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Edited Transcript of MRCY earnings conference call or presentation 28-Apr-20 9:00pm GMT

·48 mins read

Q3 2020 Mercury Systems Inc Earnings Call CHELMSFORD May 19, 2020 (Thomson StreetEvents) -- Edited Transcript of Mercury Systems Inc earnings conference call or presentation Tuesday, April 28, 2020 at 9:00:00pm GMT TEXT version of Transcript ================================================================================ Corporate Participants ================================================================================ * Mark Aslett Mercury Systems, Inc. - President, CEO & Director * Michael D. Ruppert Mercury Systems, Inc. - Executive VP, CFO & Treasurer ================================================================================ Conference Call Participants ================================================================================ * Jonathan Frank Ho William Blair & Company L.L.C., Research Division - Technology Analyst * Jonathan Phaff Raviv Citigroup Inc, Research Division - VP & Analyst * Kenneth George Herbert Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst * Michael Frank Ciarmoli SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst * Peter J. Arment Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst * Peter John Skibitski Alembic Global Advisors - Research Analyst * Seth Michael Seifman JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst * Sheila Karin Kahyaoglu Jefferies LLC, Research Division - Equity Analyst ================================================================================ Presentation -------------------------------------------------------------------------------- Operator [1] -------------------------------------------------------------------------------- Good day, everyone, and welcome to the Mercury Systems Third Quarter Fiscal 2020 Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the company's Executive Vice President and Chief Financial Officer, Mr. Mike Ruppert. Please go ahead, sir. -------------------------------------------------------------------------------- Michael D. Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [2] -------------------------------------------------------------------------------- Good afternoon, and thank you for joining us. On the phone with me today is our President and Chief Executive Officer, Mark Aslett. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations. Please turn to Slide 2 in the presentation. Before we get started, I would like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's financial outlook, future plans, objectives, business prospects and anticipated financial performance. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2, in the earnings press release and the risk factors included in Mercury's SEC filings, including the new cautionary statement and risk factor related to COVID-19. I'd also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles, or GAAP, during our call we will also discuss several non-GAAP financial measures, specifically, adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue and acquired revenue. A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release. I'll now turn the call over to Mercury's President and CEO, Mark Aslett. Please turn to Slide 3. -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [3] -------------------------------------------------------------------------------- Thanks, Mike. Good afternoon, everyone, and thanks for joining us. We hope you and your family are staying safe and healthy. I'll begin today's call with the business update. Mike will review the financials and guidance, and then we'll open it up for your questions. First, I'd like to say thank you to all the courageous health care workers on the front lines of fighting this pandemic. Our thoughts and prayers go out to all of them at this very difficult time. Second, I'd like to express how deeply thankful we are to our employees, their incredible resolve and the sheer will they've demonstrated in overcoming the challenges that we're facing. Mercury rose to these challenges very early on. Well before the coronavirus was declared a pandemic, we set up a COVID crisis team and defined 3 goals to guide our decision-making and actions. Number one was to protect the health, safety and livelihoods of our employees; second, reduce and mitigate operational and financial risks in the business; and third, continue to deliver on our commitments to both our customers and shareholders. Finally, when the defense industrial base became designated essential, we added a fourth goal, which is to continue the mission-critical work Mercury does every day to support the ongoing security of our nation. We've used these goals, along with our purpose, culture and values as a touchstone for setting our priorities as we transitioned our operating model to a daily crisis mode. I think this made an enormous difference to our speed in communicating and taking action and in how effectively we reduced and mitigated risk to our employees and to the business. In mid-March, Mercury was classified as critical infrastructure as defined by the Department of Homeland Security. This exempted our U.S. facilities from local, state and federal stay-at-home mandates. Before that, however, we were impacted mainly in California by temporary shutdowns at some of our manufacturing sites. These closures were due to stay-at-home orders that varied from county to county. Once Mercury was designated as an essential business at the national and state level, we resumed normal operations at those sites. Meanwhile, everyone in the company who could began working from home. And at the same time, we adjusted workplace conditions significantly for everyone else to create physical distancing and make things safer inside of our facilities. Turning to Slide 4. While all that was going on, we still ended up delivering a very strong quarter with record bookings, record backlog, a 1.2 book-to-bill, and 11% organic growth versus a strong Q3 last year. Total revenue, net income, adjusted EBITDA, EPS and adjusted EPS came in above the high end of our guidance with all hitting new records for the quarter. It was also a very strong quarter in terms of new design wins and free cash flow. So all in all, an outstanding effort by the entire team. Looking ahead, we're aware of the risks that we face, especially around the supply chain, our manufacturing facilities and hiring. We believe Mercury has the strength and liquidity to endure a range of possible downside scenarios. We feel good about our strategy and the plans we have in place as well as our continued ability to execute. Moving to Slide 5. We've truly leaned in to take care of those employees who we deem to be most vulnerable as this crisis developed. The feedback we received has been amazing and I'm very proud of what we've been able to do for our people. Touching on the highlights. We continue to pay hourly employees working in our California sites that were shut down temporarily. We'll do the same at other facilities that may be impacted as the crisis continues. We've increased overtime pay to 2x the regular rate and enhanced our sick leave policy. In addition, we've created a $1 million emergency relief fund, which we will increase if need be. Through this fund, we made immediate payments to our hourly employees experiencing financial burdens and hardship. We also gave managers discretion to approve additional amounts as necessary. These payments, we've learned, met 2 kinds of needs. Initially, they helped our lower paid employees stock out on food and supplies as well as deal with other issues related to stay-at-home. More recently, although Mercury's employees are still gainfully employed, many family members have lost their jobs, creating a second wave of financial burden and worry. The relief fund is now helping to buffer this secondary financial impact while they wait for unemployment insurance and other federal programs to kick in. Mercury's purpose, culture and values are not only about delivering results for customers and shareholders, but about helping and caring for one another. The fiscal year revenue and adjusted EBITDA guidance we're providing today, which is unchanged from our previous guidance on the top end, reflects our confidence in Mercury's business as well as the resolve of our employees to overcome the challenges that may lie ahead. As Mike will discuss in detail, we expect the fourth quarter to include another year of double-digit growth in revenue and adjusted EBITDA, including 13% to 14% organic revenue growth. Turning to Slide 6. The new business conditions remain robust. The coronavirus has not diminished the threat environment, and our nation's defense priorities have not changed. Looking forward, we don't expect the COVID crisis to have a near-term material impact on defense spending. The majority of Mercury's business is mission-critical to our customers and end users, which are largely U.S.-based. We're maintaining a dialogue with them, and our engineering and operations teams are working hard to deliver on our commitments. That said, the COVID crisis did have some impacts in Q3. We saw some slowdowns as customers began transitioning to work from home. This resulted in some brief delays in order approvals and order flow. The industry-wide suspension of travel affected new business activity as well. Since then, we've seen these issues improve somewhat as everyone has become more attuned to working remotely. Against this backdrop, Mercury performed very well on the top line in Q3. We continue to believe that we're targeting and participating in the right parts of the market. The wave of modernization occurring in radar, EW and C4I continues to drive growth in the business. Demand in weapon systems, space, avionics processing and mission computing as well as secure rocket servers remains healthy. Mercury's strong bookings and design win activity in Q3 continued to be driven by the 3 major trends that we discussed in the past: supply chain delayering by the government and the primes, the primes' flight to quality suppliers and the increased outsourcing by our customers at the subsystem level. For years now, we've invested in our people, processes, technologies and trusted domestic manufacturing to support the continued organic growth in the business. These investments are proving their worth now. Going forward, we believe that they will be even more important given our national dependence on foreign supply chains and manufacturing. We continue to deliver our products and services to our customers, and the fundamentals that drive growth in our business have not changed. We've been closely monitoring our supply chain, which is predominantly U.S.-based. During Q3, we made some forward inventory buys and preordered raw materials to mitigate risk in both the short as well as the midterm. Thus far, however, the pandemic's impact on our supply chain suppliers has been relatively low. The key supply chain issues that we're facing are twofold. The first is that suppliers may be financially vulnerable. This applies more so to those suppliers that are heavily exposed to the commercial aerospace sector. As you know, commercial aerospace has been significantly more impacted by COVID than defense. The other major supply chain risk is the potential for COVID-related manufacturing disruptions, that is temporary site shutdowns that could affect the supply of U.S. sourced components to Mercury. We're also facing other operational risks, the first being the potential for COVID-related disruptions within Mercury's own manufacturing facilities. We're closely monitoring the time to peak infection and the effects that social distancing is having in flattening the curve in communities around our manufacturing sites. We've done a tremendous amount to communicate with and educate employees as well as to increase physical distancing and reduce the risk in the event occurring inside one of our facilities. That said, this risk does remain elevated. The other risk relates to the hiring of new talent. Although our time-to-hiring metric has not changed that much, our ability to hire in a timely manner could be affected if the COVID crisis continues for a prolonged period of time. The outcomes are hard to determine right now but based upon the planning and the scenarios that we've run, the overachievement in Q3 and Mercury's record third quarter backlog, we currently feel good about our ability to deliver against the goals and objectives we set for fiscal '20. As outlined on Slide 7, we're optimistic about Mercury's opportunities for continued growth driven by the trends I just discussed. At this stage, we have not changed our long-term baseline forecast for low single-digit growth in overall defense spending. That said, there are 2 risk factors to consider. One is the potential for a prolonged CR in government fiscal '21 related to the election. The second is that as we continue to see massive fiscal stimulus, the potential for those dollars to crowd out discretionary spending, including defense, exists over the long term. While recognizing these uncertainties, we're still focused on the goal of delivering organic revenue growth at a rate that far exceeds the industry average, and we have the balance sheet strength to supplement this organic growth with M&A. From an M&A perspective, we continue to focus on the Sensor and Effector Mission Systems and C4I markets, looking for deals that are strategically aligned and have the potential to be accretive in both the short and long term. That said, the M&A market is effectively shut right now, given the challenges associated with determining asset values, pricing risk and conducting forecast diligence. Once we get through the crisis, we anticipate seeing more opportunities than before. Certain companies may be motivated to sell in this environment. They look for a partner that's fiscally sound, has a great culture and values, has done the right things for employees and has continued to deliver for customers and shareholders. We are one of those companies. As an employer and an acquirer of choice, we believe Mercury will emerge from this crisis stronger than before, and we were already very strong. Our balance sheet is sound. The business is performing well, and we've got an exceptionally talented and dedicated workforce. When M&A activity resumes, and we believe it will, we'll be in a strong position to continue to execute on our strategy, namely, to deliver strong margins while growing the business organically and supplementing that organic growth with disciplined M&A and full integration. We believe this strategy will continue to generate significant value for our shareholders over the long term as we execute our plans in 5 areas: first, to grow our revenues organically at high single to low double digits, averaging 10% over time and to supplement this high level of organic growth with acquisitions. The second is to invest in new technologies, our facilities, manufacturing assets and business systems as well as continuing to invest in our people. Third is manufacturing in-sourcing as well as driving stronger operating performance across our manufacturing locations. Fourth, we're seeking to grow revenues faster than operating expenses. This will allow us to continue investing in organic growth while maintaining strong operating leverage in the business. And finally, we're fully integrating the businesses we acquire to generate cost and revenue synergies. These synergies, combined with other areas of the plan, should produce attractive returns for our shareholders. This strategy has worked very well for Mercury over the past 5 years. Given our ability to execute, we're confident that Mercury will extend this record of success. We have a clear picture of where we think the risks are greatest. We've been diligent in working to reduce and mitigate those risks, and we're committed to doing everything that we can to finish the year with a strong fourth quarter. With that, I'd like to turn the call over to Mike. Mike? -------------------------------------------------------------------------------- Michael D. Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [4] -------------------------------------------------------------------------------- Thank you, Mark, and good afternoon, again, everyone. I'll begin by echoing Mark's comments and extending my appreciation to our employees for the outstanding work they did this quarter. Thanks to their efforts, we were able to leverage Mercury's strong financial position to adapt to the new environment and deliver record results in Q3. As Mark said, we acted quickly to protect the health, safety and livelihoods of our employees. We worked to reduce and mitigate both supply chain and manufacturing risk, and we continue to fulfill our commitments to our customers. In order to support our customers, we accelerated some of our product deliveries during the quarter, helping them derisk their businesses. We also acted quickly to identify and assess potential COVID-19 impacts on our financial position. Early on, the biggest risk we saw was the potential for multiple site closures for an extended period of time as a result of government stay-at-home orders that were being implemented. In response, we ran various scenarios looking at the impact of prolonged shutdowns on our cash flow. We entered Q3 with an extremely robust capital structure with over $900 million of liquidity between cash on hand and our unfunded $750 million revolver. In all the scenarios we examined, including potential closure of our manufacturing company-wide, we determined that Mercury would have ample liquidity to continue to fund the business for an extended period of time. Since we've been designated as an essential business, extended shutdowns of our facilities as a result of government orders have not occurred nor do we think they are likely to occur. Overall, we believe we are well positioned to continue to execute our strategy while simultaneously managing risk related to COVID-19. While this risk does remain elevated, we are maintaining the top end of our previous guidance for the fiscal year and raising the bottom end now that we are in the fourth quarter. I'll provide more detail around our guidance later in the presentation. Turning now to Slide 8 and our third quarter results. Total bookings for Q3 increased 32% year-over-year to a record $250 million, driving a 1.2 book-to-bill ratio. As Mark mentioned, we did see some COVID-19 impact as our customers transitioned to working from home, but those issues did not have a material impact on our bookings or ending backlog. In Q3 and so far in Q4, we've not seen a slowdown in new business activity as a result of the ongoing pandemic. In Q3, revenue increased 19% year-over-year to a record $208 million, exceeding the top end of our guidance of $190 million to $200 million. This outperformance was primarily driven by timing of revenue, including the early customer deliveries that I mentioned. Organic revenue was up 11% in Q3, and we currently expect organic growth of 13% to 14% for the full fiscal year, assuming no material impact as a result of COVID-19. Adjusted EBITDA for Q3 increased 21% year-over-year to a record $47.1 million. This exceeded our guidance of $42 million to $44 million, driven primarily by higher revenue as well as higher gross margin due to program mix and increased manufacturing throughput. Adjusted EBITDA margin was 22.6% for the quarter. This compares with our guidance of 22.1%, again, reflecting program mix and increased throughput. In Q3, we expanded our definition of adjusted EBITDA to include an add-back for incremental COVID-related expenses, totaling approximately $400,000 for the quarter. These costs related primarily to enhanced compensation and benefits for employees. It also included incremental supplies and services to support social distancing and to maintain safe and healthy conditions inside our facilities. Slide 9 presents Mercury's balance sheet for the last 5 quarters. Entering Q3, Mercury had cash and cash equivalents of $182 million, no debt and a $750 million unfunded revolver. This gave us a great deal of flexibility as we face potential negative financial impacts associated with COVID-19. In March, the pandemic's impact on the financial markets was uncertain, and it looked like there was a chance that state and local governments could, at some point, close Mercury's facilities. As a result, we decided to draw $200 million from the revolver out of an abundance of caution. We'll continue to evaluate the markets and the impact of COVID-19 on our financials with an eye toward paying down the $200 million when the conditions are favorable. After tapping the revolver, Mercury finished Q3 with cash and cash equivalents of $407 million. We had $200 million of debt from the funded portion of the revolver, and we still have the remaining $550 million available. So despite continued uncertainty, we remain extremely well positioned from a liquidity standpoint. During Q3, we also decided to advance purchase inventory in order to mitigate potential disruptions to the supply chain. While materials were ordered, they were not delivered by the end of the quarter, so there was an immaterial impact to our inventory balance at the end of Q3. We do expect to see some impact to our Q4 inventory. Turning to cash flow on Slide 10. Free cash flow for Q3 was $19.2 million, representing 41% of adjusted EBITDA, which was slightly above our expectations. We saw a $300,000 impact to Q3 free cash flow as a result of COVID-19 expenses primarily related to the employee relief fund. We expect to see additional COVID-related expenses in Q4. Capital expenditures in Q3 were $10.9 million or 5.2% of revenue compared to $11.3 million or 5.8% last quarter. CapEx was slightly lower than we expected due to COVID-19 as some equipment scheduled to be delivered in Q3 was delayed into Q4. We expect CapEx to increase in Q4 as we continue to invest in the business, including our custom microelectronics buildout in Phoenix. Year-to-date, our free cash flow as a percentage of adjusted EBITDA is 43%. For Q4, we are expecting a lower percentage, driven by increased capital expenditures and an investment in inventory as a result of COVID-19. For the year, we continue to expect free cash flow as a percentage of EBITDA to be approximately 40%. I'll now turn to our financial guidance, starting with the full year fiscal '20 on Slide 11. As we've discussed, our outlook for fiscal '20 remains strong, although risk remains elevated due to the uncertainties around COVID-19. The full year guidance we're providing assumes no major supply chain disruptions, no extended shutdowns of any of our facilities and no material change in customer behavior, none of which have occurred to date. While our guidance assumes no major disruptions due to COVID-19, our guidance range does incorporate some room for temporary disruptions in the event they were to occur. For the full fiscal year, we now expect revenue of $785 million to $795 million, representing growth of 20% to 21% from fiscal '19. This is consistent with our previous guidance and reflects our outlook for 13% to 14% organic growth. Total GAAP net income for fiscal '20 is expected to be $76.1 million to $78.3 million or $1.38 to $1.42 per share. Adjusted EPS is expected to be in the range of $2.12 to $2.16 per share, an increase of 15% to 17% compared to fiscal '19 results. Our fiscal '20 guidance for adjusted EBITDA is $173 million to $176 million or approximately 22.1% of revenue. This is an increase of 19% to 21% from fiscal '19. Finally, we expect CapEx for fiscal '20 to be approximately 6% to 7% of revenue and free cash flow to be approximately 40% of adjusted EBITDA. I'll now turn to our fourth quarter guidance on Slide 12. This guidance reflects our outperformance in Q3 coupled with our belief that Mercury's actions in response to COVID-19 have derisked Q4 to some extent. It also incorporates, as I mentioned, room for temporary disruptions should they occur during the quarter. Doing the math based on our actual results for the first 3 quarters, we're forecasting Q4 revenue in the range of $205.8 million to $215.8 million, an increase of 16% to 22% compared with Q4 last year. Q4 GAAP net income is expected to be $17.6 million to $19.8 million or $0.32 to $0.36 per share. Adjusted EPS is expected to be $0.54 to $0.58 per share. And finally, adjusted EBITDA for Q4 is expected to be $46.4 million to $49.4 million, representing approximately 22.5% to 22.9% of revenue. Turning to Slide 13, in summary. Our record Q3 results are a testament to the phenomenal employee team we have at Mercury. We believe Mercury's business remains aligned with fundamental trends in our industry, and our record revenue and bookings highlight that. The company's strong cash flow and capital structure position us well, not only in this time of uncertainty, but also to continue to execute on our strategy. Meanwhile, during this time of unprecedented challenge and change, the 4 goals that Mark outlined will continue to serve as a touchstone for our decision-making and actions. And as we come out of this period of uncertainty, we're confident in our ability to continue executing on our long-term value creation strategy of margin expansion and organic growth supplemented with strategic M&A. With that, we'll be happy to take your questions. Operator, you can proceed with the Q&A now. ================================================================================ Questions and Answers -------------------------------------------------------------------------------- Operator [1] -------------------------------------------------------------------------------- (Operator Instructions) I show our first question comes from Pete Skibitski from Alembic Global. -------------------------------------------------------------------------------- Peter John Skibitski, Alembic Global Advisors - Research Analyst [2] -------------------------------------------------------------------------------- Very nice quarter. Guys, I think that on the strong bookings in the quarter, I know you talked about not having any big problems there, but I'm wondering if you sense at all that DoD actually tried to accelerate bookings in the quarter to help -- because we're just seeing them take a lot of actions to help out subcontractors, I think, both from a bookings perspective and then changing progress payments and obviously, some of the OEMs have been very public about helping out subcontractors. So I'm just wondering if you thought things maybe could have been even a little bit better this quarter had DoD not taken some of these actions. -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [3] -------------------------------------------------------------------------------- I don't believe so, Pete. We didn't really see too much change in terms of customer behavior during the quarter once we got beyond the period of them transitioning to work-from-home. So I don't believe the options that DoD took to accelerate paid performance payments or -- had an impact on Mercury in terms of our bookings. -------------------------------------------------------------------------------- Peter John Skibitski, Alembic Global Advisors - Research Analyst [4] -------------------------------------------------------------------------------- Okay. Any expectation for bookings in the fourth quarter? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [5] -------------------------------------------------------------------------------- Right now, we think that the fourth quarter is going to be another strong quarter. -------------------------------------------------------------------------------- Operator [6] -------------------------------------------------------------------------------- Our next question comes from Sheila Kahyaoglu from Jefferies. -------------------------------------------------------------------------------- Sheila Karin Kahyaoglu, Jefferies LLC, Research Division - Equity Analyst [7] -------------------------------------------------------------------------------- So just my first question, you noted some risks around COVID, but maybe can you talk about some opportunities, does it put pressure on some smaller suppliers, so are the primes coming to you guys a bit more? What sort of new business wins does this open up? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [8] -------------------------------------------------------------------------------- Sure. It's a good question, Sheila. I think probably in the short term there, it's hard to transition to different suppliers. We do it in the period of time that you're talking about. However, I do believe that over the mid to long term, I do think it's going to open up more opportunities and potentially result in Mercury continuing to take share from some of the companies that maybe aren't as well positioned from a capability or from a balance sheet perspective, like we are. I also think that, as you look forward, our business model is very well positioned, right? So the fact that we're spending very high levels on R&D, wherein our customers need to get access to technologies and capabilities more quickly and more affordably, I think plays well in this environment. And I think there's also going to be opportunities as there's a discussion that I think -- that I believe will continue around is it capacity or is it more capability that we need. And I think from a capability perspective, we're very well positioned. So we're going to continue to focus on the areas that we have been because we think that that's where the money is flying. But I do think there's going to be more opportunities as a result of what's happened. -------------------------------------------------------------------------------- Sheila Karin Kahyaoglu, Jefferies LLC, Research Division - Equity Analyst [9] -------------------------------------------------------------------------------- And you gave some very candid remarks in your prepared dialogue in terms of risks longer term as stimulus might take away from defense funding, I guess you're on track to grow double digits this year. How do we think about fiscal '21 and beyond? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [10] -------------------------------------------------------------------------------- You know, we're not going to guide fiscal '21 on this call. We'll do that on the next call. Yes, we haven't adjusted, as I said in my prepared remarks, the outlook for growth right now. Our view for quite some time is that it's been low single digits in terms of the growth overall. As we've discussed, the growth in the defense budget is actually not the primary driver of our growth. What is the predominant driver of our growth is really more outsourcing by our customers, which we think is going to continue as well as us transitioning to more subsystems and capturing more content. So yes, the potential exists over the long-term potential crowding out of discretionary spending. However, I think we're pretty well positioned, all things considered. -------------------------------------------------------------------------------- Operator [11] -------------------------------------------------------------------------------- Our next question comes from Peter Arment from Baird. -------------------------------------------------------------------------------- Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [12] -------------------------------------------------------------------------------- Just maybe a follow-up on that comment. Just your 13% to 14% organic growth this year, is there a way to parse out how much of that is coming from outsourcing? I mean I know in the past, you've talked about certainly a few hundred basis points or so that was added on top of you outgrowing the budget, but it seems like that trend is obviously accelerating. -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [13] -------------------------------------------------------------------------------- Yes. I mean it's always hard to actually parse that because, again, there's not a tremendous amount of publicly available information or research that you can point to. One of the areas that we have discussed in the past is the growth in subsystems. And the majority of our revenue, the outsource -- for this -- coming from our customers associated with outsourcing is at the subsystems level. And our subsystems revenue was up 22% in the third quarter year-over-year and is up 27% over the last 12 months. So we think that the outsourcing trend is continuing. And we're -- it's a core part of the strategy, as you know. -------------------------------------------------------------------------------- Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [14] -------------------------------------------------------------------------------- Yes. No, for sure. And then just following up on your comments on M&A that you made in your prepared remarks. Obviously, I understand the pause in activity in the short term, but we've certainly heard about some disruptions from -- on the private equity world about doing deals in this environment. Do you think that's going to prove to be an advantage for you? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [15] -------------------------------------------------------------------------------- I believe that there's going to be more opportunities once we get out of this period from an M&A perspective. I think it could be a catalyst for certain companies that maybe push them over the edge in terms of whether they're on the fence of deciding to sell or not. If they do, I truly believe they're going to want to join a company that has done the right thing during this crisis, that is well positioned for continued growth, that is fiscally sound and growing and has got great cultures and values. So I do believe that there's going to be more opportunities. And it was very interesting in terms of the quarter itself. I mean at the very start of the quarter, it was very, very active from an M&A perspective. But when the crisis really took a hold, we saw things really grind to a halt almost mid-quarter. So we do think it's going to come back. It's hard to determine exactly when. -------------------------------------------------------------------------------- Michael D. Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [16] -------------------------------------------------------------------------------- Yes. And Peter, I would just add to that that we do have an incredibly strong balance sheet. And with the market for private equity, as you mentioned, in terms of the capital markets and raising financing I do think our balance sheet and capital structure are going to be a competitive advantage for us, and I do think we'll see some good opportunities coming out of this. -------------------------------------------------------------------------------- Operator [17] -------------------------------------------------------------------------------- Our next question comes from Seth Seifman from JPMorgan. -------------------------------------------------------------------------------- Seth Michael Seifman, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [18] -------------------------------------------------------------------------------- Good results. Just curious, you touched on this in the near term with regard to the CapEx commentary, but when we think about some of the expansion efforts that you guys have underway that takes some time to build out, including microelectronics, do you see this having any impact on the timing of how those projects get done, projects that involve CapEx and facility movement and stuff like that? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [19] -------------------------------------------------------------------------------- So we saw some delays in the third quarter, Seth, with respect to trusted microelectronics initiatives in Phoenix, and it was largely a slowdown in some of the equipment deliveries just because of, obviously, the COVID situation. I don't think it's going to really impact, however, the -- when you step back the overall opportunity set that we're pursuing. We actually did receive our first award contract or purchase order during the quarter, which was pretty exciting, given the stage of where we're at. So I don't think it changes the big picture, but we did see some delays in the -- during Q3. -------------------------------------------------------------------------------- Michael D. Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [20] -------------------------------------------------------------------------------- Yes. And Seth, as we talked about, we -- for the trusted microelectronics, that wasn't a revenue item in fiscal '20. That's a growth opportunity for fiscal '21 and beyond, so just to echo what Mark said in terms of we don't see it having an impact for the short delay of the CapEx. -------------------------------------------------------------------------------- Seth Michael Seifman, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [21] -------------------------------------------------------------------------------- Right. Right. And then to follow up, I mean, the answer to this question might be kind of obvious but just to maybe put a little fine point on it. You called out the COVID-related expenses in the quarter. I think it was $400,000 and mostly related to your employee support. So the actual cost of implementing distancing measures throughout your offices and facilities, I mean, I totally understand why you're separating out and it makes sense, but it also seems like it was not very significant. And I'd also assume that maybe since the start-up of that happened in March, that would be the period where those costs might be relatively elevated since they're starting up. And so this is something that all of us are thinking about kind of for the first time. So when we think about the implementation of that going forward, I mean, would you expect that to grow significantly from -- I mean, I guess it would be 3 months instead of one, but you would also have done a lot of the basic work. So how do we think about that? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [22] -------------------------------------------------------------------------------- Yes. So I mean, fortunately, in terms of what could have been a major expense, which is preparing to work from home, we already had that infrastructure in place for quite some time. It's been an important part of our kind of growth initiative to put a video-based collaboration infrastructure in place, which enabled us to very rapidly transition nearly 60% of the workforce to move -- to operate from home. Most of the funds that were spent were really about helping out our hourly paid employees and trying to take care of them in the initial phase and then as the unemployment rate spiked and as they were being impacted via other family members and the burden that they've put on the family. I don't think that we're going to see a significant increase in the -- that expense. That said, it all depends on what happens, right? And so to go back to the scenarios that Mike kind of referred to in his prepared remarks and where we think the risk is, one of the risks is that if we saw a temporary shutdown of various facilities, then obviously, we'll be tapping into the use of that emergency relief fund to continue to take care of employees. So right now, we don't see that it's going to increase, but it depends on what happens. I don't know, Mike, if you would like to add anything there. -------------------------------------------------------------------------------- Michael D. Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [23] -------------------------------------------------------------------------------- Yes. I mean it's a good question, Seth, in terms of the cost. I mean you mentioned the fact that we were -- most of this was within 1 month of March, and we will have 3 months in Q4. The biggest portion of that $400,000 expense was the employee relief fund, which was about $300,000 of the $400,000. As Mark talked about, that is a $1 million relief fund, and we would like to get that money into the hands of our employees. So we hope to see that pick up in Q4, but we'll see. The other thing that we see is some expenses associated with work-from-home and social distancing, as you mentioned, that while we had some in Q3, we expect those in Q4 as well. But as Mark said, it's really hard to forecast. One thing I would point out is if you look at our guidance, we did not forecast anything associated with those costs because we don't guide discrete expenses. From an adjusted EPS, adjusted net income perspective, that will be added back as we do incur them. I will tell you, from a GAAP EPS and GAAP net income perspective, that could be a little dilutive to our Q4 results. But overall, our goal is to do what's right for the employees, and we hope we can spend as much of the fund as possible. -------------------------------------------------------------------------------- Operator [24] -------------------------------------------------------------------------------- Our next question comes from Ken Herbert from Canaccord. -------------------------------------------------------------------------------- Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [25] -------------------------------------------------------------------------------- Just -- Mark, just wanted to be clear. It sounds like the guidance doesn't imply or doesn't factor in any sort of material delays either from your supply chain or at your own facilities, obviously, as a result of COVID, correct? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [26] -------------------------------------------------------------------------------- That is correct. So as Mike said in his prepared remarks, we can absorb some temporary delays but nothing of major significance. -------------------------------------------------------------------------------- Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [27] -------------------------------------------------------------------------------- Okay. And is it -- I mean, you mentioned you've helped mitigate the risk a little bit through a little inventory build, and it sounds like you're working with suppliers, mainly where you could potentially see a little more risk. And it doesn't sound like these are big steps necessarily. So fair to say with how things look now, it shouldn't be -- I mean, obviously, who knows where we are in the duration here, but you're not expecting any sort of material step-down in terms of the impact either on your operations, but I guess, more specifically, your supply chain. -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [28] -------------------------------------------------------------------------------- I believe that's correct, Ken. So I think if you -- as you kind of go back to what I said in the prepared remarks, there's really, I think, 3 risks that we see. The first is a potential impact to our supply chain. We began focusing on our supply chain actually in January. The initial focus was on Asia. It very quickly then morphed into other international, particularly Europe and then the U.S. We've got 80% of our spend is with roundabout 81 suppliers. We're all over it. So we know exactly what's happening with those suppliers who have been impacted, who are back online, the parts that we need for the next several quarters. We're tracking it daily. So we've done a tremendous amount, literally beginning in January to, I think, buy down risk to our financial plan. The second area is obviously risk to our own manufacturing facilities. And I would say that as a company, we reacted much sooner than many companies in terms of the actions that we took, and we were certainly ahead of some of our customer locations as well. The high impact was, obviously, we ceased traveling very, very early on. And then on March 13, that was the last day in the office for the majority of those employees that could work from home. And so we transitioned 60% of the employees to work from home literally over a weekend because we already had the infrastructure in place that would allow us to do that effectively. And that created significant distancing in our facilities, which compared to large manufacturing facilities, such as in the aerospace industry, are nowhere near as dense anyway because we're doing electronics manufacturing, which just by its very nature, aren't as people-intensive. And then we did a tremendous amount inside of those facilities to improve the distancing itself. And we've continued to communicate with and educate not only all of our managers weekly on an all-manager call, but all of our employees weekly via videos and text-based communications to continue to educate them on what we need them to do to protect their health and safety as well as all of our livelihoods. And right now, that's gone exceptionally well. We haven't had any COVID -- confirmed COVID cases inside of our facilities, and everyone is continuing to work with all of our facilities remaining open. And so we're very focused on trying to keep it that way. But we could be impacted, but we've done everything that we possibly can, we believe, to reduce the risk to the business, and we're going to continue to do so. The third one, as I mentioned, is really hiring. And right now, yes, we haven't seen any changes to our hiring metrics. We've got 100 open positions. So we are still hiring because we're still growing. We expect to continue to grow. We're still hiring people. But just given the uncertainty, we could see those hiring metrics change over time, but right now, we haven't. So those would be the kind of the 3 risks that we see, and we're working them all hard. -------------------------------------------------------------------------------- Operator [29] -------------------------------------------------------------------------------- Our next question comes from Michael Ciarmoli from SunTrust. -------------------------------------------------------------------------------- Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [30] -------------------------------------------------------------------------------- Nice quarter. Glad to hear everybody is safe and healthy. Mark, maybe just to stay on that initial line of questioning where Ken was asking, talking about building inventory to absorb some delays. Where are you seeing specifically the most risk in the supply chain? I mean what types of products or inventory have you built up? And are you comfortable that some additional supply chain strain might not materialize with -- do you think you have enough buffer on hand? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [31] -------------------------------------------------------------------------------- Yes. Mike, do you want to go through the inventory? And I'll kind of talk about what we've been doing. -------------------------------------------------------------------------------- Michael D. Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [32] -------------------------------------------------------------------------------- Yes, sure. So Mike, in terms of the inventory impact in Q4 that we talked about in the buy forward, what we talked about was, and Mark mentioned that early on, this was something that was in Asia then went to Europe, and we were on top of the supply chain early. And we worked to identify our critical suppliers. We looked at our top 80% of inventory or supplier spend. We went through and specifically analyzed our critical suppliers even if they weren't in that top group, and we went out and we looked to advance purchase materials, where possible. From a financial perspective, that didn't have a material impact on Q3. As I mentioned in my prepared remarks, we do expect to see some in Q4. Those -- the orders that we put in have promise dates in Q4, but some roll into the first part of fiscal '21 as well, and we're working to expedite that as much as we can. But overall, I would say that we're doing everything we can to mitigate risk. But at this point, the supply chain and our suppliers are continuing to deliver. We're keeping an eye on all the critical suppliers. We're having our ops team and purchasing team are talking to our critical suppliers every single day to track the key deliveries. So we haven't seen anything yet, but we are doing everything we can to mitigate it and make those advanced purchases. -------------------------------------------------------------------------------- Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [33] -------------------------------------------------------------------------------- Yes. So what... -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [34] -------------------------------------------------------------------------------- So I was just going to say, the -- what it really boils down to is those component parts where there are limited sourcing options, right, that's what we are very, very focused on. And there's obviously a number of those as we kind of look out over the next several quarters, we're looking at lead times and working with the different suppliers. So some of that is pulling in material early, so we get the supply that we need. In some instances, we're looking for part-for-part alternatives, and we've done that very effectively. And then we're just literally on it on a daily basis. So the purchasing team has done an amazing job, I think, really reducing the risk to our financial forecast, but it's obviously not 0. -------------------------------------------------------------------------------- Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [35] -------------------------------------------------------------------------------- Yes. No, I appreciate that and all the color. I was actually just wondering what specific parts and components. I mean are you guys seeing pressure on circuit boards, switches, any kind of the graphics capability? What specifically are you guys -- what specific components and parts that you see the most risk around that you've had to buy excess inventory? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [36] -------------------------------------------------------------------------------- Yes. I'm not going to get into the specifics, but I can tell you, there's 125 different parts from 27 different suppliers that we're working on a daily basis. So we're all over it, Mike. -------------------------------------------------------------------------------- Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [37] -------------------------------------------------------------------------------- Okay. And then just I know you talked about having another strong bookings quarter in the fourth quarter. What's the line of sight look like in terms of, I guess, the go-forward pipeline? Do you envision that any of the potential programs that might be in the midst of a down select, they could be delayed, whether it's due to social distancing, if there are competitive bake-offs or what have you? Do you think that has an impact on your bookings? I mean certainly, it sounds like not in Q4, but any way to tell how much risk there is in the pipeline of seeing a slide out of awards? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [38] -------------------------------------------------------------------------------- Not that we see right now. Doesn't mean that it couldn't change going forward, but I can tell you that the sales team are very focused. They're very active. I think everyone has become attuned much more to working from home, and business is still getting done. It's more challenging, obviously, but I think right now, we haven't seen any impact. -------------------------------------------------------------------------------- Operator [39] -------------------------------------------------------------------------------- Our next question comes from Jon Raviv from Citi. -------------------------------------------------------------------------------- Jonathan Phaff Raviv, Citigroup Inc, Research Division - VP & Analyst [40] -------------------------------------------------------------------------------- Good to hear from you all. On the M&A question, I was just -- I guess I'm kind of trying to sort out. When do you see that market unsticking, so to speak? Is it just a matter of you, Mike, when you can get on a plane again? Is it a matter of just volatility in the market calming down? Because I imagine you had some things in the pipeline before all this hit, so I'm kind of wondering, are those frozen or are new deals sourcing frozen? Just a little more color on M&A and what you're looking to do, because you guys clearly have a lot of balance sheet to pull on here. -------------------------------------------------------------------------------- Michael D. Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [41] -------------------------------------------------------------------------------- Yes, I mean, you're right. And as Mark said, the -- coming into the quarter, the pipeline was quite strong, and it was incredibly busy period of time before COVID hit. In terms of the timing for a rebound, it's hard to know. Right now, we think most buyers are really focused on the same things we are, which is taking care of their people and honoring their commitments to their customers and shareholders, and sellers are doing the same thing. I think, Jon, the key is going to be getting to an environment where there's some predictability to near-term earnings as well as future earnings. And luckily for us, defense appears to offer more visibilities than a lot of the other sectors. But I do think as states begin to open up, employees start returning to the workplace, travel, as you say, starts again, I think you're going to see the activity pick back up. And I think we're going to be really well positioned once it does. -------------------------------------------------------------------------------- Jonathan Phaff Raviv, Citigroup Inc, Research Division - VP & Analyst [42] -------------------------------------------------------------------------------- And then you brought up earlier, Mark, both in prepared remarks and in response to a question earlier about potential crowding out and then various sort of spending. Kind of aside from just the crowding out budget thing, how does Mercury position itself for a world in which national priorities could at least expand? So you have swap requirements for defense applications, but also maybe swap requirements for medical and health care applications. I know you guys used to be in medical previously, and you got out of it for a structural reason, and good for you on that. But going forward, how do you think about the sort of big picture, very long-term opportunity sets for the company heading into a post COVID kind of world? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [43] -------------------------------------------------------------------------------- Yes. It's a good question, Jon. I think for now, yes, we're going to continue to just do what we've been doing. I think there's still an enormous opportunity around just the modernization of the different electronics inside of the defense industry, which are where we're primarily focused. And I think there's still a tremendous opportunity from an M&A perspective. As I said earlier, I think there's probably even more opportunity from an M&A perspective. So there could be additional opportunities as things continue to progress, and we'll -- we're obviously pursuing a significant one right now in the trusted microelectronics space, which is a major area of growth, we believe, in the long term. But we want to stick at what we're good at, what we know and not necessarily to diversify. -------------------------------------------------------------------------------- Operator [44] -------------------------------------------------------------------------------- (Operator Instructions) I show our next question comes from Jonathan Ho from William Blair. -------------------------------------------------------------------------------- Jonathan Frank Ho, William Blair & Company L.L.C., Research Division - Technology Analyst [45] -------------------------------------------------------------------------------- Can you maybe, I guess, give us a little bit of additional color on how your acquisition integration efforts are going? And with -- particularly with some of the recent acquisitions, does COVID potentially slow down anything relative to your prior plans there? -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [46] -------------------------------------------------------------------------------- Yes. So I would say that we have done a pretty good job. I mean the only one that's really outstanding at this point is Alpharetta, which is the APC acquisition. We began to go through the work to transition them to their business systems. And we did the kick off, but then obviously we got impacted with the inability to travel, so it has moved to the right a little bit. That said, the business is performing extremely well, and the team is very excited to be part of Mercury. What was very interesting to me as we -- kind of stepping back, as we've addressed the COVID crisis, the business model has really come into play in a couple of different ways. We've talked a lot about deploying a matrix organizational structure that gives us scalability as the business continues to grow. That matrix organization actually really helped us very, very quickly deploy a set of capabilities and responses across the business that I think help mitigate a lot of risk much sooner had we not been a full integrator. And so the fact that we've got an organizational structure and a model and we believe in full integration has actually helped us respond to a crisis, not only create value through an M&A. So it's another good reason to continue to do what we have been doing, and we'll get back on track once we're able to travel again, but it's not impacting the financial performance, Jonathan. -------------------------------------------------------------------------------- Jonathan Frank Ho, William Blair & Company L.L.C., Research Division - Technology Analyst [47] -------------------------------------------------------------------------------- Great. And then just as a quick follow-up, more on a big picture level, do you think COVID maybe accelerates some of the trends that you've already been seeing around delayering and particularly given the risks now of having multiple sub primes and subcontractors having to work in different facilities on a single project, if you could maybe consolidate that down to a few that truly are adding value? Just wondering if, again, from a big picture perspective, you think that maybe could play out over the long run. -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [48] -------------------------------------------------------------------------------- Yes. So if you think of the industry trends that we've talked about, delayering is one, and that is continuing to happen and we see it. What I think is probably going to be the more dominant theme around the macro level trends is that flight to quality suppliers as a result of just the impact that COVID has had. I think it's exposed some vulnerabilities from a supply chain perspective around dealing with small businesses that aren't necessarily as well capitalized or able to deal with the risks and the challenges that COVID has presented. And so I think people are going to step back and figure out who are the companies within their supply chain that they really need to deal with and partner with in the long term. And we've been doing that very well, I think, over the last 5 years. And I think we're going to see even more of it going forward. The other thing that obviously this has exposed is just the domestic supply chain and the need to bring back some of that capability to the U.S. And as you know, we have invested in our own trusted domestic manufacturing facilities for quite some time. And I think that's going to play out as well. So I think we're well positioned, just given everything that we had previously been doing with the strategy that is even more important with what has just happened. -------------------------------------------------------------------------------- Operator [49] -------------------------------------------------------------------------------- Mr. Aslett, it appears there are no further questions. Therefore, I'd like to turn the call back over to you for any closing remarks. -------------------------------------------------------------------------------- Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [50] -------------------------------------------------------------------------------- Okay. Well, thank you very much for taking the time to listen in today. We look forward to speaking to you again next quarter. Thank you. -------------------------------------------------------------------------------- Operator [51] -------------------------------------------------------------------------------- Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.