Mercury Systems Q4 2024 Earnings Call Transcript

Quartr
Provided by Quartr
August 13, 2024

There are 9 speakers on the call.

Operator

Good day, everyone, and welcome to the Mercury Systems 4th 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. Please 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 have not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.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 with generally accepted accounting principles or GAAP, during our call, we will also discuss several non GAAP financial measures, specifically adjusted income, adjusted earnings per share, adjusted EBITDA and free cash flow. A reconciliation of these non GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release. I'll now turn the call over to Mercury's Chairman and CEO, Bill Ballhaus.

Speaker 1

Please turn to Slide 3.

Speaker 2

Thanks, Dave. Good afternoon. Thank you for joining our Q4 fiscal year 2024 earnings call. We exited FY 'twenty four with positive momentum, delivering results in line with or ahead of expectations, and I look forward to that momentum continuing as we enter into FY 'twenty five. Today, I'd like to talk through 3 topics.

Speaker 2

First, some introductory comments on our business and results as we closed FY24. 2nd, a progress update in each of our 4 priority areas established just over a year ago, delivering predictable performance, building a thriving growth engine, expanding margins and driving improved free cash flow. And third, expectations for our performance as we enter FY 'twenty five and longer term. And then I'll turn it over to Dave, who'll walk through our financial results. Before jumping in, I'd like to thank our customers for their collaborative partnership and the trust they put in Mercury to support their most critical programs and our Mercury team for their dedication and commitment to delivering mission critical processing at the edge.

Speaker 2

One other note, I'd like to thank Nelson Erickson for his contributions to Mercury over the years. I know many of you have interacted with Nelson on the Investor Relations front. Nelson has elected to pursue a new opportunity outside of Mercury, and we wish him well in his future endeavors. Please turn to Slide 4. In FY 'twenty four, we made considerable progress addressing transient challenges in the business.

Speaker 2

As we enter FY 'twenty five, I'm optimistic about our strategic positioning as a leader in mission critical processing at the edge and our expectations on delivering predictable organic growth with expanding margins and robust free cash flow. Our Q4 and full year results were in line with or ahead of our expectations. Q4 bookings of $284,000,000 1 point $2,000,000,000 for the full year, in line with our guidance of $1,000,000,000 and representing our FY 'twenty four book to bill of 1.22 Q4 revenue of $249,000,000 $835,000,000 for the full year, above the midpoint of our guidance Q4 adjusted EBITDA of $31,000,000 up 42% year over year and Q4 free cash flow of 61,000,000 dollars 26,000,000 for the full year, keeping with or exceeding our guidance of free cash flow positive for the fiscal year. Q4 free cash flow was up $58,000,000 year over year and represents the highest quarterly free cash flow in the company's history. We ended the Q4 with $181,000,000 of cash on hand after paying down $25,000,000 of debt.

Speaker 2

These Q4 results reflect solid progress in each of our 4 priority focus areas with highlights that include retiring risk across our remaining challenge programs, most notably executing the plan on the return to initial pilot production on our common processing architecture area expanding our record backlog to over $1,300,000,000 up 16% year over year additional streamlining of our operations enabling increased positive operating leverage as we return to organic growth and reversing the multi year trend of growth in working capital with net working capital down 15% year over year and sequential reductions in inventory and unbilled receivables. With this progress in FY 'twenty four, we are entering FY 'twenty five with a clear path toward delivering predictable organic growth, expanding margins and improved free cash flow. Please turn to Slide 5. Following those introductory comments, I'd like to spend time on each of our 4 focus areas, starting with our first focus area, delivering predictable performance. In the 4th quarter, we delivered improved operating performance and were able to more effectively mitigate what we believe to be the transitory challenges that have obscured the underlying performance of the business.

Speaker 2

In Q4, we recognized approximately $16,200,000 of items that we believe are transitory, down from $39,000,000 in Q3, including $9,700,000 of net EAC change impact across our portfolio, $2,900,000 of inventory reserves and scrap and $3,600,000 associated with contract settlement reserves. These items impacted Q4 revenue by approximately $9,700,000 gross margin by approximately $12,600,000 with the remainder impacting operating expenses. The approximately $9,700,000 of net EAC change impact is a 38% reduction from what we experienced last quarter and consisted of approximately $4,400,000 from our challenge programs and approximately $5,300,000 spread across the remaining programs in our portfolio. Although still greater than we would like to see, the magnitude of these items is the lowest in 4 quarters and reflects the progress we are making in driving toward predictable execution and steady growth. As shown on Slide 6, with respect to the challenge programs, since the end of the third quarter, we progressed by completing, exiting or retiring risk on 3 additional of the original 19 programs.

Speaker 2

We believe we have now retired risk on 13 of the original 19 challenge programs that have materially contributed to earnings volatility in recent quarters. For the 6 remaining programs, 2 are nearing completion and represent ordinary course risk going forward. The other 4 remaining programs are associated with the common processing architecture. As I mentioned, we have successfully executed on our return to initial pilot production in our common processing architecture area. We're in the final phases of reliability testing with significant risk retired and are on a deliberate path to ramp up toward full rate production in the first half of the fiscal year, leveraging additional capital equipment and trained resources that we have in place.

Speaker 2

Given the progress in FY 'twenty four, we will no longer separately address the challenge programs going forward, but we will keep you informed with regard to progress on our common processing architecture. Please turn to Slide 7. Turning now to the 2nd focus area, driving organic growth. Bookings for the quarter were $284,000,000 resulting in a 1.14 book to bill. Our backlog, now at a record 1,300,000,000 dollars is up 16% year over year.

Speaker 2

Notably, when we look at FY 'twenty four bookings, approximately 80% of our firm fixed price bookings are production in nature, which we believe is a good leading indicator that the mix shift toward production is progressing in our firm fixed price portfolio. Some wins in the quarter worth noting. A large production order from a prime contractor for Mercury Processing Solutions to be integrated on a key U. S. Air Force program of record.

Speaker 2

Multiple large production orders for processing solutions employed in air and missile defense systems for U. S. And international customers, including some which are actively engaged in Ukraine and others which will provide critical capability in support of NATO ongoing operations in Europe and elsewhere multiple production orders for F-thirty five related electronics content cutting across various subsystems in both our processing technologies and signal technologies business units and a 13,200,000 cost plus development award from the Office of Naval Research to advance sensor processing technologies, which will enable radar and EW capabilities to be designed on much shorter timelines by increasing the modularity of components at the chip level and leveraging the latest commercial chips from major semiconductor providers within a smaller and lighter footprint. These awards are important not only because of their value and impact on our growth trajectory, but also because they reflect our customers' trust in Mercury to support their most critical franchise programs. We know from engagements with our customers that our unique capabilities providing mission critical processing at the edge align well with our customers' priorities and strong demand in growth markets, including sensors and effectors, electronic warfare, avionics and C4I.

Speaker 2

Please turn to Slide 8. Now turning to our 3rd priority focus area, expanding margins. We believe FY 2024 was an unusual transitory year where we delivered margins well beneath our targets. These shortfalls were primarily driven by the previously discussed impacts that we view as transitory and negative operating leverage from relatively low production volume largely tied to development program delays. Looking forward, to achieve our adjusted EBITDA margin targets, we are focused on the following levers: executing on our development programs and minimizing cost growth impacts getting back toward a more historical 20eighty mix of development to production programs, driving organic growth to generate positive operating leverage and achieving cost efficiencies.

Speaker 2

I've discussed on this call our program execution and cost growth containment efforts along with our organic growth efforts. Regarding cost efficiencies, as mentioned in prior calls, we implemented a series of cost reduction actions during FY 'twenty four as we streamlined and realigned our organization structure resulting in significant cost savings previously announced. In Q4, we completed top to bottom leadership selection for the corporate reorganization initially announced in January, organizing our U. S.-based business units into 2 product business units and an integrated processing solutions business unit and centralizing our engineering, operations and mission assurance functions. Additionally, we stood up an advanced concepts group that's focused on advanced technologies, innovation and strategic growth pursuits.

Speaker 2

With this significant effort behind us, we exited FY 'twenty four with a streamlined cost structure, an integrated organizational construct and a strong leadership team that is well poised to build on our momentum coming out of FY 'twenty four and drive improved performance toward our targeted business profile. Please turn to Slide 9. Finally, turning to our 4th priority focus area, improved free cash flow. We continue to make progress in reducing net working capital, which is down $93,300,000 year over year after years of expansion. Inventory is down sequentially by $8,000,000 from $343,000,000 in Q3 to $335,000,000 in Q4.

Speaker 2

Notably, while inventory is flat year over year, WIP is up 44% year over year from $82,000,000 dollars to $118,000,000 reflecting an increased mix of inventory progressed toward delivery. Unbilled receivables are down year over year $79,000,000 or 21%, driven by Q2, Q3 and Q4 billings, which were the 3 highest billing quarters on overtime revenue contracts in the company's history. This record level of billings reflects our relentless focus on progressing our programs in order to deliver for our customers and in turn invoice and collect cash leading to the free cash flow record performance in Q4. We believe the operational process rigor we've implemented in FY 'twenty four related to program execution and hardware delivery, just in time material and appropriately timed payment terms will lead to continued reduction in working capital and improved free cash flow performance going forward. Please turn to Slide 10.

Speaker 2

Entering FY 'twenty five, I have high confidence in our team, our leadership position in delivering mission critical processing at the edge and our expected ability over time to deliver results in line with our target profile of above market top line growth, adjusted EBITDA margins in the low to mid-twenty percent range and free cash flow conversion of 50%. Although we will not be providing specific guidance this early in the year for FY 'twenty five, I will provide the following color. In FY 2025, we expect to make further progress on the 2 primary challenges we have been tackling over the last year, specifically high working capital and the high mix of development programs, which we expect to see reflected in our FY 'twenty five financials in the following two ways. First, as we continue to focus on bringing down working capital, we expect to allocate meaningful operational capacity to advance programs with large unbilled receivable balances, which generates cash, but relatively low revenue given that on many of these programs, a large percentage of revenue has been previously recognized. As a result, we expect our top line for FY 'twenty five to be relatively flat year over year with the first half in line with last year and an increase in run rate as we exit the fiscal year and begin to allocate more operational capacity away from legacy programs with high unbilled balances toward production programs.

Speaker 2

2nd, while we have made significant progress on development programs across our portfolio, our current backlog margin is lower than what we expect to see on a go forward basis, driven primarily by a small number of low margin development programs and programs that incurred adverse EAC adjustments in FY 2024. Given that a large percentage of our backlog converts over the next 12 months, although we expect low double digit adjusted EBITDA margins overall for FY 'twenty five, we expect adjusted EBITDA margins to start off in the high single digits for the first half of the year and then expand in the second half as we complete these lower margin development efforts and continue to shift our mix toward production. Finally, given our recent strong free cash flow performance in Q4, we are expecting to be cash flow positive again in FY 'twenty five with second half free cash flow higher than the first half. In summary, given the operational improvements over the last 12 months and our momentum coming out of Q4, I expect that our performance in FY 'twenty five, in particular our exit run rate, will represent a positive step toward our target profile. As we progress through the first half of the year, I look forward to providing additional insights relative to our expectations for second half and full year performance.

Speaker 2

With that, I'll turn it over to Dave to walk through the financial results for the Q4 fiscal year 2024, and I look forward to your questions. Dave?

Speaker 1

Thank you, Bill. Our performance in Q4 was in line with our expectations, and I will echo Bill's comments that the actions we've taken throughout the year have supported the improved performance that we delivered during the Q4 and highlights the initial progress that we've made given our objective to transition the business toward delivering predictable performance, building a thriving growth engine, expanding margins and driving improved cash flow. We continue to expect a resource shift toward follow on production awards that in turn we believe will begin to rebalance our portfolio more heavily toward higher margin predictable production programs as well as consume further existing inventories. We are also making strides in releasing working capital, especially related to unbilled receivables. We expect to see these transitions become more apparent in our financial results during fiscal year 2025.

Speaker 1

Progress in our 4 priority focus areas is highlighted by a few key milestones that we achieved during the quarter. These milestones included our ability to retire risk across the majority of our remaining challenge programs, expanding our record backlog to over $1,300,000,000 continuing to streamline our operations to drive margin expansion and reversing the multiyear trend of growth in working capital. With that, please turn to Slide 11, which details our 4th quarter results. Our bookings for the quarter were $284,000,000 with a book to bill of $1,140,000,000 yielding a backlog of $1,300,000,000 up $186,000,000 or 16% year over year. Revenues for the 4th quarter were $249,000,000 down $5,000,000 or 2% compared to the prior year of $253,000,000 This represents an improvement over our earlier outlook that we described during our Q3 earnings call driven by material receipts scheduled for Q1 arriving in Q4.

Speaker 1

As you may recall, we maintain a wide range in guidance as there were uncertainties in the Q4 that could have resulted in adverse impacts driving our performance to the lower end of our range. And conversely, the timing of material receipts planned in the Q1 of fiscal 2025 would drive our results to the higher end of our range. As Bill noted, we experienced approximately $10,000,000 of net EAC change impacts affecting revenue in the quarter as compared to approximately $16,000,000 in the Q3 of fiscal 'twenty 24. The $10,000,000 which was the lowest net EAC change impact in the last five quarters was comprised of approximately $4,000,000 related to our challenge programs and nearly $6,000,000 spread across multiple other development and programs associated with the common processing architecture, representing approximately 65% of the impact. As Bill stated, we believe we have successfully executed on our return to initial pilot production.

Speaker 1

We are in the final phases of reliability $1,000,000 of net EAC change impact related to the large number of other development and production programs, we realized ordinary course execution challenges across the program portfolio. Gross margin for the 4th quarter increased to 29.5% from 26.6% in the prior year. Gross margin grew during the quarter primarily due to lower net EAC change impact of approximately $19,000,000 as compared to the prior year. Operating expenses increased approximately $5,000,000 year over year, primarily due to higher SG and A expenses of approximately $11,000,000 and increased restructuring and other charges of $6,000,000 as compared to the prior year. These increases were partially offset by lower R and D expense of approximately $8,000,000 driven by our workforce reductions.

Speaker 1

The increase in SG and A was primarily driven by higher stock based compensation expense of approximately $8,000,000 in the current quarter as compared to the prior year. In the Q4 of the prior year, there were forfeitures of nearly $7,000,000 from our former CEO's stock based compensation. The Q4 of fiscal 2024 also included $3,600,000 of contract settlement reserves. The increase in restructuring and other charges was driven by the previously announced workforce reduction that eliminated approximately 100 positions, resulting in restructuring and other charges approximately $7,000,000 in the current quarter. The headcount savings combined with other non headcount savings, including discretionary and third party spend primarily within R and D and cost of revenues are expected to yield annualized savings of approximately $15,000,000 a portion of which is expected to be reinvested in the business with the remainder supporting improved profitability and operating leverage for our 2025 fiscal year.

Speaker 1

GAAP net loss and loss per share in the 4th quarter were $10,800,000 and $0.19 respectively as compared to GAAP net loss and loss per share of $8,200,000 and $0.15 respectively in the prior year. The decrease in year over year earnings is primarily a result of higher operating expenses of $5,000,000 driven by SG and A, restructuring and other charges. The decrease was also impacted by higher non operating expenses, including net incremental other expense of approximately $2,700,000 and interest expense of $2,000,000 These decreases were partially offset by higher gross margin of approximately $6,000,000 driven primarily by lower net EAC change impacts during the quarter as compared to prior year. Adjusted EBITDA for the Q4 was $31,200,000 compared to $21,900,000 in the prior year. Adjusted earnings per share was $0.23 as compared to adjusted earnings per share of $0.11 in the prior year.

Speaker 1

The year over year increase was primarily related to lower loss from operations in the current year as compared to the prior year. Free cash flow in the Q4 was an inflow of $61,400,000 as compared to an inflow of $3,800,000 in the prior year. The increased free cash flow was primarily driven by incremental cash provided by operations of $59,000,000 in the current year as compared to the prior year. Turning to our full year results on Slide 12. Fiscal year 2024 was another solid year for bookings.

Speaker 1

Our book to bill was 1.22 compared to 1.10 in fiscal year 2023, yielding a backlog of over 1,300,000,000 dollars Fiscal year 2024 revenues were $835,000,000 down 14% compared to the prior year. Our fiscal year revenue decline was largely the result of net EAC change impact of $73,000,000 and the deliberate pause on common processing architecture production. Gross margin for the fiscal year 2024 decreased to 23.5% from 32.5% in the prior year. Gross margin contracted by approximately 900 basis points, primarily as a result of net EAC change impacts and incremental manufacturing adjustments, especially as related to inventory reserve, warranty expense and scrap. Operating expenses for the fiscal year increased approximately $5,000,000 compared to the prior fiscal year, primarily due to higher restructuring and other charges as well as higher SG and A expenses as compared to the prior year.

Speaker 1

These increases were partially offset by decreases in R and D and amortization expenses as compared to the prior year. GAAP net loss and loss per share in fiscal 2024 were 137,600,000 dollars and $2.38 respectively, as compared to GAAP net loss and loss per share of $28,300,000 and $0.50 respectively in the prior year. The year over year decrease was a result of approximately $73,000,000 of net EAC change impact, additional manufacturing adjustments and contract settlement reserves. 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 the incremental tax benefit year over year.

Speaker 1

Adjusted EBITDA for fiscal year 2024 was $9,400,000 compared with $132,300,000 in the prior year. The decrease was primarily related to lower gross margin and reduced operating leverage. Free cash flow for the fiscal year was an inflow of approximately $26,100,000 compared to an outflow of $60,100,000 in the prior year. The increase in the current year primarily driven by the progress we've made in converting our unbilled and trade receivables to cash. Slide 13 presents Mercury's balance sheet for the last 5 quarters.

Speaker 1

We ended the 4th quarter with cash and cash equivalents of approximately $181,000,000 after making a $25,000,000 payment against our revolver. We have $592,000,000 of funded debt under our revolver. Those receivables Billed receivables increased approximately $20,000,000 sequentially due to the timing of invoicing collections in the quarter and $10,500,000 reduction to our receivables factoring in the period. Unbilled receivables decreased sequentially approximately $21,000,000 due in part to continued successful execution in billings across the program portfolio. Inventory decreased sequentially 8,000,000 dollars primarily as a result of the increased throughput across a number of programs.

Speaker 1

Notably, while inventory decreased approximately $2,000,000 year over year, WIP is up approximately 44% from our prior fiscal year end, reflecting an increased mix of inventory that has progressed toward delivery. Prepaid expenses and other current assets decreased sequentially approximately $26,000,000 primarily from the income tax refunds during the quarter of $24,000,000 Accrued expenses increased during the Q4 primarily due to $20,000,000 of accrued compensation costs related to our incentive compensation plans and payroll expense. Deferred revenues increased approximately $3,000,000 in the quarter as a result additional milestone building events achieved during the Q4. Working capital decreased approximately $62,000,000 or 10% in the 4th quarter and approximately $93,000,000 or 15% year over year. These decreases evidence the progress we've made in reversing the multi year trend of growth in working capital with sequential reductions in inventory and unbilled receivables.

Speaker 1

Turning to cash flow on Slide 14. Free cash flow for the Q4 was $61,400,000 as compared to $3,800,000 in the prior year. As Bill noted, this marks the highest quarterly free cash flow in the company's history. As Bill had outlined in his earlier comments, we will not be providing detailed guidance for FY 'twenty five at this time, but I would point you to Slide 10 for some qualitative comments. In closing, we believe continuing to execute on our 4 priority focus areas 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 our business.

Speaker 1

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

Thank you. We will now begin the Q and A session. Your first question comes from the line of Pete Skibitski with Alembic Global. Please go ahead.

Speaker 3

Hey, good evening, guys. Nice quarter. Maybe we could start out talking about the CPA area and the 4 challenge programs there. You seem pretty confident that it's going to shift to full rate production. I don't know if we should think the end of the Q1 or the end of the second quarter, but maybe go into more detail about the reliability testing and why you're confident that will complete.

Speaker 3

And what it does complete, are those 4 programs not going to generate a meaningful amount of revenue this year? Is that the right way to think about it? Thanks.

Speaker 2

Yes. Thanks, Pete. So just to reiterate where we are, we've gone through root cause corrective action, put in place the manufacturing process changes based on our understanding of the root cause and the material science, have been very deliberate in ramping up the production line with a lot of in process testing along the way and really pressure testing the corrective actions that we put in place all of that has been going to plan. So I feel really good about the progress to date and how things are progressing. We have plans to ramp up to full rate production in the first half of the year.

Speaker 2

And as I mentioned, the critical path to ramping up is really behind us. We have the capital equipment in place. We have the additional people trained that we need in order to ramp up to full rate production. So I feel pretty confident about the path we're on to ramping up. And so we have a backlog that we need to deliver on.

Speaker 2

I think there is a combination of programs where the majority of the revenue has been recognized and backlog where we will recognize revenue. And we'll work out how we allocate the production across the capacity as we ramp that up. And so that will play out over time as we work our way through the first half. But I'm anticipating that as we work our way through the first half, we will get up to full rate production. We'll work through the unbilled and the backlog associated with those programs.

Speaker 2

We're holding the 4 programs open really through the ramp up of production. But as I said, everything seems to be going to plan. And then as we said before, as we ramp this production up and we make progress on delivering to our customers, there are follow on opportunities that we're expecting to see. So, I'm pretty optimistic about where we are right now. Feel very pleased with the progress that the team has made and look forward to working our way through the first half which I think will give us much better visibility into the second half based on the progress that we actually make.

Speaker 2

Hopefully, that's helpful.

Operator

Your next question comes from the line of Jonathan Ho with William Blair. Please go ahead.

Speaker 1

Hi, good afternoon and let me echo my congratulations on the strong quarter. Just wanted to understand, when we look at your I guess there isn't formal guidance, but when we look at 2025, what are the levers that could swing your results either more positively or negatively as we look towards the future? And it does seem like you have stronger visibility. So, what is sort of maybe keeping you from giving that guidance? Thank you.

Speaker 2

Yes. So, first, let me just speak to the visibility. A year ago, we were talking about the path toward our targeted profile and in particular, our margin profile. And we had a number of factors that would bridge us from current level of performance to that targeted margin profile. And it was things like, 1st, reducing the volatility that we had seen in the business tied to EACs, inventory write downs, contract matters, RMA reserves, etcetera.

Speaker 2

2nd, making progress on our cost structure. We built this business through 15 acquisitions over 9 years and you know really needing to integrate the business and drive efficiency into our cost structure. We talked about a mix shift toward production and the margin uplift that would come with that. And then the rest of the bridge toward our target margins was really around other efficiencies and operating leverage that we would see primarily driven by the volume increases associated with development programs transitioning to production over the next couple of years. So you fast forward to today and your comment on visibility, our backlogs hit a record high and that provides a certain level of visibility.

Speaker 2

We've also made great progress over the last 12 months in a couple of those areas in the bridge. First, in reducing the volatility and you can clearly see the trends as we've worked our way through the year and then how we were able to work our way and manage that volatility in Q4. We made very significant progress on our cost structure and driving efficiency through the cost structure and you saw the progression through the year and the run rate savings that we talked through. So now as we think about going forward, the things that I'm keeping an eye on that will really dictate the speed to which we move towards our target profile and that's above industry growth rates. Its EBITDA margins in the low to mid-20s and its free cash flow conversion at 50%.

Speaker 2

So the speed with which we'll move toward that targeted profile will be dictated by some things that happen in 2025 and some things that happen outside of 2025. In 'twenty five, in the first half, you know, we're focused on development program execution because that really drives how quickly production programs will ramp up. In particular, the ramp up of our common processing architecture because as I just mentioned, there's unbilled and cash, there's revenue tied to backlog and then there are follow on production awards that will come with that. And then we have other follow on production bookings tied to development programs that we've been executing on, we've recently completed and we plan to complete. And then we also have our operational capacity which as we said in our prepared remarks in the near term we're allocating the programs with high unbilled balances which will free up a lot of cash but there won't be much revenue associated with that.

Speaker 2

So that's what our qualitative commentary is all based on. So to your question of what would lead things to impact our financials faster, I think it would be our completion of development programs, the success in the ramp up of our common processing architecture production line, how fast our development programs are how fast our development programs are transitioning to production and when we see those production bookings and how quickly we're able to burn down the unbilled balances so we can free up the operational capacity and put it back toward backlog with revenue. So those are the factors, those are the things that we're focused on. And my expectation is, as we work our way through the first half of the year, we'll get really good insight obviously into our progress in each of those areas, but then the implications on our outlook for the second half of the year and the full year. So those are the things that we're thinking about and what I think we can point to as to what will drive the second half and whether things happen quicker or not.

Speaker 2

So I know Jonathan a long answer to your question, but hopefully that rounds out the picture.

Operator

Your next question comes from the line of Ken Herbert with RBC Capital Markets. Please go ahead.

Speaker 4

Yes. Hey, good afternoon. Thanks for taking the question. I just wanted to ask, as you look at the sort of the push towards continued risk reduction and getting obviously to the 20eighty split, you talked about in terms of development production programs. When do you expect to sort of cross that threshold?

Speaker 4

And then as part of that, there seems to be significant sort of new business opportunities today just when you look at the growth in sort of spending outlays today and a lot of what's happening in defense markets around missile, missile defense and other areas, what is your appetite for sort of new business these days? And are you able to participate in some of the sort of some of the opportunities today as you continue to drive down the risk profile?

Speaker 2

Yes. Ken, great question. Thanks for the question. Well, look, I think we feel very good about the market, the tailwinds, our positioning and I think that's evidenced by what we're seeing in our bookings at 1.22 for the year, our book to bill and a record backlog. What we've been really focused on based on what we've seen in the business over the last several quarters is managing the volatility in the business and specifically what we bring into the backlog.

Speaker 2

So this last year in FY 'twenty four, we brought in a number of development programs, but many of them were cost plus in nature, which we think is much more aligned toward us working on next generation products, introducing innovation, getting new platform positions, but having a set of contract terms that are more commensurate with the risk than what we've seen looking backwards where we felt like we had a high concentration of firm fixed price development programs. So we feel like we're striking the right balance of pursuing new opportunities, taking advantage of the opportunities in the market and our positioning, but doing it in a much more appropriately risk adjusted manner with the cost plus nature of the contracts. Pulling those aside, getting to your mix question, when we look at our firm fixed price bookings over the last year, we've seen about 80% of our firm fixed price bookings as production bookings versus development. So, I think that's a leading indicator of the mix shift moving in the right direction. And then in addition to that, over the next 12 months, since such a high percentage of our backlog converts to revenue over a 12 month period, the margin dynamic that I referred to where our margin today in our backlog is slightly lower than what we would expect to see going forward driven by a small number of legacy development programs that were either impacted by EACs or have very low margin or where we're investing because we think the return warrants the investment.

Speaker 2

Because we think the return warrants the investment, I think that should all transition over the next year and be replaced by higher margin bookings and we already started to see that in FY 'twenty four and so have a good feel that we'll be transitioning that backlog margin out over the next 12 months and see the improvements that we expect to see. So, anyways, I think that transitioning to the mix should continue to happen over the next 12 months and we don't think that we're passing on any market opportunities because of some new approach to risk. We think we're pursuing those opportunities, but with the right contract terms around them.

Operator

Your next question comes from the line of Michael Ciarmoli with Truist Securities. Please go ahead.

Speaker 5

Sorry, can you guys hear me?

Speaker 2

Yes. Now we can hear you again. Hi, Michael. How's it going, Michael?

Speaker 5

Sorry about that. Good, good. Sorry about that, guys. Just first a clarification. Are the PA related programs, are they going to be margin dilutive relative to normal historical fixed price programs once they do or relative to production programs when they ramp up?

Speaker 2

I don't think so at all. Okay. First of all, there's nothing around the root cause corrective action that would even incrementally affect our gross margin on those programs. And I think this is an area where there's strong demand, there's tailwinds in the market, we have differentiation and really a unique capability to meet very stringent mission requirements that if anything I could see the opposite effect and actually being additive. So no concerns about them being diluted to our margins.

Operator

Your next question comes from the line of Sheila Kahyaoglu with Jefferies. Please go ahead.

Speaker 6

Thank you, guys. Maybe just on the last point with EBITDA margins, they were better in Q4, but then stepped down just given the backlog dynamics you both talked about. So is that just timing and we should expect low double digits to be sort of the normalized level in 2025 and stepping up in 2026?

Speaker 2

Well, I think there's 2 impacts and I'll start and then Dave can chime in. But I think the 2 impacts are both the backlog margin dynamic that I pointed to and then just volume. And so, we're expecting to start off the first half of the year in high single digits. But as we move to the back half of the year and we see the margin transition in the backlog and we also see the additional volume in the second half, we expect to see an improvement in our margins tied to those effects of the transition of the backlog and the positive operating leverage. But Dave, please add if there's Yes.

Speaker 1

No, I think that's right, Sheila. I mean, it is largely driven by the margin in the backlog. And so we expect that to increase as we go through the year and we're replacing new bookings for things that we're burning out of backlog. And as we complete some of the contracts that we have some tailwinds on from the prior EACs, but then it is the other side of it is exactly what Bill said, we've been a business that largely in the first half of the year has lower volume and then ramps up in the second half of the year and you saw that again in the Q4. And so that volume will definitely drive improved operating leverage and higher EBITDA in the back half of the year.

Operator

Your next question comes from the line of Jan Franz Engbrecht with Baird. Please go ahead.

Speaker 7

Good evening, Bill and Dave. Congrats on nice set of results. I'm on for Peter today. My first question, a big focus in fiscal year 2024 was focusing on retiring the technical risk outside of the common processing architecture and you're very much on track with your prior messaging having solved at least 13 of these. But is there anything that you're tracking internally in terms of unbilled receivables or any metric or ratio that you want to achieve in fiscal year 2025 that we can sort of track over the next few quarters as you report?

Speaker 2

Well, look, I think the KPIs are really consistent with driving toward the target profile that we've been very consistent in describing and that's above industry growth rates for the top line, EBITDA margins in the low to mid-20s and free cash flow conversion of 50%. And addressing the 2 transient primary transient challenges that we've seen in the business which is a high mix of development programs and high working capital. FY24 we made significant progress on the development programs and mitigating technical risk. We also made considerable progress on the working capital and that's a KPI that we continue to be focused on and expect to see that continue to come down in FY 2025. And also in FY 'twenty five, see a step up in those KPIs associated with our targeted profile.

Speaker 2

So step up in our top line growth rate, step up in our margins and again being free cash flow positive for the year. So I think it's just a continuation of the KPIs that you've heard us talk about for the last year and certainly our focus for the last year and the four priorities that we put in place just over a year ago.

Operator

Your next question comes from the line of Pete Skibitski with Olympic Global. Please go ahead.

Speaker 3

Yes, thanks guys. Just want to understand something, because LTAM, it's a big program opportunity for you, I know. And I just want to understand more on that front. Is it one of the 4 CPA programs? And I asked because I think Raytheon got a very large I think it's sort of an LRIP order.

Speaker 3

And so I would expect you guys to receive an order from them at some point, I guess relatively soon. And so I was just wondering if you could give some color on that for us. If it's one of the remaining issue programs and whether or not it is, should we expect a large booking later this year related to that?

Speaker 2

Yes. Thanks Pete. And I'm sure you've seen the recent announcement from Raytheon about their funding and I won't comment on that, but which we think is good news. To answer your question directly, it is not one of our challenge programs and it is separate from the 6 that I addressed, the 2 that I think are just ordinary course risk and then the 4 that are tied to the CPA. And it is a program where it represents us successfully completing a development program and then in FY 'twenty four getting a production award.

Speaker 2

I also think it reflects our disciplined approach to execution and how we're approaching that program, meaning strong program management, system engineering upfront, being very disciplined in how we order material and stage it consistent with our integrated master schedule and are executing on that program in a very deliberate manner right now. So, it's one of the programs we feel very good about. We talked about in the past that we do expect that to be a driver of organic growth going forward and our expectations remain the same on that front.

Operator

Your next question comes from the line of Michael Ciarmoli with Truist Securities. Please go ahead. Hey

Speaker 5

guys, thanks for taking the follow-up. I guess, Bill, you touted the book to bill being strong. Bookings are down 2 years in a row. I mean, are you guys losing share? And can you talk to that and talk to whether or not the core underlying business is actually showing growth?

Speaker 2

I'd say the one dynamic that we've seen relative to bookings in FY 'twenty four is that some of the challenges that we've had on development programs have led to delays in bookings. I wouldn't characterize them as lost bookings. And I think a great example of that are follow on orders associated with our common processing architecture where we deliberately stood down the line so that we can put in place the corrective actions. We're ramping it up and we expect to see follow on orders coming as we make deliveries to our customers. And when I think about our pipeline, our conversion, our conversion rates, I don't see anything in our conversion that gives me concerns around competitive dynamics and losing market share.

Speaker 2

So we feel good about our book to bill given where we are. I think that's a good leading indicator of where we're headed. And if anything, we've just seen some delays rather than losses tied to the development programs.

Operator

Your next question comes from the line of Noah Poponak with Goldman Sachs. Please go ahead.

Speaker 8

Hey, everyone.

Speaker 2

Hey, Noah.

Speaker 8

Thanks for the time. You referenced I think you referenced a few years of transition from development to production in the main programs that you're alluding to in that mix transition. Does your fiscal 'twenty six look like the medium term profile that you're referencing? Or should we be thinking of more than just fiscal 2025 as kind of transition years to that run rate profile? And when do you next expect the business to have positive GAAP net income on a full year basis?

Speaker 2

I'll let Dave take the last one. Let's see, on the transition, as I think about, again, the bridge from where we are toward our target profile, Really, with the progress that we made in FY 'twenty four, there are 2 pieces of the bridge that I'm most focused on. One is the transition out of backlog of the remaining low margin development programs and the programs that have been impacted by the FY 'twenty four EACs, that's going to give us a step up towards our targeted EBITDA margins. The rest of the step primarily is going to come from the volume lift that we'll see from development programs that we have in house that we've executed on where we're awaiting the transition or working through the transition to production. Now there's a number of those programs, it's not 1 or 2, it's a number of them and they each have their own profile, but as to roll forward into revenue.

Speaker 2

But as I think about our organic growth over the next couple of years, it's going to be primarily driven by those development programs and their transition to production and they happen on different timelines. We talked about LTAMs as more near term, but we have a number of other programs that will be feathering in as we exit 'twenty five, as we work our way through 'twenty six, and get full run rate benefit of those programs in the back half of 'twenty six and 'twenty seven. So there's a number of different programs. But as I think about our organic growth for the next couple of years, I think we have good line of sight tied to the development programs that we've won, executed on and are working our way through the transition from development to production.

Speaker 1

Yes. And I think I would point back to Bill's comments and around the color we're putting around FY 2025 and that's that we I point back to our adjusted EBITDA margins that we expect, which is low double digit adjusted margins overall in fiscal 2025.

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. Thanks. Thank you, operator, and thanks, everyone, for your interest and participation today, and we look forward to providing another update on Q1 FY 'twenty five in our next earnings call. Thanks very much. Thank you.

Operator

This concludes today's conference call. Thank you for your

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Earnings Conference Call
Mercury Systems Q4 2024
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