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

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

Okay, super. We'll do, Jonathan, and thank you for the invitation present today. So as Jonathan said, my name is Mark Aslett, the President and CEO of Mercury. And with me here today is Mike Ruppert, our Chief Financial Officer. So we'll just go through a half a dozen slides and just give you a brief overview of Mercury. So -- okay. So not sure what happened there, a little bit of a technical glitch. 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 on here 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. So turning to Mercury at a glance, so Mercury has been around since 1981. This is actually our 40th year in business. Company went public on the NASDAQ in 1998. What we've been doing really over the last decade or so is pioneering a next-generation defense electronics company. And what we've done is positioned Mercury at the intersection of the high-tech world in defense. So we operate as a high-tech company, but our end market is the defense electronics industry. Our purpose is to make commercially available technology, profoundly more accessible to the defense industry as a whole. From a capabilities perspective, our goal is to be able to provide all of the different types of processing solutions that go onboard a military platform. In particular, those that require the concepts of trust and security. 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 today, we're actually enjoying the defense industry's highest current employee Glassdoor ratings, which is critically important for the war on talent. Next slide, please. So a little bit about Mercury by the numbers. It's around about 2,400 employees today. And many of those hold a security clearance for the DoD work that we do. 25 facilities around the world. 35 years in the defense industry, overall. Really what makes us unique, and I think it's a central part to the success of the company is the amount of money that we're spending on innovation. And so this year, we'll spend around about 13% of our revenue on internally funded R&D, which is 4 to 5x a rate higher than the overall industry average. We're involved in over 300 different programs and platforms. So we've done a great job really diversifying our revenue stream over the course of the last 10-plus years. And again, we're working with all of the major defense primes. From a numbers perspective, we're June ending company. So what you see on the right-hand part of the chart is our numbers over the last 5 full fiscal years. So 28% revenue CAGR, '15 through '20, and we've averaged 11% organic growth over that period, which is far higher than the overall industry growth. We've been able to actually grow our margins at a much faster rate than revenue, largely because as we're acquiring companies, we're seeking to fully integrate them, which presents both revenue as well as cost synergies over time. And finally, we are a highly acquisitive company. We've completed 13 transactions since fiscal year '14. Next slide, please. So just touching upon just some of the major programs and platforms that we're involved with. And you can see here that it's organized down the left-hand part of the chart in the 2 major market segments in which Mercury operates. So sensor and effector mission systems as well as C4I. The market size for what we provide at the Tier 2 level, which is largely computing and RF capability is round about $40 billion market. So we're participating in a large and faster-growing part of the market. And as you can see from just a selection of the programs that we are participating on, yes, we believe that we're well aligned with the national defense strategy. And the ongoing pivot to the Asia Pacific region, which is turning out to be the pacing threat. Next slide, please. So from an investment highlight perspective. So Mercury is a very innovative and growth company, as I mentioned, sitting at the intersection of tech and defense. We focus the business on large and the faster-growing part of the overall defense market. We have created this pretty transformational business model that we think is well aligned with defense procurement reform and the needs of our customers and their customers going forward. The major secular growth opportunities that we're benefiting from are outsourcing by our customers at the subsystem level. Delayering as our customers are seeking more rapid and more affordable solutions and then reshoring, in particular, in the trusted microelectronics domain. What's driving the growth in the business is our ability to capture more content on various programs and platforms over time, either organically or as well through M&A. Finally, as I mentioned, M&A is a very important part of the strategy. We're successfully acquiring and then fully integrating businesses that have allowed us to actually expand our addressable market as well as our capability set as well as our growth rate over time. Next slide, please. So the final slide, we think that the financial profile you see here in the inverted pyramid really does demonstrate the uniqueness of our strategy at work. And our financial goals and objectives really can be described quite simply. We're looking to generate high margins. shown here is greater than 20%. We're looking to grow the business on average over time organically at high single digits to low double-digit rates. And then we're looking to supplement that high level of organic growth with acquisitions to deliver 20% total company growth on an annual basis. What you see here on the right-hand part of the chart in the last 3 columns is Mercury's actual performance over different time periods. And so -- and then in the middle column, you can compare Mercury's actual performance with an index of other similar companies in the defense industry operating at the Tier 2 level. And so what you see is that Mercury's actual financial performance, whether it be margin profile, organic growth or total company growth is far in excess of the industry average. We then stepped back and actually compared Mercury's financial performance with similarly sized companies operating on both the NASDAQ and the New York Stock Exchange. And the measurement that we used was between $1 billion and $7 billion of market cap. And our actual performance places Mercury, not only at the high -- at the tip of the pyramid for the defense industry, but we're up there in terms of the top 2% or 3% of all publicly traded companies of a similar size. So this inverted pyramid is not just the manifestation of our strategy at work. It's also the goals and objectives that we have going forward. So with that, why don't I hand it back over to you, Jonathan, and we can start to get out some of your questions.

Fantastic. Maybe starting out, Mark and Michael, can you talk a little bit about your broader acquisition roll up strategy and perhaps help us understand what inning we are in, in terms of your ability to execute this strategy? Just given Mercury's growth and size and scale over the past few years?

Sure. So we have been highly acquisitive. And yes, I would probably begin by saying that the pipeline is probably the busiest that it's ever been. So I think the market is very, very active. And we just announced another acquisition here, the acquisition of Pentek quite recently. The way in which we think about M&A is really thematically. And yes, we've kind of got really 3 major themes going on as we speak that we continue to prosecute. One is continuing to build up sensor processing business. There, we did a fair number of acquisitions in the RF and microelectronics domain. It's also where the most recent acquisition of Pentek fits. We have been building up a rugged and secure Rackmount Server business that is associated with the C2I market. And then also building up a business in avionics and mission computing. So those are the kind of 3 major themes that we have. I tell you that there are a whole host of other themes that are connected to the overall strategy of the company, Some of which we haven't yet begun to talk about. So there's plenty of opportunity for us ahead. The way in which we've used M&A is really primarily to gain access to new technologies and capabilities that are aligned to our themes. But we've also used it very, very successfully to move into close adjacencies. And the best example of that, that I could give, Jonathan, is that Mercury historically is really participated in the sensor and effector mission systems market. And most recently, we've moved into the C4I market, which is far larger than Mercury's traditional market and which we also expect over the next 5 years to actually be the fastest-growing part of our business. The final area that we've used M&A is to really kind of capture additional content and capabilities on our nation's most important programs and platforms.

That makes a ton of sense. And so far, you've executed that strategy with a lot of effect in terms of being able to sustain the organic growth longer term. Do you potentially have to pursue larger targets over time? Or is it going to be maybe looking at a greater frequency of targets that are similar to the existing size? Is there enough sort of low-hanging fruit out there, just given your comments around the pipeline?

Sure. So I definitely think that there's plenty of opportunities out there, right, just given the themes that we have and other themes that kind of, call it, in the wings. As a company and as a leadership team, we're -- I would say we're not driven to scale the business just for the sake of scale. I mean, we are really focused on becoming a more capable company in the eyes of our customers. And for us, it's all about value creation. What's nice about the inverted pyramid model that I just went through is that we can achieve our growth goals at the total company level in a number of different ways. We can continue to do what we have done, which is acquiring a number of companies in any particular year or as the company has increased so naturally do the size of the deals. And so we're kind of seeing both happen at once. We're seeing the opportunity to potentially increase the frequency, just given the pipeline over time as well as for the average deal size to continue to increase. And we've seen both of those things happen.

That makes a ton of sense. During the last conference call, you referenced some challenges that your customers face with their programs. Is there a risk that this becomes kind of a new normal and that the primes are just being forced to take on more risk in terms of their work? And at the same time, does this create more opportunity for Mercury to offload some of that technical risk from the primes as they continue to struggle?

Yes. So it's a -- I mean the couple of examples, I think that we gave on the earnings call around just some of the execution risk. I don't think necessarily is representative of what we could potentially expect going forward. It was a very specific set of circumstances and challenges that we faced. That being said, I think our belief remains the same that our customers will continue to outsource more work to companies such as Mercury because we're able to do things far more quickly and far more affordably than what they're doing in-house for the sorts of capabilities that we provide, obviously, not for everything. And a lot of that is tied to our investment model. So again, this year, we'll spend approximately 13% of our revenue on internally funded R&D when the industry as a whole is spending 2%, 2.5%. And much of that investment of 2%, 2.5% that our customers are spending isn't permeating down to the levels that -- for the capabilities that we are providing, hence, the greater outsourcing. So if anything, we believe that outsourcing will continue because of what we're able to do and because of the benefits it provides our customers.

Got it. Got it. As Mercury has grown more diversified, part of the benefit was that the company would have less dependency on large programs. However, part of your strategy is also to capture more content on programs as well. Can you talk about how you balance maybe the risk of having more concentration along with the opportunity provided by just having a larger capability set where you can actually capture more business?

Yes, it's a great question. So I think we've done a pretty good job diversifying our revenue stream inside of our core markets, right? So to be clear, we're not looking to step outside of what is the core of the company's strategy. But today, we've got many more programs than say what we had back in fiscal year '14 where we had a relative high degree of concentration around a few programs. Today, as we look out over the next 5 years, we -- no single program accounts for more than 5% of revenue or is expected to. And we've got a bigger programmatic base what we're trying to do is to align our investment profile in organic internally funded R&D or our M&A dollars with the national defense strategy, and our customers' critical programs or the franchise programs in the industry, programs that will be around for the next 10 or 20 or even more years and to capture as much related content on those programs over time because those are the programs that we think are obviously aligned with where the threats are and hence, where the money will flow. And we've done a pretty good job of executing that strategy over the last 7 or so years.

Got it. Got it. And then maybe stepping back and taking a look at some of the budgets that are out there, do you see more or less over the next few years? How do you think about the potential for competition for discretionary dollars in the budget? And is Mercury, maybe a little bit better positioned or isolated because of the types of programs that you're playing in?

Yes. So clearly, I think there is going to be more demand on discretionary spending, including defense going forward. But as we've seen in the past, typically what dictates both the altitude as well as the direction of defense spending is around the threats that we face as a nation. And I think as we step back and just looking what's happened over the course of the last year or the last 5 years, it's pretty clear that the environment is becoming even more challenging. And so our belief is that investment in defense spending will likely continue to grow, but probably at low single-digit rates, which is kind of what we've just seen in the most recent defense budget request. But what we have tried to do, Jonathan, is really participate in the faster-growing parts of the marketplace that really are aligned with those emerging threats that we face as a nation. And which means that, that combined with the other drivers of growth, which is the largest of which is probably outsourcing and then things like delayering and reshoring should mean that we could continue to grow above the growth in the overall defense spending environment.

Absolutely, absolutely. How do we think about the DoD supply chain risk? And is that a potential, again, opportunity for Mercury to gain share, given your onshore capabilities? Can you talk a little bit about what the DoD has been doing to sort of derisk the supply chain, particularly given some of the exemptions that have been given in the past?