Business context and reporting period
Mercury Computer Systems, Inc. filed this unaudited Form 10-Q for the first quarter of fiscal 2012, the three months ended September 30, 2011. The company supplies embedded signal- and image-processing systems and software, primarily to defense customers. Its reportable segments are Advanced Computing Solutions (ACS) and Mercury Federal Systems (MFS). Unless noted otherwise, financial amounts below are in U.S. dollars.
Financial performance and liquidity
- Revenue: $49.1 million, down 6% from $52.1 million a year earlier. ACS revenue fell 10% to $45.4 million, primarily due to a $10.3 million decline in commercial sales, partly offset by $5.0 million higher defense sales. MFS revenue rose 125% to $4.2 million, driven mainly by a wide-area persistent-surveillance contract.
- Profit and margins: Gross profit was $29.9 million; gross margin rose to 60.9% from 58.8%. Operating income decreased to $3.6 million from $5.2 million, with operating margin of 7.3% versus 10.1%. Net income was $2.7 million versus $3.6 million; diluted EPS was $0.09 versus $0.16. The prior-year quarter included a $52,000 discontinued-operations loss.
- Costs: R&D rose 9% to $11.9 million, while SG&A declined 4% to $13.6 million. Acquired-intangible amortization increased to $816,000 from $319,000, primarily following the LNX acquisition. Stock-based compensation was $2.0 million.
- Cash flow: Operating cash flow was $4.2 million, down from $9.4 million. Capital spending was $1.6 million and reported free cash flow was $2.6 million, versus $7.8 million. Cash and cash equivalents ended at $165.9 million, up $3.0 million from June 30, 2011. The filing attributes weaker operating cash generation in part to increased inventory and other working-capital uses.
- Balance sheet and debt: Total assets were $354.8 million and current liabilities were $31.7 million at September 30. Mercury had no borrowings under its $35 million revolving credit facility and reported compliance with its covenants. Capital-lease obligations were $156,000. Restricted cash was $3.0 million.
- Other measures: Adjusted EBITDA, a non-GAAP measure, was $8.7 million versus $8.8 million. The company had 30.6 million common shares outstanding as of October 31, 2011; quarterly weighted-average basic shares were 29.3 million versus 22.9 million.
Material changes and notable items
- Gross margin improved 210 basis points, attributed mainly to program mix and $1.8 million of royalty revenue; manufacturing variances, inventory provisions and scrap partly offset the benefit.
- ACS operating income declined to $5.0 million from $7.9 million, primarily reflecting lower revenue. MFS moved from a $497,000 operating loss to $493,000 operating income, supported by higher revenue and improved gross margin.
- Operating cash flow fell by $5.1 million year over year. Investing cash flow shifted from $15.9 million provided to $1.7 million used; the prior-year period included $18.0 million from the sale of auction-rate securities.
- The January 2011 LNX acquisition included potential cash earnout consideration of up to $5.0 million. Mercury expected to achieve the targets and pay the full earnout; the recorded contingent-consideration liability was $4.9 million.
- Three large defense contractors accounted for 51% of revenue: Raytheon 21%, Northrop Grumman 18%, and Lockheed Martin 12%. The Joint Strike Fighter program alone represented 16% of revenue.
Outlook, risks and contingencies
Mercury provided no specific revenue or earnings guidance. Management said existing cash, operating cash generation and available credit were expected to cover anticipated cash needs for at least the next 12 months, while noting acquisitions could require additional financing. Management highlighted uncertainty around defense funding and the possibility of a continuing U.S. government budget resolution beyond calendar 2011. It also cited risks including changing customer orders and product mix, program delays, component shortages, competition, technology changes, acquisition integration and fixed-price contract costs.
Contractual obligations totaled $32.1 million, including $16.7 million of purchase obligations, $13.6 million of operating leases, a $1.6 million supply-agreement commitment and $156,000 of capital leases. The supply agreement may require a penalty for inventory not purchased by August 2012; the company recorded approximately $586,000 for the anticipated penalty. Standard product agreements can include intellectual-property indemnities that may be unlimited in some instances. Ordinary-course legal proceedings and tax audits were not expected by management to have a material adverse effect. The company reported effective disclosure controls and no material change in internal controls.
Important facts for investors to verify
- Whether the revenue decline in ACS commercial sales persists and whether defense sales and MFS growth continue.
- Whether the improved gross margin, including the contribution from royalty revenue, is sustainable.
- Whether inventory growth and weaker operating cash flow reverse, and how working capital affects liquidity.
- Progress toward LNX earnout targets and the timing and amount of payment.
- Defense-budget developments, customer/program concentration and compliance with credit-facility covenants.
- The eventual cost of the end-of-life inventory supply agreement and any material developments in legal, tax or indemnification matters.