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

Thank you for joining us for our Growth Stock Conference. My name is Jonathan Ho, and I'm the analyst for William Blair & Company following Mercury Systems. With us today is Michael Ruppert, the Chief Financial Officer of the company. And before we begin, I am required to inform you that a complete list of research disclosures or conflicts of interest is available at our website at www.williamblair.com. With that, I'll hand over to Michael for the presentation.

Thanks, Jonathan. And thanks for having us here today. It's great to be back in person at a conference and get a chance to go through an overview of Mercury. Just like Jonathan gave his disclaimer, I'll start with ours. Just so you know, the presentation does include certain forward-looking statements. And due to risks and uncertainties, actual results may differ materially from anything you see or hear today. So please take the opportunity to review our safe harbor statement or for more disclosure on our risks, please see our Form 10-K. So a little bit about Mercury. Mercury was founded in 1981. So we've actually been around for over 40 years. We went public on the NASDAQ in 1998. And today, we trade under the ticker MRCY. And what makes Mercury unique is that we've pioneered a transformational business model at the intersection of the high tech and defense industries. Let me talk about that a little bit as we go through the presentation. But at the core of what we're doing is we're making commercial technology, so cutting-edge, commercial technology, profoundly more accessible to the defense industry. And the way we're doing that is we're investing significantly in research and development dollars to take commercial technology and make it so that it can be used in the defense industry. So making it safe, making it secure, making it trusted. And that's at the heart of what we do. And our goal is to provide all of the processing solutions on every military platform that's out there that requires trusted and secure computing. So think of us as a technology company, making computers at the heart of what we do for the defense industry. Our customers are the defense prime contractors. You can see here, we're on over 300 programs. I'll touch on the programs here in a second. But we've really set up the company to meet their increased outsourcing needs. And when we talk about Mercury's growth and you see some of what we've been able to do over the last couple of years, you'll see that we've been able to grow faster than the overall market. And a lot of that is driven by the outsourcing trend that we've seen. And from a purpose perspective, we've got a strong culture as a company. We're a very innovative company, consistent with our technology, heritage. We're focused on our employees, which is critically important to us. We're also focused on our customers and the end user. So touching on some of our numbers on this slide, you can see that we've got about 2,300 employees today, many of which who hold security clearances based on the type of work that we're doing. We've got 26 global state-of-the-art facilities. We've invested significantly in our facilities over the last couple of years. We're mostly domestic, although we do have a couple of facilities in Europe. As I mentioned, we've been around for over 40 years as a tech leader in the aerospace and defense industry. We're on 300-plus programs. We've got 25-plus prime customers, and we really do business with all the key companies in the A&D industry. Now one of the things you see, the 4 to 5x on this slide, one of the things that's core to our business model is our investment in R&D. And so we've got a commercial technology business model. And so we're investing 4 to 5x the amount that's typical in R&D compared to the rest of the defense industry. And that really has allowed us to differentiate ourselves from our competitors and then leverage our proprietary technology across a base of different programs. From a financial perspective, we are a June fiscal year ended company, so we just finished our fiscal '21. And you can see that in fiscal '21, we did $924 million of revenue. We did $202 million of EBITDA. From a growth perspective, we are a growth company. We've grown our revenues at a CAGR of 24% from fiscal '14 to fiscal '21 and our EBITDA at a CAGR of 37%. We're an acquisitive company as well, so we've grown organically. We've got a good strategy around organic growth, but M&A is an important part of the strategy as well. And you can see that we've completed 15 acquisitions over the last few years since fiscal '14. We'll talk a little bit about M&A, but M&A for Mercury starts with strategy. We're very focused on the defense electronics industry, and our strategy around M&A is focused. And we integrate our acquisitions as well, which is an important thing to know. Touching quickly on some of our programs. I obviously won't go through this, but we've got a great group of programs. We're a diversified company. No program makes up more than 5% of our revenue. But you can see here, we've got a great group of programs in C4I as well as the Sensor and Effector Mission Systems markets. We're on naval surface fleet. We're on subsurface fleet, fixed-wing aircraft, UAVs, missiles, munitions, et cetera. So a great group of programs. You can see over the right some of our customers, a great group of customers. But we do feel that our programs and our technologies are well aligned with where the defense industry is going right now. So this slide, I mentioned M&A briefly. We do have a very disciplined and focused M&A strategy. And what this slide looks at is the defense electronics market, and we are a pure-play defense electronics company. Historically, we started out in the radar segment of the defense electronics industry. We were providing modules and subassemblies, very high-performance modules and subassemblies, primarily for use in radar applications. And over the last 10 years or so, we've done 2 things. We've used M&A to expand into adjacent markets. And so we've gradually moved into electronic warfare and more recently, the C4I market. And so we've got a near adjacent strategy. We've also used M&A to increase our content on board the platforms within each of these subsegments. And when you combine those 2 things in terms of more content within each of these segments as well as the expansion, that's really what's driven our growth above industry averages. So this slide just looks at our financial performance and really the results of the strategy -- that strategy over the last 5 years. And you can see some of our key metrics by year here in the blue bars as well as the CAGRs from fiscal '16 to fiscal '21. The green arrows is our growth from fiscal '20 to fiscal '21. And I'm not going to go through all this, but you can see that we've been able to grow all our key metrics over this period of time. Revenue at a 28% CAGR, backlog, adjusted EBITDA, adjusted EPS as well. So we think our strategy is working and has driven the financial performance that you see here. So what this slide does is it really compares that financial performance that I just talked about to a group of other companies. And so Mercury set out to have a unique strategy that allows us to grow both organically and inorganically while maintaining and really expanding industry-leading margins. And this page shows that we've been able to do exactly that. So what this does is it compares Mercury to all other publicly traded companies with market caps between $1 billion and $5 billion. And you can see on the left, there's 1,242 of those companies. And what we did is we applied a couple of filters that were consistent with our strategy. So first, we looked at the companies that were highly profitable. We define that as LTM EBITDA margins greater than 20%. We then set off those highly profitable companies, which ones are consistently high-growth companies. We define that as a revenue CAGR, a 5-year revenue CAGR of greater than 10%. And then we said, of those highly profitable, high-growth companies, which ones have really been able to vault themselves forward in their last fiscal year and grow greater than 20%? And when you apply those 3 filters, what you can see is that you get down to only 30 companies across all industries out of that original group of 1,242 companies. And it's right at the tip of that inverted pyramid where Mercury has positioned ourselves, and it's really the core of our financial strategy. Now you can see our numbers over to the right for fiscal '20 and fiscal '21. EBITDA margins of 22%, a 5-year CAGR at 28%. You'll see in fiscal '20, our revenue growth was 22%. If you were to look back at fiscal '19, fiscal '18, fiscal '17, you'd see similar growth above 20%. So right at the tip of the pyramid is what we've been able to do. If you look at '21, we were only 16% revenue growth. So we're still in the top 10% of those companies, but we did see a slowdown in fiscal '21 and into fiscal '22, organically, really related to some of the outside influences. We saw a slowdown related to COVID. We saw some supply chain delays and then we had some delays on some of our bigger programs. And that slowed down growth a little bit. As I said, we're still in the top 10% of all these companies, but not at the tip of the pyramid. And as we look, though, at fiscal '23 and beyond, we think we're incredibly well positioned to continue to be in this unique category of companies. The last thing that we did on this page is we compared our financial performance to a Tier 2 defense index to our peers. And what you can see is that we definitely have a business model that's different than most of the defense industry. So we've got higher margins, higher near-term growth and higher long-term growth. And again, for everyone here, the crux of this slide is not to really focus on what we've done, but this is the core of our financial strategy. We want to maintain and grow industry-leading EBITDA margins. We want to grow organically at high single-digit, low double-digit rates, and then we want to supplement that with M&A. And I'll talk a little bit more about that. So quickly, investment highlights. We are an innovative growth company at the intersection of high tech and defense. That's core to our organic growth above industry average. It's our business model, which is a high-tech business model. We're a pure-play defense electronics company but we are focused on the larger, growing and more well-funded markets or submarkets within the defense industry. So we think that we can grow in any defense budget environment. That having been said, we do think there's some significant tailwinds in the defense budget, and I'll talk about that here shortly. I mentioned our R&D investment, investing 4 to 5x the defense industry average in terms of R&D. That's allowed us to accelerate growth and leverage our proprietary technology across numerous platforms. We're benefiting from some key trends, including outsourcing. And one of our strategies has been to move from selling integrated -- or modules to full integrated subsystems, and that's driving more outsourcing from our customers, which is probably the largest secular growth driver for Mercury. We're also seeing supply chain delayering and reshoring of capabilities to the U.S., and we've invested in that. We've got a low-risk content expansion strategy that I talked about, selling more content on our platforms. And then finally, as I mentioned, M&A is an important part of our strategy. And M&A is something we view as a core competency in identifying opportunity, diligence in opportunities as well as integrating opportunities, so we do integrate our acquisitions. So looking forward, we think we have a strategy that's well aligned with the market needs and that we can continue to grow, staying very focused on our current strategy in our current markets. So we're going to continue to invest to grow organically. We're going to expand our capabilities and market penetration through M&A, through strategic and disciplined M&A. We're going to continue to invest in those technologies that really differentiate us. And that's trusted, secure, which is critically important for the defense industry. We just launched a program called 1MPACT that I'll talk about briefly, but it's really our value creation plan and it's focused on continuously improving our operational capability and expanding our scalability because as we've got to a run rate of $1 billion, we realized we needed to do things different. We've launched 1MPACT, and that's a key part of our strategy. And then finally, key to it all is attracting and retaining the right talent, especially in these labor markets. So I talked a little bit about our capabilities and our strategy, turn quickly to some of the major trends that we're seeing within the defense industry. We think our strategy is really well aligned with these. So first, we're clearly seeing a sea change in defense industry spending. We see bipartisan support for additional defense spending as a result of the Russia-Ukraine conflict. I'll show a couple of slides here in a second that look at the defense spending outlook. But suffice it to say, we think there's going to be significant growth in both domestic as well as international defense spending. That defense spending has been catalyzed by Russia and Ukraine, but that's not where the funding is predominantly going. We're in a challenging global security environment. The national defense strategy is focused on near-peer threats. While we talk about Russia as being the immediate threat, China is viewed as the pacing threat. So a lot of the funding from additional defense spending is going to go towards those near-peer threats. And it's areas where Mercury plays, and I think we'll benefit from that. Electronics. So we are a computing company, and we focus on electronics. And electronics are really driving a lot more of the share of military platform cost and value. I've got one more slide on that, which I think is pretty interesting in terms of the growth. But electronics are taking up a larger portion of the value of both new platforms as well as the modernization of existing platforms, and there's a wave of modernization that's going on right now. Number four, on here, investment and innovation challenges. As the industry has returned to growth, many of our customers are actually struggling to increase their headcount to replace the challenges they have with an aging workforce. And in the industry, there's also a limited amount of R&D that our customers can spend. And so they're very focused on spending that R&D on the biggest systems, the biggest opportunities and less on what Mercury does because they can get the capabilities from Mercury. So as the industry has returned to growth, we're actually seeing an increase in the outsourcing trend that we talked about, which is our largest secular growth driver. And then number five, here, you can see access to commercial technology. In order for the DoD to succeed, we've got to be able to access commercial technology. And the amount being spent in the commercial market on things like semiconductors and microelectronics, it just dwarfs what's being spent in the defense industry. But that commercial technology needs to be adapted for use in the defense industry. It has to be trusted. It has to be secure, and that's #6 here in terms of the imperative for U.S.-produced technology. And Mercury has invested significantly in terms of making commercial technology secure and domestically designed and developed. So touching briefly on the outlook for defense spending. And this is the U.S. defense spending. I'm not going to go through this whole page. It's a busy page. But suffice it to say that the outlook for defense spending as a result of recent events has changed significantly. If you look prior to the Ukrainian conflict, it was an expectation that defense budgets were going to be relatively flat, but that view has shifted rapidly in recent months. And when you think back about where this funding is going to go, if you look prior to the Ukrainian conflict, the threat of great power competition was more theoretical that -- to think that Russia or China could invade another country was much more theoretical. What we've seen with Russia is that's catalyzed into a reality. And so that's driving defense spending. And if you look on the left-hand side of the slide, this was produced by a consulting firm called Renaissance Strategic Advisors, who we work closely with. They focus on the defense industry. And what they've put together here is a potential upside defense spending scenario. And I say upside, but I think their view is it could be a reality. And so what it looks at in the blue line is the fiscal '22 budget request. The yellow line or the mustard line is the fiscal '23 budget request, which was done after the invasion of Ukraine, but not fully reflecting the defense spending increases that we expect coming out of that conflict. And so if you look at the orange #3 line, you can see a potential upside scenario with fiscal '21 to '26 CAGR of 5-plus percent. And you're looking at a fiscal '23 -- government fiscal year '23 spending of above $800 billion and $900 billion by fiscal '27. So a sea change in defense spending. Mercury, we think we've positioned ourselves extremely well for any defense budget environment. But clearly, increasing defense budgets is going to support our long-term outlook. And then it's not just domestically, it's also internationally. And so this slide looks at the potential growth in European defense spending over the next decade. And on the slide on the left, you can see the black line looks at the expected international European defense spending over -- prior to the invasion of Ukraine and it was a CAGR of 3.4%, expecting some modernization in Eastern Europe related to the threat from Russia, in the West related to recapitalization of their major platforms. So there was expected to be growth, but not the growth we're expecting now. And what that blue line looks at is if all European NATO nations went to the 2% of GDP target as required by NATO, you'd see an additional $1 trillion of defense spending in Europe over the next 10 years. Now it's not likely to be that top line. It's probably somewhere in between. But I think the takeaway is that we're going to see increased U.S. defense spending as well as international defense spending. One thing to point out is that the European and defense industrial base does not have the capability to deal with the increased demand. And so this is not just an opportunity for Europe. It's obviously an opportunity for U.S. defense companies as well. So I talked about the defense spending. This is an interesting slide because one of the trends I mentioned was the shift of the value of platforms to electronic systems. And when you think about the commercial market, we often say that we don't have cars anymore, we have computers that drive. We don't have airplanes anymore, we have computers that fly. The defense industry is no different. And if you look at this page, you can see a past generation of, an example, air, sea and land platform, and where it is currently. And what it looks at is the percent of the value of the platform that's made up by defense electronics and the number of electronic subsystems onboard each of these platforms. And you can see that there's been a dramatic increase in terms of the percentage of electronics in each of these platforms. And if you look over to the right, what this is, is the evolution of the system value going forward. And so this is the present day on the kind of the left column there with software, electronics and then the platform itself. If you look at a notional future, you can see that it's dominated by the digital competencies, so software and electronics. And so we think this is a trend that when you think about what Mercury is trying to do, we're trying to provide all processing and computing solutions within defense electronics onboard military platforms. So we think this is a big opportunity for us. In terms of the size of the market, I -- in previous slide looked at how we've expanded in these markets from an M&A perspective. So I'm not going to go into this too much, but we do play in the defense electronics market. It's a $130 billion market annually. The whole market is not available to us. We play in the Tier 2 portion of that market, which is about a $42 billion market. So when you think of our sales about a run rate of $1 billion, we think we have a lot of opportunity to continue to grow within this market without expanding outside of defense electronics. So this slide looks at our acquisitions, investments and how it's driven our growth opportunity. And when you think about Mercury, we talk about bookings, we talk about backlog. But the real way to think about us from the long-term growth prospects is design wins. And so when you're making a computer subsystem, you're designed into a program, you're designed in that program for life. You don't get redesigned out, and programs in the defense industry can last 5, 10, 20 years. And what this shows is the top 30 programs and the lifetime value of those programs. And you can see how from fiscal '16 to fiscal '22, it's almost tripled. And we today have $11 billion in lifetime value just from our top 30 programs. So I've talked about our financial performance, this is just a summary of how the business has evolved, both financially and operationally. And you see our revenue grew at 4.4x. Financially, EBITDA grew 9.2x. But the operational metrics here are telling. Over the last 7 years, we've done 15 acquisitions. Our headcount has increased 3.6x. We've more than tripled our facilities even as we've been integrating facilities. Now the biggest thing on this page is the subsystem revenue, I would argue. It's grown at 7.5x compared to total revenue of 4.4x. And what that is, is us moving from selling modules and subassemblies to selling full integrated subsystems. But when you make that switch, it changes the way that you run the business. You're now selling bigger systems than just systems on commercial terms. And it increases the complexity of the business. And it's this growth and it's this complexity that led us to launch an initiative we call 1MPACT. And I'll talk about that here in the next slide, but we think that's critical for our growth and to get to the next phase of growth. So what is 1MPACT? 1MPACT, as I said, we launched, we got to $1 billion of sales on a run rate basis. And we realized with the increased complexity of the business, we needed to do things differently. So we proactively launched 1MPACT to lay the foundation for the next phase of our value creation at scale. As part of that, we changed our processes, we've changed our systems. We also expect to see EBITDA margin expansion. We've talked about $30 million to $50 million of adjusted EBITDA by fiscal '25. We've recognized a good portion of that in fiscal '22. And it's also helping us continue to invest in the business as over the last couple of quarters, we've had some industry headwinds. In addition to the margins, though, we're focused on working capital improvement, especially in areas like inventory and unbilled, we see opportunities there. And you can see that on this slide, the areas where we're focused on. You might ask, hey, $30 million to $50 million in terms of EBITDA margins. You've already got $27 million. When you look at the bottom bullet, you can see that some of the other initiatives that we've recently launched, they take longer to show up in the financials. But we're very confident in terms of the margin expansion opportunity. And it's not on this slide, but a really important part of 1MPACT is M&A. And what we think we can do is we've launched 1MPACT. We've set up a Chief Transformation -- we hired a Chief Transformation Officer, set up an office to run 1MPACT. And as we look at M&A, this is going to give us the opportunity to continue to do M&A at the same pace, but also accelerate the integration and accelerate the synergies that we can get out of those acquisitions. So I talked about the inverted pyramid on the previous slide in our financial performance. What this slide does, it just summarizes that we have a clear path to stay there. So not only do we want to maintain margins, we want to expand those EBITDA margins. You can see over to the right the ways that we think we can do that. 1MPACT is an important part of that. We want to grow organically at high single digit, low double digit over time. We think we're aligned with the right parts of the DoD budget. We think we've got the right strategy. We're seeing increased outsourcing, so we feel good about that. And then finally, we want to supplement that margin expansion and organic growth with M&A. And today, we've got a large pipeline of opportunities. We've got good financial capacity, and we've got a good pipeline of opportunities. So we think we're well positioned to do that. So just in summary, we've got a -- Mercury has a strong track record of organic growth, profitability and strategic M&A. We've invested significantly in the business over the last 5 years, which is differentiating us from our competitors. We're poised for continued organic growth. We've launched 1MPACT to facilitate margin expansion. And as I just mentioned, we're well positioned for future M&A with the pipeline of opportunities and financial flexibility. And then finally, we've got a clear strategy to maintain this unique profile. So we feel good about where we are today and about the growth prospects of the company. So with that, we'll finish up.

Thank you so much, Michael. And we'll continue the discussion in [ G&A ].