Mercury Systems, Inc. — Form 10-Q Summary
Reporting period: Fiscal third quarter and first nine months ended March 31, 2016. Amounts below are in U.S. dollars; financial figures are in millions unless noted. The company supplies secure processing and defense electronics solutions through Mercury Commercial Electronics (MCE) and Mercury Defense Systems (MDS). Comparative results exclude the divested Mercury Intelligence Systems business, which is reported as discontinued operations.
Financial performance
| Metric | Quarter ended Mar. 31, 2016 | Year-over-year | Nine months ended Mar. 31, 2016 | Year-over-year |
|---|---|---|---|---|
| Revenue | $65.9 | +$6.3; +11% | $184.7 | +$14.0; +8% |
| Gross margin | 46.3% | Down 0.6 percentage points | 46.9% | Up 0.7 percentage points |
| Operating income | $6.8 | +$0.7 | $16.3 | +$5.9 |
| Continuing-operations income | $4.5 | $4.7 prior year | $11.3 | $8.3 prior year |
| Net income | $4.5 | $3.7 prior year | $11.3 | $4.4 prior year |
| Diluted GAAP EPS | $0.13 | $0.14 prior year | $0.33 | $0.13 prior year |
| Adjusted EBITDA (non-GAAP) | $14.6 | $11.5 prior year | $39.0 | $30.2 prior year |
| Adjusted EPS (non-GAAP) | $0.25 | $0.22 prior year | $0.67 | $0.55 prior year |
Quarterly revenue growth reflected higher SEWIP, SABR, E2D Hawkeye and DEWS sales, partly offset by lower F-35 and Patriot revenue. Nine-month growth was led by P8, DEWS, E2D Hawkeye, SEWIP and Reaper, partly offset by Patriot and F-35. Quarterly gross margin weakened on mix; nine-month margin improved on stronger higher-margin digital processing products. Nine-month MDS adjusted EBITDA declined to $0.8 million from $1.4 million, primarily due to a $1.5 million increase in inventory reserves.
Quarterly continuing-operations income was slightly below the prior year despite higher operating income, in part because the tax provision rose to $2.5 million from $1.5 million. The prior-year net income comparisons also include losses from discontinued MIS operations: $1.0 million for the quarter and $3.9 million for the nine-month period. Adjusted EBITDA and adjusted EPS are management-defined non-GAAP measures; the company cautions that similar measures may not be comparable across companies and that excluded expenses may recur.
Cash flow, balance sheet and liquidity
- Cash and cash equivalents were $84.2 million at March 31, 2016, versus $77.6 million at June 30, 2015. Current assets were $206.6 million and current liabilities $42.0 million.
- For the first nine months, operating cash flow was $21.8 million versus $19.5 million. Capital expenditures were $4.9 million, giving reported non-GAAP free cash flow of $16.9 million versus $16.1 million.
- Investing cash use was $15.2 million, including $9.8 million for the LIT acquisition. Financing cash use was negligible; the company also spent $4.2 million retiring shares. Receivables and unbilled receivables increased, using $14.9 million of operating cash in aggregate.
- No borrowings were outstanding at March 31 under the then-existing KeyBank revolving credit agreement; $168.4 million of borrowing capacity was available, with $4.9 million in letters of credit outstanding. The company reported compliance with its covenants.
- At quarter-end, total liabilities were $47.0 million and shareholders’ equity was $367.7 million. Goodwill was $173.7 million and intangible assets $17.2 million.
Material developments, outlook and risks
- Post-quarter acquisition: On May 2, 2016, Mercury completed its $300 million cash-free, debt-free acquisition of Microsemi’s custom microelectronics, RF and microwave solutions, and embedded security operations. The deal closed after the reporting date and is not reflected in the March 31 balance sheet. Purchase-price allocation was not yet complete.
- Acquisition financing and dilution: Funding included a new $200 million senior secured term loan, cash on hand, and approximately $94.4 million net proceeds from an April public offering of 5.175 million shares. A $100 million revolving facility was undrawn at closing. Mercury estimated about $9.6 million in transaction and bank-financing fees, plus approximately $1.7 million in offering expenses.
- Outlook: The filing provides no specific revenue or earnings guidance. Management said available cash, operating cash generation, financing capabilities and credit availability were expected to meet anticipated cash needs for at least 12 months, based on its then-current plans and conditions. This statement preceded the acquisition closing and related borrowing.
- Key operating risks: Results depend on defense-program funding and timing, government spending, customer orders, program mix, component supply and successful delivery of engineering and manufacturing programs. Three customers accounted for 57% of quarterly revenue; Lockheed Martin represented 26%, Raytheon 17% and Northrop Grumman 14%. The filing also identifies material exposure to the integration, expected benefits, costs and financing of the Carve-Out Business acquisition.
- Debt and impairment risks: The company warned that post-acquisition indebtedness could constrain cash flow and flexibility, expose it to variable-rate increases and increase covenant and refinancing risks. A one-percentage-point interest-rate change was estimated to change annual cash interest expense by approximately $2.0 million before principal payments. Goodwill and intangible assets were expected to increase materially with the acquisition and remain subject to impairment risk.
- Commitments and contingencies: At March 31, purchase obligations were $31.0 million, all due within one year; scheduled operating lease obligations totaled $39.0 million. The new Andover headquarters lease carries a stated base-rent obligation of $21.1 million over 12 years. The company said ordinary-course litigation was not expected to have a material effect, but some intellectual-property indemnification obligations may be unlimited. An IRS audit of fiscal 2013 could reduce uncertain tax benefits by up to $0.8 million within 12 months; management did not expect that reduction to affect the effective tax rate.
- Other unusual items: The quarter included $1.6 million of acquisition-related costs, principally related to the subsequently completed Microsemi transaction. Nine-month results also included $0.2 million of impairment expense related to a pre-existing relationship in connection with the LIT acquisition. The company expected nominal restructuring charges through fiscal 2017 if it could not sublease part of its Chelmsford headquarters.
Important facts for investors to verify
- Post-acquisition debt, interest expense, covenant headroom and available revolver capacity, including how acquisition funding affected liquidity.
- Whether the acquired business meets integration, synergy, customer-retention and earnings expectations, and the final purchase-price allocation and related intangible assets.
- Defense-program funding, order timing and revenue trends, particularly customer and program concentration and the effect of product mix on margins.
- Working-capital conversion and cash generation, given the increase in receivables and unbilled receivables and the scale of purchase commitments.
- The sustainability of reported earnings alongside recurring stock compensation, acquisition costs, restructuring charges and other adjustments excluded from non-GAAP measures.