Good day, everyone, and welcome to the Mercury Systems Second Quarter Fiscal 2024 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, Dave Farnsworth. Go ahead, Mr. Farnsworth.

Good afternoon, and thank you for joining us. With me today is our Chairman and Chief Executive Officer, Bill Ballhaus. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our Web site at mrcy.com. The slide presentation that Bill 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'd 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 Chairman and CEO, Bill Ballhaus. Please turn to Slide 3.

Thanks, Dave. Good afternoon. Thank you for joining our Q2 FY24 earnings call. Today, I'd like to talk through three topics; first, some introductory comments on our business and results; second, an update on the progress we are making in each of our four priority areas, delivering predictable performance, building a thriving growth engine, expanding margins and driving improved free cash flow; and third, expectations for our performance both for FY24 and longer term. Then I'll turn it over to Dave who will walk through our financial results and guidance in more detail. Please turn to Slide 4. As I said in the past, while FY24 is a transitional year, I'm optimistic about our strategic positioning as a leader in mission critical processing at the edge, the attractiveness of our business model and our outlook over time to deliver predictable organic growth while expanding margins and robust free cash flow. During Q2, we made solid headway in each of our four priority focus areas and in addressing what we believe to be the two transitory dynamics in our business I referenced last quarter; transitioning our high mix of development programs to production and converting our high level of working capital into significant cash flow. We believe this progress is evident in three highlights from the quarter; strong bookings, solid free cash flow and better than expected progress in closing out our challenge programs, most of which are development in nature. First, we delivered near record bookings in the quarter with a 1.65 book-to-bill. Our bookings were anchored by a number of important program wins that we believe will drive future growth. These awards reflect customer recognition of the unique value we deliver, the reliance on us for their most critical franchise programs and ongoing healthy demand. Second, we delivered strong…

Thank you, Bill. I'll start with our second quarter fiscal '24 results and then discuss our full year fiscal '24 outlook. As expected, our financial performance in the second quarter was below that of the prior year across all P&L metrics. As discussed in our last earnings call, fiscal '24 is a transition year where the organization is seeking to execute on both our challenge and development programs and then progress to the follow-on production awards. Through that transition, we expect to recognize the small proportion of remaining revenues on the challenge program contracts, but more importantly, we expect to move towards releasing significant working capital balances, especially related to unbilled receivables. We then anticipate shifting our resources to execute on the follow-on production awards, which we believe will begin to rebalance our program portfolio more heavily towards higher margin predictable production programs as well as consume existing inventories. We continue to expect this transition to occur throughout fiscal '24 and into fiscal '25. In Q2, we made meaningful progress towards this rebalance with some positive early indicators emerging. First, our bookings for the quarter was $325 million with a book-to-bill of 1.65. Second, we completed exited or retired risk on four more challenge programs in the quarter for a total of eight programs through the first half of fiscal '24, better than the five we had expected. We continue to be on track to transition a majority of the approximately 20 challenge programs by the end of the fiscal year. Finally, we generated over $45 million of operating cash flow, $37 million of free cash flow and improved working capital by approximately $70 million in the quarter. Cash flow generation in the quarter was primarily a result of strong collections, including a higher volume of customer advances as we…

Thanks, Dave. With that, operator, please proceed with the Q&A.

[Operator Instructions] Your first question comes from the line from Peter Arment from Baird.

Bill, I'm just trying to understand on the cost growth breakdown. The $14 million that was derived from one of your challenge programs, I guess, it's just tied to one program, the $14 million of cost growth. Will that one specifically be eliminated as you're thinking about having the majority of these done this fiscal year or do we expect that, that's one of the troubled ones that will linger a little bit?

The short answer is that program will be active for a while. But maybe if I gave some color on what was behind the cost growth, it might be helpful to understand what's happening with that program. And it's actually, in some ways, sort of unique. This is a challenge program that includes development, low rate production and a production run. Most of our development programs just contain the development activities or low rate production. This one is unique in that it includes a long production run. And what we discovered in the quarter as we worked our way through development and then we worked our way through the first few units in production that we got a good view on the unit economics or the unit costs that then informed an updated estimate on the production. And so the big cost growth in the quarter that we recognized was tied to the impacts of what we learned and how that pertained to the production. So while that program will be around for a while, we think we have a much clearer view of what we need to do to execute on that program and what the production will look like. So hopefully, that color commentary is helpful.

And just a follow-up, if I could. Just given all the cost growth and a lot of Mercury over the last several years was built up through kind of M&A, are any of the business impaired, or how do we think about that just thinking about risks from a financial standpoint?

I'll let Dave speak to that in a second. There's one more piece of color commentary that I wanted to make about the program that I referenced. And that is that even after we made the adjustments to our ETC for the production run, the margin profile on that program is still above, what I call, the composite average of our gross margin across our full portfolio. So it's just another, I think, helpful piece of information to round out that picture. But on the impairment question, I'll go ahead and turn it over to Dave.

When we do an assessment around impairment, we do that at a gross level so we don't look at the individual components. And we don't maintain goodwill at that level, we maintain it at the overall level. So we always do an analysis on the overall company and where we stand from a goodwill impairment standpoint.

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

I wanted to ask first, I noticed in the filing that the percentage of sales to some of the key customers is down kind of lower than it's been, below the 10% disclosable threshold. And I guess how do we kind of think about what that means and how do we think about that with regard to the kind of underlying trend of prime contractor outsourcing that kind of underlies the Mercury business case?

I think those percentages are going to bounce around a little bit quarter-to-quarter. So I wouldn't pay too -- or at least I personally don't pay too much attention to that. To the extent that they do go down, I think it does show the robustness of our backlog and the diversification of our backlog. And the thing that I'm really focused on, around customer health and desirability of our products in the marketplace and the strength of demand is to look at our backlog. And right now, we're staring at a record backlog. We had a near record bookings for the quarter, which I think is the strongest indicator of our customer health and the health of our business looking forward. Dave, anything you want to add?

I would just mention that it is the threshold at 10% and it does vary. If you look at it historically it varies. I think some of them dip just below and some of them pop up just above in a given quarter. So I don't think there's a significant shift in any of these.

And again, I go back to the backlog and I think that reflects the trust that our customers have in us with respect to their franchise programs. And we mentioned a couple of the specific bookings that we received in the quarter that I think speak to that fact.

And then maybe just I think one of the key things that people think about as they -- or maybe one of the key ingredients in the model as you think about where -- without the guidance and with the results being so variable now, some number in the outyears to anchor around, and it's probably the gross margin. And so if you wanted to think about a kind of conservative case where things don't necessarily all turn out your way and some of these things -- still struggling with some of these things for a while. What's kind of a fair way to think about, not necessarily next quarter but as people try to anchor around what the company might be able to do here in the future, a fair way to think about that gross margin number?

I'll start and then Dave can chime in. I mean specifically, we don't guide to gross margins. What we have said and which we continue to believe to be true is that when you look across our portfolio, our range of gross margins is 30% typically for development programs and 40% for our production programs. And what really drives our gross margins is the mix associated with development and production. And so as we think about margin targets going forward, we more think about EBITDA targets going forward. And I would just refer you to the bridge that we put in prior investor presentations where we think the key to getting to those margins is around minimizing the volatility in our development programs and the EAC impacts. And despite the numbers in the quarter, we feel like we're making very good progress to boxing the risk associated with the development programs and the EAC volatility. Second, it's transitioning the development programs to production and we are making very good progress on that front. One of the big bookings in the quarter is evidence of that. But as we're progressing our way through development, we're getting closer line of sight to converting them to production, its continued efficiency in our cost structure. And again, this quarter, and with the negative operating leverage, it won't show through this year but we expect it to go through next year, the efficiencies that we've driven into our cost structure. And then ultimately, in the near term, driven by the organic growth associated with converting our production programs to development, positive operating leverage. And that's really the path from where we sit today to our targeted margins that are in the low to mid-20s, and that's still our view on the target margins for the business. So I'll pause there. Dave, anything that you would like to add to that?

I think that's right. And as Bill said, margins in the low 20s, he's referring to EBITDA margins, just to be sure. And we've reiterated and looked at and we still feel confident in the long term model that we’ve laid out in the past and that has the gross margins that we believe this business should be able to generate and continue to believe that.

And just to go back -- to bring your question and the first question that we had on the call together, the one program that caused really the majority of the volatility in the quarter was the challenge program that included the development, the low rate production and the long production run. It had an impact in the quarter, because we have revised estimates of our percent complete. And so we had some reversals in the quarter that basically had the cumulative catch-up in the quarter. But again, when we look at the gross margins of that program going forward, still above the average gross margins of our profile across that spectrum of 30% to 40% that I reiterated for development in our production programs. So hopefully, that's helpful. Hopefully, it gives you better insight in how we're thinking about the target margins of the business and really focused on target margins when it comes to EBITDA margins.

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

Thank you for the additional color on the challenge programs that you just provided. One thing I wanted to better understand a little bit is that you have scrutinized these trouble programs and implemented processes in the past. Can you help us understand why it took so long to sort of identify these additional issues? And maybe help us understand why this time you have more confidence that you've got a handle on it?

One thing that I'll iterate is where we're seeing EAC growth in the challenge programs, in general, it's not repeat issues. So if you look across the list of programs, the 19, with the exception of the one, we had very little volatility in the quarter. Where we did see the issue on the one program represented the fact that we're progressing the program. So we worked our way through development, that's a positive. We worked our way through the low rate production. And as we did, we learned more about the unit economics and specifically the unit cost that informed our view of the production. So I understand the question around why it took so long, but it really has taken us progressing through the different phases of this program in particular. And again, this one has a different profile, because it includes development, low rate production and a longer production run. On most of the development programs in general and our challenge programs, we have the opportunity to complete the development. So there may be some risk associated with completing the development. But at the end of the development, we get to the design baseline, we have an opportunity to execute on a small number of units so that we can get a good baseline for the unit economics, and in particular, the unit cost, and then we're able to factor that into bids for production contracts that are follow-on. So in this particular case where we have development, low rate production and a longer run production associated with it, within this one program, we have the risk associated with those three phases, which is relatively unique. So it may seem like it took us a while to get to the EAC and really understanding it. But we had to do the work and progress through development and low rate production in order to inform and update our view on the production run. So that's really the background on that.

Just one quick one as a follow-up. How flexible have your partners been to sort of work with you on these revised either contract terms or prepayments? Does this have an impact on your future relationships as well?

On payments themselves, Jonathan, could you please clarify?

So you referenced sort of going back to renegotiate some of the contracts and then having some acceleration in terms of the payment. So I just wanted to understand if that impacts the relationships, whether your partners or end customers have been willing to work with you? Just trying to understand sort of the dynamics around those discussions.

Yes, thank you for clarifying the question. And this ties back to what we've talked about now for a couple of quarters about, in general, our more cash efficient approach to our operations. And that has a couple of comments. One is how we order material and better stage it with the timing of deliveries. And the second piece of it is the contract terms that we put in place so that we can better align progress with progress payments historically. And one of the reasons why we have a large unbilled balance is our payment terms speak to us being able to bill invoice and collect cash only once we're complete and deliver the units. And so one of the things that we've done operationally is work to align our payment terms with progress payments. And so that, I think, is the renegotiation that you're referring to. And what I would say is, in general, it's not a big deal because our customers, in many ways, our incentives are aligned. So when we build them, they're able to collect cost, invoice their customers and collect cash. So our incentives are aligned. And as a result it's typically not a difficult conversation for us to have with our customers. Anything, Dave, that you would add to that?

I would add to that. When you think about the relationship and you're asking about our customers and working with our customers, I mean, a reflection of our customers’ thoughts and you know working with us, I mean, it’s reflected in the strong bookings we had that you see. These are customers who largely we have these customers have had them for a long period of time, and they're working with us. Bill has met with several of the customers even on the areas with the challenge programs. So he's working with those customers. And they want us to get to the answers the final activity so that we can get into production. They need these products where we have a unique capability to deliver these products and you see it reflected in our growing backlog and in our bookings that we've seen. As Bill said, we see some transitory kind of impacts but our customers understand that and then they’re working with us.

And then the other thing I'll add, Jonathan, and this may have been part of what you're asking as well, we did mention that we had some contract fulfillment in the quarter that resulted in a transitory impact, I think, of $5 million. In general, those discussions and what was behind the settlements had nothing to do with us trying to negotiate different payment terms, better align payments with progress payments, et cetera. They were completely different matters, specific to those contractual relationships, and not reflective of us trying to negotiate different terms with our customers. So in the event that, that was part of the question, I want to provide that color.

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

This is Kyle Wenclawiak on for Sheila. I appreciate the legwork you guys are doing around cost savings and the cash focus nowadays. But I just want to hone in on the profitability guide for this year, because it seems like the two uncertainties are kind of what you just mentioned around contract exits. So first question there is maybe how much of the backlog or revenue bridge is maybe up for negotiation? And then second part being the cost savings, it seems like a lot of that is pretty exhaustive, so maybe some color around why you didn't hone in on a more profit shakeout this year?

I'll take a stab at the two questions, and then Dave, maybe can fill in. First, on just the cost savings piece of it. As we’ve said in prior calls, I don't think of that as a onetime activity. I think of it as an ongoing activity to drive efficiency in our organization and our structure. And I think we've been pretty consistent in demonstrating that that's our focus with what we announced in Q1, the further enhancements that we rolled out in January, and we'll continue to look at opportunities to improve our cost structure. And I think that's a very natural thing to do in a business like ours that's been built up through acquisitions over a period of time for us to continue to look for opportunities to better integrate the business. As far as the contract, I guess, on the first question around…

This is Dave, Kyle, if it's all right. If I understood the question, it was around, of the $1.3 billion of backlog we have, how much of that backlog do we think would be -- I don't know what the right word would be, potentially renegotiated. Is that what you were driving for?

Yes, maybe how much of the backlog is maybe the lower margin work that you'd look to either exit or I mean, I guess, renegotiate?

I think about it very differently. That isn't a dynamic that we're currently thinking about or working on. I mean we feel very good about the backlog that we have in place. And again, like I said, it's a record backlog coming off of a great bookings quarter. The risk that we see in the business really is isolated to what we consider to be about 20% of the business, that's where we've seen volatility in the business. And the remaining 80% of our business has performed very predictably and we expect it to continue to perform predictably. And we're really focused in not so much on contract renegotiations or anything like that, but it's the execution in the 20% of our business. In particular, that includes this one common processing architecture technology that cuts across a few programs that we need to finalize the work that we have currently underway so that we can get to a design that is not just producible, which is where we are today, but producible at scale, so that we can perform very predictably and profitably and that’s our focus. So it’s less about the $1.2 billion backlog that we have and it's more about this one part of our business that represents 20%, and this common technology is a subset of that 20%.

And that's not to say that we feel like 20% of the business is at risk. What we're saying is that there's contained within that segment of the business that piece of business is where we see the highest concentration of risk that we're working through. But as Bill said, Kyle, I don't see a significant exposure for renegotiation settlement in our backlog.

And then I think the other thing that I would add relative to that area where we're focused on the technical work, we feel very good about our long term positioning there, because we're differentiated, we're sole source, we're baselined on programs where the capability is mandatory. And our customers are incentivized, we believe, with us to get to the other side on these technical issues, so that we can get to the person runs and get the product into their hands. So hopefully that paints a little bit clearer picture of the technical issues that we're describing.

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

Just to stay on that topic, I mean, looking at the guidance cut, I mean, can't we just say the high end of the prior $1 billion to the low end now at $800 million, isn't that 20% of the business? So I mean, it seems like 20% of the overall business has been kind of compromised here.

Yes, and I think I would say that when we look at the reduction in the range, it is largely in that business unit where we see the biggest reduction in the revenue. Because as we looked at the first half and the adjustments that we've taken that have impacted revenue, they've largely been in that business, as Bill said. And as we look at the volume going forward, as we both talked about, we're going to get these programs lying flat on the development before we really start producing in volume into the production. And that transition to make it seamless and to make it smooth without variability in the future needs to be completed before we move ahead. And that's why you're seeing we're not having as much early material receipts as we've had in the past. We're managing that carefully, so we don't end up in a situation where things are -- where we brought in things that design changes are still happening, too. And so yes, a significant part of that reduction in the range is driven by that part of the business.

And I would just offer too that it's really a timing around that volume and pushing to the right of that volume. And that's as a result of us being very methodical and working our way through the technical issues to get to a robust baseline that we can produce very predictably and profitably and at scale. And the reason why we're doing that is because we're very excited about the prospects for this part of our business. It's highly differentiated. We have sole source positions. We see a significant growth opportunity in front of us in this area with attractive gross margins, similar to when I walked through with the one challenge program where we had the major source of our impact this quarter still operating at very healthy gross margins going forward. And so we're very excited about our piece of this business. This volume reduction largely associated with that part of the business is a push out to the right.

And Michael, I would say it is a thoughtful, intentional view on our part of making that decision to not add to the risk profile by bringing that in -- by executing that early.

Just the last one, the $150 million guidance cut at the midpoint, you called out the revenue headwind from cost growth in the quarter in volume in the quarter. What's sort of the breakdown for the year if you can bridge kind of the $23 million in cost growth you saw this quarter? Is it fairly balanced, or how should we think about that?

I think the way I would look at it is, as we talked about, we're not trying to guide the back half from a profitability standpoint. It is if you take the first half and you take the reduction that we saw the shortfall in revenue, it's starting with that as the starting point that that's in the number for the year and then taking a look at exactly what Bill said, the intentional shifting of execution on contracts until we've got some of these things laying flat on that piece of our portfolio, not certainly on our entire portfolio.

Mr. Ballhaus, 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. And I very much appreciate everybody listening into our call this afternoon and the questions, and we look forward to providing you an additional update next quarter. Thank you very much.

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