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Mercury Computer Systems (MRCY) Q4 2019 Earnings Call Transcript

Motley Fool Transcribing, The Motley Fool
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Mercury Computer Systems (NASDAQ: MRCY)
Q4 2019 Earnings Call
Jul 30, 2019, 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

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, Mike Ruppert. Please go ahead, sir.

Mike Ruppert -- Executive Vice President and Chief Financial Officer

Good afternoon, and thank you for joining us. With me today is our president and chief executive officer, Mark Aslett. If you have 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 & 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.

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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 -- President and Chief Executive Officer

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 of performing extremely well. Our total revenues have continued to grow faster than the industry average.

Organically, revenue for fiscal 2019 was up 12%, compared with 7% in FY '18. We supplemented at this high level of organic growth with strategic M&A, completing four acquisitions while also making solid progress, integrating previously acquired businesses. After reloading the balance sheet with our recent equity offering, we were 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 in action.

It's also the latest step forward in our plan to build out an industry-leading C4I business. Without its background, let's turn to our financial results on Slide 4 starting at the fiscal-year level. Total bookings and revenue for fiscal 2019 were up 39% and 33% from FY 2018 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 totalled 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. [Inaudible] and 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, our next-generation missile system, and Aegis. Q4 was 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 classified radar program, E2D Hawkeye, Filthy Buzzard, F-35, and Triton.

Mercury continued to deliver strong levels of profitability in the quarter with adjusted EBITDA of 1% from a strong Q4 of fiscal '18. Free cash flow came in at 45% of adjusted EBITDA. Turning to Slide 5, we continued 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 five transactions in the last 12 months, totaling $228 million of capital.

Over the last five years, again, including APC, we 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 five 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 on 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 customer's 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 are 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 as well as the Abrams battle tank. We're very 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 10 times APCs 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 five years, we strategically focused our growth investments on building out our own domestic manufacturing capabilities. We've now begun a multi-year 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 complete the build out of our trusted digital SMT capability and in-source 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's occurring in the high-tech commercial world for use inside of 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're 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 continue the 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 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 under way 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 two-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 and 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 three 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, weapons 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 ISR airborne radar processing application in Q4. Defense prize architecture has been in development for some time and will be used across multiple programs.

We're also beginning to see significant design 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 secure, 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. Since from an effective revenue accounts to 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 and activity and opportunities for organic growth. Over the longer term, our baseline forecast is for overall defense spending to increase the 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 on 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 five areas.

First, is to drive high single-digit, low double-digit organic revenue growth supplemented by acquisitions. This is consistent with a 26% compound annual growth and total company revenue we've delivered over the last five fiscal years. The second is to invest in new technologies, our 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 in-sourcing, as well as driving stronger 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 growth faster than operating expenses, creating strong operating leverage in the business. And finally, we're fully integrated in 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 that has been so successful for us over the past five 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?

Mike Ruppert -- Executive Vice President and Chief Financial Officer

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 we're 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 the 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 in our Q4 fiscal 2019 results.

Mercury's total bookings increased 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 4% from Q4 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 over achievement on the topline 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 salesforce, 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 four 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 a $1.84 per share, up 30% from a $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 five quarters.

As I mentioned, Q4 was very active from a balance-sheet perspective. We entered 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 rates 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 zero 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 us 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 and action.

Turning into cash flow on Slide 13. Mercury delivered record free cash flow in fiscal '19, our Q4 free cash flow with $17.1 million, representing 45% of adjusted EBITDA. For fiscal '19 as a whole, free cash flow with $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, we're $8.8 million or 5% of revenue. This was up, as expected, from 3.7% of revenue for the first three 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 toward 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 farther ahead, we believe the investments we are making this year will position Mercury well to continue to expand adjusted EBITDA margins over the next few years. With that as background started on the topline 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. Heightened 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 into 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 $1.22 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 2019. 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 toward 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 microelectronic 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 payment 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 in 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 four 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.

Questions & Answers:


Operator

Thank you. [Operator instructions] And our first question comes from the line of Seth Seifman with J. P. Morgan.

Your line is now open.

Seth Seifman -- J.P. Morgan -- Analyst

Thanks very much, and good afternoon. I wanted 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.

Mark Aslett -- President and Chief Executive Officer

Yeah. 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'd 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 the theme that we saw throughout fiscal 2019.

Mike Ruppert -- Executive Vice President and Chief Financial Officer

Yes. Seth just to add that when we entered the year, if you look back at our guidance in fiscal '19, our revenue dramatically outperformed 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 opportunities to do so and still deliver record results.

Seth Seifman -- J.P. Morgan -- Analyst

Sure. Absolutely. And then just as a follow up. The first quarter margin -- 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 as a little bit more of a one-time and having the exit rate be more of a go-forward margin?

Mike Ruppert -- Executive Vice President and Chief Financial Officer

Yeah. 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 that 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 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 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 got it 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.

Mark Aslett -- President and Chief Executive Officer

So I think we do, as Mike said in his prepared remarks, 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 is -- 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, well above the industry-average growth rates. And when we see those opportunities, yes, we're probably going to lean in.

Seth Seifman -- J.P. Morgan -- Analyst

Excellent. Thanks very much.

Operator

Thank you. And our next question comes from the line of Jon Raviv with Citi. Your line is now open.

Jon Raviv -- Citi -- Analyst

Hey, thanks, guys, and good afternoon. Hey, how are you? Just following on the margin question, could you just clarify some language in the slides between staying above 20% versus driving to the higher end of that business model range and that sort of the difference between, say mid-term and or near to mid-term versus longer-term aspirations?

Mike Ruppert -- Executive Vice President and Chief Financial Officer

Yeah. 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 -- 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 currently see in -- seeing it play out. So no, no contradiction from our perspective in terms of wanting to continue to grow EBITDA to the high end of ranges.

Mark Aslett -- President and Chief Executive Officer

So if remember, Jon, 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 two 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 is obviously been above that number.

Jon Raviv -- Citi -- Analyst

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? Please offer some perspective on the risks and opportunities in that dynamic. Is it seems like combined businesses to drive one of their own [Inaudible], sounds like it's an opposition to your strategy to capture more outsourcing? So any thoughts on industry M&A and on the primes would be -- grateful for that.

Thank you.

Mark Aslett -- President and Chief Executive Officer

Yeah. 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 double on a percentage basis, the next closest company. So I do think there's 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 five years, we've invested in over $285 million on R&D. We've invested over $95 million on capex, and including APC, $800 million of capital in M&A -- so for a combined total of close to $1.2 billion.

And we're focusing that 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, a very significant and far out strip, all the companies in the space. And we think it's the primary reason that actually the rate of outsourcing is 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.

Jon Raviv -- Citi -- Analyst

Thank you.

Operator

Thank you. And our next question comes from the line of Sheila Kahyaoglu with Jefferies. Your line is now open.

Sheila Kahyaoglu -- Jefferies -- Analyst

Thank you, and good afternoon.

Mark Aslett -- President and Chief Executive Officer

Hi, Sheila.

Sheila Kahyaoglu -- Jefferies -- Analyst

Thanks. 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 maybe how you guys think about capex and building that out on your own versus doing a deal to do so?

Mark Aslett -- President and Chief Executive Officer

Sure, Sheila. So as I said in my prepared remarks, there's actually really two different types of manufacturing capabilities that 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 in-source the manufacturing of our secure processing product line, which we've largely completed.

What we talked about on the call for an expansion perspective was really the other part of the Phoenix facility that really came to us again through the acquisition of the micro semi 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 that leading conduit for that capability into the defense industry. So we're going to buildup, the capability set that we already have, expanded that to become that leading company.

Sheila Kahyaoglu -- Jefferies -- Analyst

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

Mark Aslett -- President and Chief Executive Officer

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 it from a trend perspective, this delayering occurring that certain companies in the space would actually like to deal directly with companies at the tier two as opposed to buying a complete, fully integrated tier-one solution. So it allows them to do things more affordably, probably more quickly, and to add to their own volume. And so what the APC acquisition gives us it's assets to some of the display technologies that compliment and some of the processing capabilities in avionics and mission computing that we previously acquired.

Sheila Kahyaoglu -- Jefferies -- Analyst

Thank you.

Operator

Thank you. And our next question comes from the line of Peter Arment with Baird. Your line is now open.

Peter Arment -- Robert W. Baird -- Analyst

Thanks. Good afternoon, Mark, Mike.

Mark Aslett -- President and Chief Executive Officer

Hi, Peter.

Peter Arment -- Robert W. Baird -- Analyst

Hi, Mike. Just a clarification on the capex. You said targeting the 5% level. I thought that was a pretty originally the target for fiscal 2019? Did some capex shift out or just maybe you could just clarify that first?

Mike Ruppert -- Executive Vice President and Chief Financial Officer

Yeah, it did, Peter. I mean, so we are expecting 5% in fiscal '20, came in a little lower than that around 4% in fiscal '19. Main reason for that is the West Coast to 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.

Peter Arment -- Robert W. Baird -- Analyst

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

Mike Ruppert -- Executive Vice President and Chief Financial Officer

Yeah. That's what we're shooting for, and I did point out the 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 into the beginning of next. So capex in Q1 threw out a number 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.

Peter Arment -- Robert W. Baird -- Analyst

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

Mark Aslett -- President and Chief Executive Officer

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

Peter Arment -- Robert W. Baird -- Analyst

OK. And of that commercial piece, is it on a larger commercial aircraft programs or bizjets or what exactly is...

Mark Aslett -- President and Chief Executive Officer

So 737, A320 is an example.

Peter Arment -- Robert W. Baird -- Analyst

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.

Mark Aslett -- President and Chief Executive Officer

So in the avionics, the strategy is really around aerospace and defense. I think that's our target market in total. Obviously we're heavily weighted toward defense today, but we do see opportunities there. Our business with Airbus, an example, has grown very substantially over the last few years, the 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.

Peter Arment -- Robert W. Baird -- Analyst

Great color. Nice quarter. Thanks.

Mark Aslett -- President and Chief Executive Officer

OK. Thanks Peter.

Operator

Thank you. And our next question comes from the line of Ken Herbert with Canaccord. Your line is now open.

Ken Herbert -- Canaccord Genuity -- Analyst

Hi, good afternoon.

Mark Aslett -- President and Chief Executive Officer

Hi, Ken.

Ken Herbert -- Canaccord Genuity -- Analyst

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 the investments in the first half maybe just driving a little bit more caution there?

Mike Ruppert -- Executive Vice President and Chief Financial Officer

I think that -- so we did have a good improvement in working capital in fiscal '19 compared to fiscal '18. As you recall, in fiscal 2018, we were building up a lot of the inventory associated with the in-sourcing. And so we're pleased with where we are from a working capital perspective, Ken, but we do still see additional opportunities in 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 DSO is that we're focused on, but really, I think, the opportunity we see is on the inventory side.

Ken Herbert -- Canaccord Genuity -- Analyst

And would it be fair to assume, just based on your comments around timing and margin, that that shouldn't accelerate as we go through the year and maybe more of an improvement in the second half of the year?

Mike Ruppert -- Executive Vice President and Chief Financial Officer

Yeah, 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.

Ken Herbert -- Canaccord Genuity -- Analyst

OK, great. Thanks. 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 could maybe point to that we could watch out for -- is that, 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?

Mark Aslett -- President and Chief Executive Officer

Yeah. So we think it is picking up. I'll give you a couple of examples. I mean this past quarter, we won two enterprise secure processing radar applications for two 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 inhouse, 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 for the sorts 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, 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, it's alive and well. As I mentioned, we had 85% growth in our subsystems business for fiscal year '19. It was up 51% in Q4 alone. So we're pretty excited about what we see happening, and we're very well positioned.

Ken Herbert -- Canaccord Genuity -- Analyst

Great. Thank you very much for the color.

Mark Aslett -- President and Chief Executive Officer

Thank you.

Operator

Thank you. And our next question comes from the line of Michael Ciarmoli with SunTrust. Your line is now open.

Michael Ciarmoli -- SunTrust Robinson Humphrey -- Analyst

Hey, good evening, guys. Thanks for taking the questions here. Nice quarter. Nice bookings.

Mark, just on EPC, can you maybe tell me a little bit more on the strategic fit? I mean the price tag 3 times sales or 11 times 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 one.

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 you threw out 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?

Mark Aslett -- President and Chief Executive Officer

So it's important, because it ties back to the delayering trends. What we see in 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 then what the government in certain primes would like. And the actual display technology is a key gauge way of being able to add new technology and the associated processing on the platform, whether it would be for different weapons applications or for different types of sensors. The sensors themselves are going through a complete kind of refreshed to -- from really more smaller stand-alone-type units into what is known as large area displays.

These large area displays needed to be highly ruggedized, touch capable, capable of operating, and 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 I mentioned, but also on the trainer, Blackhawk and other platforms. So we think it's strategically important. 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.

Michael Ciarmoli -- SunTrust Robinson Humphrey -- Analyst

Got it, OK. 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 the upper end of that range -- do you think is it still reasonable given that, what we're looking at is going to be some significant investments in new weapons systems, new capabilities. You're going to have that mix shift with new programs start, and obviously there'll 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 mixed shift change or design wins keep on coming and you take more see ride over time?

Mike Ruppert -- Executive Vice President and Chief Financial Officer

Yeah. Mike, I'll take a cut at 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 liked 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 -- when those transitions, specific program that the margin should increase over time. But what we are seeing is we're seeing incredible level, and we're looking at 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 contracts, we continued to think that we've got a lot of new contracts that the transition, but we continue to see a lot of opportunities. And you can see that in the gross margin guidance for fiscal '20.

Mark Aslett -- President and Chief Executive Officer

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

Michael Ciarmoli -- SunTrust Robinson Humphrey -- Analyst

Got it, very good. Thanks guys.

Operator

Thank you. [Operator instructions] And our next question comes from the line of Jonathan Ho with William Blair. Your line is now open.

Jonathan Ho -- William Blair and Company -- Analyst

Hi, good afternoon. Just wanted to start out with a high-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?

Mark Aslett -- President and Chief Executive Officer

Yeah. So the shift toward 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 early stage of that subsystem design and development, either that we're funding or we're getting additional funding from our customers in the form of CRAD, we typically see some gross margin, pressure, but its those subsystems actually transition into production and 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 toward subsystems, which is really where the outsourcing is occurring, is critically important to our growth, as well as scaling the business over time, Jonathan. So it's a good thing.

Jonathan Ho -- William Blair and Company -- Analyst

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 costs opportunities on that side?

Mark Aslett -- President and Chief Executive Officer

Yeah. 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 technologies, they've got some amazing programs, and we see a really good fit. So it's a good business.

Jonathan Ho -- William Blair and Company -- Analyst

Thank you.

Operator

Thank you. 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.

Mark Aslett -- President and Chief Executive Officer

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

Operator

[Operator signoff]

Duration: 65 minutes

Call participants:

Mike Ruppert -- Executive Vice President and Chief Financial Officer

Mark Aslett -- President and Chief Executive Officer

Seth Seifman -- J.P. Morgan -- Analyst

Jon Raviv -- Citi -- Analyst

Sheila Kahyaoglu -- Jefferies -- Analyst

Peter Arment -- Robert W. Baird -- Analyst

Ken Herbert -- Canaccord Genuity -- Analyst

Michael Ciarmoli -- SunTrust Robinson Humphrey -- Analyst

Jonathan Ho -- William Blair and Company -- Analyst

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