Q1 2023 Mercury Systems Inc Earnings Call
Good day, everyone and welcome to the Mercury Systems' first quarter fiscal 2023 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 asthma.
Now received a copy of the earnings press release, we issued earlier. This afternoon you can.
You can find it on our website at <unk> Dot com.
The slide presentation that Mark and I will be referring to is posted on the investor Relations section of the website under events and presentations.
Please turn to slide 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 each of plans objectives business prospects.
And anticipated financial performance these.
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 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.
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 Aslib, 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.
Mercury's bookings increased 34% year over year in the first quarter following 27% growth in Q4 of fiscal 'twenty two.
Actual results in the quarter exceeded the high end of our guidance across all metrics and we're raising the low end of our full year outlook as a result.
The largest bookings in the first quarter were outcomes. The SDA tranche trucking layer into Amcs. You also received the F 18, and seaward block two orders that moved from Q4.
Driven by strong Q1 bookings our book to Bill was one $1 seven in Q1, and one dot one four over the last 12 months.
<unk> grew 22% year over year.
This backlog combined with strong bookings expected in Q2 and through the remainder of the year position us well to deliver increased revenue and EBITDA in Q2, and the second half of fiscal 'twenty three.
Our results for the first quarter reflected the second half weighting if orders in fiscal 'twenty. Two together with continued order delays long semiconductor lead times and all of the supply constraints Q1 is also typically our seasonally weakest quarter.
Total revenue increased 1% year over year organic revenue was down 4%. The fault better result in Q1 last year.
We expect organic growth to turn positive in the second quarter.
Our largest revenue breakdowns for F 35, <unk> aegis F <unk> and sealant.
Q1, adjusted EBITDA was down 19% year over year as expected. This was driven primarily by the second half weighting of orders in fiscal 'twenty, two and program mix.
We expect margins to increase in Q2 and as the year progresses.
Free cash was an outflow of $73 million, which we believe will be the low watermark for the year.
This primarily reflected order delays and supply chain disruptions that affected the timing of collections in the quarter as well as purchase of raw materials to support future revenues in.
In addition, we saw customers unusually holding payments at the end of the quarter.
We expect free cash flow to improve substantially in Q2 and grow through the second half of fiscal 'twenty, three resulting in positive free cash flow for the year.
We continue to see high levels of new business activity.
<unk> in Q1 totaled more than $135 million in estimated lifetime value.
Turning to slide four Q1 marked the beginning of Mercury's full fiscal year dealing with the effects of the pandemic in the near term our business and the industry will continue to face challenging macro forces.
However, it's clear that the issues impacting us today and not demand related.
Supply and timing related this short term and then not unique to mercury.
We're executing our plan to control what we can and we are optimistic about the future given our positioning.
After several years of Covid related challenges, we believe that we've entered a multiyear period of accelerating growth and profitability.
Most of the periods post sequestration in 2013.
Reflecting back to the beginning of the pandemic Mercury's fiscal 'twenty was the health care crisis phase, we navigate this period well with minimal impact on our employees operations and financials.
Bookings revenue and adjusted EBITDA were up more than 20% year over year.
In fiscal 'twenty, one we saw a COVID-19 related slowdown in orders bookings.
Bookings didn't grow as much in the second half as we anticipated declining, namely 8% for the year are booked.
Book to Bill fell to zero point 95 from the prior year's warmed up to the lowest in more than a decade.
Revenue still grew 16% year over year, and adjusted EBITDA was up more than 14%.
In fiscal 'twenty, two we saw the full effects of Covid beginning early in the year.
Delta, there and reduced our manufacturing productivity and the defense budget was delayed 165 days.
We experienced significant semiconductor supply chain disruptions and higher <unk> as well as inflation all magnified by the prior years on a slowdown in the second half.
As a result total revenue grew 7% in fiscal 'twenty, two less than we had anticipated.
Organic revenue declined 5% and we ended the year with adjusted EBITDA margins roughly flat.
Supply chain disruptions had an outsized impact on H, one H two linearity.
Working capital investments increased as the year progressed with free cash flow turning negative as a result.
However, bookings rebounded strongly in FY 'twenty, two growing 21% year over year, leading to a $1 zero eight book to Bill and crossing a $1 billion for the first time.
Most of this rebound occurred in the second half with bookings growing 33% versus <unk> two of the prior year.
This will be the timing coupled with dramatically longer semiconductor lead times is resulting in a fiscal 'twenty three financial performance also being more backend loaded than we experienced pre pandemic.
Unlike last year, however, bookings in fiscal 'twenty three are off to a great start.
We expect faster growth in the second quarter and the first half to be much improved versus H, one fiscal 'twenty two.
This sets the stage with strong full year bookings and a positive book to Bill.
We believe that Q1 marked the bottom in fiscal 'twenty three for organic revenue growth free cash flow and margins.
Given the strong order flow, we anticipate a return to organic growth in the second quarter.
For fiscal 2003 as a whole.
We expect to deliver strong earnings and positive free cash flow as well as improved working capital efficiency over time as the supply chain headwinds subside.
As I said earlier, while Mercury has experienced since the start of the pandemic is much the same as sequestration nearly a decade ago in terms of the multi year impact on our financial results.
The enhancements that we made in the business at that time led to accelerated growth and value creation over the next five years.
For fiscal year 13 through 18, Mercury ranked second and first among our tier two defense peers to a compound annual growth in revenue and adjusted EBITDA, respectively.
Similarly through impact with strengthening our business fundamentals once again.
Looking forward to fiscal 'twenty four we believe that lead times are high in semiconductors will begin to improve in the second half.
We've already begun to see a shortening of semiconductor lead times on the low end.
We expect stronger bookings in organic growth continued margin expansion and greatly improved free cash flow as we released working capital all of which should position us for further growth and value creation as we move forward.
Turning to slide five we believe today's geopolitical environment is the most challenging since the Cold War.
The risks related to China, and Taiwan are potentially more significant than what we're experiencing today with Russia, and Ukraine and the timeline is moving to the left.
The semiconductor industry and the defense industrial base in Europe , and the U S. I know what they need to be to build the military stockpiles and the new capabilities required in this threat environment.
We appear to be heading into a super cycle in the U S and Allied defense spending the challenge however for both the government and the defense industry is clearly on the supply side, whether it be the availability of semiconductors and other materials labor or now inflation.
In the near term the industry is dealing with an ongoing shortfall in government contracting personnel.
We're also beginning the new fiscal year under a defense budget continuing resolution.
This means the contracting environment will likely remain challenging in the short term.
We're not expecting a defense appropriations bill until after the mid term elections.
On a positive note once that bill has passed the GFY 2003 budget is currently expected to increase year over year.
That said given inflation, the real defense spending and buying power increases could be far less.
So overall the demand environment is strong and appears to be getting stronger.
Though the industry is dealing with headwinds we believe that the temporary we expect to see a shift to tailwind to us defense spending grows and supply chain conditions improve.
Turning to slide six at the Mercury level, the supply chain environment remains challenging but stable.
Although we are still seeing supply delays and isolated quality issues, we're experiencing fewer supplier decommit compared with Q4.
Lead times overall have not increased but is still extremely low to the high end semiconductors.
That's very sophisticated end to end processing platform pause some of the most critical A&D missions high end processing represents about 70% of our business and its when mercury likely has the largest opportunity to grow over the next five years.
It's also where the global supply chain has been less disrupted high in semiconductors with the Haas at many of our offensive and defensive weapon systems and has rapidly become the long lead time for defense development and production.
Prior to the pandemic semiconductor process the lead times with 10 to 12 weeks they.
They increased rapidly in the second half of fiscal 'twenty, one and now range from 52 to <unk> 99 weeks.
Putting this in perspective this means that high in semiconductor material orders that we are placing today support revenues in the third and fourth quarters of fiscal 2004.
It's not until this point that we believe that lead times and availability will begin to improve.
Throughout this multiyear period, we've used the strength of our balance sheet to invest in working capital to mitigate supply chain risks as best we can.
Positioning mercury to deliver stronger and more consistent results over time.
When the supply chain conditions normalize we expect a significant release of cash related to inventory and unbilled receivables from our balance sheet.
We're also continuing to deal with semiconductor related inflationary pressures semiconductors equate to 38% of our direct suppliers spend far more than our peers. We believe.
We've taken aggressive steps to maintain the strongest possible margins in this environment and they're working.
These include repricing standard products and incorporating price adjustment mechanisms in our rate space businesses and multiyear proposals.
We've also shortened the validity of our quotes to capture any near term inflationary effects.
Given the short cycle nature of our model is slightly at the impacts of supply chain inflation will begin to diminish over time as these actions result in more of that business being priced at market rates.
We're making good progress in managing the industry headwinds.
Program.
Much like our approach to sequestration, we're laying the foundation for Mercury to achieve its full growth and profit potential over the next five years.
We've seen tremendous changes since we launched impact at the beginning of fiscal 'twenty two.
We began by simplifying and streamlining our organizational structure and strengthening the leadership team and we continue to do so.
Mitch Steve is a former chief growth officer, who joins US from Raytheon 12 months ago recently took the helm as president of our processing division, which accounts for approximately 70% of total company revenue.
Mentioned is mercury well and has hit the ground running in his new role.
We also focused impact on margin expansion initiatives in fiscal 'twenty two.
Pushing their execution deeper into the business.
Effective October the third island could should join us to accelerate these efforts is our senior VP of execution excellence.
Alan was previously at Raytheon, and then missiles and defense Division will be responsible for supply chain operations Engineering and program management reporting to me, we're pleased to welcome Alan to the team.
As the environment became more challenging in fiscal 2007, we pivoted impact towards those areas that can help mitigate risk and deliver the most immediate financial benefits.
This year. In addition to pricing we continue to focus on supply chain risk mitigation working capital burn down and accelerated cash release.
Another initiative is our R&D investment efficiency and returns building on the progress last year.
Our digital transformation initiatives and engineering and operations will help improve our cost structure and performance over the long term as well.
We're also making good progress in our facility footprint strategy in Q1, we consolidated two engineering teams and our new Central Excellence in Fremont, California, We're on track to consolidate our Mesa, Arizona facility into the Phoenix sites in the second quarter and we expect to release two additional buildings in California.
By the end of fiscal 'twenty three.
As it relates to M&A impact is about leveraging our proven ability to integrate and grow acquired businesses, but it is a greatest scale going forward.
The environment continues to be active and we will 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.
As usual I'll start with our first quarter results and then move to our Q2 and fiscal 'twenty three guidance.
As market discussed Mercury its first quarter results exceeded our guidance across all metrics, despite the supply chain and inflationary headwinds.
Excluding Q1 from a demand perspective, we have excellent visibility into Q2 and the second half.
As a result, we're raising the low end of our fiscal 'twenty, three guidance and expecting a cash flow positive year.
Turning to our Q1 results on slide seven booking.
Bookings were $267 million up 34% compared to Q1 'twenty two.
Our book to Bill was one $1 seven compared to <unk> 89 in Q1 2002.
For the last 12 months ended Q1 'twenty three our book to Bill was 114.
The rebound in our book to Bill indicates the positive demand environment.
Our backlog at the end of the quarter was a record $1 8 billion up 22% from Q1 'twenty two.
Our 12 month backlog was up 25% compared to last year and up 7% compared to last quarter, providing us good visibility into the remainder of fiscal 'twenty three.
Coupled with bookings on key programs that we expect to receive in Q2, we are optimistic about our results for <unk>, two and the full year.
Revenue in Q1 increased 1% year over year to $228 million exceeding the top end of our guidance of $215 million to $225 million.
Organic revenue was $216 million and acquired revenue, which included Appalachian Atlanta micro was $12 million.
Gross margins for Q1 were down approximately 500 basis points year over year.
As expected, we had a smaller proportion of higher margin production revenue in the quarter.
Q1, gross margins also reflected material and labor inflation.
As we move through fiscal 'twenty, three we expect to see higher gross margins as a result of program mix and are gradually stabilizing macroeconomic environment.
Adjusted EBITDA for Q1 was $31 2 million above our guidance of 27% to $30 million.
Our adjusted EBITDA margins were 13, 7% for the quarter down 330 basis points from 17% in Q1 fiscal 'twenty, two primarily driven by gross margins.
Adjusted EBITDA margins exceeded our Q1 guidance range.
As I'll discuss shortly free cash flow for the first quarter was an outflow of approximately $73 million.
This was primarily due to award timing and continued supply chain disruption.
We also observe delayed payment behavior across our customer base.
Slide eight presents Mercury's balance sheet for the last five quarters.
Our balance sheet remains strong with significant capacity under our $1 1 billion revolving credit facility.
Driven by the anticipated strong cash flow generation in H, two we expect to be well positioned to delever the balance sheet, while continuing to invest in the business.
We ended Q1 with cash and cash equivalents of $52 million and approximately $512 million of debt funded under our revolver.
The sequential increase was primarily related to the free cash outflow.
During the quarter, we swapped $300 million of our floating rate debt to fixed rate.
We now have fixed so far at 379%.
At our current leverage levels that implies approximately 5% interest on a majority of our funded debt.
Which positions us to continue to allocate capital at attractive rates.
As a result of the macroeconomic environment over the last five quarters, we've invested approximately $250 million in working capital.
Port performance obligations to our customers and ensure delivery on critical programs.
This investment primarily consists of accelerated material purchases to mitigate the risks associated with the supply chain volatility and contracting delays that mark discussed.
This has resulted in increased unbilled receivables and inventory.
The majority of these material purchases are for programs that are aligned with the dod's strategic priorities and on which Mercury is a sole source supplier.
Supply chain conditions normalize and our customer performance obligations are completed we expect unbilled receivables and inventory to convert to cash and decreased substantially as a percentage of annualized sales.
Turning to the specifics accounts receivable in Q1 were $495 million of $47 million increase from Q4 2002.
Within that increase billed receivables were up approximately $20 million, primarily as a result of customer payment behavior.
Unbilled receivables increased approximately $27 million.
Our intentional strategic shift to more integrated sub systems, which meet the criteria of overtime revenue recognition, our unbilled receivables have naturally increase at.
At the same time macroeconomic conditions across the contracting environment supply chain and to a lesser extent labor markets are impacting our ability to complete program billing milestones and putting further pressure on unbilled receivables.
We continue to take a disciplined and proactive approach to unlocking unbilled receivables, including negotiating legacy contract terms to incorporate progress our performance based payments.
We're including these payment structures in all new contract awards.
We expect these actions to drive Unbilled receivable is down as a percentage of annualized over time revenue throughout fiscal 'twenty, three and fiscal 'twenty four.
Inventory increased approximately $17 million in Q1 dollars 23, compared to Q4 2002 <unk>.
And semiconductor lead times range from 52 to 99 weeks as Mark discussed.
We continue to lean forward on accelerating raw material purchases to support customer delivery schedules and mitigate supply chain risk in future quarters.
Additionally, as with Unbilled receivables shortages in key parts have hindered our ability to deliver finished goods to our customers.
We're working with our supply partners to accelerate deliveries of key components in order to deliver finished goods to our customers.
Turning to cash flow on slide nine last quarter, we forecasted a free cash outflow in Q1, driven by lower net income onetime payments as well as working capital build associated with continued supply chain constraints.
However, the outflow was larger than expected at $73 million, primarily due to customer contracting delays within the quarter.
Reflecting the proximity of award receipts quarter, and expected billings and cash collections in the quarter were lower than expected.
We expect the majority of these Q1 delays to result in billings or cash collections in Q2.
We also observe delayed payment behavior across our customer base in Q1 with payments due as of quarter end not being paid until the first weeks of Q2, resulting in an increase in billed receivables.
Although it wasn't used in Q1, we've put an accounts receivable factoring facility in place to address this in the future if necessary.
As Mark said, we believe Q1 was the low point of fiscal 'twenty, three and free cash flow.
We expect free cash flow to improve in Q2 and grow through the second half leading to positive free cash flow for the year.
Looking forward, we believe that our financial results for fiscal 'twenty three will reflect the early impacts of a potentially substantial longer term release of working capital from our balance sheet, especially as the supply chain headwinds subside.
I'll now turn to our financial guidance, starting with Q2 on slide 10.
Forecasting in the current environment remains challenging our.
Our guidance incorporates to the extent, we can potential impacts associated with ongoing supply chain constraints and material and labor inflation as well as the continuing resolution and a midterm election year.
For Q2, we currently expect revenue in the range of $225 million to $240 million.
This is approximately 6% growth at the midpoint compared to the second quarter last year.
We currently expect gross margins to increase from Q1. So we continue to be cautious with regard to supply chain variability and material inflation.
In the second half of fiscal 'twenty, three we expect gross margins to increase as we complete several of our lower margin development contracts.
The revenue growth in H, two is expected to be driven by higher margin production programs.
We expect adjusted EBITDA for Q2 to be $38 million to $42 million, representing 17, 2% of revenue at the midpoint.
This is approximately 350 basis points higher than Q1 and in line with Q2 fiscal 'twenty to actual margin.
For Q2, we currently expect free cash flow to be near breakeven to slightly positive with Q1, marking the low point in fiscal 'twenty three.
I'll now turn to our guidance for full year fiscal 'twenty three on slide 11.
In Q1, the team work to mitigate risks within our control, resulting in mercury exceeding the high end of guidance.
Our updated full year guidance builds on the Q1 over performance, but remains cautious based on our risk outlook for the remainder of the year.
The near term outlook for the industry and the macroeconomic environment remains far from certain.
However, the demand environment continues to improve and we believe our strong Q1 will be in retrospect, Mercury's low point for organic growth and margins in fiscal 'twenty three.
As a result, we are raising the low end of our previous guidance for revenue and adjusted EBITDA for the year.
Driven by 34% year over year bookings growth. We ended Q1 with a 12 month book to Bill of 114 and record backlog.
For fiscal 'twenty, three we expect double digit growth in bookings and improved bookings linearity, leading to continued growth in our backlog and greater visibility to our forecasted revenues.
We also expect a positive book to bill for the year.
From a revenue perspective, we now expect total company revenue of one one to $1 5 billion in fiscal 'twenty three.
This represents 2% to 6% growth year over year, and approximately flat to 4% organic growth.
While this organic revenue guidance is still below our target business model, we're beginning to see the rebound driven by the strong bookings momentum over the last 12 months.
We continue to expect fiscal 'twenty three to be second half weighted based on the midpoint of our guidance ranges, we expect approximately 45% of revenue in each one and 55% in each two with organic growth accelerating in <unk> and into fiscal 'twenty four.
As I mentioned, our current backlog and expected Q2 bookings should provide strong visibility and backlog coverage as we enter <unk>.
Adjusted EBITDA for fiscal 'twenty, three is expected to be in the range of 202 $5 million to $215 million up 1% to 7% from fiscal 'twenty to <unk>.
Adjusted EBITDA margins are expected to be approximately 20% to 25%.
The increase in our EBITDA guidance for fiscal 'twenty, three is driven by Mercury's outperformance in Q1.
Like revenue, we expect adjusted EBITDA and EBITDA margins to be heavily weighted towards the second half.
As revenue ramps through the year, we expect an increase in gross margins and operating leverage to lead to adjusted EBITDA margin expansion.
From a free cash flow perspective, we're targeting approximately 30% of adjusted EBITDA in fiscal 'twenty three.
This estimate assumes the current R&D capitalization tax laws delayed or repealed.
As I've said, we expect cash flow to begin to normalize in each to driving improved conversion for the full year.
With that I'll now turn the call back over to Mark.
Thanks, Mike turning now to slide 12, we believe that Mercury couldnt be better positioned strategically.
We entered fiscal 'twenty, three with a record backlog and strong new business momentum, we anticipate strong bookings a positive book to Bill and a return to organic growth with revenue eclipsing 1 billion for the first time.
We expect to deliver improved margins better working capital efficiency and positive free cash flow.
This should lead to improved fiscal 'twenty three results positioning us for a stronger year in fiscal 'twenty four is the supply chain headwinds begin to recede.
Looking further ahead our plans for the next five years remains intact Mercury's fundamentals are strong and with impact should improve over time.
Defense budgets domestically and internationally are poised for rapid growth, we believe that we're well positioned to continue benefiting from industry trends, including supply chain delayering and re shoring as well as increased outsourcing at the subsystem level.
We anticipate that a greater percentage of the value associated with future defense platforms will be driven by electronic systems content when mercury participates.
We're building the company, we set out to create from a capability perspective, and our addressable market continues to expand as a result.
This is being driven in large part by our strategic move into mission systems, and the potential to deliver innovative processing solutions at chip scale.
Model Sydney at the intersection of Hi, Tech and defense positions us well.
We believe that Mercury can and will continue to grow at high single digit to low double digit rates organically as the current headwinds diminish.
In addition to organic and M&A related growth. Our five year plan includes continued margin expansion driven by impact leading to stronger adjusted EBITDA as well as improved working capital efficiency and cash conversion.
Executing on our long term strategy of the past decade, we've improved margins by 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.
In closing I'd like to recognize the entire mercury team for a tremendous effort during these challenging times.
A sincere thanks to all of you.
Operator. Please proceed with the Q&A.
Thank you.
If you would like to ask a question. During this time simply press star followed by the number one on your telephone keypad.
We asked today that you limit yourself to one question and one follow up thank you.
Your first question today comes from the line of Jonathan Ho with William Blair.
Your line is now open.
Hi, congratulations on the strong quarter.
I wanted to understand a little bit better can you maybe help us understand how you are pricing actions maybe flow through for the balance of the year.
And what that could mean in terms of either improvements to gross margins or on the cash flow side.
Sure. So we've done a fair bit Jonathan.
<unk>, we had two major initiatives one related to procurement, where we stood up a procurement organization is seeking to purchase things more efficiently.
And then the second is that we stood up a pricing team.
Two initially.
So that price.
Price our products more in line with the value that we provided.
Both of those areas have actually ended up really helping to offset some of the inflationary pressures that we're seeing and I think we're actually being pretty successful doing that.
So in.
In the microelectronics business, it's a very strong as a year.
We actually did a pretty much an across the board price increase associated with all our commercial products.
Then.
Non commercial business we are also.
Pretty aggressively looked at passing on the costs associated with the inflationary pressures.
To all of our customers as well as actually addressing.
Contract contracts going forward to make sure that we're capturing the.
The inflationary pressures on a go forward basis as well so Mike I don't know if you'd like to maybe comment further.
From a financial perspective.
No I think you hit it Mark Jonathan the only thing I would add is that as you look at our guidance.
We do have.
Inflation pressure embedded in our guidance, but at the same time.
<unk> said were working to offset that through through pricing. So there is some in there, but we're mitigating the piece of it in our guidance as well.
Great and then just as a quick follow up when it comes to some of the customer behavior around payments do you have any concerns at all around collections quality or receivables and when when does that sort of maybe start to normalize in terms of the cash conversion. Thank you.
Okay.
Yes, so I'll take that one so Jonathan that we feel very good about the quality of the assets that are on the balance sheet and the collectability.
About the unbilled receivables to build receivables as.
As well as the inventory because if you step back the majority of that is material purchases that we've made four programs.
That are aligned with the strategic priorities that we're designed in on.
And so it really is just a matter of time.
The balance sheet unwind once we deliver on those final.
Performance obligations to our customers.
Hey, Mike Let me, let me jump in because I think I think it's important to just kind of step back.
And really maybe delve into this.
More details so.
Yes, most of the challenges that we part.
From both a working capital perspective, and cash flow are clearly due to the very challenging supply chain environment.
We expect that those challenges are actually going to continue throughout 2023.
We've seen some improvement I think the in quarter supply at the can mix has improved somewhat versus the fourth quarter, which we're grateful for however, I think the challenge is still very much related to extremely long semiconductor lead times, particularly on the high end and the general scarcity.
Those devices overall.
I think we're seeing more.
Also seeing more rapid and treatment end of life only devices, which is particularly.
The challenge in the defense industry, given life cycles, as well as now both material and labor inflation and it fit us probably more than most because 70% of our business is related to <unk>.
The same.
So as a reminder.
<unk> 22, 45% of our business is actually recognized this point in time revenue recognition will put it another way when we recognize revenue when we actually deliver the product that's actually a much larger percentage than other companies in the industry. The remainder of the revenue recognition is really over.
Hi.
Yeah.
Unfortunately, we don't get to choose what type of revenue recognition, we use it's really due to.
To the accounting rules dictate that.
So let me talk a little bit about the business model and why cash flow has been impacted so you really get a better understanding what's going on.
And why in particular working capital has begun as builds and why we believe our cash flows have been impacted really on a temporary basis.
So at point in time revenue, we typically purchase inventory to support future customer deliveries and we can hold is largely based on our manufacturing lead times, which for.
So products have historically been quite short.
The model is actually work really well in the past <unk>, given us tremendous flexibility to deal with mix changes and quarter to quarter revenue volatility and it's also a reason why actually our guidance track record historically has been so strong over many years, because we've been able to actually absorb some of the bumps in the road.
So from period to period.
If I look back into 2021.
<unk> 2021 is when semiconductor lead times quite suddenly and dramatically lengths, and which really disrupted our model as well as obviously the whole industry and online.
Unlike our customers and given our position in the industry and we typically don't receive multiyear rewards.
So this became.
Lead times became a challenge for the industry last quarter and it's clearly continued into this quarter as well and its a major reason that many of our customers top and bottom lines have certainly been impacted.
The truth is however, if you look at the what's actually happened the seeds of this with so many quarters ago.
Likely back in 2021 itself, which has taken a little bit of time for it to actually show it as a prime contractor level.
So the approach of short term duration contracts low T isn't the defense industrial base is really an artifact of defense industrial policy, and it's pretty clear that it needs to change.
We're actually to build.
A resilient.
Supply chain and industrial base as the industry moves more towards award production footing.
So back to Mercury.
The programs that we're buying inventory for the defense programs of record.
We designed dean and typically have sole source positions. These.
These programs are usually an outright element of full rate production.
And so these types of programs and products, we've definitely seen a build in inventory semiconductor lead times dramatic these length during the pandemic and we need to purchase additional inventory way sooner than we normally would have to support our customer as well as our financial commitments.
In addition, the semi industry more rapidly end of life the older legacy components, which meant we stock up on those two.
As others have commented this earning season semiconductor partial insurance also held our planned product deliveries, which created more.
With inventory with so the cash consumptions largely been enroll materials and with precipitated by the change in the semi industry.
Now we view this as an investment in our future and that of our customers, it's absolutely consume cash.
On the other side related unbilled overtime revenue recognition.
The remainder.
How we recognize revenue.
This is by far the most common type of revenue recognition in the industry and it's the default to many of our customers now.
We've used this model it being the correct accounting treatment as we success being successful in winning larger sub systems business, which has really been a significant driver.
Both in the business.
And in this area, we're buying inventory, but we're pegging it to a specific product ground. The challenge here again. This has really been supply related inclusion, including challenging supply quality labor shortages in the dramatically longer semiconductor lead times as.
As I just mentioned.
Certain of our legacy contracts meant that we couldnt collect cash until we actually ship the final units and with the parts shortages. We've ended up with partially built units that are also tied up working capital.
So we believe that the cash tied up in inventory and Unbilled receivables should start to release over time.
Dramatically improving our cash flow conversion rights.
We sold it was pretty important to really kind of dig down a level and just help people understand what's going on so thanks for the question Jonathan.
Thank you.
Your next question comes from the line of Sheila K you glue with.
Jefferies. Your line is now open.
Hi, its actually Scott on for Sheila, but Mark you talked about some of the importance of M&A for kind of impact initiative I mean, given the movement in rates, we've seen year to date, how is the M&A environment shifted and how are you kind of think about any change the return profile you're looking at.
Mike do you want to take that one.
Yes sure Scott.
Listen we are definitely seeing a move in rates over the last couple of.
Weeks months and quarters and its impact at the industry I think that when you look at valuations in the industry just definitional eight based on higher discount rates those could come down.
That having been said there are a scarcity of assets out there and for good assets I think that they're going to continue to garner good multiples and we've seen some of that recently I think from our perspective, we're just going to keep doing what we've been doing and we're pretty disciplined in our M&A approach.
Very careful with the cases, where we're underwriting when we're doing our valuation, especially in the environment that we're in right now with a lot of uncertainty.
I think that from our perspective, we've got a good good.
Good capability when it comes to M&A and as I mentioned in my prepared remarks, when you look at the revolver, we have $1 $1 billion revolver. It does give us a lot of capacity to focus on M&A at attractive rates when the time when the time is right.
And then maybe just a quick follow up on impact I mean, you're over a year into it now I mean, what successes have you really been able to point to and are there any areas, where it's maybe been a little more challenging than you had previously expected.
Yeah. So good question. So I think these actually achieved with law right. So it begun by us really simplifying streamlining.
Business into the structure that we have today, we dramatically strengthened the leadership team and then we said that by really focusing on some key areas.
One was procurements, we stood up eight.
Direct or procurement centralized procurement organization.
To help us actually take advantage of the scale of what we have today, we put in place in AI and machine learning based procurement tool.
It is actually paid huge dividends.
The supply and challenging supply chain environment.
We still have a pricing organization inside of the business as well.
To be able to price our products more more appropriately now of those two items and the short really helped to mitigate.
The 10% to 20% increases that we're seeing.
<unk> semiconductor inflationary pressure, so we've been able to mitigate that effect that.
We've also I think done a fair amount of work looking at R&D investment efficiency kind of going through project by project.
Eliminating any low return projects to be able to ensure that we're focusing in the right areas.
We've done a good job from an employee engagement and from a retention perspective as you know the labor market is a very very challenging.
Right now with the great resignation and I think we've done a good job.
<unk>, our employees as well as being able to hire.
The people that we need to continue to grow the business. We've also made substantial progress.
Looking at our facility footprint.
Just a few of the.
The reductions in terms of the number of facilities that we've already.
Don over the course of the last 12 months.
And we've got several others that.
We expect to complete by the end of this fiscal year.
Over and above that I would say that we've done a tremendous amount of work on the digital transformation. We are just completing the rollout of the new digital manufacturing execution system.
We.
Or in the process of migrating our engineering tools to the Amazon Calpine cloud, which is going to give us better productivity and scalability and efficiency over time.
And so yes, so we've actually done the loss Unfortunately.
Think we're not really seeing the benefits of what we've done just given the.
Challenges that we've seen around productivity in the supply chain, which are linked but over the course of the next five years, we do believe that we're going to see substantial margin expansion.
As well as.
Substantially improved.
Cash flow generation.
Yes.
Thank you.
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 nice results.
Mark I know you've spent a ton of time here on the free cash flow but.
I mean, you've got customers holding back payments and I mean, what are your customers. I mean are we are we think in the <unk>.
Prime contractors.
Trying to better understand what that dynamic is like they're holding back payment and simultaneously you are investing in inventory and working capital to support. These programs. Yet you are taking all the risk on your balance sheet with your cash flow while there.
We are all basically buying back stock.
How is that dynamic working among the customers.
Yes, it's a good question, let me, let me kind of maybe terminated at a high level and I'm sure Mike will.
Tribute so yes, we did see some hold box at the end of the quarter.
Give you an example.
One particular customer paid us for two things and then the third which was also in June .
We got paid on the first day of the new quarter right. So it's not like the withholding for long periods of time, but.
But we definitely saw some whole box at the end of the quarter. The yellow thing that affected US. Mike is also just the timing of specific orders and in particular, our three largest orders.
In the in the first quarter.
Yeah, all ended up moving to the right and taking.
The revenue and the <unk>.
Cash associated with those.
Outside of the cash window. So it's a number of things thats going on.
But look I think the last two quarters at an industry level, Mike in terms of revenue and top and bottom line.
There have been challenging overall and.
Thank you.
We're seeing some changes in behavior associated with that.
Mike I don't know if you would like to maybe add.
To that.
Yes, no I think you hit on it I mean, Mike the only thing I would add is that the business models and market spend a good bit of time going through it between us and our prime customers are different and he just talked about that we are doing things to change the dynamic, especially <unk>.
Round.
Unveiled receivables.
We're negotiating with customers now to get more favorable milestones.
<unk> payments on new and existing programs programs, we've got updated processes internally. So we're trying to change the way we contract with customers. So it's not all of our balance sheet being used to support these programs and so that's why we think we're going to see some some unwinding.
The working capital going forward.
Yes.
Yes, if you think that what we've done from a cash thing.
Five things that we're focused on right.
Obviously looking to drive the cash conversion burning down the unbilled receivables and inventory, but doing it in a way in which it doesn't put revenue execution and on time delivery at risk right. So.
Gregory auction is usually a reaction.
Yes, we are.
Absolutely enhanced our demand planning processes.
Part of impact we've put in place.
Leverage level and scalable tools to drive the demand signal luck accuracy and Montreal your identification.
The commitments that we need to make all materials all.
To focus in on those parts shortages given the unprecedented lead times.
Third thing that we've got a major focus on <unk>.
So on negotiating milestones with customers.
And.
Part of the issue that we've had.
Some of the legacy contracts is when we've shifted towards an subsystems revenue, we didn't necessarily half milestone or performance or progress payments, we're now going back and making sure that we got those all in the commercial side of the business rapidly getting cash upfront.
We're also prioritizing the labor resources to make sure that we can actually liquidate those unbilled balances as well.
Labor is critically important right. So I think we're very much as I mentioned as part of the impact conversation focused on retention and resourcing.
To ensure that we're actually mitigating any execution challenges related to shortages in staffing and then finally I think over the longer term, yes. It was we were moving up.
The industry in the value chain.
And going after much larger proposals.
What we've done in the past, we're very much focused on strengthening our bid proposal and captured.
Yes.
To dry.
And protections for Mercury in the future. So we're all over it.
And.
I think as Mike said, we think that the.
<unk>.
The cash flow volume in Q1 should.
It should improve in Q2 and as the year progresses.
Got it that's helpful and just one quick follow up unrelated.
The budget dynamic in the continuing resolution do you guys.
Your kind of internal planning do you think we get a full bill before yearend or based on mid terms, if we see.
Fleet turnover at our Red wave or Bluewave do you think.
Any signing of the Bill will have to wait for new Congress to get seated. So we've run through maybe end of January February timeframe.
I think our operative assumption right now is that we get the bill before year end.
Your guess is as good as behind Mike right on the what the election.
Results are going to be and how that might affect things.
We're expecting a relatively short.
<unk>, which we've obviously taken into account in terms of our guidance.
Got it helpful. Thanks, guys.
Thanks.
Your next question comes from the line of Austin Muller with Canaccord. Your line is now open.
Hi, good afternoon.
<unk>.
Just my first question here.
Do you expect that pressure on some of the NATO European allies due to the economy and inflation could delay new orders for modernization programs by maybe a year or more relative to the U S.
Uh huh.
Yeah, It's a good question.
I think.
My gut would say probably not.
Yeah.
Clearly with what's happening over in the Ukraine.
The threat environment that you usually kind of dictates both the altitude and the timing.
Defense spending and clearly nine months into this the situation is not great.
So.
Yeah.
So my gut says is that we're going to continue to see increased spending in Europe .
Whether it's immediate.
A little bit longer time will tell but I think they are acting with a sense of urgency awesome.
Okay that makes sense and can you call out any specific key program deliveries in the second half.
Anticipate will support the step up in free cash flow.
Okay.
So in the second half you know I think we've got some.
Pretty significant programs.
Yes.
Rattling through a few of the <unk>.
Top of my head we built.
Filthy buzzard.
<unk>.
Beginning to ramp again.
We're expecting a very large IDI Q this quarter.
As well as delivery orders ramping up as the year progress.
Aggressive.
I think F 16, you know it will be a.
A significant contributor.
Yeah.
The large new Eli off program.
Uh huh.
Large microelectronics program. So there's a number of programs that we expect.
To ramp.
In the second half of the.
Yeah, and Austin, the only thing I would add on that Tim is from a working capital release perspective, while there is orders that we need to drive revenue and bookings Theres other things that we're working on from a release of working capital perspective, and we've seen unbilled and programs being delay.
Because of supply chain delays because of contract penetration.
And as we work through those in the second half that will also help that working capital. In addition to the growth programs that Mark just described.
Okay awesome. Thank you for all the details.
Mr. <unk>. It appears there are no further questions. Therefore, I would like to turn the call back over to you for any closing remarks.
Okay, well. Thank you very much everyone for joining us here. This evening and we look forward to speaking to you again next quarter. Thank you.
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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