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

Jonathan Ho - William Blair Seth Seifman - JP Morgan Michael Ciarmoli - SunTrust Greg Konrad - ‎Jefferies Peter Arment - Baird Brian Ruttenbur - Drexel Hamilton.

Good day everyone and welcome to the Mercury Systems Second 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..

Good afternoon, and thank you everyone 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, seek 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 any U.S.

government shutdown or extended continuing resolution, effects of continuing 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, changes in tax rate or tax regulations, changes to generally accepted accounting principles, difficulties in retaining key employees and customers, and 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, 2017.

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 and 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'll open it up for your questions. Mercury continued to deliver solid results in the second quarter fiscal 2018, organically and in our acquired businesses.

We came in at/above the high end of our guidance in all of our metrics achieving record revenue, bookings and backlog. Design win activity was strong and our key programs are doing well, we're seeing more opportunities in the marketplace and we continue to execute successfully on our M&A, market penetration and market expansion strategies.

We made solid progress from an operational perspective, thanks to another great effort by the Mercury team. We continue the consolidation of our RF manufacturing locations associated with the integration of Delta Microwave. We completed the Richland Technologies Systems integration.

We also continued the insourcing activity of our world class trusted digital and microelectronics manufacturing facility in Phoenix. Finally, we announced the acquisition of Themis Computer which is expected to close in early February.

Looking quickly at some of the numbers; total revenues for Q2 including the acquired businesses were up 20% year-over-year. Our largest revenue programs in the quarter were Aegis, SEWIP, F-35, E2D Hawkeye and Filthy Buzzard. Total bookings were up 24% from Q2 last year and our book-to-bill was a strong 1.14.

Our largest bookings programs were F-35, JUS [ph], Aegis, Paveway and Patriot. Adjusted EBITDA for Q2 on a consolidated basis was up 17% year-over-year and a 23% revenue within our target model.

With the business firing on all cylinders, the main uncertainty we face relates to the defense budget which was not approved at the end of calendar 2017 as we and others have anticipated. The government is still operating under a continuing resolution which given the current political climate could be extended.

The consensus view however is that there will be an FY18, FY19 budget deal that eliminates the budget cuts followed by an FY18 defense appropriation by mid-February. Given that we still expect Mercury second half of fiscal '18 will be stronger than the first.

We expect to continue to deliver above industry average growth in revenue and profitability for the full fiscal year. Our confidence in the outlook reflects Mercury's strong market position and positive momentum as we begin Q3. The underlying industry growth drivers are alike and well.

As I mentioned, we exited the second quarter with record backlog, the level of new business pursuits and designing activity remains the highest I've seen since joining the company. Our win rate is strong and we continue to take share. Finally, we believe that we're at the beginning of a multi-year increase in defense spending.

We're targeting the most rapidly growing parts of the aerospace and defense electronics market and expanding our offerings to customers. The acquisitions that we've done have dramatically increased the size of our total addressable market, they have also allowed us to move up substantially higher in the value chain.

Our design wins and growth reflect our continued success in broadening and deepening our relationships with key customers and our position on major programs. Our topline performance also reflects the substantial investments that we've made in internally funded R&D for critical and differentiated technology for use onboard military platforms.

As well, it reflects the trusted domestic manufacturing capabilities we've created in the RF, digital and custom microelectronics domains. In executing on our strategy we closely aligned Mercury with the DOD's most important investment priorities.

We participate in two major markets; sensor and effective mission systems in C4I and we're seeing strong growth in both of those areas. In sensor and effective mission systems, this growth is being driven by a wave of sensor modernization affecting a broad range of platforms.

In the radar domain, the industry is shifting to AESA or Actively Electronically Scanned Arrays. We're seeing significant activity associated with upgrades in electronic warfare. We're beginning to see increased modernization activity in EOIA [ph] in response to the new threats that are developing around the world.

As well, we're seeing growing investment in readiness and modernization in the weapons systems domain, primarily associated with replenishment of stocks in that space. Long-term, we are anticipating continued weapon systems growth driven by modernization activity related to new security, safety and EW requirements.

Sensor and effective mission systems is the market in which we've participated in the longest. Revenue from this portion of the market has grown 22% over the past 12 months and it now commands to 72% of total company revenue. In Q2 revenue for the sensor and effective market was up 20% versus the same period last year.

We're also seeing a wave modernization in C4I, those other types of computers onboard the platform that aren't related to sensor processing. This is now the fastest growing part of our business reflecting that C4I is a market that we've just recently entered.

Mercury C4I revenues have grown 290% over the past 12 months compared with the prior period and now represent 12% of total company's revenue. In Q2 our C4I revenues grew 105% year-over-year. Our growth in both, the sensor and the effective C4I markets reflects the impact of three industry trends we've discussed for some time.

The first is outsourcing; our defense prime customers are outsourcing more at a higher level than they have in the past. As a result of our investments in R&D and our focus on pre-integrated subsystems, Mercury is ideally positioned to provide them with high quality, lower cost solutions than they can deliver internally.

Second, we continue to see a flight to quality in both RF and secured processing; we're taking share in these domains as a result. The price is seeking to deal with fewer, more capable suppliers, suppliers who are willing and have the capacity to coinvest significant into R&D dollars.

At the same time the primes are seeking partners that like Mercury has scalable and trusted capabilities and manufacturing assets that combined deliver innovations with high quality, faster and more affordably. Trend number three relates to both the government as well as the primes seeking to delayer their supply chains.

Some of the major platform integrators are working to make their solutions more affordable. They are doing this by reaching deeper down into the industrial base to partner with companies at the Tier-2 level, the companies that are funding innovation.

Supply chain [indiscernible] creates the potential for larger deals and strong growth process over the longer term. With our commercial business model we've positioned ourselves as an ideal partner as the delayering trend evolves. Our strategic acquisitions over the past several years have allowed us to move up the value chain to the mid-Tier-2 level.

This in turn has expanded and improved our ability to provide affordable subsystems. In the past 24 months we've completed or announced six acquisitions, putting a total of $575 million of capital into highly strategic deals of various sizes.

These transactions all share a common strategic rational, they've expanded our addressable market and customer offerings while generating cost and revenue synergies overtime. In line with the strategic rational, acquiring Themis Computer will provide us with a platform for accelerating our growth through further penetration of the C4I market.

Themis has a large installed base and is designed as a provider of rugged roth [ph] bound service for some of the largest army and navy server programs; as a result, Themis strongly complements Mercury's presence in this area, as well as in the subsurface market.

As we focus our efforts on C4I, we believe we can offer additional capabilities to Themis's customers, most notably through our industry leading security IP portfolio; this will help to meet their unique requirements in growing demand for securing prostate [ph] computing. We look forward to the Themis team becoming part of the Mercury family.

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 continue 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'll continue to target acquisitions that expand our addressable market in aerospace and defense electronics, domestically and internationally and it's scale with technology platform that we've built. We'll remain focus on assembling critical and differentiated solutions with secured sensor and mission processing.

We plan to continue acquiring smaller capability led tuck-ins while seeking to capitalize on larger opportunities as and when they present themselves. In summary, we believe Mercury is on-track for another great year in fiscal '18. We're pioneering in next-generation defense electronics business model and it's working very well.

We have unique and differentiated technologies, we substantially increase the size of our addressable market, our low risk content expansion growth structure is producing great results, we're targeting the largest secular growth opportunity in defense which is outsourcing, we're taking share and we're seeing high levels of activity based on our investment and capability set.

Mercury is delivering well above industry average growth and we've built a platform that we can continue to grow organically, as well as scale through additional acquisitions. At the same time, our plant integration and manufacturing synergies are materializing as anticipated.

Given our results in Q2, our record backlog, our current business and defense budget outlook we're anticipating continued strong performance as a remainder of the year. As a result, we're increasing the midpoint of our full year fiscal '18 guidance for both revenue and adjusted EBITDA. Gerry will take you through the guidance in just a minute.

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 company's financial results, I will note that unless otherwise stated, we will be discussing those 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.

Collectively, the contributions of these businesses comprise what we will prefer to as acquired revenue for purposes of this call. 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 defined as revenue associated with acquired businesses that have been a part of Mercury for four full quarters or less.

After the completion of four full quarters, acquired businesses will be treated as organic for current and comparable historical periods.

I'll turn now to Mercury's second quarter results which were strong on both a consolidated basis and organically, highlighted by record revenue, bookings and backlog, as well as progress on yet another strategic acquisition.

Total revenue increased 20% from Q2 last year to a record $117.9 million, exceeding our guidance range of $112.5 million to $116.5 million. Organic revenue for Q2 increased 12% year-over-year to $104.9 million, up substantially from the 7% organic growth rate recorded in first quarter of fiscal '18.

Acquired revenue was $13 million, which is not comparable to Q2 of fiscal 2017 due to the inclusion this year of Delta Microwave and RTL which were not a part of Mercury in Q2 of last year. Our customers are seeking growth through foreign military and international sales and we are successfully leveraging this trend.

For Q2 of fiscal '18, international revenue including foreign military sales was $27.9 million, or 23.7% of total revenue. This compares with 15.3% of revenue in Q2 of fiscal '17 and is up 87% over last year.

At our investor day, we talked about the business in terms of three industry tiers where Mercury participates; components, modules and subassemblies and integrated subsystems. On a last 12 months basis, components revenue has grown 109% while modules and subassemblies revenue has grown 21%, both driven primarily by our acquisition activity.

Integrated subsystems revenues which are largely driven through the organic business have grown 7% on an LTM basis providing a rough indicator of what we see as growth in the overall rate of outsourcing.

At the end of Q2 components represented 34% and modules and subassemblies represented 35% of Mercury's total revenues respectively while integrated subsystems represented nearly one-third of total revenues. These percentages reflect the fact that we're acquiring businesses at the Tier-3 or component, module and subassembly levels.

We then seek to move those businesses up the value chain by progressively integrating more components into modules and subassemblies and overtime to migrate these lower tier elements into our integrated subsystems capabilities and offerings.

These percentage of total revenues numbers will move around depending on the sizes and frequency of our acquisitions and how we're doing with respect to our strategy. That said, we're very pleased with the progress that we're making with this aspect of our strategy and the opportunities that creates with and for our customers.

Turning now to bookings; total bookings for the second quarter were up 24% year-over-year, driving a 1.14 book-to-bill ratio. We ended the quarter with record total backlog of $376 million, up 18% from $319 million a year ago. Approximately $310.4 million or 82% of our Q2 backlog is expected to ship within the next 12 months.

Mercury's revenue and bookings growth continue to translate into solid profitability organically and in our acquired businesses. We anticipated slightly lower gross margins and slightly higher operating expenses for Q2 and adjusted EBITDA landed squarely at the midpoint of our percentage guidance range for the quarter.

Our gross margin for Q2 was approximately 46%, compared with 48.3% a year ago driven by product mix. This is slightly below our Q2 guidance, but still well within our target business model.

The outcome was driven primarily by a large last time component buy on behalf of a customer which carried a low margin, while Q2 of '17 had a proportionately larger amount of high margin royalty revenue.

Total Q2 operating expenses were $43.3 million versus our guidance of $41.7 million to $42.8 million, and $38.4 million for the same period last year.

OpEx was slightly higher than anticipated, primarily due to transactional expenses related to our acquisition activities and modest restructuring costs associated with our ongoing facilities realignment and consolidation in California, neither of which are included in guidance.

We're continuing to make good progress in realizing the expected integration synergies associated with our recent acquisitions, as well as capturing the benefits of our in-house U.S. manufacturing operation in Phoenix.

GAAP net income for the second quarter of fiscal 2018 was $9.1 million or $0.19 a share, up 76% from $5.2 million or $0.13 a share for Q2 last year and well above the top end of our Q2 guidance. This is based on approximately $47.4 million weighted average diluted shares outstanding for the quarter.

The increase year-over-year and the outperformance versus guidance largely reflect revenue growth that continue to outpace growth in operating expenses, as well as tax benefits associated with the federal tax reform legislation signed into law this December.

Q2 GAAP net income reflected an aggregate tax benefit of approximately $1.6 million related to the new tax law.

Looking ahead to full year fiscal '18, we expect to see an overall tax benefit of about 2% compared with a prior tax regime reflecting a partial benefit from the new law in the second half after being blended with our prior tax rate in the first half.

Looking further ahead to fiscal '19, our estimated tax rate for planning and guidance purposes will be 30% reflecting an estimated benefit of approximately five points compared to Mercury's prior 35% estimated tax rate.

Although the new corporate rate is 21% or 14 points lower than our prior estimated rate of 35%, three primary items related to deductions are expected to offset about 9 points of this rate differential. First, the deduction for state taxes provides less of a benefit due to the lower federal rate.

Second, the limitation on executive compensation deductions has been expanded to apply to a broader group of individuals and also the capture forms of compensation that were previously not limited by the cap on deductibility, namely performance based compensation.

Third, we historically benefited from the Section 191 manufacturing deduction which has been eliminated for tax years beginning after December 31, 2017. These factors combine with various other tax changes, create the upward impact on the effective rate.

While Mercury benefited in Q2 from a GAAP perspective, tax reform had a slightly negative impact of approximately $0.03 per share on Mercury's adjusted EPS for the second quarter which still came in at $0.28 per share.

This represents the low end of our guidance range of $0.28 to $0.30 per share and compares with adjusted EPS of $0.30 a share in Q2 of fiscal '17.

This is primarily because the favorable Q2 impact of the tax reform legislation reduced the value of deferred tax liabilities, primarily intangibles which are add-backs to adjusted EPS, meaning the total value of the add-backs is somewhat smaller and adjusted EPS is therefore somewhat lower.

Driven by Mercury's strong growth and solid profitability, adjusted EBITDA for Q2 of fiscal 2018 increased 17% to $26.9 million from $23 million in Q2 of last year. This is slightly above the high end of our Q2 guidance of $25.3 million to $26.8 million and represents 22.8% of revenue.

As expected, for the first six months of the year, adjusted EBITDA was 23% of revenue, well within the long-term target range of 22% to 26%. Turning to the balance sheet; Mercury ended the second quarter of fiscal 2018 with cash and cash equivalents of $32 million compared with $46.2 million a year earlier.

As anticipated, inventory increased in Q2 as we continue to migrate production to our Phoenix U.S. manufacturing operations. In the process, we're internalizing an additional layer of what formerly was part of our supply chain adding into our inventory the materials and labor associated with conversion of those materials at later stages of production.

The lead times and transformation steps associated with converting that additional layer of inventory into finished goods also lengthens inventory cycle times. Managing this important manufacturing shift which is ongoing has also led us to increase the amount of buffer stocks that we keep on hand as we continue transitioning more products in-house.

Overtime, we expect this buffering to diminish as we move to more steady state production and begin realizing more production efficiencies. Mercury's operating cash flow for Q2 of fiscal '18 was $8.8 million compared with $14.2 million last year.

Our cash flow reflects the buildup of inventory associated with our expanded in-house manufacturing capabilities offset in part by a 9 day decrease in day sales outstanding in Q2 compared to Q1. We continue to expect fiscal 2018 to yield stronger cash flows compared to fiscal '17 as cash flow strengthened through the second half of the year.

Cash flow from operations in Q2 was partially offset by $4 million of net capital spending. As anticipated, capital expenditures were substantially lower than the $7.7 million occurred in Q2 of last year. Net of CapEx, free cash flow for Q2 was $4.8 million compared with $6.5 million a year ago.

In terms of Mercury's financial position, we continue to maintain a conservative approach to the balance sheet. We concluded Q2 well-positioned to continue executing on our capital deployment strategy supporting future growth both organically and through acquisitions. The estimated benefits of tax reform further support this deployment strategy.

Entering Q3, we maintain flexibility in our capital structure and good access to capital with an untapped $400 million revolving credit facility and an unused universal self-registration filed in Q1. The revolver will fund our anticipated $180 million acquisition of Themis Computer which is subject to networking capital and net debt adjustments.

As Mark said, Themis is an extremely good strategic fit with Mercury aligning very well with our target model and creating an excellent platform for continued penetration into the C4I market.

Themis has a record of strong organic growth driven by established positions on well-funded programs, delivering an estimated $57 million of revenue in calendar 2017 with an adjusted EBITDA margin approaching 23%. In addition to potential revenue synergies, we anticipate realizing about $1 million of run rate cost synergies overtime.

Consistent with our past practice, there will likely be some modest initial investment in order to realize run rate synergies and align R&D spending which could be slightly dilutive to the bottom line margin ratio at the outset. However, the deal is expected to be immediately accretive to Mercury's adjusted EPS and adjusted EBITDA.

Again echoing Mark's comments, we see this as an important and exciting opportunity and we look forward to having the Themis team onboard and helping us drive Mercury's future growth as we continue penetrating the C4I market. I will turn now to our financial guidance for the third quarter and full fiscal year 2018.

For purposes of modeling and guidance, we have assumed no restructuring and no acquisition or non-recurring financing related expenses and an effective tax rate of 33% in the periods discussed which includes the impact of tax reform.

The guidance also assumes weighted average fully diluted shares outstanding of approximately 47.5 million shares for Q3 and 47.7 million shares for the full fiscal year. Finally, our guidance does not include Themis because the acquisition has not yet closed.

As the transaction is expected to close during Q3, we anticipate providing updated guidance that includes Themis when we report our Q3 earnings. Our guidance for Q3 and fiscal '18 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 our major product lines and across many of our programs, as well as our enhanced manufacturing capabilities.

We are planning that R&D internal investments will remain at or near the high end of 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 expect to see improvement in our free cash flow for the year as we continue to grow and our CapEx is reduced versus fiscal '17.

We continue to expect CapEx to be modestly higher in the back half of fiscal '18 based on our integration plans but for the full year to be consistent with our goal of 5% of revenue or less.

With that as background, for the third quarter of fiscal 2018, on a consolidated basis we are forecasting total revenue in the range of $116 million to $120 million, an increase of 8.1% to 11.8% over Q3 of fiscal 2017. Gross margin for Q3 is expected to be approximately 46.6% to 47%.

Q3 GAAP net income is expected to be in the range of $7.8 million to $9 million or $0.16 to $0.19 per share. Adjusted EPS for Q3 is expected to be in the range of $0.33 to $0.35 per share.

This estimates assumes approximately $4.2 million of depreciation, $5.7 million of amortization of intangible assets, no fair value adjustments from purchase accounting and $4.7 million of stock-based and other non-cash compensation expense.

Adjusted EBITDA for the third quarter of fiscal '18 is expected to be in the range of $26.3 million to $28 million representing approximately 22.7% to 23.3% of revenue at the forecasted revenue range.

For the full fiscal year 2018, we now expect Mercury's total revenue to increase to between $460 million and $468 million, an increase from our prior guidance. Currently gross margins for the year are expected to be between 46.5% and 46.8% and operating expenses are expected to be in the range of $167.3 million and $169.7 million for the year.

Total GAAP net income for fiscal '18 is expected to be in the range of $38.4 million to $40.4 million or $0.81 to $0.85 a share. Adjusted EPS is expected to be in the range of $1.33 to $1.37 per share.

We currently expect total adjusted EBITDA for fiscal '18 of approximately $106 million to $109 million and at approximately 23% of revenue, well within the range established by our current target business model.

As Mark said, although the federal government has continued to operate under a CR, we still expected in fiscal 2018 as in the past several years our second half will be stronger than the first half and Mercury will deliver another year of strong growth and financial performance. 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 Jonathan Ho of William Blair. Your line is now open..

I just wanted to start out -- also maybe a few clarifications around your organic growth this quarter and were you guys satisfied with the organic growth and are you seeing sort of the translation from some of the acquisitions that you've made over the past couple of years; show up in terms of those numbers?.

Yes, we were very happy with it this quarter Jonathan. In Q2 the organic revenue grew 12% year-over-year versus 7% last quarter.

I think as we've said in prior calls, we're actually being very successful taking the acquisitions that we've done previously and through the investments that we've made in the business and the channel that we have -- being able to inflect the growth rate of those business northwards versus what they would do on a standalone basis; so yes, we're pretty happy with the results..

And then just in terms of the Themis business; I think you said in the press release that this was growing pretty quickly but is there any sort of metric you can give us in terms of how quickly that business is growing?.

So we actually haven't disclosed the growth rates and obviously we don't yet own the company, it is the deal having to close. We're estimating that they are doing roughly $57 million of revenue per calendar year '17 with an EBITDA that is roughly in line with ours at 23%.

So we'll have more to say about it on the call next quarter and our recommendation will be to hold off, try to include any of the revenues from that acquisition, given that we'll have more to say about it on the Q3 call..

And then just one final one in terms of the impact from the government shutdown and lack of budget clarity; I mean you guys have executed through CRs in the past, is there anything different about this time or any sort of impact that you're seeing that maybe changed from last quarter?.

I think, if you look at what I said in my prepared remarks I think last quarter we were anticipating that there would be a defense budget appropriation by the end of the calendar year, obviously that didn't happen, it's played over into the new calendar year, we were operating under another continuing resolution following a short shutdown of the government.

So it's clearly more challenging than what we've seen, our expectation right now based upon the consensus view is that there will be an FY18, FY19 budget deal that removes the prior budget cuts associated with sequestration followed by an FY18 defense appropriations by mid-February.

So that's what we based off our guidance on and we certainly hope that that happens..

Our next question comes from Seth Seifman of JP Morgan. Your line is open..

I guess in looking at the strong bookings and the backlog growth that you guys had during the quarter, if you could talk a little bit about how much of it came from sort of positions that you have on existing programs that are growing versus maybe how much of it came from share gain and you talked in the past a little bit about how you're gaining share and kind of whether you see that share gain accelerating from where it was three months ago or whether it's at the same pace or starting to level up?.

I think overall we continue to perform extremely well. As we talked about on the call, if you look at our two major market segments in Q2, sensor in effect [ph] which is the more traditional part of our business was up 20%.

If you kind of go down the level inside of that market segment, really what is driving the growth is a couple of different areas; the first is EW and the EW business increased 38% in Q2 fiscal year '18 versus the prior year.

So clearly, that is well above the growth rates in the industry which suggest that we continue to do well, meaning taking share, as well we've obviously got some programs that are in production. The weapon systems arena is also an area that we continue to benefit from, that particular market segment was up nearly three-fold versus the prior period.

And then as I said in my prepared remarks, we're also beginning to see some modernization activities in the EOIR [ph] space which for us is relatively small percentage of our revenue today, but we believe it's going to be larger going forward as some of the programs that we're winning and our customers are pursuing hopefully move into production.

So we're very pleased with how the business is performing and Gerry, I don't know if you want to add anything?.

Yes.

So one other dimension that I mentioned on the prepared remarks section is this, transition that we're seeing to the integrated subsystems, so I noted the 7% year-over-year increase but the important factor is that that's on the back of a 26% increase year-over-year last year, so you can really see the way we're executing that strategy and that cuts across those dimensions that Mark was talking about and so it in effect protects both, the organic and the acquired businesses as we assemble those capabilities together.

And we do think that we're unique in that regard, and so we're extremely happy to see that happening because those unique capabilities we think also leave us very well positioned with those customers as we look forward..

Thanks for that Gerry. If you kind of take it from more of a technology level, there is really two areas that we've talked about in the past that we're taking shifts.

One is in the RF domain, and I think we've mentioned that there is a couple of different industry participants that are really struggling right now and we continue to take share from them, primarily in EW but also we're seeing some opportunities in the radar domain from an RF perspective.

The other is in secured processing and as you know, this has been a theme for us for many years and in fact, we're now on our fourth generation of embedding critical security technology into the processing infrastructure at a time when our customers needed both domestically, as well as to enable foreign military sales, and we're clearly taking share in that domain as well.

So we're extremely pleased with how we're positioned and the progressing side of the business..

And then just as a follow-up, if you look at the National Defense strategy that the Pentagon released last week and what they say in the business section talks about looking to do faster development, more iterative development, more frequent upgrades; I would imagine that that's something that works to your benefit but at the same time it's probably something that's very easy to put in your strategy document and much more difficult to translate into the real world.

And so I guess, whether you've picked up on any movement in this direction at the department already and how focused you see the customer being on this item and the degree to which you think your customers the defense primes see this as something that would drive further outsourcing..

It's a great point and obviously I think we believe that we're extremely well aligned with the national defense strategy is laid out by secretary modest.

I mean the themes were asked when you kind of look at that is the fact that we're moving into a period where we're focusing on what he describes as the great part competition with really more strategic practice and specifically targeting China and Russia.

As we know, both of those countries have got much more sophisticated technology and capabilities than some of the terrorist threats that we faced historically and a lot of that is leading to this wave of modernization that we see occurring in really the core of our business on the sensor side, as well as C4I modernization.

From a business model perspective, I think you also hit the nail on the head and we've seen under Secretary [ph], a real focus on trying to not only improve -- continue to improve the affordability which is being an ongoing theme but also speed up the rate at which new technology is introduced down range largely because the threats are moving very rapidly, the military needs to be able to keep up with the pace at which these threats are occurring.

And so the fact that we've got a business model that produces technology much more quickly, much more affordably at lower risk than the older way of doing it, we think bodes extremely well for Mercury in the longer term. So we were very pleased with what Secretary might have said and our positioning with respect to that..

Our next question comes from the line of John [ph] of Citi..

Just talking about some of the budget ups and downs right now; can you just describe almost the mechanism by which an extended CR and/or shutdown impacts your financials, I mean are you seeing your customers slow their spending in reaction to that?.

Not that we can identify specifically but clearly, I'm sure that there is concern with the very short shutdown and the fact that we are in an extended CR compared to what we've had in the past.

And the impact of any future shutdown or an extended CR, obviously will really depend upon the duration of any potential shutdown and how the DOD and our customers respond..

Can you just review some of the things that you've done now, sort of got the impression that between larger backlogs and market penetration strategy; no one is immune from these sorts of things but these things have to be purchased, the things have to be done especially in the context you guys are being a lot smaller than the total defense budget.

I mean what have you done to almost derisk or minimize risk or mitigate risk around these sorts of things that weren't in….

It's a great point.

So we've obviously worked extremely diligently since fiscal 2013 to reduce our dependency on what we would describe as book ship revenue and the way in which we've done that is by really building up our backlog and so we've ended Q2 with a record backlog and we've had multiple records in a row and it's totaling now $376 million and we've got a very strong 12 months forward revenue coverage.

So in essence what we've been doing is we've been focusing on reducing the amount of book ship is really buying down the amount of risk in the business period to period.

So to put this in perspective, and to put and find a point on it, if we went back to say fiscal Q2 of fiscal '13, the book ship in the core of the business which was MCE operating segment at that time, it was round about 45%. If you look on an LTM basis, the amount of book ship revenue that we have is round about 15% of total revenue.

So there has been a dramatic reduction in terms of the risks that we've had as we focused on building the backlog..

Our next question comes from the line of Michael Ciarmoli of SunTrust. Your line is open..

Just to stay on that line of questioning with the continuing resolution, Mark, I mean the guidance for the remainder of the year, had we had a budget in place, would that have changed your outlook at all? I'm just trying to -- maybe if you can specifically quantify if there has been an impact at all? Did it prompt you guys to maybe introduce a little bit more conservatism in the forecast given the unknown and I'm sure we're going to have shutdown talks three weeks from now as well..

Well, I mean it's hard to say specifically Mike. I mean, what we try to do is take into account a multitude of practice when we guide and obviously if we look at where we're at with the budget, we do anticipate that there have been a budget deal, a multi-year budget deal with an appropriation.

So we think that we've taken that in account into the guidance and that's the numbers that you already went through..

Got it.

What about on the -- I think in the prepared remarks you guys mentioned the electro-optic infra-red saying you plan to grow it and it will be bigger, can you walk us through that? I mean, if I envision your kind of investor day slides, you've shown all the mission kind of silos there and you didn't really have a major presence in EOIR, so what's the strategy there to grow that business; is it organic growth or you're going to target more specific M&A in that capability to drive growth? Do you have enough internally with design wins to drive a meaningful amount of growth there, maybe just elaborate a little bit?.

Sure. So the chart that you're talking about is the market segmentation chart and that chart specifically is really more focused on demonstrating how it is that we're executing from an M&A. Mercury is already participating in EOIR and if you go back, we're on a program called [indiscernible] which is the preeminent wide area motion inventory platform.

We're seeing a different type of requirement in EOIR and I'm not going to go specifically into detail because I think it's a relatively sensitive area but we do think that we've got the processing capability to go after that market opportunity that's going to require a tremendous amount of compute horsepower.

So although it's a small percentage of the business today, it's roughly 3% of total revenue; we are seeing double-digit growth rates and these are in early stage, call it tech demonstrated programs but if any of these programs kind of go into production over the longer term we think it could be another important driver of growth combined with the other sensor upgrades that we're involved with..

And then last one, maybe Gerry, just housekeeping.

Funding Themis on the revolver, what should we expect while interest expense probably not so much in the third quarter, fourth quarter, will that have a meaningful impact on financials that we should be thinking about at all in fiscal '18?.

So you should start thinking about as soon as we do issue some guidance and we actually have taken out the debt as we said we expect or fund through the revolver, so assuming that all goes to plan we would see some interest expense in Q3 and then we'd see a full quarters load in Q4.

It's going to still be a pretty modest debt level at about 1.5 turns, little under that net of our cash; so -- and it's a very good rate in terms of the revolver. So it is what it is but we haven't updated any of the numbers yet to reflect that..

Our next question comes from the line of Greg Konrad of ‎Jefferies. Your line is open..

I just wanted to go back to CR for a minute, you talked about how you've kind of derisked your own business but I think some of the businesses that you target on the M&A front are -- maybe a little bit more susceptible to the issues of having these extended budget negotiations; can you maybe talk about how that's impacted the M&A market and then on top of that with tax reform have you seen any change in sellers expectations?.

Certainly for the business that we've recently acquired as well as the one that is pending, we don't think that there are any significant impacts that we can identify this time that is different than what I previously described.

With respect to tax reform, and the change in rates, I think it probably does have a longer term impact in terms of sellers expectations with the high potential cash flow associated with the lower tax rate..

And then you talked about revenue synergies a couple of times in the prepared remarks, is there any way to kind of quantify what you look for when looking at targets in terms of upside from generating those revenue synergies?.

Yes. So a big part of what we focused on is that content expansion strategy that we talked about previously.

Mercury has built out a very strong strategic account sales model where we're dealing with the highest level of our customers on down and that's important because when our customers are actually outsourcing they are entrusting us with very important part, a critical technology element of their overall system.

So when we're looking to acquire a business, we're looking for ways in which we can insert that technology to create a better solution for the customer in the short and longer term and I think we've been doing that very, very successfully given the growth rates that we've been experiencing..

The other thing is, we clearly look as we're evaluating what we can do with an acquisition and how might it change as a business once it's a part of Mercury. The technology point that Mark made is very important and is one of our key considerations.

But we also look at our ability to leverage a channel which is very strong, so we're looking at the overlap from a customer standpoint, from a program standpoint, as well as the technologies that are either something that we're very familiar or is very closely adjacent to what we're already doing which is what gives us the ability to introduce those capabilities to the customer and also integrate those capabilities with the more highly integrated offerings that we set out to our customers..

And Themis is a great example of that; so if you think about it's really very complementary from a position perspective with respect to both companies, customers as well as the programs, and we do think that there is a strong ability for them to leverage the channel that we've created.

Now they've already got a strong position in the rugged server markets and I think one of the potential synergy is that -- is the fact that Mercury has got an industry leading security IP portfolio that many of Themis's customers and programs we believe will benefit from.

So it's really a highly complementary -- in the case of Themis, highly complementary acquisition.

We also view it as a platform, right, so we're in the early stages of penetrating the C4I space, that's already over 10% of the total company revenue, the fastest growing market segment in which we're participating and we think that we're at the early stages of the growth in this particular sector..

Next question comes from the line of Peter Arment of Baird. Your line is open..

Mark, I guess thinking about your discussion around Tier-3 to Tier-2 kind of moving into that integrated subsystems; I think you mentioned roughly 32% or 33% of your revenue mix -- as you continue to grow the capabilities, how quickly does that continue to increase? I mean, will this eventually be 50% of the mix? How should we think about that..

So the way I would think about it Peter is, it's a little hard to prognosticate what portion of the mix but what we want to see is what we have seen and I think I mentioned it in earlier response which is that we're selling more of those subsystems.

Now if we go out and do another acquisition similar to those that we've done in the past what it does is dilute that percentage because we're acquiring entities that are down at the lower level and then what we're trying to do is again incorporate their capabilities into the portfolio of offerings but also into the specific solutions that we're offering so that we begin to leg up through to higher levels of integration in terms of what we're offering the customer.

That does a couple of nice things for us; one is, obviously it gives us the optimal ability to leverage our channel, it also protects our positioning in those programs because we're more and more comprehensively and therefore tightly anchored into those as we capture content and that's what's helping to drive program values up and order values which is a trend that we've seen pretty persistently in the business in recent years.

So again, our goal is to keep building that up and then diluting it by acquiring more capabilities of other companies and building them up as we go in creating kind of virtuous cycle to it.

I can certainly feel that by far the majority of all of the new design win activity is actually at the subsystem level; so it's consistent with the theme of our customers actually outsourcing at a higher level, seeking the deal with company such as Mercury that are able to provide more affordable solutions more quickly with lower risk but not only the companies that are able to lean in from an R&D but also the companies that can actually manufacture and the capabilities that we built in the trusted manufacturing, domestic manufacturing is turning out to be a very significant competitive advantage for us..

That's one of the reason we've meet our transition so carefully is that it's a really important element of what we do and what we do for the customers and we do not want to disrupt that at all..

No, I was thinking indirectionally that it would have a high correlation if we continue to build record backlogs, so that's what it sounds like certainly.

And then just regarding kind of the pipeline, Themis closing here early February; what's your comfort level around historically leverage, just -- whether there is opportunities that are still out there to do larger deals or you still think that there is plenty of kind of tuck-in deals?.

I think as I said [indiscernible], we're focused on the smaller capability like tuck-ins, as well as the larger opportunities as and when they present themselves.

You know, that we've got an in-house M&A team that has build very strong relationships, both on the larger side as well as on the smaller side and we're pretty much getting a look at everything that is out there.

We are pretty disciplined in our approach, we're not just looking to gain scale for the sake of it, we're seeking to deals that are very strategically aligned with the strategy that we laid out in investor day and we're going to continue to do that.

I would say right now that there is a fair number -- the market is quite active, let's put it that way..

Next question comes from the line of Brian Ruttenbur of Drexel Hamilton. Your line is open..

Just one quick question on tax; you're given guidance for 30% and fiscal '19, do you anticipate that that tax rate could go down into the 20s, the high 20s at least in 2020 or 2021 and what can you do to adjust that and is there anything that you can do to get your overall tax rate down into those ranges?.

We aren't looking at something that would cause us to change our view as yet.

There are probably a handful of nuances around things like the compensation deductions and as the company grows in size, that becomes probably a smaller overall percentage and therefore has less of an adverse impact in terms of the now lost portion of deductibility and so on. So it's more of a proportionality issue than anything else.

And then the other thing is that our guidance does not include any discrete items, so that's the major element that we will see from time to time but as we've said in the past because that will vary and can vary pretty considerably from period to period, we don't build that into the general rate forecast..

And then are any of your acquisitions that you're looking at or that you're currently in the process of doing, will that NOLs or something like that help you in the future to lower that tax rate?.

No. We don't really see any continuing benefit from an NOL standpoint, love it if we had it, sometimes we have an opportunity to pickup some of that through an acquisition which has happened in the past, so it's certainly something that we consider at the time as we're evaluating the acquisitions.

The other thing and I don't think I called this out specifically but we don't see on the tax front any adverse consequence associated with team repatriation from overseas earnings and so on; so anything that we do because of course we now do own some overseas operations, we'll certainly take the new tax regime into effect which is overall favorable..

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 all very much for listening. We look forward to speaking to you again next quarter. Thank you..

This conclude today's conference. Thank you for your participation and have a wonderful day..