Mercury Systems, Inc. — Form 10-Q Summary
Business context and period: The filing covers the fiscal second quarter and six months ended December 31, 2016. Mercury supplies secure sensor and mission-processing systems primarily to defense and intelligence programs. Comparisons with the prior year are materially affected by acquisitions: the Microsemi carve-out business was acquired in May 2016, and CES was acquired in November 2016.
Financial performance
| Metric | Three months ended Dec. 31, 2016 | Six months ended Dec. 31, 2016 |
|---|---|---|
| Revenue | $98.0 million, up 62% | $185.7 million, up 56% |
| Gross margin | 48.3%, versus 49.2% | 46.8%, versus 48.8% |
| Operating income | $9.0 million, versus $6.4 million | $12.7 million, versus $9.5 million |
| Net income | $5.2 million, versus $5.0 million | $9.0 million, versus $7.9 million |
| Diluted EPS | $0.13, versus $0.15 | $0.23, versus $0.23 |
| Adjusted EPS (non-GAAP) | $0.30, versus $0.23 | $0.52, versus $0.42 |
| Adjusted EBITDA (non-GAAP) | $23.0 million, versus $12.6 million | $41.2 million, versus $24.4 million |
Acquired businesses contributed $26.0 million of second-quarter revenue and $50.3 million for the six-month period from the carve-out business; CES contributed $4.0 million in each period. Management attributed the remaining revenue increase primarily to higher activity in Reaper, LRDR, F-35 and Filthy Buzzard in the quarter, and Aegis, LRDR and F-35 for the six months, partly offset by lower Patriot and SEWIP revenue. Because the acquisitions were not included in the comparable prior-year periods, reported growth is not fully comparable.
Gross-margin declines reflected product mix and acquisition-related inventory step-up amortization ($0.9 million for the quarter; $2.9 million for six months). Six-month net income also benefited from a $2.8 million discrete tax benefit related to excess tax benefits on stock compensation; the six-month tax provision was $0.5 million on $9.5 million of pretax income.
Cash, debt and liquidity
- Cash and cash equivalents were $46.2 million at December 31, down from $81.7 million at June 30, 2016.
- Six-month operating cash flow was $24.5 million, compared with $18.8 million. Capital expenditures were $13.8 million, producing reported non-GAAP free cash flow of $10.8 million, versus $15.7 million.
- Investing cash use was $52.6 million, including $38.8 million for CES and $13.8 million of property and equipment purchases. Financing cash use was $7.3 million, including $7.6 million for retirement of common stock and $2.5 million of term-loan principal payments.
- Term-loan principal outstanding was $197.5 million before unamortized debt issuance costs; the reported balance-sheet debt was $190.7 million in total, including current maturities. The loan’s stated interest rate was 3.0%. No revolver borrowings were outstanding; the filing reports $100 million of available revolver capacity, with $5.6 million of letters of credit outstanding. Mercury reported compliance with credit-agreement covenants.
- Management stated that cash, operating cash generation, available credit and financing capabilities should meet anticipated requirements for at least the next 12 months. It expected $15–16 million of capital expenditures for the headquarters build-out and integration activities in fiscal Q3.
Material developments, outlook and risks
- CES was acquired for a net purchase price of $38.8 million, funded with cash. Its preliminary purchase accounting included $22.3 million of goodwill and $15.1 million of identifiable intangibles. The company noted that fair-value estimates remained subject to adjustment.
- On February 1, 2017, Mercury completed a follow-on offering of 6.9 million shares, including the full overallotment, for $216.3 million after underwriting fees and before other expenses. Intended uses include acquisitions, debt repayment or refinancing, working capital, repurchases and capital expenditures. This subsequent event substantially increases cash and shares outstanding.
- No specific revenue or earnings guidance was provided. Management cited defense-program funding and timing, customer order patterns, competition, technology changes, component availability, fixed-price contract estimates, acquisition integration and realization of synergies, and interest-rate changes among the risks that could affect results.
- Three customers—Raytheon, Lockheed Martin and Northrop Grumman—represented 45% of quarterly revenue and 38% of six-month revenue. Legal matters were not expected to materially affect financial position, results or cash flows. Non-cancelable purchase commitments totaled $41.6 million, due within one year; potential intellectual-property indemnification payments may be unlimited in some cases.
- Management reported effective disclosure controls and no material change in internal control during the quarter, while noting that integration of the acquired businesses into its controls was ongoing. The filing reported no material changes in market-risk exposure or risk factors from the prior annual report.
Important facts for investors to verify
- How much reported growth and margin performance is attributable to acquired businesses versus organic operations, and whether acquisition synergies are being achieved.
- The effect of inventory step-up amortization, acquired-intangible amortization, acquisition costs and stock-based compensation on GAAP earnings and non-GAAP adjustments.
- Post-offering cash, debt repayment plans and dilution following the 6.9 million-share issuance.
- Cash conversion and capital-spending needs, including the headquarters project, integration spending and working-capital trends.
- Customer and defense-program concentration, contract execution risks, and the outcome of the IRS audit and purchase-accounting measurement periods.