Mercury Systems, Inc. — Q2 FY2014 Form 10-Q
Business context and period. The filing covers the quarter and six months ended December 31, 2013. Mercury supplies processing systems, software and services for commercial, defense and intelligence applications. Its reportable segments are Mercury Commercial Electronics (MCE) and Mercury Defense and Intelligence Systems (MDIS). Results are unaudited; amounts below are in millions unless stated otherwise.
Financial performance
| Metric | Three months ended Dec. 31, 2013 | Prior-year quarter | Six months ended Dec. 31, 2013 | Prior-year six months |
|---|---|---|---|---|
| Revenue | $53.1 | $49.8 | $107.0 | $99.2 |
| Gross margin | $24.9; 47.0% | $17.6; 35.3% | $47.5; 44.4% | $38.0; 38.3% |
| Operating loss | $(2.1) | $(7.1) | $(6.0) | $(18.3) |
| Net loss | $(1.0) | $(4.8) | $(3.3) | $(12.0) |
| Adjusted EBITDA (non-GAAP) | $5.1 | $1.0 | $8.7 | $2.6 |
Quarterly revenue grew 7%; six-month revenue grew 8%. Higher MCE defense sales more than offset weakness in MDIS. Gross-margin improvement reflected favorable product mix and, in the quarter, $2.3 million of royalty revenue at 100% margin. The prior-year comparisons also included purchase-accounting charges of $1.3 million in the quarter and $2.0 million in the six months. R&D expense increased 35% in the quarter, primarily due to lower customer-funded development and higher prototype expense.
Cash flow and liquidity. For the six months, operating cash flow was $9.5 million, versus cash use of $8.4 million in the prior-year period. Capital expenditures were $3.9 million and reported free cash flow (non-GAAP) was $5.6 million, versus $(10.1) million. Cash and equivalents were $44.5 million at December 31, up from $39.1 million at June 30, 2013. Current assets were $144.5 million and current liabilities $24.3 million. The company stated that cash, expected operating cash flow and available financing should cover anticipated needs for at least 12 months.
Debt and commitments. No borrowings were outstanding under the $200 million senior unsecured revolver; letters of credit were $4.3 million and reported borrowing capacity was $57.1 million. Mercury said it complied with its covenants. Purchase commitments totaled $18.0 million, all due within one year; contractual obligations, including leases and capital leases, totaled $41.7 million. No material capital-expenditure commitments were reported.
Material changes and segment trends
- Quarterly MCE revenue rose 14% to $42.3 million, while MDIS revenue fell 25% to $10.6 million. Aegis revenue increased $13.5 million company-wide in the quarter; MDIS was affected by lower DRFM jammer sales and customer funding delays.
- For the six months, MCE revenue rose 24% to $85.8 million and MDIS declined 27% to $21.7 million. Growth in Aegis, Patriot, SEWIP and other programs was partly offset by lower Gorgon Stare and DRFM jammer revenue.
- Customer concentration was significant: Lockheed Martin, Northrop Grumman and Raytheon together accounted for 55% of quarterly revenue and 48% of six-month revenue. The Aegis program alone represented 27% and 16%, respectively.
- International sales declined to $9.3 million in the quarter from $11.7 million, but rose to $24.7 million for the six months from $21.9 million.
Outlook, risks and other notable items
On January 27, 2014, Mercury announced an acquisition-integration restructuring involving facility consolidation, centralized administrative functions and R&D realignment. It expected approximately $4.9 million of charges in the second half of FY2014, including $3.3 million in Q3 for a 54-position reduction, and approximately $4.2 million in FY2015. The company expected the plan to finish by FY2015 and generate $16 million of gross annualized savings beginning in FY2016. These are management estimates, not revenue or earnings guidance.
Key risks cited include defense-program funding and timing, customer order variability, fixed-price contract cost overruns, component shortages and quality delays, acquisition integration and realization of savings, competition, export regulation changes, and retention of key employees and customers. Three months’ and six months’ results may not indicate full-year results. Legal matters were not expected to have a material financial impact; certain IP indemnities may be unlimited. Management reported effective disclosure controls and no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether Aegis and other program demand, and the funding timing behind MDIS contracts, support sustained revenue and margin performance.
- Whether the restructuring stays within the projected $9.1 million of charges and achieves the expected $16 million annualized savings from FY2016.
- How much reported margin improvement depends on favorable product mix, royalty revenue and prior-year purchase-accounting comparisons.
- Customer and program concentration, working-capital trends, and the basis for the stated $57.1 million of revolver availability.
- Whether the company can realize its deferred tax assets; management reported approximately $3.2 million of net deferred tax assets and no valuation allowance against federal deferred tax assets.