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

Okay. Good morning, everybody. This is Noah Poponak here from the Goldman Sachs Aerospace and Defense Equity Research team. Happy to be starting our next session with Mercury Systems. With us from the company is CEO, Mark Aslett; and CFO, Mike Ruppert. We will have the team here start with a quick introduction, going through a few slides with a brief overview. And then I will start my Q&A session, and we'd be happy to take questions from the audience at the end as well. So Mark, with that, thanks very much for joining us, and I'll turn it over to you.

Thank you very much, Noah. Pleased to be here. Welcome to the Goldman Sachs Industrials and Materials Conference. As Noah said with me here today is Mike Ruppert, our Chief Financial Officer. Next slide, please, Mike. So the presentation in 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. 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 Mercury, kind of a brief overview. So today -- or this year is actually our 40th year of being in business. Today, we have positioned the company and pioneered a next-generation business model that positions Mercury at the intersection of tech and defense. Our goal is to make commercially developed technology profoundly more accessible to the defense electronics industry. From a capabilities perspective, what we're seeking to do is to be able to provide all of the different types processing solutions that go on board a military platform, in particular, those that require the concepts of security and trust. As you'll see, we're involved in some of our nation's most important programs and platforms, working with all of the major defense prime contractors, and we continue to enjoy the defense industry's highest current employee Glassdoor ratings. Next slide, please. So Mercury by the numbers. So around about 2,300 employees today, different facilities around the world, which is a mix of production, engineering and then G&A type facilities. We've been in the defense electronics industry for over 35 years. Really, at the heart of our model is the fact that we are investing significantly more than the industry as a whole, 4 to 5x the amount in terms of internally funded R&D, which is driving innovation and hence, growth. We're also investing significantly in terms of capital expenditures, building out trusted domestic manufacturing capabilities in the 3 different areas in which we're majorly participating. We've got a quite a diverse revenue stream. We're involved in over 300 different programs and platforms today, working pretty much with all of the major primes. From a financial perspective, around about $800 million at the end of our last fiscal year, fiscal year 20. We've grown the business over the course of the last 5 years at a 28% CAGR and 11% organically over that same period. Our EBITDA has actually grown faster than that as we've acquired and then fully integrated businesses, which is a core part of our strategy. And we've completed 12 transactions over the course of the last 6 or so years. Next slide, please. So just touching the 2 major markets in which we're participating. You see down the left-hand side of the screen, sensor and effector mission systems. That is Mercury's traditional market. It's kind of the heritage of the business. And more recently, we moved into a larger market, the C4I market. And so our goal is to be able to provide, as I mentioned, all of the different types of processing solutions whether they're associated with processing real-time data coming from the different sensors on a military platform or whether they're associated with command and control or platform and mission management. And so this is just simply a selection of some of the programs and platforms that we're involved with. Next slide, please. So from an investor highlight perspective, I think Mercury is a very innovative company, and we're sitting at the intersection of the tech world and defense to make commercially developed technologies profoundly more accessible. That's even more important in this environment just given the threats that we're facing. We have focused the business on large and the faster-growing parts of the overall defense electronics market. And so the markets in which we're participating are expected to grow at a rate that is above the overall growth in defense spending. We've created a very unique and transformational business model. And at the heart of that is the amount of money that we're spending on innovative, commercially developed technologies for use inside of A&D. The major industry trends that we're benefiting from is greater outsourcing by our customers at the subsystem level, supply chain delayering, particularly in the C2I and C4I markets overall. And then reshoring all the development and manufacturing and more and more capabilities that goes into military platforms. We think we've created a very low-risk growth strategy. That basically is where we're seeing simultaneous both content and market expansion. And these 2 things coupled together that is driving the organic growth rate that we've experienced over the last 5 years. Finally, M&A for us is an integral part of our strategy. And we are full integrators, seeking to generate both cost and revenue synergies over time. Next slide, please. So Mercury's strategy and financial profile really does demonstrate the uniqueness of the strategy. And you can see our financial profile or our goals and objectives in the inverted pyramid here shown on the left-hand part of the slide. So we're seeking to generate strong margin, shown here is greater than 20%. In the middle part of the pyramid, we're looking to grow the business organically. It's high single digits to low double digits, averaging 10% over time. And then we're looking to layer on top acquisitions to generate additional growth, shown here is around about 20% on an annual basis. To the right, you can actually see our results over multiple time frames. So -- but in total, over the course of the last 5 years. So we delivered strong margins, 23%, [ '17 ] through [ '19 ] average, averaging 22 in [ '20 ] and [ '21 ]. We've grown our business, as I mentioned, over the course of the last 5 years, at a rate that exceeds the 10% that you see here that is the organic growth rate, but we've averaged 10% over that period. And then the total company revenue growth, again, including acquisitions, has been far in excess of our goals. If you compare our actual results with the middle column that you see here, which is an index of Tier 2 companies that are operating in the A&D industry. On a relative basis, our results are far greater than the overall industry average, as shown by this index. And then finally, I think our results compare very favorably with all publicly traded companies of a similar size, shown here is between $1 billion and $7 billion. And so this is the actual results that we've shown or being able to deliver, but it also is a representation of our goals and objectives going forward, which have not changed. So with that, I think I'll hand it back to you now.

Okay. Mark, thanks so much for that. I think the big question right now on investors' minds after the last earnings update, where you call up for top line organic revenue growth to slow down a little bit over the next few quarters before then reaccelerating sort of back half of next year and beyond next fiscal year. Is -- how can investors be confident that this is transitory, this is a transition, and that this isn't simply the defense budget slowing and choppiness around some individual programs, happens when the defense budget is slowing. And that you can maintain your spread versus the end market. But if the end market's slowing, your growth rate slows. Talk us through in more detail, how we can expect a reacceleration eventually in growth rate?

Sure. So maybe step back a little bit and kind of describe what happened throughout the year. So it has been a challenging year from a bookings perspective. But fundamentally, our belief is that we can continue to do what we have been doing, which is delivering high single-digit to low double digit, averaging 10% over time. Our belief in that hasn't changed. And obviously, we think that we can continue to deliver M&A, just given the strength of the balance sheet. But as we reflect back over the course of the year, it begun with a tough Q1, actually, where we had a large foreign military sale that moved from Q1 into fiscal year 22. And it wasn't related to COVID, it wasn't related in the defense budget per se. This was a customer having to reengineer the solution just based upon some specific needs, and that program moved to next year. So it wasn't canceled, but it didn't move, and that was a $35 million delay. We saw some delays in -- as the new administration came in and looked at the weapon systems arena. In particular, they were looking at sale of various offensive systems to various countries in the Middle East and that impacted our bookings as well as our organic growth during the year. I think that we're through that from what we can see right now. And then most recently, I think, as I talked about on the earnings call, we saw a delay on -- an order delay on a large naval EW program. That program was SEWIP, where we believe that we were going to get the order in January, then it was February, then it was March, and it ended up. Our customer got their order on April 2. And then finally, we saw some delays on a large airborne program, the F-35, where our customer has had an issue with one of their suppliers that has impacted our bookings as well as our organic revenue growth. Now if you take those last -- maybe take the first one, the last 2, so why do we feel pretty good about our ability to continue to grow? Well, basically, it's because we believe there's short-term movement. It's not a fundamental reset in growth, but we have seen some delays. So that large FMS order, we believe, has moved into fiscal year 22. So it's basically coming back, is our understanding, next fiscal year. If you look at the SEWIP program, it basically moved a -- across a quarterly boundary and the shipset count is a little lower. But fundamentally, SEWIP will continue to be one of our top 5 programs over the course of the next 5 years. So we feel pretty good about that because it's upgrading the naval surface fleet EW capabilities, which is in line with the threats that we're facing. The F-35 delays, we've got a lot of different content on the F-35. The delays that we saw was around the development issues that our customer suppliers had around what is known as the ICP, the integrated core processor, as well as the advanced memory system, that program as well, although it will impact -- has impacted bookings and will impact organic growth next year, we believe it's a very well supported program. It, too will be -- will remain in our top 5 revenue programs over the course of the next 5 years. In actuality, we believe that we're going to see growth in F-35 revenues over the course of the next 5 years. So although we've seen some turbulence this year, and we think that we might continue to see some delays in the first half, we still think fundamentally that the business can continue to grow, just given the design wins that we've won as well as the major industry trends that we're benefiting from.

Okay. That's helpful. You highlighted in your -- in the opening slides that you're on over 300 individual programs. So on the one hand, I would think if you're highlighting, it's not exactly 3 programs. So you're sort of highlighting 3 programs, over 300 programs, just 1% of the company, I would think that would get lost in the noise of your strong organic growth rate. Is it just that where the delays have happened just happens to be in some of your largest programs because otherwise, those numbers sort of still confusing a bit.

Yes. It's true. So if you look at those 2 programs, in particular, SEWIP, as well as the F-35 are important -- are large programs for us. They're both at the year level in our top-5 programs. So when you see some short-term perturbations or delays, it can't impact overall. The other phenomena that we've seen is, obviously, we've got more programs transitioning into production as well. And so the timing of the new growth programs, although it's really positive, can impact things as well.

Okay. That makes sense. And just to make sure we all have the sequencing correct. The guidance implies approximately flat organic revenue growth in the fourth quarter. And I interpret your comments on the call to suggest kind of flat to slightly low single-digit organic growth in the first half of '22, moving into stronger growth in the second half of '22. Is that the cadence?

Yes. So we didn't specifically kind of guide the first half per se. But what we said is that we're expecting that exiting this year, our backlog will be up high single digits, which will support mid- to high single digits growth for fiscal year 22 as a whole and then mid-teens total company prior to any additional acquisitions. We do expect that the fourth quarter will be stronger in bookings. The book-to-bill will approach 1 for the year as a whole. I'm talking about fiscal '21 here. But we expect that the environment that we've seen in -- over the course of the last couple of quarters will persist through the first half of next fiscal year. So that was kind of the outlook that we gave as well as kind of what we think is likely going to happen.

Yes. Noah, I would just add. We'll provide more formal guidance for fiscal '22 next quarter. But I would say the way you're thinking about it is correct. It is going to be a second half weighted year in light of the bookings we've seen year-to-date. We expect, as Mark said, Q4 bookings to pick up. But the way you're thinking about the first half of fiscal '22 is correct.

Yes. And just back [ to -- not to half on ] the F-35, but in the guidance that we gave, I did mention that mid- to high single-digit organic growth was after a 2-point -- approximately 2 point reduction in organic growth related to the F-35. So that one program alone basically would, had those delays not occur, taken our organic growth outlook back into that high single digit, which is in line with our goals, Noah.

Okay. And in looking at that high single to low double averaging 10% organic [indiscernible] beyond 2022, is that -- are you able to articulate that view just based on the framework you've had for a while and the trends in the market? Or do you have specific bottoms-up from your teams, by segment [indiscernible] program buildups that show you that in your plan?

Yes. It's a great question. And so it's actually both, right? So if you look at what has happened inside of the company over the course of the last 7-or-so years, we substantially increased the lifetime value of our top 30 programs and pursuits. And so we've gone from an estimated lifetime value of around about $5 billion in 2015 to today, that number is north of $10 billion. And so as those programs transition into production, we've already won many of them. And that's what's actually giving us the confidence that it's going to drive future growth. So as an example, LTAMDS is in there, right? LTAMDS is the largest single program, I think, we've won in the company's history. Right now, we're delivering the initial capabilities associated with the first order, which was 6 radars, which has actually taken LTAMDS into a top 5 revenue program in fiscal year -- or recently. As we look out over the next 5 years, LTAMDS will also be in the top 5. So we're seeing some of the transition of some of the growth programs that we've previously won, the design wins, now transition into production. But to answer your questions, yes, I mean, when we basically build up our outlook and forecast for the next 5 years, which is kind of the planning period that we model, it's basically line item by line item tied to specific programs and platforms, looking at the content that we have, the expected timing and building up the model that way. So then if you step back and you say, what are the major trends and themes that we're benefiting from, it's clearly things like outsourcing, delayering, which we've talked about in C2I, we are taking share in various different areas and then finally things like the reshoring.

Okay. That's really helpful. Maybe staying on those trends and elaborating there a little bit. Delayering and outsourcing seem to have some risk of reversing a bit in a slower budget environment where there's somebody above you in the supply chain that doesn't want to give up the work anymore[ , is ] kind of risk or do I have that wrong? And then maybe elaborate a little bit more on the new market [indiscernible] I know you talked about going from components to subsystems, where are you doing that the most? And where is there the most opportunity?

Yes, yes. Okay. So if you look at outsourcing, for what we do, I don't believe that the trend is going to reverse. If anything, I think it's going to continue. Why? Because fundamentally, what's driving the outsourcing trend is the ability of our -- or the desire of our customers to get access to better technology, far more quickly at lower risk than what we've been able to in the past. And that's how it is that we've kind of set up the company and capabilities. So we're basically able to either develop or integrate technology far more quickly and far more affordably than our customers can do it in-house. And that goes back to that, in this year 13% of our revenues that we're spending on internally funded R&D. We're dramatically [ outspending ] our customers to the types of capabilities that we're providing. So I don't believe that you're going to see a -- bring that work in-house, if anything, in the security domain. We've now got larger teams of people than our customers have and those teams have dispersed over time. So they haven't even got the capabilities even if they wanted to. So I think the outsourcing trend is going to continue. And if you think about what is that driven, it's driven a pretty significant increase in the ASP of various programs and platforms over time. So we've kind of gone from being a product company into providing more complete subsystem solutions, meaning the size of the programs and our ASP on those programs have increased over time, which is good. Now what's also happened along the way is that we've won many more programs, right? Some of them are in the early stages, some of them are already beginning to transition into production. But we've also diversified our revenue base. So we've got content expansion going on. The second piece that's happened is that simultaneously we've had market expansion. And this has been, I believe, an accelerant as well. And so historically, Mercury has really participated in what is known as the sensor and effector mission systems market, here, we're providing very, very specialized processing that go on platforms associated with the sensors themselves, so radar, EW, SIGINT, COMINT capabilities. And we're providing the processing solutions. Few years ago, we decided that what we wanted to do was to move into all of those other types of computers that go on board a military platform. And there are really 2 major categories there that we have moved -- that we're now providing capabilities on. One is known as C2I, command, control and intelligence processing. Here, we did the acquisitions of Themis and Germane. And that C2I market is a fast-growing part of our business. It's tied to some macro level national defense strategy trends, such as JADC2, Joint All-Domain Command and Control, which is critically important as we're thinking about the adversaries that we're facing going forward. The second area is in what is known as platform and mission computing. And here, we're seeing the delayering trend, where the services are seeking to gain access more open systems architectures, bypassing some of the Tier 1s, and this is around things like avionics and mission computing. So those 2 areas actually end up being larger than Mercury's traditional market. And I believe, over the next 5 years will be the fastest-growing parts of our business. So think of us as basically winning bigger programs as the outsourcing is occurring and then expanding the market segments that we historically have participated in from not just the sensor processing where we had some market expansion, but into this other giant market called C4I. So that's really what's going on.

Yes. Okay. That's a lot going on and pretty interesting. One follow-up on the situation with the F-35 and recognizing that you've won a lot of new content on a lot of programs, and there's a lot going on there. But -- and the F-35 has always been unique. But it strikes me that intertwined in a lot of what you just described is commercial off the shelf, ready to go technology, faster to market, speed, cost. That's what's driving these tech refreshes of existing platforms. That's what's happening with the F-35, why are there delays? And that's supposed to be faster market, lower risk.

Yes.

Should we be worried that this industry is just too technologically sophisticated to ever really have to -- to have you benefit from these speed-to-market opportunities that you can because you have a commercial model or is the F-35 just its own beast?

I think it's just -- it's its own beast. Yes. So it is a pretty sophisticated upgrade that they're going through with the Tech Refresh 3. And it's significantly behind schedule. That being said, whether it's a new platform or whether it's upgrades, we're going to benefit. And we're already benefiting from the upgrades on other platforms. I'll give you a couple of examples. So the F-16 that Northrop talked about on their earnings call, there's a significant refresh underway on the radar side of things, on a program that is known as SABR. So scalable agile beam radar. It's basically that shift from the old type radars to an AESA. So Mercury was in the prior generation, and now we're participating in the upgrade of that specific radar. It is underway as we speak. It began with certain foreign military sales that actually helped to fund some of the modernization effort. And now that capability is getting rolled back into the domestic fleet, which is far larger. Another good example that Northrop talked about on the earnings call is the E-2D Hawkeye. That platform itself is going through a wave of modernization as well associated with the underlying electronics on the platform. We're seeing modernization occurring on the F-15 and F-18, and that was the 2 programs that POC, the most recent acquisition that we completed, is participating on. So in -- you always yes -- I mean, the risk is always seeing some delays. If it's a technologically sophisticated capability that's being delivered, and we're seeing that in the F-35. But we've got a host of those that are transitioning, and we're seeing the benefits from today.

Okay. That helps a lot. Mike, let's maybe move over to you on some of the financials below the top line. With the company's margins, I know there's several moving pieces in fiscal '21 versus '20. And then again in '22 versus '21, maybe just level set us on those? And then how should we be thinking about the longer-term margin potential of the business at this point?

Yes. So you're right, there's been some moving parts associated with gross margins as well as EBITDA margins to a degree. So let me start with EBITDA margins, and then we can talk about gross margins, if that makes sense. So if you step back and you look at our fiscal '20 EBITDA margins, they were 22.1%. If you look at our fiscal '21 midpoint of our guidance, the EBITDA margins are 22.1%. Now what's important to note there is that we completed the POC acquisition in December. So we've had them or will have had them for 2 quarters in fiscal '21. And just based on the nature of their business, that's dilutive to our EBITDA margins. And so in fiscal '21, that's probably about 30 basis points of dilution, Noah. So without that, it'd kind of be at 22.4% and that's as we've increased, as Mark mentioned, R&D pretty significantly as a percentage of sales and then invest in the business. So in the core business, we are seeing some margin expansion. If you look into fiscal '22, again we haven't provided guidance yet. We'll do that on the next call. But as you look at the investments we're making in the business, some of the transitions of the programs, we do think we'll see pre-POC some continued margin expansion. Again, we'll provide some more guidance next quarter, but we'll probably have 100 basis points impact associated with POC. So we improved pre-POC about 30 basis points in '21, [ price ] similar levels in '22, but 100 basis points down from -- because of POC. Now you look forward and what we've consistently said is we see the 3 prongs of what we're trying to do, organic growth, margin expansion and then supplementing that with M&A. Mark just talked about how we're going to continue the organic growth. We do see the opportunity for continued margin expansion, EBITDA margin expansion as we go forward. And that's going to be driven by a couple of things. It's going to be driven by the program mix as we move some of these programs, starting really in fiscal '23 from the LRIP phases into full-rate production. We think that the R&D investments that we've been making over the last couple of years with R&D as a percentage of sales, again pre-POC, above 13% that we're going to see some leverage from that. And that doesn't mean we're slowing down R&D, but we're able to leverage some of the investments that we've made in Avionics mission computer and the trusted microsystems as well as in secure processing that should allow us some margin expansion. And then finally, it's operating leverage as we grow revenue at a high single digit, low double-digit rate, but grow SG&A, a little slower than that. So we do see once we get to fiscal '23 and beyond, the opportunity to accelerate that EBITDA margin expansion.

Where should we expect approximately R&D as a percentage of revenue to land in a year where you're making a normal amount, not a heavy loaded amount of investments?

Yes. So if you look back historically and see where our R&D has been, it's jumped around a little bit. And sometimes, that's based on the opportunities we're seeing, sometimes it's based on the amount of customer-funded R&D that we might have in a year. So if you look at fiscal '18, we were a little under 12%. Fiscal '19, we dropped to 10.5%. And then '20, we were at 12.4% and then year-to-date, again, pre-POC because there's some dilution because they have a different business model, but in the first half, we were above 13%. Now if you look forward in terms of R&D as a percentage of sales, I think we used to talk about 11% to 13% as a target model. I think that POC will have a slightly dilutive impact on that as a percentage of sales, but probably about [ 1 ] point. So I think 10 to 12, you could see some decline from the levels that we're out today without sacrificing the organic growth of the business because the one thing we're focused on is investing for growth but we do see the opportunity to continue to grow without sacrificing R&D. So in short, I'd say, to answer to your question, it's probably somewhere between 10% and 12%, inclusive of POC.

Okay. So with that sort of 100 basis points or more of R&D, normalization plus mix plus some leverage on higher volumes, the kind of 22 that you're at to end the year here can have a few hundred basis points of expansion potential over a few years?

We believe so, yes. Absolutely.

Okay. And then you guys were pretty clear on the cash conversion inputs on the call, so I won't rehash that. Maybe in speaking to deployment, you mentioned in the overview, you have an acquisition model, and you've been successful there in the past. How is that looking now? How is the opportunity set? Are there things to do? What are you seeing out there on that front?

Mike?

Yes, sure. I mean, it's extremely busy. And we've got a great pipeline of opportunities. We closed the POC acquisition in December. There was a break in M&A activity because of COVID, but that's definitely picked up kind of August of last year post-Labor Day. As I mentioned, we were able to announce and close the POC acquisition in December. We're incredibly busy in Q3, our fiscal Q3, so calendar Q1 of this year, looking at a lot of different types of deals, small, medium and large. Today, the pipeline is very strong. We've got the financial capacity. We don't have a lot of leverage. And from our perspective, we're well positioned to keep doing what we've been doing, right? And it's the organic growth, the margin expansion that we just discussed and supplementing that with strategic M&A and integrating that M&A, which we think has created a lot of value for our shareholders. So pipeline, large opportunities. We're going to deploy it in those key growth areas that Mark has discussed, and we've got the pipeline to do that.

Awesome. Okay. We've gone a few minutes over the allotted time. So I will wrap it up there. Gentlemen, thanks so much for being with us. We really appreciate it.

Thanks, Noah.

Appreciate it. Thank you.

Have a good day.