Good day, everyone, and welcome to the Mercury Systems Third Quarter Fiscal 2021 Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the company's Executive Vice President and Chief Financial Officer, Michael Ruppert. Please go ahead, sir.

Good afternoon, and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events & Presentations. Please turn to Slide 2 in the presentation. Before we get started, I would like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's financial outlook, future plans, objectives, business prospects and anticipated financial performance. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2 in the earnings press release and the risk factors included in Mercury's SEC filings. I'd also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles or GAAP, during our call, we will also discuss several non-GAAP financial measures, specifically adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue and acquired revenue. A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release. I'll now turn the call over to Mercury's President and CEO, Mark Aslett. Please turn to Slide 3.

Thanks, Mike. Good afternoon, everyone, and thanks for joining us. I'll begin with the business update. Mike will review the financials and guidance, and then we'll open it up for your questions. Mercury delivered a strong third quarter of fiscal '21. Thanks to an outstanding effort by the team, total revenue and adjusted EBITDA came in above the high end of our guidance. We continue to execute strategically, investing in R&D and CapEx to drive organic growth while supplementing this growth with strategic M&A. Looking back at Q3, it was a strong quarter for new design wins, and we delivered record revenues, adjusted EPS and adjusted EBITDA. But the timing of bookings remained a challenge. Our results continue to reflect the impact of COVID, the change in administrations, delays in foreign military sales as well as customer program execution issues. We've already closed a number of the orders delayed in Q3 and expect substantially increased bookings and a positive book-to-bill for the fourth quarter. For fiscal '21 in total, we're anticipating a slight decline in bookings year-over-year and a book-to-bill approaching 1. We now expect to deliver approximately 6% organic growth year-over-year and at a total company level, 14% to 15% growth. All in all, we're pleased with this strong performance in a difficult year. While I normally wouldn't provide fiscal '22 guidance until our Q4 call, I thought it would be helpful to provide an initial view. Our optimism and outlook for the business remain positive. We believe, however, that the challenging environment may persist through the first half of next fiscal year. We expect our backlog exiting fiscal '21 to be up high single digits year-over-year. And as a result, we currently anticipate mid- to high single-digit organic revenue growth for fiscal '22 as a whole. This includes…

Thank you, Mark, and good afternoon again, everyone. Mercury delivered solid results in Q3. Total revenue, adjusted EBITDA and adjusted EPS all exceeded our guidance. Total revenue and adjusted EBITDA were both records for Mercury. And while Q3 bookings were impacted by the factors Mark discussed, our backlog remains healthy. We're positioned for a strong fourth quarter and another record year in fiscal '21. Looking further ahead, our recent design win activity and sole-sourced, designed-in positions and well-funded programs set the stage for strong revenue growth and margin expansion going forward. Let's turn now to our Q3 results on Slide 11. Total bookings for Q3 were $210 million, down 16% year-over-year. This compares to a strong Q3 '20 where we had near record bookings and a book-to-bill of 1.2. Q3 bookings were flat compared to last quarter. Our book-to-bill for Q3 was 0.82, and for the last 12 months, our book-to-bill was 1.01. As Mark said, Mercury's bookings and book-to-bill this quarter and year-to-date have been impacted by COVID, the change in administration and FMS delays. Looking ahead, in Q4, we expect a book-to-bill above 1, and for the full year, we now expect a book-to-bill approaching 1. Mercury ended the third quarter with backlog of $894 million, up 16% from Q3 '20. Backlog expected to ship within the next 12 months was $546 million, equating to 61% of backlog. Over 95% of total backlog is expected to be delivered within the next 24 months. Total company revenue increased 23% from Q3 last year to a record $257 million, exceeding the high end of our guidance of $245 million to $255 million. Our revenue base continues to be highly diversified. No single program represented more than 10% of total revenue in the quarter. POC, which is considered acquired revenue in…

[Operator Instructions] And our first question will come from the line of Peter Arment with Baird Equity Research.

Mark, so just, I guess, everyone is going to focus on organic growth. So I might just kick that off. I mean can you just maybe talk about what we've seen in the last several quarters? There's been kind of a deceleration, and you're kind of alluding to it continuing. But when we try to square that against kind of outsourcing, delayering, all the kind of trends that you talk about, maybe you could just provide us with any kind of more details that get us to kind of square that all up.

Sure. So I mentioned really what has happened from a bookings perspective throughout the year. And it's clearly been more challenging than what we had anticipated. We've been impacted by COVID delays, the change in administrations, delays in FMS as well as now customer program execution issues. So we have been -- or we now expect 6% organic growth for fiscal '21, which is lower than what we previously thought. We saw some bookings delays, in particular, in the third quarter on a naval -- large naval EW program that's in production. That was around about $18 million that basically slipped from Q3 into our Q4. But it didn't just affect our bookings in the quarter. It also lowered our organic growth rate for the year. Probably one of the other ones that I would kind of touch upon is that, as I mentioned, we started or we've seen a customer, in particular, program execution issue on a large airborne program, which in itself lowered our organic revenue growth by about 1.5 points for the whole year. So just those 2 things alone account for 2.5 points of organic growth compared to what we thought coming in. And you add those back, and we're back at that goal of high single-digit to low double-digit organic revenue growth. Now that said, the programs themselves are fine. They're well-funded programs. They're just experiencing different delays actually for different reasons. So our outlook going forward, as I mentioned, for fiscal '22, is now kind of mid- to high single-digit organic growth with 14 -- mid-teens growth in total next fiscal year. So fundamentally, there's nothing really changed with respect to our outlook, but we are experiencing some delays.

Our next question is going to come from the line of Sheila Kahyaoglu with Jefferies.

Yes. I mean just sticking on that, Mark, appreciate the color on the large airborne program and that's deflating your growth this year and somewhat coming back next. Can you maybe just talk about how you think about your accelerating growth in a flatlining budget environment? What are you seeing in your bookings and your design wins? And can you maybe elaborate on that? What gives you confidence in the out-years for high single-digit growth?

Yes. So I think as I said in the prepared remarks, we do expect that the environment that we're currently in is likely going to continue into the first half of next fiscal year, hence, the guidance that we gave. If I look at what's going to drive organic growth next fiscal year to offset some of the headwinds that we faced, it's really a number of different things. So we're expecting various FMS programs to drive growth. If you remember, back in the first quarter of FY '21, we had a $35 million an FMS sale that moved from Q1 into next fiscal year. In addition, we're seeing some very strong demand related to our secure product -- our secure processing product line. We're involved in various radar upgrades that -- some of which are moving into production for the tech refreshes. So F-16 SABR, E-2D Hawkeye are both expected to drive growth next year. Probably the largest driver of organic growth, both next fiscal year as well as over the next 5 years, is growth that we're seeing in the C4I domain. And that's really spread across multiple different programs in both C2, comms as well as platform and mission management. And then finally, we're expecting continued growth in EW organically on programs such as ALR-69 as well as DEWS. So it's really across the board. But we do have some headwinds not only this year but coming into next. That one program that -- the large airborne program, where our customer has seen some tech delays, as I mentioned, has lowered our organic growth by 2 points next year for the -- that is encompassed in that mid- to high single-digit organic growth numbers that I gave.

And our next question will come from the line of Peter Skibitski with Alembic Global.

So Mark, for fiscal '22, if we end fiscal '21 with the 1 or approaching 1 book-to-bill, you're saying the environment is going to be the same in the first half. Is it mid- to high single-digit organic growth in fiscal '22? Is that still a pretty risky target right now? How should we think about that?

So I mean, again, we haven't kind of finished our full budget. But based upon the work that we've done to date, kind of going over all the individual line items from the -- in the various programs, we feel pretty good about the outlook that we've given. We're expecting that backlog exiting this fiscal '21 will be up high single digits year-over-year. We are on some strong programs. We've got a number of programs that are transitioning from the development phase into production. And so although we do expect that the environment in the first half could be -- could remain somewhat challenging, I think the guidance that we gave or at least the early outlook, we feel good about, Pete.

And our next question will come from the line of Seth Seifman with JPMorgan.

Just a follow-up quickly on Pete's question. That outlook for next year, is there much risk to that from a continuing resolution?

So yes, we do believe that there's going to be a relatively short continuing resolution, which we baked into account in terms of the outlook that we've given, Seth.

Okay. And then just as a follow-up with regard to semiconductors more broadly and some of the shortages in that area. How, if at all, is that affecting Mercury? And to what extent is it a watch item?

Sure. So I think the supply chain team has done a pretty good job really navigating 2 challenges. Obviously, the first is just the impact that we've seen with COVID throughout the supply base. I think we've been able to manage that pretty effectively. It hasn't really impacted our top line. And most recently, the team has been very focused obviously on the semiconductor space, and we're managing our way through that as well. So there are no specific impacts to date, but it's certainly something that they're working literally every week.

And our next question will come from the line of Michael Ciarmoli with Truist Cap Securities.

Just to clarify, first, the organic growth in 4Q, does anything change with the POC run rate? Are you going to be negative in the -- negative year-over-year in the fourth quarter?

No. We're expecting flat organic growth in the fourth quarter, Mike, largely due to the strong fourth quarter last year as well as the various program delays that I mentioned. So the large naval EW program, as I mentioned, is expected to impact organic growth by more than 1 point.

Okay. Okay. And then just the other one. Gross margin, it looks like an all-time low. Any -- I know you called out maybe mix and POC, but -- and I know you don't -- you're focused more on EBITDA margin these days. But anything -- as we think about the longer-term trend here and gross margins, I mean the continuous decline there, any other thoughts or color or anything we should be mindful of there on the gross margins going forward into '22?

Mike, let me just jump in and just correct something that I just said. The large naval EW program that I mentioned, the delay in the bookings that we've seen and a slight reduction in the order quantities will affect organic growth in the fourth quarter by around 3 points, not 1, as I previously stated. So Mike, do you want to talk about the gross margin?

Yes. So Mike, I think you hit it. I don't think there's anything specific in terms of gross margins that's fundamentally changing. The 2 drivers during the quarter were POC, which is -- has lower gross margins than us. I mentioned in my prepared remarks that has a 180 basis point impact to that 41.1%. And then the COVID expenses, which had a 100 basis point impact. So if you kind of adjust for those, you would have been 43%, 43.9%, somewhere around that. The rest is program mix this quarter. We had CRAD was up significantly year-over-year, was up 18% organically, so excluding POC. And that's what's really driving it. If you step back, and Mike, look at where we were, gross margins in fiscal '20 at 44.8%, I think when you look at the year level for us and you take into account COVID, which we think will probably have about 100 basis point impact on gross margins for the year, and you take into account POC, which will have about a 100 basis point impact on gross margins for the year, that you're going to be at very similar levels to where we were in fiscal '20.

Our next question will come from the line of Jonathan Ho with William Blair & Company.

I just wanted to, I guess, dig into your comment around potentially discretionary dollar competition leading to some additional outsource trends. Can you maybe elaborate a little bit more on what you're hearing out there and maybe what the potential could look like if we were to start to see that budget pressure play out?

Sure. So I think clearly, we're all seeing just the continued stimulus under -- or proposals under the new administration. I think overall, we were pretty pleased with what the overall budget submission was and the outlook there. But over time, I think we could continue to see pressure on the defense budget. And that's obviously offset by what happens from a national security perspective. Yes, I think the growth that we're seeing is being continued to be driven by growth in subsystems or outsourcing at the subsystem level. In the third quarter, our subsystems revenue was actually up 55% to now 76% of the total. And over the last 12 months, it's up 49% to 66% of the total. So I think it's reflecting what we're seeing more generally happening, Jonathan, where our customers are seeking more rapid and more affordable and open solutions. And with the investments that we're making in R&D, we're able to do that more quickly and more affordably than they can do it in-house. So if there are additional pressures on the defense budget, we think that outsourcing will continue. And we think that they're well positioned to be able to take advantage of that.

And our next question is going to come from the line of Noah Poponak with Goldman Sachs.

Mark, maybe you can help me better understand how this came up on you seemingly kind of quickly because you've had some positive updates to the market recently, including the last earnings period. And the categories of things you're citing have been going on for a while, COVID delays, the change in administration. And we're not really seeing those impact other hardware companies. So just kind of better help me understand how this, I guess, maybe snuck up quickly. And if you could more precisely quantify these buckets, and when you get them back, I think that would be really helpful because otherwise, it kind of just looks and sounds like general buckets while there's a deceleration happening in the end market. So if we could just put a little more detail around that, that would be helpful. And then, Mike, what are you spending on COVID? Because the absolute dollar numbers in the margins -- and then you started the year with 40% to 45% on the free cash to EBITDA, and you had that in the middle of the year. So the rate of change there in an absolute dollar sense is pretty large for what you're attributing it to. If you can tell us what you're spending on there.

Sure. So let me begin with the bookings and kind of maybe step back and -- so the second half of the year as we came into it was more second half weighted. And I guess the challenge that we face with bookings now is kind of built as the year progressed. And right out of the gate in the first quarter, if you remember, we had a challenge related to FMS. We had a $35 million order move out of Q1 into next fiscal year as our customer ended up having to reengineer the solution with the end customer. We saw continued impact as the year progressed, in particular, in the weapon systems arena. As the new administration, reviewed the sale of various offensive systems into the Middle East, that impacted FMS sales. But in weapon systems, we've seen various delays associated with the Navy, not just the large EW naval program that I mentioned, but we saw some naval airborne programs also get pushed from what was going to be the start of the year, Q2. Then it moved to Q3. Now it's in Q4. So there's been kind of a sliding effect throughout the year. The one that, I guess, is for us somewhat new is the impact that we saw around this large airborne program, where our customer was impacted by a delay from one of their suppliers. That -- to put a number on it, it was a reduction of $20 million for the year. So it's not been one large thing. It's been a number of things that I guess have built as the year progressed. And we're at a point, obviously, being in the fourth quarter where it's unlikely that some of these deals are going to pop up in the final quarter of the year. So some of them have moved into fiscal Year '22, and some of them will impact us because the order moved to '23. And that large airborne program, in effect, what's happening is that we're skipping a year, which is why we've actually reduced our organic growth by 2 points on that program, to give that mid- to high single-digit next fiscal year. So it's a number of different things, some of which have moved throughout the year and remained inside it, some of which have moved to next fiscal year. And that one particularly one, which, as I mentioned, is $20 million, moved to '23 for us.

Mark, what happened on that program?

So the -- our customer supplier is substantially delayed in providing 3 different types of technologies that are associated with a major tech refresh. There are 2 parts of it that affect us. So right now, we think it's been pushing to the right, pushing to the right, pushing to the right. They believe that they're making progress, but the refresh itself is pretty significantly delayed.

Okay. And Mike, can you help me out with what you're spending on related to COVID that you're referring to?

Yes. I mean -- so if you step back, Noah, you mentioned the 40% -- 40% to 45% guidance at the beginning of the year. As we discussed, that didn't include the COVID expenses. And you're right, that's one of the big aspects of our cash use for the year. I mentioned in my prepared remarks that we're expecting 25% conversion for the year. The expansion CapEx is about 10 points, so it'd be 35%. COVID investments, we're looking at about $10 million to $11 million of cash outflow this year. That's primarily related to the testing, the PCR testing that we're doing at our facilities. That's the biggest piece of that. We also have the employee relief fund and some other things this year. That probably had a 5 point impact on the conversion or will have a 5 point impact on the conversion for the year. Also related to COVID, we've talked about we invested in inventory to derisk the supply chain. So that's really the COVID investments. And then there's been a handful of kind of one-off items this year. We've been -- if you look at the acquisition expenses in Q2 and Q3, we've been incredibly busy. That's been a cash outflow. And then I've mentioned a couple of the others here and there, payment for [ kind of ] shareholders, a little under $3 million. We changed our health care providers. That was $3 million. So just a handful of things, but the big 2 really are the expansion CapEx and the COVID investments.

[Operator Instructions] Our next question will come from the line of Austin Moeller with Canaccord Genuity.

This is Austin on for Ken. All right. So just a question for me, and this was somewhat implied in a prior question. So obviously, right now, we've got the chip shortage going on. And recently, the Biden administration had met with various officials from the semiconductor industry at the White House, and they're looking to figure out how to meet this chip shortage. And then you had recent commentary within the last week from Intel's CEO that it could take 2 years or more to ramp back up to pre-COVID levels. So from Mercury's perspective, obviously, you guys -- there's concerns about downward pressure on the DoD top line. So potentially, how could Mercury -- or could Mercury use the Arizona and the New Hampshire facilities to maybe provide some of the supply to meet the unmet demand in the consumer electronics sector? And could that be done within that 2-year time frame?

Yes. It's -- probably not, Austin. So the focus on the trusted microelectronics facility in Phoenix is to be able to provide very specialized capabilities on -- for next-generation applications, primarily for DoD use. So it's not a high-volume facility where we're providing silicon to -- for commercial applications. We really have positioned ourselves at the intersection of tech and defense to be able to take the commercially available silicon and then transform it for use for defense applications. So unfortunately, I don't think that we're really going to be able to provide much assistance there.

And our next question comes from the line of Ronald Epstein with Bank of America.

Just a couple of questions for you guys. Sorry about that. I was on mute. Just on R&D and tax, I mean, what impact do you expect to see in the next fiscal year given the change in the tax code? If it's not somehow reversed, you're going to amortize your amortize your R&D expense now over 5 years, what headwind does that present for you guys?

Yes. So Ron, we do think it's counter to what the U.S. is looking to encourage, which is investment in the U.S. So it may be reversed. We'll see. That having been said, assuming the law stays as is written, we have to amortize our R&D over 5 years. We estimate that it's a $30 million to $40 million impact to our fiscal '23. So the law will go into effect in calendar '22 or fiscal year taxpayer. So it would be a $30 million to $40 million impact to fiscal '23 cash flow.

Got it. Got it. And then some of the COVID expenses you talked about, are they billable to the customer? Or do you guys just have to eat them?

We really -- since we're selling most of our products on commercial terms, we're not billing these back to the government. This is an investment that we're making, and there's no reimbursement from 3610 or anything like that.

Got it. Got it. And then maybe a bigger picture question. When you look at folks like Taiwan Semi, potentially -- I mean it looks like maybe high probability potentially of building a fab in Arizona and more, how can I say it, more commercial silicon being fabricated in the U.S. What opportunity does that present for you guys to work with the commercial manufacturers in the defense end market, right? I mean because the defense end market is so small compared to the broader silicon market, is there a role that you guys can play as these companies start to onshore fabs?

Yes, absolutely, Ron. So even if they do bring back more of the fabs and the manufacturing here domestically -- Intel is obviously doing that in Arizona. TSMC is talking about it. TSMC is obviously the fab partner for companies such as Xilinx and others. That doesn't alone solve the problem because I think the capabilities for use in defense as you look at the way in which the market is evolving to more triple-based architectures means that there needs to be a party that sits between those silicon manufacturers or developers as well as the defense end market. And Mercury is kind of positioning ourselves to be that company. So we're partnering with some of the biggest silicon companies in the industry, getting access to the raw silicon itself, and we're looking to be able to combine those silicon from different vendors to secure it using our IP and then package it here domestically for the specific end-use cases in defense. So we play a really important role. And obviously, I think it'd be even better if those -- if the domestic manufacturing does come back. And so we're able to get that silicon here domestically as opposed to it coming offshore and us just packaging it and securing it in the Phoenix facility. So there's still absolutely a role to play even if they do build those fabs in Phoenix like they're talking about.

Mr. Aslett, it appears there are no further questions. So I would like to turn it over to you for any closing comments.

Okay. Well, thank you very much for joining this evening. We look forward to speaking to you again next quarter. Thank you.

Once again, we'd like to thank everyone for participating in today's Mercury Systems conference call. We appreciate your participation and ask that you please disconnect. Thank you.