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

The floor is yours.

Great. Well, thank you very much, Sheila. I really appreciate the opportunity presenting here today. As Sheila said, with me is Mike Ruppert, our Chief Financial Officer. So next slide, please, Mike. So the presentation does contain some forward-looking statements. Due to risks and uncertainties, the actual results may differ. So please take the opportunity of reviewing our safe harbor statement. So a little bit about the company. Today, Mercury is pioneering a next-generation defense electronics company. And what we've done is really create a very unique business model. We're really a tech company that's operating successfully at scale inside of the defense industry. Our goal is to make commercially available and adapted technologies profoundly more accessible to the defense industry as a whole. From a capabilities perspective, think of us as basically providing all of the different types of computers that go onboard military platforms, particularly those that are required to be developed and produced domestically and for those that require embedded security capabilities. We are working on some of our nation's most important programs and platforms. Our customers are the major defense primes, and we're serving their increased outsourcing needs. From a fiscal perspective, we've got a very strong financial profile. We just finished our fiscal year '20. We reported 2 days ago. Over the last 5 years, we delivered a 28% compound annual growth in revenue and have averaged 10% organic growth annually over that 5-year period. We've been able to grow our profitability at a rate that is far faster than the growth in revenue. And we're very pleased to actually have achieved the defense industry's highest current employee Glassdoor ratings. Next slide, please. So from a strategy perspective, we spent $1.3 billion over the last 5 or 6 years really creating this very unique model. As I mentioned, we have proven that a tech company really can operate successfully on behalf of all stakeholders, customers, shareholders, employees, inside of the defense industry operating as a high-tech company. What we've been able to do is really create a very different and transformational business model. And at the heart of that is really the investment level. So this past year, we spent more than 12% of our revenues on R&D when the defense industry average is around about 2%. We're developing technology differently. So it's all about design reuse and doing things more quickly and more affordably. We've got industry-leading technology and a highly cleared workforce. We've invested in trusted domestic manufacturing as well as development here in the U.S., which is obviously very important in this environment. From a growth perspective, what's driving the growth is that we've got simultaneous expansions going on in parallel. So the first is we've moved from being a product company into subsystems. We're penetrating our existing market, which is sensor and effective mission systems, while simultaneously moving into C4I. And finally, we see the opportunity of actually creating some very unique capabilities at chip scale. Completed over 11 transactions over the last 5 years, and we built the M&A capability in terms of origination, execution and integration inside of the company. So we seek to fully integrate the acquisitions that we do, basically developing cost and revenue synergies over time that has led to very, very strong financial results. Next slide, please, Mike. So what you see here in the -- at around about '20. If you look at our actual results shown here on the right-hand part of the chart, you'll see that our actual results are even better than our goals and objectives. So 22% is in the defense industry. And in fact, what we did is then compare ourselves to all publicly traded companies whose market cap is between $1 billion and $7 billion, irrespective of the exchange -- Sheila, we can get into some of the questions.

Great. Thanks so much, Mark, for that. So you just provided -- you ended your fiscal year we got a lot of questions on the defense budget outlook. Clearly, a question for you. You have a stated target of...

So we've been very vocal saying that we expect it kind of low single-digit rates, which is still, at this point in time, our belief is what's actually going to happen in the short term. We'll see what happens over time as a result of the massive fiscal stimulus and whether or not any defense crowding out occurs. But...

What's the share gain from outsourcing? And then you also have some big program wins like LTAMDS that are driving that?

Yes. There really -- there are 4 major kind of industry drivers that we see happening, 3 that we've talked about for quite some time. And the fourth one that we'd like to call the suppliers. And here, I think we saw during sequestration, and we're seeing again on the COVID scenario, the companies that are maybe less well capitalized or aren't growing at the rate at which we are, unable to invest in the business, either in capital or in R&D, to meet the needs of the customers longer term. And so we're taking share. And the fourth one that we think is important is now, obviously, trusted domestic supply chains. And we are doing all of the work from a development and manufacturing domestically. So those are the major trends. Now I would say probably the most dominant one for us is outsourcing because as our customers have outsourced more, they're outsourcing at the subsystem level, which means that we're capturing more of the content and the deal sizes are increasing.

And then in terms of your addressable markets, you have these great slides at your Analyst Day that break up your adjustable markets. How do you think about areas that offer the most opportunity for share gain in some of those faster-growing areas?

Yes. So the 2 major markets in which we participate are what is known as sensor and effector mission systems. That's about a $16 billion, $17 billion market. And then we, most recently, entered C4I, which is actually even larger than our traditional market. What we're seeing right now is that a wave of modernization that's occurring onboard military platforms specifically in radar and EW. And so for fiscal year '20, our radar revenues were up 43% year-over-year to 29% of the total, and EW is up 26% year-over-year to 20% of the total. So we're clearly seeing a wave of modernization occurring. The other driver, as you said, really, what is known as C4I. It's one of those other types of computers that go onboard a military platform. And those are at the market that we just really begun to enter a few years ago through acquisition. And that represents a significant opportunity for us because when the DoD upgrades the underlying sensors, it has a knock-on effect to also upgrade the command and control or the combat systems, which are those other computers that we're now providing. So as I kind of look forward, I think we are expecting to grow in both the markets along the lines of the longer-term goals, the high single-digit, low double-digit rates. Over the next 5 years, we're probably going to see increased growth in C4I as a rate compared with sensor and effector mission systems. And that's primarily because it's operating off a slightly smaller base. So overall, I think we expect to see growth in both of the markets in which we're operating, Sheila.

Sure. And then I wanted to turn to 2 COVID questions. One is a bit more short term, one's longer term. In terms of the short-term effect, you mentioned you do have a lot of facilities in California and Arizona where COVID is surging right now. How are you managing your own manufacturing but also any supply chain interruptions that you might have?

Yes. So we obviously began our COVID efforts, believe it or not, in January, yes, because we have our facilities around the world. We began our U.S. mitigation efforts in February. And a lot of that was supply chain related, and we haven't really seen any major impacts on our supply chain. The risk, as we see it right now, as you said, is really more domestic in nature. And it's because of the surge of the virus that we're seeing in and around some of our facilities. So in particular, in Arizona, we've seen some significant increases there, as well California. And we're seeing surges beginning in both Alabama as well as Georgia. So what we have begun to -- we've done everything that all other companies are doing in terms of temperature checking. 60% of our employees are working from home, so creating substantial depopulation of the facilities. We've used -- we're using mandatory masks. We've had that in place for months now. We're doing temperature screening and symptom checking. Everything that is kind of, call it, the staples. What we just rolled out, however, and we just began it in Phoenix, is mandatory COVID testing of anyone that's working in our facility. And we think that, that is going to be the best way for us to be able to maintain the business continuity inside of the plants. And we're in the process of rolling that across some cases. We haven't had any of the facilities impacted per se. And as you can see from the results that we just delivered, we're continuing to deliver record financial results.

And then just longer term, whether it's COVID related or not, just how does the U.S. DoD look at reexamining its own supply chain? And how do you think about maybe potential -- a more domestic push in terms of microelectronic capabilities?

Yes. It's a great question. So clearly, I think we have seen as a nation, right, the fact that being reliant in critical areas, whether it be our health care supplies or our technology where it's manufactured offshore, in particular, in many instances, in potentially China, which is our largest adversary, is maybe not a great idea. We recognized that really probably 7 years ago. And we began to build out our own trusted domestic manufacturing capabilities in 3 different domains. The first is in RF, radio frequency, capabilities. So we just finished another facility on the West Coast. We insourced our manufacturing from a previously outsourced contract manufacturing model in our secure processing product line into Phoenix. And most recently, we're building out or extending our capabilities in trusted microelectronics, and we're underway there. The reason that that's important is that really the commercial silicon is at the heart of the capabilities of many of our military platforms. And much of that is developed domestically but is actually manufactured offshore. And the DoD in a recent study has basically now said that having trusted and secure microelectronics domestically is their #1 technology priority. And so we feel very well positioned there to -- and it's really the next leg of growth in the business, we believe, longer term.

No, that's super helpful. And then just moving on to a few program-specific items. You won -- you were a partner with Raytheon on LTAMDS. How do we think about that program and the investment involved with that?

Yes. We partnered with Raytheon, and they demonstrated several radars in the sense of and that included some of Mercury's most contemporary investment in innovation. So we feel super happy that they won. It's a potential $20 billion opportunity for Raytheon, for Mercury. It's probably the largest single program that we've won in our entire history. It's in the high hundreds of millions. It was our #1 design win this fiscal year. It was also our second-largest booking at a company level in fiscal year '20 and our third-largest booking in the fourth quarter. So -- and those bookings should turn into revenues beginning in our fiscal year '21. And those are particular bookings for the first 6 systems that Raytheon is under contract with the Army to produce. So we're super excited about it. It's a great win for us. It's a long-term program and introducing some of our technology. We also won 2 new design wins on LTAMDS actually in the fourth quarter. So we're continuing to expand our content footprint on the program even as we speak. So a great program, thrilled to be a part of it and we invested heavily on our own -- out of our own internal R&D budget to [ help break that one ].

Yes, you mentioned 12% of R&D to sales versus 2% for the primes. Is that investment now behind you? Or given you keep -- you have 2 more design wins that's upcoming investment, how do we think about that?

Yes. So the 12% obviously wasn't just for LTAMDS, right? We've invested in LTAMDS actually not just this past year but in prior years as well. So it's been an ongoing investment. And our whole investment model is to really align and develop technology that can be used many times over on our customers' franchise program. So it's kind of design once, reuse many times. We are in a period -- I think a very unusual period. The level of modernization activity and new design wins is the highest we've ever been. The lifetime value of our top 30 programs and pursuits right now, it is over $10 billion of potential value to Mercury. And we would have only -- the only reason I think that we have been able to capture that amount of potential content is through the investments that we're making. So yes, we feel pretty good about it. We're -- the R&D level is up over 40% in fiscal '20 compared to fiscal '19. We think it's going to maintain kind of at a high level going forward because of the opportunity set that we see for the capabilities that we're providing.

And then just talking about radars more broadly, both the new and the retrofit opportunity. How do you think about those opportunities, whether it's up 16, up 35, if you can comment on that?

Yes. We're -- boy, I mean radars was our #1 category of design wins in fiscal year '13 -- sorry, fiscal year '20, we had 13 design wins and over $1.2 billion of new design win value in fiscal '20 alone. And it really expands the government in terms of all domains. It's naval radars. It's airport radars. It's ground-based radars, such as LTAMDS. We're seeing a ton of new activity in modernization. LTAMDS is obviously a new radar, but there's a lot of retrofitting going on. So we're obviously on the F-16 SABR radar, which is an upgrade that's going on with the Air National Guard right now with Northrop Grumman. There's international upgrades on the F-16 as well. We're on E-2D Hawkeye. We're on P-8. We're on the F-35. We're on Aegis. If there's a radar, it's probably got some Mercury technology in it without the base of -- in that domain. So it's basically both new as well as upgrades.

And then I just wanted to talk about space for a second. How large is your exposure? It seems to be the hot area right now. And given your capabilities, how do you think about that?

So it's low as a percentage of our revenue today. It's only about 1% to 2%. So kind of it's not a primary driver for us. I'd tell you that we're getting pulled into it because what they want to do with the shift from GEO to LEOs is to increase the amount of processing and storage onboard. Those -- in the LEO orbit, it's rad tolerant as opposed to rad hard. And so we actually have technology flying in various satellites already, and it is an opportunity for us. But right now, it's a relatively small percentage of the revenue.

And then switching gears to profitability. Going back to the R&D question, 12.5% of sales, up 40% year-over-year. How do you decide the return profile is worth your while, customer funded versus company funded?

Yes. Mike, do you want to answer that?

Yes, sure. So I mean we talked about it, Sheila, on the earnings call, as you said. I mean R&D was up significantly this year and 43% year-over-year to 12.4%. And what we talked about in terms of fiscal '21, we see the opportunities, and they are going to continue. When we think about the return on those investments, we're really looking at -- and a lot of, by the way, Sheila, the R&D is developing technology for specific programs that we can use on those programs, but then we can reuse those over and over again so that we own the IP. So when we're looking at returns, we're looking at the returns on those specific programs in terms of our role. And one thing, as you think about pricing as well, by investing that R&D, that gives us the margins that we get over time. And then we can also reuse that IP on current and future programs, which then increases the return associated with it. So I think we've got a pretty good track record of developing unique technologies, leveraging those for specific programs and then being able to leverage those for future programs as well.

That's helpful. And then one more on profitability. How do we think about pricing? How price-sensitive are the prime contractors? What drives their pricing decisions? How much of their decision is based on price versus the technology you offer, whether they decide to insource or outsource that product?

Yes. And truly, we're operating on the cutting-edge and solving problems that our customers can't solve with existing technologies. So although many times our customers have a price to win, a target that we're seeking to hit, for the capabilities that we provide that are very highly specialized, they wouldn't say that they're necessarily price sensitive. We typically are funding the R&D ourselves, as you know. So it's not really like a prime model where the government is funding, in essence, the innovation, we're funding that level of investment ourselves. And then we're selling on commercial terms to the primes. What we offer, and the reason that our customers are actually outsourcing more today at the subsystem level, is that it's actually far more affordable to buy a preintegrated subsystem from Mercury than what it is with them buying technologies from different companies and doing the integration themselves. And the reason that's the case is the integration costs for these next-generation technologies dwarf the cost of the individual product procurement. And so the reason that we're growing so successfully and our customers are outsourcing more is that we provide a tremendous amount of economic benefit through the technology model that we're using that results in a far more affordable solution to them overall. So hopefully, that was helpful.

No, that is. And then maybe, Mike, this one is for you because it's on free cash flow or, Mark, feel free to answer. How do you think about your free cash flow conversion to an adjusted EBITDA basis going forward given some of these investments are behind you? You have a long-term target of 50%. You guided your fiscal '21 in the 40% to 45% range.

Yes. So I'd start by saying we're really pleased with the cash flow generation of the company and the base business because if you look over the last couple of years, we've really been able to invest in areas like expansion CapEx, and we just spent a lot of time talking about R&D. And so the cash flow generation of the base business is allowing us to invest to grow. In fiscal '18, we went out, we set the target that you talked about, the 50% free cash flow to adjusted EBITDA. We're very close to that in fiscal '19. What really drives it lower is the expansion CapEx. And in fiscal '20, our CapEx -- we came into the year knowing that we were going to invest in some specific programs, specifically the trusted custom microelectronics business, our CapEx was elevated. We're a little over 5% of sales. And so we hit 40% -- slightly over 40% this year. Going into fiscal '21, as you referenced, we guided 40% to 45%. Again, that's driven by the expansion CapEx. When will we get back to that 50% target? Once we get back down to our maintenance CapEx levels. And so I think that our CapEx is going to be driven -- a lot of times it's driven by acquisitions as we integrate or other growth opportunities, and I think we've got a good track record of return. So I think you can look in fiscal '22 and beyond if we return to those maintenance CapEx levels, that's when we'll be back down at that 50% target.

And then last question maybe for you both. M&A is part of the strategy, I believe, 11 acquisitions in over 5 years. How do you think about both the mix of debt and equity to fund those? And then you mentioned the pipeline is picking up and quite strong, maybe if you could comment on that a little bit more.

So why don't I talk about the pipeline, and then Mike can talk about the cap structure. So clearly, it's been very quiet, right, over the last, call it, 6 months or so, right, as a result of COVID. There hasn't been a lot of deals done. We are seeing activity pick up in the 2 markets that we're seeking to acquire, which is in the sensor and effector mission systems as well as C4I. And we're pretty pleased actually with how robust the pipeline is, and we're hopefully going to start and get busy here sometime soon. So -- and obviously, the capital structure is in great shape, right? We've got over $1 billion of financial capacity to go do deals. And I'll let Mike talk about whether it's debt or equity or a mix of both and how that might evolve over time. Mike?

Yes, I mean, Mark said it, we're really well capitalized. We're in a net cash position. We have over $225 million of cash. We don't have 0 -- we have 0 debt. We have a $750 million unfunded revolver. And honestly, the cost of capital right now and the cost of debt on our revolver is extremely, extremely attractive. So as we think about acquisitions in the pipeline, we're going to use debt because of that cost of capital. That having been said, we're very cognizant of being over-levered. And so we'll be careful about that.

That's perfect. Thank you, Mark and Mike, for telling the Mercury story. And with that, that will conclude our webcast. Thanks, everyone, for joining.

Thank you, Sheila. Bye.

Thank you, guys. Bye.