to be conservative on the impact of the, let's call it, the unknown unknowns that we try to consider in our guidance.

But if you look at what's in our plan, we do have about 100 basis points associated with inflation and pricing that we won't be able to pass through. As we just talked about with Mike, we're using everything we can on our 1MPACT initiatives to pass that through. But that's currently in our guidance.

The rest of it really is around program mix. And that goes to what we were talking about earlier, which is a lot of the production programs that we have, are pushing production into the second half of this fiscal year or into fiscal '24. But we've got growth programs. We've talked about AMCS in the past, which is still in the development phase, that in fiscal '23, that's still in the development phase, probably goes to production sometime in fiscal '24.

We've got other programs within our microwave business. We've got a classified space program that's in development that will go into production in fiscal '24 and a handful of programs like that. F-18, parts of F-18 that we're doing are currently in development in the higher-margin production [world] (66:50)in that case, is towards the second half of '23. So a handful of things that are driving the lower margin in our guidance. Inflation is part of it, but then the program mix is another part of it which was impacted by the supply chain and contracting environment. So things were pushed to the right.

Let me just step back a little bit because I think there's -- obviously, there's a whole bunch of things hit the industry this quarter. And to me, it feels like we're in the midst of a multiyear industry event that was precipitated by COVID. And yes, clearly, I think we're all being measured in terms of what happens on a quarterly basis. But if you step back, we're actually -- given the guidance that we've just given, we're heading into actually our fourth fiscal year of dealing with the primary and the derivative effects of COVID. And actually, each year, it's had a really somewhat distinct set of characteristics that have actually affected the subsequent year.

And so given the relative short cycle nature of our business versus our customers and the size of their respective backlogs, the effect may not always be as readily apparent depending upon the time frame. And so it's pretty complex what's going on when you step back from it. But I think we're clearly seeing the effects now moving its way up the industry. The supply chain disruption that hit the industry pretty hard this quarter, the seeds of that was sewn many quarters previously. It is just hard to see and even more difficult to forecast. So we began to see the effects of that in our fiscal year '20 -- '21, sorry.

We got through the initial phase with the health care crisis phase of COVID in '20 pretty much unscathed. But we did see the effects of the order slowdown in '21. We had a 0.95 book to bill. That obviously affected the revenue and the profits associated with '21. And we're now clearly seeing the uptick in bookings in '22, but it was back half weighted. Bookings for the year were up 33%. For the second half '22 and for the year as a whole, we're up 21%. And as I mentioned before, we're actually expecting a strong bookings cadence in the first half. And our customers just had a very strong book-to-bill.

So it's clearly not a demand issue. But we started to see the effects from a supply chain perspective in the second quarter, and it's kind of -- it's continued throughout the year. We also saw the effects of the great resignation, meaning it was harder to actually find the right engineering and manufacturing talent that we needed to continue to grow the business. And those challenges, I think, became more of an issue as the year progress. And I think that's what you're clearly seeing in the industry right now. We saw -- begin to see the effects of inflation in the fourth quarter. And as we're now heading into the full year '23, we're expecting a greater effect.

So I think given the fact that we're guiding for the full year and given how this is a multiyear effect, we are somewhat more conservative just in our outlook just given everything that's going on, there are a lot of unknowns right now that we feel that we need to take into account. So they're temporary, they're short term, we believe, and the outlook looks great going forward. But clearly, the industry has been impacted.

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

Okay. Well, thank you very much, everyone, for joining us. We look forward to speaking to you again next quarter. Take care. Bye-bye.

This concludes today's conference call. Thank you for attending. You may now disconnect.