Q4 2022 Mercury Systems Inc Earnings Call
Good day, everyone and welcome to the Mercury systems fourth quarter fiscal 2022 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 Rupert.
Please go ahead Sir.
Good afternoon, and thank you for joining US with me today is our president and Chief Executive Officer, Mark out here.
Not received a copy of the earnings press release, we issued earlier. This afternoon, you can find it on our website at <unk> Dot com.
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 two 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 two 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 Wassa, it's got several non-GAAP financial measures.
Typically adjusted income adjusted earnings per share adjusted EBITDA free cash flow organic revenue and acquired revenue.
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 asthma, Please turn to slide three.
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.
Before we begin I'd like to recognize the entire mercury team tremendous assets through the course of an exceptionally demanding gear.
As Youll strong performance, we delivered record bookings revenue and adjusted EBITDA for the fourth quarter.
That said the core room were more challenging than we anticipated due to lingering pandemic impacts the extended defense budget July continued supply chain disruption labor market constraints and growing inflationary pressures.
Despite these challenges our bookings increased 27% year over year in Q4 to a record $352 million, leading to a one one book to bill and record backlog exiting the year.
We received the launch aegis Fms order that was delayed in Q1, which was larger than we had originally expected.
We also received the funding associated with the F 35 tier III locked 16 as anticipated among others.
Our largest bookings programs in the quarter with Aegis F 18, F 35, P J K and the SDA tranche trucking layer.
Total revenue was up 16% year over year and 9% organically.
Our largest revenue programs in the quarter with Aegis F 35, P. Eight MH 60 and classified radar program.
We'll continue to see high levels of new business activity.
I would say Q4 to more than $680 million, an estimated lifetime value.
For the year, we received 33, new design wins with an estimated lifetime value more than one $6 billion up 9% from fiscal 'twenty one.
On the bottom line, we delivered adjusted EBITDA margins of nearly 25% in the fourth quarter and a record $71 $6 million and adjusted EBITDA.
This is up 36% from the third quarter and up 21% from the record set in Q4 last year.
For the full year, we delivered record bookings, which grew 21% the positive book to Bill and record backlog.
Revenue increased 7% year over year, while adjusted EBITDA declined 1%.
Our largest revenue programs for the year were MH 60 F 35, the classified <unk> program P eight and aegis.
Turning to slide four notwithstanding these record results, we felt short of our guidance for Q4 in the year, primarily is the result of material and order delays has affected the timing of revenue.
We continue to see important supply mix long lead times for high end semiconductors and delayed supply deliveries.
In the past, we've been better able to mitigate short term revenue risk that wasn't possible to the same extent this year, given the supply chain and labor market disruptions.
The contracting delays also resulted in the highest accounts receivable and lower in quarter cash collections, which reduced free cash flow.
Inflationary pressures in large part related to semiconductors became more of a challenge that fiscal 'twenty two progressed.
Semiconductors equate to 38% of our external supply spend we're seeing double digit price increases.
We expect to see greater impact from material inflation and to a lesser extent labor inflation in fiscal 'twenty right.
Given the short cycle nature of our business. However, we believe these impacts will begin to normalize over time as our future business is priced at market rates.
Clearly these are unprecedented times.
So it can be sophisticated end to end processing platform Pas many of the most critical A&D missions and represents about 70% of our business today.
High end processing required tie in semiconductors, and this is why as a global supply chain has been most disrupted.
That said, it's also add mercury likely has the largest opportunity.
Over the next five years.
Fortunately the issues, we're experiencing and not demand related.
Apply and timing related the 10th right and they're not unique to mercury.
We have a plan to focus on what we can control.
Are you optimistic about the future given our positioning.
The demand environment is strong and appears to be getting stronger.
All of the defense industry is dealing with short term headwinds, we expect to see a shift to tailwind is defense spending grows and the supply chain conditions improved.
We believe that we're well positioned to deliver our results more in line with our target model in fiscal 'twenty three.
Looking ahead over the next five years, our plan remains intact.
Mercury can and will continue to grow at high single digit to low double digit rates organically is the short term challenges diminish.
Laura on Ukraine, and the most challenging global threat environment since the Cold War will likely result in a sea change in defense spending domestically and internationally.
Our advisors estimate the U S growth combined with increases in NATO defense spending to 2% of GDP could drive up to one five trillion dollars of additional spending over the next decade.
This should lead to higher bookings from that green, the electronics systems associated with missiles and munitions.
And missile defense systems, and non systems fixed wing and rotorcraft ground vehicles and electronic warfare.
The secular trends benefiting mercury remained favorable in our view.
The demand environment is improving as demonstrated by our strong bookings and design wins, we had in fiscal 'twenty two.
We believe there is a greater percentage of the value associated with future defense platforms will be driven by electronic systems content when mercury participates.
Our addressable market continues to increase driven in large part by our strategic move into mission systems and potential to deliver innovative processing solutions at chip scale.
Our model sitting at the intersection of high Tech defense positions us as.
As a result, we expect our business to continue growing faster organically than overall defense spending over time.
In addition to organic growth our five year plan includes continued margin expansion driven by our in park initiatives.
Turning to slide five and our expectations for fiscal 'twenty right.
The defense budget outlook is improving and we expect to deliver another year of double digit bookings growth and a positive book to bill.
Despite the potential for an extended CR future mid term elections, the DMT topline budget submitted to FY 'twenty three is up from FY 'twenty two.
There also appears to be strong bipartisan support for increased defense spending.
Labor market conditions have improved somewhat in the primary health effects of Covid continue to subside.
The second order target supply chain effects will likely continue in fiscal 'twenty, three and possibly beyond.
We also expect to see greater impact from material and labor inflation for the year.
As I said, we believe that we're well positioned to deliver results more in line with our target model in fiscal 'twenty three.
We began the year with a record $1 billion in backlog and March improved forward revenue coverage versus fiscal 'twenty two.
We expect double digit growth in bookings for the year and improved bookings linearity lead to a higher backlog that visibility and reduce risk as the year progresses.
We also expect a positive book to bill for the year.
At the midpoint of guidance, we're expecting approximately $3 <unk> percent year over year growth in revenue and adjusted EBITDA.
6%, 7% increases at the high end.
We expect growth together with improved operating leverage in our impact initiatives to partially offset material and labor inflation, resulting in similar margins to fiscal 'twenty two.
In addition to record adjusted EBITDA, we expect to deliver improved free cash flow.
Our fiscal 'twenty, two bookings spreads largely occurred NIH too and as I've said, we've seen longer semiconductor lead times.
High end semiconductors lead times now range from 36 to 99 weeks three to five times pre pandemic norms.
As a result, we expect the timing of our revenue and adjusted EBITDA to be back end loaded in fiscal 'twenty, three with Q1 being the low watermark for the year.
The increased backlog, we expect as the year progresses should help improve operational execution in this challenging supply chain environment and he's the recent pressure on working capital.
This should result in improved cash level overtime.
Another year of expected double digit growth in bookings and a novel positive book to Bill in fiscal 'twenty three gives us the confidence that we can and will return to organic growth back in line with our model in fiscal 2004 provided supply chain labor market conditions normalize and again looking ahead over the next five.
Yes, our plan remains intact.
Central our impact program on slide six we began the journey a little more than a year ago with the goal of amplifying the value we create as we scale the business over time.
During fiscal 'twenty, two we simplified and streamlined our organizational structure and strengthened the leadership team.
We also focused impact on lines and quantifying developing initiatives to drive margin expansion.
As we enter fiscal 'twenty three we're taking advantage of this progress by pushing the execution of these initiatives deeper into the business.
We've used the impact processes and tools that we've developed and matured to deliver on our margin expansion goals over time.
We expect impact to generate 30% to $50 million of incremental adjusted EBITDA by fiscal 2007. This is later than originally anticipated given the expected impact of inflation in the short term.
Over the next five years impact should drive significant margin expansion Nonetheless.
This fiscal 'twenty to evolved and things became more challenging we pivoted impact towards areas that could help mitigate risk and to deliver the most immediate financial results.
This focus will continue in fiscal 'twenty three.
Through impact with seeking to derisk, the timing and availability of materials, and our supply chain and to better manage inventory.
We are implementing processes and tools to make better and more timely pricing decisions.
We're also prioritizing our human capital resources to the greatest effect.
So the contract the inflationary pressures, we're updating our commercial price list and proactively negotiating existing contracts where possible.
Our new contracts were introducing more favorable inflation related terms and milestones to drive improved cash conversion.
Another impact initiatives fiscal 'twenty, three is R&D investment and efficiency and returns following the progress in fiscal 'twenty two.
In addition, <unk> is aimed at optimizing our balance sheet by improving our working capital and asset efficiency.
Like many others in the industry as a result of the environment, our unbilled receivables balances grow.
We are using in part to focus on and improve the timeliness of our receivables cash conversion. Although we've made some progress we have more work ahead to achieve our long term cash flow objectives.
Our digital transformation initiatives and engineering and operations will help improve our cost structure performance over the long term as well, we're also continuing to consolidate and optimize our facilities footprint.
As it relates to M&A impacts are about leveraging our proven ability to integrate and grow acquired businesses.
The greatest scale going forward.
The M&A environment continues to be active and we remain focused on our existing M&A themes.
With that I'd like to turn the call over to Mike Mike.
Thank you Mark and good afternoon again, everyone.
I'll discuss our Q4 and full year results and then focus on our Q1 and fiscal year guidance.
Turning to slide seven in Q4 Mercury delivered all time company records for bookings revenue and adjusted EBITDA.
We exited Q4 with record backlog of more than $1 billion.
Our 12 month backlog was up 22% year over year.
Riding improved revenue visibility into the next 12 months.
Revenue in Q4 was up 16% and organic revenue up 9% year over year.
During the quarter, we recognize the revenue that we expected from the large aegis Fms sale.
35 tier three and other key programs that we discussed on last quarter's earnings call.
We did however experienced more supplier D commencing award delays on other programs, which had a greater than $25 million revenue impact on our Q4 results.
Acquired revenue in Q4 included 10 Tech Abbott Labs, and Atlanta, Mike Brown.
As a reminder, physical optics Corporation, which we acquired in Q2 of fiscal 'twenty. One is incorporated into organic revenue as of last quarter.
Physical optics continues to perform well despite being impacted by contract delays labor market and supply chain economics like the rest of the industry.
In fiscal 'twenty, two physical optics had revenue in line with expectations and had a 127 book to Bill.
Overall, a strong performance.
The acquisition, which was our largest in history is a critical component of our open mission systems strategy.
As planned when we bought physical optics, we continue.
To transition the business from its historical small business innovation research work.
<unk> system development and production contracts.
We're pleased with the acquisition its growth and its alignment with our strategy.
Q4, gross margins were up slightly year over year.
Both in higher margin production and licensing revenue was partially offset by increased direct allocation of engineers to customer funded programs as well as the impact of material inflation that we were not able to pass through to our customers.
As a result of the direct allocation of engineers, our internal R&D was lower as a percentage of sales compared to Q4 last year.
In Q4, we had record adjusted EBITDA of 21% year over year compared.
Compared to Q4 last year, our adjusted EBITDA margins increased 120 basis points to 24, 7%, primarily as a result of improved operating leverage.
Free cash flow for Q4 was an outflow primarily as a result of working capital and one time expenses, which I'll discuss further in a moment.
Turning to our full year results on slide eight fiscal 2002 was a record year for bookings our book to Bill was 1.8 compared to <unk>, 95% in fiscal 'twenty one.
Its rebound drove backlog higher and increases our visibility heading into fiscal 'twenty three.
Fiscal 'twenty two revenue was up 7% in total and down 5% organically.
Organic revenue was impacted by the external market conditions, including supply chain disruption labor market constraints and contracting delays.
Despite these delays in fiscal year 'twenty, one 'twenty two none of our major programs have been canceled.
Adjusted EBITDA for fiscal 2000, and <unk> was down 1% year over year, our adjusted EBITDA margins were 23% compared to 21, 9% in fiscal 'twenty, one primarily driven by program mix and inflation.
Free cash flow in fiscal 'twenty. Two there is an outflow primarily as a result of an increase in working capital as well as one time expenses.
Slide nine presents Mercury's balance sheet for the last five quarters.
We ended Q4 with cash and cash equivalents of $66 million and approximately $452 million of debt funded under our $1 1 billion revolving credit facility.
Our balance sheet is strong and we have significant financial flexibility to continue to invest in the business organically and through acquisitions.
Accounts receivable increased in fiscal 'twenty two.
This was primarily a result of Unbilled receivables, which increased approximately $61 million from Q3 fiscal 'twenty, two and $140 million compared to Q4, our fiscal 'twenty one.
This was primarily driven by the growing proportion of overtime or percentage of completion revenue as we execute on our content expansion strategy.
In Q4 over time revenue increased to approximately 60% of total revenue compared to 44% a year ago.
In addition, unbilled receivables were impacted by supply chain disruptions, which continued to delay delivery milestones and cash collections in the quarter.
We expect Unbilled receivables as a percentage of overtime revenue to return to a pre pandemic level of approximately 35%.
Supply chain conditions improve and legacy contracts roll off.
Inventory increased approximately $11 million in Q4, compared to Q3 and approximately $49 million from a year ago.
This was primarily due to the accelerated raw material purchases to support higher demand and mitigate supply chain risk in fiscal 'twenty three.
It also reflected decisions by our suppliers to end of life more key components, requiring us to invest in raw materials, we expect to see less of this dynamic in fiscal 'twenty three.
Turning to cash flow on slide 10 free cash flow for Q4 was an outflow of $28 million and $47 million for the year.
Last quarter, we forecast and expected free cash outflow in Q4, driven by one time payments as well as working capital build due to the record revenue quarter.
The Q4 outflow was further impacted by supplier delays, primarily within Unbilled receivables.
In addition in Q4, we had approximately $7 million of one time cash outflows associated with our impact initiatives acquisition expenses and shareholder settlement costs.
When the supply chain normalizes, we expect our cash conversion cycle to normalize as well.
Cash conversion to return to our target levels, which we have set at 50% free cash flow to adjusted EBITDA.
We currently expect free cash flow to improve in the second half of fiscal 'twenty three as net income grows and working capital metrics improve.
I will now turn to our financial guidance, starting with the full fiscal year 'twenty three on slide 11.
As of June fiscal year ended company, we are initiating guidance for the next 12 months and a very fluid environment.
As such our guidance incorporates to the extent, we can potential risks related to continued supply chain delays and material and labor inflation as.
As well as the potential for another continuing resolution and a midterm election year.
While these uncertainties do pose risk they are timing related and not related to demand which is strong.
On a quarterly basis, our guidance is second half weighted as a result of the bookings profile and supply chain delays that we've discussed.
We are entering fiscal 'twenty, three with strong backlog coverage given the record bookings in the second half of fiscal 'twenty two.
We also have visibility into the key programs not currently in backlog that we believe will drive our revenue.
During the year, we expect to receive bookings on programs such as F. 16, F 18, filthy Buzzard C width and others. We are designed in and have sole source positions on these programs.
For fiscal 'twenty, three we're guiding revenue of one to $1 $5 billion, representing 1% to 6% growth from fiscal 'twenty to <unk>.
Organically the high end of our revenue guidance represents a 4% increase year over year.
Based on the midpoint of our revenue guidance, we have approximately 63% of our forecast revenue in backlog. This compares to approximately 52% entering fiscal 'twenty two.
Over 90% of our fiscal 'twenty three revenue guidance is either from backlog or from programs, where we are designed in.
We expect fiscal 'twenty three revenue to be <unk>, primarily as a result of award timing and supply chain lead times.
We expect adjusted EBITDA margins to expand throughout the year as a result of program mix impact initiatives and operating leverage.
While we always tend to have years weighted towards the second half. This year, we expect that to be more pronounced as a result of the macroeconomic headwinds.
As a result, we expect approximately two thirds of our adjusted EBITDA in the second half.
Unlike the last two years, we expect our bookings to be spread relatively evenly throughout the year with a strong book to bill in each one providing significant backlog coverage going into <unk>.
Based on our current outlook for bookings, we expect to have nearly 80% of our HQ revenue in backlog driven by the key bookings I mentioned.
This is above historical levels of backlog coverage entering the second half of the year supporting the strong growth we expect in <unk>.
Our guidance range for adjusted EBITDA for fiscal 'twenty, three or $200 million to $215 million approximately flat to up 7% from fiscal 'twenty two.
At the midpoint adjusted EBITDA margins are 22%.
These margins are approximately flat year over year as the anticipated impacts of material and labor inflation are offset by impact initiatives related to procurement and pricing.
We currently expect free cash flow of the adjusted EBITDA conversion of 30% to 40% in fiscal 'twenty three.
This estimate assumes current R&D capitalization tax law is delayed or repealed.
We expect a free cash outflow in each one primarily as a result of continued supply chain disruption with free cash flow returning to target levels in each Kim as working capital increases subside.
For the year, we're expecting double digit bookings growth and a book to bill above one.
I'll now turn to our first quarter guidance on slide 12.
Our current revenue guidance for Q1 is $215 million to $225 million at.
At the high end this is flat from last year.
We expect Q1 adjusted EBITDA in the range of $27 million to $30 million.
Margins are expected to be approximately 13% of revenue compared to 17% in Q1 last year.
This is primarily a result of continued supply chain and labor inflation as well as program mix.
We expect margins to expand as we move through the year as a result of program mix operating leverage and impact initiatives offsetting inflation.
We expect a free cash outflow in Q1 as a result of continued supply chain disruption as well as onetime cash outflows associated with impact and shareholder settlement costs.
While we don't guide bookings, we are expecting strong bookings in Q1 as I said.
With a book to bill above one resulting in record backlog at the end of the quarter.
So while we expect the challenging environment to continue in the first 10 months, we believe our backlog and expected bookings and each one will position us well heading into <unk> and into fiscal 'twenty four.
Over the next five years, we expect strong top line growth as well as margin expansion consistent with our target model.
With that I'll now turn the call back over to Mark.
Thanks, Mike turning now to slide 13, the timing challenges that we've experienced the past two years are likely to continue at least through the end of fiscal 'twenty three.
See it today.
That said the demand environment remains strong and we believe that strategically mercury could not be better positioned.
We're entering fiscal 'twenty record backlog and strong new business momentum as expected.
We believe this positions us to deliver another year of double digit bookings growth and a positive book to bill with revenue exceeding $1 billion for the first time, while maintaining strong margins.
Our five year outlook remains intact, we expect increased defense spending through this period to positively impact the business.
We are well positioned to continue benefiting from the effects of increased electronic systems content supply chain delayering and re shoring and increased outsourcing at the subsystem level.
We believe the supply chain constraints and inflationary pressures that we're facing today are short term in nature.
Mercury's fundamentals are strong and within top should improve over time.
Executing on our long term strategy over the past decade, we've improved margins, while growing the business organically supplemented with disciplined M&A and full integration as a result, we've created significant value for our shareholders and expect to continue doing so.
We've also added depths and the board continuing I'm, not saying I would like to welcome Mercury's newest directors Howard Lance and Bill Bauhaus, who were elected to the board on June 24.
In closing thanks.
Thanks, once again to the Mercury team to Europe standing work and contributions.
Operator. Please proceed with the Q&A.
Thank you.
If you would like to ask a question press Star then the number one on your telephone keypad.
We asked today that you limit yourself to one question.
Thank you.
Your first question comes from the line of Pete Skibinski without Alembic Global Your line is now open.
Hey, good evening guys.
Hi.
If we think about fourth quarter topline in fiscal 'twenty three revenue guidance can you talk maybe about quantifying what part of the headwind is labor related what parts supply chain related and then just just maybe are you seeing it across all of your hundreds of programs or are there a few key <unk>.
Program sizable programs that are being unusually impacted.
Sure. So why don't you kind of give the high level and then maybe Mike can kind of fill in some of the details Pete so at a high level, we saw greater than $35 million.
Impact on bookings.
The two probably biggest impart.
Around the FHA.
And then we also sold let's see with kind of slipped out into the quarter into Q1.
Revenue I think as Mike said in his prepared remarks. It was really due to two things. It was largely due to some of the order delays, where we were actually expecting the order to be able to recognize some revenue cements a good example of that the product was built.
But then also.
We absolutely saw some supplier decommit. So we're expecting material that ended up not arriving as we had anticipated.
Well I don't know, if there's anything that you'd like to us.
Yes.
So mark did a great job.
In terms of numbers as we look at.
The impact on fiscal 'twenty to assess.
Associated with the award delays.
We estimate that that was about $22 million.
On the supply supplier Decommit and extended lead times.
$20 million in terms of.
The revenue impact in fiscal 'twenty two.
Okay.
Got it.
I'm sorry.
Kind of 50 50 also for fiscal 'twenty three.
So in fiscal 'twenty three.
We when we look at those two things what Youll see is that when we talked about in the prepared remarks is that it's more about timing during the year and so what we're seeing is that the award delays that we've had.
This year in the supplier Decommit are leading to a lower H one from a revenue perspective, and a margin perspective because of the mix of business.
And a bigger H too so.
Looking at it as a fiscal 'twenty two.
Impact right now.
So Pete just like though I think it's an important point right. So we clearly so laura.
Pretty substantial ramp in bookings in the second half, we thought that was going to occur.
We did get some impact as I mentioned, just with some orders that didn't arrive. The good thing is that the actual.
The demand environment and order flow.
<unk> pretty strong we're actually expecting very strong growth in bookings in the first half.
Which should actually help improve that linearity.
As we head into fiscal year 'twenty four so unfortunately, these step, but we're kind of in a multiyear.
Industry events here and is it.
The linearity of bookings in both fiscal year, 'twenty, one and fiscal year 'twenty two.
<unk> helped us with respect to the timing of revenue and EBITDA. So we are trying to take that into account.
As we head into the new fiscal year.
Given the challenges that the industry is experiencing but overall I think we've seen some improvements around bookings, which which we believe is going to help not only in H two but also next year as well.
Very unusual times and if I could ask just one last one we've had this chips act passed but even separate from that are you guys able to identify additional semiconductor capacity coming online and kind of the near term.
Address the shortages that you had.
Or at least lessen the MTA.
It's a great question Pete.
I think.
As I said in my prepared remarks, the and is one of our customers said.
Their earnings call right, it's time to minus right now it's pretty challenging so.
For high end semiconductor as the lead times are 36% to 19 nine weeks to put.
That in perspective.
Three to five times, what we saw pre pandemic and Thats just for the.
Uh huh.
For the semiconductor for the high end semiconductor is the increases in lead times with Gulf.
Cross Mechanicals components into connect I mean, literally it's across the entire supply chain.
The chips off won't help in the short term I think it's a strategically and critically important piece of legislation for the nation.
But that's really about how do we actually bring Bockarie Shaw.
The chip manufacturing capability to make our supply chain more resilient and it's very clear with what the industry is facing right now.
It's the right thing to do so.
<unk> help us in the short term.
So I think it's going to take.
Yes, some rollover in demand.
In the semiconductor space to really to loose.
The challenges around availability I think we're already starting to see some of that.
In certain parts of the semiconductor market memory is generally more available than what it has been in the past.
Youre seeing some freeing up of supply around lower end semiconductors associated with <unk>.
<unk> electronics, Unfortunately that doesn't really help mercury because we are producing very sophisticated processing subsystems, which is where we're still seeing the tightness in the very long lead times. So yes.
I think as the economy starts to slow down.
As you start to see some demand softened I do think you'll start to see.
Some pick up in terms of availability.
What we've also seen in the past is that when there is a scarcity.
A lot of companies over order.
Because they're concerned about the ability to actually get access to the ports.
We're hoping somewhat.
It is demand source slow the effects.
The limited supply could actually turn quite quickly, but as we see it today, we don't see that occurring.
Yeah.
We just don't have the visibility phase.
Alright fair enough. Thanks for the color guys.
Yes.
Your next question comes from the line of Peter Arment with Baird. Your line is now open.
Hey, Thanks, good afternoon, Mark and Mike.
Mike just to clarify first did you expect to be free cash flow positive. This year, and then mark or Mike wants to make a comment I'm trying to understand just the dynamics a little bit thats going on with your Unbilled receivables, you talked about 60% of kind of overtime revenue and getting back to 35%.
What are some of the key things we need to see to begin to see it happen is it just availability of the supply chain, maybe if you could just walk us through a little color that'd be helpful.
Yeah. So.
Peter Let me start with your first question in terms of free cash flow so coming into the year. We werent, we werent facing the same number of supply chain issues that we're facing today are that we did face during the year. So if you look at fiscal 'twenty, two our free cash outflow.
Is $48 million now we invest in the business, we had about $27 million of one time.
Cost really associated with impact in some of the the org redesign that we did and I mentioned some of the other onetime costs.
In my prepared remarks, but the biggest impact by far has been the supplier and contracting delays, which we estimate was probably about an $80 million impact.
On our cash flow during the year in addition to.
There's onetime cost that I just mentioned so coming into the year. We didn't expect that working capital increase that was really driven by the supply chain and the contracting delays.
I mentioned and that really shows up in Unbilled and.
The answer to your second question in terms of Unbilled and making sure that.
I clarify the percentages that we've talked about so.
If you look at our overtime revenue is increase since fiscal 'twenty from from 27% to 50.
<unk>, 55% in <unk>.
Fiscal 'twenty two so this year in the 60% that you mentioned.
Was our Q4 overtime revenue or percentage of completion.
Revenue that's related to our sub system work and that's a natural growth as we do more sub systems consistent with our customer base.
When we look at the what's the right metric for Unbilled, how do we size it and say whats the right.
Amount of Unbilled, because we're naturally going to have some.
The way, we look at that as a percentage of our overtime revenue.
So if you look back from from physical <unk> 19 to <unk>.
Fiscal 'twenty, one you'll see we averaged around 35%.
In fiscal 'twenty, two that number went up to 43% and thats, what youre seeing because of the supply chain delays.
It's delayed milestones, which delayed deliveries.
And that's the number that as we look at normalization of our working capital, we're really going to drive down and so that 43% that we ended the year with in 'twenty. Two we think a good target is 35.
Percent overtime.
We think that will unwind in fiscal little bit in fiscal 'twenty three more in the second half and then heading into fiscal 'twenty four.
Okay. So just to just talk to your right.
Yes.
The second part of that question was around the do we expect positive free cash flow in 2003.
Yes, sorry about that yes.
We do.
We've talked about 30% to 40% free cash flow to adjusted EBITDA.
Urgent for fiscal 'twenty, three that's going to be second half weighted as I mentioned in my prepared remarks, we are looking at an outflow in Q1 are and that's what we're currently forecasting but for the year. We are looking for positive free cash flow and then that normalized and even further as we go into.
Fiscal 'twenty four.
So just to clarify so if we get into like fiscal 'twenty, four and say the supply chain availability is much better than it doesn't necessarily mean, the topline story, but you could actually start seeing a lot of these unbilled receivables unwind so the right way to think about it.
Absolutely, yes, and it's also inventory. So if you look at our in general and step all the way back when.
Look at working capital as a percentage of sales you will see that before FID.
<unk> 21, and even in fiscal 'twenty, one we're around 40% prior to that were around 35%.
This year on an LTM basis, we've jumped up closer to 56% and Thats the combination of that higher unbilled as a percentage of overtime revenue.
<unk> inventory because as we've talked about we invested in inventory.
To defray some of the risk associated with the supply chain.
And we've seen inventory hasnt seen increase as we've seen contracting delays. So yes, youre absolutely right. The right way to think about it is as we get through fiscal 'twenty three and then into fiscal 'twenty. Four you should see working capital as a percentage of sales come down.
I appreciate the color. Thank you.
Okay.
Your next question comes from the line of Seth Sigman from Jpmorgan. Your line is now open.
Okay. Thanks.
Thanks, very much and good afternoon.
Guys I just wanted to ask about the.
Expect to EBITDA.
In the first quarter and that kind of.
13 ish percent margin, which even last year, which you would've considered kind of a tough quarter for profitability was 17% to 18% margin.
I mean, it would seem like that's implying something like a low <unk> type of gross margin in the first quarter.
Is that.
Is that because of inflation is that because of mix and to the extent that that is the case.
And how does that.
In Peru.
During the year.
And does that does that imply some kind of exit rate that's higher than usual.
Or does it apply a quick step up in the second quarter.
Yes.
Yeah, So you're right when we looked at when we look at Q1.
Revenue $2 15 to $2 25 is the guidance range.
We don't guide as you know, we don't guide gross margin, but we were 39% in Q1 of 'twenty, two we're going to be.
Mix is going to shift Seth so.
Don't necessarily hold me to this but we're not going to be about 300 basis points lower.
In Q1 this year than Q1 last year, so around 36% is what we currently.
Expect so.
Your numbers right and so whats driving that it is two things first is the result of production slips. So revenues lower in gross margins are down because of the engineering work that we're looking at in the first half of the year.
Lower margin and the reason for that is that the production work, where we're waiting for suppliers has gotten pushed to the second half. So that's one part of it and the second part is inflation.
We've tried to.
Taking into account in our guidance some of the inflation that we won't be able to pass through we have at least 100 basis points impact from inflation in those gross margins, but we're trying to manage that through through impacting other initiatives. So so yes. So gross margin is down about 300 basis points and in EBIT.
<unk> down 400 basis points, because we were at 13% at the midpoint of our Q1 guidance now we were 17% in Q1 'twenty two.
300 basis points from the gross margin that I just mentioned.
The 100 bps is associated with the negative operating leverage and labor inflation.
Is the other piece of it so that is what's what's driving Q1 as you look at the year Seth we are going to see a gradual increase.
In gross margins throughout the year so.
While we're just mentioned 36%.
Or that's what we're estimating for Q1, we expect that to ramp up probably be relatively similar maybe a little higher in Q2, but then in the second half of the year. We have good visibility as I said in my prepared remarks to the programs that are going to make up the revenue in the second half and therefore the March.
<unk> on those programs too so we see a nice margin.
Mix in the second half of the year is closer to $42, 43% gross margins. Then you also benefit from operating leverage because of the higher revenue in the second half.
If you step back yes.
Literally what.
I said big picture earlier.
The bookings really the last two years of being heavily weighted to the second half of the year.
So we had a massive ramp in H two this year.
The timing of those orders combined with long lead times on the materials, even though.
We pre purchased inventories wherever we have a strong conviction that the orders and the timing is going to come in.
Push the production revenue and the EBITDA to the right. So it's not like losing anything we're not yes, but from a timing perspective and the mix of business.
Is skewed towards the back half of the year like it was in fiscal year 2000 to now as I mentioned in Pete's comment.
Good thing is that we saw the ramp in bookings in the second half and not ramp in bookings or the strength in bookings is actually continuing in the first half of this year. Unlike last so we are expecting pre.
Pretty good growth year over year in the first half compared to what we experienced last year, so things do seem to be.
Moving from an order flow perspective.
Okay.
But right now we are being impacted from a timing and mix.
Got it okay I'll stick to one thanks very much.
Yes.
Your next question comes from the line of Jonathan Ho with William Blair. Your line is now open.
Hi, Good afternoon can you maybe help us understand.
A little bit more color on how quickly you can push through pricing and maybe how we should think about that margin progression over the course of that second half of 2023.
Yeah. It's a good question. So the biggest area that we're probably seeing from an inflation perspective is in relation to semiconductors.
I think there is.
As I've mentioned in my prepared remarks that can provide the 38% Barak still spend.
And not supporting the 70% of our revenue, which is coming from processing system. So.
No.
So that's the biggest impact that we're seeing.
<unk>.
The rate at which you can pass through.
The inflationary pressures.
Varies quite honestly.
So it depends upon the mix of business right, how much is cost plus versus fixed price.
Much of what you've already got in backlog when those materials come in.
I can tell you that we've got a.
Major focus salt lakes, and it's been a big part of what we're doing with impact.
Multiple different areas, we're focusing on.
I'm seeing both the pricing side of things cost estimation.
Bidden proposal practices to ensure that.
Lee pricing the effects of inflation.
While.
Looking at the commercial side of the business to make sure that we're capturing the value associated with the capabilities and the.
The value that we're providing to customers so right now.
We've just implemented a.
A standard commercial product price increase that was effective.
Cross sell microelectronics portfolio, beginning July that first.
We have got pretty.
We've narrowed the follow on.
<unk>.
We are controlling discounts.
And changed.
Contract modifications authorities internally.
Leveraging the new pricing tools that we put in place.
As we see materials, we're able to actually immediately wherever possible flow those actuals into our cost. So there's a huge amount of work going on.
And yeah, we're actually expecting to offset a fair amount of the inflation.
That we're seeing in fiscal year, 'twenty, three but maybe not all.
Thank you I'll stick to one.
Your next question comes from the line of Austin Muller with Canaccord Genuity. Your line is now open.
Hi, good afternoon, Mark and Mike.
My first question here, just how do you view the discussions that are going on around the new $30 billion F 35 orders for around 375, aircrafts, which is 22% lower than the last block buy.
How would you expect that to impact Mercury relative to maybe what you expected and do you think you could have higher margins on that smaller production loss.
Sure. So let me, let me kind of step back a little bit Austin and kind of just give a more general update only on the F 35, because I think to some extent it answers the question, but it's important to understand.
All of the moving parts all the moving parts.
We're obviously aware of just the production rebase lining and kind of what's going on.
As we've said in the past we're on multiple parts of the <unk> system across.
Different parts of our vault product line, although we.
We experienced a pretty substantial reduction in order flow in fiscal year 'twenty one.
As a result of the TL three development delays and the Covid impacts on manufacturing that resulted in the initial remarks.
Production re baseline.
Things have improved substantially since then probably one of the more important ones Ross is that L. III <unk>.
Reported on the last call.
Successfully completed.
All of the safety of flight testing requirements and delivered the first flight chipset of what is known as the <unk> T. L. Three ICP, it's the core process associated.
Associated with the F 35, they previously reported that the other elements of the systems that were at par at all which is the panoramic cockpit display.
The aircraft memory system evolves.
Well down the path.
<unk> clearly.
It was able to actually reach an agreement on locks 15 through 17, and so I think to me there were some very important.
Events that could.
During.
During our fourth quarter.
I think another really important publicly but also for the industry as a whole stepping back and looking at the F 35 for Mercury at a year level.
We saw a very substantial rebound in orders as we've expected. So our orders on that 35 were up 123% year over year with.
With $24 million of orders in the fourth quarter.
As we had expected and discussed last call we had.
We received the last 16 long lead time funding is expected.
Following the initial award that we got in the first quarter 'twenty two that's important because it actually supports our revenue plan in fiscal 'twenty, three and right now we're actually looking at a partial loss 17 ultra long lead time of award.
In the first half of <unk>.
The new fiscal year.
Yes.
Settling back to the question that you asked right in the <unk>.
Potential or the reduction in terms of the number of units I think theres. Another couple of things that are important to understand in particular with mercury. So we've been actually very successful winning new content on the program.
Actually expanding our content footprint with a couple of different customers in a.
Couple of different census, suites, both of which are moving.
So following an initial award on one of them in the third quarter, we actually receive additional orders in Q4 that is resulting in a substantially taking share from a contact.
It will turn into future.
Future revenues and profits.
The other customer and capability, we've actually completed qualification testing and anticipate an initial order in fiscal 'twenty. Three so some of those new design wins are actually coming online and a more than expected to offset a decline in terms of the unit count so overall for us.
Yes.
The content and the ISP.
<unk> to grow.
The other thing that.
I think we obviously, noting is that there is some clearly some impacts associated with what's happening in the Ukraine. This fall more interest.
In the F 35 from our NATO allies so.
Check Republic and indicated its intent to acquire 24 aircraft Greece.
Greece is requesting 20 in this prospective sales.
Color that Germany, Finland, and Switzerland. So.
All of which could help I actually offset some of the U S declined. So overall I think we've made a lot of progress the program's playing out the way in which we anticipated.
And I think there's strong demand internationally.
Great and then just a follow up.
On the tracking where I know you had mentioned the SDA constellation.
Six there's 200 satellites planned for the tracking were 684 satellites planned for the transport layer 200 for the deterrent flaring et cetera, as some of these SBA constellations start to scale do you foresee that this could maybe become a top 10 program or more relevant program.
Mercury.
I don't think its going to hit the top 10, as we see it today, but we were obviously very very pleased with the wind.
We are providing some of our space qualified for solid state drives.
And.
I think it seems to be high interest.
In that particular area. So we'll see how the space market evolves Mercury, but clearly we're thrilled to be a part of the.
Chopping layer with one of our customers.
Fantastic Thanks for all the details.
Your next question comes from the line of Michael <unk> with <unk> Securities. Your line is now open.
Hey, good evening guys. Thanks for taking my question.
A follow up on Jonathan's question, Mark or Mike can you tell us what percent of revenues are under fixed price contracts versus cost plus versus maybe the.
The more commercial catalog book shift, where you can get immediate price increases.
I don't know if you've got lots of unlike.
Yes, Mike the vast majority of our.
Programs are either commercial terms or fixed price.
So from a cost plus perspective that only has about $40 million to $50 million.
Of our fiscal 'twenty two revenue so call it 5% of the overall business.
Commercial still counts accounts for a lot of our pricing probably fit.
<unk>, 50%, plus probably around 60% and then 35% is noncommercial firm fixed price.
So to go by getting it back.
Last quarter, Mike right.
The fact that we've actually go up.
Relatively short sales cycle, and where our customers actually order capabilities for Mercury in line manufacturing lead times, probably the only time that the short cycle.
Business.
Assists with the our ability to be able to pass on those inflationary pressures versus.
Having multi year agreements, which is really not the way in which the industry works with the sub tier is right now.
Yes, I guess, that's what I'm trying to figure out that 50% is commercial.
Seems like there's more of an outsized impact then for you guys on the inflation, where you could be passing along or maybe I've got that.
That wrong.
No we are passing it through so we're seeing bigger and bigger effects internally then yes I think.
Then what we actually.
Experienced this year in terms of the margin degradation.
I think it's due to the fact that we're able to pass the prices on where appropriate.
As a commercial company or just given the short cycle nature of the business.
But it doesn't mean that we're immune again, 38% of all external spend is related to semiconductors, and we're seeing <unk> to 20% price increases.
Across the board in the different.
Got it great and then ultimately becomes a matter of timing.
When do you absorbed those costs and how quickly can you pass through we do believe it's temporary.
Got it and then just on impact I think you guys had already recognized $27 million of incremental.
Savings, but now youre pushing that.
Good morning.
It seems like you're already at that low end anything really changing on that incremental adjusted EBITDA there.
So no I mean, I think to say to 50, we believe is still a good number.
I think if anything.
Pipeline of opportunities associated with impact is increasing.
We did push out the achievement of the goal a year.
Largely because I think we're seeing the impact of inflation.
The backhaul at the back end of fiscal 'twenty, two and more so in fiscal year 'twenty three.
But overall I think impart should drive substantial margin expansion.
Over the course of the next five years, if you want to add anything Mike.
No I mean, I think you hit on it.
The thing I would say is that.
The fact that we launched impact.
Slightly over 12 months ago. It means we're really well positioned.
Facing the headwinds that we've got so while we're delaying things I think we're in a good position to offset some of the headwinds that we're seeing.
Got it thanks, guys appreciate it.
Thank you.
Your next question comes from the line of Sheila <unk> with Jefferies. Your line is now open.
Good evening guys. Thank you.
Maybe if we could just summarize some of the comments from prior whether it was <unk> question or Mike just now when we think about the fiscal 'twenty three mark margins how much of that comes from inflation I think you said 100 Bips earlier.
Versus volume inefficiencies and then development programs.
Last time I saw you at a facility or facilities are pretty good.
So how much of the impact comes from those development programs and what are those programs and when do they transition into production.
Okay.
Yes, So Sheila let me, let me take a cut at that in terms of inflation and how we position that into our guidance. We have put some inflation headwinds into the guidance that we have I mean, one thing to remember.
Is we're guiding right now in a very fluid environment with the macroeconomic headwinds and <unk>.
Trying to predict what's going to happen not just over the next six months, but over the next 12 months. So we're trying to be conservative on the impact of the let's call. It the unknown unknowns that we tried to consider in our guidance, but if you look at what's in our plan we do.
Do have about.
100 basis points associated with <unk>.
Inflation and pricing that we won't be able to pass through as we just talked about with Mike where are you.
Using everything we can on our impact initiatives to pass that through.
But thats currently in our guidance the rest of it really is around program mix.
And that goes to what we were talking about.
Earlier, which is a lot of the production programs that we have are pushing.
Production into the second half of this fiscal year.
Or into fiscal 'twenty, four, but we've got growth programs, we've talked about amcs in the past.
He is still in the development phase.
That in fiscal 'twenty, three that still in the development phase.
<unk> probably goes to production some time in fiscal 'twenty for <unk>.
Other programs within our microwave business, we've got a classified space program. That's in development that will go into production in in fiscal 'twenty, four and in a handful of programs like that.
<unk> parts of the F 18 that were doing are currently in.
Development in the higher margin production award in that case is towards the second half of 'twenty three so a handful of things that are driving the lower margin in in our guidance inflation is part of it but then the program mix is another part of it which was impacted by the supply chain and contracted.
Environments and things were pushed to the right.
Sure.
So let me just step back a little bit because I think yeah.
This is obviously there was a whole bunch of things hit the industry this quarter and.
To me it feels like we're in the midst of a multi year industry event that was precipitated by Covid and clear.
Clearly I think yes, it will be.
Measured in terms of what happens on a quarterly basis, but if you step back.
Yes, we're actually given the guidance that we've just given we're heading into actually our full fiscal year dealing with the primary in the derivative effect of Covid and actually each year as holiday really somewhat distinct set of characteristics that have actually affected the subsequent year.
And so given the relative short cycle nature of our business customers and the size of their.
Our respective backlogs.
The effect may not always be you know it was.
Readily apparent depending upon the timeframe.
And it's so it's pretty complex, what's going on when you when you step back from it but I think we're clearly seeing.
The effects now moving its way up the industry.
The supply chain disruption that hit the industry pretty hard this quarter.
The ceases out with some many quarters previously it was just hard to see an even more difficult to forecast. So we began to see the effects of that.
And our fiscal year 'twenty.
21, sorry, we got through the initial phase is the health care.
With crisis phase of Covid in 'twenty pretty much unscathed, but we did see the effects of the order slowdown in 'twenty. One we have a <unk> 95 book to Bill.
That obviously affected.
<unk>.
The revenue and the profits associated with 21.
And yes, we are now clearly seeing the uptick in bookings in 'twenty, two but it was back half weighted.
Bookings for the year were up 33%.
For the second half 'twenty, two and for the year as a whole were up 21% and as I mentioned before we're actually expecting strong bookings cadence in the first half.
Customers just had a very strong book to bill So it's clearly not a demand issue.
We started to see the effects from a supply chain perspective in the second quarter and it's kind of it.
It has continued throughout the year, we also saw the effects.
The great resignation, meaning it was harder to actually.
Find the right engineering and manufacturing town that we needed to continue.
To grow the business.
Those challenges I think became.
More.
And more of an issue as the year progressed and I think that's what you saw thats, what youre clearly seeing in the industry right now we saw begin to see the effects of yes.
Inflation in the fourth quarter and as we're now heading into the full year 'twenty. Three we are expecting a greater effect. So I think given the fact that we're guiding for the full year given how this.
This is a multi year effect.
We are somewhat more conservative.
In our outlook just given everything thats going on there are a lot of unknowns right now that we feel that we need to take into account.
So the temporary the short term we believe in the outlook looks great going forward, but clearly the industry has been impacted.
Okay, great. Thank you so much.
Mr. <unk>. It appears there are no further questions. Therefore, I would like to turn the call back over to you for closing remarks.
Okay, well. Thank you very much everyone for joining us we look forward to speaking to you again next quarter take care Bye bye.
This concludes today's conference call. Thank you for attending you may now disconnect.
Please wait the conference will begin shortly.
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