Q3 2023 Mercury Systems Inc Earnings Call
Good day, everyone and welcome to the Mercury systems third 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 Companys Senior Vice President and interim Chief Financial Officer, Michelle Mccarthy.
Please go ahead Mr Mccarthy.
Good afternoon, and thank you for joining US with me today is our president and Chief Executive Officer, Mark Aglet, you have not received a copy of the earnings press release, we issued earlier. This afternoon, you can find it on our website at MRC why 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.
Turning to slide two in the presentation.
I'd like to remind you that today's presentation includes forward looking statements, including information regarding Mercury's 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 will also discuss several non-GAAP financial measures specifically adjusted income adjusted earnings per share adjusted EBITDA free cash flow organic revenue and acquired revenue.
A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release.
I will now turn the call over to Mercury's President and CEO Mark outlet, Please turn to slide three.
Thanks, Michelle good afternoon.
Everyone and thanks for joining us.
I'll begin with a business update Michelle will discuss the financials and guidance and then we'll open it up for your questions.
First a quick note about the review of strategic alternatives, we announced last quarter.
Our review is continuing and we don't intend to disclose any new developments on the call today.
As Michelle and I will discuss we're running the business in the ordinary course as this process unfolds.
Change the execution of our strategic plan.
With that let's turn to the third quarter.
Revenue was the bulk of Hello, Yeah, and adjusted EBITDA came in at the midpoint of guidance for Q3.
So in line with our expectations and our book to Bill was 0.93.
As far as <unk> first of all in one dot one in the last 12 months.
Three backlog grew 10% year over year.
Our largest bookings programs in the quarter would be 22 F 16, aegis <unk> 64 in the classified seep wide program.
We're positioned for strong bookings growth sequentially in Q4 as planned given the timing of awards.
Q3, total revenue increased 4% year over year organic revenue, our largest revenue programs, where outcomes aegis F 16, F 35, and the classified seek wide program.
GAAP net income and GAAP earnings per share for the third quarter exceeded our guidance due to a higher than expected tax benefit.
Adjusted EPS and adjusted EBITDA declined year over year as expected free.
Free cash flow was positive excluding the R&D tax impact.
Looking forward to our results as the year level, we expect to deliver record bookings for fiscal 'twenty, three and the positive book to Bill <unk>.
Revenue is now expected to be flat to slightly up year over year.
<unk> million below the midpoint of prior fiscal 'twenty three guidance Q2 award in supply chain delays.
Organic revenue is expected to be approximately flat year over year versus the 5% decline in fiscal 'twenty two.
While the bottom line, we are lowering the range for GAAP net income and adjusted EBITDA by $34 million and $44 million at the midpoint.
Free cash flow is expected to be around breakeven in Q4 and negative for fiscal 'twenty three.
We expect lower cash outflows year over year, excluding the R&D tax.
Turning to slide four.
On a full fiscal year dealing with the derivative effects of the pandemic on the business we.
We've seen impacts in prior years and bookings in organic revenue. This year would be in the bottom line is primarily driven by lower margins.
We're experiencing temporary margin degradation for two reasons.
The first is a significant shift towards development programs and our business mix and the second is the pandemic related impacts on products and program execution, especially as it related to certain development programs.
Over the last several years, we won a significant amount of new business, both organically and through acquisitions.
These wins decrease the ratio of production to development stage programs from approximately 822, approximately 60 40 in fiscal 'twenty three corresponding with the doubling in customer funded R&D revenues.
Our typical period of performance on programs pre pandemic wasn't average approximately 18 months.
Shorter than many of our customers given where we sit in the value chain.
Over the course of the pandemic. This period increased to an average of approximately 30 months driven in part by delays in development programs.
And the initial phase development programs typically carry gross margins in the low to mid Thirty's on average.
Comparison more mature production programs gross margins are above 40% on average.
Although this elevated ratio development stage programs has pressured margins over the past couple of years and more significantly in fiscal 2003. These programs will drive mercury's future growth as they transition into production.
We expect to see a meaningful margin expansion also as they transition and our mix returns to pre pandemic levels.
This segment contributed to margin degradation as I mentioned is the pandemic related impacts on execution.
Supply chain delays and inefficiencies long semiconductor lead times tight labor markets and inflation resulted in cost growth impacting both direct costs and R&D.
In terms of R&D Mercury is a leverage commercial investment model.
Developing sophisticated new technologies and products. Please.
These highly differentiated capabilities then use across multiple programs.
The cost growth, we're experiencing is associated with certain new technology developments that are nearing completion of new product introductions, which are taking longer than planned.
The higher costs related to both labor as well as materials, driven by labor and supply chain inefficiencies.
Factoring constraints on inflation.
Approximately a dozen or so about 300, plus active programs have been affected and all but two of the effective programs and more than 90% complete in terms of the total expected costs incurred.
The good news is that once we complete the development of new product introduction activities multiple programs will quickly benefit due to our product program leverage model.
We expect these programs to complete over the next two to three quarters and transition to production based contracts thereafter.
This transition should lead to stronger fiscal 'twenty four results not only improved gross margins and adjusted EBITDA as cost pressures diminish, but also lower working capital as we quickly relief unbilled receivables through shipment invoicing and cash collections.
As I said previously our challenge is not related to end market demand, which remains strong.
Largely timing and costs related the short term and they're not unique to mercury.
We're focused on controlling what we come in this environment given the technologies that we've developed in the programs that we've won.
Structurally our business model and financial outlook ascend and we're very optimistic about the future.
Margins to naturally return to pre pandemic levels as we overcome current execution challenges and as the supply chain conditions continue to normalize.
Furthermore, <unk> expansion will follow as the late stage development programs transition to production and as we return to more normal <unk> business mix over time.
Turning to slide five we now have allocate your on board as head of execution Excellence, Mitch Stevenson now, leading our mission systems business and Roger Wells continue to leave microelectronics.
Under their leadership, we are driving continuous improvements in new product development supply chain operations and program execution.
New leadership was instrumental in clarifying the magnitude and timing of our late stage development challenges.
We're making progress on the engineering development challenges and manufacturing yields began to improve by the end of the third quarter.
We expect this progress to continue in Q4 and fiscal 'twenty four allowing for final program execution.
In addition, with through the first phase of our business systems integration in Torrance, California, the former POC.
This was delayed largely due to COVID-19 related travel restrictions and is on track to be completed in the fourth quarter.
Completing these integration activities will increase our visibility across the business, especially with respect to program execution and related labor and material cost as well as working capital.
The platform systems business, we built through a series of acquisitions over time of which Torrance is the largest part to some of the amazing capabilities.
In addition to the work that we've done around our secure processing and trusted microelectronics, we expect it to deliver long term growth in the business.
Although we made progress on the income statement in Q3, we still have more work to improve our balance sheet and cash flow.
Expect that our impact program together with improved execution will lead to increased margins a reduction in inventory and unbilled receivables, resulting in improved cash flow.
Turning to slide six and the industry operating environment, which continues to improve incrementally.
Employee hiring at Mercury continued to outpace attrition in Q3 and the supply chain is beginning to flow more smoothly.
We saw fewer supplier decommit this quarter with some supply is delivering ahead of plan.
Semiconductor is still affecting program timing and efficiency, although to a lesser extent.
Semiconductor process. The lead times peaked in Q1 of fiscal 2003 is 52 to 19 nine weeks and now range from 13% to 78 weeks prior to the pandemic. The average 10 to 12.
Although currently times on average are getting shorter constraints in certain areas is still affecting new product development and program execution.
We don't expect a significant improvement in lead times until the second half of fiscal 2004.
Semiconductor inflationary pressures remain a challenge all set in the third quarter. For example, we made approximately $10 million of end of life related semiconductor purchases, where the prices increased nearly nine X.
Our impact program launched in early fiscal 'twenty two.
It's continued to evolve until at the positive results.
We streamlined our organizational structure and significantly strengthened our leadership team, we push margin expansion and working capital efficiency initiatives deeper into the business.
In this inflationary environment, we're passing on higher costs wherever we can and we've raised prices across the board on the commercial microelectronics side of the business.
We're improving R&D investment effectiveness and consolidating our manufacturing facility footprint.
Digital transformation efforts and engineering operations and the back office should also help improve our cost structure over time.
Turning to slide seven we believe the defense spending outlook remains positive.
The defense Appropriations Bill approved last year as well as the President's budget request target substantial spending growth related to national security issues as well as continued support for you Craig.
And extended budget continuing resolution appears to be the base case scenario with government fiscal 2004, including the potential for a full year CR.
Given the geopolitical environment, there appears to be strong bipartisan support for increased defense spending.
Domestic and international defense spending is expected to grow in both the short and longer term and when we believe that mercury is well positioned to benefit from secular industry trends.
We're seeing continued growth in demand for compute capability on board military platforms, and an ongoing push for platform electronic vacation.
We also stand to benefit from supply chain, Delayering and re shoring as well as increased outsourcing by our customers at the subsystem level.
Our addressable market has increased substantially largely driven by our strategic move into platform systems and the potential to deliver innovative processing solutions at chip scale.
Our model sitting at the intersection of high Tech defense positions us well.
As we announced in March Kristine Fox Harvest and this has joined US as chief growth officer to help capture these opportunities Kristine has an impressive track record of driving growth developing new markets and building successful partnerships in defense and commercial technology businesses.
We're very pleased to welcome Christine to the Mercury team with that I'd like to turn the call over to Michelle Michelle.
Thank you Mark and good afternoon again, everyone.
I will start with our third quarter results and then move to our fiscal 'twenty three guidance and Q4 guidance.
Please turn to slide eight which details the Q3 results.
Mercury's revenue net income exceeded the high end of our guidance.
Total bookings for Q3 were $245 million, yielding a book to bill of <unk> 93 as expected.
Bookings linearity was still weighted heavily in the third month in the quarter, but improved versus the first half.
Our total backlog was at 10%.
12 month backlog was up 9% compared to Q3 last year.
We're entering the fourth quarter with forward coverage of over 80%.
And solid visibility to the remaining bookings required to achieve our forecasted Q4 revenue.
Q3 revenue was approximately $263 million up $10 million or 4% on a total and organic basis as compared to $253 million in Q3 2002.
Nevertheless in Atlanta Micro are now included in organic revenue, having completed their fourth fiscal quarter since being acquired.
Gross margins for the third quarter decreased to 34, 3% from 39, 4% in Q3 last year.
The decline was partially offset by savings in operating expenses, primarily within R&D is a higher proportion of engineers continued to incur direct labor on development programs.
As Mark mentioned over the last several quarters. We've consistently cited two key drivers of lower gross margin.
First a higher concentration of development program revenue in our MC and.
And second the derivative effects of the pandemic, resulting in program execution delays.
There's a close correlation between the two drivers that warrants a finer point.
In fiscal 19 through fiscal 'twenty, one we achieved a significant level of design win.
Both organically and through acquisition, especially as related to the physical optics Corporation acquisition.
These design wins were predominantly within secure processing and mission avionics two of our key strategic growth areas.
And translated into development contract in our backlog.
The onset of Covid in fiscal 'twenty and the transition to remote work added latency to our development effort.
Shortly thereafter supply chain delays began to limit availability of critical components, followed by the great resignation, which created labor constraint across a number of our program executing function.
We began to see some margin reduction in fiscal 'twenty, one and fiscal 'twenty, two partially offset by lower R&D expenses as more engineers charged labor directly to <unk> development programs.
This resulted in increased levels of DRAM as discussed in many of our prior earnings calls and public filings.
The higher engineering labor content, coupled with the low unit volume and most development programs contributes to average gross margin in the low to mid <unk> on these programs.
Compares to average gross margins of about 40% across our production programs.
As Mark mentioned, our proportion of development program revenue has nearly doubled from approximately 20% in fiscal 'twenty, one to approximately 40% in fiscal 'twenty three.
While the mix shift alone created initial pressure on gross margin.
The derivative effects of the pandemic created concurrent execution delays and inefficiencies.
The delays resulted in many of our largest development programs entering final testing and qualification.
23.
We have encountered technical challenges as is typical for this stage across a dozen or so of our development program.
The resulting cost growth has a compounding impact on gross margin given that many of our active development program.
Predicated on firm fixed price contract.
Remediated these challenges as required incremental labor and material both of which have experienced inflation over the last several years.
More specifically the cost growth incurred in the testing and qualification stage of these development programs.
Higher scrap charges as well as more senior engineering labor charges when the units did not yield as expected.
In accordance with GAAP, we continuously reassess our estimates to complete on these programs based on changes in facts and circumstances.
And as an estimate are applied retrospectively and when adjustments in estimated contract costs are identified such revisions require accumulative catch up of prior program margin performance.
This resulted in an outsized impact in the quarter in which the changes in estimates were identified across these development programs.
As Mark mentioned nearly all of the dozen or so development programs that have contributed to the fiscal 'twenty three cost growth are nearing completion in the next two to three quarters.
Completing these programs will not only rebalanced, our revenue and margin profile as we shift back to a production weighted contract mix.
Also reduce susceptibility to cost growth across our program portfolio.
As a frame of reference historically experienced minimal changes in our cost to complete estimate here.
Q3 outside of these dozen development programs, we continue to experience the same trend with minimal changes in these estimates.
The nearly 300 other active programs we manage.
As we complete these development programs over the next two to three quarters, we will apply the lessons learned to the follow on production contracts as well as development programs in our backlog to support more stable cost to complete estimate going forward.
As such we expect to see improved gross margin not only from the mix shift to production based contract, but also due to the recovery from cost growth specific to these programs.
In addition, where possible we are seeking cost plus fixed fee structures on new development programs.
Mitigating the impact of cost growth on future program execution.
From a working capital perspective, these dozen or so programs and then a significant primary and secondary source of growth in Unbilled receivables.
We expect our completion in the next two to three quarters to allow for the billing and cash collection of nearly $30 million.
Even more importantly, we have many other programs that leverage the same underlying technology or product or otherwise require the same specialized engineering resources currently consumed at these development programs.
Therefore, as they are completed manufacturing yields will improve across the share technology, our product and engineering resources will be redistributed across multiple other programs.
Net to allow for the billing and cash collection with an additional $60 million of Unbilled receivables.
In summary, our fiscal year 'twenty three gross margins have been pressured by both the proportion of development programs in our mix as well as execution challenges across a dozen or so these programs nearly all of which will complete in the next two to three quarters.
We expect that overcoming these challenges will not only return us to a more normal higher margin production contract Nic.
But also improved execution across multiple other programs.
As a result, we expect to see improved gross margin as well as the release of over $90 million.
An unbilled receivable.
Melting and improved cash flow and overall working capital level.
Q3, GAAP net income increased to $5 2 million or <unk> <unk> per share.
$4 1 million or <unk> <unk> per share in Q3 last year Q2.
The tax benefit of over $10 million in the quarter.
We calculated Q3 income taxes, using the discrete method a more appropriate methodology, given our year to date and expected fourth quarter results.
Our third quarter operating and pre tax results were lower year over year due to the lower gross margins just discussed as well as higher interest expense.
Adjusted EBITDA in Q3 was $43 5 million compared with $52 5 million last year again due to lower gross margin.
Adjusted EBITDA margin was 16, 5% in the quarter.
Free cash flow for the third quarter was an outflow of approximately $13 million, including the first payment of $19 million related to the change in R&D tax legislation exclude.
Excluding this free cash flow would've been an inflow of nearly $7 million better than our expectation of near breakeven entering the quarter.
Slide nine presents Mercury's balance sheet for the last five quarters.
From a capital structure perspective, our balance sheet remains strong we ended Q3 with cash and cash equivalents of $64 million.
We have $511 $5 million with funded debt under our $1 $1 billion revolver, which provides us with significant financial flexibility.
This is a positive indicators stabilization in the supply chain.
Alternate material receipt of $20 million more than planned for the quarter.
This is reflected in the growth in unbilled receivables as well as inventory for the quarter.
To some extent it is also driving an increase in accounts payable given the timing of certain peak later in the quarter.
Turning to cash flow on slide 10.
Although we saw more timely customer payment patterns, reducing our billed receivable.
It was more than offset by growth in our Unbilled receivables, primarily as a result of development program execution challenges.
In addition, some of the snapback with suppliers I just mentioned resulted in higher Q3 cash outflows.
We leveraged our receivables factoring arrangement at levels similar to the prior quarter to help offset these impacts.
Working capital continues to grow as a percentage of sales largely driven by increased unbilled receivables and inventory.
As discussed we expect continued progress towards development program completion over the next two to three quarters.
This should serve as a catalyst for the start of <unk>.
Significant reduction in Unbilled receivable and improved cash flows extending to fiscal year 'twenty four.
In addition, with the supply chain, beginning to normalize and various impact initiatives progressing we expect to have greater visibility predictability and control over inventory.
As a result, we continue to believe an appropriate target for working capital as a percentage of sales is 35% consistent with pre pandemic level.
I'll now turn to our financial guidance, starting with full fiscal year 'twenty three on slide 11.
The demand environment was strong in the first nine months of fiscal 'twenty, three and getting stronger as we begin the fourth quarter to reiterate we expect record bookings and a positive book to bill for the year.
Entering the fiscal year, we expect completion of these development programs in the first half with the follow on higher margin production award throughout the second half.
This supported higher revenue improved gross margin.
Operating leverage in the second half and especially in the fourth quarter.
Based on the development program execution challenges and related cost growth experienced to date.
<unk>, a more cautious outlook for the remainder of fiscal 'twenty three.
Our fiscal 'twenty three guidance for total company revenue is now $990 million to $1 1 billion.
This represents flat to 2% growth year over year, and approximately flat organic growth compared with a 5% decline in fiscal 'twenty two.
The reduction from our prior revenue guidance reflect award and funding delays, including follow on production award associated with our development program as well as continued supply chain delay.
GAAP results are now expected to be a net loss for fiscal 'twenty three in the range of $19 million.
$11 1 million with GAAP loss per share of 34 to 20.
We now expect fiscal 'twenty three adjusted EBITDA in the range of $160 million to $170 million down 18% at the midpoint from last year.
Adjusted EPS is now expected to be in the range of $1 36 to $1 50 per share.
We now expect negative free cash flow for the fiscal year, both with and without approximately $30 million of cash outflows related to R&D tax legislation.
I'll now turn to our fourth quarter guidance on slide 12.
For the fourth quarter. We currently expect revenue in the range of approximately $269 million to $289 million.
At the midpoint. This is a decline of about 4% year over year.
Our revenue forecast for the fourth quarter as well supported by our existing backlog with over 80% coverage entering the quarter and strong line of sight to the remaining Q4 bookings.
We expect gross margin to increase in Q4, as we complete certain of the late stage development programs as discussed.
We also expect to see improved operating leverage on higher revenue.
We expect Q4, GAAP net income to range from $1 2 million to $9 $1 million.
Expect fourth quarter, adjusted EBITDA to be $49 six to $59 6 million.
Presenting adjusted EBITDA margins of approximately 20% of revenue at the midpoint.
Looking ahead to fiscal 'twenty, four and beyond Mercury is well positioned for stronger growth.
Margin expansion and improved working capital.
We expect our current backlog and strong slate of existing programs, coupled with increased defense spending to drive a return to high single digit to low double digit revenue growth.
On the bottom line as our mixed transition from the current weighting of development programs. The higher margin production contracts, we expect to see a natural uplift in gross margin throughout fiscal 'twenty four.
In addition, as the margin headwinds from certain of our existing development contracts the side.
To see further improvement in gross margin.
At the same time continued supply chain normalization will position us to begin rebalancing the timing of material receipts with the availability of labor, allowing us to meet our customer performance obligation and a more efficient manner, resulting in improved working capital levels.
Finally, we expect continued impact savings to support margin expansion and improved cash flow in fiscal 'twenty, four and over the longer term.
With that I'll now turn the call back over to Mark.
Thanks, Michele turning now to slide 13 demand is strong and getting stronger as we begin the fourth quarter of fiscal 2003.
For the year, we expect to deliver record bookings and the positive book to Bill.
We're positioned for continued progress and a rebound in fiscal 'twenty four as we push our development programs across the finish line and transition to production overall execution improves in the supply chain conditions continue to normalize.
Driven by stronger growth higher EBITDA margins and substantially improved working capital and cash flow. We believe next fiscal year, we will begin a longer term period of improved financial performance for Mercury.
Looking out over the next five years, we are well positioned to benefit from increased defense spending both domestically and internationally.
As a result, we believe that Mercury can and will continue to grow organically at high single digit low double digits.
In addition to growth our five year plan includes margin expansion driven by better execution of the supply chain conditions normalize the shift in mix from development to production as well as continued improvements through impact.
These tailwind should lead to stronger profitability as well as greater working capital efficiency and cash conversion over time.
In closing I'd like to extend my appreciation to the entire Mercury team, which is committed and working extremely hard to deliver improved results. My sincere. Thanks to all of you.
Before we turn it over to Q&A I ask that you. Please keep your questions focused on our earnings results with that operator. Please proceed with the Q&A.
Thank you.
If you'd like to ask a question today Press star followed by the number one on your telephone keypad.
We have today that you limit yourself to one question and re queue for any follow up thank you.
Your first question comes from the line of Peter Arment with Baird.
Your line is open.
Hey, Thanks, good afternoon, Mark and Michele.
Hey, Thanks, Nick.
I guess.
I appreciate the details you've kind of explaining development mix growing in kind of.
Derivative effects.
The pandemic and what you've talked about I guess, what I'm trying to understand is that a lot of those things. We're kind of now three months ago that your development mix was growing and you were still dealing with all these lingering effects and I'm just trying to understand what kind of the change from what the implied guidance was.
So potentially at 31% adjusted EBITDA.
For the fourth quarter three months ago to now 18% to 21% just help me trying to understand or at least bridge kind of the dynamics there. Thanks.
Yes.
Sure.
Big picture.
Thank you.
We were coming into the year, yes.
Yes, we were expecting that.
These development programs will be further along than what we currently all right as a result of some of the technical challenges and we've experienced the cost growth associated with that and as a result of the delays pizza. We are also seeing some follow on award delays of high margin business. So it's.
Really kind of the two the.
Two things right.
Later than expected completion on the development programs with higher costs.
And knock on impact of high margin production awards that we're expecting in the second half.
So those are the two main drivers. The other one is that I think we also have seen some supply chain parts availability constraints.
The fact that certain business in the fourth quarter as well.
Just if I could as a follow up market does this change how you approach.
Just sort of getting on some of these larger development programs in the future just because.
Looked like.
These were technically challenging.
Just what's your approach there.
Yeah. So.
If you look at our model Peter right, we've got a product program <unk>.
Commercial investment leverage model and.
Prior to the pandemic right. We've done a really good job I think in developing new capabilities and quickly and cost effectively and then sharing those capabilities over multiple programs.
What we're experiencing here is a very small fraction of the overall program portfolio. So as Michel mentioned.
Out of a dozen programs as a 300 active programs that.
That we are currently monitoring.
And yeah. The products go into multiple program. So when you've got one issue.
Thats multiple things so it's the opposite.
Is the leverage that we have when things are working well.
That being said we are.
<unk> the late stages in terms of the development testing qualification and we do believe that once we get through it youll.
Youll start to see.
Things move much more quickly today most of the types of contracts that we have are actually still in fixed price.
Contracts with only about 10% being.
Being cost plus fixed fee, and so where possible and where it makes sense of new development programs.
Well clearly.
Seek to to move towards the cost plus fixed rate structure, but it really does need to make sense.
Depending upon the type of business in the actual business that we're pursuing largely because of our investment model. So yes.
We're far along on them, it's unfortunate that it's happened, but the critical capabilities tied to really important programs.
Okay. Thanks Mark.
Yes.
Your next question comes from the line of Seth Sigman with J P. Morgan.
Your line is open.
Thanks, very much good morning.
I guess mark.
Can you tell us.
Maybe I don't know if it's only a dozen programs maybe the top five or six programs that are driving this.
So we're not going to get into the specifics because the capabilities that.
Where we are in the final stages of development specialized in nature, and we don't want to specifically link them too.
No.
Programs.
But it is a very unique set of capabilities that we're producing.
I think the.
Very very important in terms of.
The programs in which that going into so unfortunately, I cant really disclose too much so.
Okay. So there are classified programs.
And our classified but linking certain technologies into programs.
Given what we're doing is not something that.
Yes, we would normally disclose.
Right. Okay. Okay, and then maybe just the last point on this.
Pass along as.
In terms of these programs moving towards production.
As mercury kind of finishes its work on the development.
<unk>, you're supplying it to a prime contractor.
Is there further technical risk on these programs that are out of your hands as to when the customer is going to call on you to get going on production. Once once you guys have executed on your part of the development work.
No I don't believe so Seth I think.
<unk>.
As soon as that we can ship these products our customers are going to take them because they need them for the work that they're doing so I don't believe that there is any additional risk or delays associated with that we've literally just got to get through the finishing off the development assets and ramping up the new product introduction yields.
Which we began to see at the end of Q3 so.
Hopefully.
The ones that are most important yes, we're already seeing the progress.
Okay, great. Thanks very much.
Your next question comes from the line of Ken Herbert with RBC. Your line is open.
Yes, hi, good afternoon, Mark and Michele.
Maybe mark just to just to stay on these.
As you think about the progress in terms of retiring the risk on these development and other development programs.
What's your assumption for again for the sort of a working capital release in fiscal 'twenty four I mean, how much of a tailwind could this be is it possible to quantify that prior to two official 2000 and for guidance, but I think that the impact on cash I think would be very important as we think about for next year.
Yeah, Let me let me just talk let me just it's a good question, Ken Let me, maybe kind of take it down to a level in terms of just the issues and kind of what we're doing and then I'll throw it over to Michelle who can talk about just the impact that the positive impact that we potentially see.
With respect to Unbilled so yes.
Is it working level. There are two late stage products that are in development and new product introduction activities associated with them.
As I mentioned because of our product program leverage model are affecting multiple programs on the <unk>.
First one as I said, it's a very unique.
One of the kinds of capabilities thats used across multiple programs.
So yes in the second quarter, we conducted a very extensive root cause analysis, yes, our customer in the U S government of actually agreed with our conclusions and the corrective actions that we've implemented and so at this point, we're actually monitoring the options for effectiveness and adjusting.
As we need to actually improve the product yields and throughput.
Which is kind of the stage that we're currently at so we're now currently ramping up the production in phases.
Just to give you a perspective of the progress that we've made in Q3 will be at its later than what we would have hoped and anticipated yes, we've gone from zero percent yield on this particular product varian to now almost 90%.
Against the program requirements.
And yeah, we're actually on track to build tens of systems in the first half of the fourth quarter and I think as Michel had said, we're obviously applying lessons learned.
And sure that these things don't happen in the future I will say, though it's very very sophisticated technology that hasn't been done before so that one we're actually pretty far ahead on the.
The other one.
Yes.
Extremely strong collaboration internally.
It's enabled us to actually address some of the manufacturing issues and we're actually have returned to full rate production. However, as we did that we actually experienced another issue at the end of Q3 on one of the variants that in turn is affecting multiple programs on.
That one we actually expect to deploy a software fix to resolve the issue in Q4.
So so you can kind of tell just where we're at but we really are at the.
Final stages development in qual.
Which will then obviously allow us to ramp production.
Liver the products yes.
And then invoice and collect cash and so with that just as a little bit of a background why don't I hand, it over to Michelle because these programs.
Ken for a significant amount of the Unbilled receivables that we've done on the balance sheet Michele Thanks, Mark Hi, Ken Yes from a working capital perspective, the completion of kind of a dozen or so programs that we reference will result in a.
<unk> of about $30 million.
Coming out of Unbilled as we ship that product and we think some of that relief will occur in Q4, but occurring much later than we had originally expected obviously coming into the quarter. So we're going to see that cash convert more likely in Q1 24 in Q2 of 'twenty four.
More importantly, just when we complete these dozen or so program because of that share technology product or need for those same specialized engineering resources across multiple other program those that our programs are essentially waiting in line and so there is another $60 million of Unbilled receivable that waiting for release.
So once we can resolve the technology issues.
Common product issues and redistribute those engineers to these other program. There's another $60 million that we can convert to cash, which we believe will convert also in fiscal 'twenty, four so really where you're going to see that working capital impact across these programs.
Around that Unbilled release, and we will take that $90 million and think about what it means from a working capital perspective at a 10% reduction when youre looking at kind of trailing 12 month revenues.
Great. Thank you very much.
Your next question comes from the line of Jonathan Ho with William Blair. Your line is open.
Hi, Good afternoon, I guess, one thing I wanted to understand a little bit better is that in terms of the program.
Dependencies, and specifically around the yield issues that you've been experiencing.
How do you think about sort of the deal.
Ability to remediate this and then maybe what gives you the confidence that in FY 'twenty four.
We see these issues resolved as opposed to maybe a continuation.
Just wanted to get a lit bit more clarity around this.
Yeah. So.
So again as I kind of mentioned in.
The last question.
Jonathan we're pretty far along root cause.
In the one that has probably been the most impactful.
And the customer agrees, we're actually have already begin to ramp up.
Production in phases, and the yields have improved dramatically in the third quarter.
We wished it actually has it happened earlier than that.
Because again, the fact that we weren't able to deliberate sooner. Yes has resulted in some of the follow on awards not occurring in the timeline that we've previously anticipated the second issue with respect to.
This product.
We've already begun to ramp one of the variance in production, which is fine and we're just waiting for US a software fix for the second which is teed up to the fourth quarter. So I think were far enough along that we know.
What's going on with these programs.
All of these technologies that are shared across multiple programs.
And the fact that there will be shipping products literally.
Yes.
In the first month in the second month of the quarter to the programs that our customers need the capabilities. So I think we've done enough work to understand where we're at we got to root cause ramping up production and the customers need the capabilities. So I think we've got a high degree of confidence the other thing that.
<unk>.
If you step back and you just look at these dozen programs the Michelle mentioned.
All but two of the programs are actually more than 90% complete in terms of the total expected cost and that we expect.
So these programs to be completed within the next two to three quarters in total so I think we're actually in a pretty good position.
I guess one final point is that it's the first sign that we've experienced this level of volatility I think we've got a we went back and kind of looked at the history of our estimates complete across the the very large portfolio of programs.
And we've seen very minimal.
Turbulence.
Over the course of the last three years. So it's a confluence of events very sophisticated technology, but hopefully we're near the end here.
Thank you.
Okay.
Your next question comes from the line of Sheila <unk> with Jefferies.
Your line is open.
Hey, it's Scott on for Sheila Mark, we always thought of kind.
Kind of one of your closest competitors in the space and AMETEK reported this morning.
Wanted to abaca seeing pretty strong growth with margin expansion I guess the natural question from that is just is there any market share shift happening in the market and I know it's difficult to comment on other businesses, but is there any color you might have into what's driving that delta in performance.
Yes, so as we said Scott Ryan it really related to this does not so.
The programs, where we're developing highly sophisticated technologies and capabilities. This fan out over multiple programs. It really ties to two things just the development engineering development delays associated with the capabilities and then ramping those new products into production.
So we don't think it's related to.
With respect to.
Erosion of margins with respect to competition or anything like that it's literally related to cost growth on the programs.
As we are going through this the.
Specific challenges.
Thank you Sean.
No I would just highlight the continued strong demand that we have you can see it through our bookings. Although Q3 was below one it was as expected and year to date, we're above one as we have been.
For quite some time for several of the last few quarters.
Thanks.
Your next question comes from the line of Michael <unk> with <unk> Securities.
Your line is now open.
Hey, good evening guys. Thanks, Thanks for taking the question.
Mark I, just kind of go back to.
Peter's first question I still don't understand how EBITDA got cut 45% in 90 days I mean youre talking about these 12 programs things you thought in the beginning of the year.
This was just 90 days ago, you had you had given us this implied fourth quarter.
Is there anything else happening was that just an aggressive view and I guess more on the Eac's are they are they captured in here can you tell us what the negative Acs were.
Sure. So if you go back to it as I mentioned right entering fiscal year, we'd expect it to.
Development of this program in the first half.
With follow on higher margin production awards expected in the second half.
This.
Set of circumstances that basically supported the higher revenues improved gross margin and strong operating leverage.
We forecast in the second half and especially in the fourth quarter.
Balances that we've had obviously is that it's taking us longer.
To get.
The development effort across the goal line, yes, it is not an anomaly back lit.
The estimate from this call.
In Q3, which is the cumulative catch up.
As a result of those delays it had an impact on follow on awards or.
Hi, and launch and follow on awards in the fourth quarter, which combined is roughly.
<unk> is the overall across the other is related to supply chain availability at all.
On other programs so Sean if you want to talk a bit about.
Why the the impact.
Yes, so large in the third quarter and just from an accounting perspective, how it is that you've actually got a.
Taking into account the changes in estimates.
Particular period.
Yes, sure. So mark as you said the drop is really a function of the execution delays on the development program. So it's pushing those follow on production awards outside of the <unk>.
All year.
Into 'twenty four and then the incremental costs that we are expecting not all of it program specific at this point, we're planning for unknown unknown in some cases right.
That is just a one for one dropped through to adjusted EBITDA, because again, its a cumulative catch up.
And as you said there is some <unk>.
Higher commitment have put kind of critical material receipts needed for the quarter outside of the required window. So we are in constant communication with suppliers and although we have seen some level of reduction in DS Smith.
We are constantly getting updates from the supplier.
And then in some cases, what we found was that those connects were pushing out to a point, where we cannot complete the product.
Progressing to a point, where we would be able to recognize the revenue.
But I mean.
Murray.
But I guess on January 31st I mean.
This seems like a pretty risky forecast you gave us expecting all of this to get across the finish line I mean, all of this just manifested in the next the last 90 days, though.
So yes, we've been wrestling with the development team was making progress, but then like any other late stage development as you're kind of moving into new product.
The actual NPI stage, yes.
Challenges with the yield yes, it's a very sophisticated technology that.
We couldnt get the.
The technical the through the NPI process, yielding in a way in which we previously expected. So the engineering development was actually complete.
But we couldn't actually get it through the the production processes, Yes, we've gone from.
It's hard to to actually forecast zero percent yields.
And all of the.
The engineering of the production.
Production team, yes, it was expecting that.
So over the quarter Q3, yes, we went from zero yield to actually exiting the quarter at 90% yield on one of the.
Prime rate.
New products and capabilities.
Then we have the issue on the other product variance, which we actually began to ramp.
As the quarter progressed, and then hit a southwest not so it's literally late stage development, new product introduction and quality issues that obviously, we guided at the time with the best possible information with respect to what we thought would happen and things just got pushed to the right.
The forecast was accurate coming in yes.
And as we experienced these issues, we need to step in and.
Look at the estimates.
Which is why you see the changes in Q3.
Yes, Mike.
It also just and one of the examples that Mark just went through we had execution underway earlier in the year.
Because we got to that kind of testing qualification point that Didnt meet performance back then.
The nature of the units meant that we had to scrap them in their entirety. There was no salvaging the units and these are pretty meaningful scrap event tens of thousands of dollars every time they occur every unit.
Significant rework needed at that point, we have the most senior engineers on our team working through it.
So as you can imagine higher labor costs because of the seniority of those engineers and then the material costs that are needed to recover or actually add inflated cost values right because they are more recent material purchases.
It's very dynamic in terms of how the issues are being resolved.
As Mark said, we can make our best estimate in terms of in terms of what yield will be but again, it's very dynamic it hasnt changed really throughout Q3, and it's the new facts and circumstances that are now reflected in our results for the year.
So if you could opine on the multi mic.
Yes, if you go back to the model right the product program model.
Tremendous amount of leverage associated with it and it's part of the reason that.
Customers really want to work with Mercury spending high level.
Our own money on internally funded R&D to develop these capabilities that is amortized.
We'll use the multiple programs, yes, the good news in that model. When it works is that we are able to deliver technologies and capabilities far more quickly and far more affordably than if it was on a per program model. The challenge that you've got is that.
In this particular instance, and it's probably the first time that I can recollect in my history.
I agree that this is actually occurred it just given the sophistication of the technology, where we've had challenges and again some of them are related to just the effects of the pandemic and the chances.
Auto ex Houston.
Now getting negative leverage right, meaning a couple of these technologies or products are actually holding up multiple programs now once we get through the development and the NPI activities, which will close.
The multiple programs quicker.
Quickly benefit.
Meaning that yes.
We will actually begin to make rapid progress, we believe which is yeah. So less cost growth in terms of the income statement.
Yes, it will be able to ship systems at higher margins. Once you start to ship. The systems, we will obviously be able to invoice and collect the cash and we got a significant amount of unbilled receivables right now with Michelle mentioned, so we're not done but we've made a lot of progress. Thank you.
Unfortunately with slower progress.
And what we had previously anticipated.
Okay.
Thanks for all that color guys.
Yes.
This concludes our Q&A portion of today's call and now I will turn the call back over to Mark <unk> for closing remarks.
Okay, well, thanks, very much everyone. I appreciate you joining the call today. Thank you.
This concludes today's conference call you may now disconnect.
Okay.
Okay.