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

Hello, everyone, and thank you for joining us for our first ever virtual growth stock conference. My name is Jonathan Ho, and I'm the research analyst here at William Blair & Company that covers Mercury. I'm required to inform you that a complete list of research disclosures or potential conflicts of interest is available at our website at www.williamblair.com. With us today are Mark Aslett, the Chief Executive Officer of Mercury; and Michael Ruppert, the Chief Financial Officer. Mark and Michael, thank you so much for joining us today for our conference. And for those of us that are maybe a little bit less familiar with the company, can you maybe provide a brief overview of Mercury just to level set the audience?

Sure. So maybe, Jonathan, I can use a 3 or 4 slides, and then we could get into Q&A. So welcome, everyone, and Jonathan, thank you very much for the invitation to present here today. As I said, my name is Mark Aslett, President and CEO of Mercury Systems. And with me here today is Mike Ruppert, our Chief Financial Officer. So Mike, if you go to the next slide, please. So the presentation itself does contain some forward-looking statements. And due to risks and uncertainties, the actual results may differ materially 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. Next slide, please. So a little bit about the company. So Mercury today is pioneering a next-generation defense electronics company. And the way in which we positioned the business is really a high-tech company operating inside of the defense industry. So we're sitting at the intersection of those 2 industries, which is a very important part of our model. Our goal overall is to make commercially available technology that is being developed by the high-tech world, profoundly more accessible to the defense industry. From a capabilities perspective, we're focused on building very sophisticated processing subsystems that need the concept of trust and security because many of the technologies that we're providing are going on board some of our nation's most important programs and platforms. Our customers are the major defense prime contractors and we're working on critical programs, both in the airborne, naval as well as the land domain. And increasingly, we're serving our customers' increased outsourcing needs. From a fiscal perspective, we've got a very strong financial profile. Over the last 5 years, we've grown our revenues at a total compound annual growth rate of 26%, approximately 10% organically over that same period. And over the same period, we've been able to grow our levels of profitability far faster than that, so 46% compound annual growth in adjusted EBITDA. Finally, I think one of the things that we're most proud of is that we've created a very strong and positive set of cultures and values at Mercury that has resulted in Mercury actually attaining current employee highest Glassdoor ratings. Next slide, please, Mike. So from an investor highlights perspective, we spent over $1.3 billion since fiscal 2014, really creating a growth company inside of the defense industry. We've positioned the business inside of large and fast-growing markets and markets that we believe are going to be well funded given the alignment with the national defense strategy. We've created and pioneered this next-generation business model, and we've proven that a high-tech company can operate very successfully at scale inside of the A&D industry. Our model includes R&D levels that are 4 to 5x the industry average. We are developing technology that we can reuse multiple times over. The capabilities that we have are some of the most advanced in the industry around the concepts of trust and security. And our whole business model is optimized to reduce technologies and capabilities far more quickly, far more affordably and at much less risk than they've ever been produced previously. We're producing highly sophisticated secure processing subsystems that are developed by a highly cleared workforce. We are producing and developing those capabilities in trusted facilities with a trusted supply chain. And with everything that has just happened with COVID, this has clearly been something that's very, very important. Mercury has been doing it for the last 7 years. And finally, we believe we have become a destination as well as an acquirer of choice. From a growth perspective, we're growing at far above the industry average. And what is happening there is we've got simultaneous expansions going on in parallel. So one of the first ones is that we moved from being a product company up into being now today, a provider of outsourced Tier 2 subsystems. This has driven a substantial content increase and increased the ASP of the capabilities that we're selling to our customers. We're then taking those capabilities and have done a very good job expanding into close adjacencies, selling those capabilities onto other programs and platforms, but again, working with the same customers, the major defense primes. And finally, we're in the early stages of building out a very unique chip-scale innovation strategy that could produce future highest margin content expansion. M&A has also been a very important part of our model. We're using M&A to both target new capabilities as well as to expand our markets. And given the importance of that, we built the ability to do the deal origination, the M&A execution transaction as well as the integration of the businesses, all with internal resources. The integration capability is very important. We're not a holding company. So we're seeking to fully integrate the businesses that we acquire. And that's really the primary reason this -- although our revenue has grown at a 26% CAGR, EBITDA over the last 5 years has grown at 46%. So we're extracting significant cost and revenue synergies from the acquisitions themselves. Finally, I would say that we've got a very active M&A pipeline, and we think there's going to be even more opportunities going forward. Next slide, please. So what you see here is really the manifestation of Mercury's strategy at work. And in the inverted pyramid on the left-hand side, you kind of see the financial profile that we're seeking to execute against and that we believe that we can continue to deliver upon going forward. And so to begin with, we're looking to generate high margins expressed and shown here as greater than 20%. We're looking to be able to grow our business organically at high single digits to low double-digit rates organically over time. And then finally, we're seeking to supplement that high level of organic growth with acquisitions to be able to grow total company revenue on an LTM basis at greater than 20%. So if you compare that profile with our actual results on the far right-hand part of the chart, here, you can see that our actual performance has substantially outachieved or overachieved compared to the model. So 22 points (sic) [ 22% ] of margin, 28% total company growth, which includes 10% organic growth over the period. And then over the last 12 months, 20%. If you compare Mercury's performance just with an index of Tier 2 companies of similar size and composition, just one column to the left. You see that Mercury's results are far in excess of most companies inside of the defense industry. In fact, they're so far above, we actually sought to compare ourselves with all similarly sized, publicly traded companies and at a similar size. And there are approximately 1,140 of those companies whose market cap is between $1 billion and $7 billion. If you progressively apply the filter that you see in the inverted pyramid, what you'll see is that Mercury's results is not just in the top of the defense electronics industry, but we're actually in the top 3% of all publicly traded companies irrespective of the exchange or the industry in which they're operating. So we think that we've created a very unique model that is working extremely well, and we're seeking to continue to do that going forward. So with that as a brief overview, Jonathan, maybe we can shut down the presentation and just go to Q&A.

Thank you so much for that overview, Mark. That's really helpful to just kind of level set the audience in terms of the Mercury story. Yes, I guess I have to start with some inevitable topics like COVID-19 and so maybe if we just kind of launch there. Can you talk a little bit about how Mercury has been managing through the crisis? And maybe in particular, how you thought about derisking some of your own supply chain through this process?

Yes. So I think in hindsight, we were very quick to react to the onset of COVID. And we kind of set out to begin with really defining 4 goals that would guide our decision-making and action taking. And the first of which and probably the most important was to protect the health, safety and the livelihoods of our employees. And we were one of probably the first companies and certainly far -- moved far sooner than many of our customers at sending as many of the people who could work from home to do so. What that did was basically helped dramatically reduce the density inside of our manufacturing locations. And we were seeking to protect those to the greatest extent possible. And to date, touch wood, we haven't had any COVID-related events that have resulted in any impact to those facilities, which means that our facilities continue to be open and produce. So I think that was a very positive thing. The other thing that we've done is really leaned in to try and help our employees, and particularly those that were at the lower end of the spectrum. We set up a $1 million emergency relief fund. We dramatically extended employees' sick leave, all of which, I think, built a tremendous amount of trust and helped employees feel very safe in terms of the actions that we were taking on their behalf. And so I think we've built up a tremendous amount of goodwill. The supply chain piece is also, as you mentioned, critically important. And that was something that we really began to focus in on in early January, at the very early stages of when COVID was impacting over in China. And we did a lot of things to really buy down risk and supply chain, including buying additional inventory, focusing on the right suppliers, trying to find dual source of supplies wherever we possibly can. And we're working it daily. And I think as a result of that, we've been able to manage through what has been somewhat of a challenging supply chain with really very minimal impact. And so -- and we're still doing that, obviously. We're looking out over several quarters, right down to the component level, to assess what it is that we need to do to continue to produce the products and to be able to provide those to customers.

Great. Great. And just when we think about some of the longer term implications of COVID-19, are you seeing decision makers start to pivot? Is there more of a flight to quality when they look at partners? What are some of the things that are driving that decision-making process?

Yes. So I think we've seen that from a supply chain perspective, supply chain resiliency is really important. And that concept, I think, is occurring across multiple different industries. And it's happening in defense as well. And we'd already begun to see in our customers, what we call a flight to quality supply is occurring. And we think as a result of COVID and the fact that uniquely in defense, our customers are seeking products that are developed here domestically with the trusted domestic supply chain and where security is critically important. So I think you are going to see that maybe even an acceleration of that flight to quality, and we believe that we'll continue to take share as a result of that.

Got it. Got it. Maybe taking a look at the potential for a CR going forward here, how do you think about your backlog positioning? And maybe what's different about Mercury in comparison with prior periods where there have been a little bit more challenges around CR?

Yes. So I think we're a very different company today. And we, as we exited sequestration, which was somewhat of a challenging time for the company back in 2013, I think, recognized that as a relatively short-cycle business, having a larger backlog was better than a smaller one. And we've done a really good job building that backlog. And as an example, over the last 12 months, our backlog is up over 38% when our revenue was up 20%. So that, coupled with the fact that we're a much larger business today and that we've got a much greater diversity of programs and platforms and customers, I think, positions Mercury to continue to weather the challenges that the industry may face, including a CR.

Got it. Got it. During the prepared remarks, you referenced your integration is one of your best practices, and I just wanted to understand a little bit more broadly relative to your M&A strategy. Can you give us a little bit more color on what some of those best practices are around integration? And what you're really trying to achieve in that process?

Yes. So integration, as we mentioned, right, really is a pivotal part of the strategy. For us, it really begins with assessing the cultural fit of the business. Mercury has created a very, very strong culture and positive environment that employees really like coming to work. As I mentioned, we do believe in full integration. And that -- we kind of test that right upfront as we're having conversations with potential targets is what they feel about becoming a larger part -- or a part of a larger company. So the elements of the integration strategy is that we believe in 1 brand, it's Mercury, so we're going to unify the brand. We seek to combine together like-product businesses or product lines to really gain scale and efficiencies. We seek to in-source our manufacturing into our trusted domestic manufacturing facilities that will generate cost synergies and potential margin improvements over time. We will very rapidly seek to deploy our common enterprise processes, tools and systems to create a common operating environment inside of the acquired entity. We typically seek to raise the R&D level in the companies that we acquire. So the industry, as you know, in defense, is typically spending 2% maybe 3% of their revenues in R&D. We're spending anywhere between 11% to 13% as a high-tech company operating in defense. And what offsets some of that increased R&D spending is the fact that we're looking to centralize G&A, which will generate operating leverage over time and some savings that can offset some of the increases. Probably one of the biggest things that we did as well was that quite a while ago, we dramatically changed our go-to-market model. And we shifted from being a product-oriented geographically organized sales team, to now, it's really much more around managing strategic accounts and solutions selling. So the altitude of our selling has gone dramatically higher and hence, greater outsourcing. Finally, I would say that we have got a matrix organization that we seek to deploy into the acquired company. And that's all about continuous business improvement in lean and agile methodologies. So we think that we've got a pretty sophisticated integration playbook, and we're kind of doing that all with internal resources. And we're now able to do multiple in parallel and to do them very quickly.

Yes. And Jonathan, I would just add, I mean, you've seen the results of that. It really makes us competitive from an M&A standpoint because we've been able to put the playbook together that Mark just outlined. And we've been able to, with a very proactive M&A approach, acquire companies. I think Mark mentioned in his prepared remarks, the fact that we are an acquirer of choice, which has really helped us in terms of sourcing. But what we've shown an ability to do is then take the multiples we paid and average those down, and that, that value has accrued to our shareholders. We've been able to do it from a cost perspective as well as from a revenue perspective.

Got it. Got it. And maybe just taking a look at sort of your content expansion strategy. How do you make this sort of make versus buy determination? How do you think about the ability to cross-sell and upsell once you've made the acquisitions? Like, can you maybe walk through some of the thought processes and the metrics that you use to make those determinations?

Yes. So we began with this concept that we call the sensor processing chain. And when you look at many of the systems that we're selling into, say, radar and EW applications, it consists of a certain set or suite of technologies, including RF radio frequency, analog to digital, digital to analog conversion or mixed signal. The typical type of digital signal processing that we provide, you've got storage as well as security. So we set out to basically acquire or develop that entire suite of capabilities to allow us to move from being a product company into being able to provide more complete subsystem solutions. And the thesis behind this was that if we actually integrate our own technologies, meaning our customers didn't need to buy from different vendors and to do the integration themselves, our solutions would be far more affordable and that we could do it more quickly with lower risk. And that's absolutely turned out to be the case. So what's happening today is that our customers are really outsourcing much more at the subsystem level than what they are at the individual product level. And so that's been a key element. We've kind of moved from being a Tier 3 product company up into the Tier 2 level, which has dramatically increased our ASP per system, and we're then taking those capabilities and expanding them into different submarkets. And probably one of the more significant moves that we made early on was to move from radar into EW. Probably the biggest market expansion that we have going on today is moving from selling processing subsystems associated with sensor and mission systems into all those other types of computers that go on board a military platform that is collectively known as C4I. And that market is actually much larger than Mercury's traditional market. So we've kind of gone up in terms of content and out in terms of markets. And the opportunity that we see going forward is now doing the same at chip scale, which we're pretty excited about.

Excellent. Excellent. As part of the acquisitions that you've made, you talked a little bit about security and cybersecurity is clearly near and dear to my heart. So can you talk a little bit about what you're doing in the cyber intelligence and cybersecurity realms? And maybe what that broader opportunity looks like for the company as well as maybe margin profile for that type of business?

Yes. So we're on our fourth or fifth generation of taking industry-leading embedded security IP and embedding them into our processing solutions. And why that's important is that if you think of the processing architecture, it's really the brains of the system. And these sophisticated processes are going on board some of our nation's most important offensive and defensive capabilities. And so what you're trying to do is to protect them from reverse engineering. So our adversaries, if they get their hands on a system, they're not able to get a leapfrog in terms of the technology. But also cyber resiliency of the underlying architectures themselves become increasingly important. So for me, the -- what we focus on is really is 2 major concepts. One is embedded security IP, and again, we've got industry-leading technology there. The second is the concept of trust. And that comes down to having a trusted domestic supply chain and trusted domestic manufacturing, all of which we built out over the last 7 years. So not only have we got the industry-leading security IP, but we've also got that resilient domestic supply chain and manufacturing assets that are becoming so increasingly important today. What we see going forward is that there's been a lot of discussion about reshoring the silicon industry, the ASICs, et cetera. We see the opportunity of doing the same thing down at the silicon level. As architectures kind of shift from very large and monolithic ASICS to more triplet-based capabilities coming -- where the silicon themselves come from different vendors, that's going to need to be designed to produce and secure it domestically. And that's really the kind of the next frontier for us.

That's helpful. Thank you. When we think about sort of the defense clients having their own capabilities, can we expect them to start to shift more of that content over to you over time? What are sort of the milestones that you look for, for the industry to shift over more work to Mercury?

Yes. So the -- so outsourcing is alive and well. I mean if you look at one of the metrics that we use to think about are we being successful with the strategy, is how is the outsourcing? What is the amount of revenue that we're getting from subsystems and how is that growing over time? And today, subsystems over the last 12 months is 44% of total company revenue. And it's up 27% year-over-year. So the outsourcing is absolutely happening. And it's happening because customers need a solution more affordably, faster time-to-market with lower risk, which is really what we provide. Now in some instances, and certainly for the new platforms, we're seeing more customers going directly, outsourcing its subsystems. For more, call it, legacy platforms, we may end up capturing more of the content, ultimately arriving at a subsystem over time. So whether it's a retrofit or an upgrade or a new platform, we see the migration to subsystems and outsourcing occurring.

Absolutely, absolutely. Michael, a quick question for you. When we think about free cash flow, what are some of the main drivers between the difference between adjusted EBITDA and free cash flow? And how do you think about a stronger convergence between those 2 numbers over time?

Sure. Yes. So we define free cash flow, as you know, Jonathan, as cash flow from operations less CapEx. So the target that we've set for ourselves, we did a couple of years ago, is 50% free cash flow to adjusted EBITDA conversion. And that assumes maintenance CapEx levels. And as you know, we've been investing in the business over the last couple of years, but especially over the last few years, including this year, and we expect that the conversion will be closer to 40% of free cash flow to adjusted EBITDA. Then when you look at the difference between the 2, though, EBITDA obviously doesn't take into account interest, cash taxes, CapEx, net working capital, which we're investing in as we grow organically. So as we think about it and how do you -- how should we look at free cash flow compared to adjusted EBITDA, we think that 50% target is a good level for us as we continue to grow the business. And right now, we're happy with the cash flow generation of the business.

Great. Great. Lockheed Martin has recently announced some potential delays in deliveries for the F-35 program. I know you guys are not weighted to a single program, but can you talk a little bit about the diversification within the business, the number of programs that you're on today and maybe potential exposure to some of these larger programs that are out there?

Yes. So we've got really no 10% revenue programs today. And I think over the last 7 or 8 years, we've dramatically increased the number of programs and platforms that we're involved with, which we believe has reduced the potential risk to the business. So today, we're on over 300 different programs and platforms, and we think that we're participating in the right parts of the market.

Got it. One last question from me as we've reached the end of our time. How do you think about the endgame for Mercury? Like what does the business look like now that -- once you've sort of gone through this -- your expansion and investment stage of the company?

Yes. So for me, I think the strategy that we put together is working extremely well, right? Sitting at the intersection of tech and defense and seeking to transition those commercially developed technologies and to make them profoundly more accessible is a need that we think is going to endure. We also think that processing in as many different formats, whether it be secure processing or processing at the, down at the chip level, which we're now increasingly doing, will enable the next generation of applications that currently can't be done with the existing sets of technology. So I think there's an enormous opportunity for us to continue to grow the business that we have begun, both organically as well as through M&A. And ultimately, our goal is that we'd like to be able to provide every different type of processing solution that goes on board a military platform and the ancillary technologies and capabilities associated with that. And that's what we're seeking to do. That's what we're executing against. And we're on a journey, and we think that we can continue to do what we have been doing so successfully.

Fantastic. Thank you. This has been extremely helpful. I just want to thank both Michael and Mark for participating in today's call and hope you enjoy the rest of the conference. Thank you.

Thank you. Thanks, Jonathan. Good to see you.