Mercury Systems Q2 2024 Earnings Call Transcript

Quartr
Provided by Quartr
February 6, 2024

There are 8 speakers on the call.

Operator

Good day, everyone, and welcome to the Mercury Systems' Second Quarter Fiscal 20 24 Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the company's Executive Vice President and Chief Financial Officer, Dave Farnsworth. Go ahead, Mr. Farnsworth.

Speaker 1

Good afternoon and thank you for joining us. With me today is our Chairman and Chief Executive Officer, Bill Ballhaus. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website atmrcy.com. The slide presentation that Bill and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations. Turning to Slide 2 in the presentation, I'd like to remind you that today's presentation includes forward looking statements, including information regarding Mercury's financial outlook, future plans, objectives, business prospects and anticipated financial performance.

Speaker 1

These forward looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward looking statements should be considered in conjunction with the cautionary statements on Slide 2, in the earnings press release and the risk factors included in Mercury's SEC filings. I'd also like to mention that in addition to reporting financial results in accordance 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.

Speaker 1

I'll now turn the call over to Mercury's Chairman and CEO, Bill Wallhouse. Please turn to Slide 3.

Speaker 2

Thanks, Dave. Good afternoon. Thank you for joining our Q2 FY 'twenty four earnings call. Today, I'd like to talk through 3 topics. 1st, some introductory comments on our business and results.

Speaker 2

2nd, an update on the progress we are making in each of our 4 priority areas, delivering predictable performance, building a thriving growth engine, expanding margins and driving improved free cash flow and third, expectations for our performance both for FY 'twenty four and longer term. Then I'll turn it over to Dave, who will walk through our financial results and guidance in more detail. Please turn to slide 4. As I've said in the past, while FY 2024 is a transitional year, I'm optimistic about our strategic positioning as a leader in mission critical processing at the edge, the attractiveness of our business model and our outlook over time to deliver predictable organic growth while expanding margins and robust free cash flow. During Q2, we made solid headway in each of our 4 priority focus areas and in addressing what we believe to be the 2 transitory dynamics in our business I referenced last quarter, transitioning our high mix of development programs to production and converting our high level of working capital into significant cash flow.

Speaker 2

We believe this progress is evident And three highlights from the quarter, strong bookings, solid free cash flow and better than expected progress in closing out our challenge programs, most of which are development in nature. 1st, we delivered near record bookings in the quarter with a 1.65 book to bill. Our bookings were anchored by a number of important program wins that we believe will drive future growth. These awards reflect customer recognition of the unique value we deliver, the reliance on us for their most critical franchise programs and ongoing healthy demand. 2nd, we delivered strong positive free cash flow and a reduction in net working capital.

Speaker 2

We generated over $37,000,000 in free cash flow in the quarter, along with an approximately $70,000,000 improvement in net working capital. These accomplishments were primarily driven by strong in quarter collections, reductions in our unbilled receivables and inventory and improved customer advanced payment terms. And third, We are making progress with retiring risk in and completing challenge programs. While the underlying performance of the business continues to be obscured by unanticipated cost growth on a subset of programs, we believe we have largely narrowed these risks From the original 20 challenge programs to one product line with game changing technology that comprises approximately 25% of the original challenge programs. Although we are still working through this remaining set of challenge programs, We anticipate retiring these risks on slightly more than half of the remaining challenge programs in FY24 and entering FY 2025 with a much clearer path to deliver predictable organic growth, expanding margins and strong cash flow.

Speaker 2

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

Speaker 2

Please turn to Slide 5. Following those introductory comments, I'd like to spend time on each of our 4 focus areas. Our first focus area is enhancing execution to deliver predictable performance. In Q2, we incurred a number of costs that obscured the underlying performance of the business. Specifically, we recognized approximately $48,000,000 of such items that we believe are transitory, including nearly $31,000,000 of program cost growth impact across our portfolio, Approximately $12,000,000 of manufacturing adjustments associated with specifically identified inventory reserves and higher scrap due to unfavorable yields and nearly $5,000,000 associated with contract settlements where we worked with customers to transition away from programs where we did not expect to see acceptable returns.

Speaker 2

The 8 items, which again we believe are transitory, represented the vast majority of the year over year decline across our P and L metrics. As a reminder, program cost growth identified within a given period has an overly impact on the financial results

Speaker 3

of that

Speaker 2

period. In accordance with GAAP, there is a cumulative adjustment to reduce progress and align margins on the life to date of the program, which results in a decrease to revenue and gross margin that permeates down to net income and adjusted EBITDA in the current period. Breaking down the nearly $31,000,000 of program cost growth, dollars 14,000,000 of this impact was derived from our challenge programs With nearly all of the impact tied to one single program, approximately $8,000,000 was spread across several development programs and the remaining $9,000,000 related to multiple production programs. The challenge program impact was driven primarily Similarly, the remaining program cost growth was a function in part of revised baseline cost predicated on initial unit deliveries across several development and production programs. In addition, the program cost growth reflects a risk adjusted outlook on program performance and estimates to complete across our program portfolio.

Speaker 2

As shown on Slide 6, with respect to the challenge programs, during the Q2, we made better than anticipated progress by completing, exiting or retiring risk on an additional 4 of the original 19 programs. Together with the floor completed through Q1, we believe we have now retired risk on 8 of the original 19 challenge programs that have driven earnings volatility in recent quarters. For the remaining programs, we expect to close out more than half over the remainder of the The balance of open challenge programs as well as the one program where we experienced significant program Cost growth in the quarter are tied to a common processing architecture. So while we experienced a significant P and L impact During the quarter, we believe we had made progress in isolating the primary go forward development risk in the challenge programs to this one technology area. Of note, our differentiation based on this technology has afforded us SoleSource positions on critical programs, and the functionality we provide is mandated on these programs.

Speaker 2

As such, we and we believe our customers are committed to success in this area. The challenges we are are related to efficiently and cost effectively maturing the manufacturing process to support the transition to scale production on these programs, where we see significant growth potential at attractive margins. Even for the 1 challenge program with cost growth this quarter, The current margin outlook remains above our consolidated program gross margin profile. In addition, this common processing architecture is being developed within an isolated part of our business, representing approximately 20% of our revenue, which has experienced the majority of the revenue and earnings volatility that we saw in Q2 and that we expect to see within the fiscal year. We believe resolving the challenges in this technology will go a long way to restoring growth and profitability in this part of the business and Mercury as a whole.

Speaker 2

So, despite the challenges we're working through and the corresponding investment, We believe we are well positioned as a sole source provider with large growth opportunities and solid margins as we seek to execute on the remaining development efforts and transition these programs to production. Please turn to Slide 7. Turning now to the 2nd focus area of driving organic growth. Bookings for the quarter were a near record $325,000,000 resulting in a 1.65 book to bill. We had several exciting awards for both development and production programs in the quarter.

Speaker 2

2 of our key wins in the quarter are worth noting. We received our 1st production award for LTAMs. This is an exciting and important award coming earlier than originally anticipated. While we don't expect significant revenue from this program in FY 'twenty four, we expect this program to drive organic growth in FY 'twenty five and ultimately become our largest revenue contributor in the future. We also won a large development program on a strategic weapon system, which we anticipate will drive growth in the near term and stronger growth in the future as it transitions to production.

Speaker 2

This program, while well within our technical capabilities, was awarded as a cost plus contract with favorable billing terms of at least monthly, thereby reducing the potential earnings and cash volatility through development. While we still expect the majority of our contracts to be firm fixed price, we are exploring opportunities to take certain development contracts on a cost type basis where appropriate. In addition, as I have discussed before, we are working to incorporate more robust terms in all of our contracts to more clearly define scope, support improved execution and customer satisfaction, and shortened cash conversion cycles. Finally, last week, we received a large follow on award to provide solid state data recorders for a large defense space program. This technology, which was introduced only a few years ago, is now the largest driver of growth in the military space market for Mercury, and we expect further growth opportunities for this unique commercially developed offering.

Speaker 2

These awards are important not only because of their value and impact on our long term growth, but also because they reflect our customers' continued trust in Mercury to support their most critical franchise programs. I mentioned last quarter that this effort to build an organic growth engine will occur over a longer period of time Given the time constants involved with improving book to bill levels and that our near term growth will be fueled by the transition of development programs to production where we are well positioned in the back half of this year and early FY 'twenty five. Demand remains strong and we anticipate the strong bookings momentum to continue through the year. Please turn to Slide 8. Now turning to our 3rd priority focus area, addressing our cost structure to expand margins.

Speaker 2

As we mentioned last quarter, to achieve our EBITDA margin targets, we are focused on the following levers: executing on our development programs and minimizing cost growth impacts, getting back to a historical 2,080 mix of development to production programs, driving organic growth to generate positive operating leverage and achieving cost efficiencies. In Q1, we took a series of actions designed to better align our cost structure with our scale and our financial expectations. These actions are on track to generate $24,000,000 in annual run rate savings, primarily related to SG and A efficiencies. In January, we announced a corporate reorganization in which we streamlined and simplified our operations, consolidating our 2 division structure to a single integrated structure incorporating all of our lines of business and matrix business functions, Reporting into Roger Wells, who was appointed Chief Operating Officer. This integrated approach is designed to clarify accountability and eliminate redundancy.

Speaker 2

In total, we expect this action to deliver an incremental $20,000,000 in annual run rate savings, bringing our total action run rate savings to $44,000,000 of which approximately $24,000,000 to $26,000,000 will be recognized Inside the fiscal year, though we continue to see negative operating leverage in FY 'twenty four given low revenue volume, These structural reductions will be evident in our margin profile as we expect to return to growth in FY 2025 and beyond. Please turn to Slide 9. Finally, regarding our 4th priority focus, to drive improved free cash flow. I am pleased to report that in Q2, we delivered over $37,000,000 in positive free cash flow. We made progress on converting our unbilled receivables, which were down nearly $38,000,000 in the quarter, And we continue to have strong collection trends across our build receivables.

Speaker 2

In addition, we continue to pursue advanced payments on certain contracts, which is reflected in the $23,000,000 increase in deferred revenue in the quarter. In total, net working capital decreased $70,000,000 or over 10% in the quarter. We continue to expect unbilled receivables to burn down through the fiscal year as we apply resources to completing hardware deliveries and especially as we continue to resolve challenge program. We also continue to expect inventory to decline as we receive follow on production awards. At the end of the quarter, we had cash and cash equivalents of 169,000,000 Net debt of $448,000,000 is down $39,000,000 in the quarter, reflective of our free cash flow generation.

Speaker 2

We expect to be cash flow positive for the second half of the year, which we believe will allow us significant flexibility to allocate capital. Please turn to Slide 10. As I've discussed, we continue to make progress on our 4 priority focus areas. Even so, for the 1st 6 months, our revenue and earnings are below expectations, primarily due to higher than expected cost growth and other charges as we retire risk across the portfolio, especially related to our challenging programs. Aside from these headwinds, which we believe I continue to believe this is a business capable of ultimately delivering above average industry growth with lowtomid20 percent adjusted EBITDA margins.

Speaker 2

In the second half of the year, We plan to continue to work on the transitions I discussed earlier, shifting our large portfolio of development programs to production, especially the majority of our remaining challenge programs and focusing our operational capacity on burning down our large networking capital balances, particularly in unbilled receivables and inventory. Turning to guidance, we're going to do this a bit differently for the remainder of the year as we work toward completing these transitions. Based on our first half revenue and our outlook for the second half, We are updating our guidance for full year FY 'twenty four revenue from the prior range of $950,000,000 to 1,000,000,000 to a revised range of $800,000,000 to $850,000,000 The reduction in revenue guidance is based in part on our first half revenue performance, particularly in the Q2, which included significant revenue reductions due to program cost growth. The reduction in revenue guidance is also based on reduced volumes expected in the second half as we continue to apply our operational capacity to advance late stage development programs and shift against legacy unbilled balances. As a reminder, We expect that completing late stage development programs will reduce unbilled receivables, release cash and unlock production revenue, which should drive growth and margins.

Speaker 2

This work is critically important to unlocking value, but we'll continue to deliver little revenue in FY 2024. Let me spend a little more time on the volume reduction because It is significant. As we discussed in Q1, we continue to implement a more cash efficient operating approach with operational capacity focused on completing late stage development programs and releasing unbilled receivables. This approach should generate cash, including the way to higher growth, higher margin production revenue. However, there's little revenue associated with completing this work in the near term.

Speaker 2

In addition, as we look to the second half, We are implementing a more mature process designed to ensure we have a robust, low risk approach The transition from development to scale production, particularly as it relates to the common processing architecture I mentioned previously. This work is important as part of our priority to restore predictability and profitability into the business. We will maintain the flexibility in terms of timing and in some cases cost in H2 to get this right. Turning to our outlook for earnings, including GAAP net loss and adjusted EBITDA. The reduction in our expected revenue range due to the volatility we have seen and expect to continue to see in a small subset of programs related to a single naturally results in a reduction to our GAAP earnings and adjusted EBITDA expectations as well.

Speaker 2

That said, it is difficult to provide reliable guidance estimates beyond revenue for the remainder of the year. Consistent with Q2, we may take additional actions to settle contractual arrangements that do not yield returns or aligned to our long term strategy. We may also make continued adjustments to our cost structure, where appropriate, designed to position us for positive operating leverage in FY 'twenty five and beyond. Our objective for the remainder of the year is to maintain the flexibility to take the steps necessary to complete this work As quickly as possible, in order to position the company for what we believe will be a return to predictable organic growth, improved profitability and strong cash flow in FY 2025. So, we are withdrawing our full year FY 2024 GAAP and non GAAP net earnings guidance, including adjusted EBITDA provided on November 7, 2023.

Speaker 2

As I have said in prior calls, demand remains strong. Our outlook for bookings is unchanged and we continue to expect bookings for the second half with full year bookings expected to exceed $1,000,000,000 In addition, While we expect limited free cash flow in Q3, given the strong Q2 results, we believe we will be cash flow positive for the second half and full fiscal year. As Dave will discuss, total net leverage based on our credit agreement definitions is well within our covenant threshold, And we expect cash generation to strengthen our balance sheet as we progress through the year. As we proceed through the second half of FY 'twenty four, our goals are as follows: complete or retire risk on more than half of the remaining challenge programs Retire the risk associated with the common processing technology I mentioned earlier and validate a highly producible, scalable design that can be released into production and validate capacity requirements and our ability to ramp production against our expected large and growing backlog in Q4 and into FY 'twenty five. Success in these areas, along with consistent performance against internal expectations, will give me and Dave the comfort to reestablish guidance across all financial metrics.

Speaker 2

To summarize, we are pleased with the progress we made in bookings free cash flow in the quarter and expect strong results in these areas for the year. We will continue to assess our organization and cost structure through the second half to position ourselves for positive operating leverage in FY 'twenty five and beyond. We continue to make progress on our challenge programs and are working diligently toward the goal of a quarter free of material program execution volatility in our financial results. We look forward to showing progress in this area when we speak next quarter. With that, I'll turn the call over to Dave to walk through the financial results for the Q2, and I look forward to your questions.

Speaker 2

Dave? Thank you, Bill.

Speaker 1

I'll start with our Q2 fiscal 'twenty four results and then discuss our full year fiscal 'twenty four outlook. As expected, our financial performance in the 2nd quarter was below that of the prior year across all P and L metrics. As discussed in our last earnings call, fiscal 2024 is a transition year where the organization is seeking to execute on both our challenged and development programs and then progress to the following production awards. Through that transition, we expect to recognize the small proportion of remaining revenues on the challenge contracts, but more importantly, we expect to move towards releasing significant working capital balances, especially related to unbilled receivables. We then anticipate shifting our resources to execute on the follow on production awards, which we believe will begin to rebalance our program portfolio more heavily towards higher margin predictable production programs as well as consume existing inventories.

Speaker 1

We continue to expect this transition to occur throughout fiscal 2024 and into fiscal 2025. In Q2, we made meaningful progress towards this rebalance with some positive early indicators emerging. First, our bookings for the quarter were $325,000,000 with a book to bill of 1.65. 2nd, we completed, exited or retired risk on 4 more challenged programs in the quarter for a total of 8 programs through the first half of fiscal twenty twenty four better than the 5 we had expected. We continue to be on track to transition a majority of the approximately 20 challenge programs by the end of the fiscal year.

Speaker 1

Finally, we generated over $45,000,000 of operating cash flow, dollars 37,000,000 of free cash flow and improved working capital by approximately $70,000,000 in the quarter. Cash flow generation in the quarter was primarily a result of strong collections, including a higher volume of customer advances as we successfully negotiated more favorable billing terms on newer awards. With that, please turn to Slide 11, which details the Q2 results. Our bookings for the quarter were $325,000,000 with a book to bill of $1,650,000,000 yielding backlog of $1,300,000,000 up over $160,000,000 or 14% year over year and $128,000,000 or 11% sequentially. As Bill discussed, we received 2 large awards in the quarter.

Speaker 1

LTAMs was received earlier than expected in fiscal 2024 and signifies an important franchise production program for which we are a key supplier of processing capabilities. We also won a large cost plus development program on a strategic weapon system with favorable billing terms. Revenues for the quarter were $197,000,000 down $32,000,000 or 14% compared to the prior year of $230,000,000 As expected, revenues decreased year over year as we continue to prioritize resources to execute our challenge programs, transition from our higher mix of development programs and aim to better align our operating cadence with prudent working capital management. As Bill noted, we experienced nearly $31,000,000 of cost growth impact in the quarter as compared to approximately $7,000,000 in the prior year. The $31,000,000 was comprised of $14,000,000 related to our challenge programs and $17,000,000 related to multiple development and production programs.

Speaker 1

In accordance with GAAP, this resulted in cumulative revenue adjustments to properly reflect progress on the programs due to the revised cost baselines driving an overweight impact in the 2nd quarter. The $14,000,000 cost growth impact related to our challenge programs was almost entirely driven by a single program and was a result of facts and circumstances in the quarter, specifically the cost growth related to unexpected redesign and prototype efforts of a common processing architecture following initial development unit deliveries. While we executed largely in line with expectations across the remaining challenge programs, we did experience cost growth on certain other development programs in the quarter, which impacted revenues in a similar manner, but to a lesser extent. Of the remaining $17,000,000 of cost growth impact, there will be $8,000,000 related to development programs and $9,000,000 related to production programs. The cost growth within our development programs was primarily attributable to $6,000,000 of cost growth across a suite of redevelopment programs with similar performance obligations.

Speaker 1

A majority of this cost growth was due to a revised cost baseline predicated on initial development unit deliveries and extrapolated across the remaining backlog. Similarly, we had several production programs in the first half of the fiscal year for which actual costs incurred were trending higher than the prior cost estimates. This resulted in a revised cost baseline for the remaining backlog on these programs. In addition, we experienced minor technical issues resulting in incremental rework costs across several production programs in the quarter. The scope of the issues was narrow, risk mitigation plans are in place and the issues are expected to resolve and allow for delivery on these programs beginning in Q3.

Speaker 1

Finally, as we build and mature integrated processes and management systems, We seek to continuously assess our judgments and estimates, including potential future risks and opportunities Based on the latest and best information available, we are applying our judgment consistently as we work through the full portfolio of programs. In addition and consistent with prior earning calls, we are shifting our operating cadence with the goal of more properly balancing our material purchases with contracts awards and resource availability, driving better working capital results. These factors are contributing to a temporary volume shift in our total revenue, especially our overtime revenue, which decreased by approximately $25,000,000 year over year. We expect this trend to continue through the remainder of fiscal 2024. Gross margin for the 2nd quarter decreased to 16% from 35.3% in the prior year.

Speaker 1

Gross margin contracted year over year primarily as a result of cost growth impacts as well as higher Manufacturing adjustments, especially as related to inventory reserves and scrap. As just discussed, We recorded approximately $31,000,000 of cost growth impact in the 2nd quarter. This represents approximately 23,000,000 incremental cost growth impact year over year contributing to more than 50% of the margin reduction as shown on Slide 15 in the appendix. The remaining decrease in gross margin year over year was primarily due to higher manufacturing adjustments of approximately $12,000,000 related to inventory reserves and scrap. With regard to inventory reserves, we recorded over $8,000,000 more reserves in the quarter as compared to the prior 4 quarter run rate average.

Speaker 1

This was a result of specifically identified excess and obsolete inventory in the quarter primarily due to a shift in customer demand toward our next generation product offering. In addition, we are actively marketing and selling certain of our slow moving inventory, sometimes at a discount to the current carrying value. With regard to scrap, we experienced higher levels of discrepant material, especially related to the common processing architecture involved in several of our challenge programs. Due to the nature of the technology, the discrepant material is high value and cannot be reused or reworked. We have several initiatives underway designed to address more efficient and cost effective producibility of these subsystems.

Speaker 1

We expect gross margins to recover gradually in the second half of the fiscal year. That said, we believe the full year Fiscal 'twenty four gross margins will be below those of fiscal 'twenty three given the higher than expected cost growth impacts through the first half of fiscal twenty twenty four. As Bill discussed, we believe we have successfully narrowed the scope of risk our challenge programs to a single technology related to our common processing architecture within one of our business units. We expect gross margins to continue to be impacted by unknown risks that may materialize as we progress these challenged programs through final stages of completion. In addition, we may continue to see cost growth impact as we transition from a higher than normal development program mix as well as continue to mature our operational management systems and reporting.

Speaker 1

Operating expenses decreased approximately $3,100,000 year over year due to $2,100,000 of restructuring charges, as well as $1,300,000 more of amortization expense in the prior year. That said, the Q2 of fiscal 2024 including nearly $5,000,000 of contract settlements resulting from negotiations to reduce performance obligations on customer contracts that do not align with our strategy or otherwise do not have acceptable returns in exchange for lower cash consideration. We believe these costs are not comparable to the prior year and thus our run rate operating would have decreased nearly $8,000,000 year over year, reflecting the cost savings actions executed in our Q1 fiscal 2024. As Bill mentioned, earlier this month, we announced an organizational consolidation of our divisions into 1 unified structure, incorporating multiple business units and supporting functions. The resulting workforce reduction is eliminating approximately 100 positions, resulting in expected restructuring charges of $10,000,000 to $12,000,000 in the 3rd quarter.

Speaker 1

This cost savings action is expected to yield annual run rate savings of approximately $20,000,000 In total, our cost savings actions in fiscal 2024 are expected to yield over $40,000,000 in annual brown rate savings. GAAP net loss and loss per share in the 2nd quarter was $45,600,000 $0.79 respectively, as compared to $10,900,000 and $0.19 respectively in the prior year. The increase in GAAP net loss is primarily result of approximately $48,000,000 of costs incurred in the quarter comprised of $31,000,000 of program cost growth impacts, $12,000,000 of inventory reserves and scrap expense, as well as nearly $5,000,000 of contract settlements. GAAP net loss was also impacted by the temporary volume shift in revenues as we align our operating cadence with prudent working capital management. These factors were partially offset by approximately $16,000,000 of incremental tax benefit year over year.

Speaker 1

Adjusted EBITDA for the 2nd quarter was negative $21,300,000 compared to $35,700,000 in the prior year. Adjusted loss per share was $0.42 as compared to adjusted earnings per share of $0.26 in the prior year. Consistent with GAAP net loss and loss per share, the decrease was primarily a result of approximately $48,000,000 of costs incurred in the quarter, comprised of $31,000,000 of program cost growth impacts, dollars 12,000,000 of inventory reserves and scrap expense as well as nearly $5,000,000 of contract adjusted EBITDA and adjusted loss per share was also impacted by the temporary volume shift in revenues as we align our operating cadence with prudent working capital management. Slide 12 presents Mercury's balance sheet for the last 5 quarters. We ended the 2nd quarter with cash and cash equivalents of $169,000,000 We increased our borrowings by $40,000,000 in the quarter, resulting in $616,500,000 of funded debt under our revolver.

Speaker 1

As Bill discussed, total net leverage based on our credit agreement definitions is well within our covenant thresholds. Our debt agreement allows for adjustments beyond those included in our adjusted EBITDA definition, including adjustments related to some of the headwinds that we believe are temporarily driving earnings volatility and obscuring the underlying performance of the business. We are forecasting significant headroom in the covenants for the remainder of fiscal 'twenty four and expect to end the year with lower gross debt as we deploy the positive free cash flow generated through the remainder of the year to pay down debt. Bills receivables decreased approximately $9,000,000 as a result of continued strong collections in the quarter. Unbilled receivables decreased approximately $38,000,000 primarily due to successful execution in billings across the program portfolio as well as cumulative associated with the cost growth impacts in the quarter in our contract settlements as previously discussed.

Speaker 1

Inventory decreased approximately $8,000,000 in the quarter, primarily as a result of the incremental reserve and scrap activities. Accounts payable decreased nearly $8,000,000 evidencing the shift in our operating cadence and aims at better aligning the timing of material purchases with both contract awards and resource availability. Deferred revenues increased Approximately $23,000,000 in the quarter reflecting the higher volume of customer advances as we successfully negotiate more favorable billing terms on newer awards. Working capital improved approximately $70,000,000 in the 2nd quarter as we transition through the completion of our challenge programs and start to shift the development and production mix in the program portfolio. We successfully converted unbilled to build receivables and ultimately cash in the quarter through our focused execution efforts.

Speaker 1

We also negotiated advanced payments on a number of new contracts and reduced inventory growth through effective management of our material purchases. We expect this working capital trend to continue, resulting in further progress by the end of the fiscal year, primarily driven by decreases in unbilled receivables and inventory. As we continue to execute, especially as related to our challenge programs, we expect to convert unbilled to build receivables and then cash. In addition, we expect the mix of development programs to shift to better align with historical norms. And as we receive expected follow on production awards, we believe we will consume inventory purchased in anticipation of these awards.

Speaker 1

As we have discussed on prior calls, we consider 35% of trailing 12 months revenues to be a more appropriate level of working capital for the business. Turning to cash flow on Slide 13. Free cash flow for the 2nd quarter was $37,500,000 as compared to $22,200,000 in the prior year. As previously discussed, this was primarily a result of strong collections in the quarter, including a higher volume of customer advances as we successfully negotiate more favorable billing terms on newer awards. I'll now turn to our financial guidance for the full year fiscal 'twenty four.

Speaker 1

Our results through the first half of fiscal 'twenty four have been below expectations. In addition, we expect earnings volatility may continue for the remainder of the year, including as we make intentional decisions around the strategic alignment of our program portfolio, technology investments and working capital balances. As a result, our full year results are expected to fall short of the previously issued guidance. At the start of the fiscal year, we shifted our guidance approach to guide annually rather than quarterly due to the expected volatility in financial performance As we pivoted focus to operational execution, especially related to our challenge programs, We have taken several actions designed to improve predictability within a subset of our business and key early indicators of progress emerged in the 2nd quarter. We have successfully completed 8 of our approximately 20 challenge programs and believe we are on track to complete a majority of the challenge programs by the end of the fiscal year.

Speaker 1

That said, we have experienced development challenges on a single technology within one of our business units that spans several of our remaining challenge programs. These challenges will require heightened effort and potentially increased cost through the remainder of the fiscal year. We have quantified this risk among others across our program portfolio Based on information available as of the Q2, as well as considered how best to allocate our resource capacity to further reduce working capital levels, resulting in a revised revenue range of $800,000,000 to $850,000,000 for fiscal 2024, Providing meaningful estimates of GAAP and non GAAP measures beyond revenue is challenging, including in light of the continued actions we may need to take to complete our business transition in fiscal 2024. Thus, we are withdrawing our GAAP and non GAAP guidance outside of revenues as provided on our first quarter earnings call on November 7, 2023. While we are not formally guiding beyond revenues for the remainder of the fiscal year, We can provide further perspective over certain key financial metrics.

Speaker 1

1st, we expect the demand environment to continue to support strong bookings, especially in the Q4, yielding expected fiscal 'twenty four bookings in excess of $1,000,000,000 We continue to expect these bookings to be weighted more heavily towards production based programs, supporting the start of a shift in the mix of and production programs in our portfolio. 2nd, we believe we have narrowed the risk and scope of effort within our challenge programs to a single technology in one of our business units with the remaining challenge programs executing largely in line with expectations. We have completed 8 of our approximately 20 challenge programs and continue to expect to complete a majority of all challenge programs by the end of the year. The cost growth impacts incurred through the first half, coupled with the potential for continued volatility, especially related to this single technology will negatively impact revenues and gross margin for the remainder of the year. As such, we now expect both revenue and gross margin to trend lower than the prior year.

Speaker 1

We believe operating leverage will improve as we progress through the year due to expected revenue and margin increases compounded by savings from the cost actions completed in both the 1st and third quarters of fiscal 2024. We expect GAAP net loss and loss per share as well as adjusted EBITDA and adjusted loss per share for fiscal 2024 will be meaningfully below the prior year. We expect positive cash flow for the fiscal year before any benefit the potential passage of the R and D tax legislation currently before the Senate, which we anticipate would add more than $40,000,000 of additional cash flow in fiscal 2024. While cash flow in the 3rd quarter is projected to be near breakeven, We expect significant improvement in the Q4 as we plan to complete a majority of our challenge programs, ship and build final product and convert unbilled receivables to billed receivables and then to cash. We continue to expect positive free cash flow for the year.

Speaker 1

A government shutdown or prolonged continuing resolution may pose risk to our cash flow expectations. As discussed, we expect further improvement in net working capital by the end of the fiscal year as we anticipate seeing reductions in unbilled receivables, but also inventory with more meaningful reductions expected over the longer term. In closing, we continue to be focused on 4 priorities enhancing execution to deliver predictable performance, driving organic growth, addressing our cost structure to expand margins and driving improved free cash flow conversion and release. We believe executing on these priorities will not only enable a return to historical revenue growth and profitability, but will also drive further margin expansion and cash conversion, demonstrating the long term value creation potential of the business. With that, I'll now turn the call back over to Bill.

Speaker 2

Thanks, Dave. With that, operator, please proceed with the Q and A.

Operator

Your first question comes from the line from Peter Arment from Baird. Your line is open.

Speaker 4

Yes. Good evening, Bill and Dave. Bill, I'm just trying to understand on the cost growth breakdown. The $14,000,000 that was derived from one of your challenge programs, it's I guess it's just tied to one program of the $14,000,000 of cost growth. Will that be that one specifically be eliminated as you're thinking about having the majority of these done this fiscal year?

Speaker 4

Or do we expect that that's one of the troubled ones that will linger a little bit.

Speaker 2

Yes. Hey, Peter, thanks very much for the question. The short answer Is that program will be active for a while, but maybe if I gave some color on what was behind the cost growth, it might be helpful to understand What's happening with that program? And it's actually, in some ways sort of unique. This is a challenge program that includes development, low rate production and a production run.

Speaker 2

Most of our development programs just contain the development activities or lower rate production. This one's unique in that it includes a long production run. And what we discovered in the quarter as we worked our way through development And then we worked our way through the first few units in production that we got a good view on the unit economics or the unit costs That then informed an updated estimate on the production. And so the big cost growth in the quarter that we recognized was tied to the impacts of what we learned and how that pertain to the production. So while that program will be around for a while, We think we have a much clearer view of what we need to do to execute on that program and what the production will look like.

Speaker 2

So hopefully that color commentary is helpful.

Speaker 4

Yes, very helpful. And just as a follow-up, if I could. Just given all the cost growths and a lot of mercury over the last several years was built up through kind of M and A. Is it Are any of the businesses impaired? Or how do we think about that just as just thinking about risks in the from a financial standpoint?

Speaker 2

Yes, I'll let Dave speak to that in a second. There's one more piece of color commentary that I wanted to make about the program that I referenced. And that is that even after we made the adjustments to our ETC for the production run, the margin profile on that program is still above what I call the composite average of our gross margin across our portfolio. So just another, I think helpful piece of information to round out that picture. But on the impairment question, I'll go ahead and turn it over to Dave.

Speaker 1

Yes. Thanks. Thanks, Bill. We do when we do an assessment around impairment, we do that At a gross level, so we don't look at the individual components and we don't maintain goodwill at that level. We maintain it at the overall level.

Speaker 1

So we always do an analysis on the overall company and where we stand from a goodwill impairment standpoint.

Speaker 4

Appreciate the color. I'll jump back in queue. Thanks.

Speaker 2

Okay. Thanks, Peter.

Operator

Your next question comes from the line of Seth Seifman From JPMorgan, your line is open.

Speaker 3

Hey, thanks very much and good evening.

Speaker 5

I wanted to ask first, I noticed in the filing that the percentage of sales to some of the key customers is down kind of lower than it's been below the 10% disclosable threshold. And I guess, how do we kind of think about what that means? And how do we think about that with regard The kind of underlying trend of prime contractor outsourcing that kind of underlies the Mercury business case?

Speaker 2

Yes. Well, 1st Seth, well, Seth, it's Paul. I'll go ahead and take the question. Thank you very much, by the way. I think those percentages are going to bounce around a little bit quarter to quarter.

Speaker 2

So I wouldn't pay too or at least I personally don't pay too much attention to that. To the extent that they do go down, I think it does show the robustness of our backlog and the diversification of our backlog. And the thing that I'm really focused on around customer health and desirability of our products in the marketplace and the strength of demand is to look at our backlog. And right now, we're staring at a record backlog. We had a near record bookings for the quarter, which I think is the strongest indicator of our customer health and the health of our business looking forward.

Speaker 2

Dave, anything you want to add on the

Speaker 1

No, I would just mention that It is the threshold at 10% and it does vary as if you look at historically, it varies and some of them dip just below and some of them pop just above in a given quarter. So I don't think there's a significant shift in any of these.

Speaker 2

Yes. And again, I go back to the backlog and I think that reflects the trust that our customers have in us with respect to their franchise programs and we mentioned a couple of the specific bookings that we received in the quarter that I think speak to that fact.

Speaker 3

Okay. Okay. Thanks. And then maybe just,

Speaker 5

I think one of the key things that people think about as they Or maybe one of the key ingredients in the model as you think about where without the guidance and with the results being so variable now, some number in the out years to anchor around and it's probably the gross margin. And so if you wanted to think about a kind of conservative case where things don't necessarily all turn out your way and some of these things that are still struggling with some of these things for a while. What's kind of a fair way to think about not necessarily next quarter, but as people try to anchor around what the company might be able to do here in the future, a fair way to think about that gross margin number?

Speaker 2

Yes, Seth, it's Phil. I'll start and then Dave can chime in. I mean, specifically, we don't guide to gross margins. What we have said and which we continue to believe to be true is that when you look across our portfolio, our range of gross margins is 30% typically for development programs and 40% for our production programs. And what really drives our gross margins is the mix associated with development and production.

Speaker 2

And so as we think about margin targets Going forward, we more think about EBITDA targets going forward. And I would just refer you to the bridge that we put In prior investor presentations where we think the key to getting to those margins is around Minimizing the volatility in our development programs in the EAC impacts. And despite the numbers in the quarter, we feel like we're making very good progress to boxing the risk associated with the development programs in the EAC volatility. 2nd, it's transitioning the development programs production and we are making very good progress on that front. 1 of the big bookings in the quarter is evidence to that.

Speaker 2

But as we're progressing our way through development, we're getting closer line of sight to converting them to production. It's continued efficiency in our cost structure. And again, this quarter and with the negative operating leverage, it won't show through this year, but we expect it to show through next year the efficiencies that we've driven into our cost structure. And then ultimately, in the near term, driven by the organic growth associated with converting our production programs to development, positive operating leverage. And that's the really the path from where we sit today to our targeted margins that are in the low to mid 20s.

Speaker 2

And that's still our view on the target margins for the business. So I'll pause there. Dave, anything that you I'd like to add to that.

Speaker 1

No, I think that's right. And as Bill said, margins in the low 20s, he's referring to EBITDA Margins, just to be sure. And that from a and we've reiterated and looked at and we still Feel confident in the long term model that we've laid out in the past and that has the gross margins that we believe this business should be able to generate and continue to believe that.

Speaker 2

And just to go back To bring your question and the first question that we had in the call together, the one program that caused the really The majority of the volatility in the quarter was a challenge program that included the development, the low rate production and the long production run. It had an impact in the quarter because we had revised estimates of our percent complete, and so we had some reversals in the quarter that basically had the cumulative catch up in the quarter. But again, when we look at the gross margins of that program going forward, still above the average gross margins of our profile across that spectrum of 30% to 40% that I reiterated for development in our production program. So hopefully, that's helpful. Hopefully, it gives you better insight into how we're thinking about the target margins of the business and really focused on target margins when it comes to EBITDA margins.

Speaker 3

Great. Thank you very much.

Operator

Your next question comes from the line of Jonathan Ho from William Blair. Your line is open.

Speaker 6

Hi, good afternoon. Thank you for the additional color on the challenge programs that you just provided. One thing I wanted to better understand a little bit is that you have scrutinized these troubled programs and implemented processes in the past. Can you help us understand why it took so long to sort of identify these additional issues? And maybe help us understand why this time you have more confidence that you've got a handle on it?

Speaker 2

Yes, Jonathan, thanks very much for the question. One thing that I'll iterate is where we're seeing EAC growth in the challenge programs, In general, it's not repeat issues. So if you look across the list of programs, the 2019, with the exception of the one, we had very little volatility in the quarter. Where we did see the issue on the one program represented the fact that we're progressing the program. So we worked our way through development.

Speaker 2

That's a positive. We worked our way through the low rate production. And as we did, we learned more about the unit economics and specifically the unit cost that informed our view of the production. So I understand the question around why it took so long, but it really has taken us progressing through the different phases of this program in And again, this one has a different profile because it includes development, low rate production and a longer production run. On most of the development programs in general and our challenge programs, we have the opportunity to complete the development.

Speaker 2

So there may be some risk associated with completing the development, but at the end of the development, we get to The design baseline, we have an opportunity to execute on a small number of units so that we can get a good baseline for the unit economics and in particular the unit cost and then we're able to factor that into bids for production contracts that are follow on. So in this particular case, where we have development, low rate production and a longer run production associated with it, Within this one program, we have the risk associated with those three phases, which is relatively unique. So it may seem like it took us a while to get to the EAC and really understanding it, but we had to do the work and progress through development and low rate production in order to inform and update our view on the production run. So that's really the background on that.

Speaker 6

Thank you for the clarification. Just one quick one as a follow-up. How flexible have your partners been to sort of work with you on these revised either contract terms or prepayments? This is having an impact on your future relationships as well. Thank you.

Speaker 2

On payments themselves, Jonathan, could you please clarify?

Speaker 6

Yes. So you referenced sort of going back to renegotiate some of the contracts And then, having some acceleration in terms of the payments, so I just wanted to understand if that impacts the relationships, whether your partners or And customers have been willing to work with you. Just trying to understand sort of the dynamics around those discussions.

Speaker 2

Yes, yes. No, thank you for clarifying the question. And this ties back to what we talked about now for a couple of quarters about, In general, our more cash efficient approach to our operations and that has a couple of components. 1 is how we order material and better stage it with the timing of deliveries. And the second piece of it is the contract terms that we put in place so that we can better align progress with progress payments.

Speaker 2

Historically, and one of the reasons why we have a large unbilled balance is our payment terms speak to us being able to bill, invoice and collect cash only once we're complete and deliver the units. And so one of the things that we've done operationally is work to align our payment terms with progress payments. And so that I think is the renegotiation that you're referring to. And what I would say is, in general, it's not a big deal because our customers, In many ways, our incentives are aligned. So when we bill them, they're able to collect cost, invoice their customers and collect cash.

Speaker 2

So Our incentives are aligned. And as a result, it's typically not a difficult conversation for us to have with our customers. Any

Speaker 1

I would add to that when we you think about the relationship and you're asking about our customers and working with our customers. I mean, A reflection of our customers' thoughts and feelings working with us, I mean, I think it's reflected in the strong bookings we had. That you see these are customers who largely we have these customers have had them for long periods time and they're working with us. Bill has met with several other customers even On the areas with the challenge programs, he's working with those customers and they want us to get to the answers, the final activity so that we can get into production. They need these products.

Speaker 1

We have a unique capability to deliver these products. And you see it reflected in our growing backlog and in our bookings that we've seen. As Bill said, We see some transitory kind of impacts, but our customers understand that and they're working with us.

Speaker 2

Yes. And then the other thing I'll add, Jonathan, and this may have been part of what you're as well. We did mention that we had some contract settlements in the quarter that resulted in transitory impact, I think, of $5,000,000 In general, those discussions and what was behind the settlements Had nothing to do with us trying to negotiate different payment terms and better align payments with progress payments, etcetera. They were completely different matters specific to those contractual relationships and not reflective of us trying to negotiate different terms with our customers. So In the event that that was part of the question, I wanted to provide that color.

Speaker 6

That's great clarity. Thank you.

Speaker 2

All right. Thanks, Jonathan. Appreciate it.

Operator

Your next question comes from the line of Sheila Kahyaoglu from Jefferies. Your line is open.

Speaker 7

Hi, thank you for the time. This is Kyle and Chloeak on for Sheila. Appreciate the leg work you guys are doing around cost savings and the cash focus nowadays. So I just want to hone in on the profitability guide for this year because it seems like the 2 uncertainties are what you just mentioned around contract exits. So first question there is maybe how much of the backlog or revenue bridge is Maybe up for negotiation.

Speaker 7

And then second part being the cost savings, seems like a lot of that is pretty exhaustive. So Maybe some color around why you didn't hone in on our profit shake out this year? Thanks.

Speaker 2

Yes, let me see. I'll take a stab at the two questions and then Dave maybe can fill in. First on just the cost savings piece of it. As we've said in prior calls, I don't think of that as a one time activity. I think of it as an ongoing activity to drive efficiency in our organization and our structure.

Speaker 2

And I think we've been pretty consistent in demonstrating that that's our focus with what we announced in Q1. The further enhancements that we rolled out in January and we'll continue to look at opportunities to improve our cost structure And I think that's a very natural thing to do in a business like ours that's been built up through acquisitions over a period of time for us to continue to look for opportunities to better integrate the business. As far as the contract, I guess on the first question around

Speaker 1

Yes, I just this is Dave, Kyle, if it's all right. If I understood the question was around Of the $1,300,000,000 of backlog we have, how much of that backlog do we think would be I don't know what the right word would be. Potentially renegotiated. Is that what you were Yes.

Speaker 7

Maybe how much of the backlog is maybe the lower margin work that you'd look to either exit or I mean, I guess renegotiate. Yes.

Speaker 2

No, I think about it very differently. That isn't a dynamic that we're currently thinking about or working on. I mean, we feel very good about backlog that we have in place, and again, like I said, it's a record backlog coming off of a great bookings quarter. The risk that we see in the business really is isolated to what we consider to be about 20 percent of the business. That's where we've seen volatility in the business, and the remaining 80% of our business has performed very predictably.

Speaker 2

And we expect it to continue to perform predictably. And we're really focused in not so much on contract or anything like that, but it's the execution in the 20% of our business, in particular, that includes this one common processing architecture technology that cuts across a few programs that we need to finalize the work that we have currently underway so that we get to a design that is not just producible, which is where we are today, but producible at scale so that we can perform very predictably and profitably, and that's our focus. So it's less about the $1,200,000,000 backlog that we have, and it's More about this one part of our business that represents 20% and this common technology is a subset of that 20%. Yes.

Speaker 1

And that's not to say that we feel like 20% of the business is at risk. Correct. What we're saying is that there's Contained within that segment of the business, that piece of the business is where we see the highest concentration of risk that we're working through. But as Bill said, Kyle, I don't see a significant exposure for renegotiation The settlement in our backlog.

Speaker 2

Yes. And then I think the other thing that I would add relative to that area where we're focused on the technical work, We feel very good about our long term positioning there because we're differentiated, we're sole source, We're baselined on programs where the capability is mandatory and our customers are incentivized, We believe with us to get to the other sides on these technical issues so that we can get to the production runs and get the product into their hands. So hopefully that paints a little bit clearer picture of the technical issues that we're describing.

Speaker 7

Fair enough. Thanks guys.

Speaker 2

Thanks, Kyle. Yes.

Operator

Your next question comes from the line of Michael Ciarmoli from Truist Securities. Your line is

Speaker 3

open. Hey, good evening, guys. Thanks for taking the question. Just to stay on that topic, I mean, looking at the guidance cut, I mean, Can't we just say the high end of the prior $1,000,000,000 to the low end now at $800,000,000 Isn't that 20% of the business? So, I mean, isn't it seems like 20% of the overall business has been kind of compromised here?

Speaker 1

Yes. And I think I would say that when we look At the reduction in the range, it is largely in that business unit where we see the biggest reduction in The revenue because as we looked at the first half and the adjustments that we've taken that have impacted revenue, they've largely been in that business, as Bill said. And as we look at the volume going forward, as Bill as we both talked about, We're going to get these programs lying flat on the development before we really start producing in volume into the production and that transition to make it seamless and to make it smooth without variability in the future needs to be completed before we move ahead. And that's why you're seeing We're not having as much early material receipts as we've had in the past. We're managing that carefully, so we don't end up in a Where things are where we brought in things that design changes are still happening to.

Speaker 1

And Yes, a significant part of that reduction in the range is driven by that part of the business.

Speaker 2

Yes. And I would just offer too that it's really a timing around that volume and a pushing to the right of that volume. And that's as a result of us being very and working our way through the technical issues to get to a robust baseline that we can produce very predictably and profitably and at scale. And the reason why we're doing that is because we're very excited about the prospects for this part of our business. It's highly differentiated.

Speaker 2

We have sole source positions. We see a significant growth opportunity in front of us In this area, with attractive gross margins, similar to what I walked through with the One Challenge program, where we had the major source of our impact this quarter still operating at very healthy, growth margins going forward. And so we're very excited about our piece of this business. This volume reduction largely associated with that part of the business is a push out to the right.

Speaker 1

And Michael, I would say, it is a thoughtful, intentional view on our part of making that decision to not add to the risk profile by bringing that in or by executing that early.

Speaker 3

Okay. How much just the last one, the 150,000,000 Guidance cut at the midpoint. You called out the revenue headwind from cost growth in the quarter and volume in the quarter. What sort of the breakdown for the year, If you can bridge kind of the $23,000,000 in cost growth you saw this quarter, is it fairly balanced or how should we think about that?

Speaker 1

Yes. I think the way I would look at it is, as We talked about we're not trying to guide the back half from a profitability standpoint. It is if you take the first half and you take the reduction that we saw the shortfall in revenue, it's Starting with that as the starting point that that's in the number for the year. And then taking a look at exactly what Bill said, The intentional shifting of execution on contracts until We've got some of these things laying flat on that piece of our portfolio, not certainly on our entire portfolio.

Speaker 3

Okay. All right. Perfect. Thanks, guys.

Speaker 2

Thanks, Michael. Appreciate it.

Operator

Mr. Ballhaus, it appears there are no further questions. Therefore, I would like to turn the call back over to you for any closing remarks.

Speaker 2

Okay. Well, thank you very much and I very much appreciate everybody listening into our call this afternoon and the questions and we look forward to providing you an additional update next quarter. Thank you very much.

Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.

Remove Ads
Powered by Quartr
Earnings Conference Call
Mercury Systems Q2 2024
00:00 / 00:00
Remove Ads