Mercury Systems Inc (MRCY) 2023 Q2 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems Second Quarter Fiscal 2023 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. I hope you've had the chance to review the press releases we issued earlier this afternoon. If not, you can find them 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 Presentation.

With me today is our President and Chief Executive Officer, Mark Aslett. I'm also very pleased to welcome Michelle McCarthy to the call. Serving as Mercury's Senior Vice President and Chief Accounting Officer for the past 5 years, Michelle has been an active and valuable member of our leadership team. I'm looking forward to working closely with Michelle in her new position as interim Chief Financial Officer, to ensure a seamless transition prior to my departure in February.

Turning to Slide 2 in the presentation, I'd 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. Typically, I'd start our prepared remarks with a review of our results for the quarter. However, given the other news we've announced today, I'll begin with key takeaways from those announcements. I'll then review the business. Mike will cover our financial results and guidance, and then we'll open it up for your questions. .

The Board's decision to initiate a review of strategic alternatives underscores our commitment to exploring all available avenues to enhance shareholder value. We've engaged 2 leading investment banks to pursue a range of options, including a potential sale. During the Board evaluation, we'll continue to execute on our strategic plan for growth and value creation. As you know, we need to let this process play out. And as such, we won't have further comment on it today. I want to emphasize that there can be no assurance that the transaction will result from the review. We also don't intend to disclose developments relating to this process unless and until the Board has approved a specific agreement or transaction or has terminated its review.

Now let me say a few words about Mike. As you saw from our announcement, Mike has decided to step down from Mercury to accept an opportunity as a privately held company headquartered in Virginia, where he and his family reside. Mike has been a great partner for the past 8 years. We've made significant contributions to Mercury, including helping drive our M&A strategy and many acquisitions. Mike, on behalf of myself and the entire Mercury team, we wish you all the best in your new role. We've initiated a search for a permanent successor with the assistance of a leading executive search firm. We're fortunate to have a deep bench of talent on our finance team during this transition period.

In addition to Michelle McCarthy's appointment as interim CFO, Nelson Erickson, Senior Vice President, Strategy and Corporate Development, will formally assume responsibility for Investor Relations. Last week, we also announced that Vivek Upadhyaya, who's joined Mercury as our Vice President of Financial Planning and Analysis, further bolstering our team. Over the coming weeks, Mike will work closely with Michelle, Nelson, Vivek and I to ensure a seamless handoff.

With that, let's discuss our second quarter results. Turning to Slide 4. Mercury's second quarter revenue was in line with our guidance, growing 4% year-over-year. More importantly, we returned to organic growth and generated positive cash flow in the quarter. GAAP net loss and loss per share as well as adjusted EBITDA and adjusted earnings per share go short of guidance. This was primarily due to an unforeseen delay in funding to our customer for a large FMS program. After this delay, which reduced Q2 revenue and margin by $10 million and $7 million, respectively, our results would have been up or above the high end of our Q2 guidance, which then resulted in lower Q3 guidance also, there's an additional $10 million of revenue and $7 million margin moved to fiscal '24. We're obviously disappointed with the delay in the short-term impact anticipated for this fiscal year. This is a large program and the timing is outside of our immediate control.

That said, our customers confident that their funding issues will ultimately be resolved, allowing us to recognize the entire $20 million in revenue and $14 million of margin early in this new fiscal year. Working with the customer, we've rotated in other related opportunities that we expect will partially offset the impact of this delay in the second half of fiscal '23. As we consider in the back half in our full fiscal year guidance, we are shifting our outlook to incorporate this program timing and the prolonged supply chain impacts, resulting in program delays and inefficiencies, which are temporarily affecting margins.

On the plus side, we believe that revenue is currently trending above the midpoint of our fiscal '23 guidance, while net income and adjusted EBITDA are now expected to be towards the low end. We are now in our fourth fiscal year dealing with these impacts. In addition to program delays and related inefficiencies, we continue to face long semiconductor lead times, tight labor market and inflation. These challenges, however, are not related to end market demand, which remains strong. They're largely timing related, they're short term, and they're not unique to Mercury. We continue to execute on our plan to control what we can in this environment, and we're optimistic about the future given our current positioning. Mercury's bookings for Q2 increased 14% year-over-year, the largest in F-35, F-18, LTAMDS and the classified C2 program. In nearly $60 million, the F-35 order for advanced microelectronics capabilities was the largest booking in the company's history.

Driven by the growth in bookings, our book-to-bill is 1.18 in the quarter and 1.16 over the last 12 months. Backlog grew 17% year-over-year to a record $1.12 billion, which positions us well for future growth. Despite the SMS customer funding delay, our Q2 revenue increased 4% year-over-year. Organic revenue turned positive, growing 1% versus a 13% decline in Q2 of fiscal '22. We expect to return to organic growth for the year as a whole as expected.

Our largest revenue programs in the quarter were F-35, F-16, NDSA tranche trucking layer, C8 and SAD. Q2 GAAP net income was negative and adjusted EBITDA declined year-over-year. Both were below guidance, primarily due to the FMS customer funding delay. Although revenue is trending above our fiscal '23 guidance midpoint, other financial measures, including adjusted EBITDA, are trending towards the low end, as I said, largely due to program delays and related inefficiencies. We believe these impacts are temporary in nature. We expect margins to increase as supply chain conditions begin to improve and as we realize further benefits from impact and the continued shift in our program mix through development to production.

Operating and free cash flow for Q2 were positive, a substantial improvement sequentially. We expect to deliver a breakeven to slightly positive free cash flow for FY '23, including the impact of the R&D tax legislation.

Turning to Slide 5. The defense appropriations bill was approved after the midterm elections as expected, resulting in substantial spending increases in response to national security threats. That said, the House GOP rules package adopted this month and reported deal between Speaker McCarthy and the Freedom Caucus create risk to government FY '24 discretionary spending, including defense.

An extended budget continuing resolution appears to be the base case scenario for GFY24, including the potential for a full year CR. However, although this does exist, we don't expect Congress to approve a reduction in DoD appropriations. Given the geopolitical challenges we face, there appears to be strong underlying Bipartisan support for increased defense spending. Looking ahead longer term, we believe the defense spending outlook remains positive, both domestically and internationally and that Mercury is well positioned to benefit in this environment. The growth in demand for the compute capability on board military platform shows no sign of slowing. We also stand debenture to the ongoing push for platform electronification. We believe that we're well positioned to continue to benefit from long-term industry trends. These include supply chain delayering and ensuring as well as increased outsourcing at the subsystem level.

Our addressable market has increased substantially, largely driven by our strategic move into mission systems and the potential to deliver innovative processing solutions at chip-scale. Our model sitting at the intersection of high-tech and defense positions us well.

Turning to Slide 6. The industry environment continues to be challenging in the short term. Despite incremental improvement in the second quarter, supply chain constraints continue to affect program timing and efficiency. Mercury's sophisticated end-to-end processing platform pass some of the most critical A&D missions. High-end processing represents about 70% of the business. This is where Mercury likely has the largest opportunity to grow over the next 5 years. Prior to the pandemic, semiconductor processing lead times were 10 to 12 weeks. They increased rapidly in the second half of fiscal '21 and now range from 36 to 72 weeks. Although current lead times on average are slightly shorter than in Q1, we don't expect to see a significant improvement until the second half of fiscal '24.

Semiconductor inflationary pressures remain a challenge as well. Semiconductors equate to 38% of our direct supplier spend far more than our peers, we believe. We're making good progress in mitigating the impact of higher semiconductor costs. As part of our impact program, we established a centralized procurement organization, which enabled us to improve our purchasing efficiency, while helping us deal with the effects of supply chain disruption. We also established a pricing team, repriced standard products and incorporated price adjusted mechanisms in our rate base businesses and multiyear proposals.

In addition, we implemented an across-the-board price increase in our microelectronics business. Through the pandemic, we've used the strength of our balance sheet to invest in new working capital necessary to mitigate supply chain risk as best we can. As a result, we positioned Mercury to deliver against customer commitments and generate stronger results over the time.

Turning to Slide 7. We believe that we've entered a multiyear period of accelerating growth and profitability. Demand is improving as evidenced by our strong LTM bookings and record backlog. The next several years could resemble the period post sequestration in 2013, absent a significant budget events in GFY24. Similar to the enhancements that we made in our business at that time, through impact, we're strengthening our fundamentals once again.

We launched impact early in fiscal '22 and it's evolved substantially since then. We've begun by streamlining our organizational structure and strengthening the leadership team and continue to do so. We also focus on margin expansion initiatives, and we're now pushing our execution deeper into the business. With the recent addition of Allen Couture, Head of Execution Excellence, and Mitch Stevison taking over our mission business last quarter, we've doubled down on these assets, keeping to drive continuous improvement around supply chain, operations and program execution. These areas have all been affected by the cumulative impact of operating during the pandemic, with the resulting program delays and related inefficiencies temporarily impacting margins. We believe these headwinds will diminish the supply chain and labor market conditions continue to improve leading to marketing expansion.

At the same time, we continue to focus on supply chain risk mitigation, working capital burn down and accelerated cash release. We believe that substantial cash will move off the balance sheet as a supply chain-related impacts on the business begin to unwind.

Another initiative is R&D investment efficiency and returns. In addition, our digital transformation efforts in engineering, operations and back office will help improve our cost structure and give us better productivity, scalability and efficiency over time. We're also moving on our manufacturing facility footprint strategy. We consolidated our Mesa, Arizona facility into the Phoenix site in Q2 and released 2 additional facilities as planned.

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

Thank you, Mark, and good afternoon, again, everyone. Before I discuss our results, I do want to say a few words about my decision to leave Mercury. Mercury has been a big part of my life for the better part of the decade. Since I started at the company in 2014, we've grown the business organically, completed 15 acquisitions and assembled a set of capabilities that uniquely position us in the defense industry. It's been a tremendous opportunity to be Mercury's CFO, working alongside Mark and the rest of our talented leadership team during this time.

A few months ago, I was approached by a company that had recently been taken private, based closer to my home in Virginia. This is not something I sought out. But when the opportunity was presented to me, I felt at this point in my career, it was something I had to explore. There's never a great time for a move like this, but I'm firmly committed to making this transition a success. Michelle and I have been in lot step for years, and I've developed our finance, so I know how much talent there is at Mercury. I wouldn't have made the decision to leave if I didn't have complete confidence in this team and in the company's ability to enhance value for all shareholders, including me. To our investors and analysts, it's been a pleasure getting to know all of you over the years.

Now turning to Mercury's results. As always, I'll begin with our second quarter actuals and then move to our Q3 and fiscal '23 guidance. As Mark discussed, Mercury delivered revenue in line with guidance, returning to organic growth and generating positive cash flow in Q2. Demand continues to be strong as we enter the second half. Our 12-month backlog was up 34% compared to Q2 last year, and up 10% compared to last quarter, providing us solid visibility into the remainder of the year.

For fiscal '23, we expect to deliver increased bookings versus fiscal '22, a positive book-to-bill, a record $1 billion in revenues and positive organic growth. As Mark said, we expect our performance to be heavily weighted to the fourth quarter. We believe that revenue is currently trending above the midpoint of our fiscal '23 guidance, while adjusted EBITDA is trending towards the low end, as I'll discuss. Demand remains strong, supported by our position on well-funded franchise programs. However, supply chain constraints, labor availability and inflation continue to contribute to program delays and inefficiencies.

With the post pandemic impact persisting through fiscal '23, we're experiencing shifts in high-margin production programs, including FMS sales into Q4 and fiscal '24, impacting Q3 and fiscal '23 gross margin expansion as a result.

Slide 8 covers the bookings, book-to-bill backlog and revenue growth results that Mark discussed. Worth highlighting again is the large FMS program customer funding delay that had an impact of approximately $10 million on our Q2 revenue. Given the program's high-margin profile, it also impacted profitability by approximately $7 million, resulting in the adjusted EBITDA guidance miss for the quarter. This delay in customer funding reflects the nature of FMS contracting, which requires alignment between the U.S. government and the foreign government as well as our direct customers. This being an approved FMS deal, the delay only relates to the award timing for both our customer and Mercury. We now expect this program in our fiscal '24.

As Mark mentioned, we expect this to have an approximate $20 million and $14 million revenue and adjusted EBITDA impact to fiscal '23, respectively. Gross margins for the second quarter were down 430 basis points year-over-year. As we expected coming into the quarter, gross margins reflected a higher proportion of lower-margin development revenue as well as material and labor inflation year-over-year. Gross margins were slightly lower than expectations, driven by the FMS delay, which had an approximate 140 basis point impact on gross margins. Q2 gross margin was also impacted by incremental depreciation expense and lower absorption in the quarter primarily due to our site consolidation efforts.

We expect to see higher gross margins in the second half of the fiscal year and especially in Q4. This is primarily a result of program mix shifts due to the high-margin FMS sales as well as execution on some of our larger development programs taking a little longer than expected in the current environment. GAAP net loss was $10.9 million for the quarter, while adjusted EBITDA was $35.7 million, down 6% from Q2 last year on lower gross margins. Our adjusted EBITDA margins were 15.5% for the quarter, down 180 basis points from 17.3% in Q2 fiscal '22. Again, the delay in the large FMS opportunity resulted in adjusted EBITDA and adjusted EBITDA margins being below our guidance range. Had we received this contract, adjusted EBITDA and adjusted EBITDA margins would have exceeded our Q2 guidance.

Free cash flow for the second quarter was an inflow of approximately $22 million, despite delays in payments from our customers at the end of their fiscal years. Delayed payment behavior across our customer base was partially offset by receivables factoring, which we discussed last quarter.

Slide 9 presents Mercury's balance sheet for the last 5 quarters. Our balance sheet remains strong with significant capacity under our $1.1 billion revolving credit facility. Driven by the anticipated strong cash flow generation in H2, we expect to be well positioned to delever the balance sheet while continuing to invest in the business. We ended Q2 with cash and cash equivalents of $77 million and approximately $512 million of debt funded under our revolver. At current leverage levels, the interest rate under the revolver is approximately 5%, which positions Mercury to continue to allocate capital at attractive rates.

From a working capital perspective, we've invested approximately $240 million since fiscal '21, potentially the start of the pandemic to support performance obligations to our customers and ensure delivery on critical programs. As these obligations are completed, we expect working capital, especially unbilled receivables and inventory to convert to cash and decrease substantially as a percentage of annualized sales.

Turning to cash flow on Slide 10. Last quarter, we forecasted breakeven to slightly positive free cash flow for Q2. Free cash flow for the quarter was $22 million. In Q2, we did see delays of approximately $30 million in receipts from billed receivables from our customers at the end of their fiscal year. These were partially offset through a factor in $20 million of receivables. At this point in Q3, we have received the $30 million of delayed payments from our customers. Given our fiscal year timing, we did not see any impact related to the R&D tax legislation in H1, but we're now forecasting an impact in H2.

I'll now turn to our financial guidance, starting with Q3 on Slide 11. Forecasting in the current environment remains challenging. Our guidance incorporates to the extent we can, potential impacts associated with the ongoing supply chain constraints and material and labor inflation headwinds. As a result of the high-margin FMS program moving into fiscal '24, coupled with the headwinds contributing to program delays and inefficiencies. H2 is more weighted to Q4 than Q3.

For Q3, we currently expect revenue in the range of $245 million to $260 million. At the midpoint, this is approximately flat growth compared to the third quarter last year. Although we remain cautious with regard to award timing, program execution and the current industry headwinds, we expect gross margins to increase gradually in Q3 and more dramatically in Q4 as we complete execution across several of our lower-margin development contracts. The revenue growth in H2 and especially Q4 is expected to be driven by higher-margin production programs as well as licensed sales. We expect Q3 GAAP results to range from a net loss of $5.8 million to net income of $1 million. We expect adjusted EBITDA to be $40 million to $47 million, representing approximately 17% of revenue at the midpoint. As I've said, our Q3 adjusted EBITDA margins are being impacted by the delay in the FMS sale as well as a higher proportion of development contracts.

I'll now turn to our guidance for full year fiscal '23 on Slide 12. The near-term outlook across the industry remains far from certain, but the demand environment continues to be strong, as highlighted by our continued bookings momentum. Balancing these 2 dynamics, we're maintaining our previous guidance for the year for revenue and adjusted EBITDA. From a total company revenue perspective, our guidance remains $1.01 billion to $1.05 billion in fiscal '23. This represents 2% to 6% growth year-over-year and approximately flat to 4% organic growth. Based on our current demand environment, despite the approximate $20 million slip in FMS revenue, we still expect to see fiscal '23 revenue towards the high end of this range.

GAAP net income for fiscal '23 is expected to be in the range of $13.9 million to $24.8 million, with GAAP EPS of $0.24 to $0.44 per share. The reduction at the low end and midpoint is a function of the incremental depreciation expense in the second quarter, partially offset by lower expected stock-based compensation. We're maintaining our fiscal '23 adjusted EBITDA guidance range of $202.5 million to $215 million, up 1% to 7% from fiscal '22. While we expect revenues at the high end of the range, we expect adjusted EBITDA to trend toward the lower end of the range. This is driven primarily by program mix including the FMS sale as well as supply chain-related program delays and inefficiencies also impacting adjusted EBITDA margins.

Adjusted EPS is expected to be in the range of $1.90 to $2.08 per share. The reduction from our prior guidance is also a function of the incremental depreciation expense in the second quarter. From a free cash flow perspective, we're now targeting breakeven to slightly positive free cash flow for the year. This includes approximately $36 million of cash outflows related to R&D tax legislation in H2, which we've now incorporated into our guidance.

Turning to Slide 13. I want to briefly touch on Q4, which we expect to be a record quarter for Mercury across all key metrics. But we will not formally guide Q4 until next quarter. Based on H1 actuals and our Q3 and fiscal '23 guidance, we can arrive at an implied forecast for the fourth quarter. Looking at the midpoints of our fiscal '23 and Q3 guidance ranges, Q4 revenue at the midpoint would be approximately $320 million. This is an increase of approximately 11% from our record fourth quarter last year. Given our current backlog and anticipated bookings in Q3, we expect to enter Q4 with a solid forward backlog coverage, which is the basis for our current guidance.

GAAP net income and GAAP EPS will be approximately $47 million and $0.83 per share, respectively, at the midpoint. Q4 adjusted EBITDA would be approximately $98 million and adjusted EBITDA margins to be approximately 31%. These results are driven by gross margin expansion, reflecting a mix weighted towards higher-margin production programs and licensing revenues. We also expect adjusted EBITDA margin improvement as a result of the operating leverage we've created in the business.

From a free cash flow perspective, we expect to see a strong rebound in Q4. So while Q4 would represent a record quarter across all our key metrics for Mercury, we believe we have a clear path to achieve our guidance.

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

Thanks, Mike. Turning now to Slide 14. Mercury delivered strong bookings in the second quarter. We returned to organic growth and generated positive cash flow in a still challenging environment. Demand is strong and getting stronger. Our robust H1 bookings, record backlog and substantial forward revenue coverage provide us with good visibility into the second half of fiscal '23. Timing, however, remains a risk in the short term as we win larger, more complex subsystem deals. Given the impact of the delays associated with the FMS program, we have a larger fourth quarter than previously anticipated. We have a high level of confidence in our ability to recognize the associated revenue and margin in the first half of fiscal '24. And as a result of the additional opportunities we've rotated into the plan, we're maintaining our fiscal '23 revenue and adjusted EBITDA guidance. As I said earlier, while revenue is trending above the midpoint, adjusted EBITDA is likely to come in towards the low end of guidance as a result of mix and supply chain-driven program delays and inefficiencies.

For the year, we expect to deliver strong bookings weighted toward Q4. We expect a positive book-to-bill and a return to organic growth with revenue approximately $1 billion for the first time. This should position us well for fiscal '24 as the supply chain conditions begin to normalize. We expect to deliver strong organic growth, margin expansion and improved cash flows release working capital, all of which should position us for further growth and value creation in future years.

That said, the potential for disruption around the GFY24 budget and the timing and level of the defense appropriation present additional risk. Looking further ahead, our outlook for the next 5 years remains strong. We expect increased defense spending domestically and internationally. We're well positioned strategically in the right path of the market with the right capabilities on the right programs. We believe that Mercury can and will grow organically at high single-digit to low double-digit rates. In addition to organic and M&A-related growth, our 5-year plan includes margin expansion driven by better execution as the industry headwinds subside, improved program and content mix as well as impact. This should lead to stronger profitability as well as improved working capital efficiency and cash conversion.

For more than a decade, we've successfully executed on our longer-term strategy. We've improved margins by growing the business organically, supplement with disciplined M&A and full integration. As a result, we've created significant value for our shareholders and expect to continue doing so.

In closing, I'd like to recognize the Mercury team's commitment to our success and strong performance in the second quarter. My sincere thanks to all of you. Before we turn it over to Q&A, I ask that you please keep your questions focused on our earnings results.

With that, operator, please proceed with the Q&A.

(Operator Instructions) Your first question comes from the line of Peter Arment with Baird.

The impact program you've talked about, quite a bit about on this call and in previous calls, I think you targeted net savings to be $30 million to $50 million when you look out to fiscal '25. Just wondering where that stands today? I know that you achieved at least $22 million in your first fiscal year. Can that still grow just given all the efforts you've done? And then just as a follow-up, I'll ask it now, just your confidence around kind of, is there much FMS mix in the fourth quarter that could also slide out, just given the kind of the impacts that you've had from customer shifts?

Yes. So thanks for the question, Peter. So I think we're absolutely on target for the impact savings. I think the program is going extremely well. If anything, we're probably slightly ahead of schedule compared to where we thought we were going to be at this point in time. Unfortunately, I think a lot of the efforts and the results that we've delivered aren't really showing up in our financials right now because they are simply offsetting some of the headwinds that we're facing. But for the programs on track, and we think there's substantial upside associated with it going forward. .

As it relates to FMS, we do have some FMS in the fourth quarter. As we rotated out the $20 million of revenue and $14 million of margin from Q2 and Q3, we were working with the customer able to rotate in additional revenue that partially offset is some of the shortfall due to the delay in funding. So yes, there is some revenue in the fourth quarter. I can't get the number off the top of my head, my dear.

It's not something we break out specifically, but I would say, Peter, that the magnitude of the revenue we have is much lower than the $20 million of revenue and $14 million of gross margin has slipped down.

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

I guess just on the topic of the availability of semiconductors and chips, I guess I'm wondering kind of what makes that take until the second half of your '24. We saw Intel's results last week. It seems like demand in the civil economy is really drying up. And you would think that maybe that would free up capacity more quickly for the defense industry, what makes that take so long?

Yes. So first of all, I think it's based upon the feedback that we're getting specifically from some of those semiconductor companies based upon what they think is going to happen in terms of the capacity and their ability to supply. We did see some incremental improvements, Seth, in the second quarter. Last quarter, we were talking that the semiconductor lead times on the high end in particular, the stuff that's coming out of TSMC and Hudson of the high-end Intel processing, the lead times were 52 to 99 weeks. This quarter, we did see the average come down 36 to 72 weeks. So it's still extremely long and far longer than what we saw pre-pandemic, which is in the 10- to 12-week range. So we're pleased to see the improvement and see the average coming down, but it's still on a long way to go.

Okay. And then just as a follow-up, when we look at the data that comes out in the filing, about the sales breakdown between different types of products, different customers. Is there anything there that offers a little bit more insight into the gross margin compression that we've seen, whether it's -- I mean, last quarter kind of -- we only have it as of the -- I guess, as of the September quarter so far, but fewer sales into radar applications, I guess, fewer sales into components, more sales to Lockheed. As we look through these different categories, is there anything about the mix that's changing that we can be aware of in terms of thinking about the gross margin and the profitability of different types of sales?

Not specifically at the macro level, Seth. I think if anything, what we are seeing is just the cumulative effect of operating under the pandemic and the delays that we've seen on programs and resulting in efficiencies. So if things are taking longer, we've seen cost growth and that's clearly what is impacting the margin. As we look forward, as we've said, is more of these programs going to get out of the development phase and into production, we'll start to see some mix shifts and some margin improvements there, coupled with some probably better efficiencies in supply chain, so less of a headwind. And then continued benefit from impact is really what's going to drive the margins as we go forward. So I don't know, Mike, if you would like to add anything to that.

No. I mean, Seth, you'll see the detail when the Q comes out in terms of subsystems, components, modules. I think what Mark said is correct. It's going to be -- you're not going to see anything there significant that's going to stand out as the driver of the margin degradation. It really is these new program starts that we've talked about as the development programs transition over time to production. They're just taking a little longer in this environment. And then we expect that to transition in fiscal '24. So nothing specifically to point to in the Q more just around the trends that we're expecting in Q4 and in fiscal '24.

Obviously, Seth, the FMS program that moved, that was pretty high margin based upon the capabilities that we're providing. It includes IP licenses and royalties. And we do see a pickup of that as we're going into the second half as well. So the mix in terms of capabilities and the programs really do matter, and it's unfortunate that the customer has this funding delay that moved the $20 million of revenue and $14 million out of the year.

Your next question comes from the line of Ken Herbert with RBC.

I wanted to ask, Mark, on the free cash flow guidance, sorry if I missed it, but as you think about sort of breakeven to slightly positive, call it, $60 million in the second half of the year. How does that split between the third and fourth quarter? Or what's the guidance implied for the cadence of cash in the second half of the year?

Yes. Ken, I'll take that one. It's Mike. So when we look at the second half, it is going to be more weighted to Q4. We think Q3 prior to the R&D tax, I'll give you a split between those between Q3 and Q4. But prior to the R&D tax payments, we think Q3 is going to look a lot like Q2, which we expected coming in prior to factoring to be breakeven to slightly positive, and that's what we're seeing in Q3 right now. Now that's pre the R&D tax payment, which we estimate is going to be $23 million in Q3, it's going to be $13 million in Q4 to get to the $36 million that we mentioned in the prepared remarks. So what we're looking at is a free cash outflow in Q3 and the magnitude of $20 million and Q4 is going to make up the difference as we see the higher net income, higher op income, and we actually expect working capital in Q4 to release especially in unbilled and inventory, which is driving the cash flow for the year.

Yes, that's helpful. And it sounds like for cash earnings or cash and earnings, obviously, a pretty significant ramp in the fourth quarter. Is there any program you'd specifically called out maybe around progress payments or anything like that, that we should keep in mind as significant or material swing factors in the fourth quarter? Or there could either be potential risk or that are obviously embedded in what's going to help sort of hit the full year number? It seems like a pretty aggressive ramp in the fourth quarter.

Yes. Go ahead, Mike. Go ahead.

I was just going to say, it's definitely a large quarter, Ken, but we do feel good. The good news as we look at it is we have good backlog coverage right now going into H2 and into Q4. We've got good visibility into the programs that aren't in backlog that make up the balance of our FY '23 and specifically the Q4. So we're entering with strong backlog coverage, a majority of the remaining are recurring programs, programs for which we're designed in on. We also have, and I think Mark touched on it briefly, we have improved visibility and coordination into the supply chain than we had in H1. So still risk around it, but we feel better about it.

And then we've got line of sight into some key execution milestones that drive revenue in Q4 on a couple of key programs. So there's still uncertainty in the environment, supply chain contracting delays, things that we've talked about. We're working to control what we can. But overall, we feel good about the demand environment and the programs we're just cautious on the items that are out of our control. And just from a profitability perspective, we obviously expect margin expansion in Q4, and that's going to drive cash flow as well.

Yes. So Ken, just following up, the kind of 5 things, right? So the higher-margin program mix in the second half as we talked about -- we do have a pickup in high-margin IP licenses and some royalties on various programs. We are anticipating fewer execution delays and some inefficiencies. We saw supply chain, I would say, improve incrementally in the second quarter. And so as the conditions stabilize and as hiring continues to pick up, yes, I think we've got fewer headwinds there.

Impact, I think, continues -- here we've got continued savings relating to pricing initiatives that we undertook early in the year. We've got some procurement savings. And this quarter, we had some facility footprint consolidation. We've got further consolidation in Q3 that will lead to savings. And then finally, just obviously, better absorption and better overhead leverage largely as a result of the higher revenues. So although it's a big quarter, I think we've done the work and we know what's going to drive the increase.

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

Just wanted to start out with some of the delayed payments that you were seeing from your customers. Are you seeing that behavior maybe persist? Or are you sort of building that into your guidance, just given some of the challenges around cash flow management that everybody is sort of facing?

Sure. Jonathan, we saw it a little bit in Q1. We talked about it on the Q1 earnings call. We saw a little bit more of it in Q2. Now remember, our fiscal Q2 is our customers' year-end. So we did see them managing receivables to us at the end of the quarter. And as we mentioned, it was about $30 million that we saw held that was due for us in the quarter. We've received all of that already in Q3. So it was just a couple of weeks or less than a week delay as they straddled their fiscal and calendar years.

Going forward, I think we've got a really good group of customers that only pay on time. And so we're managing that with them. We also put in the factoring facility that I mentioned, and we used it exactly for this reason, Jonathan, which was a tool that we have that's a very low cost of financing to us in order to mitigate the impacts on our cash flow statement and our financials because of our customer behavior. So we feel good that we're in a position to manage it from an organic standpoint, but we also have a tool in the factoring facility should we need to use it, should we see this behavior continue.

Got it. Got it. That's helpful. And then in terms of some of the pricing actions that you've taken, how should we be thinking about like the timing and sort of the magnitude of how that flows through? Like I know there's a variety of different actions across both the pricing of services as well as products, but any color would be helpful?

So pricing has obviously been 1 of the major elements of the NPAT program. And so we stood up a pricing center of excellence to try and drive strategic pricing and best practices in both pricing and cost estimation depending upon the part of the business. In the commercial portfolio, I think the team has done a really good job. And we're actually offsetting a significant amount of the inflationary pressures that we're seeing on the semiconductor side of things. So focus on value-based pricing. We're looking at the discounting and the [court solidarity].

And I think as I mentioned on the last call, we did do and across the board price increase in our commercial products at the start of the year, that is really the major driver of offsetting the inflation pressures that we see there. On the noncommercial portfolio, it's slightly different, right, here, that's largely some of the cost disclosure type of the business. Here, we're really mainly focused on wherever we possibly can, passing through both material and the labor inflation costs that we see as well as trying to do a better job monitoring the scope creep with customers and monetizing those as well.

Now depending upon the type of contract and the -- what's already in backlog, the ability to be able to pass through those costs, obviously, there could be a time difference there. But I think overall, the team is doing a pretty good job. I think the inflationary headwinds with the work that we've done -- detrimental to what we thought they could be coming into the year.

Mike, do you like to add anything?

No, you got it.

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

So it seems like there's a lot going on, Mark. Just both externally with the Board and internally. Maybe can you just talk to us about how you're balancing all the internal factors and what you're most focused on now in terms of the business? Is it just ensuring the sales come through? Is it supply chain? If you could talk to us a little bit about that. You mentioned R&D as well.

Sure. So it's a good question. So I think the demand environment continues to be strong. So we're still very, very focused on the top line bookings. As we said, we're up 14% year-over-year. We had a 1.18 book-to-bill in the quarter and 1.16 over the last 12 months, growing backlog 17%, which gives us pretty good confidence and coverage along with the bookings that we expect in Q3 and Q4. So clearly, what the team is very focused on right now is the execution in the second half. It was unfortunate that we saw those FMS delays, which has made the year more back-end loaded. But we did talk about the coverage that we've got, which is far higher than what we had coming into the second half last fiscal year. So we'll continue to focus on mitigating the supply chain in the semiconductor lead times, which continues to be a challenge albeit incrementally improved.

Hiring, I think, is that for the third quarter in a row. We are actually hiring more people than all even. And so -- but we still got open recs along with the rest of the industry, and it's important for us to continue to fill those positions as we're looking at the growth in the business going forward. So I would say that the team is very focused on just execution. We are focused on growing the business and focusing on continuing to deal with the cumulative effect of the pandemic, Sheila.

Sure. No, that's helpful. And if I could follow up, I don't know if you mentioned this in the room and answer to a question. The FMS sale that slipped out, you said was $20 million of sales and $14 million of earnings associated with it. Was that right?

That's correct. Yes. It's $10 million in Q2 and the same in Q3.

Okay. So it's a pretty high-margin contract in terms of thinking about that?

It is. So it's a mix of capabilities. So again, there's hardware associated with it. But based upon the capabilities that there's also revenues and royalties.

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

Kind of staying on what Sheila was asking with kind of internal, external, a lot going on. Just, I guess, Mark, labor has been tight to begin with. How do you think about managing talent right now, talent loss and doesn't this potential announcement of strategic alternatives? I mean, can't that add to disruption and kind of take employees off the ball focusing on execution. So how do you kind of think about managing that risk right now?

Yes. So I mean, look, it's a possibility, obviously, with just what we are now. But I do think that we've got a fair amount of hiring momentum inside of the company. I think there's obviously a lot of growth ahead of us. And I think we're a great company to work for. So I don't see necessarily a major challenge with respect to retention.

On the attraction side of things, I think we're really focused on 2 areas: one is on the direct labor side of things. And I don't really believe that the announcements that we made this morning through this afternoon around the potential process will have an impact there. Probably the more challenging areas on the engineering side. But again, yes, I think we've got a great employee value proposition and yes, I feel pretty confident just based upon the momentum that we're going to be able to actually make the highest that we need.

Got it. Got it. And then just a follow-up, entirely separate. You guys have obviously -- you talked about the demand environment. We've seen a very strong book-to-bill for the last several quarters. How are you thinking about the bookings environment over the back half of the year, especially now with the budget in place?

Yes. So I think we're expecting, again, strong bookings sequentially H2 over H1, Mike. I think just with some of the recent shift, [solid] than the more of the growth in the fourth quarter, just given some of the movements that we've seen. But we're expecting strong growth year-over-year with a positive book to bill. So I think this is not a demand issue. Obviously, the demand environment is very strong. If anything, these are kind of short-term timing issues and really a result of the cumulative effects of the pandemic.

Got it. And to be clear, you think you can do -- you did 600 -- almost $30 million in bookings second half last year, you think you guys can do better than that is what you're saying?

So this year, if you look at, H1 was far stronger than the prior year. So the weighting of bookings was far more balanced. So for the year, we do expect bookings to be up substantially. Just given the waiting H1, H2, I think it's going to be more of a sequential story than it is year-over-year in H2.

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

So my first question here, if we just stay on the topic of the supply chain, if we do continue to see lead times come down, I mean, I know it's sort of an incremental improvement in the second quarter, but it's still notable. Do you expect you're going to be reducing inventory stockpiling if lead times continue to fall? And do you expect as we go into potentially a recession here that materials costs might come down for Mercury?

Mike, why didn't you take the first and I'll take the second one.

Yes. So with regards to the balance sheet, Austin, as the supply chain normalizes, as we've discussed, we do expect to see an unwind of inventory and an increase in inventory turns and also has been impacting our unbilled receivables where we've been unable to deliver in some circumstances because of long lead times or even a shortage of parts. And once that normalizes, we expect both those accounts, inventory and unbilled decrease, which is why we think there's stronger cash flow in Q4, but really heading into fiscal '24 as things begin to normalize, we expect that there should be a significant reduction in working capital, again, once that supply chain normalizes.

And then on the semiconductor side of things, clearly, I think part of the semiconductor marketplace has rolled over on the lower range, largely as a result of what is going on, on the consumer electronics side of things. The high end, as I mentioned, is still -- although it softened somewhat from the lead time, it's come down a little bit on average. It's still far longer than what it was pre pandemic. And so we haven't seen much movement there. In fact, if anything, the prices are going the other way still. The high-end semiconductors, we've seen price increases from Intel, from Xilinx from analog devices. And so the high end is still -- pricing is still pretty challenging. On the lower end side of things, we have been able to negotiate better pricing in some parts of the market, but it's still pretty challenging out there, Austin.

Okay. And then just to follow up on that. I think you said in the remarks, you're sort of anticipating improvement in the lead times in the second half of fiscal year '24. What are you seeing on your end that gives you confidence in that? Is that what's been communicated to you from TSMC and Intel? Or how should we think about the timing there?

Yes. So we're obviously not in contact with TSMC directly. If we're dealing with the companies whose chips are actually fab in the TSMC facility as well as other facilities offshore from various other companies. And so the 36 to 72 with lead times that I mentioned, is what we are seeing right now with respect to the part that we've got on the high end of semiconductors. And so these are the logic devices, the FPGAs that go into many of our processing systems. And so we're getting the input from our suppliers as to what they're seeing. And we'll see what happens as things continue. Hopefully, they continue to come down.

Your next question comes from the line of Noah Poponak with Goldman Sachs.

Mike, thanks for spending time with us and working with us over the years and all the best going forward.

Thanks, Noah.

It's been a funky 1.5 years or 2 years. If I kind of zoom out and try to sort of recalibrate for it, the top line actually never really gotten that bad. There's kind of 3 distinct quarters where the revenue decline is a little more severe and then a few words -- really actually not that severe, and that's kind of it. Relative to that, the margin change is more significant and pretty volatile in the year. And then the cash flow change is very significant and the working capital, in particular. I guess how do I square all of that? When you kind of look back at this 18- to 24-month window, why is the profitability and the cash flow so much more volatile than the top line?

Sure. So I think, yes, it's a good question. So it has been a few years, and each year has been slightly different in terms of the impact. And so bookings bottomed down, I think, in the third quarter of fiscal year '21. Organic growth actually bottomed out this quarter. We had 1% organic growth in Q2 versus a 13% decline. So we've got various metrics beginning to head in the right direction. If you look at the margin profile, it's really, I think, as a result of kind of what's happened a little bit with respect to linearity. So over the course of the pandemic as lead times dramatically increased, and as we started to see just the perturbations in the supply chain in terms of supply decommits, it obviously created push more of the business into H2, which obviously had an impact on margins in the first half. And then you've got the general inefficiencies associated with just the impacts that we've been facing. So the margin pressure is pretty much all related to the pandemic and the effects associated with that. There's nothing underlying the business.

And if anything, I think as we look forward, as a result of the shift from development into production, ability mix as well as the ongoing benefits of impact, we see substantial opportunities for margin growth. And then the cash flow, I think, as you know, is very much tied up with the balance sheet, again, is the supply chain conditions became far more challenging as lead times actually increased. We ended up leveraging the balance sheet to make sure that wherever possible we can meet our customer commitments on an inventory side. And then again, on the unbilled side of things, that's where we saw the effects of part shortages and which type working capital up in unbilled. So ultimately, cash collects everything, and that's where we saw the greatest volatility. Mike, I don't know if you want to jump in there?

No, I think that's -- I think Mark hit it. I mean just given some numbers, if you look back and just starting with adjusted EBITDA, the measure of profitability. When you look back fiscal '19, '20, '21, we were all around 22%. We came into fiscal '22, we dropped down to 20%. I think we talked about publicly that we had about 70 basis points or so as a result of supply chain inflation you look at fiscal '23 and where our guide is 20.3% at the midpoint and probably have a similar 70 basis point inflation impact. So those 2 would push it 21% and the reduction there from 22% from '19 to '21 down to '21 and '22 and '23 is really a result of the development programs that we've talked about.

And so as Mark said, when we look at EBITDA margins going forward, and we'll guide fiscal '24 when we get to our Q4. But we do see the opportunity for EBITDA margin expansion. So I don't think anything's fundamentally changed in the business from a profitability perspective. When you look at gross margins, there's a lot more movement. As you know, we had COVID expenses in fiscal '21, running through our gross margins. We had some movements between development programs and production on a quarterly basis. We've had a physical optics acquisition, which impacted gross margins. And then, again, on a quarterly basis, things like this FMS sale, our program mix makes -- create some volatility. But again, going to EBITDA, looking over the long term, a couple of key metrics, and we think the profitability of the business structurally is the same with opportunity for upside in fiscal '24 and beyond.

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

Okay. Well, look, thank you very much for taking the time to join us this evening. Lots of news from Mercury. We look forward to speaking to you again next quarter. Thank you.

This concludes today's conference call. Thank you for attending.