Mercury Systems, Inc. — Form 10-Q Summary
Reporting period: Fiscal second quarter and six months ended December 31, 2011. Financial statement amounts are in U.S. dollars; amounts below are generally in millions unless stated otherwise.
Business context and reporting period
Mercury designs and sells embedded computing, signal- and image-processing systems, and related services for defense and commercial markets. Its two segments are Advanced Computing Solutions (ACS) and Mercury Federal Systems (MFS). For the six-month period, ACS generated 93% of revenue and MFS 7%.
On December 30, 2011, Mercury acquired KOR Electronics and its subsidiary Paragon Dynamics, Inc. (PDI) for a net purchase price of $70.4 million, funded with cash. KOR expands electronic-warfare and radar-simulation offerings; PDI adds intelligence-analysis and data-fusion services. Their operating results were excluded from the reported periods because the acquisition closed at period-end and was deemed immaterial.
Financial performance and liquidity
| Metric | Three months ended Dec. 31, 2011 | Three months ended Dec. 31, 2010 | Six months ended Dec. 31, 2011 | Six months ended Dec. 31, 2010 |
|---|---|---|---|---|
| Revenue | $68.0 | $55.5 | $117.1 | $107.6 |
| Gross margin | 60.2% | 57.0% | 60.5% | 57.9% |
| Operating income | $13.5 | $6.5 | $17.1 | $11.8 |
| Net income | $9.0 | $5.2 | $11.7 | $8.8 |
| Diluted earnings per share | $0.30 | $0.22 | $0.39 | $0.37 |
| Cash provided by operations | $11.0 | $8.1 | $15.2 | $17.5 |
| Free cash flow (non-GAAP) | $9.1 | $6.1 | $11.7 | $13.9 |
Quarterly revenue rose 22%, driven by 23% growth in ACS and 46% in MFS. For the six months, revenue increased 9%; ACS grew 7% and MFS 73%. Higher defense sales, including radar-related business, more than offset lower commercial revenue. Improved gross margin reflected a shift toward higher-margin defense work and favorable program mix, partly offset by higher manufacturing costs and warranty and inventory provisions.
At December 31, cash and cash equivalents were $105.0 million, down from $162.9 million at June 30, 2011, principally due to the acquisition payment. Current assets were $199.0 million and current liabilities $39.2 million. Operating cash flow was $15.2 million, while investing activities used $74.2 million, including $70.4 million for the acquisition; financing activities provided $1.1 million.
Mercury reported no borrowings under its $35 million revolving credit facility. The facility matures February 11, 2014, includes a 1.0 minimum quick-ratio covenant and minimum adjusted-EBITDA covenants, and was in compliance at quarter-end. The company stated that cash, operating cash generation, and available credit should cover anticipated needs for at least 12 months, though additional funding could be needed for future acquisitions.
Material changes versus the prior comparable period
- Quarterly operating income more than doubled, and net income increased from $5.2 million to $9.0 million. Six-month operating income rose to $17.1 million from $11.8 million.
- Defense sales drove growth and improved gross margin; commercial revenue declined, particularly in semiconductor and commercial computing markets over the six-month period.
- Six-month operating cash flow decreased to $15.2 million from $17.5 million, and free cash flow fell to $11.7 million from $13.9 million, despite higher net income.
- Cash declined by $57.9 million from fiscal year-end, chiefly reflecting the KOR/PDI acquisition. Goodwill increased to $132.5 million, including $52.9 million attributed to the acquisition.
- Six-month effective tax rate rose to 34% from 30%; management attributed the change mainly to the timing of federal research and development tax-credit benefits.
Outlook, commentary, risks, and unusual items
- The filing provides no specific revenue or earnings guidance. Management cautioned that quarterly orders can fluctuate with customer delivery needs and that defense-budget funding and timing remain uncertain.
- Three customers represented 74% of quarterly revenue and 64% of six-month revenue: Raytheon, Northrop Grumman, and Lockheed Martin. Major programs also accounted for significant revenue, including Joint Strike Fighter and a classified airborne radar program.
- The Department of Justice is investigating alleged conduct by former PDI employees in 2008–2009 that may have violated the Procurement Integrity Act. No resolution or litigation had occurred. Mercury reported contractual indemnification and a $10.65 million acquisition escrow supporting indemnification obligations; management did not expect a material financial impact.
- Mercury disclosed $16.4 million of purchase obligations, $16.3 million of operating-lease commitments, and a $1.6 million remaining potential penalty under an inventory supply agreement. It had accrued approximately $0.6 million for the expected supply-agreement penalty.
- Other stated risks include defense funding uncertainty, customer order patterns, program delays, component shortages, acquisition integration and synergy execution, competition, and potential unanticipated costs on fixed-price work. Management reported no material change in previously disclosed risk factors or market-risk exposure.
Important facts for investors to verify
- Whether KOR and PDI deliver the expected growth and synergies, and how final purchase-price allocations or acquired results evolve.
- The DOJ investigation’s eventual outcome and whether indemnification and escrow fully cover related exposure.
- Customer and program concentration, particularly the high share of revenue from three defense contractors and a small set of programs.
- Whether higher defense sales and improved margins persist as commercial demand, defense budgets, and program funding change.
- Working-capital trends and cash generation, including the decline in six-month operating and free cash flow.
- Compliance with credit-facility covenants and the adequacy of liquidity for acquisitions and contractual commitments.