Good day, everyone and welcome to the Mercury Systems Third 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 Senior Vice President and Interim Chief Financial Officer, Michelle McCarthy. Please go ahead, Ms. McCarthy.

Good afternoon and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you have 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. Turning to Slide 2 in the presentation. I would like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's 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, Michelle. Good afternoon, everyone and thanks for joining. I'll begin with the business update. Michelle will discuss the financials and guidance and then we'll open it up for your questions. First, a quick note about the review of strategic alternatives we announced last quarter. The review is continuing, and we don't intend to disclose any new developments on the call today. As Michelle and I will discuss, we're running the business in the ordinary course as this process unfolds and continue to execute on our strategic plan. With that, let's turn to the third quarter. Revenues above the high-end and adjusted EBITDA came in at the midpoint of guidance for Q3. Bookings were in line with our expectations and our book-to-bill was 0.93, this follows 1.18 in the first half and 1.10 over the last 12 months. Q3 backlog grew 10% year-over-year. Our largest bookings programs in the quarter were V-22, F-16, Aegis, AH-64 and a classified CSfC program. We are positioned for strong bookings growth sequentially in Q4 as planned given the timing of the awards. Q3 total revenue increased 4% year-over-year as an organic revenue. Our largest revenue programs were [indiscernible], Aegis, F-16, F-35, and a classified CSfC wide program. GAAP net income and GAAP earnings per share for the third quarter exceeded our guidance due to a higher-than-expected tax benefit. Adjusted EPS and adjusted EBITDA declined year-over-year as expected to be cashflow as positive excluding the R&D tax impact. Looking forward to our results of the year level, we expect to deliver record bookings for fiscal '23 and the positive book-to-bill. Revenue is now expected to be flat to slightly up year-over-year, 30 million below the midpoint of prior fiscal '23 guidance due to award and supply chain delays. Organic revenue is expected to be approximately…

Thank you, Mark, and good afternoon again, everyone. I'll start with our third quarter results and then move to our fiscal '23 guidance and q4 guidance. Please turn to slide eight, which details the Q3 results. Mercury's revenue and net income exceeded the high-end of our guidance, while adjusted EBITDA came in at the midpoint. Total bookings for Q3 were 245 million, yielding a book-to-bill of 0.93 as expected. Bookings linearity was still weighted heavily in the third month of the quarter but improved versus the first half. Our total backlog was up 10% and 12-month backlog was up 9%. Compared to Q3 last year. We're entering the fourth quarter with forward coverage of over 80% and solid visibility to the remaining bookings required to achieve our forecasted Q4 revenues. Q3 revenue was approximately 263 million up 10 million or 4% on a total inorganic basis, as compared to 253 million in Q3 '22. Avalex and Atlanta Micro are now included in organic revenue, having completed their fourth full fiscal quarter since being required. Gross margins for the third quarter decreased to 34.3% from 39.4% in Q3 last year. The decline was partially offset by savings in operating expenses, primarily within R&D, as a higher proportion of engineers continue to incur direct labor on development programs. As Mark mentioned, over the last several quarters, we've consistently cited two key drivers of lower gross margins. First, a higher concentration of development program revenues in our mix. And second, the derivative effects of the pandemic resulting in program execution delays. There's a close correlation between these two drivers that warrants the finer point. In fiscal '19 through fiscal '21, we achieved a significant level of design wins, both organically and through acquisition, especially as related to the Physical Optics Corporation acquisition. These…

Thanks, Michelle. Turning now to Slide 13. Demand is strong and getting stronger as we begin the fourth quarter of fiscal '23. For the year, we expect to deliver record bookings and a positive book-to-bill. We are positioned for continued progress and a rebound in fiscal '24, as we push our development programs across the finish line and transition to production, overall execution improves, and the supply chain conditions continue to normalize. Driven by stronger growth, higher EBITDA margins and substantially improved working capital and cash flow, we believe next fiscal year will begin a longer-term period of improved financial performance for Mercury. Looking at over the next five years, we're well positioned to benefit from increased defense spending, both domestically and internationally. As a result, we believe that Mercury can and will continue to grow organically at high single digits to low double digits. In addition to growth, our five-year plan includes margin expansion, driven by better execution as the supply chain conditions normalize the shift in maximum development to production, as well as continued improvements through 1MPACT. These tailwinds should lead to stronger profitability, as well as greater working capital efficiency and cash conversion over time. In closing, I'd like to extend my appreciation to the entire Mercury team, which is committed and working extremely hard to deliver improved results. My sincere thanks to all of you. Before we turn it over to Q&A, I ask that you please keep your questions focused on our earnings results. With that operator, please proceed with the Q&A.

Thank you. [Operator Instructions]. Your first question comes from the line of Peter Arment with Baird.

I guess, I appreciate the details you kind of explained development mix growing and kind of the derivative effects of the pandemic and what you've talked about, just what I'm trying to understand is that a lot of those things were kind of known three months ago that your development mix was growing. And you were still dealing with all these lingering effects. And then just trying to understand like kind of the change from what the implied guidance was of potentially 31% adjusted EBITDA, for the fourth quarter, three months ago to now 18% to 21% just help me try to understand at least bridge kind of a dynamic, sir. Thanks.

So big picture, I think, as we were coming into the year, we were expecting that these development programs would be further along than what we currently are, right, as a result of some of the technical challenges. And we've experienced the cost growth associated with that. And as a result of the delays, Peter, we've also seen some follow-on award delays of high margin business. So it's really kind of the two things, right, the later than expected completion on the development programs with higher costs, plus a knock-on impact for higher margin production VARs that we're expecting in the second half. So those are the two main drivers. The other one is that I think we also have seen some supply chain pass availability constraints that have affected certain business in the fourth quarter as well.

Just as if I could as a follow up Mark, does this change how you approach just sort of bidding on some of these larger development programs in the future? Just because it sounds like these were technically challenging. What's your approach there? Thanks.

So yes, I mean, if you look at our model, Peter, right, we've got a product program, commercial investment leverage model. And prior to the pandemic, right, we've done a really good job, I think, in developing new capabilities, and quickly and cost effectively, and then sharing those capabilities over multiple programs. What we're experiencing here is a very small fraction of the overall program portfolio. So as Michelle mentioned, it's about a dozen programs or 300 active programs that we are currently managing. The products go into multiple programs. So when you've got one issue, it'll affect multiple things. So it's the opposite of the leverage that we have when things are working well. Yes. That being said, we are nearing the late stages in terms of the development test and qualification. And yes, we do believe that once we get through it, you'll start to see things move much more quickly. Today, most of the types of contracts that we have are actually firm fixed price contracts with only about 10% being cost plus fixed fee. And so where possible, and where it makes sense on new development programs, we will clearly seek to move towards the cost-plus fixed fee structure. But it really does need to make sense depending upon the type of business and the actual business that we're pursuing, largely because of our investment models. So we're far along on them. It's unfortunate that it's happened, but the critical capabilities are tied to really important programs.

Your next question comes from the line of Seth Seifman with JPMorgan. Your line is open.

I guess Mark, can you tell us maybe, I don't know if it's only a dozen programs, maybe the top five or six programs that are driving this.

So we're not going to get into the specifics, because the capabilities that we're in the final stages of development are specialized in nature. And we don't want to specifically link them to known DoD programs. But it is a very unique set of capabilities that we're producing. And I think they're very, very important in terms of the programs in which they're going into. So unfortunately, I can't really disclose too much, Seth.

Okay. So they're classified programs?

They are not classified, but linking certain technologies into programs, just given what we're doing is not something that we would normally disclose.

Okay. And then maybe just the last point on this pass along is, in terms of these programs moving towards production, as Mercury kind of finishes its work on the development, presumably, you're supplying it to a prime contractor? Is there further technical risk on these programs that's out of your hands, as to when the customer is going to call on you to get going on production once you guys have executed on your part of the development work?

No, I don't believe so, Seth. But I think, as soon as we can ship these products, our customers are going to take them, because they need them for the work that they're doing. So I don't believe that. There's any additional risk or delays associated with that. We've literally just got to get through the finishing up the development efforts and ramping up a new product introduction yields, which we began to see at the end of Q3. So hopefully, on the ones that are most important, we're already seeing progress.

Your next question comes from the line of Ken Herbert with RBC. Your line is open.

Maybe, Mark, just to stay on these, as you think about the progress in terms of retiring the risk on these development and other development programs. What's your assumption, again, for the sort of working capital release in fiscal '24? I mean, how much of a tailwind can this be? Is it possible to quantify that prior to official '24 guidance, but I think that the impact on cash I think would be very important as we think about the next year.

It's a good question, Ken. Let me maybe kind of take it down level in terms of just the issues and kind of what we're doing. And then I'll throw it over to Michelle, who can talk about just the impact that -- the positive impact that we potentially see, with respect to unbilled. So, the working level, there are two late-stage products that are in development and new product introduction activities associated with them that as I mentioned, because of our product program, leverage model is affecting multiple programs. On the first one, as I said, it's a very unique, one of a kind set of capabilities that's used across multiple programs. And so, in the second and third quarter, we conducted a very extensive root cause analysis. Our customer in the U.S. government have actually agreed with our conclusions and the corrective actions that we've implemented. And so at this point, we're actually monitoring the options for effectiveness and adjusting as we need to actually improve the product yields and throughput which is kind of the stage that we're currently at. So we're now currently ramping up production in phases. And just to give you a perspective of the progress that we made in Q3, albeit it's later than what we would have hoped and anticipated. Yes, we've gone from 0% yield on this particular product bearing to now almost 90%, against the program requirements. And yes, we're actually on track to build tensor systems and the first half of the fourth quarter. And I think, as Michelle said, we're obviously applying lessons learned to ensure that these things don't happen in the future. I will say, though, it's very, very sophisticated technology that hasn't been done before. So that one, we're actually pretty far ahead on. The other one, we have an extremely strong collaboration, internally, that's enabled us to actually address some of the manufacturing issues. And we're actually returned to full production. However, as we did that, we actually experienced another issue at the end of Q3 on one of the variants that, in turn is affecting multiple programs. On that one, we actually expect to deploy a software fix to resolve the issue in Q4. So you can kind of tell just where we're at that we really are at the final stages of development and quell, which will then obviously, allow us to run production, deliver the products, and then invoice and collect cash. And so with that, this is a little bit of a background, why don't I hand it over to Michelle, because, you know, these programs can for a significant amount of the unbilled receivables that we built on the balance sheet. Michelle?

Yes. Thanks, Mark. Hi, Ken. Yes, from a working capital perspective, the completion of kind of the dozen or so programs that we referenced will result in a reduction of about $30 million, coming out of unbilled as we ship that product. And we think some of that release will occur in Q4, but occurring much later than we had originally expected, obviously, coming into the quarter. So we're going to see that cash convert, more likely in Q1 of '24, and Q2 of '24. But almost more importantly, is just when we complete the dozen or so programs, because of that either shared technology product or need for those same specialized engineering resources across multiple other programs. Those other programs are essentially waiting in line, right, and so there's another $60 million of unbilled receivables, that's waiting for release. So once we can resolve the technology issues, or the common product issues, and redistribute those engineers to these other programs, there's another $60 million that we can convert to cash, which we believe will convert also in fiscal '24. So really, where you're going to see that working capital impact across these programs, is around that unbilled release. And we take that 90 million and think about what it means from a working capital perspective, it's a 10% reduction, when you're looking at kind of trailing 12-month revenue.

Your next question comes from the line of Jonathan Ho with William Blair. Your line is open.

I guess one thing I wanted to understand a little bit better is that in terms of the program, dependencies, and specifically around the yield issues that you've been experiencing, like how do you think about sort of the ability to remediate this? And then, maybe what gives you the confidence that in FY '24, we'll actually see these issues resolved, as opposed to maybe a continuation? Just want to get a little bit more clarity around this?

Yes. So again, as I kind of mentioned in the last question, Jonathan, we're far along. Yes, root cause in the one that has probably been the most impactful, and the customer agrees, we're actually have already begun to ramp up production in phases. And the yields improved dramatically in the third quarter. Now, we've wished it actually had happened earlier than that because again, the fact that we weren't able to deliver it sooner has resulted in some of the follow-on awards not occurring in the timeline that we'd previously anticipated. The second issue with respect to this product, you had already begun to ramp one of the variants in production. Yes, which is fine. And we're just waiting for a software fix for the second, which is teed up for the fourth quarter. So I think we're far enough along that we know what's going on with these programs or these technologies that are shared across multiple programs. And the fact that one -- and there will be shipping products literally in the first month and the second month of the quarter to the programs that our customers need the capabilities. So I think we've done enough work to understand where we're at. We've got to root cause ramping up production, and the customers need the capabilities. So I think we've got a high degree of competence. The other thing that if you step back, and you just look at these dozen programs, that Michelle mentioned, the two of the programs are actually more than 90% complete in terms of the total expected cost. And that we expect for these programs to be completed within the next two to three quarters in total. So I think we're actually in a pretty good position. And I guess one final point is that it's the first time that we've experienced this level of volatility. I think we've got -- we went back and kind of looked at the history of our estimates to complete across the very large portfolio of programs. And we've seen very minimal turbulence over the course of the last three years. So, it's a confluence of events, very sophisticated technology, but hopefully we're near the end here.

Your next question comes from the line of Scott Wylie with Jefferies. Your line is open.

Hey, it's Scott on for Sheila. Mark, we always thought of Abaco was kind of one of your closest competitors in the space and Advantech reported this morning. And like they point into Abaco's seeing pretty strong growth with margin expansion. I guess a natural question from that is, is there any market share shift happening in the market? And I know, it's difficult to comment on other businesses. But is there any color you might have into what's driving that delta and performance?

Yes. So as we said, Scott, right, it's really related to this dozen or so sets of programs where we're developing highly sophisticated technologies and capabilities that span out over multiple programs. It really ties to two things, just the development, engineering developmental delays associated with the capabilities and then ramping those new products into production. So we don't think it's related to anything with respect to erosion of margins with respect to competition or anything like that. It's literally related to cost growth on the programs as we are going through this specific challenges. Michelle, if you want to add anything to that.

No, I would just highlight the continued strong demand that we have, you can see it through our bookings. Although Q3 was below one, it was as expected and year-to-date we're above one as we have been, for quite some time for several in the last few quarters.

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

Mark, I just got to go back to Peter's first question. I still don't understand how EBITDA got cut 45% in 90 days. I mean, you're talking about these 12 programs, things you thought in the beginning of the year, but I mean, this was just 90 days ago, you had given us this implied fourth quarter. I mean, is there anything else happening? Was that just an aggressive view and I guess more on the EACs, are they are captured in here? Can you tell us what the negative EACs were?

Sure. So if you go back to it, as I mentioned, right entering fiscal year, we'd expect the development of these programs in the first half year with follow on higher margin production awards expected in the second half. It's this set of circumstances that basically supported the higher revenues, improved gross margin and strong operating leverage, that we forecast in the second half and especially in the fourth quarter. The challenges that we've had, obviously, is that it's taking us longer to get the development effort across the goal line. That's not only affected the estimates from the [indiscernible] in Q3, which was the cumulative catch up. But as a result of those delays, it had an impact on follow on awards also expected higher margin follow-on awards in the fourth quarter, which combined is, transfer roughly two-thirds of the overall drop, the other is related to supply chain availability on other programs. So Michelle, and if you want to talk a little bit about why the impact was so large in the third quarter. And just from an accounting perspective, how it is that you've actually got a team to account the changes in estimates in a particular period?

Yes, sure. So, Mark, as you said, the drop is really a function of the execution delays on the development program. So it's pushing those follow on production awards outside of the fiscal year and into '24. And then the incremental costs that we are expecting, not all of the programs specific at this point, the planning for unknown unknowns in some cases, right? That is just a one for one drop through right to adjusted EBITDA, because, again, it's a cumulative catch up. And then, as you said, supplier commitments have put kind of critical material receipts needed for the quarter outside of the required window. So we are in constant communication with suppliers. And although we have seen some level of reduction in decommits, we are constantly getting updates from those suppliers. And in some cases, what we found was that those commits were pushing out to a point where we could not complete the product or progress it to a point where we would be able to recognize the revenue.

But I guess on January 31, I mean, this seems like a pretty risky forecast, you gave us expecting all this to get across the finish line. I mean, all of this just manifested in the net the last 90 days, though?

So we've been wrestling with a development, and the team was making progress. But then, like any other late-stage development as you kind of moving into the actual NPI stage, yes, we had challenges with the yield. It's a very sophisticated technology that we couldn't get the technology through the NPI process yielding in a way in which we previously expected. So the engineering development was actually complete. But we couldn't actually get it through the production processes. We've gone from -- it's hard to actually forecast 0% yield, none of the engineering or the production team was expecting that. Over the course of Q3, we went from 0% yield to actually exiting the quarter at 90% yield on one of the primary products and capabilities. Yes, then we had the issue on the other product variants, which we actually began to ramp as the quarter progressed, and then hit a software snag. So it's literally late-stage development, new product introduction and quell issues that, obviously, we guided at the time were the best possible information with respect to what we thought would happen, and things just got pushed to the right. So, the forecast was accurate coming in. And as we experienced these issues, we needed to step back and look at the estimate and complete, which is why you see the changes in Qs, right.

Yes, Mike. I would also just add one of the examples that Mark just went through, we had execution underway earlier in the year. But because we got to that kind of testing qualification point, we didn't meet performance specs. The nature of the units meant that we had to scrap them in their entirety, there was no salvaging of the units. And these are pretty meaningful scrap events, 10s of 1000s of dollars every time they occur every unit. So there was significant rework needed at that point. We have the most senior engineers on our team working through it. And so as you can imagine higher labor costs because of the seniority of those engineers, and then the material costs that are needed to recover are actually at inflated cost values, right? Because they're more recent material purchases. So it's very dynamic in terms of how the issues are being resolved. And as Mark said, we can make our best estimate in terms of what yield will be, but again, it's very dynamic and it has changed really throughout Q3, and it's the new facts and circumstances that are now reflected in our results for the year.

So if you go back to the model, right, that's the product program model, it's got a tremendous amount of leverage associated with it. And it's part of the reason that customers really want to work with Mercury, right, we're spending high levels of our own money on internally funded R&D to develop these capabilities. That is amortized or used over multiple programs. The good news in that model, when it works, is that we are able to deliver technologies and capabilities far more quickly and far more affordably than if it was on a per program model. The challenge that you've got is that, in this particular instance, and it's probably the first time that I can recollect in my history, at Mercury this has actually occurred, it's just given the sophistication of the technology, where we've had challenges and again, some of them were related to just the effects of the pandemic and the challenges that are on execution. And we're now getting negative leverage, right meaning, a couple of these technologies or products are actually holding up multiple programs. Now, once we get through the development and the MPI activities, which will close, the multiple programs, it'll quickly benefit, meaning that will actually begin to make rapid progress, we believe, which is, less cost growth in terms of the income statement, and we'll be able to ship systems at higher margins. Once we start to ship the systems, we'll obviously be able to invoice and collect the cash. And yes, we got a significant amount of unbilled receivable tied up right now, as Michelle mentioned. So, yes, we're not done, but we made a lot of progress in Q3, just unfortunately with slower progress than what we had previously anticipated.

This concludes our Q&A portion of today's call, and I will turn the call back over to Mark Aslett for closing remarks.

Okay. Well, thanks very much, everyone. Appreciate you joining the call today. Thank you.

This concludes today's conference call. You may now disconnect.