Good day, everyone, and welcome to the Mercury Systems First Quarter Fiscal 2020 Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the company's Executive Vice President and Chief Financial Officer, Mike Ruppert. Please go ahead, sir.

Good afternoon, and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events & 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 strong results for the first quarter of fiscal '20, extending the momentum from fiscal '19 with record revenue, backlog and net income. The industry environment is positive, and our business model is performing extremely well. We continue to execute strategically by investing in our people, technologies and capabilities, growing organically and supplementing organic growth with strategic M&A. Given the strong start to the year, we're raising our fiscal '20 revenue guidance. In addition, we now expect to deliver 11% to 12% organic growth for the year. Turning to our Q1 financial highlights on Slide 4. Our revenues are growing faster than the industry average. Total revenue for the first quarter increased 23% from Q1 of fiscal '19, exceeding the high end of our guidance. Organic revenue was up 17% compared with 6% growth in Q1 last year. Our largest revenue programs in the quarter were next-generation missile system, SEWIP, Filthy Buzzard, E-2D Hawkeye and CPS. Q1 was another very strong quarter for new business. Total bookings were up 21% year-over-year to $216 million, leading to a record backlog and a book to bill of more than 1.2. Our largest bookings programs in the quarter were PGK, Filthy Buzzard, P-8, Patriot and Filthy Badger. But we also delivered strong levels of profitability. Adjusted EBITDA was up 16% from Q1 last year, exceeding the high end of our guidance. As expected, free cash flow came in at 40% of adjusted EBITDA, reflecting year-end bonus payments as well as our acquisition integration and growth investments. Turning to Slide 5. For an operational perspective, we're making great progress integrating prior acquisitions and investing in the business for future organic growth. Over the past several years, we've built out our own domestic manufacturing capabilities. We're now making progress on a multi-year journey to improve both working capital efficiencies and the manufacturing operations themselves. This quarter, we expect to complete the build-out of our West Coast RF plant and facility consolidation plan. At that point, we'll have created state-of-the-art RF manufacturing facilities on both the east and west coasts. In addition, as we announced on October 15, we're investing $15 million to expand the scope of our trusted microelectronics business in Phoenix. The build-out of the clean room is underway, and we're ordering capital equipment. As background, we acquired this microelectronics business from Microsemi in 2016. This performed extremely well under Mercury's ownership since then, more than doubling in revenue with improved profitability. Our goal for this next round of investment is to take the business in Phoenix to the next level. We're positioning Mercury as a leading merchant supplier for commercially developed custom silicon to the defense industry. The DoD needs access to commercial silicon technology, given the dynamics of R&D funding and where innovation is occurring. We believe Mercury is uniquely positioned to meet this need. As a high-tech company that operates in defense, we have proven expertise in complex systems design, embedded security, silicon integration and trusted manufacturing. Our new capabilities in Phoenix will allow us to deliver next-generation heterogeneous silicon open architectures and military-grade computing at chip scale using the most advanced commercially available technologies. These technologies will enable new applications in radar, EW, missile systems and communications as well as AI autonomy. We believe this is an opportunity with significant innovation and organic growth potential for Mercury over the mid- to longer term. As well, it has the potential to provide our defense prime customers and the DoD with much needed trusted microelectronics innovation. We're very pleased to have Tom Smelker join our team as VP and General Manager to lead this initiative. Tom brings 2 decades of experience developing semiconductor technologies for embedded defense computing and system security. In addition, as we announced on September 25, Bill Conley has joined Mercury as Chief Technology Officer after serving as the Director for Electronic Warfare at the DoD for the past 4 years. Bill is widely known in the industry and universally respected. His decision to enter the private sector as part of Mercury is a testament to our unique position at the intersection of commercial innovations that matter and the government's top defense priorities. We're also continuing to make solid progress integrating Mercury's previous acquisitions. Themis and Germane are now fully integrated. The Athena and Syntonic business systems integration are essentially complete. We're in the final phase of integrating GECO Avionics, which should be complete this quarter. And we're underway on the integration of APC, which closed on September 23. The APC team brings us highly differentiated capabilities in support of our strategy to build out an industry-leading avionics processing and mission computing business. The team is very excited to be part of Mercury, and we're already seeing new opportunities as a result of the acquisition. Turning to Slide 6. The defense funding and industry growth environment remains favorable. The 2-year defense budget deal provides funding through government fiscal '21. We're currently operating under a CR, which goes through November 21. We're cautious, however, that the current CR could be extended further. Defense spending is trending higher, especially the investment accounts. The DoD is prioritizing rapid modernization and next-generation technologies and capabilities, which align well with our strategy. The level of new program soft and design win activities remains elevated. We're seeing substantial growth in the estimated lifetime value of our top 30 programs and pursuits. This growth has been driven by 3 industry trends that we've discussed in the past. These trends include, first, supply chain delayering by the government and the primes; second, the flight to quality suppliers by the primes; and the most important, increased outsourcing by our customers at the subsystem level. We continue to see outsourcing as the largest sector of the growth opportunity in defense. Market activity related to modernization in radar, EW and C4I remains very high. We're seeing new opportunities in weapon systems, space, avionics processing and mission computing as well as secure and embedded rugged service. For example, during the first quarter, we won a new design to provide secure rugged servers on a classified program whose lifetime value we currently estimate in $300 million. We will notify that we won a processor upgrade on the Apache attack helicopter in our avionics and mission computing business. In addition, Raytheon recently announced they won LTAMDS, the Patriot missile defense system replacement, which is a major win for Mercury. The theme underpinning these activities is the shift towards safe, secure and trusted processing architectures. We believe that more of the technology that goes into our military platforms will need to be designed and produced in the U.S. As a result, we've been making significant investments to develop and manufacture secure hardware and software capabilities domestically. Our customers are supplementing Mercury's high level of internally funded R&D with R&D of their own. Given the substantial combined investment, we've been able to rapidly adapt our commercially available technologies to new and emerging defense opportunities. Both our target markets are growing faster than the defense market overall. Sensor and effector revenue accounted for 57% of total revenue in Q1, increasing 29% from Q1 last year. C4I revenue increased 11% year-over-year to 28% of Mercury's total revenue. Turning to Slide 7 and looking forward. We're positive about our business outlook. We're seeing very high levels of new design win activity and opportunities for continued growth. Over the longer term, our baseline forecast is for overall defense spending to increase at low single-digit rates. Our goal is to deliver organic revenue growth at a rate that exceeds this industry average. We're also well positioned to supplement our high levels of organic growth with M&A. We continue to be successful acquiring and rapidly integrating businesses that fit well with Mercury. The M&A pipeline is robust, and we're seeing interesting opportunities of varying sizes that are consistent with our strategy. We intend to remain active and disciplined in our approach to M&A, focusing on the Sensor and Effector Mission Systems and C4I markets as we have in the past. We're looking for deals that are strategically aligned and have the potential to be accretive both in the short and long term. The combination of strong margins and organic revenue growth, supplemented with disciplined M&A and full integration, forms the core of our strategy. We believe this strategy will continue to generate significant value for shareholders over the longer term as we execute our plans in 5 areas. First is to drive, on average, double-digit organic revenue growth supplemented by acquisitions. This is consistent with a 26% compound annual growth in total company revenue we've delivered over the last 5 fiscal years. The second is to invest in new technologies, our facilities, manufacturing assets and business systems. We will also invest heavily in our people. Third is manufacturing in-sourcing as well as driving strong operating performance across our manufacturing locations. The goal here is to enhance margins, quality and on-time delivery while improving working capital efficiencies over time. Fourth, we're seeking to grow revenues faster than operating revenues. This will allow us to continue investing in organic growth while maintaining strong operating leverage in the business. And finally, we're fully integrating the businesses we acquired to generate cost and revenue synergies over time. These synergies, combined with other areas of the plan, should produce attractive returns for our shareholders. So in summary, we remain focused on executing the strategy I just outlined. It's been successful for us over the past 5 years, and we look forward to extending this record of success. Our organic growth is accelerating, and expanding our trusted microelectronics business should add to this momentum over the longer term. We're bullish about the M&A pipeline, our manufacturing initiatives are delivering results, and our acquisition integrations are progressing well. Driven by these positive dynamics, we're anticipating another year of double-digit growth in revenue and adjusted EBITDA in fiscal '20, now including 11% to 12% organic revenue growth. Mike will take you through the guidance in detail. And so with that, I'd like to turn the call over to Mike.

Thank you, Mark, and good afternoon again, everyone. Mercury started fiscal '20 with strong first quarter results. Total revenue, adjusted EBITDA and adjusted EPS were up from Q1 last year. We delivered solid bookings growth and concluded the quarter with record backlog. Mercury's revenue outperformance gives us the flexibility to continue making growth investments in the business while still exceeding our expectations for adjusted EBITDA. In addition to delivering strong financial results in Q1, we completed the acquisition of American Panel Corporation, which we funded with cash on hand. We remain active on the M&A front, and as Mark said, our pipeline remains robust. Our acquisition integrations remain on track, and we're continuing to realize the forecasted cost and revenue synergies. Given Mercury's strong performance in Q1, we're increasing our full year fiscal '20 guidance for revenue, adjusted EBITDA and adjusted EPS. This guidance includes approximately $2 million of operating expenses related to the custom microelectronics initiative in Phoenix that Mark discussed. For the remainder of the year, we expect to continue investing in the growth of the business while still delivering record results. Turning now to the metrics on Slide 8. Mercury's revenue and bookings growth continued to translate into solid profitability in Q1. Total bookings increased 21% year-over-year, driving a 1.22 book-to-bill ratio. We ended the quarter with record backlog of $711.8 million, an increase of 40% compared to Q1 of fiscal '19. Backlog expected to ship within the next 12 months increased 32% from Q1 last year to $499.2 million. Total revenue increased 23% from Q1 last year to $177.3 million, exceeding our guidance of $160 million to $170 million. Organic revenue was up 17% year-over-year, and as Mark said, we now expect 11% to 12% organic growth for the year. Gross margin for Q1 was 44.2%, above our guidance of 43.5% and above 42.8% in Q1 of fiscal '19. Gross margin was up year-over-year primarily due to program and product mix and an inventory step-up associated with the acquisition of Germane in Q1 of fiscal '19. Gross margins in Q1 '20 also benefited from planned cost synergies associated with the acquisition integration of Themis and Germane. In Q1, internal R&D was $21.9 million compared to $14.9 million in Q1 of fiscal '19. As a percentage of sales, R&D was 12.3% compared to 10.4% a year ago and 11.5% last quarter. This increase is primarily driven by our increased investment in secure processing products to support recent design wins. SG&A for Q1 was $30 million, an increase of 21.1% from $24.7 million in Q1 last year, driven by both our organic growth as well as the inclusion of acquisitions over the last 12 months. As a percentage of sales, SG&A was 16.9% compared to 17.1% in Q1 of fiscal '19. GAAP net income and EPS in the first quarter increased 157% and 119% year-over-year, respectively. The increase was driven by strong operating performance as well as a lower effective tax rate this quarter as a result of discrete tax benefits associated with stock-based compensation. Adjusted net income for the first quarter increased 31.9%, and adjusted EPS was $0.44 per share, up 13% from $0.39 in Q1 last year. Adjusted EBITDA for Q1 increased 16% year-over-year to $36.7 million, exceeding our guidance of $32 million to $34 million as a result of higher-than-expected revenue and gross margin. Adjusted EBITDA margin was 20.7%, above our guidance of approximately 20%. Finally, free cash flow, which we define as cash flow from operations less capital expenditures, was $14.7 million compared with $16.3 million in Q1 of fiscal '19. Capital expenditures in Q1 were up by approximately $6 million from a year ago as we continue to invest in growing the business. Slide 9 presents Mercury's balance sheet for the last 5 quarters. The Q1 fiscal '20 balance sheet includes the APC acquisition. Mercury ended Q1 fiscal '20 with cash and cash equivalents of $161.3 million. Our cash balance was down $96.6 million from $257.9 million at the end of Q4. This reflected the acquisition of APC as well as a $14.6 million use of cash related to the vesting of restricted stock awards. The decrease was partially offset by free cash flow generation in the business. From a capital structure perspective, we remain well positioned with continued flexibility and good access to capital. At the end of the quarter, we had 0 debt and $161 million of cash on the balance sheet. In addition, we have a $750 million unfunded revolver with attractive rates. This provides us with significant financial capacity for future R&D and capital investments to drive organic growth as well as capacity to execute on our M&A pipeline. Turning to cash flow on Slide 10. Operating cash flow for Q1 was $24.3 million, up 21.4% from $20 million in Q1 of fiscal '19. Free cash flow for Q1 was $14.7 million or 40% of adjusted EBITDA. This compares to our annual target of 50% on a normalized basis. As we discussed on last quarter's earnings call, Q1 free cash flow reflects payments of year-end bonuses as well as expansion CapEx. CapEx in Q1 was $9.6 million or 5.4% of revenue, driven primarily by our West Coast RF facilities consolidation and investment in Phoenix. This compares with CapEx of $3.7 million or 2.6% of sales in Q1 last year. As we announced earlier this month, we expect our capital investment in the Phoenix expansion to be around $15 million in fiscal '20. As a result, we now expect free cash flow to come in at approximately 40% of adjusted EBITDA for the year. I'll now turn to our financial guidance, which includes APC. Starting with Q2 guidance on Slide 11, you can see that we're forecasting revenue to be $185 million to $195 million. Q2 GAAP net income is expected to be $13.9 million to $15.4 million or $0.25 to $0.28 per share. Adjusted EPS is expected to be $0.46 to $0.48 per share. Finally, adjusted EBITDA is expected to be $38.5 million to $40.5 million, representing approximately 20.8% of revenue. Turning to Slide 12. Our guidance for fiscal '20 reflects the outlook that Mark discussed, highlighted by continued growth and profitability. For the full fiscal year, we now expect revenue of $775 million to $790 million. This guidance represents 18% to 21% growth from fiscal '19 and is an increase from our previous guidance. We now expect organic growth of 11% to 12% for fiscal '20, up from the 10% we mentioned on last quarter's call. Total GAAP net income on a consolidated basis for fiscal '20 is expected to be $72.9 million to $77.8 million or $1.32 to $1.41 per share. Adjusted EPS is expected to be in the range of $2.03 to $2.11 per share, an increase of 10% to 15% compared to fiscal '19 results. Our guidance for adjusted EBITDA is $169.5 million to $175.5 million or 21.9% to 22.2% of revenue. As I mentioned, this increased guidance includes approximately $2 million of operating expense associated with the expansion in Phoenix. We expect CapEx for fiscal '20 to be approximately 6% to 7% of revenue, reflecting our integration activities, ongoing investment in the business and the expansion in Phoenix associated with our trusted microelectronics strategy. Turning to Slide 13 in summary. Mercury's Q1 was another excellent quarter with great operating results across the board. Our organic growth was strong. We had record revenue and backlog. We completed the acquisition of APC. And our M&A pipeline continues to be robust. As a result, we're well positioned to make substantial growth investments in the business while still delivering another record performance in fiscal '20. With that, we'll be happy to take your questions. Operator, you can proceed with the Q&A now.

Our first question comes from Sheila Kahyaoglu from Jefferies.

Good quarter. Mark, in your prepared remarks, you mentioned the LTAMDS win. You were called out with Raytheon. Can you talk about that contract, what the OTA structure means for you and just how the Mercury team is part of that contract?

Sure. So we're obviously very excited that Raytheon won the program. We've been working with them for a number of years, and we've actually invested quite significantly in our own internal R&D. From the program itself, actually, it includes some of Mercury's most advanced processing capabilities. So yes, we're thrilled to be a part of the team and the success that they've had. Clearly, it was a clean-sheet design, and I think that was a large part of the win. I think we contributed from a technology perspective. To put it in context for Mercury, we actually think it's potentially the largest single program that we've won in our history.

Is there any way to size what it means in terms of a content value or a lifetime program value for you?

Well, maybe the best way of thinking about that is that, in the third quarter, we're expecting a large booking, around about $30 million, which equates to a portion of the $384 million that Raytheon is going to get for the 6 radars that they're on the contract to deliver. So if you kind of do the math, yes, we've got significant content on the program. And listening to Tom on the call, he expects that, conservatively, it's a $20 billion program for them upgrading around about 250 systems that exclude the potential for forward-deployed radar. So it's a very, very large opportunity for Mercury over time. And our content on the program is significantly larger than what it was on the predecessor, which is the Patriot system. So we're pretty excited, Sheila.

Awesome. And then maybe just one on the CapEx, how we see it normalize into next year and if you could give any color on the capacity utilization and how we should be thinking about it.

Yes, Sheila, sure. So we don't guide CapEx beyond this year, as you know, but this year, we have expansion investment; we said 6% to 7% of revenue and CapEx associated with the Phoenix build-out and some of the integrations, including the West Coast facility. The capacity utilization and what we're building out in Phoenix for the microelectronics strategy that Mark discussed, I'll let him discuss that a little bit.

Sure. Yes. There's really two things happening in parallel. The first is that we're coming to the end of the build-out of our West Coast RF facility, where we're basically going to consolidate other RF locations into that one plant. That sets us up for continued growth in RF, and we're seeing some nice opportunities that we feel pretty good about in the facility we're building. The way to think about the investment in the trusted microelectronics facility in Phoenix is basically about being able to build the capability set. So we're actually expanding the scope as the source of trusted devices that we can manufacture there. And so we're obviously in the early phases of building out that clean room as well as the manufacturing equipment. But we do think that, that's a substantial opportunity for us in the longer term.

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

Nice quarter. If you could talk a little bit about the gross margin in the quarter. It's kind of in the range of what we've seen for the past year but maybe a little stronger at least than I had been expecting coming in, and some of the mix headwinds or tailwinds you faced and kind of how to think about where we go from here in terms of the cadence.

Sure, Seth. It's Mike. So for the quarter, we did overachieve the gross margin. We had guided around 43.5%, and came in a little higher than that. We don't talk profit by program, but it really was just program and product mix during the quarter. Going forward, as we look and you look at the annual guidance, we think that the gross margins are going to be similar to what we guided last quarter, a little bit higher, but no fundamental changes in the business overall.

I think we also benefited a little bit, Seth, from some of the integration activities that we have underway with the integrations of Themis and Germane.

Okay. Great. Is there anything to consider regarding the recent high-profile acquisition reform changes at the Pentagon and how they might impact Mercury?

Yes. So, I mean, clearly, we're seeing more use of 804 and OTAs. The LTAMDS award was an OTA contract. I think what they're looking to do is to be able to develop new technologies more quickly and deploy them more rapidly as well and then also get industry to participate in the funding associated with that. So the use of OTAs and, in particular, the use of nontraditional defense contractors plays very nicely with kind of our position in the industry as a business that's spending anywhere between 11% to 13% of its revenue on advanced R&D capabilities and are able to do things more quickly and more affordably, which is one of the major reasons that more work has been outsourced. So we think that contracting reform actually benefits Mercury as we saw in the LTAMDS award.

And our next question comes from the line of Pete Skibitski from Alembic Global.

Nice quarter. Guys, in the past, under continuing resolutions, I think Mercury's revenue has been a little bit inconsistent. I guess for the second quarter, you should have a CR for virtually the entire quarter. So are you feeling, for some reason, because of backlog maybe or just because of the stage of the cycle we're in, that this time, the CR will have less of an impact on 2Q in fiscal '20? Or are you still a little bit concerned in terms of how long it could last? Just want some color on that.

Sure. So given the strength of the current backlog, we actually don't expect any major impact to our 2020 financial outlook based upon the CR as it's described today, which ends on November 21. We're assuming that the actual CR itself could last 6 months or less, and we don't believe that there's material risk to our guidance and our ability to deliver the numbers that we've just outlined. And obviously, as the year progresses and we get better visibility into what happens with the defense appropriations bill, we'll update our guidance, but for now, we feel pretty good about our position, Pete.

Okay. Sounds good. And then, Mark, can you talk a little bit more about Bill Conley and electronic warfare? I mean it's obviously kind of a big push, I think, in terms of the peer threat right now in DoD, and you've got a strategic hire. Can you talk maybe about how R&D efforts might change with Bill coming on board? And I know he's got a lot of ideas I read about. Just would love for you to kind of expand on what that could mean to Mercury.

Yes. So, I mean, Bill is obviously a very well-known guy and trusted in the industry. He was pretty excited to come to Mercury given the business model. And I described that we're really at the intersection of the development of high technology for the use inside of the DoD. Bill's background, although he ran EW strategy for the last 4 years, he's touching a whole host of other areas, including microelectronics strategy, AI and various other initiatives. We're obviously participating in many of those areas in various ways. And he was pretty excited to be able to join a high-tech commercial company that's operating inside of the defense industry and bring his knowledge to bear. We don't think that it changes our business model, investment levels or focus right now. I think he's got a pretty good perspective on what we're focused on, and he believes that we're investing in the right areas.

And our next question will come from the line of Jon Raviv from Citi.

On the silicon effort, you made a significant decision to invest in expanding that capability. What is your perspective on the profitability and return of this type of business? How does this affect your target range of 22% to 26%?

Yes. So we haven't been very specific, Jon, other than to say that the current microelectronics business that we have that we acquired as part of the Microsemi Carve-Out acquisition back in 2016 has more than doubled in size, and we've been able to increase the level of profitability in that business over the last 3 years. The custom microelectronics business that we currently own is actually the most profitable product line that we have inside of the company. So it's a nice area. We see the potential of significantly innovating in the space. And we do think it has the potential of continuing to provide profitable organic growth over the longer term.

But I would add, Jon, that it is in the preliminary phases. If you look at fiscal '20, just to highlight it, I mentioned in my prepared remarks that we don't have any revenue associated with this effort in FY '20, and we do have $2 million of OpEx. So that's in our guidance, take a look at that. But as Mark said, the probability should be nice as it ramps up, but it's not a near-term item.

Great. And then regarding long-term organic revenue growth, can you clarify your statement about expecting double-digit organic revenue growth over the long term? Historically, you've mentioned high single to low double digits. Is there any change there, or should we anticipate double-digit organic growth moving forward?

Yes. So we've averaged, on average, over the last 5 years, 10% organic growth. So whether it's high single digit, low double digit or, on average, over time, double digits, we feel good about those numbers. I think we're seeing a tremendous amount of opportunity based upon the markets in which we're participating, which appear to be areas that the DoD is focusing on. So we feel pretty good about our potential to keep that high level of organic growth going, Jon.

And our next question will come from the line of Ronald Epstein from Bank of America.

It's Kristine Liwag dialing in for Ron. Mark, you've mentioned this $15 million capital investment a few times, and it sounds like it's a very profitable business line. Can you expand more on what you're providing that the market currently does not have here to make it so profitable for you? And also, what specific capabilities are you building out? And how vertically integrated will you be?

Yes. So our goal is that we're seeking to create secure and trusted chip-scale open architectures, basically defense applications, using the best commercially available silicon that's being developed in the high-tech world. So we're not necessarily doing the ASIC design, but we're taking chiplets from other companies and doing the engineering design and manufacturing of those devices specifically for defense applications.

Helpful. And then if you're taking these designs from other companies, how do you assure that the company that you're acquiring from don't have suppliers that come from unsecured suppliers like Chinese suppliers, for example?

Because we're actually getting access to the best silicon. The companies that we are teaming with have trusted processes in place. We're doing the packaging of those trusted devices here domestically in DMEA certified facilities.

I understand. Once you've completed the capital expenditure and invested the money, do you have existing programs to utilize the capacity at this plant, or will you need to secure new business to make use of this capacity?

At the initial stages, we are concentrating on developing the clean room and qualifying the manufacturing processes while also designing prototype devices for the initial application, which I won't detail. We are already engaged in discussions with several customers regarding that application. It's still early in the process, and we'll need to get the initial devices operational. The low-rate initial production won't commence until fiscal years '21 and '22, as mentioned by Mike in his earlier comments. Therefore, we have ample capacity to start with, and we are investing in the business for future growth.

And our next question will come from the line of Peter Arment from Baird.

Mark, you achieved 17% organic growth this quarter and have a solid double-digit plan for the year. Can you quantify how much of this growth is coming from outsourcing, considering the mentioned contact structure in LTAMDS and other factors? It seems like you are in a strong position. Are you able to provide those details?

Not quantify specifically, Peter, but yes, I can tell you that we're seeing increased levels of outsourcing really across the board. I think I talked about winning radar enterprise processing architecture last quarter that was mentioned on one of our customers' calls in the last week or so. The last time around, they did the work in-house. On LTAMDS, we picked up more content that was previously done in-house. So the outsourcing trend is clearly alive and well. Given the level of investment that we're making and the shift to secure and trusted processing architectures, we're exceptionally well positioned, Peter.

Yes, Mike, regarding the adjusted EBITDA margin, this quarter it is 20.7%, and for the next quarter, it's projected at 20.8%. Based on your guidance, it seems you expect a much stronger second half. Is this increase primarily due to mix, or are you also seeing benefits from synergies? Could you provide some additional insight on this?

Yes. You're right, at the highest level, if you look at the midpoint of our guidance for Q2, it's 20.8%. Midpoint for the year is 22%. So we are expecting, on an EBITDA basis, the second half to be stronger. That's the combination of slightly higher gross margins, but then also we're, on the flip side, investing in the business as I mentioned in my prepared remarks. So yes, the second half is looking better from an adjusted EBITDA margin because of that.

We also said, Peter, that we expected the year, from a revenue perspective, was slightly more back-end-weighted in the second half than the first. So we've got extra volume there in H2.

And our next question will come from the line of Michael Ciarmoli from SunTrust.

It was a good quarter. Mark, regarding the continuing resolution, it has no effect on the fiscal '20 revenue plan. What are your thoughts? Do you anticipate any changes in the near term concerning bookings? You have experienced a series of strong bookings quarters. If we remain under a continuing resolution for the next three to six months, do you foresee a possibility of a slowdown in bookings?

We don't, actually. We feel pretty good about our bookings potential. The pipeline looks very strong, Mike, and we're expecting a continued positive book to bill.

Got it. And just going back to Kristine's question on the build-out in Phoenix. I mean have you guys already secured design wins for these initial devices that you're working on, that don't go into LRIP until '21 and '22?

Well, the devices don't exist, right? Yes. So we better go do the design as well as the actual prototype and get through the build-out of the manufacturing facility. But we have had, with a couple of our teammates, pretty detailed discussions around what it is that we're trying to do in the very specific applications that these devices are targeted for. There's a very high level of interest. So although we haven't technically got a design win the way in which we would score that, there's significant interest out there, Mike.

Got it. And are there presumably going to be all digital systems on secure chips? Is that what we're kind of referencing here?

So it's a mixed signal devices that include security IP. Obviously, we have invested heavily in embedded security, and we've got a tremendous amount of intellectual property there. That's combined with our ability to do trusted manufacturing as well as system-level design at chip scale, with the clearances that we have and the trust in the cleared facilities really puts Mercury in a very unique position.

And can you give us a hint without maybe just general broad strokes, which end market? I mean is this more electronic warfare? Does it have to do with any of the emerging hypersonic opportunities out there?

So I think the application is obviously going to evolve over time, but it's targeted at the markets in which we're currently participating, so radar, EW, missiles, munitions. But the capability set, as it evolves, will allow new applications such as AI, machine learning, and autonomy for edge processing applications, and I won't go too much further than that.

Got it. And then just last one. You mentioned a couple of times, I think, working capital efficiencies. What should we specifically look for as you guys start to undertake more of those actions? I mean should we see improvement in inventory? Or what specifically should we pay attention to on that front?

Yes. So, I mean, if you look at working capital, we're starting to see some of those efficiencies. So working capital as a percentage of revenue was down over 3 points year-over-year. So we build out the manufacturing facilities. We're obviously in a multi-year journey to now try and improve the asset utilization, the efficiency from a working capital over time, but it does take time. We are starting to see some benefits.

And our next question will come from the line of Jonathan Ho from William Blair.

Congrats on the strong results. As you add more capabilities and broaden the portfolio, are you seeing the primes come to you more often? And basically, are you participating in nearly sort of every program design opportunity going forward?

So, I mean, I think we're viewed, Jonathan, really, as a trusted partner, and we have really leaned in and invested heavily in R&D, particularly in the secure and trusted processing domain. One of the biggest trends that we see is that these new architectures or compute or processing architectures, whether it be the C4I applications or whether it be Sensor and Effector Mission Systems processing. That shift to secure and trusted systems is something that we're seeing a lot of opportunity around. I truly believe that we're a leader in this space. So yes, I think we're getting pulled into a lot of opportunities.

Got it. And then just relative to the faster or accelerated development cycles, does that then help widen the gap in terms of your capabilities relative to competitors? And can you maybe help us understand a little bit better why you're able to do this faster and better than others?

Yes. So look, I think it's a great question. If you look at the LTAMDS as an example, Raytheon took a different approach. I think they took a clean-sheet design for the LTAMDS radar and wanted to demonstrate to the Army that they have next-generation technology not just on the gun level where they've invested heavily for quite some time, but in other parts of the system in which Mercury participated. They fielded a very advanced radar, and they invested in that; we invested in that. They were able to develop and demonstrate those capabilities at the design level, and the radar performed extremely well. The fact that we're willing to fund high levels of R&D, we can do things quickly, we can do things more affordably than our customers were able to do in-house.

And our next question comes from the line of Noah Poponak from Goldman Sachs.

Mike, regarding the organic growth calculation for the quarter, you had the first quarter actual number and the first quarter from 2019, and you mentioned the $19 million in revenue from acquisitions made last year. If I exclude that $19 million from the first quarter, the growth rate is 10% instead of 17%. Interestingly, if I include the partial Germane in the first quarter of 2020 but exclude it from the previous year's figures, that gives me the 17%. Is that the correct calculation, or is there something I'm missing?

Yes. No, the calculation is we consider something organic once it's been part of Mercury for four full quarters or more. At that point, it gets rolled into the organic calculation. And so this quarter still unacquired would have been Germane, GECO, Athena, Syntonic, and a very, very small amount of APC, which we own for just a couple of days. But once those are with us for 4 full quarters or more, then they are considered organic. I can walk you through the actual calculation later if you want, but that's the fundamental calculation we're doing.

In the back of the press release, in the tables, we show the calculation, Noah, period-to-period. And when we do the period-to-period, once it flips from acquired to organic, we obviously restate prior periods. So you can truly get an apples-to-apples comparison.

What are you restating?

The prior period where it was previously organic.

Oh, I see, I see. Okay. Got it. The backlog and the bookings behind that, that revenue growth, have obviously been moving along pretty quickly here. You mentioned earlier some things that may go in the middle of this year. Curious if you have any thoughts for us on where backlog or bookings growth could end the year for you.

Yes, we don't actually guide either backlog or bookings, but we do expect a positive book to bill.

Okay, Mike, last question. Regarding cash flow, you have increased capital expenditures for the year and this quarter. If I estimate that at around 2.5% to 3% of revenue, you would have achieved over 50% conversion of free cash flow into EBITDA. However, there was also a significant working capital challenge this quarter. How did you manage that? Was there something else contributing to the performance that we should anticipate reversing, or what factors are responsible for this?

No, I mean, first of all, I think your math in terms of the target for the year, if we had been at normalized CapEx, might have been above 15%. I think the answer there is, yes, it could have been. When we talked last quarter on the earnings call, we said that we were expecting CapEx of about 5% of revenue. That did include some expansion CapEx, but we were still targeting 50% of free cash flow to adjusted EBITDA. If CapEx had been lower than that 5%, we would have had the opportunity to overachieve. Now with the additional CapEx associated with the trusted microelectronics strategy of $15 million, we're targeting 40% for the year. From a working capital perspective, you've got to remember, Q1, we have bonus payments, and you'll see some of the items there that make working capital a little bit more of a use of cash in Q1. But working capital as a percentage of sales is looking good, and for the year, we feel good about where we stand from a cash flow perspective.

In the first quarter, we completed the acquisition of APC, which added to our inventory, although we only had them for about a week. This acquisition benefited our balance sheet, but it did not significantly affect our income statement.

Yes. It's an important point; make sure you're looking at the cash flow statement or use the working capital around the balance sheet.

And we have a follow-up from Pete Skibitski from Alembic Global.

It looks like you guys got active in the quarter on the repurchases, I guess, coincidence with the shares coming in. Is this something we'd expect to see more consistently going forward if the shares kind of lag here at this level?

Yes. So just to clarify the dynamic on that, we do not have a share repurchase program in place. What that was in Q1, a lot of our restricted stock vest in Q1. And to settle with the tax payments associated with that, we net settled the shares, and that's the use of cash for us, and that's what you see there. It's not a capital allocation strategy.

Okay. Got it. Last one, maybe more for Mark. You had mentioned a while back that you guys have been approved to make radiation-hardened electronics by several OEMs, I think, for LEO satellites. And DoD has this new space architecture that's kind of evolving pretty fast, it looks like. I think that emphasizes smaller satellites. And then, of course, we have the commercial side that's out there with a lot of big plans. Can you talk about kind of maybe the size of that business for you guys right now, plus sort of how big it could get midterm, the opportunities there?

Yes. So it's small today, Pete. We're not a major participant in that other than in rad-tolerant storage devices for LEO applications. That part of our business is small, but it's actually growing quite rapidly. We had another design win for a classified application in the first quarter. So it's small. We're not really participating in the space too much other than in those areas. But it's something that we'd like to explore longer-term, and maybe it's an opportunity for M&A.

And we have a follow-up from Jon Raviv from Citi.

Just on the free cash conversion down to 40% this year from what I understood. Is there a reasonable path back to 50% in the near term? Or how long do you think it will take to get back there? You mentioned a multiyear process for the build-out.

So we're only guiding for the year, Jon, in terms of what we see, the expansion CapEx is largely associated, as Mike said, with the build-out of the new capabilities in Phoenix as well as our integration activities. So we'll have more to say about what we expect in terms of future CapEx and normalization and free cash flow as we guide in the out years.

Jon, I would just add, when we put the 50% free cash flow to adjusted EBITDA target in place, that is a long-term goal based on maintenance CapEx levels.

And we have a follow-up from Noah Poponak from Goldman Sachs.

Mike, you mentioned briefly in the prepared remarks that the M&A pipeline looks robust. Maybe you could just expand on where it is compared to 3 to 6 months ago, just how robust. Would you be surprised if you didn't have another deal by the end of the year?

Yes. I mean, the M&A market continues to be very active. Our pipeline of acquisitions that fit with us and our strategy is very strong right now. There's a lot of activity. That's why we did the equity offering early in the year, so we could deploy that capital on M&A. We're seeing a lot of the proprietary deals that we've looked at over the last couple of years. Those are becoming actionable. Significant deal flow is coming to auction. APC is a good example of that. So a lot of activity out there. We continue to be disciplined in our approach to M&A. But it is our number one capital deployment or use of cash. So we expect to continue to be active on the M&A front.

All right. Thank you. And Mr. Aslett, 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 for listening. We look forward to speaking to you again next quarter. Thank you.