Q4 2019 Earnings Call
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Elite H E L. Eli.
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Era A.I.E.R.A.
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<unk> is included as an appendix to todays slide presentation and in the earnings press release.
I'll now turn the call over to Mercury's, President and CEO Mark Aslett, Please turn to slide 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 your questions.
Fiscal 2019 was another very successful year for Mercury, we ended the year with strong results in the fourth quarter, including record bookings backlog and revenue.
The industry environment is positive in our strategy and business model are performing extremely well.
Our total revenues continued to grow faster than the industry average organically revenue for fiscal 19 was up 12% compared with 7% in Fyeighteen.
We supplemented this high level of organic growth with strategic M&A, completing four acquisitions, while also making solid progress integrating previously acquired businesses.
After reloading the balance sheet with our recent equity offering with strategically well positioned for continued organic and M&A driven growth in fiscal 20.
The acquisition of American panel Corpora Corporation, or APC, which we expect to close later this quarter is another great example of our strategy in action. It's also the latest step forward in our plan to build out an industry leading supply business.
With that as background lets turn to our financial results on slide four starting at the fiscal year level.
Total bookings and revenue for fiscal 19 were up 39% and 33% from Fyeighteen, respectively. Both hitting all time Records Mercury's book to Bill for acquiring 19 was a strong one point to our year end backlog increased 39% to record levels. There was also a great year for new design wins, which totaled more than $1 billion in potential lifetime value.
On the bottom line GAAP net income for fiscal 19 increased 14% year over year, adjusted EBITDA was up 27% hitting a new record.
Free cash flow more than doubled to 49% of adjusted EBITDA working capital continued to improve and we significantly strengthened the balance sheet.
For the fourth quarter revenue increased 16% in total and 4% organically year over year.
Absent certain revenue that moved into Q4 fiscal 18, our organic growth would have been 12%.
Our largest revenue programs in the quarter was SEAWIP filthy Buzzard F 35, and next generation missile system and aegis.
Q4 was an effective an exceptionally strong quarter for bookings, which exceeded $200 million for the first time.
Total bookings were up 41% year over year, leading to a record backlog and a book to bill of 1.36.
Our largest bookings programs in the quarter were for classified radar program in two D. Hawkeye Filthy Buzzard F 35 and Triton.
Mercury continued to deliver strong levels of profitability in the quarter with adjusted EBITDA up 1% from a strong Q4 fiscal 18.
Free cash flow came in at 45% of adjusted EBITDA.
Turning to slide five.
We continue to be successful acquiring and rapidly integrating businesses that fit well with our strategy.
The pace of acquisitions has picked up in recent quarters.
Including APC, we will have completed five transactions in the last 12 months totaling $228 million of capital.
Over the last five years again, including APC, we deployed more than $800 million and 11 acquisitions.
As a result, we have increased total revenue and adjusted EBITDA at compound annual growth rates of 26% and 46% respectively.
We've also had a positive book to bill in each of the last five years and have averaged 10% organic revenue growth.
Our model of strong margins and high organic revenue growth supplemented with disciplined M&A in full integration is the embodiment of our strategy.
We believe this strategy will continue to generate significant value for our shareholders over the longer term.
Our current focus in M&A is to build capabilities and scale in the seaborne market.
We continue to build out our rugged secure server business and as well our new business focus on mission computing and avionics processing.
This business consists of CES RTL gecko avionics and now a PC.
As we've done in sensor processing subsystems, our goal in the avionics processing space is to build our industry, leading solutions using open systems architectures. They should meet our customers demand for next generation technologies more quickly and more affordably.
Turning to slide six acquiring APC advances us further in this direction in an area, where the supply chain Delayering, we've talked about is beginning to take hold.
CES RTL in gecko focus on providing safety certifiable avionics processing capabilities.
APC complements these capabilities by providing very advanced ruggedized displays for the mental military aerospace ground vehicle and commercial aerospace markets.
APC was founded in 1998 and is based in Alpharetta, Georgia, they're a leading innovator in large area display technologies that are increasingly deployed on a wide range of next generation platforms.
In addition, their products are incorporated into a wide range of established platforms, including the Apache attack helicopter. The F 15 F 16, F 18, and F 35, as well as the Abrams Battle tank.
We're very pleased to welcome the APC team to the Mercury family.
The business employs around 100 people they generated approximately $36 million of revenue over the 12 month period ending June 2019.
The purchase price of $100 million was entirely funded with cash on hand. This represents about 10 times apc's LTM adjusted EBITDA net of the expected tax benefit.
Acquiring APC will enable us to complete compete for larger avionics opportunities as well as play a more significant role in military digital convergence.
Turning to slide seven for an operational perspective, we continue to make solid progress integrating prior acquisitions and investing in the business for future growth.
Over the past five years, we strategically focus our growth investments on building out our own domestic manufacturing capabilities.
We've now begun a multi year journey to improve both working capital efficiencies on the manufacturing operations themselves.
These assets include our West Coast RF manufacturing locations, where we expect to complete the consolidation activity in the first half of fiscal 20.
They also include our advanced Microelectronic Center in Phoenix here, we complete the build out of our trusted digital lesson capability and an in source the manufacturing of Mercury secure processing product line.
The other type of manufacturing, we do in Phoenix is trusted custom microelectronics, we plan to make additional capital investments in this part of the business in Fytwenty onto Fivetwenty one.
Our goal is to become the leading conduit for the silicon innovation, that's occurring in the high Tech commercial world for use in size the defense industry.
Commercial silicon vendors, a struggling to deal with the low volumes and complexities of the defense industry defense on the other hand desperately needs access to commercial innovation and investment. We believe Mercury is strongly positioned to address this need given that we are a high tech company that operates in the defense industry.
Our plan is to expand our trusted microelectronics capabilities in Phoenix to develop and grow this area of the business.
It's an area that we believe has significant long term potential to mercury from an innovation and financial perspective, as well as to the defense industry.
At the same time, we continue to focus on acquisition integration, we're making solid progress Tennyson jemaine has been substantially integrated.
The migration to Mercury's business systems and processes are complete and we expect to achieve Defar security compliance for these businesses in the first half of this fiscal year.
The combined tennis and domain business is performing well operationally and financially we have a great team in place and we're executing against our value creation blueprint.
This is focused on improving the margin profile of the business over time, while introducing mercury's industry, leading embedded security capability into their rugged server product line.
The second way beyond ex integration is underway and on track as well the business is off to a strong start weve seen some interesting avionics processing opportunities as a result of the acquired assets we've assembled.
It's still early days, the Athena instant tonic integrations, but both businesses are on track with where we thought they would be at this point in time.
Turning to slide eight we continue to be in the most favorable defense funding an industry growth environment I've seen since joining mercury.
We're pleased with the recent two year bought defense budget deal defense Appropriations authorizations and outlays are trending higher.
We're also seeing increased investment accounts spending the spending prioritizes modernization and next generation technologies and capabilities, which in turn favor Mercury.
All of this is leading to a high level of new program starts and design win activity and substantial growth in the estimated lifetime value of our top 30 programs and pursuits.
This organic and M&A driven growth reflects the impact of three industry trends that we discussed in the past.
These and trend East trends include first as I mentioned supply chain delayering by the government and the primes second the flight to quality supply is buying the primes and most important increased outsourcing by our customers at the subsystem level.
Our sub system revenues increased 85% year over year in fiscal 2019% to 44% of total company revenue.
We continue to see outsourcing is the largest secular growth opportunity in defense.
Mercury's also strongly position in well funded defense budget priorities among them radar and E.W. modernization weapon systems secure rugged service mission computing and avionics processing.
The level of market activity remains very high a major driver being radar modernization one of our key customers receive their first production award for our own the Isa Airborne radar processing application in Q4.
This enterprise architecture has been in development for some time and will be used across multiple programs.
We're also beginning to see significant design win opportunities in the missile defense domain with upgrades of ground based radars and command and control.
In these areas R&D strategy is based upon the belief that more of the technology that goes into us military platforms will need to be secure as well as designed and produced in the U.S.
We are pursuing this opportunity by making significant investments to develop secure hardware and software technologies domestically.
Our customers are responding in kind by supplementing Mercury's high level of internally funded R&D with R&D of their own.
As a result of this substantial combined investment we've been able to rapidly adapt our commercially available technologies to these new and emerging opportunities.
Both our target markets continue to grow faster than the defense market overall sensor to affect the revenue accounted for 62% of total revenue in Q4, increasing 17% from the fourth quarter last year.
In supply revenue increased 32% year over year to 26% of total revenue.
At the full year level, censoring effect and Sify revenues increased 18% on a 110% respectively.
Turning to slide nine and looking forward.
Our business outlook remained strong driven by the high levels of new design win activity and opportunities for organic growth.
Over the longer term our baseline forecast is for overall defense spending to increase at a low single digit rates.
Mercury's goal is to continue delivering organic revenue growth at a rate that exceeds this industry average.
We're also well positioned to continue supplementing our high level of organic growth with smart strategic M&A.
The M&A pipeline remains very robust we continue to see interesting opportunities of varying sizes that are consistent with our strategy with APC being the most recent example.
We intend to remain active and disciplined in our approach to M&A focusing on the censoring effect emission systems Unsi for end markets as we have in the past.
We continue to look for deals that are strategically aligned have the potential to be accretive in the short term and promise to create long term shareholder value.
Overall, our strategy and business model are working extremely well.
We remain confident that we can achieve the high end of our model over time by continuing to execute our plan in five areas.
First is to drive high single digit low double digit organic revenue growth supplemented by acquisitions.
This is consistent with a 26% compound annual growth in total company revenue we've delivered over the last five fiscal years.
The second is to invest in new technologies, our facilities manufacturing assets and business systems. We will also continue to invest heavily in our people.
Mercury's become a destination employer under an acquirer of choice.
Our ability to attract and retain the talent we need to support our growth has never been better.
Third is manufacturing in sourcing as well as driving strong operating performance across our manufacturing locations. The goal here is to enhance margins and on time delivery, while improving working capital efficiencies over time.
Fourth we're ensuring that revenues grew faster than operating expenses, creating strong operating leverage in the business and finally, we're fully integrating the businesses, we acquired to generate cost and revenue synergies.
These synergies combined with other areas of the plant should continue to produce attractive returns for our shareholders.
So in summary, we will continue to execute on this model has been so successful for us over the past five years, we're anticipating another year of double digit growth in revenue and adjusted EBITDA in fiscal 20, including at least 10% organic revenue growth.
Mike will take you through the guidance in detail and so with that I'd like to turn the call over to Mike Mike.
Thank you Mark and good afternoon again, everyone.
Mercury concluded a great fiscal 19 with strong financial results in the fourth quarter, including record bookings backlog and revenue.
Operating and free cash flow were also strong and aligned with our expectations.
In addition, our record operating results. It was an active quarter for acquisitions and balance sheet reloading, we announced and closed this internet can at Dana transactions and completed negotiations with American panel Corporation.
We also raised 455 million of proceeds in a follow on equity offering providing the financial flexibility, we need given the strength of our M&A pipeline.
As a result, mercury is well positioned to deliver another year of growth and profitability in fiscal 20.
Turning now to slide 10, and our Q4 fiscal 19 results Mercury's total bookings increased 41% year over year to a record $241 million driving a 1.36 book to bill ratio.
We ended the quarter with a record backlog of $625 million.
Up 40% from Q4 fiscal 18.
Total revenue for Q4 increased 16% year over year to a record $177 million exceeding the top end of our guidance of $164 million to $173 million.
Organically revenue increased 4% from Q4 fiscal 18, which benefited from $11 million of revenue that slipped from Q3, excluding that $11 million in Q4 last year organic revenue for Q4 fiscal 19 would have been up 12% year over year.
Gross margin for the fourth quarter was 45.1%. This is above our guidance of 43.6% to 44.5% and above our gross margin of 44.7% in Q4 last year.
The increase from last year, largely reflects the program mix and operational efficiencies.
In Q4, R&D was up sequentially by 2.9 million growing to $20.3 million from $17.4 million in Q3.
R&D as a percentage of sales was 11.5%.
Looking forward, we expect to continue to invest a high level of R&D to take advantage of the numerous organic growth opportunities we are seeing.
As DNA for Q4 was up 12% to 30.7 million from $27.4 million last quarter.
This increase was driven by the inclusion of the tenants in tonic as well as the additional investments we've made in the business.
GAAP net income and GAAP EPS in the fourth quarter increased 27% and 19% year over year, respectively.
Adjusted EPS for Q4 was 47 cents per share.
Adjusted EBITDA for Q4 was $37.9 million exceeding our guidance of $34.1 million to $37.1 million as a result of higher than expected revenue and gross margin.
Adjusted EBITDA margin was 21.4% for the quarter at the top end of our guidance of 20.8% to 21.4%.
Putting this in context Mercury's overachievement on the topline has given us the flexibility to invest in the business, while still exceeding our expectations for adjusted EBITDA.
As we prepare for continued organic and M&A related growth, we are investing in R&D, our Salesforce program management, HR and finance as well as operations.
Given these investments coupled with our growth momentum.
We're well positioned to continue to deliver on our financial model high single digit low double digit organic revenue growth adjusted EBITDA margins above 20% and continued strategic M&A.
Free cash flow, which we define as cash flow from operations less capital expenditures was also strong in the quarter.
Capital expenditures were $8.8 million in Q4 fiscal 19 or 5% of sales.
The higher Capex. This quarter was primarily driven by consolidation of our west coast RF manufacturing locations, which we expect to complete in the first half of fiscal 20.
Turning to our full year results on slide 11.
Fiscal 19 was another excellent year for Mercury with record bookings backlog revenue adjusted EBITDA, adjusted EPS and free cash flow.
Total bookings increased 39% year over year to $783 million driving a 1.2 book to bill ratio.
Backlog at year end was $625 million up 40% from fiscal 18.
Total revenue increased 33% year over year to $655 million exceeding the top end of our guidance of $642 million to $651 million.
Mercurys organic revenue growth was 12% year over year.
Gross margin for fiscal 19 was 43.7% above our guidance of 43.3% to 43.5%. This compares with 45.8% last year. The decrease from fiscal 18 is due to the inclusion of Germain systems program mix and a higher level of customer funded R&D.
Internal R&D expense for fiscal 19 increased by $10.1 million year over year as a percentage of sales R&D decreased from 11.9% in fiscal 18% to 10.5% this year.
The percentage decrease was primarily driven by a higher level of customer funded R&D in fiscal 19.
As we've discussed in the past this is a precursor to the higher margin hardware annuities that we expect in the future.
9% in fiscal 18.
Over the last four years, we've been able to reduce SDMA as a percentage of sales from 21% in fiscal 15% to 16.9%. This year highlighting the operating leverage that we continue to build into the business.
GAAP net income and GAAP EPS for fiscal 19 increased 14% and 12% year over year, respectively.
Adjusted EPS increased to a $1.84 per share up 30% from $1.42 per share for fiscal 18.
Adjusted EBITDA for fiscal 19 increased 27% year over year to $145.3 million or 22.2% of revenue at the high end of our guidance of 22% to 22.2%.
Free cash flow for the year was also strong.
Slide 12 presents Mercury's balance sheet for the last five quarters as I mentioned into Q4 was very active from a balance sheet perspective.
We entered the quarter with $277 million of debt and then close the syntactic in Athena acquisitions, which increased our debt to $325 million.
We then raised $455 million of equity, which was utilized to pay down the revolver.
In conjunction with the offering and paying down the revolving debt. We also terminated the 175 million interest rate swap we had in place.
As we enter fiscal 20, we believe mercury is well positioned from a capital structure perspective.
Reflecting strong internal cash generation and the proceeds from our equity offering we have zero debt and $258 million of cash on the balance sheet.
We intend to fund the acquisition of APC with a portion of this cash.
In addition, we have a $750 million unfunded revolver.
This provides us with significant capacity for future growth investments organically as well as through M&A.
Our focus on acquiring businesses that fit with our M&A strategy and integrating them into Mercury is delivering results as planned.
We continue to see a robust pipeline of M&A opportunities.
We're confident that we'll be able to continue to deploy capital prudently and accretive Lee on strategic acquisitions with APC being just the latest example of our strategy in action.
Turning to cash flow on slide 13, Mercury delivered record free cash flow in fiscal 19.
Our Q4 free cash flow was $17.1 million, representing 45% of adjusted EBITDA.
For fiscal 19, as a whole free cash flow was $70.8 million up 151% from $28.2 million in fiscal 18.
Free cash flow as a percentage of adjusted EBITDA was 49%.
Operating cash flow for the fourth quarter was $26 million compared with $25.6 million in Q4 last year and for fiscal 19 operating cash flow was $97.5 million compared with $43.3 million last year.
Working capital for the fourth quarter was a $9 million use of cash compared with $5.8 million in Q3.
For fiscal 19, as a whole working capital was a $22.7 million use of cash compared with $53.8 million in fiscal 18.
This reduction highlights the working capital improvement we've delivered during the year.
Capital expenditures in Q4 were $8.8 million or 5% of revenue.
This was up as expected from 3.7% of revenue for the first three quarters of fiscal 19, reflecting continued acquisition integration and growth related investments.
For the full fiscal year capital expenditures were $26.7 million compared with $15.1 million in fiscal 18.
Ill now turn to our financial guidance, starting with the full 2020 fiscal year on slide 14.
This guidance does not include any estimates for APC, which we announced today, but don't expect to close until towards the end of fiscal Q1 contingent upon HSR approval and other closing conditions.
Based on the estimated closing date, we don't expect APC to have a material impact on our Q1 results, we will provide updated guidance, including APC on our next earnings call.
As you can see we're expecting another record year in fiscal 20, we're anticipating strong revenue growth both organically and overall.
We expect to continue investing in R&D and SDMA to take advantage of the organic growth opportunities, we're seeing while at the same time continuing to deliver record results.
In fiscal 20, we expect revenue to progressively increase throughout the year and the percentage split between first and second half revenue to be similar to fiscal 19.
As such we expect operating leverage to improve on a quarterly basis with adjusted EBITDA margins, expanding as we grow revenue faster than expenses.
Looking further ahead, we believe the investments we are making this year well positioned mercury well to continue to expand adjusted EBITDA margins over the next few years.
With that as background starting on the top line for the full 2020 fiscal year. We currently expect revenue of $740 million to $760 million representing growth of 13% to 16% from fiscal 19.
As Mark said, we're expecting at least 10% organic revenue growth for the year.
Consolidated gross margin for fiscal 20 is currently expected to be 43.6% to 44.2%.
Based on our current revenue forecast, we expect Mercury's gross margin to continue to reflect the organic growth dynamics Mark discussed heightened new design win activity more new program starts in the mix and recent acquisitions.
That said as the year progresses.
We expect incremental gross margin expansion as a result of operational efficiencies as well as several programs transitioning from the engineering phase in the higher margin production phases.
Consolidated operating expenses for fiscal 20 are expected to be $235.2 million to $240.2 million, including an estimated $27.6 million of amortization expense.
In fiscal 20, we expect R&D as a percentage of sales to increase to approximately 11% compared to 10.5% in fiscal 19.
We expect the percentage to be higher in Q1, and progressively decline as a percent throughout the year as revenues grow faster than R&D.
We expect SGN as a percentage of sales to be approximately 17% similar to fiscal 19 results.
We expect this percentage to be higher in h., one than in H. too.
Our guidance assumes interest income for fiscal 20 of approximately $5.6 million. This excludes the impact of the cash purchase price for APC and any additional acquisitions during the year.
Total GAAP net income on a consolidated basis for fiscal 20 is expected to be $66.5 million to $72.4 million or $1.20 to $1.31 per share.
Adjusted EPS is expected to be in the range of $1.97 to $2, an eight cents per share.
Our fiscal 20 guidance for consolidated adjusted EBITDA is $160.5 million to $168.5 million or 21.7% to 22.2% of revenue.
This is an increase of 10% to 16% from fiscal 19.
On a quarterly basis, we expect fiscal 20, adjusted EBITDA margins to progressively increase throughout the year.
We expect Capex for fiscal 20 to be approximately 5% of revenue weighted towards the first half.
Fiscal 2000, Capex will reflect our continued investment in the consolidation of our West coast RF manufacturing locations, which we expect to complete in the first half of the year. We also expect to invest in our trusted microelectronics capabilities in Phoenix as well as our corporate headquarters to accommodate the increased development work, resulting from recent design wins.
Turning now to our first quarter guidance on slide 15, we are forecasting consolidated total revenue in the range of $160 million to $170 million.
Q1 fiscal 20 gross margins are expected to be 43.5%, which is up from 42.8% in Q1 fiscal 19 as a result of favorable program mix.
Q1, GAAP net income is expected to be $11.5 million to $13 million or 21 to 24 cents per share.
Adjusted EPS is expected to be 39 to 42 cents per share.
Adjusted EBITDA for Q1 is expected to be $32 million to $34 million, representing approximately 20% of revenue.
For the full year, we expect our adjusted EBITDA margin to be 21.7% to 22.2% of revenue.
We expect Capex in Q1 to be approximately 7% of sales as we complete our acquisition integrations and invest in our Phoenix micro electronic business.
In Q1 of fiscal 20, we expect free cash flow to adjusted EBITDA to be approximately 30% to 40% due to year end bonus payments and higher capex for full year fiscal 20, we believe that 50% free cash flow to adjusted EBITDA remains a reasonable target.
Turning to slide 16 in summary, we completed a strong Q4 and fiscal 19 with record bookings revenue and annual cash flow. The guidance I. Just provided reflects the continued momentum were seeing in the business. We completed four acquisitions in the year and are on track in our acquisition integration initiatives. We have been successful in our capital raising efforts and our M&A pipeline continues to be robust.
Our results during fiscal 19 provide mercury the opportunity to continue investing in the business, while still delivering another record performance in fiscal 2000.
With that we'll be happy to take your questions. Operator, you can proceed with the QNX.
Thank you.
Ladies and gentlemen, if you have a question at this time. Please press the star in the 10-Q under its tone telephone.
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And our first question comes from the line of Seth Sigman with JP Morgan. Your line is now open.
Thanks, very much and good afternoon.
I wanted to.
I wanted to ask a little bit about the profitability and.
You laid out some of the incremental R&D ash DNA lower gross margins and the first part of the year.
Maybe you could talk a little bit more detail about sort of the opportunities that emerge.
It sounds like opportunities that emerge during the quarter.
That.
Maybe do you see the.
The utility of the incremental investment.
Yes. So this is mark I wouldn't say it was necessarily during the quarter I think we continue to operate in a.
Pretty dynamic environment from a growth respective clearly we've seen some significant increases in government spending in R&D TNT.
Thus driving a lot of new design win activity in the areas that I'd mentioned in my prepared remarks.
And so we're going to continue to invest in the business from a growth perspective to go capture those new design wins.
So it's a continuation of the theme that we saw throughout fiscal 19.
And then just add that when we entered the year. If you look back at our guidance.
In fiscal 19, our revenue dramatically outperformed what we thought it was going to be as we went through the year saw the opportunities.
As Mark said, we thought it was a good time to continue to to invest in the business because we have the opportunity to do so and still deliver record results.
Sure absolutely and then just as a.
As a follow up then the.
The first quarter margin EBITDA adjusted EBITDA margin versus the full year margin implies an exit rate at the end of the year that.
Kind of nicely above.
The the guide for the full year and so.
I mean would you think of the full year as kind of a go forward type of margin or at or think of the first half investment that we are seeing is a little bit more of a.
One time and having the exit rate be more of a go forward margin.
Yes, no I think set the way you're going to see through the year.
Talk a little bit about it in the prepared remarks.
Is this a couple of dynamics first is when we talk about the revenue split in we think that in fiscal 20 is going to be similar to fiscal 19. So if you look back it was around 40, 546% nature one.
Gross margins for the year.
Guidances midpoint is about 44%.
And 43.5% for Q1, so we expect some increase.
In the second half as the as you said to average 44% gross margin for the year. So we see that picking up through throughout the year.
R&D I mentioned about 11% of sales for fiscal 20 was 10.5% in fiscal 19.
And if you look at the increase in Q4 of fiscal 19, and you run rate that you will see that we've already made some investments. So the ramp up to 11% is almost just run rate in Q4, and then adding some some small growth to that but as you say on a percentage basis, we expect that to come down as revenues grow but the R&D doesn't grow as fast and then SDMA is the other piece of it which I mentioned would be about 17% of sales that's flat with 19.
But since we expect revenue to be greater and H. Twod and H one the percentage of SDMA will be a little higher and H one than than low and lower in age too so at the EBITDA level.
You're going to see the same trend that you're picking up on 22% for the year, we guided 20% in Q1.
So we'd expect H one to be lower in the second half to be higher and I think what you're seeing when you step back from all of that is the operating leverage that we're building into the business. So you are really going to see it.
We think in the second half.
Of fiscal 20, because we're making the investments now and then we think will be incredibly well positioned going into fiscal 21 and beyond.
So I think we do as Mike said in his prepared remarks that we do see the opportunity for EBITDA margins to expand in the out years, just given the operating leverage that we see in the business.
Now that being said is is I said, just literally ILEC and the question that you Australia, there's a lot of opportunity to invest if ross to continue.
To grow the business organically at well above the industry average growth rates and when we see those opportunities.
Yeah, we're probably going to lean in.
Excellent thanks very much.
Thank you and our next question comes from the line of Jon Raviv with Citi. Your line is now.
Hey, Thanks, guys and good afternoon.
Hey, how are you.
Just following on the on the margin question.
Can you just clarify some of the language in the slides feel between.
Staying above 20% versus driving to the higher end of that business model range is that sort of the difference between.
Say mid term in or near to mid term versus longer term aspirations.
Yes, I mean, I think from from an EBITDA perspective.
John Nothing's changed and we want to drive and continue to increase EBITDA margins.
Over the over the long term.
In Q1, we were at 20% as our guidance and as we just discussed we see that ramping up throughout the year.
So we see the the operating leverage in the business and we want to continue to grow that fiscal 21 and beyond and as I mentioned that we think you'll see some of it.
In H. two this year.
As we currently seen it seeing it play out so no no contradiction from our perspective in terms of wanting to continue to grow EBITDA.
To the high end of ranges. So if you remember John in the non Investor presentation. We've got an inverted pyramid slide that compares to kind of Mercury's financial profile.
With Dod of all publicly traded companies as well as an index of Tia to defense companies that particular, slide references and EBITDA margin greater than 20%.
So it's kind of consistent with the performance that we have delivered which has obviously been above that number.
Got it understood and then also could you guys offer some perspective on industry, M&A, which seems to be probably based on financing internal investments and creating investment pools to go after opportunities.
Please offer some perspective on the risk is opera risks and opportunities in that dynamic as it seems like combining businesses to drive more of their own erad would on it on its face sounds like it's an opposition to your strategy to capture more outsourcing so any thoughts on industry M&A and on the prime so be it would be great for that thank you. Yeah, clearly I think we're in an environment that is requiring.
Great a level of investment is you know yes.
Mercury is probably got one of the highest internal R&D to revenue spend ratios, but its probably double.
The.
On a percentage basis.
The next closest company. So I do think there's been some loaded tool.
And potentially some transactions driven by that we feel really good about the position that we're in I mean, we're investing significantly in the business to put it in perspective on a cumulative basis over the last five years, we've invested over $285 million on R&D you know, we've invested over 95 million on Capex.
When including APC $800 million of capital and M&A. So for a combined total of close to $1.2 billion.
And we're focusing not investment in a very very specific.
Set of areas, which is building.
Are these very sophisticated processing subsystems for use on board platforms. So we think that the investments that we're making.
A very significant and far outstrip all the companies in the space and we think its a primary reason that actually the rate of outsourcing is increased leading to the substantial growth that we saw in off subsystems revenue year over year.
Yeah, which result, 85% compared to fiscal 18, so yes, I think investment is important in this environment.
And we feel that we're well positioned Joan.
Thank you.
Thank you and our next question comes from the line of Sheila Kahyaoglu with Jefferies. Your line is now.
Thank you and good afternoon.
Hi, Thanks, I was just wondering if you could expand upon your comments.
Within the Phoenix.
Facility and expanding that manufacturing capability, what that adds to your vertical integration.
Capacities then maybe.
How you guys think about Capex and building that out on your own versus doing a deal to do so.
Sure Sheila so.
As I said in my prepared remarks is actually really two different types of manufacturing capabilities that we have in Phoenix. The first is the digital eseventy capability that we have build out over the last couple of years.
The primary driver of that is you know which is for us to be able to in source the manufacturing of off secure processing product line.
Which we've largely completed.
What we talked about on the call from an expansion perspective was really the all the ports of the Phoenix facility.
That really came to us to gain through the acquisition of the Microsemi Carbout assets.
And what we see here is the opportunity of growing substantially all custom microelectronics capability and what we see happening in the in the commercial world is actually an explosion.
In the amount of specialized silicon.
Whether it be for AI for autonomy for.
Machine learning for mixed signal applications.
And the defense industry desperately needs to get access to that and so what we're doing is kind of positioning ourselves.
Given that were horizontal company inside of the industry and operating as a high Tech company to become the leading conduit for the up the capability into the defense industry. So we're going to build up the capability set that we already have but expand that.
To become not to become the leading company.
Got it and then.
Just on APC, maybe if you could talk about what opportunities it opens up.
How it combines with get though and.
Who you're competing with their show so us. Some so we are combining it together we will combine it together with the other acquisitions that we've done with the space those specifically CES.
With RTL and most recently gecko avionics and we're looking to be able to provide a full set of capabilities.
In a in the avionics suite and to do the job providing it to our existing customers and what we see happening.
Is that this is we talk about it from a trend perspective this de layering occurring.
Certain companies in this space would actually like to deal directly with companies at the tier two as opposed to buying a complete fully integrated tier one solution.
So it allows them to do things more affordably, probably more quickly.
And to add some of their own value and so what the APC acquisition gives off.
He is our access to some of the display technologies that complements.
Sort of the the processing capabilities in avionics and mission computing that we previously acquired.
Thank you.
Thank you and our next question comes from the line of Peter Arment with Baird. Your line is now open.
Yes. Thanks.
After remarks, Mike.
Hi, Peter.
Hey, Mike just a clarification on the Capex, you said, you're targeting the 5% level.
I thought that was originally the target for fiscal 19 did some capex shift out or just.
Maybe you could just clarify that first.
Yes, It did Peter I mean, so we are expecting 5% and in fiscal 2008 came in a little lower than that around 4% in fiscal 19 main reason for that is the west coast to facility consolidation that we've been talking about pushed out a little bit from the second half of this year into the first half of next year and that's really what's driving that.
Got it and then on just I know you don't formally give a free cash flow guidance, but is still the kind of the targeting at 50% of.
Adjusted EBITDA is still a good bogey here when we think about fiscal 2000.
Yes, Thats what were shooting for and I did point out that Q1 is going to be lower.
So of the 5% Capex for fiscal 2008 is going to be front end loaded primarily because of the west coast consolidation that slipped from this year into the beginning of next so capex in Q1.
Throughout a number around 7% as an estimate and so thats going to put some pressure on free cash flow conversion in Q1, So I mentioned, 30% to 40%, but for the year, even though we're expecting 5% of Capex, we still are targeting the 50% free cash flow to adjusted EBITDA conversion rate.
Got it and then mark on APC.
Kind of the end market mix it sounds like it's heavily defense oriented, but there is also a little bit of commercial.
Can you give us a little color on that or how much there is of of commercial yeah. So.
So the defense market is 80% commercial is 20%.
Okay and of that commercial pieces, it and is it on.
A larger commercial aircraft programs are bizjet or what exactly so.
737, Athree hundred 20 is an example.
Got it.
And just.
Comfort level for having some of that commercial.
You.
Just historically I think you've always focused on the on the defense piece.
So in the avionics via the strategy is really around aerospace and defense.
Yeah, I think that thought target market in total obviously were heavily weighted towards defense today, but we do see opportunities the business with that box. As an example has grown very substantially over the last few years as a result of the CES acquisition that we did over in Geneva, and we see additional opportunities. So.
Yeah, It's primarily defense, but you know the the aerospace exposure just given what they do is welcome as well.
Great color nice quarter. Thanks, Okay. Thanks, Peter.
Thank you and our next question comes from the line of Ken Herbert with Canaccord. Your line is now open.
Hi, good afternoon.
Hi, Ken.
Mike I just wanted to follow up on the free cash flow question I mean, it looks like.
The guidance implies maybe five to 10 million ish in terms of working capital benefit in 20.
You, obviously had a had a really good year and working capital of 19.
Are there other opportunities to maybe do a little bit more with working capital then in 20 or as you know the investments in the first half maybe just driving a little bit more caution there.
I think that.
So we did have good improvement in working capital in fiscal 19 compared to fiscal 18 as you'll recall in fiscal 18, we were building up a lot of the inventory associated with the in sourcing.
So we're pleased with where we are from a working capital perspective, again, but we do still see.
Additional opportunities and one of the areas in terms of the Opex, where we're investing in.
Is our is our operations and we've talked about also some of the facility consolidation and we see opportunities on the inventory side that we're focused on right now there's tweaks other where in terms of dsos that were focused on but really I think the opportunity. We see is on the inventory side.
And would it be fair to assume just based on your comments around timing and margin that that should accelerate as we go through the year and maybe more of an improvement in the second half of the year.
Yeah, I mean, obviously, we're not guiding the timing of it but yes, I do think that we should see gradual improvement.
In terms of inventory turns as we go through the year.
Okay, great. Thanks, and if I could mark just one question I mean, you called out outsourcing, which is obviously something you've called out as an opportunity.
For many quarters and it clearly seems like Thats, playing out but I'm just curious with where we are with the budget with clearly some of the pressure on primes in the growth. They're seeing have you seen and then inflection in those opportunities recently or is there anything in particular, you can maybe point to that we could we could watch out for is that is that maybe steps up I mean I agree it's a secular trend, but I'm just curious how you've seen that play out here recently, just considering the budgets and the strength and the bookings that your customers are saying yeah. So we think it is picking up and I'll give you a couple of examples I mean this this past quarter.
We want to enterprise secure processing rate all.
Applications for two different customers. So literally it are they going to base. The next generation radar processes around away and outsourced Mercury solution.
Yeah, both of which are actually examples of the outsourcing trend what we see.
It's a little counterintuitive, you would think that with growth maybe they would be.
To bring more work in house, but it's actually the opposite.
Although they are actually hiring.
Customers, they're not hiring quickly enough.
To even address the aging workforce and there is a growing skills gap.
If the sorts of stuff that we do.
We've also seen it.
Clearly an increase in the use of OTI a contracting.
OTI, a cone trucks that are requiring.
The defense primes to basically embedded.
Funds.
Yes.
Pardon.
Larry.
With that.
So.
Yes.
I think that.
Correct.
Thanks.
With that.
The book.
Total defense contractors, which obviously Mercury is and then finally I think the other thing that is driving the outsourcing trend is the greater need for agility and speed in these next generation competitions and not plays very very nicely with our technology development model, So outsourcing is alive and well.
As I mentioned, we have 85% growth.
You know subsystems business.
For fiscal year 19, it was up 51% in Q4 alone. So you know we're pretty excited about what we see happening and we're very well positioned.
Great. Thank you very much for the color.
Thank you.
Thank you and our next question comes from the line of Michael.
Sure Michael Ciarmoli. Your line is with Suntrust. Your line is now open.
Hey, good evening guys. Thanks for taking the questions here nice nice quarter nice bookings.
Mark just on just on the PC, Tim could you maybe tell me a little bit more on the strategic fit I mean the.
The price tag.
Three times sales or 11 times EBITDA, you know I've always thought of displays being a little bit more commoditized. There the platform exposure seems to be a little bit more legacy.
Just.
You mean in the comments you gave you sounded like you wanted to give some of your customers on the option of not going to the full integrated tier one. So I guess, you really don't need the scale to compete there, but just just may be a little bit more I mean, it seems like there's so many other areas I mean, you threw out autonomy artificial intelligence machine learning.
Whether it's secure computing it just seems like there's so many other market channels and silos to bill White white displays.
So it's important because it ties back to the de layering trend you know what we see at a very high level is that the government on seven of the primes want to move away from kind of vendor lock, where this proprietary into pet into dependent architectures that is resulting in a low a technology refresh rates.
And the introduction of new capabilities, then waltz, the government and certain crimes would like.
And the actual display technology is a key gateway they've been able to odd new technology and the associated processing onto the platform whether it be for different weapons applications all for different types of senses.
The census themselves are going through a complete kind of refresh two from really more small is standalone type units into what is known as large area displays. These large area displays needs to be highly ruggedized.
Ill touch capable capable of operating at heads up display type capabilities, while still providing redundancy and APC is going to very unique set of technologies and capabilities.
Not only in some of the you know the platforms that I mentioned, but also on near the trainer.
Blackhawk.
And all the other platforms. So we think it's strategically important it's a natural extension of the mission computing capability in the avionics processing capability that we have.
And our customers are asking for it Mike.
Got it got it okay. That's helpful.
Just one more on the gross margins you've got the long term target, 45% to 50% we've sort of been.
The lower end of that range.
Is that is at the upper end to that range. You know do you think is it still reasonable given that what we're looking at is going to be some significant investments in new weapons systems, new capabilities, you're going to have that mix shift with with new programs start.
Obviously, it will be a very good thing for revenue growth and bookings but.
Does that naturally keep the margins, maybe a bit more depressed as I sort of some of that mix shift change or design wins keep on coming in you take more fee right over time.
Yes, Mike I'll take a I'll take a cut at that one I mean, I think that if you look back on gross margins, where we've been.
They have come down as you know over the last couple of years because of what you just said right. It's that it's the new program wins, we've seen a little bit of pressure from some of our acquisitions like Germain, but the big driver is the additional customer funded R&D.
And we've always said, we like to customer funded R&D, because while lowers gross margins. It is the precursor to the hardware higher margin hardware annuities that we will see over the years and what we've always talked about is that will when those transitions specific program that the margin should increase over time, but what we are seeing is we are seeing an incredible level and we're looking at in fiscal 20 as well as new program starts and you can see that in our guidance for gross margins for the year.
So I think that when when you look at our portfolio contracts. We continue to think that we've got a lot of new contracts that transition, but we continue to see a lot of opportunities and you can see that on the gross margin guidance for fiscal 20.
So I think the way to think about as we talked about on prior calls is that.
Gross margins kind of hovering where it is.
It is we continue to grow the business over time, you will see the operating leverage you'll see EBITDA margins continue to expand that's the goal.
Got it got it very good thanks, guys.
Thank you.
Again, if you have a question. Please press Star then one can you touch tone telephone.
And our next question comes from the line of Jonathan Ho with William Blair. Your line is now open.
Hi, good afternoon.
Just wanted to start out with a higher level questions. As we think about the implications of having more subsystem or revenue can you give us maybe a sense of what that means for your margins and maybe ability to expand more content.
Yes, so the shift towards subsystems is really driven a pretty substantial growth in terms of all content on a program basis as well as the potential lifetime value of the programs.
If you're in an early stage of that sub system design and development, yeah, either that we're funding or getting additional funding from from our customers in the form of sea Rod.
We typically see some gross margin.
Yes pressure, but as those subsystems actually transition into production.
Which we have a number of those.
You are likely to occur during fiscal 20, you start to get the benefit of that higher margin annuity. So we think that the shift towards subsystems, which is really where the outsourcing occur is occurring is critically important to our growth.
As well as scaling the business over time, Jonathan So it's a good thing.
Got it and then just relative to APC, how do we think about the longer term operating margin profile or EBITDA margin profile compared with the other lines of your businesses and are there similar maybe cost opportunities on that side.
Yeah, so actually APC in EBITDA level is.
In line with our model, it's actually slightly accretive to where we are right now.
And so it's a nice business they've got great technology, they've got some amazing programs and we see a really good fit so.
It's a good good business.
Thank you.
Thank you Mr. as 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 for listening everyone. We look forward to speaking to you again next quarter take care.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude todays program. You may all disconnect everyone have a great day.