Mike Ruppert – Executive Vice President and Chief Financial Officer Mark Aslett – President and Chief Executive Officer.

Jon Raviv – Citi Seth Seifman – JPMorgan Greg Konrad – Jefferies Peter Arment – Baird Jonathan Ho – William Blair Mike Ciarmoli – SunTrust Ronald Epstein – Bank of America Merrill Lynch Brian Ruttenbur – Drexel Hamilton.

Good day everyone and welcome to the Mercury Systems Third 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, Mike Ruppert. 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.

Before we get started, I’d like to remind you that today’s presentation includes forward-looking statements, including information regarding Mercury’s financial outlook, future plans, objectives, business prospects, and anticipated financial performance.

These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. Our forward-looking statements should be considered in conjunction with the cautionary statements in today’s earnings release and the risk factors included in Mercury’s SEC filings.

I’d also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles or GAAP. During our call, we will also discuss several non-GAAP financial measures. Specifically adjusted income, adjusted earnings per share, adjusted EBITDA and free cash flow.

A reconciliation of these non-GAAP metrics is included in the earnings press release, we issued this afternoon. I’ll now turn the call over to Mercury’s President and CEO, Mark Aslett..

Thanks, Mike. Good afternoon, everyone and thanks for joining us. Before we dive in, I’d like to say, how happy I’m to have Mike Ruppert with us today, in his new role as a CFO. Our acquisition related growth, since Mike joined Mercury three years ago is a testament to both his industry experience and capabilities as a leader.

Mike has been running our combined finance and M&A teams as CFO since mid-Q3 and he’s off to a great start. As expected, we’re already seeing a high level of integration in our corporate development, finance and accounting team activities. So Mike, welcome aboard. With that, I’ll turn now to the business update.

Michael will review the financials and guidance. And then, we’ll open it up your questions. Q3 was more challenging than we had originally anticipated, as a result of the prolonged continuing resolution.

Despite this brief setback, which I’ll talk about in a moment, we’re reaffirming our prior guidance for the full fiscal year and raising the range including Themis.

At the midpoint, our updated consolidated guidance would result in approximately 20% growth in both revenue and adjusted EBITDA year-over-year, substantially, faster growth in the industry as a whole. Big picture nothing has changed. Mercury’s growth engine continued to perform strongly in Q3, as did the business overall.

As we said in the past, we expect to continue growing at high single-digit low double-digit rates organically, supplemented by strategic and accretive acquisitions. For fiscal 2018, we’re currently expecting 7% organic growth.

Looking back over the past five years and assuming the midpoint of consolidated guidance will deliver 20% total revenue and over 60% adjusted EBITDA compounded annual growth.

We’ve made substantial investments to achieve results at this level, including above industry average internal R&D funding, CapEx to buildout our insource money factoring capabilities as well as working capital to support overall growth in the business.

We believe our strategy is working extremely well and we expect to extend Mercury’s record of above average performance in fiscal 2018. Turning to Q3, because of the funding delays the quarter became progressively more backend loaded compared to our plan. Ultimately, $11 million of revenue moved from Q3 to Q4.

The largest impact doesn’t see with Block 2, where although we booked an order for $16.8 million. $8 million of associated revenue moved to Q4. At this point in Q4, we’ve already shipped the majority of the delayed SEWIP Block 2 revenue and with the budget now approved we do not expect budget related revenue delays to impact Mercury this quarter.

We delivered record bookings of $150 million, which resulted in a 1.3 book-to-bill and we ended the quarter with another record backlog totaling $429 million. The design win activity remain high with several important new wins across the customer base during the quarter.

Our design win pipeline is robust with significant opportunities in C4I, radar, EW, EOIR, and weapon systems. Our key programs continue to do well. We’re seeing excellent organic growth opportunities in the marketplace. We continue to execute successfully in our market penetration and market expansion strategies.

All-in-all the opportunity set in the levels of new business and design win activity remain the highest I seen since joining Mercury. Our win rate is strong and we continue to take share. It appears that M&A activity within the industry is picking up speed.

Our long term team member Nelson Erickson is now running this part of the business reporting to Mike. Now since in his lead or been involved with all of our transactions and is well respected within the business and industry. Our M&A pipeline is likely the largest and most actionable it has been.

We’re seeing a number of interesting opportunities of varying sizes all of which are aligned with our strategy. This was another good quarter for Mercury from operational perspective. We close the Themis acquisition and the integration is off to a good start.

Bookings, revenue and margin for the acquired business were in line with our plan, and we’re excited about the team. We’re also enthusiastic about the Themis platform, which presents us with new opportunities to grow organically and make further acquisitions in the C4I space.

During the quarter, we continue the consolidation of our three West Coast RF manufacturing locations. We signed a lease for a building adjacent to our existing Oxnard, California plant where we plan to take occupancy in earlier FY2019.

Once the buildout is finished, moving the remaining West Coast microwave facilities to the new location will complete the consolidation and acquisition integration of Delta Microwave. The buildout of our Phoenix operation is the associated insourcing of our digital manufacturing continues.

The team introduced new capabilities during Q3, while growing throughput 50% versus the prior quarter. The forecasts synergies and timeline remain on-track. Taking a quick look at our Q3 financial results. Total revenues increased 8% year-over-year to $116.3 million.

Our largest revenue programs in the quarter were Aegis, F-35, Filthy Buzzard, E2D and Patriot. Adjusted EBITDA for Q3 on a consolidated basis was up 3% year-over-year. Total bookings for more than $150 million up 41% from Q3 last year, and as I mentioned our book-to-bill was a strong 1.3.

Our largest bookings programs in the quarter in the quarter was SEWIP Block 2, EGNOS, ELTA, APG-79 and REPA [ph]. Exiting Q3 with an approved fiscal 2018 defense budget, record backlog and having shipped the majority of the delayed revenue, set us up the strong growth in Q4 and to the fiscal year.

With the capabilities we required and built internally, we believe that we are also well positioned to benefit from an improving defense budget environment over the longer term.

Our design wins to above industry average growth reflects our continued success in broadening and deepening our relationships with key customers and opposition on major programs.

The substantial growth investments that we’ve made over the past several years to strengthen our performance in winning new business these include most notably in funding high levels of R&D for commercially developed and highly differentiated military technologies.

As well we’re creating trusted domestic manufacturing capabilities in the RF, digital and custom microelectronics domains. At the same time, the acquisitions that we’ve completed have dramatically increased the size of our total addressable market.

We’re targeting to the most important growing areas in aerospace and defense electronics, sensor and effective mission systems in C4I. Our growth in the first area is being driven by a wave of sensor modernization on a broad range of platforms. In the radar domain, the industry is shifting to AESA or Actively Electronically Scanned Arrays.

And there is significant activity associated with upgrades in electronic warfare. We’re also beginning to see increased modernization activity in EOIR along with growing investment in readiness and modernization in the weapon systems domain. Sensor and effective mission systems is the market in which we’ve participated the longest.

This part of the business has grown 12% over the last 12 months to 61% the total revenue. In large part driven by 269% increase in weapons systems. In Q3 reflecting the delayed shipments, our sensor and effective revenue decreased 7% versus the same period last year.

We’re also seeing increased modernization activity C4I, those are the types of computers onboard platforms that aren’t related to sensor processing. Our C4I revenues have grown 192% over the past 12 months compared with the prior period and now represent 23% of total company revenue. In Q3, C4I revenues grew 160% year-over-year.

As we’ve discussed previously, our growth in both, the sensor and effective in C4I markets, reflects the impact of three industry trends; outsourcing, the flight to quality and supply chain delayering. Our defense prime customers are outsourcing more the high level than they have in the past.

By investing in R&D and focusing on pre integrated subsystems we’ve ideally positioned Mercury to provide them with high quality, lower cost solutions and they can deliver internally.

At the same time the primes are seeking to deal with fewer, more capable suppliers, suppliers who are prepared to co-invest in the internal R&D and have scalable and trusted manufacturing capabilities in and assets in both RF and secured processing. We’re taking share in both domains as a result of this flight to quality.

And finally the government and the prime seeking are seeking to delay their supply chains. In response some of the major platform integrators that working to make their solutions more affordable. They’re partnering with companies at the Tier 2 level, the ones that are funding the innovation.

Mercury’s transformed itself into a Tier 2 company over the past several years positioning ourselves as the ideal partner as the delayering trend evolves. We’ve accomplished this transformation through strategic M&A, over the past 27 months we completed six acquisitions totaling $575 million of capital in deals of various sizes.

These transactions all share a common strategic rationale, they’ve expanded our addressable market and range of customer offerings while generating cost and revenue synergies over time. Going forward we intend to remain active and disciplined in our approach to M&A.

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 domestically and internationally and it’s scale with technology platform that we’ve built.

We’ll remain focus on assembling critical and differentiated solutions to secured sensor and mission processing. We plan to continue acquiring smaller capability led tuck-ins while capitalizing on larger opportunities as they present themselves. In summary, Mercury is on-track for another great year in fiscal 2018.

Our strategy, technology, capabilities and ongoing programs and platforms are well aligned with the DoD’s roles and missions. Our business model is working extremely well. We substantially increased the size of our addressable market and our growth strategies producing great results.

We build a platform that we can continue to expand organically as well as scale through acquisitions. Our M&A pipeline is healthier than ever before and our planned integration manufacturing synergies are materializing as anticipated.

We’re anticipating a strong performance in the fourth quarter and the above industry average growth in revenue and profitability for the full fiscal year. Mike will take you through the guidance in detail. And with that, I’d like to turn the call over to Mike.

Mike?.

Thank you, Mark and good afternoon again everyone. Before we go through the company’s financial results, I want to provide a couple of personal thoughts. Serving as Mercury’s CFO is an honor and a great opportunity.

Based on my experience here over the past three years I can say with the upmost confidence that I’m stepping into this new role at an exciting time for Mercury. Our prospects for growth have never been brighter.

We’ve invested in the business over the last few quarters as we’ve insourced our manufacturing, we’ve upgraded our facilities and integrated our acquisitions and the M&A pipeline is as robust as I’ve seen it since starting at Mercury.

So as I take on this role I believe we’re well positioned to continue to create value through strong organic growth as well as strategic, synergistic and financially accretive acquisitions.

Equally as important, our team is strong in addition to having Nelson and Erickson heading up M&A as Mark mentioned, Michelle McCarthy recently joined Mercury as our new Chief Accounting Officer. Since taking on this role I’ve been very impressed with the talent and professionalism of our entire finance and accounting team.

I’m looking forward to working with Nelson, Michelle and everyone on our M&A, finance and accounting teams to deliver value for all our stakeholders in the years ahead. now to the Financial Review. As a reminder, our consolidated results include two categories of revenue, organic and acquired.

Acquired revenue is revenue associated with the businesses that have been part of mercury for four full quarters or less. After the completion of four full quarters, revenue from acquired businesses is treated as organic for current and comparable historical periods.

on this call, acquired revenue includes the contributions of Delta Microwave, which we acquired in Q4 of fiscal 2017 as well as RTL and Themis acquired during the first and third quarters of fiscal 2018 respectively. I’ll turn now to Mercury’s third quarter results.

As Mark said, the government funding delays led to shifts in the timing of revenues and related billings that couldn’t fully be mitigated by quarter’s end. nonetheless, Mercury’s business remained fundamentally strong. we continued to deliver solid organic growth with high profitability, supplemented by strategic and accretive M&A.

Bookings were up 41% year-over-year to a record $150 million, and we ended the quarter with record backlog. Our revenue increased 8% from Q3 last year to $116.3 million excluding Themis, which we owned for two months in the quarter, revenue would have been $106.8 million. this is roughly flat compared to Q3 a year ago.

on an organic basis, revenue for Q3 decreased 6% year-over-year to $100.6 million versus the 12% organic growth rate recorded in the second quarter of fiscal 2018. this decrease was driven by the approximately $11 million of SEWIP Block 2 and other revenue, which shifted from Q3 to Q4.

Absent to delayed revenue organic growth would have increased 4% and we currently expect 7% organic growth for fiscal 2018. acquired revenue for Q3 was $15.7 million, which again reflects contributions from Delta Microwave, RTL and Themis. international revenue for Q3 including foreign military sales was $22 million or a 19% of total revenue.

this compares with $19.5 million of revenue in Q3 of fiscal 2017, representing a 13% increase year-over-year. Radar revenue for Q3 was up 13% year-over-year and continues to be a strong market for us. electronic warfare revenue decreased 46% year-over-year driven by the movement of SEWIP Block 2 from Q3 into Q4.

electronic warfare bookings increased to 41% year-over-year showing the continued strength of this end market. revenue from radar and electronic warfare together accounted for 49% of consolidated total revenue compared with 64% in Q3 last year.

I’ll turn now to the three industry tiers, where Mercury participates; components, modules and subassemblies, and integrated subsystems. components revenue for Q3 was up 21% year-over-year while modules and subassemblies revenue declined by 7%.

the decline in modules and subassemblies was primarily a result of the SEWIP Block 2 revenue slipping in the Q4. integrated subsystems revenue was up 19% year-over-year. At the end of Q3, components represented 26% of Mercury’s total revenue, modules and subassemblies 36% and integrated subsystems represented 38%.

Turnout now to bookings, total bookings for the third quarter were up 41% year-over-year driving a strong 1.3 book-to-bill ratio. we ended Q3 with record total backlog of $429.3 million, up 35% from $318 million a year ago. approximately, $321 million or 75% of this backlog is expected to shift [Technical Difficulty].

moving down the income statement, our gross margin for Q3 was 45.4%, compared with 47.3% a year ago. this decline was driven by program mix as well as the inventory step-up related to the Themis acquisition. Q3 operating expenses were $45.9 million, compared with $39.1 million for the same period last year.

the $6.8 million increase was largely a result of increased operating expenses from the acquired businesses, higher amortization expense and acquisition restructuring impairment costs. taxes for Q3 were $2.2 million resulting in a tax rate of 37.4%. the tax rate was impacted by approximately $0.2 million of discrete items.

we expect our effective tax rate to decrease to 34% in Q4. GAAP net income for the third quarter was $3.7 million or $0.08 per share, down 47.6% from $7 million or $0.16 per share in Q3 last year. this is based on approximately $47.5 million weighted average diluted shares outstanding for the quarter.

adjusted earnings per share was $0.30, up 3% from $0.29 for Q3 last year. and finally, our adjusted EBITDA for Q3 increased 3% to $25.8 million from $25 million a year ago. Turning to the balance sheet, we ended the third quarter of fiscal 2018 with cash and cash equivalents of $44.2 million.

operating cash flow for Q3 was $0.9 million compared with $24.9 million for Q3 last year and $8.8 million in the second quarter of fiscal 2018. Free cash flow defined as cash flow from operating activities, less capital expenditures was negative $2.6 million in Q3 compared to a positive $11.9 million in Q3 fiscal 2017.

The lower cash flow in the quarter was primarily driven by lower net income due to the extended CR as well as higher net working capital. Trade accounts receivable increased by $14.1 million from last quarter.

This reflected approximately $6 million from the Themis acquisition and approximately $8 million associated with a higher volume of shipments at the end of the quarter.

Inventory was up $11.2 million from Q2 reflecting approximately $8 million of acquired Themis inventory as well as inventory associated with SEWIP Block 2 and other revenue, which shifted out of the quarter. Excluding these two impacts inventory would have decreased as anticipated.

We expect to see continued improvement in our inventory metrics over the next few quarters. The other major driver of networking capital this quarter was accounts payable. Accounts payable decreased by $4.8 million from Q2 as the payables associated with inventory purchased in the second quarter came due.

This was partially offset by the acquired Themis payables of $4.5 million. In Q3, we had $3.5 million of capital expenditures as anticipated, capital expenditures were substantially lower than the $13 million incurred in Q3 of last year. From a capital structure perspective, we continue to maintain flexibility and good access to capital.

In addition of $44 million of cash on the balance sheet, we have $205 million of remaining revolving credit subsequent to the $195 million we tapped for the acquisition of Themis. Our Q3 results reflected two months of Themis related interest expense totaling $1 million and we will see a full quarter’s impact in Q4.

On a pro forma basis including Themis for the full year our balance sheet remains conservatively levered at under 1.5 times net debt to pro forma EBITDA. Given the strength of our M&A pipeline, we want to make sure, we maintain that flexible capital structure.

We’ve seen an increase in M&A opportunities in companies that fit extremely well with Mercury and our strategy. In addition of organic growth we see the continue to ability to create value through the acquisition strategy we’ve followed over the last few years.

I’ll now turn to our financial guidance, starting with the full fiscal 2018 year, and then for the fourth quarter. For purposes of modeling and guidance, we’ve assumed no restructuring and no acquisition or nonrecurring financing related expenses in the fourth quarter.

We’ve assumed an effective tax rate of approximately 34% for the fourth quarter excluding discrete items. The following guidance also assumes weighted average fully diluted shares outstanding of approximately $47.6 million and $47.5 million for Q4 and the fiscal year respectively. Our guidance reflects the outlook that Mark discussed.

We’ve already booked, shipped and recorded a majority of the revenues associated with the orders that were delayed in Q3. We’ve entered the fourth quarter with record backlog. We’re continuing to see strong growth in design wins in our major product lines and across many of our programs.

Our acquisition integration and manufacturing initiatives are tracking according to plan. As a result, we anticipate that Mercury will deliver strong growth and solid financial performance for both Q4 and fiscal 2018.

With that as background for the full 2018 fiscal year, we expect revenue excluding the Themis Computer business in a range of $464 million to $468 million, this compares with our prior guidance of $460 million to $468 million. So we are raising the bottom end and increasing the midpoint. This guidance represents growth of 14% to 15% from fiscal 2017.

Including Themis, we expect Mercury’s total consolidated revenue for fiscal 2018 to increase to between $487 million and $492 million up 19% to 20% year-over-year. Gross margin for the year on a consolidated basis is currently expected to be between 45.7% and 45.8%.

Consolidated operating expenses are expected to be in the range of $177.9 million and $178.4 million for the year. Total GAAP net income on a consolidated basis for fiscal 2018 is expected to be in the range of $40.2 million to $41.8 million or $0.85 to $0.88 per share.

Consolidated adjusted EPS is expected to be in the range of a $1.35 to a $1.38 per share. We currently expect total adjusted EBITDA for fiscal 2018 of approximately $111 million to $113.5 million on a consolidated basis, and at approximately 23% of revenue within the range established by our current target business model.

Turning now to Q4 and doing the math based on our actual results for the first three quarters. We’re forecasting consolidated total revenue in the range of $146.7 million to $151.7 million. Q4 GAAP net income is expected to be in the range of $9.4 million to a $11 million or $0.20 to $0.23 per share.

Adjusted EPS for Q4 is expected to be in the range of $0.40 to $0.43 per share. This estimate assumes approximately $4.3 million of depreciation, $7.6 million of amortization of intangibles, $0.3 million of fair value adjustments from purchase accounting, and $4.5 million of stock based and other non-cash compensation expense.

Adjusted EBITDA for the fourth quarter is expected to be in the range of $33.2 million to $35.7 million, representing approximately 22.6% to 23.5% of revenue at the forecasted revenue range. With that, we’ll be happy to take your questions. Operator, you can now proceed with Q&A..

[Operator Instructions] And our first question comes from the line of Jon Raviv with Citi. Your line is open..

Hey, guys, good afternoon..

Hi, Jon.

How are you?.

Good. Thanks. I was wondering, if you could just talk a little bit about the 7% organic growth this year.

I realize that the target, you typically talk about is relatively broad, but just why 7% this year and what the confidence is in getting that to accelerate or the possibility that accelerating into FY2019?.

Yes. So we did basically say that we think that growth rate is approximately 7% to this fiscal year that will obviously, relate to a much higher growth rates, as you know 17% organically in Q4. If you step back some years, it going to be a little higher organic growth rate – some a little less.

And so we still feel that high single-digit low double-digit is a good number for us. The primary reason however, if you look at that the organic growth rate isn’t higher this fiscal year is due to the fact that we actually completed a very large homeland defense radar program in fiscal 2017, which totaled $20 million.

So the delta between twenty fiscal 2018 and fiscal 2017 is approximately $18.5 million. So if you exclude that revenue on a period-over-period basis, our organic growth rate would actually be greater than 12%. So it really just depends on what’s happening programmatically, Jon..

Got it. And then on gross margins, just seem to be little bit low again in this quarter, it was from your half year guidance until next year. But now how do you see that trending going into FY2019. You mention mix being initiative, I know I mean there’s a reality there and I guess more broadly is, if we get off a 23% adjusted EBITDA margin.

Assume you don’t make any more deal?.

Yes. So it’s a big picture. I think the guidance range or the – that we have from our pro forma target model perspective is still good. You know that 45% to 50%, as we’ve said, it really depends on what is happening from a program mix perspective that largely dictates any variability.

This quarter, we don’t see a quiet Thesis and as Mike said in his prepared remarks, there was some inventory step up that affected gross margins during the fourth quarter. So we think that the gross margin range that we have in the model is good.

How it is that we increase the adjusted EBITDA from the current forecast to run about 23% to the higher end of the range is basically operating leverage.

As we continue to grow the top line and benefit from the insourcing of manufacturing and the fact that expenses should continue to grow at a rate that is slower than the overall top line, it will eventually grow into that 22% to 26% model..

And then just last one. Can we expect to see that benefit starts to grew in first quarter of 2019, on the levers….

No, we’re not going to talk – we’re not going to talk about specifically 2019 at this point, Jon, because, we’re near our guiding for Q4..

All right. Thanks..

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

Thanks very much. Okay, good afternoon.

You spoke a little bit earlier about more opportunities for M&A, I wonder if you could highlight in the various end markets that you guys call out whether it’s see the sensors or C4I, where you see more opportunity? And then also you talked about wanting to maintain financial flexibility and how the current balance sheet structure gives you that, but sort of what should we think about as being adequate flexibility?.

Yes. So why don’t I take the first part of that question. And then Mike can take the balance sheet part. So the M&A pipeline is likely the largest and most actionable that we’ve seen since we really started our M&A program. And I think, Mike feels the same way too. There’s a lot of opportunity in the areas that we’ve kind of laid out.

So we continue to see more opportunity in the C4O market, specifically, around Mission Computing and Avionics, which is a target focus for us, following the acquisition of CS that we did 18 months or so ago. And then we also see additional opportunities in this – in the rugged rock service space. And we just completed the acquisition of Themis.

And as we said on the last call, we really see Themis as a platform in which we can continue to buildout. And so there are clearly opportunities in that regard, we see opportunities in the security space.

A couple of years ago, we did a very interesting IP acquisition of business down in Huntsville that is turned out to be extremely important as we continue to deliver trusted and more secure processing solutions. So we kind of see a range of opportunities but still very, very much in line with the strategy that we’ve laid out with that.

Mike would you like to take the second part of that question..

Yes. In all, also add on that I do agree that the pipeline is stronger than I’ve seen it, since I’ve been here. We have a lot of opportunities both big and small.

And I think that gets to the capital structure, if you look where we are today, Seth, we consider ourselves relatively modestly leveraged and we have less than $200 million drawn on our $400 million revolver, we’ve got another $150 million accordion feature on that revolver from a leverage perspective.

We’re under 1.5 times the net debt to pro forma EBITDA. So we think we’ve got good flexibility right now, but we’re always thoughtful about our capital structure, so as not to restrict optionality and both in terms of our acquisitions strategy and operations.

And I think we’ve got a pretty good track record of finding good targets that fit strategically with us. And we’ll evaluate those as they come along..

Great. Thanks very much..

Thank you. So our next question comes from the line of Greg Konrad with Jefferies. Your line is now open..

Good evening. I just wanted to follow-up on the last question. I mean, you mentioned that the pipeline is fuller than it’s ever been. I mean, is there a catalyst for that, I mean, is that the fiscal year 2018 budget.

Why is that pipeline bigger than it’s been in the past?.

Yes. I think – I mean from my perspective, it’s a handful of things. Obviously, the budget is positive, the outlook for a lot of these companies is positive. And they’re seeing additional growth and the reality as well as the valuations are high, right now, relative to where they’ve been over the last two and 10 years.

So I think that is propelling a lot of buyers to explore their alternatives. But we’re looking at small deals that are found our own in a lot of times, we see those are driven by personal interest. We’re looking at carve-outs associated with some of the – some bigger multi-industry companies.

And those are driven, I think by focusing their business as well as there’s some benefits now from the tax laws where makes it less owners. So I think that the pipeline and the reason it’s picking up is, generally, because the budget. But each deal we look at is little different, Greg..

Thank you. And then just shift to the organic side, I mean – I think, we’ve heard some contractors still trying to figure out how this the fiscal year 2018 dollars which ended up being bigger than expected flow thorough? And there’s probably an element of capacity constraints to maybe meet some of that funding.

I mean – have you had any conversations? Or do you look at the 2018 budget is maybe a catalyst for the outsource trend that you’ve talked about in the past?.

So, we kind of looked at the budgets and the individual programs that we’re apart over the micro level and we saw a quarter roughly 10% increase in funding of those programs in GFY 2018 versus 2017 an additional 3% growth the following year.

However, I think that’s more directional in nature right because we’re obviously not involved in every part of our program and clearly there are timing differences between appropriations and outlays, but directionally I think we are headed into a better budget environment and we think that we’re pretty well positioned in the areas that are going to continue to see increase funding flows specifically around modernization in a sensor and effective mission side of things and increasingly in C4I.

So we feel pretty good about our position, Greg..

Thank you. And our next question comes from the line of Peter Arment with Baird. Your line is now open..

Thanks, good afternoon Mark, Mike.

Hey, Mark on the Themis deal now you’ve owned it for, roughly I guess three months, you may be updated should thoughts on the integration process there I think you want to mention maybe $1 million or something around there for cost synergies but maybe give us your thoughts around how you’re approaching the integration there for this deal?.

So it’s a good question. So the Themis acquisition I think the way in which we described it previously, we really see as a platform. So it’s got a great management team, they build a very strong set of technologies and capabilities they’re involved in some really good programs. And so the initial acquisition of Themis is not necessarily a cost play.

It’s all about how it is that we’re going to actually use that as a platform to continue to grow in the C4I space and to potentially acquire into. And that’s very much what it is that we’re focused on. From a an organic perspective, the feedback from customers has been tremendous.

We’re already seeing additional opportunities with the fact with Mercury has acquired them in terms of new pursuits, and we were actually recently informed that literally as a direct result of Mercury acquiring them – they’ve been selected on an important subsurface program which is also been an area that we have been targeting.

So overall we couldn’t be happier with the business and the opportunity for us to continue to grow it organically as well as to add to it from an M&A perspective..

And just as a follow-up to that.

On the inventory side, is there a difference the way they either outsource and versus your approach on the insource and then how should we expect that the kind of change going forward?.

So not too much of a difference, I mean we did acquire approximately $8 million inventory with the purchase of Themis this quarter, but let me kind of step back and just talk a little bit about what’s going on with inventory specifically because clearly there is some things flying around in the market that I think would be a good opportunity for us to respond to.

So if you look at all in LTM basis, inventory is up $45 million and it has been a use of cash. Now we actually see this really as an investment in the business from an organic growth perspective, And it really boils down to four things.

The first is that it’s an acquisitive company we clearly have added inventory and seen the step up associated with that inventory over the last couple of years. And I just mentioned we’ve actually acquired $8.7 million of inventory associated with Themis.

Probably the most important however, is being the fact that we’re focusing on in-sourcing our manufacturing. And so we’ve added $10 million to $12 million of component level inventory associated with standing up the USMO, which is our manufacturing operation in Phoenix.

And the way to think about that is that previously when we’re outsourced, that inventory, the component level inventory would have been on that contract manufacture we wouldn’t have owned it. But because we now build out our facility and because we’re actually ramping up production we need to have that component, component stock.

Now we’ve also, as we’ve transitioned from that contract manufacturing model to actually ramping up internal production as I mentioned in my prepared remarks, the throughput at the USMO actually increased 50% quarter-over-quarter.

We also wanted to ensure that we were able to manage the risk both from operational, from a financial and to ensure that we could meet our custom commitments. And so we’ve added an additional $8 million of safety stock associated with that.

So the third area is that we’ve got very rapid organic growth in the other part of the Phoenix business and to put it in perspective that is part of the business that came to us through the acquisition micro-semi one of the areas that we were very focused on with weapon systems and the business in Phoenix itself has actually grown or is expected to grow 31% of this fiscal year.

And that in large part that is being driven by substantial growth in our weapons systems business. And weapon systems is up 269% alone in the last 12 months. Now to support that our organic growth we needed to invest in the inventory to support it which we have. And so we purchased an additional $9 million of inventory in two areas.

The first is end of life semiconductor and the second is we’ve actually purchased semiconductor component materials in parts of the semi market where we’ve seen lead times increasing. And so in essence we’re fueling the organic growth that we see in the business.

So that’s really what’s been going on with inventory which has been a significant investment. So having build out the facility in fiscal 2017 and ramping the growth in working capital this year, next fiscal year is all of that optimization.

And so think of it that we’ve been on a three year journey, 2017 building at a facility high CapEx that’s now significantly reduced. We’ve built at the working capital moving into fiscal 2018 to support the growth and next year we’ll get back to more normalized levels and focusing on improving efficiency..

Is great color. Thanks Mark..

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

Hi guys, could you hear me, okay..

We can Jonathan. Yes..

Perfect. Just wanted to – I guess focus on some of your comments around design wins.

Are you seeing that translate into increases in either content or maybe capturing more wallet share you with some of these new wins just given in a progress in the strategy?.

We are Jonathan.

It was actually a pretty amazing quarter in terms of just the things that we’re getting involved with I mean we were selected by a couple of customers on a army ground radar program that’s going to go through a tech refresh, was selected by another incumbent on a different but other very important ground radar program where we’re expecting additional content.

We’ve been pursuing a very large classified radar for probably 10 years and had a major breakthrough this past quarter in both the RF side of things where we’re displacing a company. As well as actually potentially winning the process of refresh, which was previously done in-house..

Yeah. We have one being selected in a number of naval C2 and other ground radar applications as a result of the Themis acquisition. so the level of design win activity in new pursuits is as I said in my prepared remarks probably, the highest that I’ve seen since joining the company..

Great. And then just to talk a little bit more about the Phoenix facility. can you give us a sense of what ending wherein in terms of capacity utilization and what further opportunities you have and maybe just the current pace that you’re integrating to drive back that capacity..

Yeah. So go back to – kind of go back to the journey a little bit and think about what we’ve been up to in the last three years. So, if you look at the fiscal 2017. Fiscal 2017 for us was a significant year from a capital expenditure perspective and it really was investing in two things.

The first was investing in our new headquarters facility as you know; the least in our prior headquarters in chance to those expiring and we needed to move to accommodate the additional space that we needed to meet our organic growth needs. This second investment was exactly what you were talking about.

it was related to the Microsemi Carve-Out acquisition.

When we bode the Microsemi businesses, we saw the opportunity as insourcing our digital money factoring and this was a very significant synergy of the deal and it was really the primary reason that allowed us to raise our target financial model from what was then the 18% to 22% adjusted EBITDA to the current goal of 22% to 26%.

but to do that, we needed to build out the Phoenix facility, which we basically did during 2017 and 2018. so if you look at it from a CapEx perspective, 2017 was a significant increase and we’re expecting currently that our CapEx in fiscal 2018 will decrease by $18 million.

Now, with that build out of that facility in place as I just went through fiscal 2018 is all about basically insourcing the manufacturing and ramping up the production rate and we’re really in the – call it, the midst of that right now. so we saw a 50% increase in throughput in the last quarter alone.

but the working capital builds really began at the end of fiscal 2017 and this moved into fiscal 2018. So this particular quarter if you look at it from an inventory perspective, absent the acquisition of Themis and absent the inventory associated with the deals that moved to Q4, our inventory growth was basically slightly negative.

So we’ve kind of seen that build somewhat ameliorate.

and now, it’s about continuing to ramp the capacity and the throughput in that facility, and as we move into fiscal 2019, it’s all about optimization; it’s optimizing that facility to ensure that we can continue to grow, but from my perspective, I mean I’m extremely proud of what the team has been able to do.

the Phoenix is a state-of-the-art; it’s a trusted manufacturing facility. it recently was awarded the Frost & Sullivan manufacturing leadership award. the production is ramping, and the facility itself is critical to both our strategy, our growth and our profitability goals as I mentioned.

So I think we’ve managed a very, very complex outsourcing to insourcing transition with no disruption to the business and it’s supporting the growth objectives..

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

Hey, good evening guys. Thanks for taking the questions. Mark, you were sort of on a role there, when you’re answering Peter’s question about inventory and maybe, anything else that’s negative in the marketplace or being miscommunicated that you’d want to address now, SEWIP program or anything else on your mind..

It’s a great point, Mike. Yeah. So, why don’t I clear up some of the confusion on that specific program and SEWIP basically stands for, as you know, Surface Electronic Warfare Improvement Program, and it’s a collection of individually funded programs and each of the programs provide distinct yet complementary capabilities over time.

the individual programs themselves are actually a different life cycle stages and are run by different prime contractors. and we’re actually performing work on two major programs; SEWIP Block 2 and SEWIP Block 3.

Block 2 is a very well funded program; the program is currently in full rate production and is a meaningful contributor to our financial results of the year level. however, that doesn’t mean that the program itself will produce ratably each quarter. It can’t be somewhat lumping.

block 3 on the other hand, which I think is where some of the confusion is in the marketplace, has experienced some delays and it’s in the engineering phase, and it’s basically immaterial to our current financials. so if you kind of give a brief update on what we see happening on Block 2 and Block 3.

So late in fiscal Q3, Lockheed received a $119 million block 2 contract award modification. And in turn on the last working day of the quarter, we received a $16.8 million full rate production award, which was actually a 16% increase versus the prior year.

we currently expect the SEWIP Block 2 will be our largest – second largest revenue program growing 35% year-over-year and our fourth largest bookings program. block 3 as I mentioned, is an important program, it’s an integral part of the Navy’s Surface EW upgrades.

the program is slightly behind schedule, but we understand that it’s actually performing better and the DoD more importantly is very eager to get to milestone C and sought to deploy the system to put the materiality block 3 in perspective, we’ve completed $2.9 million of engineering work over the last 12 months.

So, it’s basically immaterial to our financial results and so I think there was some confusion as to block 3 and block 2. Block 3, we expect to get some long lead time funding associated with the first LRIP next fiscal year and if you look at the GFY budget, the funding for Block 3 is increased substantially; it’s of 80% in GFY 19 to $420 million.

So the program is alive and well, it’s an important capability and we’ll well positioned on both..

Got it. that’s helpful.

Mark, just some housekeeping, on the bookings and backlog, was there any material contribution from Themis to each of those metrics?.

So, the bookings – Themis had a strong bookings quarter as did we. So both organically as well as in terms of a positive book-to-bill Mike, but we’re not going to break out the bookings per se..

Got it. What about just the continuing resolution, the bookings environment for you was very strong, and obviously, it sounds like a bulk of that revenue mix was tied to one program, but you’ve dealt with continuing resolutions in the past and with anything is that different. I know we had the shutdown, but usually you kind of….

yeah..

Had that impact you on the bookings, what was different this time versus prior..

yeah. So it’s a good question, Mike, I think on the last call, we’ve anticipated that would kind of get through the CR by mid-February and it basically moved into March, and the largest impact that we had was on SEWIP Block 2. As I mentioned there were a couple of other deals that also got impacted that totaled the $11 million.

But lucky to received the SEWIP Block 2 contract modification award literally right at the last day of the quarter. So it just that kind of things bunching up to the back end of the quarter because of the extended or prolonged CR is really what hit us.

So we have CRs, I think each and every year for probably the last seven years, but this was longer than what we’ve seen in the past and it was really that hit us..

Got it.

And then just last one housekeeping, you probably had some more time to digest the tax law changes, any more thoughts on the long term 30% tax rate or should we still be thinking about that same target?.

Yes, Mike, as we’re not going to hit on that right now. We’ll provide more guidance on that on our next call when we provide our guidance for fiscal 2019..

Got it. Thanks guys..

Thank you. And our next question comes from Ronald Epstein with Bank of America Merrill Lynch. Your line is now open..

Hi, good evening guys.

So how many operating margins like cut in half, maybe not quite 60% of what they were – how sequentially quarter-over-quarter or year-over-year, I mean what happened there, like I don’t get that, I understand the top-line growth, but it’s not profitable and there’s no cash, so help me understand why this is good?.

So if you look at the – actually learnings ofthe working capitals off, right in terms of Q3, because I think we hit it only in the prepared remarks, Ron..

Yes, so Ron, maybe we start with cash, because that’s clearly an issue that we want to be able to explain both for the first three quarters and for Q3. So if you look at what happened in the first three quarters, the biggest use of cash was what Mark talked about, it was the inventory by far.

And the second was accounts receivable, and in Q3 we had two things if you look at the balance sheet on that the accounts receivable. We see that AR increased in Q3 by $14 million, $6 million of that was from Themis, $8 million was from an organic increase.

And that was really driven primarily by the back end nature of the quarter due to the extended CR that Mark talked about that reduced the in quarter collections and thereby increased AR at the quarter end. So we actually saw a cash outflow of close to $10 million in Q3 associated with AR.

And what we’ve also seen over the last couple quarters, and as I’ve come in, it’s one of the things that that I’m focused on where I think we’ve got good opportunity, is if you look at accounts receivable for the first three quarters of the year, we did see an increase in Q1 and Q2 as well, as our DSOs grew disproportionately to revenues, so AR grew with revenue, but DSOs grew as well.

And the primary driver of that that we saw was towards the end of the year or so our customers’ fiscal year, the calendar year 12/31 or Q2 was our customers are really managing their cash in their AP at the end of the year. And if you look to Q1 and Q2, we saw an uptick in average days late from our customers that drove DSOs higher.

So we think there’s a lot of opportunity to reduce DSOs going forward. We’ve seen the actions of our customers in terms of late payments have already started to ameliorate someone. So we expect DSOs to go down. The third thing that you saw this quarter from the cash perspective was accounts payable.

And so accounts payable went down by about $10 million and that that increase is related to the increase in inventory over the last quarter, so inventories now increased significantly over the first half of the fiscal year, that slowed in Q3 as we talked about and we expect the inventory turns as Mark said to improve going forward.

But this quarter we reduced the AP associated with those inventory builds. So when you look at the cash flow it’s our opinion you need to take it in the whole story in terms of what has happened over the last three quarters plus what happened this quarter.

We think we’re really well positioned to going forward, working capital, the metrics associated with inventory turns AP as a percentage of sales or AR day sales outstanding. We think there’s a lot of opportunities in each of those areas going forward. Hope that helps a little bit on the cash flow question..

When would you expect to see free cash flow as a percentage of net income get back to a level of 80% something like that.

Most defense companies have pretty predictable free cash flow, so when will we expect that to happen for you guys?.

So we expect that I mean, if you look at the inventory, it’s already basically declined a little bit quarter-over-quarter.

So what I mentioned is, I was talking about the journey that we’re on, one year, two year or three, year three is really where we’re focused on the optimization right, we’re still in the build phase of all the ramp face of getting that USMO up and running. So fiscal 2019, we should begin to see the improvements in EBITDA to free cash flow run..

Improvements. All right.

And then, if you guys can speak to the margin, so operating margins in the quarter of 5.9%, I mean some of your competitors in the space of operating margins of 20%, so I’m just trying to get my head around why the operating margin less than 6%?.

Well, I think just a couple of housekeeping things on that. So 5.9% EBIT margins that did include $1.3 million of acquisition costs and other related expenses. We had $1.4 million of restructuring and other, and we also had $7.1 million of amortization of other intangibles associated with the acquisitions.

So when you look at big picture of what happened, gross profit as we discussed did go down was 45.4%, some of that was related to the step up of the inventory associated with Themis acquisition. SG&A was 21.1%, it was relatively constant as a percentage of sales of 18.2%. And then R&D is stayed consistent with our model at 12.9%.

So I think what you’re seeing on the bottom line is some of those one-time costs associated with the acquisition..

The other thing as well, right, as we said, we had $10 million or a $11 million of revenue basically moved from period to period. It’s not only because our revenues would have been in line with the guidance that we gave in our adjusted EBITDA would have actually being above the high end of the range..

All right. Okay guys. Thank you..

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. Just a quick wrap up. I know that you haven’t given 2019 yet, and will probably after this quarter.

But it seems like growth should be accelerated in 2019 versus 2018 on internal basis and margin should be expanding is that correct after hearing all the Q&A and jumping in especially after the last Q&A, last question falling [ph].

Can you talk a little bit about at least generally which direction things are going that there’s an acceleration are you anticipate acceleration business?.

So we’ll have more to talk about that on the next call Brian, I’m not going to get into discussion around fiscal 2019 on this call..

Okay, thank you. And we have a follow-up question from the line of Jon Raviv with Citi. Your line is now open..

Hi, thanks guys for squeezing me in.

Just on the margin question, is there somewhere, I mean year-on-year commercial business model somewhat, how do you guys thinking about incremental margins in this business?.

So, I think if you look at say, well, we’ll see more in Q4, let’s put it that way here with the incremental revenue that we have focused on generating in both organically as well as the acquired in the revenues that moved, my belief is that you’re going to start to see kind of the operating leverage if work..

All right. Thank you so much. .

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

Okay. Well, let’s thank you all very much for listening. We look forward to speaking to you again next quarter. Thank you..

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