Mercury Systems, Inc. — Q3 Fiscal 2023 10-Q
Reporting period: Third quarter and first nine months ended March 31, 2023; comparable periods ended April 1, 2022. Amounts below are in millions of dollars except per-share data.
Business context and financial performance
Mercury supplies processing technology and products for aerospace and defense programs. It reports one operating and reportable segment. Management noted that quarter-to-quarter orders can vary with customer delivery needs and do not necessarily indicate future trends.
| Metric | Q3 FY2023 | Q3 FY2022 | Nine months FY2023 | Nine months FY2022 |
|---|---|---|---|---|
| Revenue | $263.5 | $253.1 | $720.6 | $698.5 |
| Gross margin | $90.3; 34.3% | $99.8; 39.4% | $249.3; 34.6% | $275.4; 39.4% |
| Operating income (loss) | $2.0 | $10.0 | $(12.8) | $4.0 |
| Net income (loss) | $5.2 | $4.1 | $(20.1) | $(5.6) |
| Diluted EPS | $0.09 | $0.07 | $(0.36) | $(0.10) |
| Adjusted EBITDA (non-GAAP) | $43.5 | $52.5 | $110.3 | $128.9 |
| Adjusted EPS (non-GAAP) | $0.40 | $0.57 | $0.89 | $1.38 |
| Operating cash flow | $(3.2) | $(4.3) | $(33.9) | $0.6 |
| Free cash flow (non-GAAP) | $(12.7) | $(10.3) | $(63.8) | $(18.9) |
Liquidity, debt and cash flows
- At March 31, cash and cash equivalents were $64.4, versus $65.7 at July 1, 2022. Current assets were $937.9 and current liabilities $220.2.
- Long-term debt was $511.5, up from $451.5 at July 1, 2022. The revolving credit facility has $1.1 billion capacity and matures February 28, 2027; the company reported compliance with its covenants. A $300 million interest-rate swap fixes that portion of borrowings at 3.79%.
- Nine-month cash used in operations was $33.9, principally reflecting higher inventory, unbilled receivables and costs in excess of billings, and higher interest and tax payments. Capital expenditures were $30.0. Net revolver borrowings were $60.0.
- Inventory increased to $342.8 from $270.3, while unbilled receivables and costs in excess of billings rose to $376.7 from $303.4. Management cited program execution delays and long-lead materials affecting billing milestones.
- Non-cancelable purchase commitments were $142.7, all due within one year. The company said available cash, operating cash generation, revolver capacity and financing capabilities should meet anticipated needs for at least 12 months.
Material changes and management commentary
- Q3 revenue rose 4.1%, but gross margin fell 510 basis points to 34.3%. Management attributed weaker margins to a higher mix of lower-margin development work and execution challenges, including higher-than-expected labor and material costs on certain programs.
- Nine-month revenue increased 3.2%; management attributed $19.0 of the increase to acquired revenue and $3.2 to organic growth. Radar and C4I revenue increased, while integrated subsystems and naval-platform revenue declined.
- Interest expense rose to $6.7 in Q3 from $1.7 and to $17.8 for the nine months from $3.4, reflecting higher rates and borrowings. The quarterly net profit included a $10.4 income-tax benefit despite a $5.3 pretax loss; the nine-month tax benefit was $13.6 on a $33.7 pretax loss. Management used a discrete tax method and reported releases of reserves for uncertain tax benefits.
- Remaining performance obligations were $505.8 at March 31; the company expects to recognize approximately 63% as revenue within 12 months. These obligations exclude certain short-duration and cancellable contracts.
- Restructuring and other charges were $2.8 in Q3 and $6.4 for nine months, mainly severance and 1MPACT facility optimization and consulting costs. The company also recorded a $3.1 cumulative depreciation adjustment in Q2 for an immaterial error in useful lives assigned to certain leasehold improvements.
- The board was reviewing strategic alternatives, and the filing identifies a potential sale of the company among risks. Strategic-review-related costs included $1.3 in Q3; management expected further related costs. The filing also notes a CFO-role transition.
Outlook, risks and contingencies
- No specific revenue, earnings or margin guidance is provided in this filing. Management said results for the interim periods are not necessarily indicative of the full fiscal year.
- Key risks include defense-program funding and timing, customer order patterns, supply-chain and component delays, program execution and quality issues, inflation and labor availability, acquisition integration and expected synergies, interest rates, and retaining employees and customers during the strategic review.
- The company estimates approximately $30 million of fiscal 2023 cash impact from tax rules requiring capitalization and amortization of research and development costs.
- An environmental demand from former site owner National Technical Systems concerns alleged groundwater contamination and possible remediation costs near a former Mercury predecessor facility in Acton, Massachusetts. The company said it is too early to determine its responsibility. A separate former sales representative arbitration concluded with an award of $72,000.
- Standard intellectual-property indemnities may involve unlimited future payments in some circumstances. The filing says ordinary-course legal matters are not expected to materially affect financial position, results or cash flows.
Most important facts for investors to verify
- Whether development-program execution improves and gross margins recover, particularly on programs with higher-than-expected labor and material costs.
- Whether inventory and unbilled receivables convert into deliveries, billings and operating cash flow, and whether liquidity remains adequate.
- Debt costs, revolver availability and covenant compliance as interest rates and borrowing needs evolve.
- How much of the $505.8 remaining performance obligations converts to revenue on the stated timetable, and whether customer funding or delivery delays affect conversion.
- Progress and potential costs or outcomes of the strategic-alternatives review, including any effects on employee and customer retention.
- Tax-benefit sustainability and cash effects, as well as developments in the Acton environmental matter and other contingencies.
- Non-GAAP measures alongside GAAP results: adjusted EBITDA and adjusted EPS exclude specified items, and the company says similar costs may recur.