Mercury Systems Inc (MRCY) 2022 Q3 法說會逐字稿

Good day, everyone, and welcome to the Mercury Systems Third 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, Michael 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 & 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 for your questions.

Mercury continued to perform well in Q3, delivering strong results across the board. As expected, it was a challenging quarter due to order delays as well as supply chain and labor market constraints, but our team continues to successfully manage these headwinds. It was a record quarter for bookings, leading to a 1.17 book-to-bill and record backlog. As a result, we expect to deliver a strong Q4, positioning Mercury for a return to organic growth in fiscal '23. This organic growth, coupled with margin expansion driven by our 1MPACT initiatives as well as our M&A program, should lead to strong performance overall next year.

Looking ahead longer term, our 5-year plan continues to target high single-digit to low double-digit organic revenue growth over time, coupled with margin expansion and M&A. We're on track to achieve these goals. We're dismayed by the unprovoked attack and humanitarian crisis unfolding in the Ukraine and hope for a speedy resolution. Our confidence in our longer-term growth outlook has increased since the invasion, given the broader implications for Europe. We believe that over the course of the next 10 years, we'll see substantial growth in incremental defense spending, both domestically and internationally.

We don't anticipate an impact on our revenues in the short term due to the nature of the military assistance provided to Ukraine. However, we do expect to see an increase in bid and proposal activity, resulting in higher bookings in the midterm and over the next 5 years.

Turning to our Q3 results on Slide 4. We saw substantial bookings growth in the third quarter. Bookings increased 41% year-over-year and were up 25% sequentially. Our largest bookings programs were LTAMDS, CH-53K, F-16, [P1171] and a classified radar program. Despite this very strong performance, we did face bookings challenges in Q3. The largest impact was the further delay in the award for the FMS program that began seeing delays in Q1 of last year. Our customer currently expects to receive their award in May, resulting in an award to Mercury in late June. The majority of the products are currently in inventory.

Additionally, the F-35 TR3 Lot 16 order that we received earlier in the year was partially funded in the third quarter with the remainder expected in Q4. The biggest upside this quarter was LTAMDS. In Q2, we reported that our next LTAMDS booking for domestic and international production had likely moved to fiscal '25. This delay created headwinds for fiscal '23 as well as our 5-year plan. That said, our customers are seeing increased demand signals associated with missiles and missile defense.

In Q3, we were pleased to receive 2 awards for LTAMDS totaling $27 million. The larger of the 2 awards was for long lead time materials associated with future production. These awards contributed to our strong total bookings for the quarter and helped to partially mitigate the largest FMS order delay. This quarter, we expect to receive an RFP from Raytheon for additional LRIP systems, which may partially reverse the delay we reported in Q2.

Mercury's total revenue for Q3 was down 1.5% from our prior year record as anticipated, reflecting the orders that slept as well as the supply chain and labor market challenges. Our largest revenue programs in the quarter were F-35, LTAMDS, MH-60, F-16 and CDS. We continue to see high levels of new business activity, and our pipeline remains strong. Design wins in Q3 totaled more than $360 million in estimated lifetime value.

Through the first 3 quarters, we received 22 new design wins with an estimated lifetime value of more than $1 billion. Year-to-date, the total estimated lifetime value of our design wins is up 14% from the same period a year ago. Adjusted EPS and adjusted EBITDA were in line with our Q3 guidance. Free cash flow was negative and down from Q2, primarily due to the impact of supply chain headwinds on working capital.

Turning to Slide 5. Following record bookings in Q3, we expected an acceleration in Q4, leading to record bookings, a positive book-to-bill and record backlog in revenue for fiscal '22 as a whole. Despite the industry headwinds and order delays, we anticipate total company revenue growth of approximately 8% to 10% for fiscal '22, exceeding $1 billion for the first time, together with record adjusted EBITDA.

We've been largely successful in our efforts to mitigate the supply chain, labor market and COVID-related disruptions. That said, we continue to see in-quarter supplier decommits and long lead times of semiconductor components and materials. We're also seeing the impacts of inflation, some of which we can pass on and some we can't.

The team is staying in close contact with our suppliers and placing orders for accelerated material procurement. Nonetheless, during Q3, the supply chain constraints increased revenue churn, pushing revenue linearity to the back end of the quarter. This resulted in lower in-quarter cash collections which affected free cash flow. All our manufacturing facilities have remained open and productive throughout the pandemic.

Early in Q3, we did, however, see some labor productivity impacts as a result of Omicron, which peaked in January, also affecting cash flow. We expect the tight labor market as well as supply chain constraints to remain headwinds for some time.

We're pleased that effective yesterday, Steve Ratner joined the Mercury team as our Senior Vice President and CHRO, reporting to me. Steve was previously at Raytheon Technologies, where he led human resources for a 16,000-person $16 billion division. Having Steve's expertise and proven leadership couldn't be more timely. Core to our growth is having a world-class team in place. Steve will help lead our efforts to attract, retain and develop the talent we need to continue growing and scaling the business.

Turning to Slide 6. We proactively launched our 1MPACT program a year ago. 1MPACT's goal is to achieve Mercury's full growth and adjusted EBITDA potential organically and through M&A over the course of the next 4 years and it's progressing well. We anticipate a $27 million net benefit related to 1MPACT actions taken and planned in fiscal '22. These actions have been key to our success in managing the industry headwinds and continuing to achieved strong financial results this fiscal year.

As we move towards more normal conditions, we expect the benefits of 1MPACT to be additive to the savings we've been able to deliver to date. We continue to expect 1MPACT to generate $30 million to $50 million of incremental adjusted EBITDA by fiscal '25. We're on track to meet this target with upside opportunities that would allow us to potentially deliver greater value earlier than originally anticipated. 1MPACT is aimed at improving our organic growth as well as the fundamentals of the business. It's enabling us to better align with our customers' priorities and to partner with them on larger opportunities. As a result, we expect to continue to take share and grow faster than the industry over time.

1MPACT is also aimed at optimizing our balance sheet by improving our working capital and asset efficiency. In addition, we see substantial potential through 1MPACT to expand our margins. We're focusing on 5 major areas: first, organizational efficiency and scalability; second, procurement and supply chain; third, facilities optimization, and fourth; scalable common processes and systems. The fifth area is R&D investment efficiency and returns. Mercury's investment in R&D outpaces our customers and the competition. We believe this investment is in line with where the defense industry is headed. It's allowing us to deliver innovations more quickly and more affordably, and we're taking share as a result. We've proven that a high-tech investment model can operate successfully at scale on behalf of all stakeholders.

Turning to Slide 7, as it relates to M&A. 1MPACT is about leveraging our proven ability to integrate and to grow acquired businesses, but it is a greater scale going forward. Including our recent Avalex and Atlanta Micro acquisitions, both of which are performing well. We have deployed $620 million in capital since December of 2020. Looking ahead, we believe the 1MPACT will allow us to increase our deal cadence and potentially the size of our transactions, compounding the impact on value creation.

In addition to 1MPACT, we strengthened our balance sheet this quarter, and we believe that we can continue to execute successfully on our M&A strategy going forward. The environment continues to be active, and we remain focused on our existing M&A themes, secure sensor processing, open mission systems, C3, and trusted microelectronics. We intend to remain disciplined in terms of deal pursuits, diligence, pricing and integration.

Turning to Slide 8. We expect Mercury's revenue to continue growing faster than overall defense spending over time, driven primarily by organic growth. We focused the business on larger and faster-growing parts of the defense market and now participate in more than 300 different programs. We designed in on our top programs with the majority being sole-sourced positions.

Congress has passed the FY '22 Defense Appropriations Bill, which was 6% higher than the $715 billion initial request. The DoD top line submitted for FY '23 is $773 billion. This represents approximately 8% growth over the original FY '22 request and 2% over the Appropriations Bill. This growth is intended to address the effects of inflation and modernization needs as well as the war in Ukraine. That said, we believe the FY '23 budget will likely be revised upwards as the bill moves through the appropriations process later this year.

Despite the expectation of the CR as a result of the midterm elections, there appears to be strong bipartisan support for increased defense spending. We believe we're experiencing a potential sea change in defense spending and priorities with profound implications for the U.S., Europe and our allies, both in the short and long term. This is due to the war in Ukraine and the Russian threat to NATO and non-NATO countries as well as the risk associated with China and Taiwan.

Our advisers estimate the U.S. growth combined with potential increases in NATO and Allied partner defense spending to 2% of GDP could drive more than $1.5 trillion of additional defense spending over the course of the next decade. We don't see Mercury's revenues benefiting from this incremental spending in the short term given the nature of our offerings. However, over time, we do expect to see increased bid and proposal activity. This should lead to higher bookings in the electronics associated with missiles and munitions, air and missile defense systems, un-manned systems, fixed wing and rotorcraft, ground vehicles and electronic warfare. This activity should further support the achievement of our high single-digit to low double-digit organic growth goals over the course of the next 5 years.

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

Thank you, Mark, and good afternoon, again, everyone. As Mark discussed, we delivered record bookings and backlog in Q3. While we have updated our fiscal '22 guidance as a result of the current macro environment, we are still expecting record financial results for the fourth quarter and full fiscal year.

Looking further ahead to fiscal '23, we anticipate continued strong bookings and a return to organic revenue growth. Together with improved operating leverage and our 1MPACT initiatives, we expect this growth to result in margin expansion and increased adjusted EBITDA versus fiscal '22.

Turning to our results on Slide 9. Q3 was a record quarter for bookings, which were up 41% compared to Q3 '21 and up 25% from last quarter. Our book-to-bill was a strong 1.17%. Year-to-date, our book-to-bill is 1.05 and bookings are up 18%. We finished Q3 with record backlog of $996 million, up 4% compared to Q2. Our 12-month backlog was $638 million, up 17% year-over-year and 11% sequentially, providing improved revenue visibility into the next 12 months.

Although we experienced supply chain-related program delays during the quarter, the team did a great job actively managing resources to progress other programs, thereby minimizing top and bottom line impacts. As a result, Q3 revenue came in at the high end of our guidance at $253 million. Organic revenue was $234 million, down 9% year-over-year and slightly better than our expectations coming into the quarter. Acquired revenue, which included Pentek, Avalex and Atlanta Micro was $19.3 million. Our POC acquisition, which we closed in December of 2020, is considered organic revenue in Q3.

Gross margins were 39.4% compared to 41.1% in Q3 fiscal '21, primarily related to program mix including higher engineering content associated with programs in the quarter. Operating expenses were up 7% compared to Q3 last year, in large part driven by the recent acquisitions and related amortization expense as well as $6.3 million of restructuring and other charges, most of them related to third-party consulting costs associated with our 1MPACT program.

R&D was $25.4 million, down 16% compared to Q3 last year. As a percentage of sales, R&D was 10%. This was lower than expected coming into the quarter, mainly driven by engineering resources allocated directly to customer-funded programs. Q3 GAAP net income was $4.1 million or $0.07 per share. Adjusted net income was $32.2 million or $0.57 per share. Adjusted EBITDA for Q3 was $52.5 million. Our adjusted EBITDA margins were 20.7% compared with 21.3% in Q3 fiscal '21. This reflects lower gross margins and negative operating leverage as organic revenue declined year-over-year, while we continued to invest for growth.

Free cash flow for Q3 was an outflow of $10.3 million. Similar to Q2, cash flow was impacted as a result of supplier delays. We also experienced direct labor shortages in January due to Omicron. This impacted the timing of deliveries in the quarter and therefore, cash flow as well.

Slide 10 presents Mercury's balance sheet for the last 5 quarters. We ended Q3 with cash and cash equivalents of $92 million compared to $105 million in Q2, driven primarily by the free cash outflow. Mercury ended the quarter with approximately $452 million of debt.

During the quarter, we upsized and extended the maturity of our revolving credit facility from $750 million to $1.1 billion at attractive rates. The increased capacity provides a significant financial flexibility, and we're confident in our ability to continue to supplement our organic growth with strategic acquisitions.

From a working capital perspective, unbilled receivables increased $48 million from Q2. This was driven by the growing proportion of overtime revenue in our mix as we execute on our content expansion strategy. The increase was amplified by the impacts of supply chain disruptions, which delayed delivery milestones and cash collections in the quarter.

Winning more outsourcing business from our customers has been the primary driver of our above-industry average growth rates. Like our customers, we recognize most of our revenue associated with the development and production of subassemblies and subsystems on an overtime or percentage of completion basis. Revenue is recognized as we perform work and progress on our performance obligations.

Billings, on the other hand, are typically subject to the completion of specific milestones such as the final delivery of an end product. As a result of our content expansion strategy, we've seen an increase in the proportion of overtime revenue to our total revenue. In Q3, overtime revenue increased to approximately 55% of total revenue compared to 47% a year ago. Also in Q3, supplier component decommits and extended lead times delayed final shipment milestones on certain programs. To minimize the financial impact, the team did an excellent job responding by actively managing available resources across other programs wherever possible.

Although we met our revenue and adjusted EBITDA goals, these component shortages did delay planned deliveries. This resulted in lower in-quarter cash collections than previously anticipated. Inventory increased approximately $8 million in Q3, mainly due to accelerated raw material purchases to support higher demand and mitigate supply chain risk in Q4 and into fiscal '23. Going forward, we will continue to consider prebuys for key components where we believe our supply chain could be at risk, seeing it as a cost-effective short-term insurance policy. That said, we expect inventory turns to improve as we move into fiscal '23.

Turning to cash flow on Slide 11. Free cash flow for Q3 was an outflow of $10.3 million. This was largely due to the impacts of supplier delays and direct labor shortages on our delivery and milestone linearity as well as advanced inventory purchases. In total, we saw approximately a $40 million cash flow impact in Q3 related to supplier delays, primarily within unbilled receivables, as I discussed. We expect the majority of the Q3 supplier delays to be resolved in Q4 with the timing of deliveries and billings resulting in cash conversion in either Q4 or early in fiscal '23.

We continue to experience delays and extended lead times for semiconductor components and other materials in the fourth quarter. As a result and similar to Q3, we expect a free cash outflow in Q4 primarily due to continued supply chain constraints. The team remains focused on minimizing supply chain impacts, both operationally and financially. We expect our unbilled receivables and cash conversion cycles to normalize as these headwinds subside.

I'll now turn to our financial guidance, starting with full year fiscal '22 on Slide 12. I'll begin by noting that our guidance for both Q4 and the year assumes no incremental acquisition-related expense. While we experienced order delays in the first half of the year, we saw continued momentum in domestic contracting activity in Q3, which we expect to continue in Q4. Program funding is also flowing down, and our conversations with our customers have been positive.

Our fiscal '22 guidance is based on our current outlook on key programs driving Q4, including the large FMS sale, funding on F-35 TR3 and other programs that Mark discussed. We are, however, adopting a more cautious organic revenue and margin outlook for fiscal '22, reflecting program mix and continued macro headwinds in Q4, which we expect to pressure margins. As a result, we're reducing our prior revenue and adjusted EBITDA guidance for fiscal '22 by $5 million and $10 million, respectively, at the midpoint of the ranges.

We now expect total company revenue of $1 billion to $1.02 billion, representing 8% to 10% growth from fiscal '21. Organically, the midpoint of our revenue guidance represents a 3% decline year-over-year. This reflects the supply chain and other risks that have impacted our year-to-date revenue performance. GAAP net income for fiscal '22 is expected to be $24.4 million to $29.3 million or $0.44 to $0.52 per share, reflecting year-to-date restructuring and other charges as well as acquisition-related and amortization expenses.

This also reflects nonoperating activity and discrete tax benefits in fiscal '21, which are not guided for fiscal '22. Adjusted EPS for fiscal '22 is expected to be in the range of $2.34 to $2.44 per share. Adjusted EBITDA for fiscal '22 is expected to be in the range of $210 million to $217 million, up 4% to 7% from fiscal '21. Adjusted EBITDA margins are now expected to be approximately 21% to 21.3%. This compares with our prior guidance of approximately 22%, largely due to program mix. We're expecting double-digit bookings growth and a book-to-bill above 1 in fiscal '22, providing good visibility as we enter fiscal '23.

I'll now turn to our fourth quarter guidance on Slide 13. While we've adjusted our guidance in light of the headwinds I discussed, we're forecasting all-time company records for revenue, net income and adjusted EBITDA. And while there are still order timing, supply chain and labor market risks, we're entering Q4 with record backlog and forward coverage of approximately 70% of our forecasted Q4 revenues with solid visibility to the remainder.

We also expect a strong Q4 from a gross margin perspective. The mix of programs that we expect to drive our growth is weighted towards higher-margin production programs and licensing revenue. Our current revenue forecast for Q4 is $301.5 million to $321.5 million. This represents the biggest revenue quarter in Mercury's history, surpassing our prior record by nearly $60 million at the midpoint.

GAAP net income is expected to be $30.1 million to $35.5 million or $0.53 to $0.63 per share. The comparison with Q4 last year reflects the expected incremental 1MPACT-related expenses and amortization expenses. Our guidance for Q4 also includes restructuring and other charges of $3.3 million related to the 1MPACT initiative.

Driven largely by higher gross margins and operating leverage on sales growth, we expect Q4 adjusted EBITDA in the range of $81.1 million to $88.1 million. Margins are expected to be approximately 27% of revenue at the midpoint, up more than 600 basis points from Q3. Q4 adjusted EPS is expected to be $0.96 to $1.06 per share. We expect free cash flow for Q4 to continue to be impacted by the macro environment, including continued supply chain disruption.

We also expect 1MPACT program cash outflows and working capital investments associated with quarter-over-quarter revenue growth. As a result, we expect a free cash outflow in Q4. We expect free cash flow to normalize in fiscal '23. While we don't guide bookings, we are expecting record bookings in Q4 with a book-to-bill above 1.0, resulting in record backlog at the end of the quarter. This should position us well as we move into fiscal '23.

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

Thanks, Mike. Turning now to Slide 14. Mercury enters the fourth quarter of fiscal '22 with strong backlog and bookings momentum. We believe this will set the stage for a strong fiscal '23, as we return to our organic growth, continue to manage the industry challenges and expand margins through 1MPACT.

Looking ahead longer term, our model sitting at the intersection of the high-tech industry and defense, positions us well for a period in which the U.S. and the allies are likely to make substantially increased investments in national security. We believe that our strategic investments in secure processing, trusted microelectronics and open mission systems will continue to drive growth in our business.

Mercury is well-positioned to continue to benefit from the ongoing effects of supply chain delayering and reshoring as well as increased outsourcing at the subsystem level by our customers. Our strategy is to improve margins while growing the business organically, supplemented with disciplined M&A and full integration. By executing on this strategy, we've created significant value for our shareholders for nearly a decade, and we expect to continue doing so.

In closing, I'd like to extend my appreciation to the entire Mercury team for the outstanding work they've done during this challenging time. Our focus continues to be executing our strategic plan and driving value for all our shareholders. The purpose of today's call is to discuss our third quarter earnings results and outlook, and we ask that you please keep your questions focused on those topics.

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

(Operator Instructions)

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

So Mike, I appreciate all the color on free cash flow outlook. And I guess, if you can give us maybe a little bit more on the working capital build you expect in the fourth quarter, given kind of all the EBITDA that's coming in and why that's not converting and maybe where working capital goes over time because it's a pretty high level at Mercury. And as you do more work on a percentage of completion basis, should there be more milestone payments that aren't necessarily associated with delivery so that the advance balance grows in a way that's more kind of commensurate with the unbilled so that working capital isn't such a huge percentage of sales relative to the larger companies?

Yes. So a couple of questions in there, Seth. So let me try to hit on them. First of all, in terms of cash flow and as we look at Q4 and what happened in Q3 in terms of working capital, as you said, the biggest use of cash was working capital really in unbilled receivables because of supply chain delays. And as we look at Q4, we actually expect a similar impact to what we saw in Q3. So while we expect some of the unbilled to come down in Q3, we have other programs where we're seeing supply chain decommits and we actually think unbilled are going to be up at the end of Q4 due to program timing and milestones.

When you look at inventory, we expect it to be relatively flat as we continue to deal with the supply chain. And then you mentioned we do have a big Q4. As a result of that, at the end of the quarter, we expect billed receivables to be up due to the timing of deliveries on the heels of that large revenue quarter. So from a working capital perspective, in Q4, we do continue to expect it to be a use of cash. Now we expect that to normalize as we go into fiscal '23 with unbilled coming down to more normal levels. We look at unbilled as a percentage of our overtime revenue. And we do think that, that's going to come down over time. And a lot of the reasons that you discussed. We're working with our customers on milestone payments, negotiating better milestones around those contracts, especially in this environment.

And then we also expect inventory turns to increase as we get into fiscal '23 as the supply chain -- the pressures of the supply chain abate because, as you know, we've been pre-purchasing inventory as a result of that. So I think that in answer to your question, our business model is different than the primes and some of our customers. So we are going to have more working capital in general. That having been said, I think there's opportunities as we go into fiscal '23 for that to come down, really driven by unbilled reduction in inventory terms increasing.

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

Mark, this maybe an unrealistic question, but just given all the supply chain challenges, I mean, just when you think about your business model getting back to kind of high single-digit or low double-digit growth, is it unrealistic to think that that's back in play for fiscal '23, just given the industry-wide challenges that you guys are caught up in?

So I think overall, Peter, I think the opportunity for us to continue the model that we have, right, at high single-digit, low double-digit, yes, we feel good about it over time. We're not going to guide right now on fiscal year '23. But if you think about what we said in the prepared remarks and what we expect to have happen in the fourth quarter, we are expecting bookings to actually accelerate over the 41% growth that we had year-over-year in Q3, resulting in substantial growth at the year level as well as a huge increase in terms of backlog as well. So I think it positions us well for a return to organic growth next fiscal year. But as I say, I'm not going to guide specifically '23. We'll hold that for the next call.

Your next question comes from the line of Pete Skibitski with Alembic Global.

Can we drill down more, Michael, into gross margin? I feel like there's a couple of things going on there. One, is some of the acquisitions you guys have wanted time to improve kind of fundamental margins there. And also, you talked about mix a little bit also. I'm wondering, as you head into 4Q, do you expect those 2 items to move in the right direction for you in the fourth quarter and into '23 in terms of -- particularly in terms of mix, are you fundamentally kind of changing to a more production-focused mix? Or is it a little volatile? Are we heading out to greater than 40% kind of from here on out? I was just wondering if you could clarify that.

Yes. So when you look back at the gross margins over the last couple of years, Pete, we have seen a lot of moving parts. Fiscal '20 kind of pre our Physical Optics acquisition, we were closer to 45% gross margins or 44.8%. In fiscal '21, we were 41.7%. What you saw there was the Physical Optics acquisition, which has a different business model than ours, was slightly dilutive to gross margins. It had 110 basis point impact on gross margins, and we only owned it for half of the year. '21, we also had 100 basis points from COVID expenses because as we invested in testing to make sure we had business continuity during the pandemic. And then we also, in fiscal '21, we had a good mix of new program starts.

So if you look at fiscal '22, and we don't guide gross margins, you're going to see that the Physical Optics Corp. is acquisition. We've now had it for a whole year. So that's going to be dilutive to gross margins, probably around 200 basis points for the year. And then we're seeing some pressure due to the supply chain in terms of inflation, although we have been able to pass most of that through. But the biggest movement in fiscal '22 compared to fiscal '21 is program mix. And it's related to a lot of new program starts that we have that are in development that are going to transition into production going into fiscal '23 and beyond.

So as we look into fiscal '23, we do see gross margin expanding as more of those programs transition to production. And as we look forward beyond that, a lot of the things that we're doing around 1MPACT are focused on gross margin expansion as well. So we see a lot of opportunity. And then just quickly on Q4, yes, we do in Q4, expect to see gross margin expansion from where it's been year-to-date. Because in Q4, we've got more production programs and some licensing fees, and that's what you're seeing driving some of the EBITDA margin expansion in our Q4 guidance.

Okay. That's great color. And last one related to that is, guys, as you look at the kind of the 2 new budgets, '22 and '23, is there any reason to think development mix a year out could switch dramatically? Because obviously, you'll have things like LTAMDS and whatnot, and hopefully, F-35 go into production, and those are big. But you've got a lot of new R&D spend also. So I'm just wondering how you're thinking about the broad opportunity for mix changes going forward?

Yes. I think we've won a lot of early-stage programs, right? The amount of CRAD that we've had has continued to decline both this year as well as last. We do see a pickup in certain programs next fiscal year. I think as you know, right, this year -- or last year, sorry, we saw a substantial decline in bookings in the F-35 that impacted the business. We're clearly seeing the rebound. Similarly, on other programs, Filthy Buzzard was also impacted, that's in production. We're expecting that to rebound as well as SEWIP. The whole naval modernization franchise was impacted as part of COVID and yes, the impacts of the shipyard.

So I do think that, yes, the amount of business that we have in production will continue to grow. That said, when you look at the '23 budget, whilst procurement is flat, the amount of R&D increased by over 9% to an all-time high. So I think you're seeing some shifts in the budget towards new technologies and capabilities in line with the emerging threats, in particular, the peer threats, which I think bodes well for Mercury and its business model. So we've got some good programs. I think our business model is aligned and it literally does come down to mix.

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

Just wanted to maybe drill down a little bit around some of the ability for you to pass through pricing from your customers. I think your comment was that you could pass some through, but some you could not. Can you just give us a sense of how we should think about sort of those pricing pass-throughs and your ability to execute that?

Sure. So let me take a crack at it and maybe throw it over to Mike at the end. So I think if you look at the majority of our revenue today is fixed price, and we're largely operating on the commercial terms. This year, with POC, we estimate that roughly $40 million is cost-plus reimbursable. The cost-plus type contracts do allow you to pass on higher cost to the customer where fixed price contracts typically do not. .

So the effects to our margin, Jonathan, really in the short term, depends upon what's in backlog and when those increased costs flow through. Unlike many of our customers who have multiyear backlogs that can help buffer the near-term impact. That being said, we do have typically shorter production cycles, which does allow us to potentially more frequently pass on the price increases, either as a next program tech insertion or during the next production run, and it really depends upon the circumstances.

So in addition to that, the passing on the inflationary costs really also depends upon the contractual terms. In most cases, that was down to actual inflation escalation causes. So we've actually been doing a ton of work on that associated with 1MPACT. We've actually been reviewing every contract as it comes up for renewal. And looking, as part of our other 1MPACT work streams, in particular, procurement and pricing, ways in which we can manage the inflationary pressures that we're seeing.

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

Mark, I wondered if you can address 1MPACT a little bit. I mean, it looks like from your slide, you expect, by the end of this fiscal year, you're at sort of a $25 million -- or $27 million benefit of the $30 million to $50 million you targeted by '25. So it seems like you're pretty well along the way. My question would be, is there the opportunity to expand this as you think about sort of what you've achieved so far? But then on the flip side, has what's happened in Eastern Europe changed your thinking at all around how you're spending this money and how you're looking at this restructuring?

Sure. So it's a good question. So I think we're pretty pleased, Ken, with the progress that we're making around 1MPACT. Yes, the -- we started off really looking at the organizational structure, things like spans and layers. And we got through that, the majority of that organizational efforts pretty early on. And that was the majority of the $27 million. Right now, we're focused really on other what we believe to be drivers of margin expansion going forward.

So we talked a little about pricing. We are in the process of developing a pricing center of excellence to leverage best practices in both pricing and cost estimating across the business. We've had a tremendous amount of work going on in the procurement side of things. In particular, we're ramping up several initiatives to better drive economies of scale and enhanced demand management whilst also reducing the complexity of the supply chain. And in Q3, we implemented a new AI-based tool, which will enable much greater automation and analytics in the procurement process, which should allow us to harvest much better insights over time into the supply base. So pretty happy with what's going on there.

Another big one is around footprint and operational excellence. We -- in the Q3, we completed the consolidation of our San Jose and Fremont facilities. But we've got more to do there. When you're looking at facilities optimization, it takes time and tremendous amount of planning. And so we've got a detailed set of work underway looking at that as well. The final one is around R&D investment efficiency and ROI. And investing in R&D is a critical area that's driven really the growth in Mercury's business historically. And we always, I think, invest above the industry average, just given the fact that we're sitting at the intersection of tech and defense.

As we look at Ukraine, I think in the short term, just given the nature of the capabilities that have been requested as part of the military assistance, there's probably not a tremendous amount of short-term upside. As I've said, we do think that over the next 2 to 3 years, we are going to likely benefit with sales from new or upgraded F-16s in Eastern Europe. I think clearly, there's going to be additional F-35s sold to both Western Europe and potentially Canada. I think there's opportunities in various precision munitions.

And then very clearly, air and missile defense system. So we're on Patriot, we're on THAAD, we're on LTAMDS, Aegis Ashore, Aegis. And so I think there's really good upside potential just given the substantial increase in defense spending that we expect across Europe over the course of the next decade.

Okay, that's helpful. And if I could just real quick, Mike, I know you're not talking about fiscal '23 in detail yet. But when you refer to cash flows returning to normal levels, how should we think about sort of normal maybe on an EBITDA or a conversion basis? Or is that something you're prepared to provide at this point?

Yes. I mean, we'll provide more guidance when we get to fiscal '23 as we see how things play out in terms of supply chain and some of the other headwinds that we've seen. Historically, Ken, we've set a target of 50% free cash flow to adjusted EBITDA. And I think that's still a good target going forward.

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

Mark or Mike, just to play maybe devil's advocate a bit. I mean you've got -- you're calling for a 5-year view, calling for margin expansion. We've seen some of the challenges over the past couple of years. I mean, I think at one point, the deal target was 45% to 50% gross margins. I mean I know you're talking right now about general mix and some of these new start programs.

But it seems like we're going to be in an environment here of the continuous RDT&E and new start programs. I mean you've got the savings from 1MPACT, which, if we just run the model, maybe you get to 24% EBITDA margins. I guess what can you tell us in terms of the confidence level in expanding these margins on a go-forward basis versus what we saw over the trailing 3 to 5 years?

So I think, yes, our confidence level is high, Mike. I think we have won a bunch of programs. I think those programs are expected to go into production over time. The major drivers from a margin expansion perspective as it relates to 1MPACT are the pricing initiatives. I just went through some of the things that we're doing there. Procurement, both direct and indirect, which we think is a significant opportunity.

And then over time, leveraging and managing our footprint as well as driving operational excellence. So we've already got a tremendous amount of work underway with the analysis and the work stream to basically drive those. So I think we are going to see margin expansion. And it's likely above the number that you threw out on the call there. Mike, I don't know if you want to comment at all from your perspective.

No, that's spot on. I'd just reiterate, I think we have a lot of confidence in it over the next 5 years. And Mike, if you look at a lot of our programs right now, they are -- and as we look at the 5-year plan, we've got visibility into those transitioning into production. That's things like T-45, [B22], other programs like that, that are in development now that are going to transition to production.

So I think we're going to see gross margin expansion based on our contract mix over the next 5 years. We're also going to see R&D leverage as we take the investments we've made over the last couple of years and put them across our whole portfolio. And then SG&A. I think we're going to see operating leverage as well as we grow revenues faster than we grow expenses.

And then on top of that is the 1MPACT initiatives that Mark discussed. So I would just reiterate, I think we have a lot of confidence that we'll be able to expand margins over the next 5 years, supported by the current product or the current program with as well as 1MPACT.

Got it. Those programs, I mean, looking forward, do you see licensing revenues becoming more of a prominent driver? Or is that -- just thinking about the high margin kind of drop through from those types of revenues. Is that in the mix going forward?

We do have some licensing revenues, Mike, going forward. That's part of our business model. But the bigger expansion that we're going to see is these new development programs that have lower margins moving into full rate production.

Yes, as we look out over the longer term, Mike, the other area that we think is pretty important is the trusted microelectronics business, right? So if you remember way back when the genesis of that strategy was when we acquired the microelectronics assets from Microsemi. We since obviously built that business out and are focused on in 2.5D and 3D microelectronics capability. And as you know, a tremendous amount of focus there. So as that continues to ramp and to build, and we're at a very early stage today. And it's actually -- it's dilutive to margins in the trusted microelectronics piece, that will also be a driver of margin expansion.

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

Just my first question here, can you talk or delineate some of the key programs that drove the 17% year-over-year increase in inventory build in the quarter? I know you had mentioned an FMS program.

Yes. So Austin, I think there was a couple of things that drove the working capital balance. Inventory was one and the other was unbilled receivables. We've had a variety of programs that drove the unbilled receivable balance up and have a quite a few examples of situations where we were working on the program, we got 80% complete. Milestones were based on final delivery and that was delayed because of supply chain disruption.

And so that's really what's been driving the working capital inventory. There's not specific programs. I mean we are buying parts for specific programs, but it's more around those parts that we use in a lot of our products. And one thing to remember is that we are an electronics company, we're a computer company. And from a direct material perspective, nearly 40% of our direct materials are related to semiconductors. And from an inventory perspective, that's one of the areas we've been focused in terms of prebuying those capabilities because that's where we're seeing the longest delays and supplier decommits.

Okay. That's helpful. And then just a follow-up. Do you expect electronic warfare to sort of be the key driver of foreign military sales for the company over the coming years? Just given you look at the Ukraine conflict, Russia's extensive use of the Krasukha-4 system, and China is almost certainly certain to use it in the Asia Pacific region, if they're going to threaten like Taiwan or the Senkaku Islands.

Yes. I would say right now, based on what we see, probably the biggest driver for Mercury is in the radar domain associated with air and missile defense. But we're also leveraged to EW as well. And so there's clearly going to be opportunities there also.

Your next question comes from the line of Christopher Rieger with Berenberg.

I'd like to ask about R&D, which over the past quarter was about 10% of sales, a bit relative to your historical average, but you kind of addressed in your prepared remarks. But could you please sort of talk about out what your current R&D spending priorities are? And perhaps how these may have perhaps changed over the past several months, particularly in light of 1MPACT-related efficiency initiatives and what has transpired on the geopolitical stage? I know you've kind of touched on it a little bit, but any further color there would be appreciated.

Yes. So I don't think the priorities and focus areas have changed too much. I think we've got a strong belief that the investments that we're making in our focus areas around secure processing, open mission systems, C2I processing as well as trusted microelectronics is very, very well aligned with the national defense strategy and clearly aligns with the shifts that we've seen as a result of the invasion of Ukraine. So the areas that we're focused on are literally those, open mission systems, secure sensor processing, trusted microelectronics and really JADC2. It's what we've really built the company around and our R&D is heavily focused on that.

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

Maybe I have some other questions. Can you square away what's going on with cash flow and your supply chain commentary with regards to expected revenues? The revenue decline is much less than what we're seeing in the margin contraction and the cash impact. So maybe can you talk about those dynamics and what makes them normalize?

Yes. So Sheila, on the guidance, you're right. From a revenue and margin perspective, the revenue was down. We just brought the top end of the range down by $10 million. So the midpoint was reduced by $5 million. We brought EBITDA down, guidance by $10 million. That was really associated with program mix and the timing of production getting pushed into next year on some key programs. So that's the majority of the change from a revenue and margin perspective.

From a cash flow perspective, in Q3, we saw more, as I talked about, supplier component decommits and extended lead times, which delayed the final shipment milestones associated with a lot of our programs. That resulted in lower in-quarter collections than expected, which drove our cash flow down. Now we had expected unbilled and inventory reductions to normalize in Q4. But as we look at the current quarter, we look at the programs and we're still dealing with the supply chain, we think we're going to see a similar dynamic in Q4. So it's really the supply chain that is pushing the cash into fiscal '23. And we think as we get into fiscal '23, we expect that to normalize.

So Sheila, let me just jump in there a little bit and give you a little bit more color, right? When you look at the $5 million lowering of the revenue guidance, it was really 2 programs that moved. One, was the F-18. We experienced some contracting delays in Q3 that pushed the expected award into Q4. But based upon the timing or the delay in Q3 and the timing of the award into Q4, it lowered the amount of in-quarter book and ship revenue that we previously anticipated.

The second was T-45. Here, we had some supply delays that impacted some of the ongoing development efforts. That program, we were expecting the initial production award. We're now expecting that in fiscal year '23. Those combined were way more than the actual $5 million drop in revenue. So we were able to recover some of the shortfall or the delays that we saw. The other thing is that from a margin perspective, we did have at least one high-margin licensing deal associated with certain of our capabilities that moved into next year as well. And that was clearly one of the bigger drivers on the EBITDA side.

Okay. And then maybe one more. I think you guys mentioned CH-53K, MH-60 programs. I have heard you talk about in CDS, I don't -- I'm not sure what that one is. But how big of contributors are they? And how should we think about them going forward?

Yes. So they came to us through the acquisition of our Physical Optics business. As you know, we have been focused on building out a next-generation avionics and mission computing business. And we've, in essence, hand selected 6-or-so businesses that fit together really, really well that plays into the delayering trends.

So with that business came a host of some great programs, CH-53, MH-60. Additional work on F-16, additional work on F-18, additional work on the F-15EX, T-45, a host of different programs. So -- and actually, this past quarter, we just won 2 new design wins on the CH-53. So there -- I wouldn't say they're in the -- they're not in the top 5 programs, but they are in the top 20 going forward. So important programs for us and are expected to grow over time.

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

Okay. Well, thank you very much, everyone, for listening. We look forward to speaking to you again next quarter. Take care. Thank you.

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