Mark Aslett - President, Chief Executive Officer.

- :.

Good day, everyone, and welcome to the Mercury Systems Third Quarter Fiscal 2020 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, Mr. Mike Ruppert. Please go ahead, sir..

Good afternoon and thank you for joining us. On the phone 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 www.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 & Presentations. Please turn to slide two 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 two, in the earnings press release and the risk factors included in Mercury's SEC filings, including the new cautionary statement and risk factor related to COVID-19.

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 three..

Thanks Mike. Good afternoon everyone and thanks for joining us. We hope you and your family are staying safe and healthy. I'll begin today's call with a business update. Mike will review the financials and guidance and then we'll open it up to your questions.

First, I’d like to say thank you to all the courageous healthcare workers on the front lines that are fighting this pandemic. Our thoughts and prayers go out to all of them at this very difficult time.

Second, I’d like to express how deeply thankful we are to our employees, their incredible results and the sheer will they demonstrated in overcoming the challenges that we're facing. Mercury rose to these charges very early on.

Well before the coronavirus was declared a pandemic we set up a COVID crisis team and defined three goals to guide our decision making and actions. Number one was to protect the health, safety and livelihoods of our employees.

Second, reduce and mitigate operational and financial risks in the business; and third, continue to deliver on our commitment to both our customers and shareholders.

Finally, when the defense industrial base became designated essential, we added a fourth goal, which is to continue the mission critical work Mercury does every day to support the ongoing security of our nation.

We've used these goals along with our purpose, culture and values as a touchdown for setting our priorities as we transitioned our operating model to a daily crisis mode. I think this made an enormous difference to our speed in communicating and taking action, and in how effectively we reduced and mitigated risk to our employees and to the business.

In mid-March Mercury was classified as critical infrastructure as defined by the Department of Homeland Security. This exempted our U.S. facilities from local, state and federal state mandates. Before that however we were impacted mainly in California by temporary shut downs at some of our manufacturing sites.

These closures reduced the stay-at-home orders that vary from county to county. Also Mercury was designate as an essential business at the national and state level. We resumed normal operations at those sites.

Meanwhile, everyone in the company who could, began working from home and at the same time we adjusted workplace conditions significantly for everyone else to create physical distancing and make things safer inside of our facilities.

Turning to slide four, while all that was going on, we still ended up delivering a very strong quarter with record bookings, record backlog, a 1.2 book-to-bill, an 11% organic growth versus a strong Q3 last year.

Total revenue, net income, adjusted-EBITDA, EPS and adjusted EPS came in above the high end of our guidance, with all hitting new records for the quarter. It was also a very strong quarter in terms of new design wins and fee cash flow, so all-in-all an outstanding effort by the entire team.

Looking ahead, we are aware of the risks that we face, especially around the supply chain, our manufacturing facilities and the hiring. We believe Mercury has the strength and liquidity to endure a range of possible downside scenarios. We feel good about our strategy and the plans we have in place, as well as our continued ability to execute.

Moving to slide five, we truly leaned in to take care of those employees who we deemed to be most vulnerable as this crisis developed. The feedback we received has been amazing and I'm very proud of what we've been able to do for our people.

Touching on the highlights, we continue to pay hourly employees working in our California sites that were shut down temporarily. We’ll do the same at other facilities that may be impacted as the crisis continues. We've increased overtime pay to 2x the regular wage and enhanced our sick leave policy.

In addition, we created a $1 million emergency relief fund, which will increase if need be. Through this fund we made immediate payments to our hourly employees experiencing financial burdens and hardship. We also gave managers discretion to approve additional advance as necessary. These payments we learned met two kinds of needs.

Initially they helped our lower paid employees stock up on food and supplies, as well as deal with other issues related to stay-at-home. More recently, although Mercury’s employees are still gainfully employed, many family members have lost their jobs creating a second wave of financial burden and worry.

The relief fund is now helping to buffer the secondary financial impact, while they wait for unemployment insurance and other federal programs to kick in. Mercury’s purpose, culture and values are not only about delivering results for customers and shareholders, but about helping and caring for one another.

The fiscal year revenue and adjusted EBITDA guidance we are providing today, which is unchanged from our previous guidance on the top end, reflects our confidence in Mercury's business, as well as the result of our employees to overcome the challenges that may lie ahead.

As Mike will discuss in detail, we expect the fourth quarter to include another year of double digit growth in revenue and adjusted EBITDA, including 13% to 14% organic revenue growth. Turning to slide six, the new business conditions remain robust.

The coronavirus has not diminished the threat environment and our nation's defense priorities have not changed. Looking forward we don't expect the COVID crisis to have a near term material impact on defense spending. The majority of Mercury’s business is mission-critical to our customers and end users, which are largely U.S. based.

We are maintaining a dialogue with them and our engineering and operations teams are working hard to deliver on our commitments. That said, the COVID crisis did have some impact in Q3. We saw some slowdowns as customers began transitioning to work-from-home. This resulted in some brief delays in order approvals and order flow.

The industry wide suspension of travel affected new business activity as well. Since then we've seen these issues improve somewhat as everyone has become more attuned to working remotely. Against this backdrop, Mercury performed very well on the topline in Q3.

We continue to believe that we are targeting and participating in the right parts of the market. The wave of modernization occurring in radar, EW and C4I continues to drive growth in the business. Demand in weapon systems, space, avionics processing and mission computing, as well as secure rugged servers remains healthy.

Mercury’s strong bookings and design-win activity in Q3 continue to be driven by the three major trends that we discussed in the past. Supply chain delayering by the government and the primes; the primes flight to quality suppliers, and the increased outsourcing via customers at the subsystem level.

For years now, we’ve invested in our people, processes, technologies and trusted domestic manufacturing to support the continued organic growth in the business. These investments are proving their worth now. Going forward, we believe that they will be even more important given our national dependence on foreign supply chains and manufacturing.

We continue to deliver our products and services to our customers and the fundamentals that drive growth in our business have not changed. We've been closely monitoring our supply chain, which is predominantly U.S. based.

During Q3 we made some forward inventory buys and pre-ordered raw materials to mitigate risk in both the short as well as the mid-term. Thus far however the pandemic’s impact on our supply chain and suppliers has been relatively low. The key supply chain issues that we're facing are two-fold. The first is the suppliers maybe financially vulnerable.

This applies more so to those supplies that are heavily exposed to the commercial aerospace sector. As you know, commercial airspace has being significantly more impacted by COVID than defense.

The other major supply chain risk is the potential for COVID related manufacturing disruptions, that is temporary flight shutdowns that could affect the supply of U.S. sourced components to Mercury. We are also facing other operational risks. The first being the potential for COVID related disruptions within Mercury’s own manufacturing facilities.

We are closely monitoring the time to peak infection and the affects that social distancing is having in flattening the curve in communities around our manufacturing sites.

We've done a tremendous amount to communicate with and educate employees, as well as to increase physical distancing and reduce the risk in event occurring inside one of our facilities. That said, this risk does remain elevated. The other risk relates to the hiring of new talent.

Although our time to hiring metric has not changed that much, our ability to hire in a timely manner could be affected if the COVID crisis continues for a prolonged period of time.

The outcomes are hard to determine right now, but based upon the planning and the scenarios that we’ve run, the overachieving in Q3 and Mercury’s record third quarter backlog, we currently feel good about our ability to deliver against the goals and objectives we set for fiscal ‘20.

As outlined on slide seven, we are optimistic about Mercury’s opportunities for continued growth, driven by the trends I just discussed. At this stage, we have not changed our long term baseline forecast for low single digit growth in overall defense spending. That said, there are two risk factors to consider.

One is the potential for a prolonged CR in government fiscal ‘21 related to the election. The second is that, as we continue to see massive fiscal stimulus, the potential for those dollars to crowd out discretionary spending, including defense exists over the long term.

While recognizing these uncertainties, we are still focused on the goal of delivering organic revenue growth at a rate that far exceeds the industry average, and we have the balance sheet strength to supplement this organic growth with M&A.

From an M&A perspective, we continue to focus on the Sensor and Effector Mission Systems and C4I markets looking for deals that are strategically aligned and have the potential to be accretive in both the short and long term.

That said, the M&A market is effectively shut right now given the challenges associated with determining asset values, pricing risk and conducting focus diligence. Once we get through the crisis, we anticipate seeing more opportunities than before. Certain companies may be motivated to sell in this environment.

They look for a partner that’s fiscally sound, has a great culture and values, has done the right things for employees and has continued to deliver for customers and shareholders. We are one of those companies.

As an employer and an acquirer of choice, we believe Mercury will emerge from this crisis stronger than before and we were already very strong. Our balance sheet is sound and the business is performing well and we’ve got an exceptionally talented and dedicated workforce.

When M&A activity resumes, and we believe it will, we’ll be in a strong position to continue to execute on our strategy; namely, to deliver strong margins while growing the business organically and supplementing that organic growth with disciplined M&A and full integration.

We believe this strategy will continue to generate significant value for our shareholders over the long term as we execute our plans in five areas. First, to grow our revenues organically at high single to low double digits averaging 10% over time and to supplement this high level of organic growth with acquisitions.

The second is to invest in new technologies, our facilities, manufacturing assets and business systems, as well as continuing to invest in our people. Third is manufacturing insourcing, as well as driving stronger operating performance across our manufacturing locations. Fourth, we are seeking to grow revenues faster than operating expenses.

This will allow us to continue investing in organic growth, while maintaining strong operating leverage in the business. And finally, we are fully integrating the businesses we acquire to generate cost and revenue synergies. These synergies combined with other areas of the plant should produce attractive returns for our shareholders.

This strategy has worked very well for Mercury over the past five years. Given our ability to execute, we're confident the market will extend this record of success. We have a clear picture of where we think the risks are greatest.

We've been diligent in working to reduce and mitigate those risks and we're committed to doing everything that we can to finish the year with a strong fourth quarter. With that, I’d like to turn the call over to Mike. Mike..

Thank you, Mark and good afternoon again everyone. I'll begin by echoing Mark's comments and extending my appreciation to our employees for the outstanding work they did this quarter. Thanks to their efforts, we were able to leverage Mercury's strong financial position to adapt to the new environment and deliver record results in Q3.

As Mark said, we acted quickly to protect the health, safety and livelihoods of our employees. We worked to reduce and mitigate both supply chain and manufacturing risk, and we continue to fulfill our commitments to our customers.

In order to support our customers, we accelerated some of our product deliveries during the quarter, helping them de-risk their businesses. We also acted quickly to identify and assess potential COVID-19 impacts on our financial position.

Early on, the biggest risk we saw was the potential for multiple site closures for an extended period of time as a result of government stay-at-home orders that were being implemented. In response, we ran various scenarios looking at the impact of prolonged shutdowns on our cash flow.

We entered Q3 with an extremely robust capital structure with over $900 million of liquidity between cash-on-hand and our underfunded $750 million revolver.

In all the scenarios we examined, including potential closure of our manufacturing company wide, we determined that Mercury would have ample liquidity to continue to fund the business for an extended period of time.

Since we've been designated as an essential business, extended shutdowns of our facilities as a result of government orders have not occurred, nor do we think they are likely to occur. Overall, we believe we are well positioned to continue to execute our strategy, while simultaneously managing risk related to COVID-19.

While this risk does remain elevated, we are maintaining the top-end of our previous guidance for the fiscal year and raising the bottom end now that we are in the fourth quarter. I'll provide more detail around our guidance later in the presentation.

Turning now to slide eight and our third quarter results, total bookings for Q3 increased 32% year-over-year to a record $250 million, driving a 1.2 book-to-bill ratio.

As Mark mentioned, we did see some COVID-19 impact as our customer’s transitioned to working from home, but those issues did not have a material impact on our bookings or ending backlog. In Q3 and so far in Q4 we've not seen a slowdown in new business activity as a result of the ongoing pandemic.

In Q3 revenue increased 19% year-over-year to a record $208 million, exceeding the top end of our guidance of $190 million to $200 million. This out-performance was primarily driven by timing of revenue, including the early customer deliveries that I mentioned.

Organic revenue was up 11% in Q3 and we currently expect organic growth of 13% to 14% for the full fiscal year, assuming no material impact as a result of COVID-19. Adjusted EBITDA for Q3 increased 21% year-over-year to a record $47.1 million.

This exceeded our guidance of $42 million to $44 million, driven primarily by higher revenue, as well as higher gross margin due to program mix and increased manufacturing throughput. Adjusted EBITDA margin was 22.6% for the quarter. This compares with our guidance of 22.1%, again reflecting program mix and increased throughput.

In Q3 we expanded our definition of adjusted EBITDA to include an add-back for incremental COVID related expenses, totaling approximately $400,000 for the quarter. These costs related primarily to enhanced compensation and benefits for employees.

It also included incremental supplies and services to support social distancing and to maintain safe and healthy conditions inside our facilities. Slide nine presents Mercury’s balance sheet for the last five quarters. Entering Q3 Mercury had cash and cash equivalents of $182 million, no debt and a $750 million unfunded revolver.

This gave us a great deal of flexibility as we faced potential negative financial impacts associated with COVID-19. In March, the pandemic’s impact on the financial market was uncertain and it looked like there was a chance that state and local governments could at some point close Mercury's facilities.

As a result we decided to draw $200 million from the revolver out of an abundance of caution. We’ll continue to evaluate the markets and the impact of COVID-19 on our financials, with an eye towards paying down the $200 million when the conditions are favorable.

After taping the revolver, Mercury finished Q3 with cash and cash equivalents of $407 million. We had $200 million of debt from the funded portion of the revolver and we still have the remaining $550 million available. So despite continued uncertainty, we remain extremely well positioned from a liquidity standpoint.

During Q3 we also decided to advance purchase inventory in order to mitigate potential disruptions to the supply chain. While materials were ordered, they were not delivered by the end of the quarter, so there was an immaterial impact to our inventory balance at the end of Q3. We do expect to see some impact to our Q4 inventory.

Turning to cash flow on slide 10, free cash flow for Q3 was $19.2 million, representing 41% of adjusted EBITDA, which was slightly above our expectations. We saw a $300,000 impact to Q3 free cash flow as a result of COVID-19 expenses, primarily related to the employee relief fund. We expect to see additional COVID related expenses in Q4.

Capital expenditures in Q3 were $10.9 million or 5.2% of revenue, compared to $11.3 million or 5.8% last quarter. CapEx was slightly lower than we expected due to COVID-19, as some equipment scheduled to be delivered in Q3 was delayed into Q4.

We expect CapEx to increase in Q4 as we continue to invest in the business, including our custom microelectronics build-out in Phoenix. Year-to-date our free cash flow is a percentage of adjusted EBITDA is 43%. For Q4 we are expecting a lower percentage driven by increased capital expenditures and an investment in inventory as a result of COVID-19.

For the year we continue to expect free cash flow as a percentage of EBITDA to be approximately 40%. I'll now turn to our financial guidance starting with the full year of fiscal ‘20 on slide 11. As we discussed, our outlook for fiscal ‘20 remains strong, although risk remains elevated due to the uncertainties around COVID-19.

The full year guidance we are providing assumes no major supply chain disruptions, no extended shutdowns of any of our facilities and no material change in customer behavior, none of which have occurred to-date.

While our guidance assumes no major disruptions due to COVID-19, our guidance range does incorporate some room for temporary disruptions in the event they were to occur. For the full fiscal year we now expect revenue of $785 million to $795 million, representing growth of 20% to 21% from fiscal ‘19.

This is consistent with our previous guidance and reflects our outlook for 13% to 14% organic growth. Total GAAP net income for fiscal ‘20 is expected to be $76.1 million to $78.3 million or $1.38 to $1.42 per share. Adjusted EPS is expected to be in the range of $2.12 to $2.16 per share, an increase of 15% to 17% compared to fiscal ‘19 results.

Our fiscal ‘20 guidance for adjusted EBITDA is $173 million to $176 million or approximately 22.1% of revenue. This is an increase of 19% to 21% from fiscal ‘19. Finally we expect CapEx for fiscal ‘20 to be approximately 6% to 7% of revenue and free cash flow to be approximately 40% of adjusted EBITDA.

I'll now turn to our fourth quarter guidance on slide 12. This guidance reflects our out-performance in Q3, coupled with our belief that Mercury’s actions in response to COVID-19 have de-risked Q4 to some extent. It also incorporates as I mentioned, room for temporary disruptions should they occur during the quarter.

Doing the math based on our actual results for the first three quarters, we are forecasting Q4 revenue in the range of $205.8 million to $215.8 million, an increase of 16% to 22% compared with Q4 last year. Q4 GAAP net income is expected to be $17.6 million to $19.8 million or $0.32 to $0.36 per share.

Adjusted EPS is expected to be $0.54 to $0.58 per share and finally, adjusted EBITDA for Q4 is expected to be $46.4 million to $49.4 million, representing approximately 22.5% to 22.9% of revenue. Turning to slide 13 in summary, our record Q3 results are a testament to the phenomenal employee team we have at Mercury.

We believe Mercury’s business remains aligned with fundamental trends in our industry and our record revenue and bookings highlight that. The company's strong cash flow and capital structure position us well, not only in this time of uncertainty, but also to continue to execute on our strategy.

Meanwhile, during the time of unprecedented challenge and change, the four goals that Mark outlined will continue to serve as a touchdown for our decision making and actions.

And as we come out of this period of uncertainty, we're confident in our ability to continue executing on our long term value creation strategy of margin expansion and organic growth, supplemented with strategic M&A. With that, we'll be happy to take your questions. Operator, you can proceed with the Q&A now. .

Thank you, sir. [Operator Instructions]. I show our first question comes from the Pete Skibitski from Alembic Global. Please go ahead. .

Yeah, hi guys, a very nice quarter. Guys, I think that on the strong bookings in the quarter, I know you talked about not having any big problems there.

But I wondering if you sense at all that you do actually try to accelerate bookings in the quarter to help, because we’ve just seen them take a lot of actions to help out subcontractors I think both from a bookings perspective and then changing progress payments and obviously some of the OEMs have been very public about helping out subcontracts.

So I just wondering if you thought things maybe could have been even a little bit better this quarter and do you not take in some of these actions?.

I don't believe so Pete. You know we didn’t really see too much change in terms of customer behavior during the quarter, once we go beyond the period of them transitioning to work-from-home. So I don't believe the actions that DoD took to accelerate paid performance payments you know had an impact on Mercury in terms of our bookings. .

Okay, any expectation for bookings in the fourth quarter?.

Right now we think that the fourth quarter is going to be another strong quarter. .

Okay, great. Thanks guys. .

Thank you. Our next question comes from Sheila Kahyaoglu from Jefferies. Please go ahead..

Good afternoon, Mark and Mike. Thank you for the time. So just my first question, you noted some risks around COVID, but maybe can you talk about some opportunities. Does it put pressure on some smaller suppliers, so are the primes coming to you guys a bit more.

What sort of new business wins does this open up?.

Sure. It’s a good question Sheila. I think probably in the short term there, you know it’s hard to transition to different supplies. Yeah, we do it in the period of time that you're talking about.

However I do believe that you know over the mid to long term, I do think it's going to open up more opportunities and potentially result in Mercury continuing to take share from some of the companies that maybe all-is-well positioned from a capability or from a balance sheet perspective like we are.

I also think that as you look forward, our business model is very well positioned, right.

So the fact that we're spending very high levels on R&D when our customers need to get access to technologies and capabilities more quickly and more affordably, I think plays well in this environment and I think there is also going to be opportunities as the discussion you know, well I think will – that I believe will continue around you know is it capacity or it is more capability that we need, and you know I think from a capability perspective we're very well positioned.

So we are going to continue to focus on the areas that we have been, because we think that that's where the money is flowing, but I do think there's going to be more opportunities as a result of what’s happened. .

Thank you. And you gave some very candid remarks in your prepared dialogue in terms of risks longer term, as stimulus might take away from defense funding. I guess you're on track to grow double digits this year.

How do we think about fiscal ‘21 and beyond?.

We are not going to guide fiscal ‘21 on this call. We’ll do that on the next call. We haven't adjusted as I said in my prepared remarks, the outlook for growth right now. Our view for quite some time is that it's been low single digits in terms of the growth overall.

As we discussed, you know the growth in the defense budget is actually not the primary driver of our growth. What is the predominant driver of our growth is really more outsourcing by our customers, which we think is going to continue, as well as us transitioning to more subsystems and capturing more content.

So yes, the potential exists over the long term, the potential crowding out of discretionary spending; however, I think we are pretty well positioned all things considered. .

Thank you. Thanks so much. .

Thank you. Our next question comes from Peter Arment from Baird. Please go ahead. .

Yeah, good afternoon Mark and Mike. Mike, just to maybe follow-up on that comment.

Just your 13% to 14% organic growth this year, is there a way to parse out how much of that is coming from outsourcing? I mean I know in the past you’ve talked about certainly you know a few hundred basis points or so that was added on top of you out growing the budget, but it seems like that trend is obviously accelerating. .

Yeah, I mean it's always hard to actually pass that, because again there's not a tremendous amount of publicly available information or research that you can point to.

One of the areas that we have discussed in the past is you know the growth in subsystems and the majority of our revenue, the outsourcing for this current month customers were associated with outsourcing is at the subsystems level and you know our subsystems revenue was up 22% in the third quarter year-over-year, and is up 27% over the last 12 months.

So you know we think that the outsourcing trend is continuing and we are – is a co-part of the strategy as you know. .

Yeah, no, for sure. And then just following-up on your comment on M&A that you made in your prepared remarks. Obviously I understand the pause in activity in the short term, but we certainly heard about some disruptions on the private equity world about doing deals in this environment.

Do you think that's going to prove to be an advantage for you?.

I believe that there's going to be more opportunities once we get out of this period from an M&A perspective. I think it could be accomplice to certain companies that you know maybe pushed them over the edge in terms of where they were on the fence of deciding to sell or not.

If they do, I truly believe they're going to want to join a company that has done the right thing during this crisis, is well positioned for continued growth, that is fiscally sound and growing and has got great cultures and values. So I do believe that there's going to be more opportunities. And it was very interesting in terms of the quarter itself.

I mean the very start of the quarter was very, very active from an M&A perspective, but you know when the crisis you know really took a hold; we saw things really grind to a halt almost mid-quarter. So we think it's going to come back; it’s harder to determine exactly when. .

And Peter I would just add to that. We do have an incredibly strong balance sheet and with the market for private equity as you mentioned in terms of the capital markets and raising financing.

I do think our balance sheet and capital structure are going to be a competitive advantage for us and I do think we'll see some good opportunities coming out of this. .

I appreciate the comment. Thanks. .

Thank you. Our next question comes from Seth Seifman from JPMorgan. Please go ahead. .

Well, thanks very much and good afternoon and good results. Just curious, you touched on this in the near term with regard to the CapEx commentary. When we think about some of the expansion efforts that you guys have under way, that you know takes some time to build out, including microelectronics.

Do see this having any impact on the timing of how those projects get down; you know projects that involve CapEx and facility movement and stuff like that. .

So we saw some delays in the third quarter Seth with respect to our trusted microelectronics initiatives in Phoenix and it was largely a slowdown in some of the equipment deliveries, just because obviously the COVID situation.

I don’t think it’s going to really impact however you know the – you know when you step past the overall opportunity set that we are pursuing. We actually did receive our first award, you know contract or purchase order during the quarter which was pretty exciting, given the stage of where we’re at.

So I don’t think it changes the big picture, but we did see some delays in the – you know during Q3..

Yeah, and Seth as we talked about, we – and for the trusted microelectronics that wasn’t a revenue item in fiscal ’20. That’s a growth opportunity for fiscal ’21 and beyond. So to just echo what Mark said in terms of, we don’t see it having an impact for the short delay of the CapEx. .

Right, right. And then to follow-up, I mean the answer to this question might be kind of obvious, but just to maybe put a little fine point on it. You know you called out the COVID related expenses in the quarter and I think it was 400K and you know mostly related to your employee support.

So the actual cost implementing distancing measures throughout your offices and facilities, I mean I totally understand why you're separating out and it makes sense, but it also seems like it was not very significant and I’d also assume that maybe since the start-up of that happened in March, that would be the period where those costs might be relatively elevated since they are starting up, and so this is something that all of us are thinking about kind of for the first time.

So when we think about the implementation of that going forward, I mean would you expect that to grow significantly from the – I mean I guess it would be three months instead of one, but you would also have done all of the basic work, so how do we think about that?.

Yeah. So I mean fortunately, you know in terms of what could have been a major expense, which was preparing to work from home, we already had that infrastructure in place for quite some time.

It's been an important part of our kind of growth initiative to put a video based collaboration infrastructure in place, which enabled us to very rapidly transition nearly 60% of the workforce to move, you know to operate from home.

Most of the funds that were spent were really about helping out our hourly pay employees and trying to take care of them in the initial phase and then as the unemployment rates spiked and as they were being impacted via other family members and you know the burden of that put on the family, I don't think that we're going to see a significant increase in that expense.

That said, you know it all depends on what happens and so to go back to the scenarios that Mike kind of referred to in his prepared remarks and where we think the risk is, you know one of the risk is that if we saw a temporary shutdown in various facilities, then obviously we’ll be tapping into the use of that emergency relief fund to continue to take care of employees.

So you know right now we don't see that it's going to increase, but it depends on what happens. Mike, if you would like to add anything there..

Yeah, I mean it’s a good question Seth in terms of that cost. I mean you mentioned the fact that we were – most of this was within one month of March and we will have three months in Q4. The biggest portion of that 400K expense was the employee relief fund, which was about 300,000 of the 400,000.

As Mark talked about that, it is a $1 million relief fund and we would like to get that money into the hands of our employees, so we hope to see that pick up in Q4, but we'll see. The other thing that we see is some expenses associated with work-from-home and social distancing.

As you mentioned that while we had some in Q3, we expect those in Q4 as well, but as Mark said, it's really hard to forecast. One thing I would point out is if you look at our guidance, we do not forecast anything associated with those costs, because we don't guide discrete expenses.

From an adjusted EPS, adjusted net income perspective, that'll be added back as we do incur them. I would say from a GAAP EPS and GAAP net income perspective that could be a little dilutive to our Q4 results. But overall our goal is to do what's right for the employees and we hope we can spend as much of the fund as possible. .

Thanks. I appreciate the color..

Thank you. Our next question comes from Ken Herbert from Canaccord. Please go ahead. .

Hi, good afternoon Mark and Mike..

Hi Ken..

So Mark just wanted to be clear.

It sounds like the guidance doesn’t imply or doesn’t factor in any sort of material delay due to some of your supply chain or at your owned facilities, obviously as a result of COVID, correct?.

That is correct. So as Mike said in his prepared remarks, you know we can absorb some temporary delays, but nothing of major significance. .

Okay, and is it – I mean you mentioned you helped mitigate the risk a little bit through a little inventory build and it sounds like you're working with suppliers maybe where you could potentially see a little more risk and it doesn’t sound like these are our big steps necessarily.

So is it fair to say with how things look now, it should be – I mean obviously who knows where we are in the durations here, but you're not expecting any sort of material step down in terms of the impact either on your operations, but it is more specifically your supply chain. .

I believe that's correct Ken. So I think as you kind of go back to what I said in the prepared remarks, it’s really I think three risks that we see. You know the first is a potential impact to our supply chain. We began focusing on our supply chain actually in January. You know the initial focus was on Asia.

It very quickly then morphed into other international, particularly Europe and then the U.S.

You know we've got, about 80% of our spend is with round about 81 suppliers; we're all over it and so we know exactly what's happening with those suppliers, who are being impacted, who are back online, you know the parts that we need for the next several quarters and we're tracking it daily.

So we've done a tremendous amount, you know literally beginning in January to I think you know buy down risk to our financial plant.

The second area is obviously risk to our own manufacturing facilities and I would say that as a company we reacted much sooner than many companies in terms of the actions that we took and we’re certainly ahead of some of our customer locations as well.

You know the high impact was obviously we ceased travelling very, very early on and then on March 13, that was the last day in the office for the majority of those employees that you know could work-from-home and so we transitioned 60% of the employees to work-from-home literally over a weekend, because we already have the infrastructure in place that would allow us to do that effectively, and that you know created a significant distancing in our facilities, which compared to you know the large manufacturing facilities such as in the aerospace industry, are nowhere as dense anyway, because we’re doing electronics manufacturing which just by its very nature aren’t as people intensive.

Then we see the tremendous amount inside of those facilities to improve the distancing itself and we continue to communicate with and educate, you know not only all of our managers weekly on an all-manager call, but all of our employees weekly via videos and text based communications to continue to educate them on what we need them to do to protect their health and safety, as well as all of our livelihoods.

And right now that's gone exceptionally well. You know we haven't had any COVID, confirmed COVID cases inside of our facilities and you know everyone is continuing to work with all of our facilities remaining open.

And so we're very focused on trying to keep it that way, but you know we could be impacted, but we've done everything that we possibly can we believe to reduce the risk to the business and we're going to continue to do so. The third one as I mentioned is really hiring and right now we haven't seen any changes to our hiring metrics.

You know we've got like 100 open position, so we are still hiring, because we’re still growing. We expect to continue to grow. We are still hiring people, but you know just given the uncertainty, we could see those hiring metrics change over time, but right now we haven’t.

So those would be the kind of the three risks that we see and we are working them all hard. .

Great! I appreciate the color. Thanks Mark. .

Thank you. Our next question comes from Michael Ciarmoli from SunTrust. Please go ahead. .

Hey, good evening guys. Nice quarter! Thanks for taking the question. Glad to hear everybody is safe and healthy. Mark, maybe just to stay on that initial line of questioning, where Ken was asking, you know talking about building inventory to absorb some delays.

Where are you seeing specifically the most risk in the supply chain? I mean what types of products or inventory have you built up you know and are you comfortable that some additional supply chain strain might not materialize.

Do you think you have enough buffer on hand?.

Yes, Mike do you want to go through the inventory and I’ll kind of talk about what we’ve been doing. .

Yeah sure. So Mike in terms of the inventory impact in Q4 that we talked about in the buy forward. What we talked about was, and Mark mentioned that early on this was something that was in Asia, then went to Europe, and we were on top of the supply chain early, and we worked to identify our critical suppliers.

We located our top 80% of inventory or our supplier spend. We went through and specifically analyzed our critical suppliers even if they weren't in that top group. And we went out and we look to advance purchase materials where possible. From a financial perspective that didn't have a material impact on Q3.

As I mentioned in my prepared remarks, we do expect to see some in Q4. Those – you know the orders that we put in have promised dates in Q4, but some roll into the first part of fiscal ‘21 as well and we're working to expedite that as much as we can.

But overall I would say that we're doing everything we can to mitigate risk, but at this point the supply chain and our suppliers are continuing to deliver; we're keeping an eye on all the critical suppliers; we are having our ops team and purchasing team are talking to our critical suppliers every single day to track the key deliveries.

So we haven't seen anything yet, but we are doing everything we can to mitigate and make those advance purchases. .

So what [Cross Talk] I was just going to say, what it really boils down to is those component parts where there are limited sourcing options, right, that's what we are very, very focused on and there is obviously a number of those as we kind of look out over the next several quarters and looking at lead times and working with the different suppliers.

So some of that is pulling in material early, so we get the supplies that we need. In some instances we are looking for part or parts alternatives, we’ve done that very effectively, and then we’ve just literally on it on a daily basis.

So the purchasing team has done an amazing job, I think really reducing the risk to our financial forecast, but it’s obviously not zero. .

Yeah, no I appreciate that and all the color.

I was actually just wondering what specific parts and components? I mean are you guys seeing pressure on circuit board, switches, you know any kind of the graphics capability, you know what specifically are you guys, what specific components and parts are you seeing the most risk around that you’ve had to buy excess inventory?.

Yeah, I'm not going to get into the specifics, but I can tell you there’s 125 different parts from 27 different suppliers that we're working on a daily basis. So we are all over it Mike. .

Okay, and then just, you know I know you talked about having another strong bookings quarter in the fourth quarter.

What does the line of site look like in terms of I guess the go-forward pipeline? Do you envision that you know any of the potential programs that might be in the midst of a down select, you know they could be delayed whether it's due to social distancing, you know if there are competitive takeoffs or what have you? Do you think that has an impact on your bookings? I mean certainly it sounds like not in Q4, but anyway to tell how much risk there is in the pipeline of seeing a slide out of awards?.

Not that we see right now, it doesn’t mean that it couldn’t change going forward, but I can tell you the sales team are very focused, they are very active. You know I think everyone has become attuned much more to working from home, and business is still getting done. It’s more challenging obviously, but I think right now we haven’t seen any impact. .

Got it. Thanks guys. .

Thank you. Our next question comes from Jon Raviv from Citi. Please go ahead. .

Hey, thanks everyone and good to hear from you all. On the M&A question, I was just – guess I’m trying to sort out, when do you see that market unsticking so to speak, just a matter of you Mike when you can get on a plane again.

Is it a matter of just volatility in the market coming down, because I image you had some things in the pipeline before all this hit. So I’m kind of wondering if those are frozen or are new deals sourcing frozen. Just really a little more color on M&A and what are looking to do, because you guys still have a lot of balance sheet to pull on here. .

Yeah, I mean you’re right. As Mark said, coming into the quarter the pipeline was quite strong and was an incredibly busy period of time before COVID hit.

In terms of the timing for rebound, it’s hard to know, right now we think most buys are really focused on the same things we are, which is taking care of the people and honoring their commitments to their customers and shareholders and sellers are doing the same thing.

You know I think John the key is going to be getting to an environment where there's some predictability to near term earnings, as well as future earnings, and luckily for us defense appears to offer more visibility than a lot of the other sectors.

But I do think as the states begin to open up, employees start returning to workplace, travel as you say, you know starts again, I think you're going to see the activity pick back up and I think we're going to be really well positioned once it does. .

Thank you for that. And then you brought up earlier Mark both in prepared remarks and in response to a question earlier about potential crowding out and various sort of spending.

Kind of aside from the crowding out budget thing, how does Mercury position itself for a world in which national priorities could at least expand? So you have swap requirements for defense applications, but also maybe swap requirements for medical and healthcare application.

I know you guys used to do medical previously, and you got out it for a structural reason and real good for you on that. But going forward, how do you think about the sort of big picture, very long term opportunity such in the company heading into a post-COVID kind of world. .

Yeah, it’s a good question John. I think for now we're going to continue to just do what we've been doing.

I think there's still an enormous opportunity around just the modernization of the different electronics inside of the defense industry which will – where we’re primarily focused, and I think there's still a tremendous opportunity from an M&A perspective.

You know as I said earlier, I think there’s probably even more opportunity form an M&A perspective. So there could be additional opportunities as things continue to progress and we are obviously pursuing a significant one right now in the trusted microelectronics space, which is a major area of growth we believe in the long term.

But we want to stick with what we are good at, what we know and not seek necessarily to diversify. .

Thanks for hearing me on that one Mark. Seriously, thank you. .

Thank you. [Operator Instructions]. I see our next question comes from Jonathan Ho from William Blair. Please go ahead. .

Hi, good afternoon.

Can you maybe I guess give us a little bit of additional color on how your acquisition integration efforts are going and in particular with some of the recent acquisitions and does COVID potentially slow down anything relative to your prior plans there?.

Yes, so I would say that we have done a pretty good job, and the only one that’s really outstanding at this point is Alpharetta, which is the APC acquisition. We began to go through the world to transition into their business systems and we did the kick-off, but then obviously we got impacted with the inability to travel.

So it has moved to the right a little bit. That said, you know the business is performing extremely well and the team is very excited to be part of Mercury. What was very interesting to me is we kind of stepping back as we’ve addressed the COVID crisis. The business model is really come into play in a couple of different ways.

We’ve talked a lot about deploying a matrix organizational structure and it gives us scalability as the business continues to grow.

That matrix organization actually really helped us very, very quickly deploy a set of capabilities and responses across the business that I think helped mitigate a lot of risk, you know much sooner had we not been a fully integrator.

And so the fact that we’ve got an organizational structure and a model and we believe in full integration has actually helped us respond to a crisis, not only create value through an M&A.

So it’s another good reason to continue to do what we have been doing and we’ll get back on track once we are able to travel again, but it's not impacting the financial performance Jonathan. .

Great! And then just as a quick follow-up, you know more of a big picture level.

Do you think COVID maybe accelerates some of the trends that you've already been seeing around delayering, particularly given the risks now in having multiple sub-primes and subcontracts having to work in different facilities on a single project? If you can maybe consolidate that down to you know a few that truly are adding value.

Just wondering if you know again, from a big picture perspective you think that could maybe play out over the long run. .

Yeah, so when you think of the industry trends that we’ve talked about, delayering is one and that’s you know continued to happen as we see it. What I think is probably going to be the more dominant theme around the macro level trend is that flight to quality suppliers as a result of just the impact that the COVID has had.

I think it’s exposed some vulnerabilities from a supply chain perspective around dealing with small businesses that aren't necessarily as well capitalized or able to deal with the risks and the challenges that COVID has presented.

And so I think people are going to step back and figure out, who are the companies within that supply chain that they really need to deal with and partner with in the long term. We've been doing that very well I think over the last five years and I think we are going to see even more of it going forward.

The other thing that obviously this is exposed is just the, the domestic supply chain and the need to bring back some of that capability to the U.S. and as you know we have invested in our own trusted domestic manufacturing facilities for quite some time and I think that’s going to play out as well.

So I think we are well positioned you know just given everything that we had previously been done with the strategy that is even more important with what has just happened. .

Great to hear. Thank you. .

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

Okay, well thank you very much for taking the time to listen in today. We look forward to speaking to you again next quarter. Thank you. .

Ladies and gentlemen, that concludes today's conference call. Thank you for participating. You may now disconnect..