Good day everyone and welcome to the Mercury Systems Third Quarter Fiscal 2018 Conference Call. Today’s call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the Company’s Executive Vice President and Chief Financial Officer, Mike Ruppert. Please go ahead, sir.

Good afternoon, and thank you everyone for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. 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. Before we get started, 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. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. Our forward-looking statements should be considered in conjunction with the cautionary statements in today’s earnings 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 in the earnings press release, we issued this afternoon. I’ll now turn the call over to Mercury’s President and CEO, Mark Aslett.

Thanks, Mike. Good afternoon, everyone and thanks for joining us. Before we dive in, I’d like to say, how happy I’m to have Mike Ruppert with us today, in his new role as a CFO. Our acquisition related growth, since Mike joined Mercury three years ago is a testament to both his industry experience and capabilities as a leader. Mike has been running our combined finance and M&A teams as CFO since mid-Q3 and he’s off to a great start. As expected, we’re already seeing a high level of integration in our corporate development, finance and accounting team activities. So Mike, welcome aboard. With that, I’ll turn now to the business update. Michael will review the financials and guidance. And then, we’ll open it up your questions. Q3 was more challenging than we had originally anticipated, as a result of the prolonged continuing resolution. Despite this brief setback, which I’ll talk about in a moment, we’re reaffirming our prior guidance for the full fiscal year and raising the range including Themis. At the midpoint, our updated consolidated guidance would result in approximately 20% growth in both revenue and adjusted EBITDA year-over-year, substantially, faster growth in the industry as a whole. Big picture nothing has changed. Mercury’s growth engine continued to perform strongly in Q3, as did the business overall. As we said in the past, we expect to continue growing at high single-digit low double-digit rates organically, supplemented by strategic and accretive acquisitions. For fiscal 2018, we’re currently expecting 7% organic growth. Looking back over the past five years and assuming the midpoint of consolidated guidance will deliver 20% total revenue and over 60% adjusted EBITDA compounded annual growth. We’ve made substantial investments to achieve results at this level, including above industry average internal R&D funding, CapEx to buildout our…

Thank you, Mark and good afternoon again everyone. Before we go through the company’s financial results, I want to provide a couple of personal thoughts. Serving as Mercury’s CFO is an honor and a great opportunity. Based on my experience here over the past three years I can say with the upmost confidence that I’m stepping into this new role at an exciting time for Mercury. Our prospects for growth have never been brighter. We’ve invested in the business over the last few quarters as we’ve insourced our manufacturing, we’ve upgraded our facilities and integrated our acquisitions and the M&A pipeline is as robust as I’ve seen it since starting at Mercury. So as I take on this role I believe we’re well positioned to continue to create value through strong organic growth as well as strategic, synergistic and financially accretive acquisitions. Equally as important, our team is strong in addition to having Nelson and Erickson heading up M&A as Mark mentioned, Michelle McCarthy recently joined Mercury as our new Chief Accounting Officer. Since taking on this role I’ve been very impressed with the talent and professionalism of our entire finance and accounting team. I’m looking forward to working with Nelson, Michelle and everyone on our M&A, finance and accounting teams to deliver value for all our stakeholders in the years ahead. now to the Financial Review. As a reminder, our consolidated results include two categories of revenue, organic and acquired. Acquired revenue is revenue associated with the businesses that have been part of mercury for four full quarters or less. After the completion of four full quarters, revenue from acquired businesses is treated as organic for current and comparable historical periods. on this call, acquired revenue includes the contributions of Delta Microwave, which we acquired in Q4 of fiscal…

[Operator Instructions] And our first question comes from the line of Jon Raviv with Citi. Your line is open.

Hey, guys, good afternoon.

Hi, Jon. How are you?

Good. Thanks. I was wondering, if you could just talk a little bit about the 7% organic growth this year. I realize that the target, you typically talk about is relatively broad, but just why 7% this year and what the confidence is in getting that to accelerate or the possibility that accelerating into FY2019?

Yes. So we did basically say that we think that growth rate is approximately 7% to this fiscal year that will obviously, relate to a much higher growth rates, as you know 17% organically in Q4. If you step back some years, it going to be a little higher organic growth rate – some a little less. And so we still feel that high single-digit low double-digit is a good number for us. The primary reason however, if you look at that the organic growth rate isn’t higher this fiscal year is due to the fact that we actually completed a very large homeland defense radar program in fiscal 2017, which totaled $20 million. So the delta between twenty fiscal 2018 and fiscal 2017 is approximately $18.5 million. So if you exclude that revenue on a period-over-period basis, our organic growth rate would actually be greater than 12%. So it really just depends on what’s happening programmatically, Jon.

Got it. And then on gross margins, just seem to be little bit low again in this quarter, it was from your half year guidance until next year. But now how do you see that trending going into FY2019. You mention mix being initiative, I know I mean there’s a reality there and I guess more broadly is, if we get off a 23% adjusted EBITDA margin. Assume you don’t make any more deal?

Yes. So it’s a big picture. I think the guidance range or the – that we have from our pro forma target model perspective is still good. You know that 45% to 50%, as we’ve said, it really depends on what is happening from a program mix perspective that largely dictates any variability. This quarter, we don’t see a quiet Thesis and as Mike said in his prepared remarks, there was some inventory step up that affected gross margins during the fourth quarter. So we think that the gross margin range that we have in the model is good. How it is that we increase the adjusted EBITDA from the current forecast to run about 23% to the higher end of the range is basically operating leverage. As we continue to grow the top line and benefit from the insourcing of manufacturing and the fact that expenses should continue to grow at a rate that is slower than the overall top line, it will eventually grow into that 22% to 26% model.

And then just last one. Can we expect to see that benefit starts to grew in first quarter of 2019, on the levers…

No, we’re not going to talk – we’re not going to talk about specifically 2019 at this point, Jon, because, we’re near our guiding for Q4.

All right. Thanks.

Thank you. And our next question comes from the line of Seth Seifman with JPMorgan. Your line is now open.

Thanks very much. Okay, good afternoon. You spoke a little bit earlier about more opportunities for M&A, I wonder if you could highlight in the various end markets that you guys call out whether it’s see the sensors or C4I, where you see more opportunity? And then also you talked about wanting to maintain financial flexibility and how the current balance sheet structure gives you that, but sort of what should we think about as being adequate flexibility?

Yes. So why don’t I take the first part of that question. And then Mike can take the balance sheet part. So the M&A pipeline is likely the largest and most actionable that we’ve seen since we really started our M&A program. And I think, Mike feels the same way too. There’s a lot of opportunity in the areas that we’ve kind of laid out. So we continue to see more opportunity in the C4O market, specifically, around Mission Computing and Avionics, which is a target focus for us, following the acquisition of CS that we did 18 months or so ago. And then we also see additional opportunities in this – in the rugged rock service space. And we just completed the acquisition of Themis. And as we said on the last call, we really see Themis as a platform in which we can continue to buildout. And so there are clearly opportunities in that regard, we see opportunities in the security space. A couple of years ago, we did a very interesting IP acquisition of business down in Huntsville that is turned out to be extremely important as we continue to deliver trusted and more secure processing solutions. So we kind of see a range of opportunities but still very, very much in line with the strategy that we’ve laid out with that. Mike would you like to take the second part of that question.

Yes. In all, also add on that I do agree that the pipeline is stronger than I’ve seen it, since I’ve been here. We have a lot of opportunities both big and small. And I think that gets to the capital structure, if you look where we are today, Seth, we consider ourselves relatively modestly leveraged and we have less than $200 million drawn on our $400 million revolver, we’ve got another $150 million accordion feature on that revolver from a leverage perspective. We’re under 1.5 times the net debt to pro forma EBITDA. So we think we’ve got good flexibility right now, but we’re always thoughtful about our capital structure, so as not to restrict optionality and both in terms of our acquisitions strategy and operations. And I think we’ve got a pretty good track record of finding good targets that fit strategically with us. And we’ll evaluate those as they come along.

Great. Thanks very much.

Thank you. So our next question comes from the line of Greg Konrad with Jefferies. Your line is now open.

Good evening. I just wanted to follow-up on the last question. I mean, you mentioned that the pipeline is fuller than it’s ever been. I mean, is there a catalyst for that, I mean, is that the fiscal year 2018 budget. Why is that pipeline bigger than it’s been in the past?

Yes. I think – I mean from my perspective, it’s a handful of things. Obviously, the budget is positive, the outlook for a lot of these companies is positive. And they’re seeing additional growth and the reality as well as the valuations are high, right now, relative to where they’ve been over the last two and 10 years. So I think that is propelling a lot of buyers to explore their alternatives. But we’re looking at small deals that are found our own in a lot of times, we see those are driven by personal interest. We’re looking at carve-outs associated with some of the – some bigger multi-industry companies. And those are driven, I think by focusing their business as well as there’s some benefits now from the tax laws where makes it less owners. So I think that the pipeline and the reason it’s picking up is, generally, because the budget. But each deal we look at is little different, Greg.

Thank you. And then just shift to the organic side, I mean – I think, we’ve heard some contractors still trying to figure out how this the fiscal year 2018 dollars which ended up being bigger than expected flow thorough? And there’s probably an element of capacity constraints to maybe meet some of that funding. I mean – have you had any conversations? Or do you look at the 2018 budget is maybe a catalyst for the outsource trend that you’ve talked about in the past?

So, we kind of looked at the budgets and the individual programs that we’re apart over the micro level and we saw a quarter roughly 10% increase in funding of those programs in GFY 2018 versus 2017 an additional 3% growth the following year. However, I think that’s more directional in nature right because we’re obviously not involved in every part of our program and clearly there are timing differences between appropriations and outlays, but directionally I think we are headed into a better budget environment and we think that we’re pretty well positioned in the areas that are going to continue to see increase funding flows specifically around modernization in a sensor and effective mission side of things and increasingly in C4I. So we feel pretty good about our position, Greg.

Thank you. And our next question comes from the line of Peter Arment with Baird. Your line is now open.

Thanks, good afternoon Mark, Mike. Hey, Mark on the Themis deal now you’ve owned it for, roughly I guess three months, you may be updated should thoughts on the integration process there I think you want to mention maybe $1 million or something around there for cost synergies but maybe give us your thoughts around how you’re approaching the integration there for this deal?

So it’s a good question. So the Themis acquisition I think the way in which we described it previously, we really see as a platform. So it’s got a great management team, they build a very strong set of technologies and capabilities they’re involved in some really good programs. And so the initial acquisition of Themis is not necessarily a cost play. It’s all about how it is that we’re going to actually use that as a platform to continue to grow in the C4I space and to potentially acquire into. And that’s very much what it is that we’re focused on. From a an organic perspective, the feedback from customers has been tremendous. We’re already seeing additional opportunities with the fact with Mercury has acquired them in terms of new pursuits, and we were actually recently informed that literally as a direct result of Mercury acquiring them – they’ve been selected on an important subsurface program which is also been an area that we have been targeting. So overall we couldn’t be happier with the business and the opportunity for us to continue to grow it organically as well as to add to it from an M&A perspective.

And just as a follow-up to that. On the inventory side, is there a difference the way they either outsource and versus your approach on the insource and then how should we expect that the kind of change going forward?

So not too much of a difference, I mean we did acquire approximately $8 million inventory with the purchase of Themis this quarter, but let me kind of step back and just talk a little bit about what’s going on with inventory specifically because clearly there is some things flying around in the market that I think would be a good opportunity for us to respond to. So if you look at all in LTM basis, inventory is up $45 million and it has been a use of cash. Now we actually see this really as an investment in the business from an organic growth perspective, And it really boils down to four things. The first is that it’s an acquisitive company we clearly have added inventory and seen the step up associated with that inventory over the last couple of years. And I just mentioned we’ve actually acquired $8.7 million of inventory associated with Themis. Probably the most important however, is being the fact that we’re focusing on in-sourcing our manufacturing. And so we’ve added $10 million to $12 million of component level inventory associated with standing up the USMO, which is our manufacturing operation in Phoenix. And the way to think about that is that previously when we’re outsourced, that inventory, the component level inventory would have been on that contract manufacture we wouldn’t have owned it. But because we now build out our facility and because we’re actually ramping up production we need to have that component, component stock. Now we’ve also, as we’ve transitioned from that contract manufacturing model to actually ramping up internal production as I mentioned in my prepared remarks, the throughput at the USMO actually increased 50% quarter-over-quarter. We also wanted to ensure that we were able to manage the risk both from…

Is great color. Thanks Mark.

Thank you. And our next question comes from the line of Jonathan Ho with William Blair. Your line is now open.

Hi guys, could you hear me, okay.

We can Jonathan. Yes.

Perfect. Just wanted to – I guess focus on some of your comments around design wins. Are you seeing that translate into increases in either content or maybe capturing more wallet share you with some of these new wins just given in a progress in the strategy?

We are Jonathan. It was actually a pretty amazing quarter in terms of just the things that we’re getting involved with I mean we were selected by a couple of customers on a army ground radar program that’s going to go through a tech refresh, was selected by another incumbent on a different but other very important ground radar program where we’re expecting additional content. We’ve been pursuing a very large classified radar for probably 10 years and had a major breakthrough this past quarter in both the RF side of things where we’re displacing a company. As well as actually potentially winning the process of refresh, which was previously done in-house.

Yeah. We have one being selected in a number of naval C2 and other ground radar applications as a result of the Themis acquisition. so the level of design win activity in new pursuits is as I said in my prepared remarks probably, the highest that I’ve seen since joining the company.

Great. And then just to talk a little bit more about the Phoenix facility. can you give us a sense of what ending wherein in terms of capacity utilization and what further opportunities you have and maybe just the current pace that you’re integrating to drive back that capacity.

Yeah. So go back to – kind of go back to the journey a little bit and think about what we’ve been up to in the last three years. So, if you look at the fiscal 2017. Fiscal 2017 for us was a significant year from a capital expenditure perspective and it really was investing in two things. The first was investing in our new headquarters facility as you know; the least in our prior headquarters in chance to those expiring and we needed to move to accommodate the additional space that we needed to meet our organic growth needs. This second investment was exactly what you were talking about. it was related to the Microsemi Carve-Out acquisition. When we bode the Microsemi businesses, we saw the opportunity as insourcing our digital money factoring and this was a very significant synergy of the deal and it was really the primary reason that allowed us to raise our target financial model from what was then the 18% to 22% adjusted EBITDA to the current goal of 22% to 26%. but to do that, we needed to build out the Phoenix facility, which we basically did during 2017 and 2018. so if you look at it from a CapEx perspective, 2017 was a significant increase and we’re expecting currently that our CapEx in fiscal 2018 will decrease by $18 million. Now, with that build out of that facility in place as I just went through fiscal 2018 is all about basically insourcing the manufacturing and ramping up the production rate and we’re really in the – call it, the midst of that right now. so we saw a 50% increase in throughput in the last quarter alone. but the working capital builds really began at the end of fiscal 2017 and this moved into fiscal 2018. So this particular quarter if you look at it from an inventory perspective, absent the acquisition of Themis and absent the inventory associated with the deals that moved to Q4, our inventory growth was basically slightly negative. So we’ve kind of seen that build somewhat ameliorate. and now, it’s about continuing to ramp the capacity and the throughput in that facility, and as we move into fiscal 2019, it’s all about optimization; it’s optimizing that facility to ensure that we can continue to grow, but from my perspective, I mean I’m extremely proud of what the team has been able to do. the Phoenix is a state-of-the-art; it’s a trusted manufacturing facility. it recently was awarded the Frost & Sullivan manufacturing leadership award. the production is ramping, and the facility itself is critical to both our strategy, our growth and our profitability goals as I mentioned. So I think we’ve managed a very, very complex outsourcing to insourcing transition with no disruption to the business and it’s supporting the growth objectives.

Thank you. and our next question comes from the line of Mike Ciarmoli with SunTrust. Your line is now open.

Hey, good evening guys. Thanks for taking the questions. Mark, you were sort of on a role there, when you’re answering Peter’s question about inventory and maybe, anything else that’s negative in the marketplace or being miscommunicated that you’d want to address now, SEWIP program or anything else on your mind.

It’s a great point, Mike. Yeah. So, why don’t I clear up some of the confusion on that specific program and SEWIP basically stands for, as you know, Surface Electronic Warfare Improvement Program, and it’s a collection of individually funded programs and each of the programs provide distinct yet complementary capabilities over time. the individual programs themselves are actually a different life cycle stages and are run by different prime contractors. and we’re actually performing work on two major programs; SEWIP Block 2 and SEWIP Block 3. Block 2 is a very well funded program; the program is currently in full rate production and is a meaningful contributor to our financial results of the year level. however, that doesn’t mean that the program itself will produce ratably each quarter. It can’t be somewhat lumping. block 3 on the other hand, which I think is where some of the confusion is in the marketplace, has experienced some delays and it’s in the engineering phase, and it’s basically immaterial to our current financials. so if you kind of give a brief update on what we see happening on Block 2 and Block 3. So late in fiscal Q3, Lockheed received a $119 million block 2 contract award modification. And in turn on the last working day of the quarter, we received a $16.8 million full rate production award, which was actually a 16% increase versus the prior year. we currently expect the SEWIP Block 2 will be our largest – second largest revenue program growing 35% year-over-year and our fourth largest bookings program. block 3 as I mentioned, is an important program, it’s an integral part of the Navy’s Surface EW upgrades. the program is slightly behind schedule, but we understand that it’s actually performing better and the DoD more importantly is very eager to get to milestone C and sought to deploy the system to put the materiality block 3 in perspective, we’ve completed $2.9 million of engineering work over the last 12 months. So, it’s basically immaterial to our financial results and so I think there was some confusion as to block 3 and block 2. Block 3, we expect to get some long lead time funding associated with the first LRIP next fiscal year and if you look at the GFY budget, the funding for Block 3 is increased substantially; it’s of 80% in GFY 19 to $420 million. So the program is alive and well, it’s an important capability and we’ll well positioned on both.

Got it. that’s helpful. Mark, just some housekeeping, on the bookings and backlog, was there any material contribution from Themis to each of those metrics?

So, the bookings – Themis had a strong bookings quarter as did we. So both organically as well as in terms of a positive book-to-bill Mike, but we’re not going to break out the bookings per se.

Got it. What about just the continuing resolution, the bookings environment for you was very strong, and obviously, it sounds like a bulk of that revenue mix was tied to one program, but you’ve dealt with continuing resolutions in the past and with anything is that different. I know we had the shutdown, but usually you kind of…

yeah.

Had that impact you on the bookings, what was different this time versus prior.

yeah. So it’s a good question, Mike, I think on the last call, we’ve anticipated that would kind of get through the CR by mid-February and it basically moved into March, and the largest impact that we had was on SEWIP Block 2. As I mentioned there were a couple of other deals that also got impacted that totaled the $11 million. But lucky to received the SEWIP Block 2 contract modification award literally right at the last day of the quarter. So it just that kind of things bunching up to the back end of the quarter because of the extended or prolonged CR is really what hit us. So we have CRs, I think each and every year for probably the last seven years, but this was longer than what we’ve seen in the past and it was really that hit us.

Got it. And then just last one housekeeping, you probably had some more time to digest the tax law changes, any more thoughts on the long term 30% tax rate or should we still be thinking about that same target?

Yes, Mike, as we’re not going to hit on that right now. We’ll provide more guidance on that on our next call when we provide our guidance for fiscal 2019.

Got it. Thanks guys.

Thank you. And our next question comes from Ronald Epstein with Bank of America Merrill Lynch. Your line is now open.

Hi, good evening guys. So how many operating margins like cut in half, maybe not quite 60% of what they were – how sequentially quarter-over-quarter or year-over-year, I mean what happened there, like I don’t get that, I understand the top-line growth, but it’s not profitable and there’s no cash, so help me understand why this is good?

So if you look at the – actually learnings ofthe working capitals off, right in terms of Q3, because I think we hit it only in the prepared remarks, Ron.

Yes, so Ron, maybe we start with cash, because that’s clearly an issue that we want to be able to explain both for the first three quarters and for Q3. So if you look at what happened in the first three quarters, the biggest use of cash was what Mark talked about, it was the inventory by far. And the second was accounts receivable, and in Q3 we had two things if you look at the balance sheet on that the accounts receivable. We see that AR increased in Q3 by $14 million, $6 million of that was from Themis, $8 million was from an organic increase. And that was really driven primarily by the back end nature of the quarter due to the extended CR that Mark talked about that reduced the in quarter collections and thereby increased AR at the quarter end. So we actually saw a cash outflow of close to $10 million in Q3 associated with AR. And what we’ve also seen over the last couple quarters, and as I’ve come in, it’s one of the things that that I’m focused on where I think we’ve got good opportunity, is if you look at accounts receivable for the first three quarters of the year, we did see an increase in Q1 and Q2 as well, as our DSOs grew disproportionately to revenues, so AR grew with revenue, but DSOs grew as well. And the primary driver of that that we saw was towards the end of the year or so our customers’ fiscal year, the calendar year 12/31 or Q2 was our customers are really managing their cash in their AP at the end of the year. And if you look to Q1 and Q2, we saw an uptick in average days late from our customers…

When would you expect to see free cash flow as a percentage of net income get back to a level of 80% something like that. Most defense companies have pretty predictable free cash flow, so when will we expect that to happen for you guys?

So we expect that I mean, if you look at the inventory, it’s already basically declined a little bit quarter-over-quarter. So what I mentioned is, I was talking about the journey that we’re on, one year, two year or three, year three is really where we’re focused on the optimization right, we’re still in the build phase of all the ramp face of getting that USMO up and running. So fiscal 2019, we should begin to see the improvements in EBITDA to free cash flow run.

Improvements. All right. And then, if you guys can speak to the margin, so operating margins in the quarter of 5.9%, I mean some of your competitors in the space of operating margins of 20%, so I’m just trying to get my head around why the operating margin less than 6%?

Well, I think just a couple of housekeeping things on that. So 5.9% EBIT margins that did include $1.3 million of acquisition costs and other related expenses. We had $1.4 million of restructuring and other, and we also had $7.1 million of amortization of other intangibles associated with the acquisitions. So when you look at big picture of what happened, gross profit as we discussed did go down was 45.4%, some of that was related to the step up of the inventory associated with Themis acquisition. SG&A was 21.1%, it was relatively constant as a percentage of sales of 18.2%. And then R&D is stayed consistent with our model at 12.9%. So I think what you’re seeing on the bottom line is some of those one-time costs associated with the acquisition.

The other thing as well, right, as we said, we had $10 million or a $11 million of revenue basically moved from period to period. It’s not only because our revenues would have been in line with the guidance that we gave in our adjusted EBITDA would have actually being above the high end of the range.

All right. Okay guys. Thank you.

Thank you. And our next question comes from the line of Brian Ruttenbur with Drexel Hamilton. Your line is now open.

Yes, thank you very much. Just a quick wrap up. I know that you haven’t given 2019 yet, and will probably after this quarter. But it seems like growth should be accelerated in 2019 versus 2018 on internal basis and margin should be expanding is that correct after hearing all the Q&A and jumping in especially after the last Q&A, last question falling [ph]. Can you talk a little bit about at least generally which direction things are going that there’s an acceleration are you anticipate acceleration business?

So we’ll have more to talk about that on the next call Brian, I’m not going to get into discussion around fiscal 2019 on this call.

Okay, thank you. And we have a follow-up question from the line of Jon Raviv with Citi. Your line is now open.

Hi, thanks guys for squeezing me in. Just on the margin question, is there somewhere, I mean year-on-year commercial business model somewhat, how do you guys thinking about incremental margins in this business?

So, I think if you look at say, well, we’ll see more in Q4, let’s put it that way here with the incremental revenue that we have focused on generating in both organically as well as the acquired in the revenues that moved, my belief is that you’re going to start to see kind of the operating leverage if work.

All right. Thank you so much.

Thank you. And Mr. Aslett, it appears there are no further questions. Therefore, I’d like to turn the call back over to you for any closing remarks.

Okay. Well, let’s thank you all very much for listening. We look forward to speaking to you again next quarter. Thank you.