Good day, everyone, and welcome to the Mercury Systems Second Quarter Fiscal 2024 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, Dave Farnsworth. Go ahead, Mr. Farnsworth..

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

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

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

These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. 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 Chairman and CEO, Bill Ballhaus. Please turn to Slide 3..

Thanks, Dave. Good afternoon. Thank you for joining our Q2 FY24 earnings call.

Today, I'd like to talk through three topics; first, some introductory comments on our business and results; second, an update on the progress we are making in each of our four priority areas, delivering predictable performance, building a thriving growth engine, expanding margins and driving improved free cash flow; and third, expectations for our performance both for FY24 and longer term.

Then I'll turn it over to Dave who will walk through our financial results and guidance in more detail. Please turn to Slide 4.

As I said in the past, while FY24 is a transitional year, I'm optimistic about our strategic positioning as a leader in mission critical processing at the edge, the attractiveness of our business model and our outlook over time to deliver predictable organic growth while expanding margins and robust free cash flow.

During Q2, we made solid headway in each of our four priority focus areas and in addressing what we believe to be the two transitory dynamics in our business I referenced last quarter; transitioning our high mix of development programs to production and converting our high level of working capital into significant cash flow.

We believe this progress is evident in three highlights from the quarter; strong bookings, solid free cash flow and better than expected progress in closing out our challenge programs, most of which are development in nature. First, we delivered near record bookings in the quarter with a 1.65 book-to-bill.

Our bookings were anchored by a number of important program wins that we believe will drive future growth. These awards reflect customer recognition of the unique value we deliver, the reliance on us for their most critical franchise programs and ongoing healthy demand.

Second, we delivered strong positive free cash flow and a reduction in net working capital. We generated over $37 million in free cash flow in the quarter along with an approximately $70 million improvement in net working capital.

These accomplishments were primarily driven by strong in-quarter collections, reductions in our unbilled receivables and inventory and improved customer advance payment terms. And third, we are making progress with retiring risk in and completing challenged programs.

While the underlying performance of the business continues to be obscured by unanticipated cost growth on a subset of programs, we believe we have largely narrowed these risks from the original 20 challenge programs to one product line with game changing technology that comprises approximately 25% of the original challenge programs.

Although we are still working through this remaining set of challenge programs, we anticipate retiring these risks on slightly more than half of the remaining challenge programs in FY24 and entering FY25 with a much clearer path to deliver predictable organic growth, expanding margins and strong cash flow.

In addition to these Q2 highlights, we made significant progress this quarter in establishing the team and structure to lead Mercury through the next phase of our journey.

We announced a reorganization to simplify and streamline our business by eliminating redundant corporate functions and consolidating a number of functional areas into a single operating unit under the leadership of Roger Wells as our Chief Operating Officer.

In his previous role, leading our microelectronics division, Roger delivered strong results and demonstrated an exceptional aptitude for scaling business operations and expanding and converting pipeline opportunities. We also announced the addition of Stuart Kupinsky to the leadership team as our Chief Legal Officer.

Stuart brings a wealth of experience in legal leadership roles and a track record of driving dynamic change and value creation in a number of technology companies. I'm very pleased that Roger and Stuart have taken on these critical leadership roles. Please turn to Slide 5.

Following those introductory comments, I'd like to spend time on each of our four focus areas. Our first focus area is enhancing execution to deliver predictable performance. In Q2, we incurred a number of costs that obscured the underlying performance of the business.

Specifically, we recognized approximately $48 million of such items that we believe are transitory, including nearly $31 million of program cost growth impact across our portfolio, approximately $12 million of manufacturing adjustments associated with specifically identified inventory reserves and higher scrap due to unfavorable yields, and nearly $5 million associated with contract settlements where we worked with customers to transition away from programs where we did not expect to see acceptable returns.

These items, which again, we believe are transitory, represented the vast majority of the year-over-year decline across our P&L metrics. As a reminder, program cost growth identified within a given period has an overweight impact on the financial results of that period.

In accordance with GAAP, there is a cumulative adjustment to reduce progress and align margins on the life-to-date of the program, which results in a decrease to revenue and gross margin that permeates down to net income and adjusted EBITDA in the current period.

Breaking down the nearly $31 million of program cost growth, $14 million of this impact was derived from our challenge programs with nearly all of the impact tied to one single program. Approximately $8 million was spread across several development programs and the remaining $9 million related to multiple production programs.

The challenge program impact was driven primarily by unexpected redesign and prototype efforts following initial development unit deliveries. Similarly, the remaining program cost growth was a function in part of revised baseline costs predicated on initial unit deliveries across several development and production programs.

In addition, the program cost growth reflects a risk adjusted outlook on program performance and estimates to complete across our program portfolio.

As shown on Slide 6, with respect to the challenge programs, during the second quarter, we made better than anticipated progress by completing, exiting or retiring risk on an additional four of the original 19 programs.

Together with the four completed through Q1, we believe we have now retired risk on eight of the original 19 challenge programs that have driven earnings volatility in recent quarters. For the remaining programs, we expect to close out more than half over the remainder of the fiscal year.

The balance of open challenge programs as well as the one program where we experienced significant program cost growth in the quarter are tied to a common processing architecture.

So while we experienced a significant P&L impact during the quarter, we believe we had made progress in isolating the primary go-forward development risk in the challenge programs to this one technology area.

Of note, our differentiation based on this technology has afforded us sole source positions on critical programs, and the functionality we provide is mandated on these programs. As such, we and we believe our customers, are committed to success in this area.

The challenges we are facing are related to efficiently and cost effectively maturing the manufacturing process to support the transition to scale production on these programs where we see significant growth potential at attractive margins.

Even for the one challenge program with cost growth this quarter, the current margin outlook remains above our consolidated program gross margin profile.

In addition, this common processing architecture is being developed within an isolated part of our business, representing approximately 20% of our revenue, which has experienced the majority of the revenue and earnings volatility that we saw in Q2 and that we expect to see within the fiscal year.

We believe resolving the challenges in this technology will go a long way to restoring growth and profitability in this part of the business and Mercury as a whole.

So despite the challenges we're working through and the corresponding investment, we believe we are well positioned as a sole source provider with large growth opportunities and solid margins as we seek to execute on the remaining development efforts and transition these programs to production. Please turn to Slide 7.

Turning now to the second focus area of driving organic growth. Bookings for the quarter were a near record $325 million, resulting in a 1.65 book to bill. We had several exciting awards for both development and production programs in the quarter. Two marquee wins in the quarter are worth noting. We received our first production award for LTM.

This is an exciting and important award coming earlier than originally anticipated. While we don't expect significant revenue from this program in FY24, we expect this program to drive organic growth in FY25 and ultimately become our largest revenue contributor in the future.

We also won a large development program on a strategic weapon system, which we anticipate will drive growth in the near term and stronger growth in the future as it transitions to production.

This program, while well within our technical capabilities, was awarded as a cost plus contract with favorable billing terms of at least monthly, thereby, reducing the potential earnings and cash volatility through development.

While we still expect the majority of our contracts to be firm fixed price, we are exploring opportunities to take certain development contracts on a cost type basis where appropriate.

In addition, as I have discussed before, we are working to incorporate more robust terms in all of our contracts to more clearly define scope, support improved execution and customer satisfaction and shorten cash conversion cycles.

Finally, last week, we received a large follow-on award to provide our solid state data recorders for a large defense space program.

This technology, which was introduced only a few years ago, is now the largest driver of growth in the military space market for Mercury and we expect further growth opportunities for this unique commercially developed offering.

These awards are important not only because of their value and impact on our long term growth but also because they reflect our customers' continued trust in Mercury to support their most critical franchise programs.

I mentioned last quarter that this effort to build an organic growth engine will occur over a longer period of time given the time content involved with improving book to bill levels, and that our near term growth will be fueled by the transition of development programs to production where we are well positioned in the back half of this year and early FY25.

Demand remains strong and we anticipate the strong bookings momentum to continue through the year. Please turn to Slide 8, now turning to our third priority focus area, addressing our cost structure to expand margins.

As we mentioned last quarter, to achieve our EBITDA margin targets, we are focused on the following levers; executing on our development programs and minimizing cost growth impacts; getting back to a historical 20-80 mix of development to production programs; driving organic growth to generate positive operating leverage and achieving cost efficiencies.

In Q1, we took a series of actions designed to better align our cost structure with our scale and our financial expectations. These actions are on track to generate $24 million in annual run rate savings primarily related to SG&A efficiencies.

In January, we announced a corporate reorganization in which we streamlined and simplified our operations, consolidating our two division structure to a single integrated structure, incorporating all of our lines of business and matrix business functions, reporting in to Roger Wells, who was appointed Chief Operating Officer.

This integrated approach is designed to clarify accountability and eliminate redundancy. In total, we expect this action to deliver an incremental $20 million in annual run rate savings, bringing our total action run rate savings to $44 million, of which approximately $24 million to $26 million will be recognized inside the fiscal year.

Though we continue to see negative operating leverage in FY24 given little revenue volume, these structural reductions will be evident in our margin profile as we expect to return to growth in FY25 and beyond. Please turn to Slide 9. Finally, regarding our fourth priority focus, to drive improved free cash flow.

I am pleased to report that in Q2, we delivered over $37 million in positive free cash flow. We made progress on converting our unbilled receivables, which were down nearly $38 million in the quarter, and we continue to have strong collection trends across our billed receivables.

In addition, we continue to pursue advanced payments on certain contracts, which is reflected in the $23 million increase in deferred revenue in the quarter. In total, net working capital decreased $70 million or over 10% in the quarter.

We continue to expect unbilled receivables to burn down through the fiscal year as we apply resources to completing hardware deliveries and especially as we continue to resolve challenge program. We also continue to expect inventory to decline as we receive follow-on production awards.

At the end of the quarter, we had cash and cash equivalents of $169 million. Net debt of $448 million is down $39 million in the quarter, reflective of our free cash flow generation. We expect to be cash flow positive for the second half of the year, which we believe will allow us significant flexibility to allocate capital. Please turn to Slide 10.

As I have discussed, we continued to make progress on our four priority focus areas. Even so, for the first six months, our revenue and earnings are below expectations primarily due to higher than expected cost growth and other charges as we retire risk across the portfolio especially related to our challenge programs.

Aside from these headwinds, which we believe are temporary, I continue to believe this is a business capable of ultimately delivering above average industry growth with low to mid 20% adjusted EBITDA margins.

In the second half of the year, we plan to continue to work on the transitions I discussed earlier; shifting our large portfolio of development programs to production, especially the majority of our remaining challenge programs; and focusing our operational capacity on burning down our large net working capital balances, particularly in unbilled receivables and inventory.

Turning to guidance. We're going to do this a bit differently for the remainder of the year as we work toward completing these transitions.

Based on our first half revenue and our outlook for the second half, we are updating our guidance for full year FY24 revenue from the prior range of $950 million to $1 billion to a revised range of $800 million to $850 million.

The reduction in revenue guidance is based in part on our first half revenue performance, particularly in the second quarter, which included significant revenue reductions due to program cost growth.

The reduction in revenue guidance is also based on reduced volumes expected in the second half as we continue to apply our operational capacity to advance late stage development programs and shift against legacy unbilled balances.

As a reminder, we expect the completing late stage development programs will reduce unbilled receivables, release cash and unlock production revenue, which should drive growth and margins. This work is critically important to unlocking value but we'll continue to deliver little revenue in FY24.

Let me spend a little more time on the volume reduction because it is significant. As we discussed in Q1, we continue to implement a more cash efficient operating approach with operational capacity focused on completing late stage development programs and releasing unbilled receivables.

This approach should generate cash and clear the way to higher growth, higher margin production revenue. However, there's little revenue associated with completing this work in the near term.

In addition, as we look to the second half, we are implementing a more mature process designed to ensure we have a robust low risk approach to transition from development to scale production, particularly as it relates to the common processing architecture I mentioned previously.

This work is important as part of our priority to restore predictability and profitability into the business. We will remain the flexibility in terms of timing and, in some cases, cost in H2 to get this right. Turning to our outlook for earnings, including GAAP net loss and adjusted EBITDA.

The reduction in our expected revenue range due to the volatility we have seen and expect to continue to see in a small subset of programs related to a single technology offering, coupled with our focus on completing hardware deliveries in order to reduce unbilled balances naturally results in a reduction to our GAAP earnings and adjusted EBITDA expectations as well.

That said, it is difficult to provide reliable guidance estimates beyond revenue for the remainder of the year. Consistent with Q2, we may take additional actions to settle contractual arrangements that do not yield acceptable returns or align to our long term strategy.

We may also make continued adjustments to our cost structure, where appropriate, designed to position us for positive operating leverage in FY25 and beyond.

Our objective for the remainder of the year is to maintain the flexibility to take this as necessary to complete this work as quickly as possible in order to position the company for what we believe will be a return to predictable organic growth, improved profitability and strong cash flow in FY25.

So we are withdrawing our full year FY24 GAAP and non-GAAP net earnings guidance, including adjusted EBITDA, provided on November 7, 2023. As I have said in prior calls, demand remains strong, our outlook for bookings is unchanged and we continue to expect strong bookings for the second half with full year bookings expected to exceed $1 billion.

In addition, while we expect limited free cash flow in Q3, given the strong Q2 results, we believe we will be cash flow positive for the second half and full fiscal year.

As Dave will discuss, total net leverage, based on our credit agreement definition, is well within our covenant thresholds and we expect cash generation to strengthen our balance sheet as we progress through the year.

As we proceed through the second half of FY24, our goals are as follows; complete or retire risk on more than half of the remaining challenge programs; retire the risk associated with the common processing technology I mentioned earlier and validate a highly producible, scalable design that can be released into production; and validate capacity requirements and our ability to ramp production against our expected large and growing backlog in Q4 and into FY25.

Success in these areas, along with consistent performance against internal expectations, will give me and Dave the comfort to reestablish guidance across all financial metrics. To summarize, we are pleased with the progress we made in bookings and free cash flow in the quarter and expect strong results in these areas for the year.

We will continue to assess our organization and cost structure through the second half to position ourselves for positive operating leverage in FY25 and beyond. We continue to make progress on our challenge programs and are working diligently towards the goal of a quarter free of material program execution volatility in our financial results.

We look forward to showing progress in this area when we speak next quarter. With that, I'll turn the call over to Dave to walk through the financial results for the second quarter, and I look forward to your questions.

Dave?.

Thank you, Bill. I'll start with our second quarter fiscal '24 results and then discuss our full year fiscal '24 outlook. As expected, our financial performance in the second quarter was below that of the prior year across all P&L metrics.

As discussed in our last earnings call, fiscal '24 is a transition year where the organization is seeking to execute on both our challenge and development programs and then progress to the follow-on production awards.

Through that transition, we expect to recognize the small proportion of remaining revenues on the challenge program contracts, but more importantly, we expect to move towards releasing significant working capital balances, especially related to unbilled receivables.

We then anticipate shifting our resources to execute on the follow-on production awards, which we believe will begin to rebalance our program portfolio more heavily towards higher margin predictable production programs as well as consume existing inventories. We continue to expect this transition to occur throughout fiscal '24 and into fiscal '25.

In Q2, we made meaningful progress towards this rebalance with some positive early indicators emerging. First, our bookings for the quarter was $325 million with a book-to-bill of 1.65.

Second, we completed exited or retired risk on four more challenge programs in the quarter for a total of eight programs through the first half of fiscal '24, better than the five we had expected. We continue to be on track to transition a majority of the approximately 20 challenge programs by the end of the fiscal year.

Finally, we generated over $45 million of operating cash flow, $37 million of free cash flow and improved working capital by approximately $70 million in the quarter.

Cash flow generation in the quarter was primarily a result of strong collections, including a higher volume of customer advances as we successfully negotiated more favorable billing terms on newer awards. With that, please turn to Slide 11, which details the Q2 results.

Our bookings for the quarter were $325 million with a book-to-bill of $1.65, yielding backlog of $1.3 billion, up over $160 million or 14% year-over-year and $128 million or 11% sequentially. As Bill discussed, we received two large awards in the quarter.

LTAMDS was received earlier than expected in fiscal '24 and signifies an important franchise production program for which we are a key supplier of processing capabilities. We also won a large cost plus development program on a strategic weapon system with favorable billing terms.

Revenues for the quarter were $197 million, down $32 million or 14% compared to the prior year of $230 million.

As expected, revenues decreased year-over-year as we continue to prioritize resources to execute our challenge programs, transition from our higher mix of development programs and aim to better align our operating cadence with prudent working capital management.

As Bill noted, we experienced nearly $31 million of cost growth impact in the quarter as compared to approximately $7 million in the prior year. The $31 million was comprised of $14 million related to our challenge programs and $17 million related to multiple development and production programs.

In accordance with GAAP, this resulted in cumulative revenue adjustments to properly reflect progress on the programs due to the revised cost baselines driving an overweight impact in the second quarter.

The $14 million cost growth impact related to our challenge programs was almost entirely driven by a single program and was a result of facts and circumstances in the quarter, specifically on the cost growth related to unexpected redesign and prototype efforts of a common processing architecture following initial development unit deliveries.

While we executed largely in line with expectations across the remaining challenge programs, we did experience cost growth on certain other development and production programs in the quarter, which impacted revenues in a similar manner but to a lesser extent.

Of the remaining $17 million of cost growth impact, nearly $8 million related to development programs and $9 million related to production programs. The cost growth within our development programs was primarily attributable to $6 million of cost growth across a suite of three development programs with similar performance obligations.

A majority of this cost growth was due to a revised cost baseline predicated on initial development unit deliveries and extrapolated across the remaining backlog. Similarly, we had several production programs in the first half of the fiscal year for which actual costs incurred were trending higher than the prior cost estimates.

This resulted in a revised cost baseline for the remaining backlog on these programs. In addition, we experienced minor technical issues resulting in incremental rework costs across several production programs in the quarter.

The scope of the issues was narrow, risk mitigation plans are in place and the issues are expected to resolve and allow for delivery on these programs beginning in the third quarter.

Finally, as we build and mature integrated processes and management systems, we seek to continuously assess our judgments and estimates, including potential future risks and opportunities based on the latest and best information available. We are applying our judgment consistently as we work through the full portfolio of programs.

In addition, and consistent with prior earnings calls, we are shifting our operating cadence with the goal of more properly balancing our material purchases with contract awards and resource availability, driving better working capital results.

These factors are contributing to a temporary volume shift in our total revenue, especially our overtime revenue, which decreased by approximately $25 million year-over-year. We expect this trend to continue through the remainder of fiscal '24. Gross margin for the second quarter decreased to 16% from 35.3% in the prior year.

Gross margin contracted year-over-year primarily as a result of cost growth impacts as well as higher manufacturing adjustments, especially as related to inventory reserves and scrap. As just discussed, we recorded approximately $31 million of cost growth impact in the second quarter.

This represents approximately $23 million of incremental cost growth impact year-over-year contributing to more than 50% of the margin reduction, as shown on Slide 15 in the appendix.

The remaining decrease in gross margin year-over-year was primarily due to higher manufacturing adjustments of approximately $12 million related to inventory reserves and scrap. With regard to inventory reserves, we recorded over $8 million more reserves in the quarter as compared to the prior four quarter run rate average.

This was a result of specifically identified excess and obsolete inventory in the quarter, primarily due to a shift in customer demand toward our next generation product offering. In addition, we are actively marketing and selling certain of our slow moving inventory, sometimes at a discount to the current carrying value.

With regard to scrap, we experienced higher levels of discrepant material, especially related to the common processing architecture involved in several of our challenge programs. Due to the nature of the technology, the discrepant material is high value and cannot be reused or reworked.

We have several initiatives underway designed to address more efficient and cost effective producibility of these subsystems. We expect gross margins to recover gradually in the second half of the fiscal year.

That said, we believe the full year fiscal '24 gross margins will be below those of fiscal '23 given the higher than expected cost growth impacts through the first half of fiscal '24.

As Bill discussed, we believe we have successfully narrowed the scope of risk across our challenge programs to a single technology related to our common processing architecture within one of our business units.

We expect gross margins to continue to be impacted by unknown risks that may materialize as we progress these challenge programs through final stages of completion.

In addition, we may continue to see cost growth impact as we transition from our higher than normal development program mix as well as continue to mature our operational management systems and reporting.

Operating expenses decreased approximately $3.1 million year-over-year due to $2.1 million of restructuring charges as well as $1.3 million more of amortization expense in the prior year.

That said, the second quarter of fiscal '24 included nearly $5 million of contract settlements, resulting from negotiations to reduce performance obligations on customer contracts that do not align with our strategy or otherwise do not have acceptable returns in exchange for lower cash consideration.

We believe these costs are not comparable to the prior year, and thus, our run rate operating expenses would have decreased nearly $8 million year-over-year, reflecting the cost savings actions executed in our first quarter fiscal '24.

As Bill mentioned, earlier this month, we announced an organizational consolidation of our divisions into one unified structure, incorporating multiple business units and supporting functions.

The resulting workforce reduction is eliminating approximately 100 positions, resulting in expected restructuring charges of $10 million to $12 million in the third quarter. This cost savings action is expected to yield annual run rate savings of approximately $20 million.

In total, our cost savings actions in fiscal '24 are expected to yield over $40 million in annual run rate savings. GAAP net loss and loss per share in the second quarter was $45.6 million and $0.79 respectively as compared to $10.9 million and $0.19 respectively in the prior year.

The increase in GAAP net loss is primarily result of approximately $48 million of costs incurred in the quarter comprised of $31 million of program cost growth impacts, $12 million of inventory reserves and scrap expense as well as nearly $5 million of contract settlements.

GAAP net loss was also impacted by the temporary volume shift in revenues as we align our operating cadence with prudent working capital management. These factors were partially offset by approximately $16 million of incremental tax benefit year-over-year.

Adjusted EBITDA for the second quarter was negative $21.3 million compared to $35.7 million in the prior year. Adjusted loss per share was $0.42 as compared to adjusted earnings per share of $0.26 in the prior year.

Consistent with GAAP net loss and loss per share, the decrease was primarily a result of approximately $48 million of costs incurred in the quarter comprised of $31 million of program cost growth impacts, $12 million of inventory reserves and scrap expense as well as nearly $5 million of contract settlements.

Adjusted EBITDA and adjusted loss per share was also impacted by the temporary volume shift in revenues as we align our operating cadence with prudent working capital management. Slide 12 presents Mercury's balance sheet for the last five quarters. We ended the second quarter with cash and cash equivalents of $169 million.

We increased our borrowings by $40 million in the quarter, resulting in $616.5 million of funded debt under our revolver. As Bill discussed, total net leverage based on our credit agreement definitions is well within our covenant thresholds.

Our debt agreement allows for adjustments beyond those included in our adjusted EBITDA definition, including adjustments related to some of the headwinds that we believe are temporarily driving earnings volatility and obscuring the underlying performance of the business.

We are forecasting significant headroom in the covenants for the remainder of fiscal '24 and expect to end the year with lower gross debt as we deploy the positive free cash flow generated through the remainder of the year to pay down debt.

Billed receivables decreased approximately $9 million as a result of continued strong collections in the quarter.

Unbilled receivables decreased approximately $38 million, primarily due to successful execution and billings across the program portfolio, as well as cumulative adjustments associated with the cost growth impact in the quarter and our contract settlements as previously discussed.

Inventory decreased approximately $8 million in the quarter, primarily as a result of the incremental reserve and scrap activities. Accounts payable decreased nearly $8 million, evidencing the shift in our operating cadence aimed at better aligning the timing of material purchases with both contract awards and resource availability.

Deferred revenues increased approximately $23 million in the quarter, reflecting the higher volume of customer advances as we successfully negotiate more favorable billing terms on newer awards.

Working capital improved approximately $70 million in the second quarter as we transition through the completion of our challenge programs and start to shift the development and production mix in the program portfolio. We successfully converted unbilled to billed receivables and ultimately cash in the quarter through our focused execution efforts.

We also negotiated advanced payments on a number of new contracts and reduced inventory growth through effective management of our material purchases. We expect this working capital trend to continue, resulting in further progress by the end of the fiscal year, primarily driven by decreases in unbilled receivables and inventory.

As we continue to execute, especially as related to our challenge programs, we expect to convert unbilled to billed receivables and then cash. In addition, we expect the mix of development programs to shift to better align with historical norms.

And as we receive expected follow-on production awards, we believe we will consume inventory purchased in anticipation of these awards. As we have discussed on prior calls, we consider 35% of trailing 12 months revenues to be a more appropriate level of working capital for the business. Turning to cash flow on Slide 13.

Free cash flow for the second quarter was $37.5 million as compared to $22.2 million in the prior year. As previously discussed, this was primarily a result of strong collections in the quarter, including a higher volume of customer advances as we successfully negotiate more favorable billing terms on newer awards.

I'll now turn to our financial guidance for the full year fiscal '24. Our results through the first half of fiscal '24 have been below expectations.

In addition, we expect earnings volatility may continue for the remainder of the year, including as we make intentional decisions around the strategic alignment of our program portfolio, technology investments and working capital balances. As a result, our full year results are expected to fall short of the previously issued guidance.

At the start of the fiscal year, we shifted our guidance approach to guide annually rather than quarterly due to the expected volatility in financial performance as we pivoted focus to operational execution, especially related to our challenge programs.

We have taken several actions designed to improve predictability within a subset of our business, and key early indicators of progress emerged in the second quarter.

We have successfully completed eight of our approximately 20 challenge programs and believe we are on track to complete the majority of the challenge programs by the end of the fiscal year.

That said, we have experienced development challenges on a single technology within one of our business units that spans several of our remaining challenge programs. These challenges will require heightened effort and potentially increased cost through the remainder of the fiscal year.

We have quantified this risk, among others, across our program portfolio based on information available as of the second quarter as well as considered how best to allocate our resource capacity to further reduce working capital levels, resulting in a revised revenue range of $800 million to $850 million for fiscal '24.

Providing meaningful estimates of GAAP and non-GAAP measures beyond revenue is challenging, including in light of the continued actions we may need to take to complete our business transition in fiscal '24. Thus, we are withdrawing our GAAP and non-GAAP guidance outside of revenues as provided on our first quarter earnings call on November 7, 2023.

While we are not formally guiding beyond revenues for the remainder of the fiscal year, we can provide further perspective over certain key financial metrics. First, we expect the demand environment to continue to support strong bookings especially in the fourth quarter, yielding expected fiscal '24 bookings in excess of $1 billion.

We continue to expect these bookings to be weighted more heavily towards production based programs, supporting the start of a shift in the mix of development and production programs in our portfolio.

Second, we believe we have narrowed the risk and scope of effort within our challenge programs to a single technology in one of our business units with the remaining challenge programs executing largely in line with expectations.

We have completed eight of our approximately 20 challenge programs and continue to expect to complete a majority of all challenge programs by the end of the year.

The cost growth impacts incurred through the first half, coupled with the potential for continued volatility, especially related to this single technology, will negatively impact revenues and gross margin for the remainder of the year. As such, we now expect both revenue and gross margin to trend lower than the prior year.

We believe operating leverage will improve as we progress through the year due to expected revenue and margin increases compounded by savings from the cost actions completed in both the first and third quarters of fiscal '24.

We expect GAAP net loss and loss per share as well as adjusted EBITDA and adjusted loss per share for fiscal '24 will be meaningfully below the prior year.

We expect positive cash flow for the fiscal year before any benefit from the potential passage of the R&D tax legislation currently before the Senate, which we anticipate would add more than $40 million of additional cash flow in fiscal '24.

While cash flow in the third quarter is projected to be near breakeven, we expect a significant improvement in the fourth quarter as we plan to complete a majority of our challenge programs, ship and build final product and convert unbilled receivables to billed receivables and then to cash. We continue to expect positive free cash flow for the year.

A government shutdown or prolonged continuing resolution may pose risk to our cash flow expectations. As discussed, we expect further improvement in net working capital by the end of the fiscal year as we anticipate seeing reductions in unbilled receivables, but also inventory with more meaningful reductions expected over the longer term.

In closing, we continue to be focused on four priorities; enhancing execution to deliver predictable performance, driving organic growth, addressing our cost structure to expand margins and driving improved free cash flow conversion and release.

We believe executing on these priorities will not only enable a return to historical revenue growth and profitability but will also drive further margin expansion and cash conversion, demonstrating the long term value creation potential of the business. With that, I'll now turn the call back over to Bill..

Thanks, Dave. With that, operator, please proceed with the Q&A..

[Operator Instructions] Your first question comes from the line from Peter Arment from Baird..

Bill, I'm just trying to understand on the cost growth breakdown. The $14 million that was derived from one of your challenge programs, I guess, it's just tied to one program, the $14 million of cost growth.

Will that one specifically be eliminated as you're thinking about having the majority of these done this fiscal year or do we expect that, that's one of the troubled ones that will linger a little bit?.

The short answer is that program will be active for a while. But maybe if I gave some color on what was behind the cost growth, it might be helpful to understand what's happening with that program. And it's actually, in some ways, sort of unique. This is a challenge program that includes development, low rate production and a production run.

Most of our development programs just contain the development activities or low rate production. This one is unique in that it includes a long production run.

And what we discovered in the quarter as we worked our way through development and then we worked our way through the first few units in production that we got a good view on the unit economics or the unit costs that then informed an updated estimate on the production.

And so the big cost growth in the quarter that we recognized was tied to the impacts of what we learned and how that pertained to the production. So while that program will be around for a while, we think we have a much clearer view of what we need to do to execute on that program and what the production will look like.

So hopefully, that color commentary is helpful..

And just a follow-up, if I could.

Just given all the cost growth and a lot of Mercury over the last several years was built up through kind of M&A, are any of the business impaired, or how do we think about that just thinking about risks from a financial standpoint?.

I'll let Dave speak to that in a second. There's one more piece of color commentary that I wanted to make about the program that I referenced.

And that is that even after we made the adjustments to our ETC for the production run, the margin profile on that program is still above, what I call, the composite average of our gross margin across our full portfolio. So it's just another, I think, helpful piece of information to round out that picture.

But on the impairment question, I'll go ahead and turn it over to Dave..

When we do an assessment around impairment, we do that at a gross level so we don't look at the individual components. And we don't maintain goodwill at that level, we maintain it at the overall level. So we always do an analysis on the overall company and where we stand from a goodwill impairment standpoint..

Your next question comes from the line of Seth Seifman from JPMorgan..

I wanted to ask first, I noticed in the filing that the percentage of sales to some of the key customers is down kind of lower than it's been, below the 10% disclosable threshold.

And I guess how do we kind of think about what that means and how do we think about that with regard to the kind of underlying trend of prime contractor outsourcing that kind of underlies the Mercury business case?.

I think those percentages are going to bounce around a little bit quarter-to-quarter. So I wouldn't pay too -- or at least I personally don't pay too much attention to that. To the extent that they do go down, I think it does show the robustness of our backlog and the diversification of our backlog.

And the thing that I'm really focused on, around customer health and desirability of our products in the marketplace and the strength of demand is to look at our backlog. And right now, we're staring at a record backlog.

We had a near record bookings for the quarter, which I think is the strongest indicator of our customer health and the health of our business looking forward.

Dave, anything you want to add?.

I would just mention that it is the threshold at 10% and it does vary. If you look at it historically it varies. I think some of them dip just below and some of them pop up just above in a given quarter. So I don't think there's a significant shift in any of these..

And again, I go back to the backlog and I think that reflects the trust that our customers have in us with respect to their franchise programs. And we mentioned a couple of the specific bookings that we received in the quarter that I think speak to that fact..

And then maybe just I think one of the key things that people think about as they -- or maybe one of the key ingredients in the model as you think about where -- without the guidance and with the results being so variable now, some number in the outyears to anchor around, and it's probably the gross margin.

And so if you wanted to think about a kind of conservative case where things don't necessarily all turn out your way and some of these things -- still struggling with some of these things for a while.

What's kind of a fair way to think about, not necessarily next quarter but as people try to anchor around what the company might be able to do here in the future, a fair way to think about that gross margin number?.

I'll start and then Dave can chime in. I mean specifically, we don't guide to gross margins. What we have said and which we continue to believe to be true is that when you look across our portfolio, our range of gross margins is 30% typically for development programs and 40% for our production programs.

And what really drives our gross margins is the mix associated with development and production. And so as we think about margin targets going forward, we more think about EBITDA targets going forward.

And I would just refer you to the bridge that we put in prior investor presentations where we think the key to getting to those margins is around minimizing the volatility in our development programs and the EAC impacts.

And despite the numbers in the quarter, we feel like we're making very good progress to boxing the risk associated with the development programs and the EAC volatility. Second, it's transitioning the development programs to production and we are making very good progress on that front. One of the big bookings in the quarter is evidence of that.

But as we're progressing our way through development, we're getting closer line of sight to converting them to production, its continued efficiency in our cost structure.

And again, this quarter, and with the negative operating leverage, it won't show through this year but we expect it to go through next year, the efficiencies that we've driven into our cost structure.

And then ultimately, in the near term, driven by the organic growth associated with converting our production programs to development, positive operating leverage. And that's really the path from where we sit today to our targeted margins that are in the low to mid-20s, and that's still our view on the target margins for the business.

So I'll pause there.

Dave, anything that you would like to add to that?.

I think that's right. And as Bill said, margins in the low 20s, he's referring to EBITDA margins, just to be sure. And we've reiterated and looked at and we still feel confident in the long term model that we’ve laid out in the past and that has the gross margins that we believe this business should be able to generate and continue to believe that..

And just to go back -- to bring your question and the first question that we had on the call together, the one program that caused really the majority of the volatility in the quarter was the challenge program that included the development, the low rate production and the long production run.

It had an impact in the quarter, because we have revised estimates of our percent complete. And so we had some reversals in the quarter that basically had the cumulative catch-up in the quarter.

But again, when we look at the gross margins of that program going forward, still above the average gross margins of our profile across that spectrum of 30% to 40% that I reiterated for development in our production programs. So hopefully, that's helpful.

Hopefully, it gives you better insight in how we're thinking about the target margins of the business and really focused on target margins when it comes to EBITDA margins..

Your next question comes from the line of Jonathan Ho from William Blair..

Thank you for the additional color on the challenge programs that you just provided. One thing I wanted to better understand a little bit is that you have scrutinized these trouble programs and implemented processes in the past.

Can you help us understand why it took so long to sort of identify these additional issues? And maybe help us understand why this time you have more confidence that you've got a handle on it?.

One thing that I'll iterate is where we're seeing EAC growth in the challenge programs, in general, it's not repeat issues. So if you look across the list of programs, the 19, with the exception of the one, we had very little volatility in the quarter.

Where we did see the issue on the one program represented the fact that we're progressing the program. So we worked our way through development, that's a positive. We worked our way through the low rate production. And as we did, we learned more about the unit economics and specifically the unit cost that informed our view of the production.

So I understand the question around why it took so long, but it really has taken us progressing through the different phases of this program in particular. And again, this one has a different profile, because it includes development, low rate production and a longer production run.

On most of the development programs in general and our challenge programs, we have the opportunity to complete the development. So there may be some risk associated with completing the development.

But at the end of the development, we get to the design baseline, we have an opportunity to execute on a small number of units so that we can get a good baseline for the unit economics, and in particular, the unit cost, and then we're able to factor that into bids for production contracts that are follow-on.

So in this particular case where we have development, low rate production and a longer run production associated with it, within this one program, we have the risk associated with those three phases, which is relatively unique. So it may seem like it took us a while to get to the EAC and really understanding it.

But we had to do the work and progress through development and low rate production in order to inform and update our view on the production run. So that's really the background on that..

Just one quick one as a follow-up.

How flexible have your partners been to sort of work with you on these revised either contract terms or prepayments? Does this have an impact on your future relationships as well?.

On payments themselves, Jonathan, could you please clarify?.

So you referenced sort of going back to renegotiate some of the contracts and then having some acceleration in terms of the payment. So I just wanted to understand if that impacts the relationships, whether your partners or end customers have been willing to work with you? Just trying to understand sort of the dynamics around those discussions..

Yes, thank you for clarifying the question. And this ties back to what we've talked about now for a couple of quarters about, in general, our more cash efficient approach to our operations. And that has a couple of comments. One is how we order material and better stage it with the timing of deliveries.

And the second piece of it is the contract terms that we put in place so that we can better align progress with progress payments historically. And one of the reasons why we have a large unbilled balance is our payment terms speak to us being able to bill invoice and collect cash only once we're complete and deliver the units.

And so one of the things that we've done operationally is work to align our payment terms with progress payments. And so that, I think, is the renegotiation that you're referring to. And what I would say is, in general, it's not a big deal because our customers, in many ways, our incentives are aligned.

So when we build them, they're able to collect cost, invoice their customers and collect cash. So our incentives are aligned. And as a result it's typically not a difficult conversation for us to have with our customers.

Anything, Dave, that you would add to that?.

I would add to that. When you think about the relationship and you're asking about our customers and working with our customers, I mean, a reflection of our customers’ thoughts and you know working with us, I mean, it’s reflected in the strong bookings we had that you see.

These are customers who largely we have these customers have had them for a long period of time, and they're working with us. Bill has met with several of the customers even on the areas with the challenge programs. So he's working with those customers. And they want us to get to the answers the final activity so that we can get into production.

They need these products where we have a unique capability to deliver these products and you see it reflected in our growing backlog and in our bookings that we've seen. As Bill said, we see some transitory kind of impacts but our customers understand that and then they’re working with us..

And then the other thing I'll add, Jonathan, and this may have been part of what you're asking as well, we did mention that we had some contract fulfillment in the quarter that resulted in a transitory impact, I think, of $5 million.

In general, those discussions and what was behind the settlements had nothing to do with us trying to negotiate different payment terms, better align payments with progress payments, et cetera.

They were completely different matters, specific to those contractual relationships, and not reflective of us trying to negotiate different terms with our customers. So in the event that, that was part of the question, I want to provide that color..

Your next question comes from the line of Sheila Kahyaoglu from Jefferies..

This is Kyle Wenclawiak on for Sheila. I appreciate the legwork you guys are doing around cost savings and the cash focus nowadays. But I just want to hone in on the profitability guide for this year, because it seems like the two uncertainties are kind of what you just mentioned around contract exits.

So first question there is maybe how much of the backlog or revenue bridge is maybe up for negotiation? And then second part being the cost savings, it seems like a lot of that is pretty exhaustive, so maybe some color around why you didn't hone in on a more profit shakeout this year?.

I'll take a stab at the two questions, and then Dave, maybe can fill in. First, on just the cost savings piece of it. As we’ve said in prior calls, I don't think of that as a onetime activity. I think of it as an ongoing activity to drive efficiency in our organization and our structure.

And I think we've been pretty consistent in demonstrating that that's our focus with what we announced in Q1, the further enhancements that we rolled out in January, and we'll continue to look at opportunities to improve our cost structure.

And I think that's a very natural thing to do in a business like ours that's been built up through acquisitions over a period of time for us to continue to look for opportunities to better integrate the business. As far as the contract, I guess, on the first question around….

This is Dave, Kyle, if it's all right. If I understood the question, it was around, of the $1.3 billion of backlog we have, how much of that backlog do we think would be -- I don't know what the right word would be, potentially renegotiated.

Is that what you were driving for?.

Yes, maybe how much of the backlog is maybe the lower margin work that you'd look to either exit or I mean, I guess, renegotiate?.

I think about it very differently. That isn't a dynamic that we're currently thinking about or working on. I mean we feel very good about the backlog that we have in place. And again, like I said, it's a record backlog coming off of a great bookings quarter.

The risk that we see in the business really is isolated to what we consider to be about 20% of the business, that's where we've seen volatility in the business. And the remaining 80% of our business has performed very predictably and we expect it to continue to perform predictably.

And we're really focused in not so much on contract renegotiations or anything like that, but it's the execution in the 20% of our business.

In particular, that includes this one common processing architecture technology that cuts across a few programs that we need to finalize the work that we have currently underway so that we can get to a design that is not just producible, which is where we are today, but producible at scale, so that we can perform very predictably and profitably and that’s our focus.

So it’s less about the $1.2 billion backlog that we have and it's more about this one part of our business that represents 20%, and this common technology is a subset of that 20%..

And that's not to say that we feel like 20% of the business is at risk. What we're saying is that there's contained within that segment of the business that piece of business is where we see the highest concentration of risk that we're working through.

But as Bill said, Kyle, I don't see a significant exposure for renegotiation settlement in our backlog..

And then I think the other thing that I would add relative to that area where we're focused on the technical work, we feel very good about our long term positioning there, because we're differentiated, we're sole source, we're baselined on programs where the capability is mandatory.

And our customers are incentivized, we believe, with us to get to the other side on these technical issues, so that we can get to the person runs and get the product into their hands. So hopefully that paints a little bit clearer picture of the technical issues that we're describing..

Your next question comes from the line of Michael Ciarmoli from Truist Securities..

Just to stay on that topic, I mean, looking at the guidance cut, I mean, can't we just say the high end of the prior $1 billion to the low end now at $800 million, isn't that 20% of the business? So I mean, it seems like 20% of the overall business has been kind of compromised here..

Yes, and I think I would say that when we look at the reduction in the range, it is largely in that business unit where we see the biggest reduction in the revenue. Because as we looked at the first half and the adjustments that we've taken that have impacted revenue, they've largely been in that business, as Bill said.

And as we look at the volume going forward, as we both talked about, we're going to get these programs lying flat on the development before we really start producing in volume into the production. And that transition to make it seamless and to make it smooth without variability in the future needs to be completed before we move ahead.

And that's why you're seeing we're not having as much early material receipts as we've had in the past. We're managing that carefully, so we don't end up in a situation where things are -- where we brought in things that design changes are still happening, too.

And so yes, a significant part of that reduction in the range is driven by that part of the business..

And I would just offer too that it's really a timing around that volume and pushing to the right of that volume. And that's as a result of us being very methodical and working our way through the technical issues to get to a robust baseline that we can produce very predictably and profitably and at scale.

And the reason why we're doing that is because we're very excited about the prospects for this part of our business. It's highly differentiated. We have sole source positions.

We see a significant growth opportunity in front of us in this area with attractive gross margins, similar to when I walked through with the one challenge program where we had the major source of our impact this quarter still operating at very healthy gross margins going forward. And so we're very excited about our piece of this business.

This volume reduction largely associated with that part of the business is a push out to the right..

And Michael, I would say it is a thoughtful, intentional view on our part of making that decision to not add to the risk profile by bringing that in -- by executing that early..

Just the last one, the $150 million guidance cut at the midpoint, you called out the revenue headwind from cost growth in the quarter in volume in the quarter.

What's sort of the breakdown for the year if you can bridge kind of the $23 million in cost growth you saw this quarter? Is it fairly balanced, or how should we think about that?.

I think the way I would look at it is, as we talked about, we're not trying to guide the back half from a profitability standpoint.

It is if you take the first half and you take the reduction that we saw the shortfall in revenue, it's starting with that as the starting point that that's in the number for the year and then taking a look at exactly what Bill said, the intentional shifting of execution on contracts until we've got some of these things laying flat on that piece of our portfolio, not certainly on our entire portfolio..

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

Okay. Well, thank you very much. And I very much appreciate everybody listening into our call this afternoon and the questions, and we look forward to providing you an additional update next quarter. Thank you very much..

This concludes today's conference call. Thank you for your participation. You may now disconnect..