Gerry Haines - Chief Financial Officer, Executive Vice President, Treasurer Mark Aslett - President, Chief Executive Officer, Director.

Peter Arment - Baird Seth Seifman - JPMorgan Jason Gursky - Citi Jonathan Ho - William Blair Caitlin Dullanty - Bank of America Brian Ruttenbur - Drexel Hamilton Michael Ciarmoli - SunTrust Ben Klieve - NOBLE Capital Markets Greg Konrad - ‎Jefferies.

Good day everyone and welcome to the Mercury Systems first quarter fiscal 2018 conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the company's Executive Vice President and Chief Financial Officer, Gerry Haines. Please go ahead, sir..

Thank you operator and good afternoon everyone 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.

We would like to remind you that remarks that we may make during this call about future expectations, trends and plans for the company and its business constitute forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995.

You can identify these statements by the use of the words may, will, could, should, would, plans, expects, anticipates, continue, estimate, project, intend, likely, forecast, probable, possible, potential, assumes and other similar expressions.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated.

Such risks and uncertainties include, but are not limited to continued funding of defense programs, the timing of such funding, general economic and business conditions, including unforeseen weakness in the company's markets, effects of continued geopolitical unrest and regional conflicts, competition, changes in technology and methods of marketing, delays in completing engineering and manufacturing programs, changes in customer order patterns, changes in product mix, continued success in technological advances and delivering technological innovations, changes in or in the U.S.

governments' interpretation of federal procurement regulations and rules, market acceptance of the company's products, shortages in components, production delays or unanticipated expenses due to performance quality issues with outsourced components, inability to fully realize the expected benefits from acquisitions and restructurings or delays in realizing such benefits, challenges in integrating acquired businesses and achieving anticipated synergies, changes to export regulations, increases in tax rates, changes to generally accepted accounting principles, difficulties in retaining key employees and customers, unanticipated costs under fixed price product, service and systems integration engagements and various other factors beyond our control.

These risks and uncertainties also include such additional risk factors as are discussed in the company's filings with the U.S. Securities and Exchange Commission, including in our Annual Report on Form 10-K for the fiscal year ended June 30, 2016.

The company cautions readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. The company undertakes no obligation to update any forward-looking statement to reflect events or circumstances arising after the date on which such statement is made.

I would 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 or EPS, adjusted EBITDA, and free cash flow.

Adjusted income excludes the following items from GAAP net income, amortization of intangible assets, restructuring and other charges, impairment of long-lived assets, acquisition and financing costs, fair value adjustments from purchase accounting, litigation and settlement income and expense, and stock-based other non-cash compensation expense, along with the tax impacts of those items.

This yields adjusted income, which is expressed on a per share basis as adjusted EPS calculated using weighted average diluted shares outstanding. Adjusted EBITDA excludes interest income and expense, income taxes and depreciation in addition to the exclusions for adjusted income.

Free cash flow excludes capital expenditures from cash flows from operating activities. A reconciliation of these non-GAAP metrics is included in the earnings press release we issued this afternoon. I will now turn the call over to Mercury's President and CEO, Mark Aslett..

Thanks Gerry. Good afternoon everyone and thanks for joining us. I will begin today's call with a business update, Gerry will review the financials and guidance, and then we will open it up for your questions. Mercury is off to a great start in fiscal 2018. Our acquired and organic businesses continued to deliver solid results in the first quarter.

We came in just into the high end of our guidance for revenue and exceeded guidance on adjusted EBITDA and adjusted EPS. Bookings for the first quarter was strong and we had several important new design wins. Thanks to good execution by the team, it was also a successful quarter from an operational perspective.

We completed the RTL acquisition and made solid progress on the Delta Microwave integration. Last week, we opened our world-class trusted digital and microelectronics manufacturing facility in Phoenix, and during Q1 we delivered important new capabilities in RF as well as safe and secure processing. Taking a quick look at the numbers.

Total revenue for Q1, including the acquired businesses, was up 21% year-over-year. Our largest revenue programs in the quarter was SEWIP , F-35, Aegis, F-16 SABR and Filthy Buzzard. Total bookings were also up substantially from Q1 last year. Our largest bookings programs were F-35, Aegis, Predator, APG-79, and Zeus.

Adjusted EBITDA for Q1 on a consolidated basis was up 37% year-over-year and at 24% of revenue well within our target model. The growth drivers we discussed over the past couple of quarters are even more relevant today.

We began our fiscal year with another budget continuing resolution as anticipated and we currently expect that the CR could continue through the end of this calendar year. Nonetheless, we believe Mercury will continue to deliver above industry average growth in revenue and profitability in FY2018.

This reflects the positive underlying industry trends, our record backlog, and the significant investments that we have made in our technologies and manufacturing assets. It also reflects the continued success we have achieved in broadening and deepening our relationship with key customers and on key programs.

The level of new business pursuits and design activity remains the highest I have seen since joining Mercury, and our win rate is strong. These opportunities fall in two broad areas. The first area is sensor processing, our traditional strength where we continue to see growing demand in radar, EW, EO/IR, as well as weapon systems.

The second category focused on computing beyond the sensor, including mission computing, comms processing, command-and-control, combat systems, and platform management. These are new markets and long-term opportunities for Mercury and ones that we are excited about.

In this category, we recently introduced an industry leading secure rackmount blade server and completed the acquisitions of RTL and prior to that CES.

From a platform perspective, our positioning in these markets translates into a broad opportunity set ranging from the naval service fleet to fighter jets, wide-bodied signals intelligence, unmanned aerial vehicles, and ground stations.

We are currently involved in a number of high-value pursuits in both sensor and non-sensor computing, most important we are continuing to convert a high percentage of these pursuits into new design wins. The primes are transforming the way they are dealing with their supply chains, moving from procuring to partnering.

Mercury's win rate demonstrate that we position ourselves as an important facilitator and partner in this transformation. On previous calls, I’ve described the primes' new supply chain strategy in terms of three underlying trends. First is outsourcing, which appears to be accelerating as our customers wrestle with a number of challenges.

One such challenge is the volume of internal hiring required to keep pace with their recent awards and expected growth. Another is that primes need to increase their level of internal R&D spend and to focus this investment as they can no longer do everything in-house.

At the same time, they need to keep pace with the new and emerging threats continues unabated requiring them to leverage and deploy commercial technology more rapidly than ever before. We are ideally positioned to provide our customers with high quality, lower cost solutions than they can deliver internally.

We are doing this through a significant investment in R&D and by focusing on pre-integrated subsystems using the latest open standards and architectures. The second underlying trend is what appears to be an active focus by the government and the primes to delay their supply chains with the goal of making their solutions more affordable.

They are doing this by dealing directly with the companies that are actually funding and developing the innovations. Supply chain delayering creates the potential for larger deals and likely faster growth for us over the longer term.

Our strategic acquisitions over the past several years have allowed Mercury to move up the value chain to the mid Tier II level. This, in turn, has expanded and improved our ability to provide affordable subsystems. With our commercial business model, we position ourselves as an ideal partner as this trend evolves.

The third trend is what we call a flight to quality. The primes are seeking to deal with fewer more capable suppliers, suppliers who are willing and have the capacity to co-invest significant internal R&D dollars.

They are seeking partners that have scalable and trusted capabilities and manufacturing assets that combined deliver innovations with high quality, faster and more affordably. Mercury matches up well on these dimensions of quality.

We have continually increased our R&D investments on a dollar basis over the past few years to one of the highest internal R&D spend to revenue ratios in the defense industry. At the same time, we have substantially expanded and strengthened our trusted manufacturing capabilities.

As proof, in the past quarter we received two upper echelon supply quality awards from customers and just last week I was in Phoenix to host the grand opening of our world-class trusted manufacturing facility with many of our top customers and other dignitaries. Moving to our acquisition integration activities.

We continue to make progress in consolidating our three small RF facilities on the West Coast. Ultimately, we will create a state-of-the-art larger and scalable RF manufacturing location similar to what we did in Hudson, New Hampshire. The activities are under way and on track for completion early next fiscal year.

The strong position we have developed as a partner to the primes is also reflected in our design wins. We are capitalizing on increased outsourcing at the subsystem level in radar and EW modernization and in secure processing among others.

For instance, during the first quarter, we displaced a competitor as the outsourced supplier on an important radar due to our superior security solution. We also received an initial award for tactical airborne EW program that exemplifies the delayering that we see happening.

We are winning new content in the weapon systems arena as the industry works to replenish supplies in the near term and invest in new capabilities in the long term. In addition, we seeing growing opportunities driven by the increase in modernization activity related to C4I and other non-sensor related computing onboard the platforms.

On our Q4 call, I talked about design win pursuits relating to two large secure airborne processing opportunities. One pursuit recently resulted in a purchase order for our secure rackmount server and we expect additional awards as the year progresses. In the other pursuit, we were by third-party, meaning we now own multiple teams to varying degrees.

So overall, we are seeing great opportunities in sensor processing and weapon systems. We are now also moving into C4I, including executing on growth strategies and mission computing, C2I, platform management and safety certifiable avionics.

With the business model we have created and the capabilities we have developed, both organically and through acquisitions, we believe that we are strongly positioned for continued growth across our core markets.

Going forward, we intend to remain active and disciplined in our approach to M&A as we work to extend our record of growth above the industry average. We are continuing to look for deals that are strategically aligned, have the potential to be accretive in the short-term and promise to drive long-term shareholder value.

We will continue to target acquisitions that expand our addressable market in aerospace and defense electronics, domestically and internationally and the scale of technology platform that we have built.

We remain focused on the key pillars of the business, RF and secure processing, while also continuing to assemble critical and differentiated solutions for secure sensor and mission processing.

We plan to continue acquiring smaller capability led tuck-ins, such as RTL most recently, while capitalizing on larger opportunities as they present themselves. In summary, Mercury's on track for another great year in fiscal 2018. Our business model is working very well.

We are taking share and we are seeing high levels of activity based on the investments that we have made and the capability set that we have created. In addition, our planned integration and manufactured synergies are materializing as anticipated.

Given our results in Q1, our record backlog and our current business outlook, we are anticipating continued strong performance in the second quarter and we are raising our full year guidance for fiscal 2018. Gerry will take you through the guidance in just a minute.

Finally, as reminder, we will be discussing our strategy and plans for growth in-depth at our Investor Day in New York City on November 7. We sincerely hope that you can join us. With that, I would like to turn the call over to Gerry.

Gerry?.

Thank you Mark and good afternoon again everyone. Before we go through the financial results, I will note that unless otherwise stated, we will be discussing the company's financial results, comparisons to prior periods and guidance on a consolidated basis.

These consolidated results include the CES and Delta Microwave businesses we acquired in the second and fourth quarters of fiscal 2017 respectively and Richland Technologies or RTL, which we acquired during the first quarter of fiscal 2018. As a reminder, we are now reporting two categories of revenue breakdown, organic and acquired.

Organic revenue is defined as revenue attributed to businesses that have been a part of Mercury for more than four full quarters. Acquired revenue is revenue defined as associated with acquired businesses that have been part of Mercury for four full quarters or less.

After the completion of four full quarters, acquired businesses will be treated as organic for both current and comparable historical periods. For Q1 of fiscal 2018 acquired revenue includes the contributions associated with the former CES, Delta Microwave and RTL businesses. Turning now to our first quarter results.

Mercury delivered a solid start to fiscal 2018 on a consolidated basis and organically. Total revenue increased 21% from Q1 last year to $106.1 million, near the top of our guidance range of $102 million to $107 million. Organic revenue increased 7% year-over-year to $93.5 million ticking up from the 4% organic growth rate recorded in Q4 fiscal 2017.

Acquired revenue was $12.6 million, which is not comparable to Q1 of fiscal 2017 due to the inclusion this year of Delta Microwave and RTL, which were not a part of Mercury in Q1 of last year. International revenue including foreign military sales was 15.4% of total revenue compared with 16.1% in Q1 of fiscal 2017.

The decreased percentage of total revenue is largely a phenomenon of the expanded and more diverse overall revenue base offsetting a 16% year-over-year increase in the dollar volume of international revenue. Radar revenue for Q1 of fiscal 2018 was down 3% year-over-year while electronic warfare revenue increased 34%.

Revenue from radar and electronic warfare together accounted for 60% of consolidated total revenue compared with 67% in Q1 last year. As with the international split, the lower proportion of total revenue, year-over-year once again reflects Mercury's overall larger and more diverse revenue base.

As expected, the new businesses we have acquired over the past year-and-a-half have substantially expanded both our addressable market and our revenue base. Total bookings for the first quarter were up 11% year-over-year, driving 1.01 book-to-bill ratio.

We ended the quarter with record total backlog of $360.7 million, up 22% from $296.4 million a year ago. Approximately $281.7 million or 78% of our Q1 backlog is expected to ship within the next 12 months. Mercury's bookings and revenue growth continue to translate into solid profitability organically and in our acquired businesses.

Our product sales mix for the first quarter of fiscal 2018 was stronger than originally anticipated producing somewhat higher gross margins than what we expect for the fiscal year as a whole.

That said, we are continuing to realize the expected production cost efficiencies and acquisition integration synergies as well as benefits from the continuing ramp-up of our in-sourced U.S. manufacturing operations. Our gross margin for Q1 of fiscal 2018 was 47.8%, up from 45% a year ago.

This is nearly one percentage point above the top end of our Q1 guidance, due to product mix. It is also up about one percentage point on a sequential basis and close to the midpoint of our target business model.

Our bottomline this quarter also reflected solid performance in cost containment even though we have acquired several businesses and have continued to steadily increase our R&D investments over the past year. In addition, we continue to see modest restructuring costs associated with our ongoing facilities realignment and consolidation in California.

Nonetheless total Q1 operating expenses continued to increase at a lower rate than our revenue growth rate. Operating expenses in Q1 rose 13% to $40.3 million from $35.7 million in Q1 of fiscal 2017. GAAP net income for the first quarter of fiscal 2018 was $18 million or $0.38 a share.

This compares with $3.8 million or $0.10 per share for Q1 of last year. The GAAP increases year-over-year and the outperformance versus guidance largely reflect the impact of discrete tax items benefiting the most recent quarter.

These include a $7.9 million tax benefit related to stock-based compensation and a $4.1 million benefit related to net operating loss carryforwards associated with previously acquired businesses, while Q1 of last year included a $2.2 million tax benefit related to stock-based compensation.

Excluding the impact of the discrete items, GAAP EPS for Q1 of fiscal 2018 would have been $0.13 a share, also exceeding our guidance. Adjusted EPS for the first quarter increased to $0.37 a share from $0.22 a share in Q1 of fiscal 2017. This was substantially above our Q1 guidance range of $0.24 to $0.26 a share.

Adjusted EBITDA for Q1 of fiscal 2018 increased 37% to $25 million from $18.2 million a year ago. This also exceeds our Q1 guidance of $21.4 million to $23.5 million and at 23.6% of revenue is well into our long-term target range of 22% to 26%. Turning to the balance sheet.

Mercury ended the first quarter of fiscal 2018 with cash and cash equivalents of $26.1 million compared with $41.6 million a year earlier. Mercury's operating cash flow for Q1 of fiscal 2018 was $8 million compared with $10.3 million last year.

As in the sequential fourth quarter, our cash flow reflects the continuing buildup of inventory associated with our expanding in-house manufacturing capabilities and the timing of invoicing and collections for certain program activities. This shift is occurring as highly integrated subsystems become a more significant part of our overall revenue mix.

Overall, we expect fiscal 2018 to yield stronger cash flows compared to fiscal 2017 as cash flow strengthen through the second half of the year. Our cash flow from operations in Q1 was partially offset by $3.6 million of net capital spending primarily associated with the continued buildout of our trusted manufacturing operation in Phoenix.

As anticipated, capital expenditures were substantially lower than in Q4. Net of CapEx, free cash flow for Q1 was $4.4 million compared with $4.2 million a year ago. In terms of Mercury's financial position, we continue to maintain a conservative approach to the balance sheet.

In Q1, we filed a new universal shelf registration which remains unused to-date. This replaced our previous shelf registration which was scheduled to expire in early September. Overall, we remain well-positioned to continue executing on our capital deployment strategy supporting future growth both organically and through acquisitions.

I will turn now to our financial guidance for the second quarter and full fiscal year 2018. For purposes of modeling and guidance, we have assumed no restructuring and no acquisition or nonrecurring financing related expenses and an effective tax rate of 35% in the periods discussed.

The guidance also assumes weighted average fully diluted shares outstanding of approximately 47.5 million shares for Q2 and 47.8 million shares for the full fiscal year. Our guidance for Q2 and fiscal 2018 reflects the outlook that Mark discussed, highlighted by continuing strong performance both organically and in our acquired businesses.

We expect to continue delivering growth and profitability at rates higher than the industry average. We expect this performance to be driven by our record backlog, growth in major product lines and across many of our programs as well as our enhanced manufacturing capabilities.

We are planning that internal R&D investments will remain elevated versus our target model as we continue to align the R&D levels of our newly acquired businesses with that of the organic business. At the same time, we continue to invest incremental R&D dollars to capture new design wins.

Even with the incremental investment in R&D, we also expect to see improvement in our free cash flow for the year as our CapEx is reduced versus fiscal 2017.

We expect CapEx to be modestly higher in the back half of fiscal 2018 based on our integration plans but for the full year to be consistent with our goal in the vicinity of 5% of revenue or less. As Mark said, the federal government entered its new fiscal year operating under another CR, which is likely to continue through the end of calendar 2017.

Against that backdrop, we once again expect that for fiscal 2018, as in the past several years, our second half will be stronger than the first half. As a result, we expect Mercury to deliver another year of strong growth and solid financial performance.

With that as background, for the second quarter of fiscal 2018, on a consolidated basis we are forecasting total revenue in the range of $112.5 million to $116.5 million, an increase of 15% to 19% over Q2 of fiscal 2017. Gross margin for Q2 is expected to be approximately 46.1% to 46.7%.

Q2 GAAP net income is expected to be in the range of $6.1 million to $7.1 million or $0.13 to $0.15 per share. Adjusted EPS for Q2 is expected to be in the range of $0.28 to $0.30 a share.

Our estimates assume approximately $4.2 million of depreciation, $5.7 million of amortization of intangible assets, $0.1 million of fair value adjustments from purchase accounting and $5.2 million of stock-based and other non-cash compensation expense.

Adjusted EBITDA for the second quarter of fiscal 2018 is expected to be in the range of $25.3 million to $26.8 million representing approximately 22.5% to 23% of revenue at the forecasted revenue range.

For the full fiscal year 2018, we now expect Mercury's total revenue to increase to between $457 million and $468 million or approximately 12% to 15% year-over-year. Currently gross margins for the year are expected to be between 46.8% and 47.3% and operating expenses are expected to be in the range of $167.7 million and $171.2 million for the year.

Total GAAP net income for fiscal 2018 is expected to be in the range of $37.8 million to $40.7 million or $0.79 to $0.85 per share. Adjusted EPS is expected to be in the range of $1.29 to $1.35 per share.

We currently expect total adjusted EBITDA for fiscal 2018 to be approximately $105 million to $109 million and at approximately 23% to 23.3% of revenue for the year, well within the range established by our current target business model. With that, we will be happy to take your questions. Operator, you can proceed with the Q&A now..

[Operator Instructions]. Our first question comes from the line of Peter Arment with Baird. Your line is now open..

Yes. Thanks. Good afternoon Mark, Gerry..

Hi Peter.

How are you?.

Gerry, just first as a clarification on that 12% to 15% topline guidance number for revenue for this year, what's the organic number? Is there a way to arrive at that or do we have to true that up at the end of the year?.

Yes. You will have to true that up at the end of the year. We don't guide on the organic versus inorganic split. We only report it back on an historic basis. What I can tell you is that, on a pro forma basis, we still continue to target organic growth in the neighborhood of about 10%..

Okay. That's helpful.

And then just Mark, if you could just give us a little more color on how you are doing in terms of progressing into the weapons category, guided munitions? I know that it's been a big part of the carveout acquisition and how are things progressing there?.

Yes. So it's actually progressing pretty nicely, Peter. If you look in our Q1 results on a year-over-year basis, our business in weapon systems space increased greater than 250%. So we are clearly seeing our ability to take share as well as seek some growth as the DoD seeks to actually replenish stocks.

On an LTM basis, we are seeing very substantial growth as well in the business over the last 12 months is up greater than nine-fold. So we are quite pleased with the results..

Okay. And if I could just squeeze in one more.

Gerry, what's the assumption for what we should assume for the tax rate for the year?.

So we just use the flat 35% rate, Peter, because we don't guide on the discrete items. We will see, over time these stock-based compensation moves, but Q1 is far and away the largest.

We had a particularly large one this quarter and that was really driven by the ramp-up in the stock price over the period, and we get the benefit of the vesting date price. Most of our equity vesting happens in the quarter. That's why that was a little outsized this period. But as we have in the past, we will see that roll through on a quarterly basis.

Again, we’ll provide those updates but we guide at 35% which you can think of as a marginal rate..

Peter, just as a follow-up as well. I think at a year level, we are expecting that actually the weapon systems segment will likely be the fastest growth of the markets that we are currently participating in..

Thanks very much, Mark..

Thank you. And our next question comes from the line of Seth Seifman with JPMorgan. Your line is now open..

Thanks very much and good afternoon. Mark, I wonder, maybe you could shed a little more color.

You made the distinction between the sensor associated products and the computing outside of sensors, which is kind of a new market for the company and sort of what some of the challenges are in terms of penetrating that new market? The relative growth of those two markets? Is the outsourcing dynamic the same at your customers in both the traditional sensing and the non-sensing piece? And just how you see those two pieces evolving within the company?.

Yes. So I think overall we are actually really pleased with the progress that we are making there. So our move into C4I has really comprised both some organic investments in our secure rackmount blade server where we are already beginning to see business in both the naval as well as the airborne domain. We think that's going to continue going forward.

We already received an initial purchase order for an airborne opportunity where we expect additional business as the year progresses. The idea around moving into that segment actually came from one of our customers in discussion some time ago, and they basically said, look, we love what you are doing on the secure sensor side of things.

If you could do the same in other non-sensor related computing, we would love to buy that from you. So we have obviously done a couple of acquisitions in the space now. In Q1, it actually was one of the strongest growth market segments that we had, and we are expecting pretty strong growth going forward as well.

So with respect to challenges, we really don't see many right now. I think the technology that we have, some of the recent press releases that we made, customers are really pretty excited about what we are doing..

Great. Thanks.

And then maybe as a quick follow-up, if you can address what the M&A environment looks like these days?.

So I think it's pretty active. Obviously, there has been a couple of really big deals in the space that we think has probably got some long-term implications. As we have seen in the past, we remain active in the markets in which we are participating.

I think our reputation as an acquirer is very, very strong, so we are tending to see pretty much all of the deals that are out there in our target space. Mike and the M&A team is doing a pretty good job. So we continue to look at smaller and larger deals in the space..

Great. Thank you. .

Thank you. And our next question comes from the line of Jason Gursky with Citi. Your line is now open..

Great. Thanks. Good afternoon everyone..

Hi Jason..

I was wondering if you could maybe just give us your perspective on the consolidation that we have seen amongst some of your customers? And whether this creates further opportunities for you or if this puts anything at risk or if it's just a completely neutral event?.

Yes. I don't think it puts us at risk from what we can gather. I think if anything, it provides more opportunity. As a said in my prepared remarks, I think there is really in three major trends that's going on. The first is outsourcing at a higher level than what the primes have done previously, which is largely being at the module.

We continue to see more outsourcing at the subsystem level. The other trends around the flight to quality, I think, represents an opportunity for us as larger companies combine and seek to rationalize their number of suppliers.

They are clearly seeking to deal with fewer numbers, but suppliers that are able to lean in and invest more in R&D but then also buildout the manufacturing assets that's required as programs transition from algorithm into production. And we have clearly done that. We just opened up a new facility in Phoenix last week.

It was very well attended in the political arena, but also from our major customers. And the feedback that we got was extremely positive. The other trend, I think, is also a positive for us, just given the capabilities and the manufacturing assets that we have, is with respect to the delayering.

Customers are clearly seeking to deal with those companies that are truly innovating and I think as Gerry said in his prepared remarks, we continue to increase our R&D spend on a dollar basis. But then you have also got to be able to manufacture those products and we are investing there as well.

So if anything I would kind of summarize to say that our customers are continuing to rationalize their supply chain. It's moving from procuring to partnering and we believe that we are very well positioned..

Great. And then maybe just a quick follow-up, but a bigger picture question. You guys have talked about target financial model over the last several years.

Can you maybe just update us to give some current thoughts on the size that the company needs to be at from a revenue perspective to put you on a path to sustainably achieving those financial targets? And then maybe what are some of the hurdles that you have to get over between now and getting to that sustainable financial model?.

Well, so if you think about, we updated the target model when we did the acquisition of Microsemi and we added 400 basis point on adjusted EBITDA to the bottomline. We actually achieved or are inside of that model in fiscal year 2017, a full year ahead of where we thought we were going to be.

And we are actually expecting, just based upon the guidance that we have just given, to actually extend that during fiscal year 2018. So, we are already inside the model. I think as we continue to grow and demonstrate operating leverage in the business then hopefully, if we are successful, we will increase towards the higher end of the EBITDA range.

I don't know if you want to add anything, Gerry?.

Yes. And I think, you kind of asked, is there a certain size or critical mass that we need to achieve to make it sustainable, I would point out two things. One is that, we have sustained it now for over a year.

So the full 23% adjusted EBITDA for the year last year and obviously we have shown again this year and we currently expect it for the full year, based on our just updated guidance. But as much as anything, I would say it depends on the execution against the strategy not just a size question.

If you look, Mark mentioned a moment ago, that we moved into more and more subsystems. The top customers that we have these deep relationships with are using us more and more for that. If you look at it on an LTM basis, our growth in subsystems has actually outstripped our growth in the base revenue.

So it shows that that strategy is paying dividends and that we have added the right kinds of capabilities to facilitate not only our ability to deliver those solutions but the ability of our customers to tap into it for them. So I think that's really where the heart of the matter lies..

Great. Thanks guys..

Thank you. And our next question comes from the line of Jonathan Ho with William Blair. Your line is now open..

Hi. Good afternoon. Just wanted to start out with the Phoenix facility and some of the consolidation that you talked about on the West Coast and maybe what sort of margin impact we should expect and potentially the timeframe for that margin to get back..

So we don't guide on anticipated margin increases, other than to say, as we said in my prepared remarks, that we think this year we can do as well or maybe even slightly better from an adjusted EBITDA margin standpoint than we did last year. Obviously we are not yet enjoying the full benefits of all that.

We just did the ribbon cutting last week and we are continuing to invest. So we have built some room in our model for good reason and we want to harvest that over time and even through subsequent acquisitions.

Mark?.

Yes. So I think it's a good point, Gerry.

I think if you go back to the question that Seth asked, as we continue to see growth on the topline and as we complete our facilities consolidation in RF as well as complete our activities around our trusted manufacturing facility and bringing some of the secure processing work in-house then we will see some of the margin expansion.

But it's a multiyear journey. It doesn't happen in one quarter. With respect to the timing, so as I said in my prepared remarks, we are already underway in terms of the activities on the West Coast with respect to integration post the Delta Microwave acquisition.

We expect to have those facilities combined and consolidated and fully integrated by early next fiscal year. The U.S. manufacturing operations, which is the facility in Phoenix, as I said in my prepared remarks, we literally just opened that last week.

So work is already underway there and we have got additional work that will move into that facility as the year progresses. So we are actually quite pleased with the progress that we are making and we are on track and good progress overall..

Got it. And then just on a separate topic.

Given the situation in North Korea, can you give us a sense of where maybe you are seeing some incremental opportunities? And again, maybe over what type of timeframe those opportunities could be recognized?.

Well, it's hard to say, specifically with respect to North Korea because I am not sure that we have got specific insights with respect to what is happening there. But if you look at overall from a market segmentation perspective which is kind of how we tend to view things, we are seeing really strong growth across our major markets.

So talked a little bit about the growth that we are seeing in the C4I space. C4I is obviously those other types of computers that are not related to the sensor business. It is growing rapidly as a result of some organic investments as well as acquisition. The EW business is growing extremely well as well.

That, I think, is due to a lot of modernization activity and recapitalization of EW assets. What that translates into for Mercury is significant growth in the RF business. And when I talk about a flight to quality, we are clearly benefiting from a couple of different suppliers' shortfalls in that space and we continue to take share.

In the weapon systems arena, I think that is also an area that you were seeing substantial growth. As you may remember, we wanted to enter that marketplace and that was one of the major reasons that we did the acquisition of Microsemi.

And then in the radar business, which has been a mainstay for Mercury, we are expecting and seeing good growth and that is still a large part of the business. So probably the best way of viewing it is really through the lens of what we see happening in the market, Jonathan..

Thank you. And our next question comes from the line of Ron Epstein with Bank of America. Your line is now open..

Hi guys. This is Caitlin Dullanty, on for Ron tonight. Mark, you mentioned that you have won market share.

Can you discuss the competitive environment and your overall strategy to continue gaining that market share? And more specifically, as you broaden your capabilities, how are your competitors responding?.

Yes. So I would say that we are really gaining share in a couple of different areas. First is clearly in the RF domain. As I mentioned, EW market segment is growing very rapidly. We are continuing to take share across a number of different programs that we weren't a part of previously.

That in particular, is I think because the two particular suppliers that seem to be struggling.

They are not investing in the level of R&D that we are and clearly they don't have the sorts of scalable high quality trusted manufacturing that Mercury built out really during the period of sequestration, which was a particularly difficult period in the industry. So we expect that to continue going forward.

We have been building out our RF capability for the last five years now and we feel like we have got a significant lead. The other area where we feel that we are also taking share is in the secure processing domain.

And this is an area that we have invested significantly and we are actually moving into our fourth-generation of embedded security, which is critically important. Just this past quarter, we won important our radar program displacing a competitor. And this is particularly nice for us because the program is soon to transition into production.

So those will be two that I would point out directly. Beyond that, I think there are opportunities for us to gain share through the outsourcing that's occurring at a subsystem level as our customers are seeking to purchase more complete subsystems with multiple technologies. And Mercury is actually in a unique position to be able to do that.

There really is no other supplier that we know of operating at our level that's got the capabilities in RF in digital as well as processing combined with security and the advanced software that we have. So we think that our model is working extremely well and I think you can see that in our above industry average growth..

All right. Thank you so much. That's very helpful. And since you brought up R&D, if I could just ask a little bit about that.

When you look at R&D, how do you measure your return on that investment? Can you talk about a little bit about that?.

Sure. Well, I think you can look it in a couple of different ways. I mean, ultimately we are seeking to generate new higher returns. We have been very successful, not only at growing the level of our EBITDA as measured in absolute dollars, but we have very systematically increased the EBITDA as a percentage of revenue over the last four or five years.

And we have, as you know, about a year-and-a-half ago, we reset the model and we are already inside that. So that is one. The other is, obviously we look at it over the longer term and we try to assess the lifetime value of the programs that we are involved with as it relates to the content that we believe that we have selected for.

And that has also seen a very substantial increase. So we feel that we are doing a very good job increasing our R&D but for generating a significant opportunity for prolonged growth..

Yes. And I think I would kind of add to that and say that we also see it in our win rates because we are very focused. I think I mentioned in the remarks portion that we are adding into our R&D efforts for pursuit of specific opportunities. Our win rates have been very strong. That in turn adds to the pipeline.

And we have seen good steady increases in bookings and backlog, et cetera.

So we see the very systematic logical translation of the investment in R&D leading to a rich set of pursuits and a high win rate that we are translating, we think, very effectively and that's driving both our above average growth rate as well as the above average overall profitability over time..

Okay. Great. Thanks guys. That was very helpful..

Thank you. And our next question comes from the line of Brian Ruttenbur with Drexel Hamilton. Your line is now open..

Yes. Thank you very much. A quick question on the budget.

It hasn't been brought up and are we still expecting, in your guidance, timing of a passage by December, January? What are you anticipating in your guidance?.

Yes. So I think we anticipate a budget resolution by the end of this calendar year, Brian..

Okay.

And if there is a 90-day delay, what does that do to your numbers? Is it significant or not?.

Well, we don't believe so, but it's always hard to tell. We are sitting here with a record backlog. So we feel like we have got pretty good coverage. So time will tell..

Okay. And then just one follow up on M&A and the environment right now. What I have seen is whenever there is this big M&A push, there is also big fallout. People have to divest small pieces.

Is that something that you are looking at as possibly moving into adjacent areas by picking up pieces that are available?.

So I would say that we are going to remain disciplined in our approach to M&A in terms of the target areas. I do however agree with you that as a result of some of the larger acquisitions that are currently underway and may be additional acquisitions going forward, there could be some select divestitures associated with that.

And clearly if it was in-line with our strategy, we would be interested in having a look at them..

Okay. Thank you very much..

Thanks Brian..

Thank you. And our next question comes from the line of Michael Ciarmoli with SunTrust. Your line is now open..

Good evening guys. Thanks for taking the question here..

Hi Mike..

Hi guys. Maybe just on the topic of R&D, it's actually, in absolute dollar terms it's actually declined now for three straight quarters. And I know you have been talking about the elevated R&D investment. Should we be expecting a material uptick? I know previously you guys have said that it will probably run at the high end of that 11% to 13% target.

Is it still expected to be as high up to that 13% level or a bit higher, which that seemingly implies a pretty big step up? Do you guys have that in the budget? Do you see that spend flowing through here?.

Yes. So Mike, I am not sure I would agree with you on the numbers. So it was about flat Q4 to Q1. There was, I think, $13.9 million in Q4, $13.7 million in Q1. Q1 had somewhat lower revenue. So the percentage was actually higher. And both of those numbers are higher than Q1 of the prior year. So we are up about $1 million Q1-over-Q1.

So that's point number one. Point number two is, we are right at about 13% of revenue in the most recent quarter. We, as I said, expected to certainly hang at the high end of our target model, maybe even step outside of it a little bit. We have done that in the past. So it would not be the first time.

But those are typically aimed at pursuits that we feel we have a good chance of hitting on. And so it's a targeted effort but again one where, as we look at an opportunity we typically aren't thinking of it as a one-and-done.

We are looking at more franchise opportunities where we are going to apply those investments across a few different opportunities..

So if you look at it on an LTM basis, Mike, it's up close to $14.5 million, 36% year-over-year, which is less than the 43% growth on an LTM basis that we saw on the topline. So we have continued to invest and as we have said in the prepared remarks and as Gerry has just said, we expect to continue to invest in that space.

It's a really important part of the business model and it's an area that the customers really like..

Got it. And then just Mark as well, we often get asked on this outsourcing opportunity. It's pretty sizable out there, as you guys laid out, I think, the last Investor Day.

Can you provide us with any quantifiable metrics in terms of how far penetrated you are into that market right now? I mean where you are in terms of outsourcing wins? Is there any tangible hard metrics you can provide us with kind of execution against that market opportunity?.

Not on a quarter-by-quarter basis, Mike, because again think the data isn't readily available. What we see however is that, I think in at least two of our major customers, by now the majority of the new pursuits in the design wins are really outsourced at the subsystem level.

We have seen growth, I think as Gerry said, in terms of our overall product lines and that we seeing pretty substantial growth in terms of the subsystem revenues, particularly on an LTM basis. But there is nothing specifically at this point in time that I would point to with respect to market data that is hard to get a hold of.

We will have more to talk about though at our Investor Day that is coming up in November..

Okay. And then just last one for me. I know you are not going to guide to it, but the bookings outlook, you guys continue to put north of one-time book-to-bills up here. You have got challenged suppliers. You are taking share. It seems like the pipeline's pretty attractive.

Can you guys or are you forecasting, do you expect this book-to-bill and the bookings level to remain strong year here as you continue to work through the year? And maybe even does this continuing resolution pose a near-term threat for bookings? Should we maybe temper expectations this quarter? Or you feel as confident as ever?.

Yes. We feel actually pretty good about bookings potential. I think as I said, the activity level is probably the highest I have seen since I joined Mercury. We feel that we are winning more than our fair share. And I think that's a direct result of the fact that our strategy is working extremely well.

So I would say that we do expect overall positive book-to-bill for the year..

Okay..

As we have said in the past, Mike, bookings tend to be a little chunkier and therefore choppier quarter-to-quarter. So as Mark said, we feel pretty good about the year. I think the hardest challenge is always bringing new entities in and helping to drive their growth rates. And I think we have demonstrated very successfully that we can do that.

And it manifests in not only the overall growth rates, but the ability to keep those booking levels solidly positive as we have. So again overall we feel pretty good about it..

Perfect. Thanks a lot guys..

Thank you. And our next question comes from the line of Ben Klieve with NOBLE Capital Markets. Your line is now open..

All right. Thank you. Just a couple of quick questions here. So first I am looking at free cash flows. I am wondering if you can elaborate a bit on the working capital build over the last couple of quarters, particularly in regards to inventory.

Maybe if you can kind of describe the function of that increase? Was it really just a matter timing? Or was it addition of the acquisitions? Or investments ahead of production? How can we think about that build over the last couple of quarters?.

Yes. It's a good question, Ben. So the answer is yes. You kind of hit a couple of the main points. So first of all, we have brought in additional inventory as a result of doing multiple acquisitions. It's worth remembering when you do an acquisition also you bring that inventory in at a stepped-up basis.

So it comes in a little bit high and then it takes some time to work that off at normal levels. But in addition to just the step up overall because of acquisitions and being a bigger company, we have shifted to or are actually in the process of still shifting to our U.S. manufacturing operations which we dedicated last week.

That has led us to build inventory over time and included in that is also some safety stock because we don't want to put risk in the business unnecessarily as we manage through some of those transitions. And then it's also a point of note that as we shift to in-house manufacturing, we are stepping down one level in our own supply chain.

So that inherently carries slightly larger amounts of inventory with it. And then I guess the final point that I would make is, I mentioned we do more and more of these more complex and more sophisticated subsystems than we have in the past. Those tend to be bigger, as I said, more complicated, more expensive, which is nice for us.

And as we do that, they inherently involve not only more physical inventory but also more labor. And then often some of those large subsystems are actually scoring revenue on a percentage of completion basis.

And there can be timing issues around when we are recognizing the revenue as we are working through it and when we actually convert that revenue into cash over time. So those larger programs will tend to build either inventory or unbilled and then ultimately regular billed receivables over time. And then over time they convert out.

So that kind of normalizes it. So those, I think, are the main things that are going on in addition to just us being bigger..

Got you. Thanks for that Gerry. And one final quick question for me. A follow-up on an earlier question regarding international potential.

I was wondering if you could just elaborate specifically on foreign military sales? How that has evolved recently from a geographic perspective? Within foreign military sales, have you seen order flows accelerate in any particular region? Are you elaborate on that at all?.

So in Q1, I think as Gerry said in his prepared remarks, international defense revenue including FMS was actually up 16% year-over-year. On an LTM basis, it's actually up 24% year-over-year. So we are seeing pretty good growth.

It's hard to specifically tie back to a region because I don't think we have necessarily got that insight because some of the programs that we are involved with, we sell it to our customers here domestically that they are selling overseas that are encompassed in that number.

But many of our programs that we are involved with it have got FMS components..

Okay. Fair enough. Thanks a lot, Mark. Thanks Gerry..

All right. Thank you..

Thank you. [Operator Instructions]. Our next question comes from the line of Greg Konrad with ‎Jefferies. Your line is now open..

Good evening..

Hi Greg..

How is it going? I just have one question. Most of my questions have been answered.

But is there any way to quantify your win rate? And as the primes have become a little bit more coming through with their growth forecast, in a way to kind of place your growth based on higher build rates for the programs you are on versus kind of new content wins or upsize in terms of your content on key programs?.

Not specifically the win rate, Greg. Obviously that's something that we keep a close eye on and it has definitely trended northwards as we continue to take share in both RF, particularly as it relates to EW, the modernization activities as well as in the processing domain as it relates to secure processing.

But that's another number that we publish at Investor Day. We will give an update on just some of the lifetime values of the different pursuits that we are going after related to the different platforms and market segments and you will see, we hope, the increases that we have seen year-over-year, but not specifically win rates..

Thank you..

Okay, Greg..

You are welcome..

And 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 for listening today's call. We hope to see you at Investor Day in New York City on November 7. Thank you very much. Take care..

Ladies and gentlemen, thank you for participating in today's call. This does conclude the program and you may all disconnect. Everyone, have a great day..