Good day, everyone, and welcome to the Mercury Systems Second Quarter Fiscal 2019 Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the company's Executive Vice President and Chief Financial Officer, Mike Ruppert. Please go ahead, sir..

Good afternoon, and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com.

The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations. Please turn to Slide 2 in the presentation.

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

These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2, in the earnings press release, and the risk factors included in Mercury's SEC filings.

I'd also like to mention that in addition to reporting financial results in accordance with Generally Accepted Accounting Principles, or GAAP, during our call, we will also discuss several non-GAAP financial measures, specifically, adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue, and acquired revenue.

A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation, and in the earnings press release. I'll now turn the call over to Mercury's President and CEO, Mark Aslett. Please turn to Slide 3..

Thanks, Mike. Good afternoon, everyone, and thanks for joining us. I'll begin by providing a business update, Mike will review the financials and guidance, and then, we'll open it up to your questions. Mercury delivered solid results in the second quarter of fiscal 2019, building on the momentum from Q1.

We finished the first half of the fiscal year strong, coming in above the high end of our Q2 guidance for revenue, adjusted EBITDA, and adjusted EPS. In addition, we're announcing today the acquisition of GECO Avionics as part of our continued push in the C4I market.

We've now completed 5 C4I acquisitions over the past two fiscal years that have significantly expanded our capabilities and addressable market. I have more to say about the GECO transaction and our C4I strategy later in my prepared remarks. Turning to the numbers.

Revenue for the second quarter was a record and increased 35% in total and 11% organically. We now expect 9% to 10% organic growth for this fiscal year, which is up 2 to 3 percentage points from fiscal 2018. Our largest revenue programs in the quarter were F-35, Filthy Buzzard, Predator, the next-generation missile system, and DEWS.

We continue to perform well from a bookings perspective also. Total bookings for Q2 increased 29% year-over-year to $173.2 million. Our largest bookings programs included the UAV mission computer, and the next generation ground-based radar.

We also booked large orders to F-35, Aegis and MALD Our book-to-bill for the quarter was 1.09, and backlog was a record $522 million, up 39% year-over-year. On the bottom line, adjusted EBITDA was up a strong 39% from Q2 of fiscal '18. Free cash flow increased 279% year-over-year and was in line with our target yield at 50% of adjusted EBITDA.

Turning to Slide 4. Mercury's ability to win new business has never been stronger. We're in a period of significant new design win activity in new program starts. The level of pursuit and design win continues to be the highest they've seen since joining the company.

Our continued growth demonstrates that Mercury is well aligned with DoD budget priorities and the need for modernization. We're targeting the C4I in Sensor and Effector Mission Systems markets. Both segments continue to grow faster than the overall defense market.

Sensor and Effector Mission Systems accounted for 56% of total Q2 revenue, increasing 5% from the second quarter last year. The C4I market is far larger than the Sensor and Effector Mission Systems market, and looking at the estimated lifetime value of our top 30 programs, we've rapidly created $800 million of potential C4I opportunity.

We've done this through the investments that we've made and the deals that we've completed. The critical component of this potential growth is the recent acquisitions of Themis and Germane. Here, we are in the process of integrating these businesses to create an industry-leading rugged server business.

For the second quarter, C4I revenue increased 249% year-over-year to 30% of total revenue. Since fiscal 2013, we've seen the estimated lifetime value of our top 30 programs and pursuits grow significantly. This growth reflects our M&A strategy, as well as the impact of three industry trends that we've discussed in the past.

The first trend is what we believe to be the largest secular growth opportunity in defense, which is increased outsourcing by our customers at the subsystem level. Second, is the flight to quality, the price of seeking to deal with fewer, more capable suppliers.

Suppliers like Mercury, who are prepared to co-invest in internal R&D, have trusted domestic manufacturing assets, and have invested significantly in cybersecurity. Third, is supply chain delayering by the government in the Primes. We've transformed Mercury into a Tier 2 company over the past several years.

We've moved up the value chain and position ourselves to capture more subsystem content as the delayering trend evolves. As we benefit from these three fundamental trends, we're also continuing to take share from competitors.

This is largely because of the significant and focused investments that we've made in R&D, as well as building out our trusted domestic manufacturing capabilities. As you can see on Slide 5, we made solid progress in these areas during the second quarter, thanks to another great effort by the Mercury team.

Our R&D strategy has been focused on positioning Mercury as the leading U.S. supplier of secure and safety-critical processing subsystems for aerospace and defense applications. This is based in our belief that, over time, more and more of the technology that goes into U.S. military platforms will need to be designed and produced domestically.

We believe this represents a significant opportunity for Mercury. We're executing against this strategy by investing significant internally funded R&D to develop secure hardware and software technologies.

These technologies offer our customers choice and an industry-leading range of secure, embedded and enterprise computing solutions, all developed and produced domestically.

We were very pleased that 6 Mercury products in trusted computing, software, and C4I SR were recently recognized by Military and Aerospace Electronics Magazines Annual Innovators Awards Program. This recognition underscores the power of our business model to embed innovation deeply into our product development and commercialization processes.

In addition to our IRAD investments, we have funded the capital dollars necessary to build out the trusted digital SMT manufacturing facility in Phoenix, Arizona. The in-source digital production capabilities we've created in Phoenix are crucially important to our ability to continue growing the business.

We've largely completed the Phoenix buildout as planned, and we're substantially completed in our initial manufacturing insourcing plan. Now under the leadership of Amir Allahverdi, who joined Mercury in Q2, our goal is to continue to optimize all of our internal and manufacturing operations, including Phoenix, over the coming years.

The consolidation of our West Coast RF manufacturing locations is progressing. We received planning permission, and we'll soon begin the buildout of the leased facility, adjacent to our existing Oxnard, California plant. Completing this buildout will then allow us to consolidate our remaining West Coast RF operations.

We'll continue to make good progress integrating Themis and Germane, and mitigating both businesses to Mercury Systems and processes, which we currently expect to complete by fiscal year end. The combined Themis and Germane leadership team and structure is now fully deployed. Both businesses are performing well.

And combined, are generating revenue and cost synergies in line with our expectations. When we acquired Themis and Germane, our strategic goal was to insert our own domestically designed and produced secure processing capabilities into their rack server solutions over time, and for certain applications.

This activity is well underway, and the capability is being well received by customers. The feedback is that we've created a unique business and set of capabilities in line with the trend and need for secure and trusted compute solutions. We've already won 2 important new design wins with Themis and Germane being part of Mercury.

By expanding our secure processing product portfolio, we have also invested significantly over the years to build out a best-in-class cybersecurity capability to protect our own infrastructure, critical technologies and information. Turning now to Slide 6. Our business outlook remains strong.

We've seen an acceleration in defense spending this government fiscal year. This is leading to a high level of new design win activity, a strong book-to-bill, and an increase in our projected organic revenue growth rate. Over the longer term, our baseline forecast is for overall defense spending to increase at low single-digit rates.

Mercury's goal is to continue delivering organic revenue growth at a rate that exceeds this industry average. As we mentioned earlier, we now expect to deliver 9% to 10% organic growth for fiscal 2019. This is an increase from what we anticipated last quarter and above the 7% organic revenue growth we delivered in fiscal 2018.

We're well positioned to continue supplementing this high level of organic growth with smart, strategic M&A. Our pipeline is strong, and we continue to see interesting opportunities of various sizes, all of them are well aligned with our strategy.

Including the deal that we announced today, the acquisition of GECO Avionics, over the past 3 years, we've completed 8 acquisitions, totaling more than $650 million of capital. These transactions share a common strategic rationale, they're expanding our addressable markets and broadening our customer offerings, as well as our program base.

At the same time, the cost and revenue synergies they're generating are contributing to our strong financial performance. We intend to remain active and disciplined in our approach to M&A.

We'll continue to look for deals that are strategically aligned, have the potential to be accretive in the short term, and promise to create long-term shareholder value. We will seek to continue to acquire and grow within the Sensor and Effector Mission Systems and C4I markets as we have in the past.

As outlined on Slide 7, we currently have 2 M&A themes underway in the C4I markets. The first is secure rugged rackmount servers. Here, we've created one of the largest players in the space via the acquisitions and integration of Themis and Germane. Our second theme in C4I is Avionics processing subsystems.

We began building this business in November 2016 when we acquired Creative Electronic Solutions, or CES. We followed this up with a further acquisition of Richland Technologies, or RTL, in July 2017. The GECO Avionics acquisition continues that journey.

With $36.5 million purchase price, it's approximately 10.5x LTM adjusted EBITDA net of the expected tax benefits. GECO is based in Mesa, Arizona, and has more than 20 years of experience designing and manufacturing affordable, safety-critical Avionics and mission computing solutions.

Their technologies to deploy on a range of military platforms, including Boeing's Apache Attack Helicopter and KC-46 Pegasus Refueling Tanker. Our goal is to combine GECO with CES and RTL to create an industry-leading Avionics business.

We view this combination as another platform in which we can, and will likely, continue to build by looking for deals in this space. An example of the opportunities we're pursuing in this market, organically, is the Q2 design win we announced on January 3.

Our team in Geneva, Switzerland, the former CES, secured a $40 million, 10-year contract from a large aerospace and defense company to develop a set of advanced safety certifiable flight computers. Turning to Slide 8. In summary, Mercury remains on track for another year of strong performance in fiscal 2019.

Our strategy and business model are working extremely well. We're growing the business substantially faster than the industry overall. Our planned manufacturing and M&A integration synergies are materializing. We're expecting another year of double-digit growth in revenue and adjusted EBITDA, as well as strong cash flow generation.

We remain confident that we can achieve the high-end of our adjusted EBITDA target model over time by continuing to execute our plans in 4 areas. First, is to drive high single-digit, low double-digit organic revenue growth supplemented by acquisitions. This is consistent with the 20% compound annual growth we've delivered over the past 5 years.

Second, we're focused on manufacturing insourcing and driving operational improvements across all of our manufacturing locations. The goal here is to enhance margins and improve working capital efficiencies over the coming years.

Third, we're creating stronger operating leverage in the business by ensuring that organic operating expenses grow more slowly than revenue. And finally, we're fully integrating the businesses we acquire to generate cost and revenue synergies.

The synergies, combined with 3 other elements, should produce attractive rates of return for our shareholders. Given our results in Q2, our record backlog and our current business outlook, we expect to report continued strong performance in the third quarter.

We're also raising our full year fiscal '19 guidance, and Mike will take you through those numbers in detail. Before Mike begins, I'd like to note that Barry Nearhos, a partner at PricewaterhouseCoopers, was elected to Mercury's Board of Directors, and appointed to the Audit Committee in late November.

Barry has a rich history of providing global corporations with order and shared services, along with strategic business advice on M&A, corporate governance and finance. We welcome Barry to Mercury's Board. I look forward to benefiting from his experience as we continue to execute against our business objectives.

With that, I'd like to turn the call over to Mike.

Mike?.

Thank you, Mark, and good afternoon, again, to everyone. Q2 was another great quarter for Mercury. Bookings revenue, adjusted EBITDA and adjusted EPS increased substantially from Q2 of fiscal '18. Gross margin exceeded our Q2 guidance, and free cash flow was up 279% year-over-year.

We concluded the second quarter with record backlog and solid growth momentum. As a result, we're anticipating strong financial performance in the second half of fiscal '19, and we're increasing our fiscal '19 guidance for revenue, adjusted EBITDA, and adjusted EPS.

In addition to our organic growth, our strategy of acquiring businesses that fit with our strategy and integrated them into Mercury is delivering results as planned. Our recent acquisitions, Germane and Themis, are continuing to perform well on both the top and bottom lines.

The acquisition of GECO Avionics, which closed today, is another example of our strategy in action. As Mark said, it's another important step forward in our plan to expand our presence in the C4I market.

With approximately 70 employees and approximately 20 million of revenue, GECO continues to add scale to the Avionics business we've been growing over the past 2 years. Turning now to the metrics on Slide 9. Mercury's total bookings for Q2 increased 29% year-over-year to $173.2 million, driving a 1.09 book-to-bill ratio.

We ended the quarter with record backlog of $522 million, up 39% from Q2 fiscal '18. Backlog expected to ship within the next 12 months increased 25% from Q2 last year to $389.1 million.

Q2 was a strong quarter for revenue growth, total revenue increased 35% year-over-year to a record $159.1 million, exceeding our guidance of $151.6 million to $156.6 million. Organic revenue was up 11%, and as Mark mentioned, we now expect 9% to 10% organic growth for the year.

Gross margin for the second quarter was 44.6%, above the high end of our guidance of 43.9% to 44.5%, largely due to favorable program mix. This compares with 45.9% in Q2 last year, reflecting this quarter's inclusion of Germane Systems. Excluding Germane, Q2 gross margin would have increased year-over-year.

The integration of Germane into Themis and Mercury is progressing well. The teams are already working together effectively, and we're on track to deliver our expected cost synergies. Over time, we expect to see the combined Themis-Germane, achieve EBITDA margins consistent with our target business model.

In addition, we're already seeing revenue opportunities that neither company would have seen on a stand-alone basis. SG&A for Q2 increased 31% from $21.2 million in Q2 '18 to $27.8 million, driven by the inclusion of Themis and Germane, as well as the organic growth in the business.

As a percentage of sales, SG&A decreased from 18% in Q2 last year to 17.5% this quarter, highlighting the operating leverage we're creating as we continue to grow sales faster than expenses. GAAP net income and GAAP EPS in the second quarter increased by 36% and 37% year-over-year, respectively.

Adjusted EPS for the second quarter was $0.47 per share, up 68% from $0.28 per share for Q2 last year. Adjusted EBITDA for Q2 increased 39% year-over-year to $37 million, exceeding our guidance of 31.7% to $34.5 million. Adjusted EBITDA margin was 23.2% for the quarter. This compares to 22.5% in Q2 fiscal '18 and exceeds our guidance of 20.9% to 22%.

The increase was driven primarily by favorable program mix. Finally, free cash flow, which we define as cash flow from operations less capital expenditures, increased from $4.8 million in Q2 last year to $18.2 million. Slide 10 presents Mercury's balance sheet for the last 5 quarters.

We concluded Q2 well positioned to continue executing on our capital deployment strategy, supporting future growth organically and through acquisitions.

Driven primarily by Mercury's strong free cash flow, cash and cash equivalents at the end of Q2 totaled $93.9 million, up $21 million from $72.9 million at the end of Q1, and up $61.9 million from $32 million in Q2 fiscal '18. Inventory in Q2 increased by $5.2 million quarter-over-quarter and inventory turns were flat.

Accounts receivable increased $14.4 million quarter-over-quarter, while DSOs improved slightly compared to last quarter. From a capital structure perspective, we've maintained flexibility and good access to capital. At the end of the quarter, we had $240 million of debt.

Following the $36.5 million purchase of GECO Avionics, which we funded under the revolver, we now have $276.5 million of debt. Post the GECO acquisition, our balance sheet remains conservatively levered at approximately 1.4 times net debt to adjusted EBITDA. Earlier this month, we entered into a floating to fixed rate interest rate swap.

This fixes the $175 million of our $276.5 million variable rate debt at a fixed LIBOR rate of 2.54%. Meaning, that approximately 60% of our debt is now locked in at a very attractive rate. At current leverage levels, our interest rate is LIBOR plus 125 basis points, implying a pretax cost of debt of 3.79% on the fixed portion of the debt.

Turning to cash flow on Slide 11. Free cash flow for Q2 was $18.2 million, representing 49% of adjusted EBITDA. And for the first half of fiscal '19, free cash flow was at 50% of adjusted EBITDA, up 275% from the first half of fiscal '18. Operating cash flow for the second quarter increased to $25.3 million from $8.8 million in Q2 last year.

Working capital was at $3.4 million use of cash compared with a $4.5 million use of cash in Q1, and a $14.6 million use of cash in Q2 last year. Capital expenditures in Q2 were $7.1 million or 4.4% of revenue, and $10.8 million or 3.6% of revenue in H1. We expect CapEx to increase in H2 as we continue to integrate recently-acquired businesses.

Although this will reduce free cash flow in H2, our cash flow for fiscal '19 will be up significantly compared to fiscal '18. I'll now turn to our financial guidance for Q3 and fiscal '19. This guidance includes the impact of GECO Avionics.

Starting with Q3 on Slide 12, you can see that we're forecasting consolidated total revenue in the range of $162.7 million to $167.7 million, an increase of 40% to 44% compared with Q3 last year. Q3 fiscal '19 gross margins are expected to be 43.6% to 44.1%.

The decrease from Q3 last year is primarily driven by lower margin revenues from our recent acquisitions, as well as the higher proportion of new development programs in our mix. Q3 GAAP net income is expected to be $10.8 million to $12.3 million or $0.23 to $0.26 per share.

Adjusted EPS is expected to be $0.43 to $0.46 per share, up 43% to 53% compared to Q3 fiscal '18. Finally, adjusted EBITDA is expected to be $34.8 million to $36.8 million, representing approximately 21.4% to 21.9% of revenue.

Turning to Slide 13, our guidance for the fiscal year reflects both the strong organic growth and the inclusion of GECO Avionics. We're raising our previous full year guidance for revenue, adjusted EPS and adjusted EBITDA.

For the full fiscal year, we now expect revenue of $631 million to $646 million, representing growth of 28% to 31% from fiscal '18. This is a significant increase from our previous guidance of $607 million to $625 million.

At the top end, the $21 million increase from our previous guidance reflects approximately $15 million of incremental organic revenue, driven by new program design wins, as well as an anticipated $6 million of revenue from GECO Avionics. Consolidated gross margin for fiscal 2019 is currently expected to be 43.4% to 43.9%.

Our gross margin outlook reflects new design win activity and the inclusion of Germane and GECO Avionics. Consolidated operating expenses for fiscal '19 are expected to be $203 million to $207.6 million, including an estimated $27.5 million of amortization expense.

The increase from our previous guidance reflects an incremental investment in our products and our people in the second half of the year. In Q2, we exceeded the high end of our adjusted EBITDA guidance by $2.5 million. Given the opportunities we see in the market, we're modestly increasing R&D spend in the second half of the year.

Our strong financial results from the first half allow us to invest for the future, while still raising our full year guidance for adjusted EBITDA. Interest expense for fiscal '19 is now expected to be approximately $9.6 million. This reflects the estimated additional debt associated with GECO for 5 months of the year.

Total GAAP net income on a consolidated basis is expected to be $42.6 million to $46.1 million, or $0.89 to $0.96 per share. Adjusted EPS is expected to be in the range of $1.72 to $1.80 per share, an increase of 21% to 27% compared to fiscal '18 results.

Our fiscal '19 guidance for adjusted EBITDA is $138.6 million to $143.5 million on a consolidated basis or 22% to 22.2% of revenue. This is an increase of 21% to 25% from fiscal '18, and up from our previous guidance.

We expect adjusted EBITDA margins to increase over time as we integrate Germane and GECO Avionics, and recognize the anticipated synergies. In addition, we expect to gain further operational efficiencies, and we anticipate continued improvement in operational leverage as revenues grow.

We also expect gross margins to improve over time as early stage development programs move into production. As we discussed at Investor Day in November, this should lead to EBITDA margin expansion over the coming years. Finally, we expect CapEx for fiscal '19 to be approximately 5% of revenue, up from a approximately 3% last year.

This increase is driven by continued investment in the consolidation of our West Coast RF manufacturing locations and is weighted towards the second half. Turning to Slide 14, in summary. Mercury delivered a strong second quarter, setting us up for another year of strong performance in fiscal '19.

We concluded the quarter with a 1.09 book-to-bill and record backlog. Total revenue was up 35%, and organic revenue grew 11% year-over-year. Net income and adjusted EBITDA exceeded our guidance. We delivered solid operating and free cash flow, while also completing our eighth acquisition in the past 3 years.

The outperformance that we've seen in the first half of the year is allowing us to invest in the business, while also allowing us to raise our full year guidance. With that, we'll be happy to take your questions. Operator, you can proceed with the Q&A now..

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

Good afternoon, Mark, Mike. Congrats on the quarter. Mark, you mentioned C4I is now 30% of revenues. And then, that continues to progress, obviously. And you mentioned an $800 million kind of opportunity.

Can you maybe talk a little more color about, I guess, the market, what you're seeing, and some of the success that you're having early on?.

Sure. So I think there are a number of different opportunities that we're seeing. The growth in the C4I is really broken down into 2 major areas, as I kind of described a little bit on the call. The first is in the secure, rugged, rackmount server domain.

And here, we've obviously Themis and Germane, and grouping those or combining those two businesses together. We've seen opportunities and upgrades associated with upgrades in the naval subsurface fleets, as well as the naval surface fleet, as well as in airborne applications for those types of capabilities.

The second area that we've seen opportunity is in the Avionics processing subsystem domain. And that's really the primary rationale behind the acquisition of GECO that we announced this evening. And that really follows on from the other acquisitions that we've done in this space, those being RTL and CES.

And so there, we're going after opportunities in upgrades in mission computers as well as avionics processing subsystems. And one of the unique things that we bring to the table is our ability to be able to combine together the safety certifications and the embedded security.

And where we're seeing the opportunities for that is particularly in the shift towards more autonomous systems. So net-net, I think, the shift into that space, the C4I market, which is a much larger market than we've traditionally played in, I think, is presenting a significant amount of opportunity for us, Peter..

Thank you. And our next question comes from Jon Raviv of Citi. Your line is now open..

Hey. Good afternoon, everyone. On the organic growth, certainly appreciate the view to land the 10% organic growth this year. Some of your customers are growing almost at that rate, not quite.

But given new design wins pushing around, you're talking about now increasing R&D a bit more, what's the prospect for double-digit organic growth at some point in the future?.

So as I said in the prepared remarks, I think the range of organic growth that we're now giving for the year is 9% to 10%. So at the high-end of that, we've already been at double-digit rates. We are expecting, I think, a stronger performance in the second half in bookings, and with some quite significant potential. So we'll see how things evolve.

But right now, we feel pretty good about the increase that we've just made and the outlook for the remainder of the year, Jon..

Understood. And then, in terms of the margin for this year, just looking at your full year FY '19 adjusted EBITDA margin guidance, you ticked down a little bit from the last 3 months ago call.

Is that mostly due to GECO? Or how much of that is from GECO versus R&D? Maybe versus some mixed changes with the higher growth? Do you think you can sort of level set us on the contributors to the lower margin expectation for this year? Certainly appreciate that the EBITDA number is higher, but just on the percentage number. A lot of people are....

Yes. Sure, Jon. I mean, I think if you look at the guidance that we had before, the midpoint of the EBITDA was about 22.4%. You look at the midpoint of our EBITDA margin now, it's 22.1%. GECO doesn't really have a major impact on that. It's about kind of 0.1%. It's small.

So you're looking at -- though going from 22.4%, down to kind of 22.2% on the margin decline. That's really driven by the additional R&D investment that we're making in the second half, when you compare it to our previous guidance.

And that's about -- that's just a couple of million, but it has a small impact on the margins, probably 0.3%, something like that. So it's really the R&D, a little bit GECO, but it's really the additional investment. And remember that the CRAD that we've talked about in the past can impact gross margins, but that's offset by the internal R&D.

So that's not driving any changes to EBITDA from our previous guidance..

Okay. And then, just a quick follow up on that idea of the CRAD versus the IRAD. I certainly understand how they're sort of the two pieces of – two slices of the same pie.

But whether you increase IRAD plans for second half, does that change at all your CRAD wins expectations, so to speak? Or CRAD's running high, but this IRAD happened to be picking up a little bit as well?.

So we're increasing IRAD to really accelerate the development of some of our own secure and trusted motherboards, associated with the acquisitions of Themis and Germane. So we see an opportunity of continuing to capture new design wins, and we have made the decision to spend a little bit more money in the second half to accelerate that..

Yes. And to get it - Jon, to get it back into our target model. I mean, you'll see because of all the CRAD, our IRAD in the first half was about 10.3%. And what we want to do is for the opportunities that Mark just mentioned, increased our R&D in the second half to get it back into the range because we're seeing a lot of opportunities..

We are. Right. So I mean, the level of new design win activities I mentioned is literally the highest I've seen since joining the company. CRAD alone is up 62% in Q2 on a year-over-year basis.

So there is a lot of new activities underway, and we're well positioned to capture those, which is again, part of the reason that we're actually raising our total revenue guidance organically beyond the acquisitions that we just announced..

Understood. Thanks, guys. I’ll hop back in the queue..

All right. Thank you..

Thank you. And our next question comes from Sheila Kahyaoglu of Jefferies. Your line is now open..

Hi, good afternoon, Mark, Mike. Thank you for the time. Just on the Avionics market.

How could we categorize how big it is, the addressable market, for you? And then, when we look at the combination of the 3 deals, how they should contribute to the top line?.

Sure. So the overall C4I market is slightly over $17 billion, off the top of my head, Sheila, I haven't got the actual breakdown between the various lines, the C2I, the comms market, and the mission computing. But we feel the churn is really across all 3 of those submarkets. And we're actually growing the business substantially in all of them.

So it's an area that we focused on strategically, it's an area that we're pretty excited about. As I mentioned in the prepared remarks, we created over an $800 million opportunity pipeline. And the deals that we've done to date, we expect to continue to grow that over time..

Is there any way to think about how big your business is within that?.

In terms of the revenue today by market segments, let's have a quick look. So C4I in the fourth -- sorry, in the second quarter, is 30% of total revenue. On an LTM basis, it's around about 27%. So we've created a pretty significant business in really a pretty short space of time.

And the good thing about it is that we're obviously able to sell into the same customers on existing programs, as well as into existing customers on new programs. And I think we're bringing the dimension of being able to add security into those solutions. So our customers are pretty excited about the opportunity there..

Sheila, I would just add, if you're looking just at the Avionics, it's really, as Mark said in his prepared remarks, in addition to the whole C4I, it's really CES that is -- that we bought a couple of years ago. And that's really growing well..

That's doubled in size since we bought it..

That's doubled in size. Richland Technologies, which is a smaller acquisition, but gave us really important technology. And then, GECO, today, which we said was about $20 million of revenues. So it's -- we're building up mass in that business, but there's a long way to go and a huge market opportunity..

Yes..

On GECO, who competes for that product line? Would you come against like somebody like a Harris? Or is it tech companies? Who is competing with those guys?.

Yes. It's not really our customers, I mean we're selling into the same customer set. We're not looking to compete with our customers directly. But as we've seen elsewhere, many of our customers were actually looking to outsource more of the work that they're currently doing in-house at the subsystem level.

And they are focusing on being able to pull together more of the complete solution. So that's the trend that we are pursuing. And we're now pursuing it in the C4I market, as well as in the Sensor and Effector market, which is where we've been historically. So same trend, just different types of computers onboard the platforms..

Sure.

And then, last question, I think, Mike, you said, second half free cash flow decelerates, is that right? Or did I misunderstand?.

Yes. No -- so free cash flow is still solid. And we still think that free cash flow target of 50% over time is reasonable. For H1, we are right at that level. Working capital as a percentage of revenue is down. So we're happy with where the free cash flow is coming out.

What I did say is that we do expect increased capital spending in the second half of the year. That's driven by the consolidation of our West Coast facilities. We're looking at 5% CapEx as a percentage of revenue for the year. We were mid-3% for the first half. So that implies 6% in H2.

So we'll have some headwinds, so we might be a little below 50%, but we continue to be happy with how the business is generating cash. And over the long term, we still believe that 50% free cash flow to adjusted EBITDA is a good target for us. But we do have some expansion CapEx in the second half..

Associated with the acquisition integration, which is really what drives our -- the changes in CapEx on a period-to-period basis..

Thank you..

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

Thanks very much. Good evening. Just a couple of quick questions.

When you think about that facility consolidation and the work you're doing on the West Coast there, can you lay out kind of the time line? And I guess, maybe, some of the tail on that and whether, as in the past, is there some excess inventory that comes with a consolidation kind of we need to get burned off into the next year, just so we can kind of model that out?.

So we expect the opportunity to be complete by back end of this year, early next from an RF perspective. We've got to build out the facility, and then, basically move into it, consolidate some of the operations.

We've already gone from three sites down to two, so we closed an additional site -- how long ago was that? Couple of – three quarters ago?.

Yes..

And so this is kind of the final phase. We don't expect any inventory write-offs or anything like that associated with it. It's literally just building out capacity on the West Coast to be able to absorb the growth that we see in the business..

Okay. Okay. Okay.

And then, apologize if you addressed this, but the additional R&D that you're adding for the second half is focused on which area?.

So we're investing pretty modestly. It's kind of a couple of million dollars to really accelerate the development of our own additional secure and trusted motherboards associated with the acquisitions of Themis and Germane..

Okay, great. Thanks very much..

Thank you. Our next question comes from [Pete Stavisky] of Tech Global. Your line is open..

Nice quarter, guys. Hey Mark, the $40 million flight controller contract that you won, it looks like a really nice win, and it sounds like maybe that gave you some upside to get to revenue guidance next year.

Can you give us any more detail in terms of whether that's a military platform or a commercial platform? And one thing I wasn't clear about, the $40 million over 10 years in, is that just design? Or is that - or is there production opportunity on top of that as well?.

Yes. So we did the military platform. It's a medium altitude UAV, where we won the fight controller mission computer as well as the ground segment. It's working with a non-U.S. front to do that. And that really stems from the acquisition of the CES business back a couple of years ago. So we're working on the development of that.

And over time, the program will go into production. So it does have a production element associated with it. It's not really the primary driver of the growth that we're seeing this year. I think the primary driver of the increase in the forecast beyond the acquisition is some of the work that we have won on some next-generation missile systems..

Okay. Okay. Understood.

And then, just sorry if I missed this, but GECO, is it going to be accreted to GAAP EPS this year? Or are they a money-losing operation? Could you give a little more color on that?.

Yes. No, it's small. So it's effectively on an adjusted EPS basis, just slightly accretive. So $20 million of revenue run rate, but for the year, our guidance has $6 million of revenue. It's about 15% EBITDA margins in there. So a little less than $1 million of EBITDA.

And when you look at the expenses, it's really just interest expense so it's making money, but for us, it's relatively immaterial on the EPS line. From a GAAP EPS standpoint, there's, I think, about 700k of amortization just in the numbers. So it might be ever so slightly dilutive there. But on an adjusted EPS basis, it's slightly accretive..

Okay. That's helpful. Last one for me.

Just on CRAD, one thing I'm not clear about, what's the percentage of your CRAD revenue? I mean like an '18 or a '19 basis? And I guess, should we assume this could be down in fiscal '20?.

So we actually haven't broken out specifically how much it is as a percent of total revenue. But we have increased, particularly, I would say in the last 2 years, as we've seen kind of the increase in the budgets and the focus on our customers modernizing with that customers various systems.

And we're, obviously, participating heavily in those upgrades. So CRAD is up 62% in Q2, and it's up 53% on an LTM basis through the end of Q2. So I think it's going to continue in the short-term. It's hard to predict exactly what the growth rate is going to be.

But we are seeing a tremendous amount of new design win activity, really, in a number of different areas, significant opportunities in the missile defense domain where we're seeing upgrades of various ground-based radars and new radars coming online that we're participating in.

We're seeing upgrades associated with various EYR systems associated with A2AD capabilities. We talked about a little bit about the opportunity that we see in the C4I space around rugged servers and Avionics. Significant opportunities in EW to deal with kind of some of the emerging threats that we see, as well as some small form factors.

And then, two other areas that are being pretty rapid growth for us, albeit off a smaller base, is in the smart munitions domain. And then, finally, space, where we've got some very interesting technologies and we're starting to see some new design win activities. So we're involved in a lot of things.

We've got some amazing technology that we've been investing in for a period of years now, and our customers see that. And they're supplementing R&D with the some of their own to rapidly adapt that technology to those new and emerging opportunities..

Okay.

And just so I'm clear guys, CRAD comes through as either 0 market revenue? Or like low single digit margin revenue? Is that right?.

It's lower margin in the lower end of the kind of the target model that we have for gross margins. But it's not zero margin..

Okay. Thanks very much..

Thank you..

Thank you. Our next question comes from Ken Herbert with Canaccord. Your line is now open..

Hi, good afternoon..

Hi, Ken..

Mark, just wanted to ask first, if I look at the, either the quarter 11% organic growth or the full year sort of 9% to 10%, is there any way to parse that out by what you're calling out as the driver.

I mean, how much of that would be end market sort of fundamental growth versus either share gains you're seeing or as part of the secular trends you've identified? And is there any way to quantify some of the unique opportunities to Mercury relative to the broader industry growth?.

Yes. Not necessarily kind of numerically, but we are seeing broad growth over the majority -- in terms of the 2 major markets, Sensor and Effector and C4I, overall.

And then, kind of beneath the covers, if you look at the submarkets, we're pretty much seeing growth across all of our major market segments and with pretty strong book-to-bills expected in them also. Beyond that, I do believe that the trends that we've mentioned around outsourcing is alive and well.

If you look at the growth in our subsystems revenue in Q2, it was up 109% year-over-year, and our LTM subsystems revenue was up 62% through the end of Q2, which is, obviously, driven some of it by the acquisition, but a lot of it is also just organic growth where we're capturing share at the subsystem level, either through outsourcing or by taking share.

We're clearly taking share for a technology perspective in 2 different areas. One is in RF, where we've talked about historically where there's really a flight to quality, where our customers are struggling with a number of different companies, and we've been quite successful at taking away some of that business.

Some of it is next-generation, some of it is business, but it's beginning to move into production. And then, the other area is in secure and trusted computing, where we are now on our fourth generation of embedded security.

And what we're seeing is a wave of activity there, and we believe that pure computing is now really beginning to cross the chasm, and Mercury is - with some industry-leading technologies, and other companies don't, and we're beginning to take share in that space as well..

Okay. Great. That's helpful.

And then, as I look at Themis and Germane, have you talked about or can you provide any more detail on when you expect, with the ramp there and the improvement, if they start to hit sort of company margin levels? What should we expect -- or how should we view that sort of headwind to taper down over the next few quarters?.

We haven't been specific, right, about the actual timing of it. But I'll tell you that the integration of those 2 business is progressing extremely well.

I would say, we're actually slightly ahead of where we thought we were going to be, in terms of our integration activities of Themis into Mercury, and then Germane into Themis, and Mercury as a whole. So there's a lot of work underway. The team is performing extremely well. We're seeing a lot of opportunity.

And if you would like to comment on that, Mike..

Yes. Ken, what we did say is when we announced the Germane acquisition, which was on our Q4 earnings call, so we closed it in July, that we expected a run rate of $5 million of cost synergies and that we would hit that full run rate by the end of fiscal '20.

So that can provide you some guidance in terms of looking at their revenue and those synergies when we think they're going to get back to the EBITDA range. But we haven't provided a specific quarter. But....

We're on track to do..

We're on-track to hit the synergy plan that we announced and talked about on that call when we announced the transaction..

Yes..

Great. That's very helpful. And just one final question. You've talked, Mark, a few times or mentioned that bid and quote activity seems to be the highest you've seen it in quite some time.

Have you seen any acceleration now into sort of fiscal '19? And is there any - sort of any reason to expect that, that elevated level of activity wouldn't sort of maintain, at least through calendar '19?.

So I don't see a reason why it wouldn't continue. I mean, I think as I said in the prepared remarks, after organic revenue growth target, 2 to 3 points versus last fiscal year, now we're kind of expecting the range of 9% to 10%.

There's a lot of new design win activity, and a good example of that are a metric that you can point to is just that increase in CRAD that I just went through the statistics on it earlier. So we feel really good about the position, we feel really good about our capabilities, the markets that we're in, and our ability to continue to take share.

Now given the some of the early stages of those design wins, they're obviously not going to go into production for some time because we're working on some next-generation capabilities. But there's a lot of new activity underway..

Great. Thank you very much..

Thank you. Our next question comes from Michael Ciarmoli of SunTrust. Your line is now open..

Hey, good evening, guys. Thanks for taking the questions, nice quarter. Mark, just to maybe stay on the topic. I mean, you guys have talked now, I mean, there's been a lot of Q&A here about the design wins, the bid and quote activity you just covered being so high.

I mean, what are your thoughts on the pending fiscal '20 budget? I mean you've got to feel pretty good here.

And I mean, that kind of gets complemented I guess with the missile-defense review, where some of your big programs seem to be getting even more priority? And maybe even if you can talk about, is there going to be any potential opportunity for you guys on the radar and sensors that are going to be needed for both the hypersonic strike and counterstrike systems?.

Sure. So multiple questions there. I think, on the budget side, we'll see what ends up playing out for fiscal year '20. Obviously, there's a kind of range of what the alternatives here might be.

We continue to believe that if you look over a multiyear period, we're still going to be operating in kind of the low single-digit growth on a compounded basis, depending upon what your starting point is. We also believe, however, that our ability to grow above that, as we have been doing remains very strong.

We are seeing opportunities in missile-defense. So we're seeing a, I would say, probably three or four upgrades, as well as new potential missile-defense systems. And I think with our processing capability, we are well positioned in a number of those. We're also involved in a number of next-generation missile systems.

I'm not going to mention which ones they are or what type of weapons they are, but a big reason -- or a primary driver of, actually, the increase in organic revenue this fiscal year is being driven by one of those new design wins that is moving relatively quickly.

So I think we see a lot of opportunity in missile-defense, in missile systems, whether it be as a replenishment or new technologies and capabilities that need to be added to those systems. We're seeing a lot of work that is underway related to dealing with anti-access capabilities that will lead to investments in new EO/IR systems.

We're also seeing similar investments in EW where we think that we're really pretty well positioned. So, yes, I really like how we're positioned right now with respect to how the world is evolving and where we think the monies are going to flow, Mike..

Got it. Got it. Makes sense. And then, maybe just one last one here, and shifting gears, I think, you commented around opportunities for working capital efficiency.

I mean, is there anything else you guys are looking at along your supply chain? What could be insourced? I know you've kind of talked about that already on prior calls, but maybe talk more about what you can do to optimize and create more efficiencies in working capital?.

Sure. It's just not working capital. So I think as I mentioned in my prepared remarks, right, in Q2, early Q2, Amir Allahverdi joined the company. Amir ran operations for Meggitt and had a very expansive set of factories on a global basis across the world.

And Amir was really responsible for introducing what became Meggitt operating system, which is what ended up kind of leaning out their manufacturing operations. One of the biggest changes that's occurred to Mercury, or occurred inside of Mercury over the last 5 years, is the buildup of our own domestic manufacturing capabilities.

Some of which were existing that we've expanded, in particular, in RF. Orders are relatively new, such as from the custom microelectronics that we acquired with Microsemi, and then we build out the digital SMT manufacturing facility in Phoenix.

So as we are kind of entering into this next phase, it's all about looking at improving not only our working capital efficiencies, but the manufacturing operations themselves. And that work is really just beginning. And that's what we brought Amir onboard today. So we do see an opportunity, and we're already seeing some of the results.

I'll give you an example. In the U.S. alone, which is our facility, manufacturing facility, in Phoenix, the new one that we stood top, we had a record output in terms of the amount of COGS that was shipped in the second quarter. And that was a record shipment in terms of the number of boards.

We've seen a pretty significant increase in terms of on-time delivery. We've already begun to see a reduction in work-in-progress. So we're on a journey, but it's not just the facility in Phoenix.

We're going to go after improvements in all of our manufacturing operations given that we think that they're strategically important to our ability to deliver what our customers’ needs in terms of domestically developing produce technologies, and also the impact it can have on our financials. So that's where we're currently at, Mike..

Got it. Helpful, guys. Thanks a lot..

Thank you..

Thank you. And we do have a follow-up question from Jon Raviv of Citi. Your line is now open..

Thanks for taking the follow-up. I'll keep it brief. Just on capital allocation. GECO looks good. But any perspective on doing something transformative? How you're thinking about equity versus debt funding? And then also, how have conversations changed, if at all, in recent month there.

It seems that budget constraints have started away on multiples for this space?.

Okay. So I'll start it off, and I'm sure Mike will want to chip in. So we see a very robust pipeline of opportunities, and this particular opportunity, we've been in conversations with the owners of GECO for quite some time.

It's a proprietary opportunity that we uncovered and we've worked the relationship and developed the relationship that led to the deal that we announced today. The way which we think about M&A is really thematic. So we've got, as I mentioned, a couple of different themes underway in the C4I space.

Those being rugged servers, where we did the 2 significant acquisitions, Themis and Germane, to create one of the industry's leading rugged server manufacturers and developers. And the other theme is the one in Avionics processing, where we prosecuted three acquisitions in the last two fiscal years alone.

We're going to continue to acquire in that space. And there are additional opportunities that will expand those themes as they develop. And I'm not going to go into specific details as to the sort of things that we're pursuing there. But we do see the opportunity to create a potentially significant businesses through future M&A.

We're also going to continue to acquire in the other part of the market, which is Sensor and Effector. We've done several acquisitions in the RF domain. We are very choosy what type of acquisitions that we do there.

And we're looking to not just gain scale for the sake of it, but to have added capabilities that will matter to our customers, with the margin profile as much as what we're trying to do. We've also done work in the custom microelectronics domain.

We've dramatically grown the business that we acquired through Micro Semi under Mercury, and we see additional opportunities for us to continue to grow in that domain. And then, beyond that, there are probably 3 or 4, or maybe even more, themes, that we are considering and potentially pursuing at some point.

So there's a fair amount of opportunity for us to continue to grow. For Mercury, it always starts with strategy. It's not just about gaining scale, it's about creating value, and how we create value through the strategy that we're pursuing. So I'll throw it over to Mike to maybe kind of add..

Yes. Well, Jon, I'll give you a little bit more. So that's the strategy just from a tactical standpoint. You asked about the pipeline, the pipeline's really active. We're seeing deals of all sizes, small, medium, large. We're very active in terms of sourcing new deals on a proprietary basis.

GECO is a great example of that, because M&A is such an important part of our strategy, we have a very active outreach program. And as Mark said, for us, it's just sticking to our strategy in finding good strategic acquisitions, paying fair prices, and then, recognizing the cost of revenue synergies.

What we've done a good job at, we think, is being disciplined in prices we've paid over the last couple of years, even when trading multiples were relatively higher or higher than they are today. And acquisition multiples were high as well.

So we've passed on quite a few deals over the last couple of quarters and years due to valuation expectations, and prices ultimately paid. We'll see if the recent re-rating of defense trading multiples impacts transaction valuations at all. From our standpoint, we're just going to keep continuing to do what we've been doing.

And that's remain disciplined on valuation and acquiring companies that stick with our strategy..

And where we can also really extract cost on revenue synergies. That's been a really important part of our strategy. We're prepared to pay fair market price as -- where we think that we can create value for our shareholders by fully integrating the businesses into Mercury.

I think as we outlined in our Investor Day in November, when you look at the growth purchase price versus the net of the acquisitions that we've done over the past 4 or 5 years, there's a substantial delta there. And we think our strategy is working, Jon..

Thanks a lot, guys..

Thank you..

Thank you. And Mr. Aslett, it appears that there is no - or there are no further questions. Therefore, I would like to turn the call back over to you for any closing remarks..

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

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day..