Mercury Systems, Inc. (MRCY) Earnings Call Transcript & Summary

Good morning, everyone, and thank you for dialing in and attending this session. This morning, we have Mark Aslett, President and CEO of Mercury Systems; as well as Mike Ruppert, EVP and CFO of Mercury Systems. I think that the way we're going to do this, this morning: Mark is going to give some prepared remarks and then we'll have some discussion back and forth. And again, if you want to submit some questions, I think you can do it through the portal. Or if you want, you can directly e-mail some questions to me. And of course, I have some prepared questions. So without further ado, Mark?

Thanks very much, Ron. Good morning, everyone, and welcome to the BofA 2020 Transportation and Industrials Virtual Conference. As Ron said, with me here today virtually is Michael Ruppert, our EVP and Chief Financial Officer. Moving to Slide 2. The presentation itself does contain some forward-looking statements. And due to risks and uncertainties, the actual results may differ materially either from what you see or hear today. So please take the opportunity of reviewing our safe harbor statement or for additional disclosure on our risks, you can look at our Form 10-K. Turning to Slide 3, a quick overview of the business. So Mercury is pioneering a next-generation defense electronics company. We've created a very unique business model that really sits at the intersection of the high-tech world as well as the defense industry. Our goal and objective is to make commercially available technology profoundly more accessible for use inside of defense, specifically to make that technology transition more quickly, more affordably and at lower risk. From a capabilities perspective, our overarching goal is to basically provide every different type of computer that goes onboard a military platform, specifically those that require the concept of supply chain trust as well as secure computing solutions. We are involved in some of our nation's most important programs and platforms. Our customers are the major defense prime contractors. And what is really driving the growth in our business is their increased outsourcing needs, particularly at the subsystem level. From a fiscal perspective, we've actually got a quite strong financial performance. We've been able to grow our revenues in total, 26% CAGR over the last 5 years, averaging 10% organic growth over that same period. And we've been able to grow adjusted EBITDA at a rate that is far faster than that as a result of some of the things I'll describe in the presentation. Finally, we're very proud to actually have the defense industry's highest current employee Glassdoor ratings. That's particularly important as you're looking to attract new talent into the business, and we continue to grow despite the challenges that we have with COVID. And in addition, we've seen that these ratings have actually played out as part of our acquisition strategy as well. Turning briefly to Slide 4, just from an investment highlight perspective. We spent over $1.3 billion since fiscal 2014 creating this very unique model. Again, we positioned ourselves as a high-tech company inside of the defense industry. We focused the business on the large and fast-growing parts of the market, specifically those that we believe will continue to be well funded. We've created this proven transformational business model. And we think that we've proven that a high-tech company can operate successfully for all stakeholders inside of the A&D industry, specifically, employees, customers, the Department of Defense as well as the -- our shareholders. From an investment perspective, we're actually spending 4 to 5x the industry average expressed as a percentage of revenue, and our CapEx is 2 to 3x the industry average as well. And we spent that on highly differentiated technologies and capabilities for use inside of these military platforms as well as building out a trusted domestic supply chain, which has turned out to be of critical importance, and I think is -- the importance of which is increasing over time. From a growth perspective, what we have done is create a very low-risk content expansion growth strategy. And we've got multiple expansions that are occurring simultaneously. The first is, as a business, we move from being a product-oriented company into, as we moved up the value chain, now providing outsourced subsystems as a Tier 2 level to our customers. This has probably had the largest impact on our overall organic growth because the -- as we've captured more content, the average ASP of the products and solutions that we're selling have increased quite substantially. Simultaneously, what we have done is kind of moved into other submarkets or adjacencies -- close adjacencies as well as moving into other programs and platforms with similar needs. As we look forward, we also see a unique opportunity to create innovation at chip scale, which has the potential of driving the highest margin content expansion opportunity going forward. M&A has also been a very important part of our strategy. We've used M&A to basically acquire highly differentiated capabilities that match our solution sets as well as expand into those adjacent markets. We've built out the capability to do the deal origination, execution as well as the integration in-house. We are a full integrator, so we're not a holding company. We're seeking to extract cost and revenue synergies over time. And this is primarily the reason why our adjusted EBITDA has grown at a 46% CAGR over the last 5 years, whilst our total revenues have grown at a 26% rate. We seek to have multiple M&A themes going on in parallel and finally, we think we've created a business platform that we can continue to scale. Turning to Slide 5, and then I'll open it up for your questions. So Mercury's financial profile, what you see here in the inverted pyramid on the left-hand part of the slide, really demonstrates the uniqueness of our strategy at work. So we're seeking to generate high margins, expressed here as greater than 20%. We're looking to grow our business on average over time at high single-digit, low double-digit rates, shown here as greater than 10%. And then on an annual basis, we're looking to grow the business, including acquisitions at a rate that is greater than 20%. So if you look at the far right-hand part of the chart on Slide 5, you can see our actual performance over those same time frames. We've delivered 22 points of adjusted EBITDA margin, 28% compound annual growth rate averaging 10% over that period and 20% growth in the last 12 months. If you move one column to the left and compare our results with an index of Tier 2 defense companies, our results far outstrip the industry average. Moving to the far left-hand part of the chart, we actually compared our financial profile, again, shown in this inverted pyramid, with all publicly traded companies irrespective of the exchange in which they're listed or the end markets in which they're operating, of a similar size, shown here between $1 billion and $7 billion, and there are 1,140 of those companies. If you progressively apply those filters, what you end up with is the less than 30 companies that are [Technical Difficulty]

Ron, are you there?

Mike, I'm here, yes. Sorry, I was on mute.

Okay. Yes. All right. I think Mark's phone went a little haywire there. So why don't I continue while he logs back in. So I think he was just going -- yes, he was just going through Page 5, which is our unique financial profile and talking about some of the metrics that we've had as a company and comparing that on the left to all publicly traded companies with market caps between $1 billion and $7 billion. And if you look at that, the financial profile that we have when you apply those 3 filters, it starts with about 1,100 companies and it gets down to only 30 companies. And so the financial profile that Mercury has not only puts us in the top tier or unique category of all defense companies but a unique category of all publicly traded companies. And our financial strategy at the core of it is to continue to execute on this. And not only do we want to maintain EBITDA margins greater than 20%, we want to expand those margins over time. We want to grow organically at high single-digit, low double-digit rates, and we think we're really well positioned to do that. And then we want to supplement that organic growth with strategic M&A. We've got a strong record of doing that. We've completed 11 acquisitions over the last 5 years and deployed $800 million of capital. And what we think is if we can continue to do those 3 things, then we'll continue to remain in a unique category of companies, and that will continue to create value for the shareholders. So that's really the core of the strategy. And Ron, I think we can open it up to questions, and I can field them. And once Mark dials back in, he can field them as well.

I'm sorry, I'm dialed back in. I'm not sure what happened there.

Yes, yes. Your phone went cyborg. Yes, yes, we can hear you. Can you hear us, yes?

Okay.

So great. So yes, anyone -- again, if you have any questions, just fire them in. I can see some questions coming in now. But why don't I kick it off just with one maybe overarching question? There was an interesting article in the Wall Street Journal that came out late last night or early this morning about U.S. dependency on Asian suppliers for microprocessors. Then they quoted this, Taiwan, China and South Korea represent a triad of dependency for the entire U.S. digital economy. When we -- if indeed, I mean, we were to see some shifting back to the U.S. in terms of chip fabrication for microprocessors, is there an opportunity there for Mercury? And how do you think about that force, if you will, on the end markets that you're dealing with?

Sure, Ron. I do think there's an opportunity there. I think it could take some time for the actual semiconductor fabs to move back domestically. But ultimately, I think we do need a domestic supply. We, as you know, have really focused on building up our own domestic and trusted supply chain over the last 5 to 7 years, building up our own manufacturing facilities, which has been really important, and 93% of our direct supply today is actually domestic in nature. But if you go back to the semiconductor, clearly, it represents -- the offshore manufacturing represents real risk. And some of it is actually because of where it's obviously manufactured, and a lot of it is also due to the actual packaging. So part of what we've been doing is building up a trusted domestic custom microelectronics ability, which will allow us to take silicon and then customize it and package it here domestically because a lot of the risk today is actually in the packaging, where you're able to potentially insert devices that shouldn't be there that could alter the specifics of the device itself. So what we've been focused on in Phoenix is building up that capability where as the industry transitions from large monolithic ASICs into what is known as chiplet-based architectures, we can customize and take different types of silicon, FPGAs, GPUs, CPUs, along with I/O mixed-signal, which is RF and digital capability, memory, and create trusted and secure application-specific devices for use inside of the aerospace and defense industry. So even as that silicon begins to kind of move back onshore, we still see an enormous opportunity, I think, to enable the next generation of applications in defense. And part of the reason for that is not just because of the specific nature of the end use applications. But the other is that the silicon providers are very afraid of tainting their commercially developed products and technologies with what is known as ITAR, International Traffic in Arms restrictions, that could, unless they do it correctly, result in some of their technologies not being able to be exported overseas. And so the silicon industry almost needs a buffer between it and the DoD and we've really positioned ourselves to help transition those technologies again to kind of the whole business model of operating at the intersection of the tech world and defense.

So while we're on the topic of opportunities, one of the questions that has been submitted is, can you talk about the current environment and how that's presenting opportunities or expected to present opportunities for the company?

Yes. So we actually haven't seen a fundamental shift or change in our customer behavior and demand. I think the -- our national defense priorities haven't changed. And I think the [ nation still depend ] upon what we're doing, hence, industry as a whole, the defense industrial base being designated as essential. So all of our facilities are open. And we continue to do the good work we do. I think what is fundamentally driving the growth in the business is things that we've discussed in the past. Outsourcing is probably the largest driver of growth that we have in the business today, and whereas historically, capabilities outsourced by our customers at the product level is a result of what is known as COTS, commercial off-the-shelf. Today, for affordability and time-to-market reasons, we're seeing more of that opportunity in outsourcing move to the subsystems level. And our growth, subsystems revenue growth is actually up 27% over the last 12 months. So we expect for that to continue. And it's one of being able to introduce the technology more quickly, more affordably and lower risk than the alternative approach. The other one that is obviously, I think, become even more important in this environment is the shift to, call it, lower-risk suppliers. And we have obviously built up our own domestic manufacturing. We have a trusted supply chain. And what we're seeing is that in -- with the exposure in the -- to the aerospace industry that many suppliers have, some of those suppliers are in [ build difficulty ]. And so there's almost a fight to quality suppliers by our customers, and we think that that's going to accelerate as a result of what we're seeing with COVID and the impact of the supply chain, but also with the need to have that trusted domestic supply chain as well. So we've already been taking share in certain areas, and we expect to continue to do that going forward. So those have been, at an industry level, 2 primary drivers as to how it is that we've been able to grow the business faster than most.

So one of the key pillars of growth for the company has been M&A activity. And when you think about that, how do you -- I guess, first, is there a Mercury culture? I'm assuming there is, if you could describe it a bit. And how do you cultivate that in the acquisitions that you integrate? How do you measure it? And how do you overcome the -- that's not how we do it kind of concept from companies that you [ bought ]?

Yes. It's a good question. So there is a Mercury culture, and I'm not going to go into it in a lot of detail. But I think that it's something that is probably my biggest learning as a CEO by far, just the importance of that. And if you're able to shape that, the outcomes that it drives are significant, not only in terms of the financials of the business, but also the sustainability of what it is that you're [ applying ]. That clearly does play out from an M&A perspective. So to describe kind of the 3 major pillars of the culture as opposed to [ the spectrum ] at all is really 3 things. We've got a very significant focus on driving outcomes. So as a team, we are very outcome-oriented. The second is innovation. Our marketing tagline is innovation that matters. And so we're solving some of our customers' most difficult challenges. We innovate not only in terms of the technology, but also in terms of our business model that I described a little earlier and how it is that we run the company. The third that has really shone through in this environment is helping and caring for one another. So we really do put employees at kind of the heart of what we do, and our efforts that we have taken to respond to COVID has really been very well received by the employees. If I look at from an M&A perspective, the cultural fit is kind of the #1 thing that we look at because we're not a holding company and we do seek to rapidly and fully integrate and enculturate the acquired businesses. And I can kind of get through -- go through if you're interested in what that means. But very simply put, we've got -- we do all of our integrations. So when we assess the fit from a culture perspective upfront, and we're very upfront with the potential acquired companies, is to what we do and how we do it and how quickly we do it. And if -- so we're very transparent. And if the company that we're talking to is not interested in that, then we'll walk away because we've seen just the impact that a mismatch in terms of culture can have on the speed at which you can move as well as achieving the financial blueprint that you're seeking to deliver with the business. And so how we enculturate is that we basically recognize that M&A was a really important part of our strategy. And so we built the deal origination, execution and integration capability in-house. So we don't outsource anything. From an integration perspective, we're doing it all with internal resources. And each function has basically got its own acquisition playbook. And so we know what we're going to do on day 1, day 30, day 90 until the business is fully integrated. And we're able to not only prosecute multiple deals simultaneously from an execution perspective, but we also have the capacity to do the same thing from an integration perspective as well.

Yes. And one thing I'd add, Ron, is just if you look at the track record of our acquisitions, they've been great cultural fits. And most of our targets have been -- I'd say, all of our targets have been thrilled to be part of Mercury because of the advantages we offer that they didn't have before. So we're bigger. We've got a strategic sales force, which is key to increasing the growth rate of the targets that we have. And one thing that Mark mentioned in the slides is our investment in R&D. And one of the things that we've done with all of our acquisitions, we've actually increased the level of R&D and increased the innovation, which has then driven growth. And so to date, those opportunities that the targets have seen is well received, and they're thrilled to be part of Mercury.

So maybe picking up on the R&D point and increased spend there, where do the great ideas inside Mercury come from? How do you cultivate innovation and creativity in the company? How do you reward it? How should we think about that? Be it that your business model is a little bit different, right? I mean your innovation seems like it's got to be organic, not necessarily just driven by your customer.

Yes. So I think when most people think about innovation, they clearly tie it back to the technology side of things. And Mercury has always been a very innovative company, kind of on the leading edge of technology, and we're still doing that today. And what really drives that is the very intimate relationships that we have with our customers. And so we are typically engaged with them on the next generation of technologies where they're trying to solve some of the most difficult processing challenges. And yes, it's not just about the performance of the computer on the processing system. It's also around the security or the safety of it or the environmentals. And so we've got a tremendous amount of technology capability and innovation that occurs. And as you know, we've got probably the highest level of internally funded R&D in the industry that is developing those sophisticated capabilities. And we talk about a model that we call the 6 Ss that is really where we're innovating or where we're investing for innovation. One is in silicon to build this trusted custom microelectronics capability here domestically. The second is that we've got the highest performance processing solutions in the industry. The third is that everything that we do is optimize the size, weight and power as well as cooling. We've got some of the most advanced open middleware that protects our customers' applications and allows them to be able to take advantage of technology, the processing domain, so riding Moore's Law. And then we've got industry-leading embedded security and now have added the concept of safety. So we know what we're really good at and what our customers need. We've got very intimate relationships. And we're spending significant monies on that. I would also say, though, it's not just about technology. So I believe that the reason that we are as successful as we are is innovation in other dimensions, and the business model is clearly one. So we think that we have proven that a high-tech company, and we really run the company like a high-tech business in terms of investment and the speed at which we're able to move and the operating cadence and rhythm in the business, that a high-tech company can be successful inside of the defense industry. And so if you look at our financial statements in comparison to our customers, we look very different. And so we're willing to take more risk. We're investing heavily, and it's a result of that, that we're taking share and kind of disrupting other companies in the space. So the business model is disruptive. How it is that we are integrating companies, we're innovative from a people perspective. So it's not just about the technology, albeit that's a very important part of what we do. Hello?

Ron, are you on?

Yes, sorry. So I was on mute to try to save the background. I can't tell you how many times I've talked on mute. So yes. So I think with that, that is the end of the session because we've run out of time. So if anybody has any further questions, you can direct them towards us or to the team at Mercury. So thank you again, and I hope everybody has got a good conference today.

Thanks, Ron. Thanks, everyone.

Thanks, Ron.

Yes, you bet.