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Mercury Systems, Inc. (MRCY) Q2 2024 Earnings Call Transcript

Mercury Systems, Inc. (MRCY)

Q2 2024 Results Conference Call

Company Participants

Dave Farnsworth - Executive Vice President and Chief Financial Officer

Bill Ballhaus - Chairman and Chief Executive Officer

Conference Call Participants

Peter Arment - Baird

Seth Seifman - JPMorgan

Jonathan Ho - William Blair

Kyle Wenclawiak - Jefferies

Michael Ciarmoli - Truist Securities

Presentation

Operator

Good day, everyone, and welcome to the Mercury Systems Second Quarter Fiscal 2024 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, Dave Farnsworth. Go ahead, Mr. Farnsworth.

Dave Farnsworth

Good afternoon, and thank you for joining us. With me today is our Chairman and Chief Executive Officer, Bill Ballhaus. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our Web site at mrcy.com. The slide presentation that Bill and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations.

Turning to Slide 2 in the presentation. I'd 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 Chairman and CEO, Bill Ballhaus. Please turn to Slide 3.

Bill Ballhaus

Thanks, Dave. Good afternoon. Thank you for joining our Q2 FY24 earnings call. Today, I'd like to talk through three topics; first, some introductory comments on our business and results; second, an update on the progress we are making in each of our four priority areas, delivering predictable performance, building a thriving growth engine, expanding margins and driving improved free cash flow; and third, expectations for our performance both for FY24 and longer term. Then I'll turn it over to Dave who will walk through our financial results and guidance in more detail. Please turn to Slide 4. As I said in the past, while FY24 is a transitional year, I'm optimistic about our strategic positioning as a leader in mission critical processing at the edge, the attractiveness of our business model and our outlook over time to deliver predictable organic growth while expanding margins and robust free cash flow. During Q2, we made solid headway in each of our four priority focus areas and in addressing what we believe to be the two transitory dynamics in our business I referenced last quarter; transitioning our high mix of development programs to production and converting our high level of working capital into significant cash flow. We believe this progress is evident in three highlights from the quarter; strong bookings, solid free cash flow and better than expected progress in closing out our challenge programs, most of which are development in nature.

First, we delivered near record bookings in the quarter with a 1.65 book-to-bill. Our bookings were anchored by a number of important program wins that we believe will drive future growth. These awards reflect customer recognition of the unique value we deliver, the reliance on us for their most critical franchise programs and ongoing healthy demand. Second, we delivered strong positive free cash flow and a reduction in net working capital. We generated over $37 million in free cash flow in the quarter along with an approximately $70 million improvement in net working capital. These accomplishments were primarily driven by strong in-quarter collections, reductions in our unbilled receivables and inventory and improved customer advance payment terms. And third, we are making progress with retiring risk in and completing challenged programs. While the underlying performance of the business continues to be obscured by unanticipated cost growth on a subset of programs, we believe we have largely narrowed these risks from the original 20 challenge programs to one product line with game changing technology that comprises approximately 25% of the original challenge programs. Although we are still working through this remaining set of challenge programs, we anticipate retiring these risks on slightly more than half of the remaining challenge programs in FY24 and entering FY25 with a much clearer path to deliver predictable organic growth, expanding margins and strong cash flow.

In addition to these Q2 highlights, we made significant progress this quarter in establishing the team and structure to lead Mercury through the next phase of our journey. We announced a reorganization to simplify and streamline our business by eliminating redundant corporate functions and consolidating a number of functional areas into a single operating unit under the leadership of Roger Wells as our Chief Operating Officer. In his previous role, leading our microelectronics division, Roger delivered strong results and demonstrated an exceptional aptitude for scaling business operations and expanding and converting pipeline opportunities. We also announced the addition of Stuart Kupinsky to the leadership team as our Chief Legal Officer. Stuart brings a wealth of experience in legal leadership roles and a track record of driving dynamic change and value creation in a number of technology companies. I'm very pleased that Roger and Stuart have taken on these critical leadership roles.

Please turn to Slide 5. Following those introductory comments, I'd like to spend time on each of our four focus areas. Our first focus area is enhancing execution to deliver predictable performance. In Q2, we incurred a number of costs that obscured the underlying performance of the business. Specifically, we recognized approximately $48 million of such items that we believe are transitory, including nearly $31 million of program cost growth impact across our portfolio, approximately $12 million of manufacturing adjustments associated with specifically identified inventory reserves and higher scrap due to unfavorable yields, and nearly $5 million associated with contract settlements where we worked with customers to transition away from programs where we did not expect to see acceptable returns. These items, which again, we believe are transitory, represented the vast majority of the year-over-year decline across our P&L metrics. As a reminder, program cost growth identified within a given period has an overweight impact on the financial results of that period. In accordance with GAAP, there is a cumulative adjustment to reduce progress and align margins on the life-to-date of the program, which results in a decrease to revenue and gross margin that permeates down to net income and adjusted EBITDA in the current period.

Breaking down the nearly $31 million of program cost growth, $14 million of this impact was derived from our challenge programs with nearly all of the impact tied to one single program. Approximately $8 million was spread across several development programs and the remaining $9 million related to multiple production programs. The challenge program impact was driven primarily by unexpected redesign and prototype efforts following initial development unit deliveries. Similarly, the remaining program cost growth was a function in part of revised baseline costs predicated on initial unit deliveries across several development and production programs. In addition, the program cost growth reflects a risk adjusted outlook on program performance and estimates to complete across our program portfolio.

As shown on Slide 6, with respect to the challenge programs, during the second quarter, we made better than anticipated progress by completing, exiting or retiring risk on an additional four of the original 19 programs. Together with the four completed through Q1, we believe we have now retired risk on eight of the original 19 challenge programs that have driven earnings volatility in recent quarters. For the remaining programs, we expect to close out more than half over the remainder of the fiscal year. The balance of open challenge programs as well as the one program where we experienced significant program cost growth in the quarter are tied to a common processing architecture. So while we experienced a significant P&L impact during the quarter, we believe we had made progress in isolating the primary go-forward development risk in the challenge programs to this one technology area. Of note, our differentiation based on this technology has afforded us sole source positions on critical programs, and the functionality we provide is mandated on these programs. As such, we and we believe our customers, are committed to success in this area. The challenges we are facing are related to efficiently and cost effectively maturing the manufacturing process to support the transition to scale production on these programs where we see significant growth potential at attractive margins.

Even for the one challenge program with cost growth this quarter, the current margin outlook remains above our consolidated program gross margin profile. In addition, this common processing architecture is being developed within an isolated part of our business, representing approximately 20% of our revenue, which has experienced the majority of the revenue and earnings volatility that we saw in Q2 and that we expect to see within the fiscal year. We believe resolving the challenges in this technology will go a long way to restoring growth and profitability in this part of the business and Mercury as a whole. So despite the challenges we're working through and the corresponding investment, we believe we are well positioned as a sole source provider with large growth opportunities and solid margins as we seek to execute on the remaining development efforts and transition these programs to production.

Please turn to Slide 7. Turning now to the second focus area of driving organic growth. Bookings for the quarter were a near record $325 million, resulting in a 1.65 book to bill. We had several exciting awards for both development and production programs in the quarter. Two marquee wins in the quarter are worth noting. We received our first production award for LTM. This is an exciting and important award coming earlier than originally anticipated. While we don't expect significant revenue from this program in FY24, we expect this program to drive organic growth in FY25 and ultimately become our largest revenue contributor in the future. We also won a large development program on a strategic weapon system, which we anticipate will drive growth in the near term and stronger growth in the future as it transitions to production. This program, while well within our technical capabilities, was awarded as a cost plus contract with favorable billing terms of at least monthly, thereby, reducing the potential earnings and cash volatility through development. While we still expect the majority of our contracts to be firm fixed price, we are exploring opportunities to take certain development contracts on a cost type basis where appropriate. In addition, as I have discussed before, we are working to incorporate more robust terms in all of our contracts to more clearly define scope, support improved execution and customer satisfaction and shorten cash conversion cycles.

Finally, last week, we received a large follow-on award to provide our solid state data recorders for a large defense space program. This technology, which was introduced only a few years ago, is now the largest driver of growth in the military space market for Mercury and we expect further growth opportunities for this unique commercially developed offering. These awards are important not only because of their value and impact on our long term growth but also because they reflect our customers' continued trust in Mercury to support their most critical franchise programs. I mentioned last quarter that this effort to build an organic growth engine will occur over a longer period of time given the time content involved with improving book to bill levels, and that our near term growth will be fueled by the transition of development programs to production where we are well positioned in the back half of this year and early FY25. Demand remains strong and we anticipate the strong bookings momentum to continue through the year.

Please turn to Slide 8, now turning to our third priority focus area, addressing our cost structure to expand margins. As we mentioned last quarter, to achieve our EBITDA margin targets, we are focused on the following levers; executing on our development programs and minimizing cost growth impacts; getting back to a historical 20-80 mix of development to production programs; driving organic growth to generate positive operating leverage and achieving cost efficiencies. In Q1, we took a series of actions designed to better align our cost structure with our scale and our financial expectations. These actions are on track to generate $24 million in annual run rate savings primarily related to SG&A efficiencies. In January, we announced a corporate reorganization in which we streamlined and simplified our operations, consolidating our two division structure to a single integrated structure, incorporating all of our lines of business and matrix business functions, reporting in to Roger Wells, who was appointed Chief Operating Officer. This integrated approach is designed to clarify accountability and eliminate redundancy. In total, we expect this action to deliver an incremental $20 million in annual run rate savings, bringing our total action run rate savings to $44 million, of which approximately $24 million to $26 million will be recognized inside the fiscal year. Though we continue to see negative operating leverage in FY24 given little revenue volume, these structural reductions will be evident in our margin profile as we expect to return to growth in FY25 and beyond.

Please turn to Slide 9. Finally, regarding our fourth priority focus, to drive improved free cash flow. I am pleased to report that in Q2, we delivered over $37 million in positive free cash flow. We made progress on converting our unbilled receivables, which were down nearly $38 million in the quarter, and we continue to have strong collection trends across our billed receivables. In addition, we continue to pursue advanced payments on certain contracts, which is reflected in the $23 million increase in deferred revenue in the quarter. In total, net working capital decreased $70 million or over 10% in the quarter. We continue to expect unbilled receivables to burn down through the fiscal year as we apply resources to completing hardware deliveries and especially as we continue to resolve challenge program. We also continue to expect inventory to decline as we receive follow-on production awards. At the end of the quarter, we had cash and cash equivalents of $169 million. Net debt of $448 million is down $39 million in the quarter, reflective of our free cash flow generation. We expect to be cash flow positive for the second half of the year, which we believe will allow us significant flexibility to allocate capital.

Please turn to Slide 10. As I have discussed, we continued to make progress on our four priority focus areas. Even so, for the first six months, our revenue and earnings are below expectations primarily due to higher than expected cost growth and other charges as we retire risk across the portfolio especially related to our challenge programs. Aside from these headwinds, which we believe are temporary, I continue to believe this is a business capable of ultimately delivering above average industry growth with low to mid 20% adjusted EBITDA margins. In the second half of the year, we plan to continue to work on the transitions I discussed earlier; shifting our large portfolio of development programs to production, especially the majority of our remaining challenge programs; and focusing our operational capacity on burning down our large net working capital balances, particularly in unbilled receivables and inventory.

Turning to guidance. We're going to do this a bit differently for the remainder of the year as we work toward completing these transitions. Based on our first half revenue and our outlook for the second half, we are updating our guidance for full year FY24 revenue from the prior range of $950 million to $1 billion to a revised range of $800 million to $850 million. The reduction in revenue guidance is based in part on our first half revenue performance, particularly in the second quarter, which included significant revenue reductions due to program cost growth. The reduction in revenue guidance is also based on reduced volumes expected in the second half as we continue to apply our operational capacity to advance late stage development programs and shift against legacy unbilled balances. As a reminder, we expect the completing late stage development programs will reduce unbilled receivables, release cash and unlock production revenue, which should drive growth and margins. This work is critically important to unlocking value but we'll continue to deliver little revenue in FY24.

Let me spend a little more time on the volume reduction because it is significant. As we discussed in Q1, we continue to implement a more cash efficient operating approach with operational capacity focused on completing late stage development programs and releasing unbilled receivables. This approach should generate cash and clear the way to higher growth, higher margin production revenue. However, there's little revenue associated with completing this work in the near term. In addition, as we look to the second half, we are implementing a more mature process designed to ensure we have a robust low risk approach to transition from development to scale production, particularly as it relates to the common processing architecture I mentioned previously. This work is important as part of our priority to restore predictability and profitability into the business. We will remain the flexibility in terms of timing and, in some cases, cost in H2 to get this right.

Turning to our outlook for earnings, including GAAP net loss and adjusted EBITDA. The reduction in our expected revenue range due to the volatility we have seen and expect to continue to see in a small subset of programs related to a single technology offering, coupled with our focus on completing hardware deliveries in order to reduce unbilled balances naturally results in a reduction to our GAAP earnings and adjusted EBITDA expectations as well. That said, it is difficult to provide reliable guidance estimates beyond revenue for the remainder of the year. Consistent with Q2, we may take additional actions to settle contractual arrangements that do not yield acceptable returns or align to our long term strategy. We may also make continued adjustments to our cost structure, where appropriate, designed to position us for positive operating leverage in FY25 and beyond. Our objective for the remainder of the year is to maintain the flexibility to take this as necessary to complete this work as quickly as possible in order to position the company for what we believe will be a return to predictable organic growth, improved profitability and strong cash flow in FY25. So we are withdrawing our full year FY24 GAAP and non-GAAP net earnings guidance, including adjusted EBITDA, provided on November 7, 2023....

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