Good day, everyone, and welcome to the Mercury Systems Fourth Quarter Fiscal 2023 Conference Call. Today's call is being recorded. At this time, for opening remarks and introduction, 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.

Good afternoon, and thank you for joining us. With me today is our President and Chief Executive Officer, Bill Ballhaus. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website 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. 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, Bill Ballhaus. Please turn to Slide 3.

Thanks, Dave. Good afternoon, everyone, and thank you for joining us. In this call, I'll cover 3 topics: first, introductory comments on recent changes, actions taken at the company and my initial impressions; second, our priorities and focus going forward; and third, expectations for our performance both for FY '24 and longer term. I'll then turn it over to Dave to discuss our results and look forward to wrapping up with Q&A. Before diving in, I wanted to take a moment to recognize the efforts of the Mercury team. Their demonstrated resilience over time and their dedication and commitment to serving our clients in their important missions. As we've discussed throughout the company, with our recent announcements, we are on a very clear path to unlock the intrinsic value of Mercury for our customers, shareholders and employees through enhanced operational focus. As a team, we realized that what we need to do is within our control, and we all recognize that's a great place to be. Please turn to Slide 4. Let me start by summarizing some of the recent changes at the company. At the end of Q4, the Board concluded its review of strategic alternatives and implemented several important changes to put Mercury on a path of enhanced execution of our strategy. Over the past 2 months, the Board has made positive governance changes, appointing Roger Krone and Jerry DeMuro to the Board, both well-respected industry veterans with CEO experience and appointing Scott Ostfeld to the Board, who brings an important shareholder perspective. I have known these 3 individuals for a number of years, and I'm delighted to have them on the board. In addition, the Board affected a smooth leadership transition with the valuable addition of Dave Farnsworth a seasoned defense technology leader as Chief Financial Officer.…

Thank you, Bill. I'll start with a brief introduction then present our fourth quarter and fiscal '23 results as well as our fiscal '24 guidance. First and foremost, I'd like to thank Michelle McCarthy for serving as the interim CFO for the last 6 months. I look forward to working closely with her as she steps back into her role as our Chief Accounting Officer. The majority of my career spanning the last 4 decades was at Raytheon, where I served in numerous finance roles up through Vice President and CFO, Integrated Defense Systems and prior to that, as Vice President and CFO of its Intelligence Information and Services segment. The main focus in those roles was on operational finance, managing programs, developing financial plans and forecasts as well as maximizing return on invested capital with a particular focus on net working capital improvement. It was at Raytheon that I worked with Mercury as a supplier. I gained first-hand knowledge of the unique capabilities the company brings, which are critical to mission success. The ability to design and develop affordable open architecture defense electronic solutions reduces risk and accelerates time to market aligning with the drive towards outsourcing in the defense industry. In my initial weeks here, I have been impressed by the agility and drive of the Mercury team. I would also echo Bill's view regarding the strength of Mercury's long-term business model and the ability to return to above-average market growth and profitability with an enhanced operational focus. As Bill mentioned, our results for the quarter and the fiscal year were disappointing. Our financial performance throughout fiscal '23 and especially the fourth quarter obscures the underlying strength of our core business. In fact, the majority of the more than 300 active programs we are managing are performing well…

Thanks, Dave. Operator, please proceed with the Q&A.

[Operator Instructions] Your first question comes from the line of Seth Seifman with JPMorgan.

I guess maybe starting off, Bill, if you could talk a little bit about what you've seen that gives you the confidence, a, that Mercury is a national asset. And b, with regard to outsourcing, it's something that the company has talked about for some time, but I was wondering with a fresh set of eyes kind of how you see that opportunity. Is this something you talk about at the -- with the senior levels of management at the defense primes about how they want to outsource more of their cost base? Or is it something that you see that happens more on kind of a case-by-case basis? And how you think about that opportunity over time?

Yes, Seth. So thanks very much for the question. And just as a reminder, I've been in and around this space for a few decades. So when I speak to some of the trends that I see that are relevant to Mercury, many have been in place for a while or been in work for a while. And I've also having been on the Board for over a year, had a perspective coming in. And I'd say that, that perspective coming in was I've always felt like Mercury was in an outstanding position strategically in the market from a macro standpoint, based on major funding trends around defense electronics, the growth rates the opportunity to bring capability enhancements to platforms on time constants that matter, make a difference today in missions and serving men and women in uniform and having a difference in their lives. So I knew coming in that Mercury was well situated, favorable tailwinds from a funding standpoint, market growth standpoint and had established program positions on franchise programs with long duration run rates. With respect to outsourcing, that's been a trend that's been in work across aerospace and defense and cross contractors who have supported the federal government for decades. In our space, we certainly see it with the Tier 1 primes, who are really forced to focus on what are their core strengths and where are they going to focus? And in turn, where are they going to rely on the supplier base. And that's where I think we bring a very unique angle with our commercial model of investing in products that have relevance across platforms. It also drives our margin profile along with it. And so I think it's a trend that's here to stay. It's been in work for a long time and it's certainly relevant to Mercury and our positioning. So I've had a chance to see that over time from the outside to think about it certainly coming in when I joined the Board a year ago and now to see it up close and personal, while I've been in the interim role over the last couple of months.

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

Maybe, Bill, just to start off, as we think about the fiscal '24 guide and you think about the bridge on the EBITDA from sort of the [132] to the midpoint of the guidance range, how much is implied in terms of improvement from the $56 million headwind you had from the 20 programs in '23 relative to growth of the core business and other cost actions. I mean, I guess, it'd be really helpful if you can help with some detail as the key moving pieces on the EBITDA bridge.

Yes, Ken, I'll go ahead and start, and then Dave can chime in and maybe if we use Slide 7 as a reference point, if you maybe work right to left on the chart and think about FY '24 or at least I'll give you a sense of how we're thinking about it. I think we have pretty conservative assumptions around the program mix shift over time. So we're really thinking about a gradual shift in mix as we work our way through FY '24, maybe exiting the year with a more favorable mix, but pretty conservative assumptions around a gradual shift over time. As you move over to the cost reductions, we're assuming that we'll see most of the benefit from those cost reductions but not the full run rate and then we'll certainly see the normalized comps. So I think that gives you a feel for -- from the right-hand side of the chart, how we're thinking about the midpoint of guidance and implicit in that, how much we're accounting for unknown unknowns on the development programs as we work our way through the back part of execution on those programs in FY '24.

Okay. So I guess just to summarize then, obviously, the guidance implies a fairly conservative view on the improvement on the impact of the challenged programs, which theoretically could be where you could see perhaps the most upside of the guide as we think about '24?

I think that's an appropriate way to look at it. And again, I would take as a backdrop, our view on guidance this year, recognizing it's a transition year, and we've got some moving pieces as we're executing on the back portions of these development programs, we think that's a prudent way to be thinking about guidance.

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

Congratulations on the new opportunities. I guess my first question or the only question I'll ask is, with the program execution challenges, why has it taken maybe this long to resolve some of these issues? Is there some additional detail that you can provide? And what sort of gives you the confidence that you'll be able to resolve those remaining challenges that were referenced and just given -- it seems like it's a fairly large number of them.

Yes, Jonathan. And just to put things into context, when we talk about the challenged programs that are really masking the underlying performance of the business. In actuality, it's a fairly small number of programs. And we're talking on the order of about 20 programs where we have well over 300 programs across our portfolio, the majority of which are performing very predictably, very profitably and represent a very healthy business that's being obscured by these onetime effects on these challenged programs. Now I'll give you a little insight into what we've done over the last 45 days. We've brought the senior team across all relevant functions from engineering, manufacturing, our program managers, our program management leadership, and we literally have reviewed every development program. And so we started with the first 11 that the company spoke about in our Q3 call. We extended that to any development program that was deemed to have some risk profile associated with it that the teams were looking to mitigate. And then we ended by looking at the programs that were low risk. So by the time we finished that process, we had gone through every program in -- every development program in the portfolio. And we took a very stringent eye on the activities to complete those programs and our estimates to complete. And the result of that analysis is reflected in the EAC growth and the cost growth that was reflected in the quarter. How we got there, I think it's pretty clear to me at this point that as the company grew through acquisitions that we acquired some very strategic footprint and development programs that as we said in the script, are going to have a fantastic return for the company. They're going to result in new production runs on…

And if I could add, Jonathan, this is the comprehensive nature of these reviews it puts us in a position where we get -- we'll get an earlier warning of risks. And as they start to materialize, it gives us a longer runway to be able to go mitigate those risks. So seeing those things earlier and being able to react to them is a critical part of how we're going forward.

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

I guess just one quick one. And then I guess, for the past 12 to 24 months, we've heard an extremely large amount of detail about supply chain impacting this business. And I think here we are on this call, no one's brought up supply chain. So has that been a factor at all in some of the negative performance. And then the second one I wanted to ask, you've got $760 million of backlog that's shippable, can you give us any color on the margin profile there? Are some of these challenged 20 development programs critical to getting that product out the door?

Yes. Michael, thanks for the question. I guess I'll start with the second part of that. And the answer is yes. When we look at -- and we have. We've gone through a detailed review of our inventory and our unbilled, which is the bulk of order we've seen the increase in working capital over the last couple of years, the ability for us to root free up cash is largely tied to executing on these development programs. And so as we execute on the development programs, get hardware out the door, then begin the production programs associated with those. We'll not only be able to burn down the unbilled receivables, but also be able to burn down the inventory. And that's our focus right now is really releasing cash that's been trapped in the company.

Okay. Okay. What about that backlog that's shippable. I mean any color on the margin profile there?

Well, I mean, that's really in the unbilled receivables that you're referring to. I mean the -- when -- the working capital that's tied up in the business right now, it's primarily in unbilled receivables and in inventory. And what we're focused on literally program by program, is shipping hardware so that we can invoice and collect cash to burn down the unbilled receivable. And then the inventory that has ticked up over time. And that also will burn down as we transition the development programs into production because of many times, the company bought inventory ahead, thinking that the development would come to an end at a certain point in time. And as that's dragged to the right, that inventory has been in place and is awaiting production programs to get kicked off so that we can consume that inventory.

And Jonathan, this is -- or Michael, sorry, this is Dave. If I could just add a couple of thoughts. From a supply chain standpoint, the reason we're not focused on talking about that so much here is because we've actually seen it start to normalize in terms of lead times. And so where we had significant risk in the past we talked about and so had extended our purchasing to an earlier time. We're starting to go back and revisit all of those lead times, working with our suppliers to ensure we're not bringing in material too early to help us with our inventories as we go forward.

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

So much to digest in your script, and I appreciate all that you've put together. I just maybe wanted to step back from all this and I hate the sort of question, but what do you think went wrong? Was it just simply acquisitions we integrated and the company grew too quickly, not caring for margins? Do you think this is more structural or a process-oriented problem? And how do you think about the processes you'll fix if it is that over the next 12 months?

Yes. I think big picture, the company has scaled up and inorganically moved into areas that I think are very attractive areas to be in, but requires processes that are mature in areas like program management, system engineering, et cetera. And I think we're seeing the growing pains associated with that on some of these development programs. So to answer your question directly, I don't think it's so much structural. I think it's more process-oriented. And these aren't challenges that companies or leaders that have taken on development programs haven't seen before. They're very fundamental process type issues. So we have a team in place that is squarely focused on these development programs, not only on executing the ones that we have in-house, but maturing our processes so that we can execute more effectively on development programs in the future. So I would characterize it more as a process maturity challenge that we are laser-focused on and already have maturing processes underway than anything that's more structural in nature.

And I guess just on the processes over the next few months, how will you change it? How do you make the systems more mature, so there's checks? And have you found anything wrong with the contract structures on the development side that might need to be changed?

Yes. I think on the process maturity, that's a journey. But like I said, it's already well underway. So when it comes to reviewing our development programs. We're doing it with a higher frequency right now, I would say, with more rigor because of the people that we have involved in those processes. And we're getting very granular when it comes to things like burning down our unbilled in our inventory and literally looking at it program by program every week. So hopefully, that gives you a sense of some of the maturing in our processes.

Sheila, I would add to that when you talk about the structure of some of the contracts that we've had in the past firm fixed price contracts with billing at delivery, and we've been working with our customer set to ensure that we have milestones that are better aligned with how we're spending money on these programs. So we're working through that. And at the same time, we're working with our customers to ensure we have really solid alignment in our contracts around the scope of what's being performed.

Your next question comes from the line of [Jan Frans Anglebrooke] with Baird.

I'm on for Peter today. So I just had a question. In the prior release, we heard about 12 development programs that was causing most of the issues and 4 of those programs related to a single technology, but today's release called out 20 challenged program. So could you just call out, if you can, would you review sort of identified. Was this 8 additional development programs or were there existing programs? Just sort of -- just help me bridge and go from 12 to 20.

Yes. So if we put it in the context of the impacts in the fourth quarter, where we saw a difference from guidance to our actual EBITDA of about $33 million. About $29 million of that was incremental program costs that we saw. And I'd say about 1/4 of that were tied to the programs that were discussed in the third quarter call. The balance of that was tied to about an equivalent number of programs that were separate from the programs that were discussed last quarter. And so I think that gives you a sense of the programs last quarter as they're working their way through development stabilizing and then also the rigor of the review that we put in place across the rest of our portfolio and all of the other development programs in our portfolio. I think I would characterize it that way. Dave, anything to add.

No, I agree, Bill. And so the 20 programs includes -- the approximately 20 includes the 12 from the previous quarter. And what I would say is that of those initial ones, where Bill said about 1/3 of the growth that it's really driven by a very small subset of those original programs. The vast majority of them problems were resolved. The programs are on track, and there was no further degradation in the program costs.

Your next question again comes from the line of Seth Seifman with JPMorgan.

I just wanted to follow up quickly on the revenue guide. And so if we look at the midpoint, not really looking for growth in 2024 and looking for sales to be down, I guess, in the first quarter year-on-year. And I guess if you could talk a little bit about what it is in the portfolio that's preventing you from growing this year? I mean I understand there are execution problems on certain challenges -- on certain programs. But from a growth perspective, we're seeing your customers tend to be the major contractors, and we can all see revenue inflecting higher for those companies, their costs or your revenues. Why would Mercury not be participating in some of the growth we're seeing across the industry, especially when the limited growth we saw in Q4 of this year was somewhat driven, I guess, by negative EACs, which I assume won't be repeating.

Yes. Yes, I appreciate the question. And I will say that one of the benefits of this increase in mix that we have of development programs, we've talked about the fact that historically, it's been in the range of 80-20 and more recently, we shifted to 60-40, 40% development programs. I think implicit in that, our expectations of future growth tied to completing those development programs and then turning on the production programs that go with those that become long-running, predictable and highly profitable. To get there, we have to execute on and finalize the development programs. And that's really what's in front of us in '24. And more effectively, we're able to get through the development and turn on production, the sooner we'll be able to see the inflection point in the benefit of those long-run production programs in our organic growth rate. So I think we're taking a fairly balanced view of our execution in FY '24 across these development programs and the transition to turning on the production program.

And I would add, as Bill said, we're focusing our resources on these challenged programs and getting them done because the sooner we get those done, the sooner we turn on those production awards, which is going to help us across the board from a growth standpoint, from inventory, from working capital in general. And those programs where we're focusing resources are programs where incrementally, the revenue was not that great in the beginning part of the year, but it will turn into something much larger as we go forward.

And on the production portion of those programs, are those contracts established and signed? Or will you now go ahead and when the development is done then negotiate and sign production contracts with your customers on these programs?

Yes. They're not signed and they're typically dependent on the development programs being executed. But I think we view the conversion of those development programs to production programs as a very high rate. And in some cases or in many cases, we're the sole source provider. So it really comes down to just finalizing the development, delivering those first few units so that the production contracts can be awarded.

Okay. Okay. And then maybe if I could just sneak in a final one. Last week, you guys put out a press release about LTAMDS. Can you talk about the role of LTAMDS in all of this? I mean, 20 programs is -- it's not a huge number relative to the total number of programs in the company. But relative to a single program, it's a large number. Did LTAMDS figure very prominently in the challenges that you guys have had and how helpful will this be in releasing some working capital? Or is this just one of several and we shouldn't think about it having a very meaningful impact?

I would think about it more going forward as a program that we're very excited about as opposed to one that's been a major contributor to our challenged programs.

This concludes our question-and-answer session for today. I turn the call back over to Bill Ballhaus.

Well, thank you very much. I'd like to thank everybody for joining us this afternoon, and I look forward to talking during our Q1 earnings call. Thank you.

This concludes today's conference call. You may now disconnect.