Good day, everyone and welcome to the Mercury Systems First Quarter Fiscal 2023 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, Mike 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 and 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 Chief Executive Officer, 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's bookings increased 34% year-over-year in the first quarter, following 27% growth in Q4 of fiscal '22. Actual results in the quarter exceeded the high end of our guidance across all metrics and we're raising the low end of our full year outlook as a result. The largest bookings in the first quarter were LTAMDS, the SDA tranche tracking layer and AMCS. We also received the F-18 and [indiscernible] Block 2 orders that moved from Q4. Driven by strong Q1 bookings, our book-to-bill was 1.17 in Q1 and 1.14 over the last 12 months. Backlog grew 22% year-over-year. This backlog, combined with strong bookings expected in Q2 and for the remainder of the year, position us well to deliver increased revenue and EBITDA in Q2 and the second half of fiscal '23. Our results for the first quarter reflected the second half weighting of orders in fiscal '22. Together with continued order delays, long semiconductor lead times and other supply constraints. Q1 is also typically our seasonally weakest quarter. Total revenue increased 1% year-over-year Organic revenue was down 4%, a far better result than Q1 last year. We expect organic growth to turn positive in the second quarter. Our largest revenue programs were F-35, LTAMDs, Aegis, F-18 and SEWIP. Q1 adjusted EBITDA was down 19% year-over-year as expected. This was driven primarily by the second half weighting of orders in fiscal '22 and program mix. We expect margins to increase in Q2 and as the year progresses. Free cash was an outflow of $73 million which we believe will be the low watermark for the year. This primarily…

Thank you, Mark and good afternoon, again, everyone. As usual, I'll start with our first quarter results and then move to our Q2 and fiscal '23 guidance. As Mark has discussed, Mercury's first quarter results exceeded our guidance across all metrics, despite the supply chain and inflationary headwinds. Exiting Q1, from a demand perspective, we have excellent visibility into Q2 and the second half. As a result, we're raising the low end of our fiscal '23 guidance and expecting a cash flow positive year. Turning to our Q1 results on Slide 7. Bookings were $267 million, up 34% compared to Q1 '22. Our book-to-bill was 1.17 compared to 0.89 in Q1 '22. For the last 12 months ended Q1 '23, our book-to-bill was 1.14. The rebound in our book-to-bill indicates the positive demand environment. Our backlog at the end of the quarter was a record $1.08 billion, up 22% from Q1 '22. Our 12-month backlog was up 25% compared to last year and up 7% compared to last quarter, providing us good visibility into the remainder of fiscal '23. Coupled with bookings on key programs that we expect to receive in Q2, we're optimistic about our results for H2 and the full year. Revenue in Q1 increased 1% year-over-year to $228 million, exceeding the top end of our guidance of $215 million to $225 million. Organic revenue was $216 million and acquired revenue which included Avalax and Atlanta Micro was $12 million. Gross margins for Q1 were down approximately 500 basis points year-over-year. As expected, we had a smaller proportion of higher-margin production revenue in the quarter. Q1 gross margins also reflected material and labor inflation. As we move through fiscal '23, we expect to see higher gross margins as a result of program mix and a gradually stabilizing macroeconomic…

Thanks, Mike. Turning now to Slide 12. We believe that Mercury couldn't be better positioned strategically. We entered fiscal '23 with a record backlog and strong new business momentum. We anticipate strong bookings, a positive book-to-bill and a return to organic growth, with revenue reflecting $1 billion for the first time. We expect to deliver improved margins, better working capital efficiency and positive free cash flow. This should lead to improved fiscal '23 results, positioning us for a stronger year in fiscal '24 as the supply chain headwinds begin to recede. Looking further ahead, our plan for the next 5 years remains intact. Mercury's fundamentals are strong and with 1MPACT should improve over time. Defense budgets domestically and internationally are poised for rapid growth. We believe that we're well positioned to continue benefiting from industry trends, including supply chain delayering and reshoring as well as increased outsourcing at the subsystem level. We anticipate that a greater percentage of the value associated with future defense platforms will be driven by electronic systems content where Mercury participates. We're building the company we set out to create from a capability perspective and our addressable market continues to expand as a result. This has been driven in large part by our strategic move into mission systems and the potential to deliver innovative processing solutions at chip scale. Our model [indiscernible] at the intersection of high tech and defense positions us well. We believe that Mercury can and will continue to grow at high single digit to low double-digit rates organically as the current headwinds diminish. In addition to organic and M&A-related growth, our 5-year plan includes continued margin expansion driven by 1MPACT, leading to stronger adjusted EBITDA as well as improved working capital efficiency and cash conversion. Executing on our long-term strategy over the past decade, we've improved margins by growing the business organically, supplemented with disciplined M&A and full integration. As a result, we created significant value for our shareholders and expect to continue doing so. In closing, I'd like to recognize the entire Mercury team for a tremendous effort during these challenging times, my sincere thanks to all of you. With that, operator, please proceed with the Q&A.

[Operator Instructions] Your first question today comes from the line of Jonathan Ho with William Blair.

One thing I wanted to understand a little bit better, can you maybe help us understand how your pricing actions maybe flow through for the balance of the year? And what that could mean in terms of either improvements to gross margins or on the cash flow side?

Sure. So we've done a fair bit, Jonathan. As part of 1MPACT, we had 2 major initiatives: 1 related to procurement, where we stood up a procurement organization and seeking to purchase things more efficiently; and then the second is that we stood up a pricing team to initially be able to price our products more in line with the value that we provided. Both of those areas have actually ended up really helping to offset some of the inflationary pressures that we're seeing. And I think we're actually being pretty successful doing that. So in the -- in our microelectronics business, at the very start of the year, we actually did pretty much across-the-board price increase associated with our commercial products. And then in our noncommercial business, we have also pretty aggressively looked at passing on the costs associated with the inflationary pressures to all of our customers as well as actually addressing contracts going forward to make sure that we’re capturing the inflationary pressures on a go-forward basis as well. So Mike, I don’t know if you’d like to maybe comment further from a financial perspective.

No, I think you hit it, Mark. Jonathan, the only thing I would add is that as you look at our guidance, we do have some inflation pressure embedded in our guidance. But at the same time, as we said, we're working to offset that through pricing. So there is some in there but we're mitigating the piece of it in our guidance as well.

Great. And then just as a quick follow-up. When it comes to some of the customer behavior around payments, do you have any concerns at all around collections, quality or receivables? And when does that sort of maybe start to normalize in terms of the cash conversion?

Yes. So I'll take that one. So Jonathan, we feel very good about the quality of the assets that are on the balance sheet and the collectibility of both the unbilled receivables to billed receivables as well as the inventory. Because if you step back, the majority of that is material purchases that we've made for programs that are aligned with the DoD's strategic priorities that were designed in on. And so it really is just a matter of time as the balance sheet unwinds once we deliver on those final performance obligations to our customers.

Mike, let me jump in there because I think it's important to just kind of step back and really maybe delve into this in a little bit more detail. So most of the challenges that we've had from both a working capital perspective and cash flow are clearly due to the very challenging supply chain environment. And we expect that those challenges are actually going to continue throughout 2023. And we've seen some improvement. I think the in-quarter supply decommits has improved somewhat versus the fourth quarter which we're grateful for. However, I think the challenge is still very much related to extremely long semiconductor lead times, particularly on the high end and the general scarcity of those devices overall. I think we're seeing more -- also seeing more rapid and frequent end-of-life older devices which is particularly a challenge in the defense industry given life cycles as well as now both material and labor inflation. And it hit us probably more than most because 70% of our business is related to processing. So as a reminder, in fiscal '22, 45% of our business is actually recognized as point-in-time revenue recognition. Or put another way, when we recognize revenue when we actually deliver the product, that's actually a much larger percentage than other companies in the industry. The remainder of the revenue recognition is really over time. And unfortunately, we don't get to choose what type of revenue recognition we use, it's really due down to the accounting rules that dictate that. So let me talk a little bit about the business model and why cash flow is being impacted so you really get a better understanding of what's going on and why in particular working capital has begun -- is built and why we believe our cash flows have…

Your next question comes from the line of Sheila Kahyaoglu with Jefferies.

It's actually Scott [ph] on for Sheila. But Mark, you talked about some of the importance of M&A for kind of 1MPACT initiative. I mean given the movement in rates we've seen year-to-date, how is the M&A environment shifted? And how are you kind of thinking about any change to the return profile you're looking at?

Mike, do you want to take that one?

Yes. Sure, Scott. I think that -- listen, we've definitely seen a move in rates over the last couple of weeks, months and quarters and it's impacted the industry. I think that when you look at valuations in the industry just definitionally, based on higher discount rates, those could come down. That having been said, there are scarcity of assets out there. And for good assets, I think that they're going to continue to garner good multiples. And we've seen some of that recently. I think from our perspective, we're just going to keep doing what we've been doing, we're pretty disciplined in our M&A approach. We're very careful with the cases where we're underwriting when we're doing our valuations, especially in the environment that we're in right now with a lot of uncertainty. So I think that from our perspective, we've got a good capability when it comes to M&A. And as I mentioned in my prepared remarks, when you look at the revolver we have, the $1.1 billion revolver, it does give us a lot of capacity to focus on M&A at attractive rates when the time is right.

And then maybe just a quick follow-up on 1MPACT. I mean, you’re over a year into it now. I mean, what successes have you really been able to point to? And are there any areas where it’s maybe been a little more challenging than you had previously expected?

Yes. So good question. So I think we've actually achieved a lot, right? So it began by us really simplifying and streamlining the business into the structure that we have today, we've dramatically strengthened the leadership team. And then we set about really focusing on some key areas, one was procurement. We stood up a direct -- or a procurement -- centralized procurement organization to help us actually take advantage of the scale that we have today. We put in place an AI and machine learning-based procurement tool. This has actually paid huge dividends in this supply challenging supply chain environment. We still have a pricing organization inside of the business as well to be able to price our products more appropriately. Now those 2 items in the short term really helped to mitigate the 10% to 20% increases that we're seeing in semiconductor inflationary pressure. So we've been able to mitigate that a fair bit. We've also, I think, done a fair amount of work looking at R&D investment efficiency kind of going through project by project, eliminating any low-return projects to be able to ensure that we're focusing on the right areas. We’ve done a good job from an employee engagement and from a retention perspective. As you know, the labor markets are very, very challenging right now with the great resignation. And I think we’ve done a good job retaining our employees as well as being able to hire the people that we need to continue to grow the business. We’ve also made substantial progress looking at our facility footprint wrapped off just a few of the reductions in terms of the number of facilities that we’ve already done over the course of the last 12 months. And we’ve got several others that we expect to complete by the end of this fiscal year. Over and above that, I would say that we’ve done a tremendous amount of work on the digital transformation. We’re just completing the rollout of a new digital manufacturing execution system. We are in the process of migrating our engineering tools to the Amazon Gulf high Cloud which is going to give us better productivity and scalability and efficiency over time. And so we’ve actually done a lot. Unfortunately, I think we’re not really seeing the benefits of what we’ve done, just given the challenges that we’ve seen around productivity and the supply chain which are linked. But over the course of the next 5 years, we do believe that we’re going to see substantial margin expansion as well as substantially improved cash flow generation and yield.

Your next question comes from the line of Michael Ciarmoli with Truist Securities.

Mark, I know you’ve spent a ton of time here on the free cash flow. But just -- I mean, you’ve got customers holding back payments. And I mean when I hear customers, I mean, are we thinking the prime contractors? I mean I’m just trying to better understand what that dynamic is, like they’re holding back payment and simultaneously, you’re investing in inventory and working capital to support these programs, yet you’re taking all the risk on your balance sheet with your cash flow while they’re all basically buying back stock? I mean just how is that dynamic working among the customers?

Yes, it's a good question. Let me kind of maybe touch on it at a high level and I'm sure Mike will contribute. So we did see some holdback at the end of the quarter. So I'll give you an example, right? One particular customer paid us for 2 things. And then the third which was also June, we got paid on the first day of the new quarter, right? So it's not like that we're holding for long periods of time but we definitely saw some holdback at the end of the quarter. The other thing affected us, Mike, I was also just the timing of specific orders. And in particular, our 3 largest orders in the first quarter all ended up moving to the right and taking the revenue and the cash associated with those outside of the cash window. So it's a number of things that's going on. But look, I think the last 2 quarters, at an industry level, Mike, in terms of revenue and top and bottom line have been challenging overall. And I think we're seeing some changes in behaviors associated with that. So Mike, I don't know if you would like to maybe add to that.

Yes. No, I think you hit on it. I mean, Mike, the only thing I would add is that the business models and market spend a good bit of time going through it between us and our prime customers are different and he just talked about that. We are doing things to change the dynamic, especially around unbilled receivables. So we’re negotiating with customers now to get more favorable milestones and progress payments on new and existing programs. We’ve got updated processes internally. So we’re trying to change the way we contract with customers. So it’s not all of our balance sheet being used to support these programs. And so that’s why we think we’re going to see some unwinding of the working capital to going forward.

I mean if -- yes. If you think of what we've done from a cash thing, there's 5 things that we're focused on, right? We're obviously looking to drive the cash conversion, burning down the unbilled receivables and inventory. But doing it in a way in which it doesn't put revenue execution and on-time delivery at risk, right? So for every action is usually a reaction. We have absolutely enhanced our demand planning processes as part of impact. We've put in place leverageable and scalable tools to drive the demand signal accuracy and much earlier identification of the commitments that we need to make on materials or to focus in on those part shortages given the unprecedented lead times. The third thing that we've got a major focus on negotiating milestones with customers. And as part of the issue that we've had on some of the legacy contracts is when we shifted towards the subsystems revenue, we didn't necessarily have milestone or performance or progress payments. We're now going back and making sure that we got those all in the commercial side of the business, we're actually getting cash up front. We're also prioritizing the labor resources to make sure that we can actually liquidate those unbilled balances as well. Labor is critically important, right? So I think we're very much, as I mentioned, as part of the impact conversation, focus on retention and resourcing to ensure that we're actually mitigating any execution challenges related to shortages and staffing. And then finally, I think over the longer term, as we're moving up the industry and the value chain and going after much larger proposals that we've done in the past, we're very much focused on strengthening our bid proposal and capture [indiscernible] to drive better terms and protections for Mercury in the future. So we're all over it. And I think, as Mike said, we think that the cash flow is bottoming in Q1, should improve in Q2 when as the year progresses.

Got it. That’s helpful. And just one quick follow-up on related. On the budget dynamic and the continuing resolution, do you guys -- your kind of internal planning, do you think we get a full bill before year-end or based on midterm, if we see a complete turnover either Redwave or Bluewave, do you think any signing of the bill will have to wait for new Congress to get seated? So we run through maybe end of January, February time frame?

I think our operative assumption right now is that we get the bill before year-end but your guess is as good as mine, Mike, right, on the -- what the election results are going to be and how that might affect things. So yes, we're expecting a relatively short CR which we've obviously taken to return in terms of our guidance.

Your next question comes from the line of Austin Moeller with Canaccord.

Just my first question here. Do you expect that pressure on some of the NATO European allies due to the economy and inflation could delay new orders for modernization programs by maybe a year or more relative the U.S.?

Yes, it's a good question. I think my gut would say probably not. The -- clearly, with what's happening over in the Ukraine, the threat environment that you usually kind of dictates both the altitude and the timing of defense spending. And clearly, 9 months into this, the situation is not great. So my gut is, is that we're going to continue to see increased spending in Europe. And whether it's immediate or it takes a little bit longer, time will tell. But I think they're acting with a sense of urgency, Austin.

Okay. That makes sense. And can you call out any specific key program deliveries in the second half that you anticipate will support the step-up in free cash flow?

So in the second half, I think we've got some pretty significant programs. Just kind of rattling through a few off the top of my head, we've got Filthy Buzzard. That is beginning to ramp again. We're expecting a very large IDIQ this quarter as well as delivery orders ramping up as the year progresses. I think F-16 will be a significant contributor. The large new EO/IR program, the large microelectronics program. So there's a number of programs that we expect to ramp in the second half of the year.

Yes. And Austin, the only thing I would add on that too is from a working capital release perspective, while there’s orders that we need to drive revenue and bookings. There’s other things that we’re working on from a release of working capital perspective. And we’ve seen unbilled and programs being delayed because of supply chain delays because of contract definitization. And as we work through those in the second half, that will also help the working capital in addition to the growth programs that Mark just described

Mr. Aslett, it appears there are no further questions. Therefore, I would like to turn the call back over to you for any closing remarks.

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

This concludes today's conference call. Thank you for attending. You may now disconnect.