Business context and reporting period
Mercury Systems, Inc. filed this Form 10-K for the fiscal year ended June 30, 2016. The company supplies secure processing subsystems, RF and microwave systems, and related services primarily for defense and intelligence applications. During fiscal 2016, it shifted to one operating and reportable segment; previously it reported Mercury Commercial Electronics and Mercury Defense Systems separately.
On May 2, 2016, Mercury acquired Microsemi’s custom microelectronics, RF and microwave, and embedded security operations for $300 million cash, subject to post-closing adjustments. It also acquired Lewis Innovative Technologies in December 2015 for approximately $10 million.
Financial results and key metrics
| Metric | FY2016 | FY2015 |
|---|---|---|
| Revenue | $270.2 million | $234.8 million |
| Gross margin | $124.8 million; 46.2% | $110.2 million; 46.9% |
| Operating income | $24.0 million | $18.4 million |
| Income from continuing operations | $19.7 million | $14.4 million |
| Diluted continuing-operations EPS | $0.56 | $0.44 |
| Adjusted EBITDA (non-GAAP) | $57.3 million | $44.4 million |
| Cash from operating activities | $36.9 million | $32.2 million |
| Free cash flow (non-GAAP) | $29.1 million | $26.2 million |
Fiscal 2016 revenue grew 15%, primarily from defense sales, including higher SEWIP and F-16/SABR program revenue and $16.6 million contributed by the acquired business after closing. Commercial sales declined $10.8 million. Gross margin fell 70 basis points, principally from acquisition-related inventory step-up amortization; $2.8 million remained to be expensed in the first four months of fiscal 2017. Operating income and continuing-operations income increased year over year.
Fourth-quarter fiscal 2016 revenue was $85.4 million, compared with $64.1 million in the prior-year quarter. Operating income was $7.7 million versus $7.9 million; continuing-operations income was $7.5 million versus $6.1 million.
At June 30, 2016, cash and cash equivalents were $81.7 million, working capital was $177.7 million, and total assets were $736.5 million. Gross term-loan principal was $200 million, with $192.3 million of long-term debt reported net of issuance costs and $10 million classified as current. The company had a $100 million revolving facility with no borrowings, but $5.5 million of letters of credit outstanding. The term loan carried a stated 2.6% rate and is variable-rate debt. Operating lease commitments totaled $43.6 million; purchase commitments were $32.2 million.
Backlog was $287.7 million, of which $239.2 million was expected to ship or be invoiced within 12 months. Backlog includes orders that may be canceled or delayed and is not a reliable proxy for future revenue.
Material changes versus prior periods
- Revenue increased 15% year over year; defense growth more than offset lower commercial sales.
- Gross margin decreased from 46.9% to 46.2%, while SG&A and R&D declined as percentages of revenue.
- Cash used in investing activities rose to $318.2 million, mainly reflecting the Microsemi carve-out and LIT acquisitions. Financing provided $284.9 million, principally from term-loan proceeds and the equity offering.
- Mercury issued 5.175 million shares in an April 2016 offering, generating $92.8 million net proceeds. Shareholders’ equity rose to $473.0 million from $350.1 million.
- Goodwill increased to $344.0 million and intangible assets to $116.7 million, largely due to the acquisition. The preliminary purchase-price allocation included $170.2 million of goodwill for the carve-out business.
- Three defense prime contractors—Lockheed Martin, Raytheon, and Northrop Grumman—accounted for 51% of revenue, versus 61% in fiscal 2015. Lockheed represented 23% and Raytheon 20% in fiscal 2016. Radar applications generated 52% of revenue.
Outlook, commentary, risks and unusual items
Mercury did not provide a consolidated revenue or earnings forecast in the supplied filing text. Management expected approximately $10 million in annualized acquisition cost synergies by fiscal 2020, including about $2 million by the end of fiscal 2017 and $6 million by the end of fiscal 2018. These are targets, not guarantees. Management said existing cash, operating cash generation, available revolver capacity and financing capabilities should cover anticipated needs for at least 12 months.
- Defense funding and concentration: Approximately 98% of fiscal 2016 revenue came from defense-related programs. Appropriations, continuing resolutions, sequestration, program delays or cancellations, and dependence on major customers and programs could materially affect results.
- Acquisition and execution: Integration, customer and employee retention, expected synergies, and the preliminary purchase-price allocation remain important uncertainties. The acquired business represented 46% of consolidated assets, including goodwill and intangible assets, but only 6% of fiscal 2016 revenue. Management’s internal-control assessment, and the auditor’s related assessment, excluded the acquired business; integration into Mercury’s control environment was planned for fiscal 2017.
- Debt and interest exposure: The term loan is variable-rate and secured by substantially all assets of Mercury and guarantors. A one-percentage-point rate change was estimated to change annual pre-tax income by approximately $2 million. Mercury reported compliance with credit-agreement covenants at year-end.
- Supply and delivery: Mercury relies primarily on one contract manufacturer for certain products and disclosed that Benchmark would stop manufacturing certain digital processing products at its Huntsville facility. Replacement options, including internal production, were being explored. Sole-source components and fixed-price contract cost overruns are additional risks.
- Unusual items: Fiscal 2016 included $4.0 million of acquisition-related costs, $1.4 million of purchase-accounting fair-value adjustments, and a $1.9 million gain related to settlement of KOR Electronics escrow litigation. The acquisition also reduced gross margin through inventory step-up amortization. These items affect comparability; adjusted EBITDA and other adjusted measures are non-GAAP and exclude specified costs that the company expects may recur.
- Contingencies and controls: Ordinary-course litigation was not expected to have a material financial impact. The company reported $1.6 million of unrecognized tax benefits and said an IRS audit settlement could reduce these benefits by up to approximately $0.8 million. KPMG gave an unqualified opinion on the financial statements and concluded that controls were effective within the scope assessed; the carve-out business was excluded.
Important facts for investors to verify
- Track whether the acquired business is integrated successfully and whether stated cost synergies are achieved, alongside its post-acquisition revenue and profitability.
- Review term-loan amortization, variable interest costs, covenant headroom, and the remaining availability of the revolver after letters of credit.
- Assess customer, program, radar-market and government-budget concentration, including backlog conversion and cancellations.
- Monitor gross-margin trends, remaining inventory step-up amortization, fixed-price contract estimates, and the impact of the contract-manufacturer transition.
- Confirm the final acquisition purchase-price allocation, goodwill and intangible-asset impairment assumptions, and completion of acquired-business internal-control integration.
- Distinguish GAAP earnings and operating cash flow from adjusted EBITDA, adjusted EPS and free cash flow, and review the company’s reconciliation of non-GAAP measures.