Mercury Systems, Inc. — Q2 FY2019 Form 10-Q
Reporting period: Quarter and six months ended December 31, 2018. Amounts are in U.S. dollars; financial statement figures are in millions unless noted. The filing is unaudited.
Business context
Mercury supplies secure sensor and safety-critical processing products and subsystems, primarily to defense prime contractors. The company reported one operating segment. Results include Themis, acquired in February 2018, and Germane, acquired July 31, 2018; therefore, comparisons are affected by acquisitions.
Financial performance
| Metric | Q2 FY2019 | Q2 FY2018 | Six months FY2019 | Six months FY2018 |
|---|---|---|---|---|
| Revenue | $159.1 | $117.9 | $303.1 | $224.0 |
| Gross margin | 44.6% | 45.9% | 43.7% | 46.8% |
| Operating income | $19.9 | $10.9 | $33.7 | $21.3 |
| Net income | $12.4 | $9.1 | $19.9 | $27.1 |
| Diluted EPS | $0.26 | $0.19 | $0.42 | $0.57 |
- Q2 revenue increased 35%; management attributed $28.8 million to acquired businesses and $12.4 million to organic growth. Six-month revenue rose 35%, including $60.0 million acquired revenue and $19.1 million organic growth.
- Q2 net income increased year over year. Six-month net income declined, primarily reflecting the prior-year period’s $7.0 million tax benefit versus a $7.6 million tax provision in the current period.
- Gross margin fell 130 basis points in Q2 and 310 basis points for the first half. Management cited lower-margin acquired businesses, higher customer-funded research and development, and program mix; additional F-35 royalty revenue partly offset Q2 pressure.
- SG&A and R&D rose in dollars, including acquisition-related headcount, but each declined as a percentage of revenue. Q2 operating margin increased to 12.5% from 9.2%.
- Non-GAAP measures: Q2 adjusted EBITDA was $37.0 million and adjusted EPS $0.47; six-month adjusted EBITDA was $68.6 million and adjusted EPS $0.86. These exclude specified items and are not substitutes for GAAP results.
Cash flow, debt and liquidity
- Six-month operating cash flow was $45.3 million, versus $16.8 million a year earlier. Capital expenditure was $10.8 million, yielding company-defined free cash flow of $34.5 million, versus $9.2 million.
- Cash and cash equivalents were $93.9 million at December 31, up from $66.5 million at June 30. Investing cash use was $55.8 million, including $45.0 million for Germane; financing provided $37.9 million, including $45.0 million of net revolver borrowings.
- Long-term debt was $240.0 million, up from $195.0 million at June 30. The amended revolver has $750.0 million capacity and matures September 2023; the company reported covenant compliance. Letters of credit totaled $2.4 million.
- Management said cash, operating cash generation, available revolver capacity and financing capabilities should cover anticipated cash needs for at least 12 months. A January 2019 swap subsequently fixed the rate on $175.0 million of revolver debt at 2.54% through September 2023.
Outlook, risks and unusual items
- No formal revenue or earnings guidance is provided. Remaining performance obligations were $160.2 million; the company expects to recognize approximately 69% within 12 months. Contracts with original expected durations of one year or less are excluded from this figure.
- In January 2019, Mercury acquired GECO Avionics for $36.5 million, subject to customary adjustments, funded through the revolver. The purchase price allocation was not provided in this filing.
- Key stated risks include defense-program funding and timing, government shutdowns or continuing resolutions, customer order variability, competition, technology and production delays, component shortages, fixed-price contract cost overruns, acquisition integration and synergy execution, interest rates, export and procurement rules, and retention of key employees and customers.
- Purchase commitments totaled $68.7 million, due within one year; operating lease commitments totaled $61.2 million. The company disclosed $2.9 million of liabilities for uncertain tax positions, with timing of payment uncertain. Certain intellectual-property indemnities may be unlimited.
- The securities class action filed in July 2018 was voluntarily dismissed without prejudice in December and is no longer pending. Management said other pending legal matters were not expected to materially affect financial position, results or cash flows.
- Revenue recognition standard ASC 606 was adopted retrospectively effective July 1, 2018; management reported no material effect on the financial statements. The company noted it was integrating Germane into its financial control environment and reported disclosure controls effective at quarter-end.
Most important facts for investors to verify
- How much reported growth is sustainable organic growth versus revenue contributed by acquisitions, and whether acquired businesses can improve margins.
- Whether margin pressure from acquisition mix, customer-funded development and program mix persists; track GAAP results alongside adjusted measures and their exclusions.
- Debt, interest expense and liquidity after Germane and GECO acquisitions, including revolver usage, covenant headroom and the effect of the interest-rate swap.
- Customer and program concentration: Raytheon represented 25% of Q2 revenue; F-35 represented 11%. Confirm exposure to major program funding and order timing.
- Execution against remaining performance obligations, and the status of purchase accounting estimates for recent acquisitions.
- Developments in fixed-price contract estimates, component availability, tax uncertainties, legal matters and integration controls.