Good day, everyone, and welcome to the Mercury Systems Third Quarter Fiscal 2021 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, Michael 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 & 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 with the business update. Mike will review the financials and guidance, and then we'll open it up for your questions. .

Mercury delivered a strong third quarter of fiscal '21. Thanks to an outstanding effort by the team, total revenue and adjusted EBITDA came in above the high end of our guidance. We continue to execute strategically, investing in R&D and CapEx to drive organic growth while supplementing this growth with strategic M&A..

Looking back at Q3, it was a strong quarter for new design wins, and we delivered record revenues, adjusted EPS and adjusted EBITDA. But the timing of bookings remained a challenge. Our results continue to reflect the impact of COVID, the change in administrations, delays in foreign military sales as well as customer program execution issues.

We've already closed a number of the orders delayed in Q3 and expect substantially increased bookings and a positive book-to-bill for the fourth quarter. .

For fiscal '21 in total, we're anticipating a slight decline in bookings year-over-year and a book-to-bill approaching 1. We now expect to deliver approximately 6% organic growth year-over-year and at a total company level, 14% to 15% growth. All in all, we're pleased with this strong performance in a difficult year. .

While I normally wouldn't provide fiscal '22 guidance until our Q4 call, I thought it would be helpful to provide an initial view. Our optimism and outlook for the business remain positive. We believe, however, that the challenging environment may persist through the first half of next fiscal year. .

We expect our backlog exiting fiscal '21 to be up high single digits year-over-year. And as a result, we currently anticipate mid- to high single-digit organic revenue growth for fiscal '22 as a whole. This includes a 2 point reduction in organic growth, largely due to the customer program execution issues that I mentioned.

We're expecting to deliver mid-teens total company revenue growth versus fiscal '21, and that's before any additional M&A activity. This would represent another record year for Mercury..

Turning to Slide 4. This level of growth compares very favorably with our baseline forecast for overall defense spending, which is expected to be flat near term and low single-digit growth over the longer term. With the new administration in place, we could see changes or competing priorities for discretionary spending, including defense.

That said, we believe the nation's commitment to defense is strong..

Mercury is well positioned for growth in this environment. We're aligned with the National Defense Strategy, and we believe that we focus the business on large and faster-growing parts of the defense marketplace. We're targeting the waves of electronic modernization occurring in both sensor and effector mission systems and C4I.

If new pressures on the defense budget do materialize, we're likely to see an even greater focus on modernization as well as speed and affordability. This could lead to greater use of nontraditional defense contractors and contracting methodologies, supporting Mercury's ability to grow in line with our goals and objectives..

We successfully diversified our program revenue base. Mercury now participates in more than 300 different programs and platforms, substantially more than in the past. For fiscal '21, no single program is expected to be more than 5% of total company revenue or more than 5% over the next 5 years..

Since 2015, we've grown the estimated lifetime value of Mercury's top 30 programs and pursuits from approximately $5 billion to more than $10 billion. This opportunity pipeline is greater than 10x the size of our backlog and represents the basis of our future growth.

Like LTAMDS, more of our recent design wins are expected to transition into production over time. We expect these programs and this transition to drive increased bookings and backlog in the years ahead.

As a result, we believe that we're well positioned to continue executing on our goal of delivering high single-digit to low double-digit organic revenue growth..

Turning to our third quarter financial highlights on Slide 5. Mercury's total bookings were down 16% from a very strong Q3 of fiscal '20. Our book-to-bill was 0.82, while our backlog increased 16% year-over-year. Our performance remains strong on a 12-month basis. Backlog was up 16% for the period, and our 12-month book-to-bill remained positive.

Our largest bookings programs in the third quarter were a classified microelectronics program, [ THAD ], MH-60 and CPS. .

Mercury's revenue for Q3 increased 5% organically as expected and 23% in total year-over-year. Our largest revenue programs in the quarter were a classified radar program, LTAMDS, CPS, F-35 and E-2D Hawkeye. On the bottom line, Mercury's third quarter GAAP net income decreased 34% year-over-year, consistent with our guidance.

Adjusted EBITDA was up 16%, above the high end of guidance. For the last 12 months, GAAP net income remained flat, and adjusted EBITDA was up 17%. Our new business pipeline is robust, and our design wins in Q3 totaled more than $208 million in estimated lifetime value..

Turning to Slide 6. We're confident that Mercury will continue to deliver above industry average organic growth driven by prior design wins and leveraging the fundamental trends that we discussed in the past. The first trend is outsourcing by our customers at the subsystem level.

The investments that we've made enable us to do things more quickly and more affordably than our customers can do in-house, resulting in greater content for Mercury on various programs and platforms..

Second, we see the impact of delayering as the government seeks more open, affordable and rapid solutions, particularly in the C4I market. Third is the primes' flight to quality suppliers in both RF and secure processing. And finally, the government's push to create a domestic supply chain for secure and trusted advanced microelectronics. .

The DoD has identified U.S. produced trusted microelectronics is their #1 defense technology priority. Addressing this national security objective represents a significant opportunity for Mercury over time..

Turning to Slide 7. All of our facilities have remained open and productive since the start of the COVID pandemic. We've consistently put our employees' health and safety at the center of our operational and business continuity strategy. And it's proved to be the right things to do for all the company's stakeholders. .

As more of the team gets vaccinated, we're planning on gradually returning more people to the workplace. Many of the layered health and safety protocols now in place will continue well into calendar 2021. That said, the associated business continuity investments are expected to decrease as the year progresses.

Finally, our supply chain team continues to deal effectively with the impact of COVID and more recently, with the supply chain constraints in the semiconductor industry..

Turning to Slide 8. M&A remains an integral part of our strategy. The environment remains active, and we remain disciplined in our approach, both in terms of deal pursuits and diligence as well as integration. The integration of POC is on track and the business is performing well. The team is proving to be strong.

We're seeing some great new design win opportunities, and the feedback from customers is extremely positive..

Looking forward, we believe that we're well positioned to continue supplementing Mercury's organic growth with accretive acquisitions. Our pipeline is robust with multiple opportunities of varying sizes, all in line with the core of our strategy.

We believe that Mercury is seen as a great buyer given our purpose, culture and values, strategy and positioning and strong business performance. We're in a good place in terms of our financial capacity and liquidity. We intend to remain disciplined in pursuit of strategically aligned deals that can be accretive in both the short and long term..

Turning to Slide 9. Overall, our strategy remains the same, to deliver strong margins while growing the business organically and supplementing the 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 5 areas. .

The first is to grow our revenues organically at high single digits to low double digits 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 in our people.

Third is manufacturing in-sourcing as well as driving stronger operating performance across our manufacturing locations. Fourth, we're seeking to grow revenues faster than operating expenses. This should allow us to continue investing in organic growth while maintaining strong operating leverage in the business.

And finally, we're fully integrating the businesses that we acquire to generate cost and revenue synergies over time. These synergies, combined with other areas of the plan, should produce attractive returns for our shareholders..

Turning to Slide 10. Our 5-year outlook remains intact. We're targeting high single-digit to low double-digit organic revenue growth, coupled with M&A and margin expansion. We're in the right markets and align with dominant industry trends. The estimated lifetime value of our key programs and pursuits has increased substantially.

We're expecting strong conversion into bookings and backlog as these programs transition into production over time. .

We have clear purpose and positioning and a unique business model sitting at the intersection of tech and defense. We have a highly engaged workforce, and our COVID-related business continuity protocols are working well. We continue to make growth-focused investments in our people, our technology and our trusted domestic manufacturing assets.

We remain active and disciplined in our approach to M&A, and Mercury's balance sheet is strong..

We believe that delivering double-digit growth in revenue and EBITDA for fiscal '21 will be an extraordinary accomplishment by the Mercury team, especially given the COVID and industry-related challenges we faced this year.

We're very proud of their dedication, their resilience and their unwavering commitment to our customers as well as to our brave men and women in uniform..

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

Mike?.

Thank you, Mark, and good afternoon again, everyone. Mercury delivered solid results in Q3. Total revenue, adjusted EBITDA and adjusted EPS all exceeded our guidance. Total revenue and adjusted EBITDA were both records for Mercury. And while Q3 bookings were impacted by the factors Mark discussed, our backlog remains healthy.

We're positioned for a strong fourth quarter and another record year in fiscal '21. Looking further ahead, our recent design win activity and sole-sourced, designed-in positions and well-funded programs set the stage for strong revenue growth and margin expansion going forward..

Let's turn now to our Q3 results on Slide 11. Total bookings for Q3 were $210 million, down 16% year-over-year. This compares to a strong Q3 '20 where we had near record bookings and a book-to-bill of 1.2. Q3 bookings were flat compared to last quarter. Our book-to-bill for Q3 was 0.82, and for the last 12 months, our book-to-bill was 1.01.

As Mark said, Mercury's bookings and book-to-bill this quarter and year-to-date have been impacted by COVID, the change in administration and FMS delays. Looking ahead, in Q4, we expect a book-to-bill above 1, and for the full year, we now expect a book-to-bill approaching 1. .

Mercury ended the third quarter with backlog of $894 million, up 16% from Q3 '20. Backlog expected to ship within the next 12 months was $546 million, equating to 61% of backlog. Over 95% of total backlog is expected to be delivered within the next 24 months. .

Total company revenue increased 23% from Q3 last year to a record $257 million, exceeding the high end of our guidance of $245 million to $255 million. Our revenue base continues to be highly diversified. No single program represented more than 10% of total revenue in the quarter. .

POC, which is considered acquired revenue in Q3, performed well, contributing $38.5 million of revenue during the quarter. We're already seeing new opportunities as a result of POC being part of Mercury. Organic revenue grew 5% year-over-year, in line with expectations. Organic growth was driven primarily by the C4I and radar markets..

Gross margin for Q3 was 41.1% compared to 44.9% in the third quarter of fiscal '20. This reflected $2.5 million of direct COVID-related expenses charged to cost of goods sold as well as the inclusion of POC for a full quarter. COVID expenses and POC impacted Q3 gross margins by approximately 100 and 180 basis points, respectively.

The remainder of the difference was driven primarily by program mix..

Operating expenses in Q3 were up $17 million or 25%. The inclusion of POC accounted for approximately $11 million of the increase. Q3 R&D was $30.2 million, up 21% year-over-year. R&D as a percentage of sales was 11.8% compared to 12% in Q3 '20. Excluding POC, which has lower R&D as a percentage of sales, R&D would have been 13.2% of sales.

This is up 120 basis points from Q3 last year, driven by opportunities in avionics missions computers, secure processing and radar modernization as well as continued investment in our microelectronics business..

Q3 GAAP net income and GAAP EPS were down 34% and 35%, respectively, year-over-year.

These declines were primarily driven by onetime items, including a $2.5 million increase in acquisition-related expenses, a $4.3 million gain on an equity investment in Q3 last year, discrete tax benefits of $1.9 million last year that we did not have this year and a $2.3 million increase in COVID-related expenses over the prior year..

Adjusted income and adjusted EPS, which add back most of these expenses, were both up year-over-year and exceeded our Q3 guidance. Adjusted EBITDA for Q3 was up 16% year-over-year to a record $54.8 million, above the top end of our guidance of $52 million to $54.5 million, driven primarily by strong revenue growth.

Adjusted EBITDA margins for Q3 were 21.3%, in line with our guidance..

COVID-related direct expenses totaling $2.7 million were added back to adjusted EBITDA in Q3, primarily related to the employee health and safety protocols that Mark discussed. We charged approximately $2.5 million of these expenses to cost of goods sold and approximately $200,000 to operating expenses..

Operating cash flow and free cash flow for Q3 were $23.2 million and $13.2 million, respectively. Both were lower year-over-year, reflecting the continued investments we made this quarter in CapEx, R&D and COVID derisking..

Slide 12 presents Mercury's balance sheet for the last 5 quarters. We ended Q3 with cash and cash equivalents of $122 million, up from $109 million in Q2, driven by the cash flow generated in the business. We ended Q3 with $160 million of debt associated with the acquisition of POC in Q2..

From a capital structure perspective, Mercury remains well positioned with continued flexibility and great access to capital. Our net debt at the end of the quarter was minimal at $38 million. We still have significant capacity to invest for organic growth as well as M&A. As Mark said, our pipeline of M&A opportunities continues to be strong.

We were extremely active during the quarter and expect to continue to execute our M&A playbook, maintaining our disciplined approach to valuation and strategic fit..

Turning to cash flow on Slide 13. Free cash flow for Q3 was $13.2 million, representing approximately 24% of adjusted EBITDA. We had approximately $6 million of nonrecurring cash outflows during the quarter, which reduced our free cash flow conversion by approximately 11 points.

These included $2.7 million in direct COVID-related cash outflows, a $2.8 million onetime payment related to switching health care providers and $500,000 of acquisition-related expenses..

Cash flow from operations this quarter was $23.2 million compared to $30.1 million in Q3 '20. Capital expenditures in Q3 were $10 million or 3.9% of revenue. Year-to-date, capital expenditures were $34.7 million or 5.2% of revenue.

This CapEx is primarily related to facility build-outs in Andover, Massachusetts and Cypress, California, along with continued investment in our microelectronics business..

I'll now turn to our financial guidance, starting with full year fiscal '21 on Slide 14. Our guidance for both the full fiscal year and the fourth quarter includes estimates for POC. In addition, we've assumed no restructuring or acquisition-related expenses as well as an effective tax rate of 26% in Q4. .

Our updated guidance represents another year of record total revenue, above industry average organic growth and double-digit growth in adjusted EBITDA. For fiscal '21, we now expect total company revenue of $910 million to $920 million. This represents 14% to 15% total revenue growth from fiscal '20 and organic growth of approximately 6%.

This guidance is slightly lower than our prior guidance, reflecting the outlook Mark discussed..

Total GAAP net income on a consolidated basis for fiscal '21 is expected to be $63.5 million to $64.9 million or $1.14 to $1.17 per share. This is down year-over-year as a result of approximately $21 million or $0.38 per share of nonoperating investment income and discrete tax benefits that we had in fiscal '20 that will not recur in fiscal '21..

Adjusted EPS for fiscal '21 is expected to be in the range of $2.35 to $2.37 per share. This is up 2% to 3% compared to fiscal '20 as a result of both our organic performance as well as accretion from the POC acquisition.

It is worth noting that the prior year adjusted EPS included a discrete tax benefit of approximately $8 million or $0.15 per share, which is not expected in fiscal '21..

Mercury's adjusted EBITDA for fiscal '21 is expected to be in the range of $201 million to $203 million, an increase of 14% to 15% from fiscal '20. Adjusted EBITDA margins are expected to be approximately 22.1%. This is an increase from last quarter's margin guidance primarily driven by slower expense growth in the business.

We now expect capital expenditures for fiscal '21 to be approximately 5% to 6% of revenue as we continue to invest in growing the business..

Finally, for the year, we expect free cash flow to be approximately 25% of adjusted EBITDA, which is consistent with year-to-date levels. This conversion level is primarily driven by our expansion CapEx and COVID investments..

I'll now turn to our fourth quarter guidance on Slide 15. Doing the math based on our actual results for the first 3 quarters, we're forecasting Q4 revenue in the range of $236.5 million to $246.5 million, representing growth of 9% to 13% compared to Q4 '20..

Q4 GAAP net income is expected to be $19.5 million to $20.9 million or $0.35 to $0.38 per share. The year-over-year decline is a result of $8.1 million or $0.15 per share of nonoperating investment income and discrete tax benefits that we had in Q4 '20 that we will not have in Q4 '21..

Q4 adjusted EPS is expected to be $0.66 to $0.69 per share. Adjusted EBITDA for Q4 is expected to be $58.1 million to $60.0 million, representing growth of 17% to 21% compared to Q4 '20. Adjusted EBITDA margins are expected to be 24.4% to 24.6% of revenue. The higher expected margins in Q4 are primarily driven by program mix.

We expect free cash flow to adjusted EBITDA conversion in Q4 to reflect the continued investment in the business..

Turning to Slide 16. Mercury delivered solid results in Q3 with record revenues driven by outstanding execution by the team. We continue to create value through M&A. The POC integration is progressing well, and we're already seeing synergies.

We have significant financial flexibility and a large pipeline of opportunities to continue to deploy capital for strategic M&A. We're expecting to deliver record total revenue and record adjusted EBITDA for fiscal '21, and our 5-year outlook and financial model remain unchanged.

We're targeting high single-digit to low double-digit organic revenue growth supplemented by strategic M&A, leading to above industry average growth in total company revenue and EBITDA margin expansion..

With that, we'll be happy to take your questions. Operator, you can proceed with the Q&A now. .

[Operator Instructions] And our first question will come from the line of Peter Arment with Baird Equity Research. .

Mark, so just, I guess, everyone is going to focus on organic growth. So I might just kick that off. I mean can you just maybe talk about what we've seen in the last several quarters? There's been kind of a deceleration, and you're kind of alluding to it continuing.

But when we try to square that against kind of outsourcing, delayering, all the kind of trends that you talk about, maybe you could just provide us with any kind of more details that get us to kind of square that all up. .

Sure. So I mentioned really what has happened from a bookings perspective throughout the year. And it's clearly been more challenging than what we had anticipated. We've been impacted by COVID delays, the change in administrations, delays in FMS as well as now customer program execution issues.

So we have been -- or we now expect 6% organic growth for fiscal '21, which is lower than what we previously thought. .

We saw some bookings delays, in particular, in the third quarter on a naval -- large naval EW program that's in production. That was around about $18 million that basically slipped from Q3 into our Q4. But it didn't just affect our bookings in the quarter. It also lowered our organic growth rate for the year..

Probably one of the other ones that I would kind of touch upon is that, as I mentioned, we started or we've seen a customer, in particular, program execution issue on a large airborne program, which in itself lowered our organic revenue growth by about 1.5 points for the whole year.

So just those 2 things alone account for 2.5 points of organic growth compared to what we thought coming in. And you add those back, and we're back at that goal of high single-digit to low double-digit organic revenue growth..

Now that said, the programs themselves are fine. They're well-funded programs. They're just experiencing different delays actually for different reasons. So our outlook going forward, as I mentioned, for fiscal '22, is now kind of mid- to high single-digit organic growth with 14 -- mid-teens growth in total next fiscal year.

So fundamentally, there's nothing really changed with respect to our outlook, but we are experiencing some delays. .

Our next question is going to come from the line of Sheila Kahyaoglu with Jefferies. .

Yes. I mean just sticking on that, Mark, appreciate the color on the large airborne program and that's deflating your growth this year and somewhat coming back next.

Can you maybe just talk about how you think about your accelerating growth in a flatlining budget environment? What are you seeing in your bookings and your design wins? And can you maybe elaborate on that? What gives you confidence in the out-years for high single-digit growth?.

Yes. So I think as I said in the prepared remarks, we do expect that the environment that we're currently in is likely going to continue into the first half of next fiscal year, hence, the guidance that we gave.

If I look at what's going to drive organic growth next fiscal year to offset some of the headwinds that we faced, it's really a number of different things. So we're expecting various FMS programs to drive growth. If you remember, back in the first quarter of FY '21, we had a $35 million an FMS sale that moved from Q1 into next fiscal year..

In addition, we're seeing some very strong demand related to our secure product -- our secure processing product line. We're involved in various radar upgrades that -- some of which are moving into production for the tech refreshes. So F-16 SABR, E-2D Hawkeye are both expected to drive growth next year.

Probably the largest driver of organic growth, both next fiscal year as well as over the next 5 years, is growth that we're seeing in the C4I domain. And that's really spread across multiple different programs in both C2, comms as well as platform and mission management..

And then finally, we're expecting continued growth in EW organically on programs such as ALR-69 as well as DEWS. So it's really across the board. But we do have some headwinds not only this year but coming into next.

That one program that -- the large airborne program, where our customer has seen some tech delays, as I mentioned, has lowered our organic growth by 2 points next year for the -- that is encompassed in that mid- to high single-digit organic growth numbers that I gave. .

And our next question will come from the line of Peter Skibitski with Alembic Global. .

So Mark, for fiscal '22, if we end fiscal '21 with the 1 or approaching 1 book-to-bill, you're saying the environment is going to be the same in the first half.

Is it mid- to high single-digit organic growth in fiscal '22? Is that still a pretty risky target right now? How should we think about that?.

So I mean, again, we haven't kind of finished our full budget. But based upon the work that we've done to date, kind of going over all the individual line items from the -- in the various programs, we feel pretty good about the outlook that we've given. We're expecting that backlog exiting this fiscal '21 will be up high single digits year-over-year.

We are on some strong programs. We've got a number of programs that are transitioning from the development phase into production. And so although we do expect that the environment in the first half could be -- could remain somewhat challenging, I think the guidance that we gave or at least the early outlook, we feel good about, Pete. .

And our next question will come from the line of Seth Seifman with JPMorgan. .

Just a follow-up quickly on Pete's question.

That outlook for next year, is there much risk to that from a continuing resolution?.

So yes, we do believe that there's going to be a relatively short continuing resolution, which we baked into account in terms of the outlook that we've given, Seth. .

Okay. And then just as a follow-up with regard to semiconductors more broadly and some of the shortages in that area.

How, if at all, is that affecting Mercury? And to what extent is it a watch item?.

Sure. So I think the supply chain team has done a pretty good job really navigating 2 challenges. Obviously, the first is just the impact that we've seen with COVID throughout the supply base. I think we've been able to manage that pretty effectively. It hasn't really impacted our top line.

And most recently, the team has been very focused obviously on the semiconductor space, and we're managing our way through that as well. So there are no specific impacts to date, but it's certainly something that they're working literally every week. .

And our next question will come from the line of Michael Ciarmoli with Truist Cap Securities. .

Just to clarify, first, the organic growth in 4Q, does anything change with the POC run rate? Are you going to be negative in the -- negative year-over-year in the fourth quarter?.

No. We're expecting flat organic growth in the fourth quarter, Mike, largely due to the strong fourth quarter last year as well as the various program delays that I mentioned. So the large naval EW program, as I mentioned, is expected to impact organic growth by more than 1 point. .

Okay. Okay. And then just the other one. Gross margin, it looks like an all-time low. Any -- I know you called out maybe mix and POC, but -- and I know you don't -- you're focused more on EBITDA margin these days.

But anything -- as we think about the longer-term trend here and gross margins, I mean the continuous decline there, any other thoughts or color or anything we should be mindful of there on the gross margins going forward into '22?.

Mike, let me just jump in and just correct something that I just said. The large naval EW program that I mentioned, the delay in the bookings that we've seen and a slight reduction in the order quantities will affect organic growth in the fourth quarter by around 3 points, not 1, as I previously stated. .

So Mike, do you want to talk about the gross margin?.

Yes. So Mike, I think you hit it. I don't think there's anything specific in terms of gross margins that's fundamentally changing. The 2 drivers during the quarter were POC, which is -- has lower gross margins than us. I mentioned in my prepared remarks that has a 180 basis point impact to that 41.1%.

And then the COVID expenses, which had a 100 basis point impact. So if you kind of adjust for those, you would have been 43%, 43.9%, somewhere around that. The rest is program mix this quarter. We had CRAD was up significantly year-over-year, was up 18% organically, so excluding POC. And that's what's really driving it..

If you step back, and Mike, look at where we were, gross margins in fiscal '20 at 44.8%, I think when you look at the year level for us and you take into account COVID, which we think will probably have about 100 basis point impact on gross margins for the year, and you take into account POC, which will have about a 100 basis point impact on gross margins for the year, that you're going to be at very similar levels to where we were in fiscal '20.

.

Our next question will come from the line of Jonathan Ho with William Blair & Company. .

I just wanted to, I guess, dig into your comment around potentially discretionary dollar competition leading to some additional outsource trends.

Can you maybe elaborate a little bit more on what you're hearing out there and maybe what the potential could look like if we were to start to see that budget pressure play out?.

Sure. So I think clearly, we're all seeing just the continued stimulus under -- or proposals under the new administration. I think overall, we were pretty pleased with what the overall budget submission was and the outlook there. But over time, I think we could continue to see pressure on the defense budget.

And that's obviously offset by what happens from a national security perspective. .

Yes, I think the growth that we're seeing is being continued to be driven by growth in subsystems or outsourcing at the subsystem level. In the third quarter, our subsystems revenue was actually up 55% to now 76% of the total. And over the last 12 months, it's up 49% to 66% of the total..

So I think it's reflecting what we're seeing more generally happening, Jonathan, where our customers are seeking more rapid and more affordable and open solutions. And with the investments that we're making in R&D, we're able to do that more quickly and more affordably than they can do it in-house.

So if there are additional pressures on the defense budget, we think that outsourcing will continue. And we think that they're well positioned to be able to take advantage of that. .

And our next question is going to come from the line of Noah Poponak with Goldman Sachs. .

Mark, maybe you can help me better understand how this came up on you seemingly kind of quickly because you've had some positive updates to the market recently, including the last earnings period. And the categories of things you're citing have been going on for a while, COVID delays, the change in administration.

And we're not really seeing those impact other hardware companies. .

So just kind of better help me understand how this, I guess, maybe snuck up quickly. And if you could more precisely quantify these buckets, and when you get them back, I think that would be really helpful because otherwise, it kind of just looks and sounds like general buckets while there's a deceleration happening in the end market.

So if we could just put a little more detail around that, that would be helpful..

And then, Mike, what are you spending on COVID? Because the absolute dollar numbers in the margins -- and then you started the year with 40% to 45% on the free cash to EBITDA, and you had that in the middle of the year. So the rate of change there in an absolute dollar sense is pretty large for what you're attributing it to.

If you can tell us what you're spending on there. .

Sure. So let me begin with the bookings and kind of maybe step back and -- so the second half of the year as we came into it was more second half weighted. And I guess the challenge that we face with bookings now is kind of built as the year progressed. And right out of the gate in the first quarter, if you remember, we had a challenge related to FMS.

We had a $35 million order move out of Q1 into next fiscal year as our customer ended up having to reengineer the solution with the end customer..

We saw continued impact as the year progressed, in particular, in the weapon systems arena. As the new administration, reviewed the sale of various offensive systems into the Middle East, that impacted FMS sales.

But in weapon systems, we've seen various delays associated with the Navy, not just the large EW naval program that I mentioned, but we saw some naval airborne programs also get pushed from what was going to be the start of the year, Q2. Then it moved to Q3. Now it's in Q4. So there's been kind of a sliding effect throughout the year..

The one that, I guess, is for us somewhat new is the impact that we saw around this large airborne program, where our customer was impacted by a delay from one of their suppliers. That -- to put a number on it, it was a reduction of $20 million for the year. So it's not been one large thing.

It's been a number of things that I guess have built as the year progressed. And we're at a point, obviously, being in the fourth quarter where it's unlikely that some of these deals are going to pop up in the final quarter of the year..

So some of them have moved into fiscal Year '22, and some of them will impact us because the order moved to '23. And that large airborne program, in effect, what's happening is that we're skipping a year, which is why we've actually reduced our organic growth by 2 points on that program, to give that mid- to high single-digit next fiscal year. .

So it's a number of different things, some of which have moved throughout the year and remained inside it, some of which have moved to next fiscal year. And that one particularly one, which, as I mentioned, is $20 million, moved to '23 for us. .

Mark, what happened on that program?.

So the -- our customer supplier is substantially delayed in providing 3 different types of technologies that are associated with a major tech refresh. There are 2 parts of it that affect us. So right now, we think it's been pushing to the right, pushing to the right, pushing to the right.

They believe that they're making progress, but the refresh itself is pretty significantly delayed. .

Okay.

And Mike, can you help me out with what you're spending on related to COVID that you're referring to?.

Yes. I mean -- so if you step back, Noah, you mentioned the 40% -- 40% to 45% guidance at the beginning of the year. As we discussed, that didn't include the COVID expenses. And you're right, that's one of the big aspects of our cash use for the year. I mentioned in my prepared remarks that we're expecting 25% conversion for the year.

The expansion CapEx is about 10 points, so it'd be 35%. .

COVID investments, we're looking at about $10 million to $11 million of cash outflow this year. That's primarily related to the testing, the PCR testing that we're doing at our facilities. That's the biggest piece of that. We also have the employee relief fund and some other things this year.

That probably had a 5 point impact on the conversion or will have a 5 point impact on the conversion for the year. Also related to COVID, we've talked about we invested in inventory to derisk the supply chain. So that's really the COVID investments. .

And then there's been a handful of kind of one-off items this year. We've been -- if you look at the acquisition expenses in Q2 and Q3, we've been incredibly busy. That's been a cash outflow. And then I've mentioned a couple of the others here and there, payment for [ kind of ] shareholders, a little under $3 million.

We changed our health care providers. That was $3 million. So just a handful of things, but the big 2 really are the expansion CapEx and the COVID investments. .

[Operator Instructions] Our next question will come from the line of Austin Moeller with Canaccord Genuity. .

This is Austin on for Ken. All right. So just a question for me, and this was somewhat implied in a prior question. So obviously, right now, we've got the chip shortage going on.

And recently, the Biden administration had met with various officials from the semiconductor industry at the White House, and they're looking to figure out how to meet this chip shortage. And then you had recent commentary within the last week from Intel's CEO that it could take 2 years or more to ramp back up to pre-COVID levels. .

So from Mercury's perspective, obviously, you guys -- there's concerns about downward pressure on the DoD top line.

So potentially, how could Mercury -- or could Mercury use the Arizona and the New Hampshire facilities to maybe provide some of the supply to meet the unmet demand in the consumer electronics sector? And could that be done within that 2-year time frame?.

Yes. It's -- probably not, Austin. So the focus on the trusted microelectronics facility in Phoenix is to be able to provide very specialized capabilities on -- for next-generation applications, primarily for DoD use. So it's not a high-volume facility where we're providing silicon to -- for commercial applications.

We really have positioned ourselves at the intersection of tech and defense to be able to take the commercially available silicon and then transform it for use for defense applications. So unfortunately, I don't think that we're really going to be able to provide much assistance there. .

And our next question comes from the line of Ronald Epstein with Bank of America. .

Just a couple of questions for you guys. Sorry about that. I was on mute.

Just on R&D and tax, I mean, what impact do you expect to see in the next fiscal year given the change in the tax code? If it's not somehow reversed, you're going to amortize your amortize your R&D expense now over 5 years, what headwind does that present for you guys?.

Yes. So Ron, we do think it's counter to what the U.S. is looking to encourage, which is investment in the U.S. So it may be reversed. We'll see. That having been said, assuming the law stays as is written, we have to amortize our R&D over 5 years. We estimate that it's a $30 million to $40 million impact to our fiscal '23.

So the law will go into effect in calendar '22 or fiscal year taxpayer. So it would be a $30 million to $40 million impact to fiscal '23 cash flow. .

Got it. Got it.

And then some of the COVID expenses you talked about, are they billable to the customer? Or do you guys just have to eat them?.

We really -- since we're selling most of our products on commercial terms, we're not billing these back to the government. This is an investment that we're making, and there's no reimbursement from 3610 or anything like that. .

Got it. Got it. And then maybe a bigger picture question. When you look at folks like Taiwan Semi, potentially -- I mean it looks like maybe high probability potentially of building a fab in Arizona and more, how can I say it, more commercial silicon being fabricated in the U.S.

What opportunity does that present for you guys to work with the commercial manufacturers in the defense end market, right? I mean because the defense end market is so small compared to the broader silicon market, is there a role that you guys can play as these companies start to onshore fabs?.

Yes, absolutely, Ron. So even if they do bring back more of the fabs and the manufacturing here domestically -- Intel is obviously doing that in Arizona. TSMC is talking about it. TSMC is obviously the fab partner for companies such as Xilinx and others.

That doesn't alone solve the problem because I think the capabilities for use in defense as you look at the way in which the market is evolving to more triple-based architectures means that there needs to be a party that sits between those silicon manufacturers or developers as well as the defense end market.

And Mercury is kind of positioning ourselves to be that company..

So we're partnering with some of the biggest silicon companies in the industry, getting access to the raw silicon itself, and we're looking to be able to combine those silicon from different vendors to secure it using our IP and then package it here domestically for the specific end-use cases in defense. So we play a really important role.

And obviously, I think it'd be even better if those -- if the domestic manufacturing does come back. And so we're able to get that silicon here domestically as opposed to it coming offshore and us just packaging it and securing it in the Phoenix facility.

So there's still absolutely a role to play even if they do build those fabs in Phoenix like they're talking about. .

Mr. Aslett, it appears there are no further questions. So I would like to turn it over to you for any closing comments. .

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

Once again, we'd like to thank everyone for participating in today's Mercury Systems conference call. We appreciate your participation and ask that you please disconnect. Thank you..