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Edited Transcript of MRCY earnings conference call or presentation 30-Jul-19 9:00pm GMT

Q4 2019 Mercury Systems Inc Earnings Call

CHELMSFORD Aug 28, 2019 (Thomson StreetEvents) -- Edited Transcript of Mercury Systems Inc earnings conference call or presentation Tuesday, July 30, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Mark Aslett

Mercury Systems, Inc. - President, CEO & Director

* Michael Ruppert

Mercury Systems, Inc. - Executive VP, CFO & Treasurer

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Conference Call Participants

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* Jonathan Frank Ho

William Blair & Company L.L.C., Research Division - Technology Analyst

* Jonathan Phaff Raviv

Citigroup Inc, Research Division - VP

* 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

* Seth Michael Seifman

JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst

* Sheila Karin Kahyaoglu

Jefferies LLC, Research Division - Equity Analyst

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Presentation

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Operator [1]

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Good day, everyone, and welcome to the Mercury Systems Fourth Quarter Fiscal 2019 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, Michael Ruppert. Please go ahead, sir.

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [2]

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Good afternoon, and thank you for joining us. 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.

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.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [3]

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Thanks, Mike. Good afternoon, everyone, and thanks for joining us. I'll begin with the business update. Mike will review the financials and guidance, and then we'll open it up for your questions.

Fiscal 2019 was another very successful year for Mercury. We ended the year with strong results in the fourth quarter, including record bookings, backlog and revenue. The industry environment is positive, and our strategy and business model are performing extremely well.

Our total revenues have continued to grow faster than the industry average. Organically, revenue for fiscal '19 was up 12% compared with 7% in FY '18. We supplemented this high level of organic growth with strategic M&A, completing 4 acquisitions, while also making solid progress integrating previously acquired businesses. After reloading the balance sheet with our recent equity offering, we're strategically well positioned for continued organic and M&A-driven growth in fiscal '20.

The acquisition of American Panel Corporation, or APC, which we expect to close later this quarter, is another great example of our strategy and action. It is also the latest step forward in our plan to build out an industry-leading C4I business.

With that as background, let's turn to our financial results on Slide 4, starting at the fiscal year level. Total bookings and revenue for fiscal '19 were up 39% and 33% from FY '18, respectively, both hitting all-time records. Mercury's book-to-bill for FY '19 was a strong 1.2%. Our year-end backlog increased 39% to record levels. It was also a great year for new design wins, which totaled more than $1 billion in potential lifetime volume.

On the bottom line, GAAP net income for fiscal '19 increased 14% year-over-year. Adjusted EBITDA was up 27%, hitting a new record. Free cash flow more than doubled to 49% of adjusted EBITDA. Working capital continued to improve, and we significantly strengthened the balance sheet.

For the fourth quarter, revenue increased 16% in total and 4% organically year-over-year. Absent certain revenue that moved into Q4 fiscal '18, our organic growth would have been 12%. Our largest revenue programs in the quarter were SEWIP, Filthy Buzzard, F-35, a next-generation missile system and Aegis. Q4 was an accepted -- an exceptionally strong quarter for bookings, which exceeded $200 million for the first time. Total bookings were up 41% year-over-year, leading to a record backlog and a book-to-bill of 1.36.

Our largest bookings programs in the quarter were for a classified radar program, E-2D Hawkeye, Filthy Buzzard, F-35 and Triton. Mercury continued to deliver strong levels of profitability in the quarter with adjusted EBITDA up 1% from a strong Q4 fiscal '18. Free cash flow came in at 45% of adjusted EBITDA.

Turning to Slide 5. We continue to be successful acquiring and rapidly integrating businesses that fit well with our strategy. The pace of acquisitions has picked up in recent quarters. Including APC, we will have completed 5 transactions in the last 12 months, totaling $228 million of capital.

Over the last 5 years, again, including APC, we've deployed more than $800 million in 11 acquisitions. As a result, we've increased total revenue and adjusted EBITDA at compound annual growth rates of 26% and 46%, respectively. We've also had a positive book-to-bill in each of the last 5 years and have averaged 10% organic revenue growth.

Our model of strong margins and high organic revenue growth, supplemented with disciplined M&A and full integration is the embodiment of our strategy. We believe this strategy will continue to generate significant value for our shareholders over the longer term.

Our current focus in M&A is to build capabilities and scale in the C4I market. We continue to build out our rugged secure server business and, as well, our new business focused on mission computing and avionics processing. This business consists of CES, RTL, GECO Avionics and now APC. As we've done in sensor processing subsystems, our goal in the Avionics processing space is to build out industry-leading solutions using open systems architectures. This should meet our customers' demand for next-generation technologies more quickly and more affordably.

Turning to Slide 6. Acquiring APC advances us further in this direction in an area where the supply chain delayering we've talked about is beginning to take hold. CES, RTL and GECO focus on providing safety certifiable avionics processing capabilities. APC complements these capabilities by providing very advanced ruggedized displays for the military aerospace, ground vehicle and commercial aerospace markets.

APC was founded in 1998 and is based in Alpharetta, Georgia. They're a leading innovator in large area display technologies that are increasingly deployed on a wide range of next-generation platforms. In addition, their products are incorporated into a wide range of established platforms, including the Apache attack helicopter, the F-15, F-16, F-18 and F-35. We are pleased to welcome the APC team to the Mercury family.

The business employs around 100 people. They generated approximately $36 million of revenue over the 12-month period ending June 2019. The purchase price of $100 million was entirely funded with cash on hand. This represents about 10x APC's LTM-adjusted EBITDA net of the expected tax benefit. Acquiring APC will enable us to complete -- compete for large avionics opportunities as well as play a more significant role in military digital convergence.

Turning to Slide 7. From an operational perspective, we continue to make solid progress integrating prior acquisitions and investing in the business for future growth. Over the past 5 years, we've strategically focused our growth investments on building out our own domestic manufacturing capabilities. We've now begun a multiyear journey to improve both working capital efficiencies and the manufacturing operations themselves.

These assets include our West Coast RF manufacturing locations where we expect to complete the consolidation activity in the first half of fiscal '20. They also include our Advanced Microelectronics Center in Phoenix. Here, we completed the build-out of our trusted digital SMT capability and have insourced the manufacturing of Mercury secure processing product line.

The other type of manufacturing we do in Phoenix is trusted custom microelectronics. We're planning to make additional capital investments in this part of the business in FY '20 and FY '21. Our goal is to become the leading conduit for the silicon innovation that is occurring in the high-tech commercial world for use inside the defense industry.

Commercial silicon vendors are struggling to deal with the low volumes and complexities of the defense industry. Defense, on the other hand, desperately needs access to commercial innovation and investment. We believe Mercury is strongly positioned to address this need, given that we are a high-tech company that operates in the defense industry. Our plan is to expand our trusted microelectronics capabilities in Phoenix to develop and grow this area of the business. It's an area that we believe has significant long-term potential to Mercury from an innovation and financial perspective, as well as to the defense industry.

At the same time, we'll continue to focus on acquisition integration, and we're making solid progress. Themis and Germane has been substantially integrated. The migration to Mercury's business systems and processes are complete, and we expect to achieve DFARS security compliance for these businesses in the first half of this fiscal year. The combined Themis and Germane business is performing well operationally and financially. We have a great team in place, and we're executing against our value creation blueprint. This is focused on improving the margin profile of the business over time, while introducing Mercury's industry-leading embedded security capability into their rugged server product line.

The GECO Avionics integration is underway and on track as well. The business is off to a strong start. We've seen some interesting avionics processing opportunities as a result of the acquired assets we've assembled. It's still early days for the Athena and Syntonic integrations, but both businesses are on track with where we thought they would be at this point in time.

Turning to Slide 8. We continue to be in the most favorable defense-funding and industry-growth environment I've seen since joining Mercury. We're pleased with the recent 2-year defense budget deal, defense appropriations, authorizations and outlays are trending higher. We're also seeing increased investment account spending. This spending prioritizes modernization and next-generation technologies and capabilities, which, in turn, favor Mercury.

All of this is leading to a high level of new program starts and design win activity and substantial growth in the estimated lifetime value of our top 30 programs and pursuits. This organic and M&A-driven growth reflects the impact of 3 industry trends that we discussed in the past. These trends include, first, as I mentioned, supply chain delayering by the government and the primes. Second, the flight to quality suppliers by the primes; and most important, increased outsourcing by our customers at the subsystem level. Our subsystem revenues increased 85% year-over-year in fiscal 2019 to 44% of total company revenue. We continue to see outsourcing as the largest secular growth opportunity in defense.

Mercury is also strongly positioned in well-funded defense budget priorities, among them radar and EW modernization, weapon systems, secure rugged servers, mission computing and avionics processing. The level of market activity remains very high, a major driver being radar modernization. One of our key customers received their first production award for the AESA airborne radar processing application in Q4. This enterprise architecture has been in development for some time and will be used across multiple programs.

We're also beginning to see significant design win opportunities in the missile defense domain, with upgrades of ground-based radars and command and control systems. Other opportunities include EO/IR system upgrades as well as programs in the space and hypersonic domains. This quarter, we won another design start in hypersonics.

We've been making substantial investments in these areas. Our R&D strategy is based upon the belief that more of the technology that goes into U.S. military platforms will need to be secured as well as designed and produced in the U.S. We're pursuing this opportunity by making significant investments to develop secure hardware and software technologies domestically. Our customers are responding in kind by supplementing Mercury's high level of internally funded R&D with R&D of their own. As a result of this substantial combined investment, we've been able to rapidly adapt our commercially available technologies to these new and emerging opportunities.

Both our target markets continue to grow faster than the defense market overall. Sensor and Effector revenue accounts for 62% of total revenue in Q4, increasing 17% from the fourth quarter last year. In C4I, revenue increased 32% year-over-year to 26% of total revenue. At the full year level, Sensor and Effector and C4I revenues increased 18% and 110%, respectively.

Turning to Slide 9 and looking forward. Our business outlook remains strong, driven by the high levels of new design win activity and opportunities for organic growth. Over the longer term, our baseline forecast is for overall defense spending to increase low single-digit rates. Mercury's goal is to continue delivering organic revenue growth at a rate that exceeds this industry average.

We're also well positioned to continue supplementing our high level of organic growth with smart, strategic M&A. The M&A pipeline remains very robust. We continue to see interesting opportunities of varying sizes that are consistent with our strategy, with APC being the most recent example. We intend to remain active and disciplined in our approach to M&A, focusing on the Sensor and Effector Mission Systems and C4I markets as we have in the past.

We continue to look for deals that are strategically aligned, have the potential to be accretive in the short term and promise to create long-term shareholder value. Overall, our strategy and business model are working extremely well. We remain confident that we can achieve the high end of our model over time by continuing to execute our plan in 5 areas. First is to drive high single-digit, low double-digit organic revenue growth supplemented by acquisitions. This is consistent with the 26% compound annual growth in total company revenue we've delivered over the last 5 fiscal years.

The second is to invest in new technologies or facilities, manufacturing assets and business systems. We will also continue to invest heavily in our people. Mercury's become a destination employer and an acquirer of choice. Our ability to attract and retain the talent we need to support our growth has never been better.

Third is manufacturing insourcing as well as driving strong operating performance across our manufacturing locations. The goal here is to enhance margins and on-time delivery while improving working capital efficiencies over time.

Fourth, we're ensuring that revenues grow faster than operating expenses, creating stronger 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 continue to produce attractive returns for our shareholders.

So in summary, we will continue to execute on this model as being so successful for us over the past 5 years. We're anticipating another year of double-digit growth in revenue and adjusted EBITDA in fiscal '20, including at least 10% organic revenue growth.

Mike will take you through the guidance in detail. And so with that, I'd like to turn the call over to Mike. Mike?

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [4]

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Thank you, Mark, and good afternoon again, everyone. Mercury concluded a great fiscal '19 with strong financial results in the fourth quarter, including record bookings, backlog and revenue. Operating and free cash flow were also strong and aligned with our expectations. In addition to record operating results, it was an active quarter for acquisitions and balance sheet reloading. We announced and closed this Syntonic and Athena transactions and completed negotiations with American Panel Corporation.

We also raised $455 million of proceeds in a follow-on equity offering, providing the financial flexibility we need, given the strength of our M&A pipeline. As a result, Mercury is well positioned to deliver another year of growth and profitability in fiscal '20.

Turning now to Slide 10 and our Q4 fiscal '19 results. Mercury's total bookings increased to 41% year-over-year to a record $241 million, driving a 1.36 book-to-bill ratio. We ended the quarter with a record backlog of $625 million, up 40% from Q4 fiscal '18. Total revenue for Q4 increased 16% year-over-year to a record $177 million, exceeding the top end of our guidance of $164 million to $173 million.

Organically, revenue increased to 4% from Q4 of fiscal '18, which benefited from $11 million of revenue that slipped from Q3. Excluding that $11 million in Q4 last year, organic revenue for Q4 fiscal '19 would have been up 12% year-over-year.

Gross margin for the fourth quarter was 45.1%. This is above our guidance of 43.6% to 44.5% and above our gross margin of 44.7% in Q4 last year. The increase from last year largely reflects program mix and operational efficiencies.

In Q4, R&D was up sequentially by $2.9 million, growing to $20.3 million from $17.4 million in Q3. R&D as a percentage of sales was 11.5%. Looking forward, we expect to continue to invest a high level of R&D to take advantage of the numerous organic growth opportunities we are seeing.

SG&A for Q4 was up 12% to $30.7 million from $27.4 million last quarter. This increase was driven by the inclusion of Athena and Syntonic as well as the additional investments we've made in the business.

GAAP net income and GAAP EPS in the fourth quarter increased 27% and 19% year-over-year, respectively. Adjusted EPS for Q4 was $0.47 per share. Adjusted EBITDA for Q4 was $37.9 million, exceeding our guidance of $34.1 million to $37.1 million as a result of higher-than-expected revenue and gross margin. Adjusted EBITDA margin was 21.4% for the quarter, at the top end of our guidance of 20.8% to 21.4%.

Putting this in context, Mercury's overachievement on the top line has given us the flexibility to invest in the business while still exceeding our expectations for adjusted EBITDA. As we prepare for continued organic and M&A-related growth, we are investing in R&D, our sales force, program management, HR and finance as well as operations.

Given these investments, coupled with our growth momentum, we're well positioned to continue to deliver on our financial model, high single-digit, low double-digit organic revenue growth, adjusted EBITDA margins above 20% and continued strategic M&A. Free cash flow, which we define as cash flow from operations less capital expenditures, was also strong in the quarter. Capital expenditures were $8.8 million in Q4 fiscal '19 or 5% of sales. The higher CapEx this quarter was primarily driven by consolidation of our West Coast RF manufacturing locations, which we expect to complete in the first half of fiscal '20.

Turning to our full year results on Slide 11. Fiscal '19 was another excellent year for Mercury with record bookings, backlog, revenue, adjusted EBITDA, adjusted EPS and free cash flow. Total bookings increased 39% year-over-year to $783 million, driving a 1.2 book-to-bill ratio. Backlog at year-end was $625 million, up 40% from fiscal '18. Total revenue increased 33% year-over-year to $655 million, exceeding the top end of our guidance of $642 million to $651 million. Mercury's organic revenue growth was 12% year-over-year.

Gross margin for fiscal '19 was 43.7%, above our guidance of 43.3% to 43.5%. This compares with 45.8% last year. The decrease from fiscal '18 is due to the inclusion of Germane Systems, program mix and a higher level of customer-funded R&D. Internal R&D expense for fiscal '19 increased by $10.1 million year-over-year. As a percentage of sales, R&D decreased from 11.9% in fiscal '18 to 10.5% this year. The percentage decrease was primarily driven by a higher level of customer-funded R&D in fiscal '19.

As we've discussed in the past, this is a precursor to the higher-margin hardware annuities that we expect in the future. SG&A for fiscal '19 increased 25.3% to $110.7 million from $88.4 million last year. As a percentage of sales, SG&A was 16.9%, down from 17.9% in fiscal '18. Over the last 4 years, we've been able to reduce SG&A as a percentage of sales from 21% in fiscal '15 to 16.9% this year, highlighting the operating leverage that we continue to build into the business.

GAAP net income and GAAP EPS for fiscal '19 increased 14% and 12% year-over-year, respectively. Adjusted EPS increased to $1.84 per share, up 30% from $1.42 per share for fiscal '18. Adjusted EBITDA for fiscal '19 increased 27% year-over-year to $145.3 million or 22.2% of revenue at the high end of our guidance of 22% to 22.2%. Free cash flow for the year was also strong.

Slide 12 presents Mercury's balance sheet for the last 5 quarters. As I mentioned, Q4 was very active from a balance sheet perspective. We ended the quarter with $277 million of debt and then closed the Syntonic and Athena acquisitions, which increased our debt to $325 million. We then raised $455 million of equity which was utilized to pay down the revolver. In conjunction with the offering and paying down the revolving debt, we also terminated the $175 million interest rate swap we had in place.

As we enter fiscal '20, we believe Mercury is well positioned from a capital structure perspective. Reflecting strong internal cash generation and the proceeds from our equity offering, we have 0 debt and $258 million of cash on the balance sheet. We intend to fund the acquisition of APC with a portion of this cash.

In addition, we have a $750 million unfunded revolver. This provides us with significant capacity for future growth investments organically as well as through M&A. Our focus on acquiring businesses that fit with our M&A strategy and integrating them into Mercury is delivering results as planned. We continue to see a robust pipeline of M&A opportunities. We're confident that we'll be able to continue to deploy capital prudently and accretively on strategic acquisitions, with APC being just the latest example of our strategy in action.

Turning to cash flow on Slide 13. Mercury delivered record free cash flow in fiscal '19. Our Q4 free cash flow was $17.1 million, representing 45% of adjusted EBITDA. For fiscal '19 as a whole, free cash flow was $70.8 million, up 151% from $28.2 million in fiscal '18. Free cash flow as a percentage of adjusted EBITDA was 49%. Operating cash flow for the fourth quarter was $26 million compared with $25.6 million in Q4 last year. And for fiscal '19, operating cash flow was $97.5 million compared with $43.3 million last year.

Working capital for the fourth quarter was a $9 million use of cash compared with $5.8 million in Q3. For fiscal '19 as a whole, working capital was a $22.7 million use of cash compared with $53.8 million in fiscal '18. This reduction highlights the working capital improvement we've delivered during the year.

Capital expenditures in Q4 were $8.8 million or 5% of revenue. This was up as expected from 3.7% of revenue for the first 3 quarters of fiscal '19, reflecting continued acquisition integration and growth-related investments. For the full fiscal year, capital expenditures were $26.7 million compared with $15.1 million in fiscal '18.

I'll now turn to our financial guidance, starting with the full 2020 fiscal year on Slide 14. This guidance does not include any estimates for APC, which we announced today, but don't expect to close until towards the end of fiscal Q1, contingent upon HSR approval and other closing conditions. Based on the estimated closing date, we don't expect APC to have a material impact on our Q1 results. We'll provide updated guidance, including APC, on our next earnings call.

As you can see, we're expecting another record year in fiscal '20. We're anticipating strong revenue growth, both organically and overall. We expect to continue investing in R&D and SG&A to take advantage of the organic growth opportunities we're seeing, while at the same time, continuing to deliver record results.

In fiscal '20, we expect revenue to progressively increase throughout the year and the percentage split between first and second half revenue to be similar to fiscal '19. As such, we expect operating leverage to improve on a quarterly basis, with adjusted EBITDA margins expanding as we grow revenue faster than expenses. Looking further ahead, we believe the investments we're making this year will position Mercury well to continue to expand adjusted EBITDA margins over the next few years.

With that as background, starting on the top line for the full 2020 fiscal year, we currently expect revenue of $740 million to $760 million, representing growth of 13% to 16% from fiscal '19. As Mark said, we're expecting at least 10% organic revenue growth for the year. Consolidated gross margin for fiscal '20 is currently expected to be 43.6% to 44.2%. Based on our current revenue forecast, we expect Mercury's gross margin to continue to reflect the organic growth dynamics Mark discussed, heighten new design win activity, more new program starts in the mix and recent acquisitions.

That said, as the year progresses, we expect incremental gross margin expansion as a result of operational efficiencies as well as several programs transitioning from the engineering phase in the higher-margin production phases. Consolidated operating expenses for fiscal '20 are expected to be $235.2 million to $240.2 million, including an estimated $27.6 million of amortization expense. In fiscal '20, we expect R&D as a percentage of sales to increase to approximately 11% compared to 10.5% in fiscal '19. We expect the percentage to be higher in Q1 and progressively decline as a percent throughout the year as revenues grow faster than R&D. We expect SG&A as a percentage of sales to be approximately 17%, similar to fiscal '19 results. We expect this percentage to be higher in H1 than in H2.

Our guidance assumes interest income for fiscal '20 of approximately $5.6 million. This excludes the impact of the cash purchase price for APC and any additional acquisitions during the year. Total GAAP net income on a consolidated basis for fiscal '20 is expected to be $66.5 million to $72.4 million or $1.20 to $1.31 per share. Adjusted EPS is expected to be in the range of $1.97 to $2.08 per share.

Our fiscal '20 guidance for consolidated adjusted EBITDA is $160.5 million to $168.5 million or 21.7% to 22.2% of revenue. This is an increase of 10% to 16% from fiscal '19. On a quarterly basis, we expect fiscal '20 adjusted EBITDA margins to progressively increase throughout the year. We expect CapEx for fiscal '20 to be approximately 5% of revenue weighted towards the first half. Fiscal '20 CapEx will reflect our continued investment in the consolidation of our West Coast RF manufacturing locations, which we expect to complete in the first half of the year. We also expect to invest in our trusted microelectronics capabilities in Phoenix as well as our corporate headquarters to accommodate the increased development work resulting from recent design wins.

Turning now to our first quarter guidance on Slide 15. We're forecasting consolidated total revenue in the range of $160 million to $170 million. Q1 fiscal '20 gross margins are expected to be 43.5%, which is up from 42.8% in Q1 fiscal '19 as a result of favorable program mix. Q1 GAAP net income is expected to be $11.5 million to $13 million or $0.21 to $0.24 per share. Adjusted EPS is expected to be $0.39 to $0.42 per share. Adjusted EBITDA for Q1 is expected to be $32 million to $34 million, representing approximately 20% of revenue.

For the full year, we expect our adjusted EBITDA margin to be 21.7% to 22.2% of revenue. We expect CapEx in Q1 to be approximately 7% of sales as we complete our acquisition integrations and invest in our Phoenix microelectronics business. In Q1 of fiscal '20, we expect free cash flow to adjusted EBITDA to be approximately 30% to 40% due to year-end bonus payments and higher CapEx. For full year fiscal '20, we believe that 50% free cash flow to adjusted EBITDA remains a reasonable target.

Turning to Slide 16. In summary, we completed a strong Q4 and fiscal '19 with record bookings, revenue and annual cash flow. The guidance I've just provided reflects the continued momentum we're seeing in the business. We completed 4 acquisitions in the year and are on track in our acquisition integration initiatives. We've been successful on our capital raising efforts, and our M&A pipeline continues to be robust.

Our results during fiscal '19 provide Mercury the opportunity to continue investing in the business while still delivering another record performance in fiscal '20.

With that, we'll be happy to take your questions. Operator, you can proceed with the Q&A now.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Seth Seifman with JP Morgan.

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Seth Michael Seifman, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [2]

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I wanted to -- I want to ask a little bit about the profitability. And you laid out some of the incremental R&D, SG&A, lower gross margins in the first part of the year. Maybe if you could talk a little -- in a little bit more detail about sort of the opportunities that emerged. It sounds like opportunities that emerged during the quarter that made you see the utility of the incremental investment.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [3]

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Yes. Seth, it's Mark. I wouldn't say it was necessarily during the quarter. I think we continue to operate in a pretty dynamic environment from a growth perspective. Clearly, we've seen some significant increases in the government spending in RDT&E that's driving a lot of new design win activities in the areas that I've mentioned in my prepared remarks. And so we're going to continue to invest in the business from a growth perspective to go capture those new design wins. So it's a continuation of a theme that we saw throughout fiscal '19.

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [4]

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Yes. And Seth, just to add that when we entered the year, if you look back at our guidance in fiscal '19, our revenue dramatically outperformed and what we thought it was going to be. And as we went through the year, saw the opportunities, as Mark said, we thought it was a good time to continue to invest in the business because we have the opportunity to do so and still deliver record results.

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Seth Michael Seifman, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [5]

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Sure. Absolutely. And then just as a follow-up. Then the first quarter margin, EBITDA, adjusted EBITDA margin versus the full year margin implies a negative rate at the end of the year that's kind of nicely above the guide for the full year. And so -- I mean would you think of the full year as kind of a go-forward type of margin? Or think of the first half investment that we're seeing is a little bit more of a onetime and having the exit rate being more of a go-forward margin?

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [6]

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Yes. No. I think Seth, what you're going to see through the year, and I talked a little bit about it in the prepared remarks, is a couple of dynamics. First is when we talk about the revenue split, we think that in fiscal '20, it's going to be similar to fiscal '19. So if you look back, it was around 45%, 46% in H1. Gross margins for the year, guidance is -- midpoint is about 44% and 43.5% for Q1. So we expect some increase in the second half, as you said, to average 44% gross margin for the year. So we see that picking up through throughout the year.

R&D, I mentioned, about 11% of sales for fiscal '20, it was 10.5% in fiscal '19. And if you look at the increase in Q4 fiscal '19, and you run rate that, you'll see that we've already made some investments. So the ramp-up to 11% is almost just run rate in Q4 and then adding some small growth to that. But as you say, on a percentage basis, we expect that to come down as revenues grow, but the R&D doesn't grow as fast.

And then SG&A is the other piece of it, which I mentioned would be about 17% of sales. That's flat with '19. But since we expect revenue to be greater in H2 than H1, the percentage of SG&A will be a little higher in H1 than -- and lower in H2. So at the EBITDA level, you're going to see the same trend that you're picking up on, 22% for the year, we guided 20% in Q1. So we'd expect H1 to be lower and then the second half to be higher. And I think what you're seeing when you step back from all that is the operating leverage that we're building into the business. So you're really going to see it, we think, in the second half of fiscal '20 because we're making the investments now. And then we think we'll be incredibly well positioned going into fiscal '21 and beyond.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [7]

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So I think we do, as Mike said in his prepared remarks, that we do see the opportunity for EBITDA margins to expand in the out years, just given the operating leverage that we see in the business. That being said -- as I said, just literally in the question that you asked earlier, there's a lot of opportunity to invest for us to continue to grow the business organically and well above the industry average growth rates. And when we see those opportunities, we're probably going to lean in.

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Operator [8]

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And our next question comes from the line of Jon Raviv with Citi.

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Jonathan Phaff Raviv, Citigroup Inc, Research Division - VP [9]

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Just following on the margin question. Can you just clarify some of the language in the slides between staying above 20% versus driving at the higher end of that business model range? Is that sort of the difference between kind of, I'd say, mid-term and -- or near to mid-term versus longer-term aspirations?

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [10]

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Yes. I mean I think from an EBITDA perspective, Jon, nothing's changed. We want to drive and continue to increase EBITDA margins over the long term. In Q1, we were at -- 20% is our guidance. And as we just discussed, we see that ramping up throughout the year. So we see the operating leverage in the business, and we want to continue to grow that fiscal '21 and beyond. And as I mentioned that we think you'll see some of it in H2 of this year as we're currently seeing it play out. So no contradiction from our perspective in terms of wanting to continue to grow EBITDA to the high end of ranges.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [11]

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So if you remember, Jon, in the -- in our investor presentation, we've got an inverted pyramid slide that compares kind of Mercury's financial profile with that of all publicly traded companies as well as an index of Tier 2 defense companies. That particular slide references an EBITDA margin greater than 20%. So it's kind of consistent with the performance that we have delivered, which has obviously been above that number.

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Jonathan Phaff Raviv, Citigroup Inc, Research Division - VP [12]

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Got it. Understood. And then also, could you guys offer some perspective on industry M&A which seems to be probably based on financing internal investments and creating investment pools to go after opportunities? Can you just offer some perspective on the risks and opportunities in that dynamic? Because it seems like combined businesses to drive more of their own IRAD with -- on its pace, sounds like it's an opposition to your strategy to capture more outsourcing. So any thoughts on industry M&A and on the primes, it'd be -- I would be grateful for that.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [13]

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Yes. Clearly, I think we're in an environment that is requiring greater level of investment. As you know, Mercury has probably got one of the highest internal R&D to revenue spend ratios, and it's probably doubled the -- on a percentage basis, the next closest company. So I do think there has been some -- a lot of talk and potentially some transactions driven by that. We feel really good about the position that we're in, I mean, we're investing significantly in the business. To put it in perspective, on a cumulative basis over the last 5 years, we've invested over $285 million on R&D, we've invested over $95 million on CapEx, and including APC, $800 million of capital and M&A, so for a combined total of close to $1.2 billion. And we're focusing on investment in a very, very specific set of areas, which is building these very sophisticated processing subsystems for use on board platforms. So we think that the investments that we're making are very significant and far out strip, other companies in the space. And we think it's a primary reason that actually the rate of outsourcing has increased, leading to the substantial growth that we saw in our subsystems revenue year-over-year, which was up 85% compared to fiscal '18. So yes, I think investment is important in this environment, and we feel that we're well positioned, Jon.

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Operator [14]

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And our next question comes from the line of Sheila Kahyaoglu with Jefferies.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division - Equity Analyst [15]

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I was just wondering if you could expand upon your comments within the Phoenix facility and expanding that manufacturing capability, what that adds to your vertical integration capacity. And then maybe how you guys think about CapEx and building that out on your own versus doing a deal to do so.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [16]

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Sure, Sheila. So as I said in my prepared remarks, there's actually really 2 different types of manufacturing capabilities we have in Phoenix. The first is the digital SMT capability that we have built out over the last couple of years. The primary driver of that, as you know, was for us to be able to insource the manufacturing of our secure processing product line, which we've largely completed. What we talked about on the call from an expansion perspective was really the other part of the Phoenix facility that really came to us, again, through the acquisition of the Microsemi Carve-Out assets. And what we see here is the opportunity of growing substantially, our custom microelectronics capability. And what we see happening in the commercial world is there's actually an explosion in the amount of specialized silicon, whether it be for AI, for autonomy, for machine learning, for mixed signal applications. And the defense industry desperately needs to get access to that. And so what we're doing is kind of positioning ourselves given that we're a horizontal company inside of the industry and operating as a high-tech company to become the leading conduit for that capability into the defense industry. So we're going to build up the capabilities that we already have, but expand that to become that leading company.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division - Equity Analyst [17]

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Got it. And then just on the APC, maybe if you could talk about what opportunities it opens up, how it combines with GECO and who are you competing with there.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [18]

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Sure. So we are combining it together -- we will combine it together with the other acquisitions that we've done in this space. So specifically, CES with RTL, and most recently, GECO Avionics. And we're looking to be able to provide a full set of capabilities in the Avionics suite. And to do that, providing it to our existing customers. And what we see happening is that the -- as we've talked about from a trend perspective, there's delayering occurring that certain companies in this space would actually like to deal directly with companies at the Tier 2 as opposed to buying a complete, fully integrated Tier 1 solution. So it allows them to do things more affordably, probably more quickly and to add some of their own value. And so what the APC acquisition gives us is access to some of the display technologies that complements sort of the processing capabilities in Avionics and mission computing that we've previously acquired.

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Operator [19]

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And our next question comes from the line of Peter Arment with Baird.

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Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [20]

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Mike, just a clarification on the CapEx. You said you're targeting the 5% level. I thought that was originally the target for fiscal '19. Did some CapEx shift out? Or just -- maybe you could just clarify that first.

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [21]

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Yes, it did, Peter. I mean -- so we are expecting 5% in fiscal '20, came in a little lower than that, around 4% in the fiscal '19. Main reason for that is the West Coast facility consolidation that we've been talking about, pushed out a little bit from the second half of this year into the first half of next year. And that's really what's driving that.

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Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [22]

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Got it. And then on -- just -- I know you don't formally give a free cash flow guidance, but it's still the kind of the targeting a 50% of adjusted EBITDA still a good bogey here when we think about fiscal '20?

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [23]

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Yes. That's what we're shooting for. And I did point out that Q1 is going to be lower. So of the 5% of CapEx for fiscal '20, it is going to be front-end loaded, primarily because of the West Coast consolidation that slipped from this year and at the beginning of next. So CapEx in Q1 throughout a number of around 7% as an estimate. And so that's going to put some pressure on free cash flow conversion in Q1. So I mentioned 30% to 40%. But for the year, even though we're expecting 5% of CapEx, we still are targeting the 50% free cash flow to adjusted EBITDA conversion rate.

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Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [24]

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Got it. And then, Mark, on APC kind of the end market mix, it sounds like you -- it's heavily defense-oriented, but there's also a little bit of commercial. Could you give us a little color on that and how much there is of commercial?

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [25]

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Yes. So the defense market is 80% and commercial is 20%.

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Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [26]

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Okay. And of that commercial piece, is it then -- is it on a larger commercial aircraft programs or a bizjet or what exactly is that?

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [27]

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So 737, A320 as an example.

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Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [28]

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Got it. And just around comfort level for having some of that commercial, you -- just historically, I think you've always focused on the defense piece.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [29]

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So in the Avionics, the strategy is really around aerospace and defense. Yes, I think that's our target market in total. Obviously, we're heavily weighted towards defense to date, but we do see opportunities there. Our business with Airbus, as an example, has grown very substantially over the last few years as a result of the CES acquisition that we did over in Geneva, and we see additional opportunities. So it's primarily defense. But the aerospace exposure, just given what they do is welcome as well.

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Operator [30]

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And our next question comes from the line of Ken Herbert with Canaccord.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [31]

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Mike, I just wanted to follow up on the free cash flow question. I mean it looks like the guidance implies maybe $5 million to $10 million-ish in terms of working capital benefit in '20. You obviously had a really good year in working capital in '19. Are there other opportunities to maybe do a little bit more with working capital in '20? Or is -- the investments in the first half maybe just driving a little bit more caution there?

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [32]

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I think that -- so we did have a good improvement in working capital in fiscal '19 compared to fiscal '18. As you'll recall, in fiscal '18, we were building up a lot of the inventory associated with the insourcing. And so we're pleased with where we are from a working capital perspective, Ken. But we do still see additional opportunities. And one of the areas in terms of the OpEx where we're investing in is our operations. And we've talked about also some of the facility consolidation, and we see opportunities on the inventory side that we're focused on right now. There's tweaks everywhere in terms of DSOs that we're focused on, but really, I think the opportunity we see is on the inventory side.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [33]

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And would it be fair to assume just based on your comments around timing and margin that, that should accelerate as we go through the year or maybe more of an improvement in the second half of the year?

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [34]

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Yes. I mean obviously, we're not guiding the timing of it. But yes, I do think that we should see gradual improvement in terms of inventory turns as we go through the year.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [35]

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Okay. Great. And if I could, Mark, just one question. I mean you called out outsourcing which is, obviously, something you've called out as an opportunity for many quarters, and it clearly seems like that's playing out. But I'm just curious with where we are with the budget, with clearly some of the pressure on primes and the growth they're seeing. Have you seen an inflection in those opportunities recently? Or is there anything in particular you can maybe point to that we could watch out for? Is that maybe steps up? I mean I agree, it's a secular trend. But I'm just curious how you've seen that play out here recently, just considering the budgets and the strength and the bookings that your customers are seeing.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [36]

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Yes. So we think it is picking up. I'll give you a couple of examples. I mean this past quarter, we won 2 enterprise secure processing radar applications for 2 different customers. So literally, they're going to base the next-generation radar processes around an outsourced Mercury solution, both of which are actually examples of the outsourcing trend. What we see, and it's a little counterintuitive, you would think that with growth maybe they would be to bring more work in-house, but it's actually the opposite. Although they're actually hiring our customers, they're not hiring quickly enough to even address the aging workforce, and there's a growing skills gap after the sort of stuff that we do.

We've also seen clearly an increase in the use of OTA contracting -- OTA contracts that are requiring the defense primes to basically invest more upfront. And they're seeking to partner with companies such as Mercury who has the ability and the willingness to invest. As part of those OTAs, we're also seeing that the government are actually requesting or demanding that a certain percentage of the work go to non-traditional defense contractors, of which, obviously, Mercury is.

And then finally, I think the other thing that is driving the outsourcing trend is the greater need for agility and speed in these next-generation competitions. And that plays very, very nicely with our technology development model. So outsourcing is alive and well. As I mentioned, we had 85% growth in our subsystems business. For FY '19, it was up 51% in Q4 alone. So we're pretty excited about what we see happening, and we're very well positioned.

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Operator [37]

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And our next question comes from the line of Michael Ciarmoli with SunTrust.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [38]

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Nice quarter, nice bookings. Mark, just on APC, can you maybe tell me a little bit more on the strategic fit? I mean the price tag, 3x sales or 11x EBITDA, I've always thought of displays being a little bit more commoditized, the platform exposure seems to be a little bit more legacy. Just -- I mean in the comments you gave, you sounded like you wanted to give some of your customers an option of not going to the full integrated Tier 1, so I guess you really don't need the scale to compete there, but just maybe a little bit more. I mean it seems like there's so many other areas, I mean, used throughout autonomy, artificial intelligence, machine learning, whether it's secure computing. It just seems like there's so many other market channels and silos to build, why displays?

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [39]

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So it's important because it ties back to the delayering trends. What we see at a very high level is that the government and several other primes want to move away from kind of vendor lock where there's proprietary interdependent architectures that is resulting in a lower technology refresh rate and the introduction of new capabilities than what the government in certain primes would like. And the actual display technology is a key gateway, have been able to add new technology and the associated processing under the platform, whether it be for different weapons applications or for different types of sensors. The sensors themselves are going through a complete kind of refresh to -- from really more smaller, stand-alone type units into what is known as large area displays. These larger area displays need to be highly ruggedized, touch-capable, capable of operating in heads-up display type capabilities while still providing redundancy. And APC has got a very unique set of technologies and capabilities not only in some of the platforms that we mentioned, but also on the [train], Black Hawk and other platforms. So we think it's strategically important, and it's a natural extension of the mission computing capability and the avionics processing capability that we have. And our customers are asking for it, Mike.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [40]

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Got it. Got it. Okay. That's helpful. Just one more. On the gross margins, you've got the long-term target, 45% to 50%. We've sort of been at the lower end of that range. Is that -- is the upper end of that range, do you think it's still reasonable, given that what we're looking at is going to be some significant investments in new weapon systems, new capabilities? You're going to have that mix shift with new program start, and obviously, it will be a very good thing for revenue growth and bookings. But does that naturally keep the margins maybe a bit more depressed as sort of some of that mix shift change or design wins keep on coming and you take more -- see ride over time?

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Michael Ruppert, Mercury Systems, Inc. - Executive VP, CFO & Treasurer [41]

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Yes, Mike. I'll take a cut of that one. I mean I think that if you look back on gross margins where we've been, they've come down, as you know, over the last couple of years because of what you just said, right? It's the new program wins. We've seen a little bit of pressure from some of our acquisitions like Germane, but the big driver is the additional customer-funded R&D. And we've always said, we like the customer-funded R&D because while it lowers gross margins, it is the precursor to the hardware -- higher margin hardware annuities that we'll see over the years. And what we've always talked about is that will win those transitions, a specific program that the margin should increase over time. But what we are seeing is we are seeing an incredible level, and we're looking at it in fiscal '20 as well of new program starts. And you can see that in our guidance for gross margins for the year. So I think that when you look at our portfolio of contracts, we continue to think that we've got a lot of new contracts that will transition. But we continue to see a lot of opportunities, and you can see that in the gross margin guidance for fiscal '20.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [42]

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So I think the way to think about it, as we've talked about on prior calls is that gross margin is kind of hovering where it is. But as we continue to grow the business over time, you'll see the operating leverage and you'll see EBITDA margins continue to expand. That's the goal.

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Operator [43]

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(Operator Instructions) And our next question comes from the line of Jonathan Ho with William Blair.

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Jonathan Frank Ho, William Blair & Company L.L.C., Research Division - Technology Analyst [44]

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Just wanted to start out with a higher-level question. As we think about the implications of having more subsystem revenue, can you give us maybe a sense of what that means for your margins and maybe ability to expand more content?

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [45]

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Yes. So the shift towards subsystems has really driven a pretty substantial growth in terms of our content on a program basis as well as the potential lifetime value of the programs. If you're in an early stage of that subsystem design and development, either that we are funding or getting additional funding from our customers in the form of CRAD, we typically see some gross margin pressure. But as those subsystems actually transition into production, which we have a number of those likely to occur during fiscal '20, you start to get the benefit of that higher margin annuity. So we think that the shift towards subsystems, which is really where the outsourcing occur -- is occurring, is critically important to our growth as well as scaling the business over time, Jonathan. So it's a good thing.

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Jonathan Frank Ho, William Blair & Company L.L.C., Research Division - Technology Analyst [46]

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Got it. And then just relative to APC, how do we think about the longer-term operating margin profile or EBITDA margin profile compared with the other lines of your businesses? And are there similar maybe cost opportunities on that side?

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [47]

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Yes. So actually, APC in EBITDA level is in line with our model. It's actually slightly accretive to where we are right now. And so it's a nice business. They've got great technology, they've got some amazing programs and we see a really good fit. So it's a good business.

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Operator [48]

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And Mr. Aslett, it appears there are no further questions, therefore, I would like to turn the call back over to you for any closing remarks.

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Mark Aslett, Mercury Systems, Inc. - President, CEO & Director [49]

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Okay. Well, thank you very much for listening, everyone. We look forward to speaking to you again next quarter. Take care.

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Operator [50]

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Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.