Good day, everyone, and welcome to the Mercury Systems’ Fourth Quarter Fiscal 2019 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, Mike Ruppert. Please go ahead, sir.

Good afternoon and thank you 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. The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events & Presentations. Please turn to Slide 2 in the presentation. Before we get started, I would 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. 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, free cash flow, organic revenue and acquired revenue. A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release. I'll now turn the call over to Mercury's President and CEO, Mark Aslett. Please turn to Slide 3.

Thanks Mike. Good afternoon, everyone, and thanks for joining us. I'll begin with the business update. Mike will review the financials and guidance, and then we'll open it up for your questions. Fiscal 2019 was another very successful year for Mercury. We ended the year with strong results in the fourth quarter including record bookings, backlog and revenue. The industry environment is positive and our strategy and business model of performing extremely well. Our total revenues have continued to grow faster than the industry average. Organically revenue for fiscal 2019 was up 12% compared with 7% in FY 2018. We supplemented at this high level of organic growth with strategic M&A, completing four acquisitions while also making solid progress, integrating previously acquired businesses. After reloading the balance sheet with our recent equity offering, we were strategically well positioned for continued organic and M&A driven growth in fiscal 2020. The acquisition of American Panel Corporation, or APC, which we expect to close later this quarter is another great example of our strategy in auction. It's also the latest step forward in our plan to build out an industry leading C4I business. Without its background, let's turn to our financial results on Slide 4 starting at the fiscal year level. Total bookings and revenue for fiscal 2019 were up 39% and 33% from FY 2018 respectively both hitting all time records. Mercury is book-to-bill for FY 2019 was the strong 1.2. A year end backlog increased 39% to record levels. It was also a great year for new design wins, which told more than $1 billion in potential lifetime volume. On the bottom line GAAP net income for fiscal 2019 increased 14% year-over-year. Adjusted EBITDA was up 27% hitting a new record, free cash flow and more than doubled to 49% of…

Thank you, Mark, and good afternoon again, everyone. Mercury concluded a great fiscal 2019 with strong financial results in the fourth quarter, including record bookings, backlog and revenue. Operating and free cash flow we're also strong and aligned with our expectations. In addition to record operating results, it was an active quarter for acquisitions and balance sheet reloading. We announced in close the Syntonic and Athena transactions and completed negotiations with American Panel Corporation. We also raised $455 million of proceeds in a follow on equity offering, providing the financial flexibility we need given the strength of our M&A pipeline. As a result, Mercury is well positioned to deliver another year of growth and profitability in fiscal 2020. Turning now to Slide 10 in our Q4 fiscal 2019 results. Mercury's total bookings increased 41% year-over-year to a record $241 million, driving a $1.36 book-to-bill ratio. We ended the quarter with a record backlog of $625 million, up 40% from Q4 fiscal 2018. Total revenue for Q4 increased 16% year-over-year to a record $177 million, exceeding the top end of our guidance of $164 million to $173 million. Organically revenue increased 4% from Q4 fiscal 2018, which benefited from $11 million of revenue that slipped from Q3, excluding that $11 million in Q4 last year. Organic revenue for Q4 fiscal 2019 would have been up 12% year-over-year. Gross margin for the fourth quarter was 45.1%. This is above our guidance of 43.6% to 44.5% and above our gross margin of 44.7% in Q4 last year. The increase from last year largely reflects program mix and operational efficiencies. In Q4, R&D was up sequentially by $2.9 million, growing to $20.3 million from $17.4 million in Q3. R&D as a percentage of sales was 11.5%. Looking forward, we expect to continue to invest…

[Operator Instructions] And our first question comes from the line of Seth Seifman with JPMorgan. Your line is now open.

Thanks very much, and good afternoon. I wanted to ask a little bit about the profitability, and you laid out some of the incremental R&D, SG&A, lower gross margins in the first part of the year. Maybe if you could talk a little – in a little bit more detail about sort of the opportunities that emerged. It sounds like opportunities that emerged during the quarter that made you see the utility of the incremental investment?

Yes. Seth, it’s Mark. I wouldn't say it was necessarily during the quarter. I think we continued to operate in a pretty dynamic environment from a growth perspective. Clearly we've seen some significant increases in the government spending in RDT&E. That's driving a lot of new design win activities in the areas that I'd mentioned in my prepared remarks. And so, we're going to continue to invest in the business from a growth perspective to go capture those new design wins. So it's a continuation of the theme that we saw throughout fiscal 2019.

Yes. Seth just to add that when we entered the year, if you look back at our guidance in fiscal 2019, our revenue dramatically outperformed and what we thought it was going to be. And as we went through the year, saw the opportunities, as Mark said, we thought it was a good time to continue to invest in the business because we have the opportunities to do so and still deliver record results.

Sure. Absolutely. And then just as a follow-up. The first quarter margin – adjusted EBITDA margin versus the full-year margin implies a negative rate at the end of the year. That's kind of nicely above the guide for the full-year. And so, I mean, would you think of the full-year as kind of a go-forward type of margin or think of the first half investment that we're seeing as a little bit more of a one-time and having the exit rate be more of a go-forward margin?

Yes. I think Seth, what you're going to see through the year, and I talked a little bit about it in the prepared remarks is a couple of dynamics. First is that when we talk about the revenue split, we think that in fiscal 2020 it’s going to be similar to fiscal 2019. So if you look back, it was around 45%, 46% in H1. Gross margins for the year guidance is midpoint is about 44% and 43.5% for Q1, so expect some increase in the second half, as you said, to average 44% gross margin for the year. So we see that picking up throughout the year. On R&D, I mentioned about 11% of sales for fiscal 2020, it was 10.5% in fiscal 2019. And if you look at the increase in Q4 fiscal 2019 and you run rate that, you'll see that we've already made some investments. So the ramp up to 11% is almost just run rate in Q4 and then adding some small growth to that. But as you say, on a percentage basis, we expect that to come down as revenues grow, but the R&D doesn't grow as fast. And then SG&A is the other piece of it, which I mentioned would be about 17% of sales that's flat with 2019. But since we expect revenue to be greater in H2 than H1, the percentage of SG&A will be a little higher in H1 and lower in H2. So at the EBITDA level, you're going to see the same trend that you're picking up on 22% for the year. We got it 20% in Q1, so we'd expect H1 to be lower and then the second half to be higher. And I think what you're seeing when you step back from all that is the operating leverage that we're building into the business. So you're really going to see it we think in the second half of fiscal 2020 because we're making the investments now and then we think we'll be incredibly well positioned going into fiscal 2021 and beyond.

So I think we do, as Mike said in his prepared remarks, we do see the opportunity for EBITDA margins to expand in the out years, just given the operating leverage that we see in the business. That's been said is – as said just literally in the question that you asked earlier, there's a lot of opportunity to invest for us to continue to grow the business organically at well above the industry average growth rates and when we see those opportunities, yes, we're probably going to lean in.

Excellent. Thanks very much.

Thank you. And our next question comes from the line of Jon Raviv with Citi. Your line is now open.

Hey, thanks guys and good afternoon. Hey, how are you? Just following on the margin question, could you just clarify some language in this slides between staying above 20% versus driving to the higher end of that business model range, does that sort of the difference between, say mid-term and or near to mid-term versus longer term aspirations?

Yes. I mean, I think from an EBITDA perspective, Jon, nothing's changed. We want to drive and continue to increase EBITDA margin over the long-term. In Q1, we were 20% is our guidance and as we just discussed, we see that ramping up throughout the year. So, we see the operating leverage in the business and we want to continue to grow that fiscal 2021 and beyond. And as I mentioned that we think you'll see some of it in H2 of this year as we currently see in seeing it play out, so no, no contradiction from our perspective in terms of wanting to continue to grow EBITDA to the high-end of ranges.

So if remember Jon in our Investor presentation, we've got an inverted pyramid slide that compares kind of Mercury's financial profile. With that of all publicly traded companies as well as an index of Tier 2 defense companies that particular slide references an EBITDA margin greater than 20%. So it's kind of consistent with the performance that we have delivered, which is obviously been above that number.

Not understood. And then also could you guys often offer some perspective on industry M&A, which seems to be probably based on financing, internal investments in creating investment pools to go after opportunities. Can you offer some perspective on the risks and opportunities in that dynamic? Is it seems like combined businesses to drive one of their own IRAD on it pace, sounds like it's an opposition to your strategy to capture more outsourcing? So any thoughts on industry M&A and on the primes would be – grateful for that. Thank you.

Yes. Clearly I think we're in an environment that is requiring greater level of investment. Mercury has probably got one of the highest internal R&D to revenue spend ratios and it's probably double on a percentage basis, the next closest company. So I do think there's been some, a lot of talk and potentially some transactions driven by that. We feel really good about, the position that we're in. I mean, we're investing significantly in the business. To put it in perspective, on a cumulative basis over the last five years, we've invested in over $285 million on R&D. We've invested over $95 million on CapEx and including APC, $800 million of capital in M&A. So for a combined total of close to $1.2 billion and we're focusing not investment in a very, very specific set of areas, which is building these very sophisticated processing subsystems for use on board platforms. So we think that the investments that we're making, a very significant and far out strip, all the companies in the space. And we think it's the primary reason that actually the rate of outsourcing is increased, leading to the substantial growth that we saw in our subsystems revenue year-over-year, which was all 85% compare to fiscal 2018. So yes, I think investment is important in this environment and we feel that we're well positioned Jon.

Thank you.

Thank you. And our next question comes from the line of Sheila Kahyaoglu with Jefferies. Your line is now open.

Thank you and good afternoon.

Hi, Sheila.

Thanks. I was just wondering if you could expand upon your comments within the Phoenix facility and expanding that manufacturing capability. What that adds to your vertical integration capacity is and maybe how you guys think about CapEx and building that out on your own versus doing a deal to do so?

Sure. Sheila. So as I said in my prepared remarks, there's actually really two different types of manufacturing capabilities that we have in Phoenix. The first is the digital SMT capability that we have built out over the last couple of years. The primary driver of that as you know was for us to be able to in-source the manufacturing of our secure processing product line, which we've largely completed. What we talked about on the call for an expansion perspective was really the other part of the Phoenix facility that really came to us again through the acquisition of the micro semi carve out assets. And what we see here is the opportunity of growing substantially our custom microelectronics capability. And what we see happening in the commercial world is this actually an explosion in the amount of specialized silicon, whether it be for AI for autonomy for machine learning for mixed signal applications. And the Defense industry desperately needs to get access to that. And so what we're doing is kind of positioning ourselves, given that we're a horizontal company inside of the industry and operating as a high-tech company to become that leading conduit for that capability into the Defense industry. So we're going to build-up, the capability set that we already have with expanded that to become that leading company.

Got it. And then just on the APC, maybe if you could talk about what opportunities that opens up, how it combines with GECO and who we competing with there?

Sure. So we are combining it together. We will combine it together with the other acquisitions that we done in this space. Though specifically see yes, with RTL and most recently GECO Avionics. And we're looking to be able to provide, a full set of capabilities in the Avionics suite and to do that providing it to our existing customers. And what we see happening is that the – as we've talked about it from a trend perspective, this de-layering occurring that certain companies in the space would actually like to deal directly with companies at the Tier 2 as opposed to buying a complete, fully integrated Tier 1 solution. So it allows them to do things more affordably, probably more quickly and to ask them of their own volume. And so what the APC acquisition gives us it’s assets to some of the display technologies that compliment and some of the processing capabilities in Avionics and Mission Computing that we previously acquired.

Thank you.

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

Thanks. Good afternoon, Mark and Mike.

Hi, Peter.

Hi, Mike, just a clarification on the CapEx, you said targeting the 5% level. I thought that was a pretty originally the target for fiscal 2019? Did some CapEx shift out or just maybe you could just clarify that first?

Yes. It did, Peter. I mean, so we are expecting 5% in fiscal 2020 came in a little lower than that around 4% in fiscal 2019. Main reason for that is the West Coast to facility consolidation that we've been talking about pushed out a little bit from the second half of this year into the first half of next year. And that's really what's driving that.

Got it. And then on just I know you don't formally give a free cash flow guidance, but it still the kind of the targeting at 50% of adjusted EBITDA is still a good bogey here when we think about fiscal 2020?

Yes. That's what we're shooting for and I did point out the Q1 is going to be lower. So of the 5% of CapEx for fiscal 2020, it is going to be front end loaded primarily because of the West Coast consolidation that slipped from this year into the beginning of next. So CapEx in Q1 throughout a number around 7% as an estimate and so that's going to put some pressure on free cash flow conversion in Q1. So I mentioned 30% to 40%. But for the year, even though we're expecting 5% of CapEx, we still are targeting the 50% free cash flow to adjusted EBITDA conversion rate.

Got it. And then, Mark on APC kind of the end market mix, it sounds like it's heavily defense oriented, but there's also a little bit of commercial. Could you give us a little color on that or how much there is of commercial?

Yes. So the defense market is 80% and commercial is 20%.

Okay. And of that commercial piece, is it on a larger commercial aircraft programs or bizjets or what exactly is…

So 737, A320 is an example.

Got it. And just around comfort level for having some of that commercial i.e. you, just historically, I think you've always focused on the defense piece.

So in the avionics, the strategy is really around aerospace and defense. I think that's our target market in total. Obviously we're heavily weighted towards defense today, but we do see opportunities there. Our business with Airbus is an example has grown very substantially over the last few years, the result of the CES acquisition that we did over in Geneva and we see additional opportunities. So it's primarily defense, but the aerospace exposure just given what they do is welcome as well.

Great color. Nice quarter. Thanks.

Okay. Thanks Peter.

Thank you. And our next question comes from the line of Ken Herbert with Canaccord. Your line is now open.

Hi, good afternoon.

Hi Ken.

Mike, I just wanted to follow-up on the free cash flow question. I mean, it looks like the guidance implies maybe $5 million to $10 million-ish in terms of working capital benefit in 2020. You obviously had a really good year in working capital in 2019. Are there other opportunities to maybe do a little bit more with working capital in 2020 or as the investments in the first half maybe just driving a little bit more caution there?

I think that – so we did have a good improvement in working capital in fiscal 2019 compared to fiscal 2018. As you recall, in fiscal 2018, we were building up a lot of the inventory associated with the in-sourcing. And so we're pleased with where we are from a working capital perspective Ken, but we do still see additional opportunities in one of the areas in terms of the OpEx where we're investing in is our operations. And we've talked about also some of the facility consolidation and we see opportunities on the inventory side that we're focused on right now. There's tweaks everywhere in terms of DSO is that we're focused on, but really I think the opportunity we see is on the inventory side.

And would it be fair to assume just based on your comments around timing and margin that shouldn't accelerate as we go through the year and maybe more of an improvement in the second half of the year?

Yes, I mean obviously we're not guiding the timing of it, but yes, I do think that we should see gradual improvement in terms of inventory turns as we go through the year.

Okay, great. Thanks. And if I could Mark just one question, I mean, you called out outsourcing, which is obviously something you've called out as an opportunity for many quarters and it clearly seems like that's playing out, but I'm just curious with where we are with the budget, with clearly some of the pressure on primes and the growth they're seeing. Have you seen an inflection in those opportunities recently? Or is there anything in particular you could maybe point to that we could watch out for is that, is that maybe steps up. I mean, I agree it's a secular trend, but I'm just curious how you've seen that play out here recently, just considering the budgets and the strength and the bookings that your customers are seeing?

Yes. So we think it is picking off, I'll give you a couple of examples. I mean this past quarter, we want to enterprise secure processing radar applications for two different customers. So literally they're going to base the next-generation radar processes around an outsourced Mercury solution, both of which are actually examples of the outsourcing trend. What we see and it's a little counterintuitive, you would think that with growth maybe they would be to bring more work in house, but it's actually the opposite. Although they're actually hiring our customer, they're not hiring quickly enough to even address the aging workforce and there's a growing skills gap for the sorts of stuff that we do. We've also seen clearly an increase in the use of OTA contracting – OTA contracts that are requiring the defense primes to basically invest more upfront and they're seeking to partner with companies such as Mercury who has the ability and the willingness to invest. As part of those OTAs, we're also seeing that the government are actually requesting or demanding that a certain percentage of the work go to non-traditional defense contractors, which obviously Mercury is. And then finally, I think the other thing that is driving the outsourcing trend is the greater need for agility and speed in these next-generation competitions and that plays very, very nicely with our technology development model. So outsourcing, it's alive and well. As I mentioned, we had 85% growth in our subsystems business for fiscal year 2019. It was up 51% in Q4 alone. So we're pretty excited about what we see happening and we're very well positioned.

Great. Thank you very much for the color.

Thank you.

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

Hey, good evening, guys. Thanks for taking the questions here. Nice quarter. Nice bookings. Mark, just on EPC, can you maybe tell me a little bit more on the strategic fit? I mean the price tag 3x sales or 11x EBITDA. I've always thought of displays being a little bit more commoditize, the platform exposure seems to be a little bit more legacy. Just I mean in the comments you gave, you sounded like you wanted to give some of your customers an option of not going to the full integrated Tier 1. So I guess you really don't need the scale to compete there, but just maybe a little bit more, I mean it seems like there's so many other areas. I mean you threw out autonomy, artificial intelligence, machine learning, whether it's secure computing. It just seems like there's so many other market channels and silos to build white displays.

So it's important, because it ties back to the delayering trends. What we see in a very high level is that the government and several other primes, want to move away from kind of vendor lock, where there's proprietary interdependent architectures that is resulting in a lower technology refresh rate, and the introduction of new capabilities then waltz, the government in certain primes would like, and the actual display technology is a key gauge way of being able to add new technology and the associated processing on the platform, whether it would be for different weapons applications or for different types of census. The census themselves are going through a complete kind of refreshed to from really more smaller standalone type units into what is known as large area displays. These large area displays needed to be highly ruggedized, taught capable, capable of operating and heads up display type capabilities while still providing redundancy. And APC has got a very unique set of technologies and capabilities, not only in some of the platforms that I mentioned, but also on the [train], Blackhawk and other platforms. So we think it's strategically important. It's a natural extension of the mission computing capability and the avionics processing capability that we have and our customers are asking for it. Mike.

Got it, okay. That's helpful. Just one more, on the gross margins, you've got the long-term target 45% to 50%. We've sort of been at the lower end of that range. Is the upper end of that range, do you think is it still reasonable given that, what we're looking at is going to be some significant investment in new weapons systems, new capabilities, you're going to have that mix shift with new programs start, and obviously there'll be a very good thing for revenue growth and bookings. But does that naturally keep the margins maybe a bit more depressed as sort of some of that mixed shift change or design wins keep on coming and you take more see ride over time?

Yes. Mike, I'll take a cut at that one. I mean, I think that if you look back on gross margins where we've been they've come down as you know, over the last couple of years because of what you just said, right. It's the new program wins. We've seen a little bit of pressure from some of our acquisitions like Germane, but the big driver is the additional customer funded R&D. And we've always said we liked the customer funded R&D, because while lowers gross margins, it is the precursor to the hardware, a higher, margin hardware annuities that we'll see over the years. And what we've always talked about is that will – when those transitions, specific program that the margin should increase over time. But what we are seeing is we're seeing incredible level and we're looking at in fiscal 2020 as well of new program starts. And you can see that in our guidance for gross margins for the year. So I think that, when you look at our portfolio contracts, we continued to think that we've got a lot of new contracts that the transition, but we continue to see a lot of opportunities. And you can see that in the gross margin guidance for fiscal 2020.

So I think the way to think about it as we've talked about on prior calls is that your gross margins kind of hovering where it is. But as we continue to grow the business over time, you'll see the operating leverage, you'll see EBITDA margins continue to expand. That's the goal.

Got it, very good. Thanks guys.

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

Hi, good afternoon. Just wanted to start out with a higher level questions. As we think about the implications of having more subsystem or revenue? Can you give us maybe a sense of what that means for your margins and maybe ability to expand more content?

Yes. So the shift towards subsystems has really driven a pretty substantial growth in terms of our content on a program basis as well as the potential lifetime value of the programs. If you're in early stage of that subsystem design and development, either that we're funding or we're getting additional funding from our customers in the form of CRAD, we typically see some gross margin, pressure, but is those subsystems actually transition into production and which we have a number of those, likely to occur during fiscal 2020. You start to get the benefit of that higher margin annuity. So we think that the shift towards subsystems, which is really where the outsourcing is occurring, is critically important to our growth as well as scaling the business over time Jonathan. So it's a good thing.

Got it. And then just relative to APC, how do we think about the longer-term operating margin profile or EBITDA margin profile compared with the other lines of your businesses and are there similar maybe costs opportunities on that side?

Yes, so actually APC in EBITDA level is in line with our model. It's actually slightly accretive to where we are right now. And so it's a nice business. They've got great technologies, you've got some amazing programs and we see a really good fit. So it's a good business.

Thank you.

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

Okay. Well, thank you very much for listening everyone. We look forward to speaking to you again next quarter. Take care.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone have a great day.