Mercury Systems Inc (MRCY) Q1 2023 Earnings Call Transcript

Good day, everyone and welcome to the Mercury Systems First Quarter Fiscal 2023 Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I’d like to turn the call over to the company’s Executive Vice President and Chief Financial Officer, Mike Ruppert. Please go ahead, sir.

Good afternoon and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations. Please turn to Slide 2 in the presentation. Before we get started, I would like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's financial outlook, future plans, objectives, business prospects and anticipated financial performance. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2, in the earnings press release and the risk factors included in Mercury's SEC filings. I’d also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles or GAAP, during our call, we will also discuss several non-GAAP financial measures, specifically adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue and acquired revenue. A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release. I’ll now turn the call over to Mercury’s President and Chief Executive Officer, 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's bookings increased 34% year-over-year in the first quarter, following 27% growth in Q4 of fiscal '22. Actual results in the quarter exceeded the high end of our guidance across all metrics and we're raising the low end of our full year outlook as a result. The largest bookings in the first quarter were LTAMDS, the SDA tranche tracking layer and AMCS. We also received the F-18 and Block 2 orders that moved from Q4. Driven by strong Q1 bookings, our book-to-bill was 1.17 in Q1 and 1.14 over the last 12 months. Backlog grew 22% year-over-year. This backlog, combined with strong bookings expected in Q2 and for the remainder of the year, position us well to deliver increased revenue and EBITDA in Q2 and the second half of fiscal '23. Our results for the first quarter reflected the second half weighting of orders in fiscal '22. Together with continued order delays, long semiconductor lead times and other supply constraints. Q1 is also typically our seasonally weakest quarter. Total revenue increased 1% year-over-year Organic revenue was down 4%, a far better result than Q1 last year. We expect organic growth to turn positive in the second quarter. Our largest revenue programs were F-35, LTAMDs, Aegis, F-18 and SEWIP. Q1 adjusted EBITDA was down 19% year-over-year as expected. This was driven primarily by the second half weighting of orders in fiscal '22 and program mix. We expect margins to increase in Q2 and as the year progresses. Free cash was an outflow of $73 million which we believe will be the low watermark for the year. This primarily reflected order delays and supply chain disruptions that affected the timing of collections in the quarter as well as purchase of raw materials to support future revenues. In addition, we saw customers unusually holding payments at the end of the quarter. We expect free cash flow to improve substantially in Q2 and grow through the second half of fiscal '23, resulting in positive free cash flow for the year. We continue to see high levels of new business activity. Design wins in Q1 totaled more than $135 million in estimated time volume. Turning to Slide 4. Q1 marked the beginning of Mercury's fourth fiscal year dealing with the effects of the pandemic. In the near term, our business in the industry will continue to face challenging macro forces. However, it's clear that the issues impacting us today are not demand related. They're supply and timing related, they're short term and they're not unique to Mercury. We're executing our plan to control what we can and we're optimistic about the future given our positioning. After several years of COVID-related challenges, we believe that we've entered a multiyear period of accelerating growth and profitability similar to the period post sequestration in 2013. Reflecting back to the beginning of the pandemic, Mercury's fiscal '20 was in the health care crisis phase. We navigated this period well with minimal impacts on our employees, operations and financials. Bookings, revenue and adjusted EBITDA were up more than 20% over the year. In fiscal '21, we saw a COVID-related slowdown in orders. Bookings didn't grow as much in the second half as we anticipated, declining nearly 8% for the year. Our book-to-bill fell to 0.95 from the prior year's 1.2, the lowest in more than a decade. Revenue still grew 16% year-over-year. Adjusted EBITDA was up more than 14%. In fiscal '22, we saw the full effects of COVID beginning early in the year. The Delta variant reduced our manufacturing productivity and the defense budget was delayed 165 days. We experienced significant semiconductor supply chain disruptions and higher attrition as well as a nation, all magnified by the prior year's order slowdown in the second half. As a result, total revenue grew 7% in fiscal '22, less than we had anticipated. Organic revenue declined 5% and we ended the year with adjusted EBITDA margins roughly flat. Supply chain disruptions had an outsized impact on H1, H2 linearity. Working capital investments increased as the year progressed, with free cash flow turning negative as a result. However, bookings rebounded strongly in FY '22, growing 21% year-over-year, leading to a 1.08 book-to-bill and crossing $1 billion for the first time. Most of this rebound occurred in the second half with bookings growing 33% versus H2 of the prior year. This order timing, coupled with dramatically longer semiconductor lead times is resulting in our fiscal '23 financial performance also being more back-end loaded than we experienced pre-pandemic. Unlike last year, however, bookings in fiscal '23 are off to a great start. We expect faster growth in the second quarter and the first half to be much improved versus H1 of fiscal '22. This sets the stage with strong full year bookings and a positive book to bill. We believe that Q1 marked the bottom in fiscal '23 for organic revenue growth, free cash flow and margins. Given the strong order flow, we anticipate a return to organic growth in the second quarter and for fiscal '23 as a whole. We expect to deliver stronger earnings and positive free cash flow as well as improved working capital efficiency over time as the supply chain headwind subside. As I said earlier, what Mercury has experienced since the start of the pandemic is much the same as sequestration nearly a decade ago in terms of the multiyear impact on our financial results. The enhancements that we made in the business at that time led to accelerated growth and value creation over the next five years. For fiscal years '13 through '18, Mercury ranked second and first among our Tier 2 defense peers for compound annual growth in revenue and adjusted EBITDA, respectively. Similarly, through impact with strengthening our business fundamentals once again. Looking forward to fiscal '24, we believe that lead times for high-end semiconductors will begin to improve in the second half. We've already begun to see a shortening of semiconductor lead times on the low end. We expect stronger bookings and organic growth, continued margin expansion and greatly improved free cash flow as we release working capital, all of which should position us for further growth and value creation as we move forward. Turning to Slide 5. We believe today's geopolitical environment is the most challenging since the Cold War. The risks related to China and Taiwan are potentially more significant than what we're experiencing today with Russia and Ukraine and the timeline is moving to the left. The semiconductor industry and the defense industrial base in Europe and the U.S. are not what they need to be to build the military stockpiles and the new capabilities required in this threat environment. We appear to be heading into a super cycle in U.S. and allied defense spending. The change, however, for both the government and the defense industry is clearly on the supply side, whether it be the availability of semiconductors and other materials, labor or now inflation. In the near term, the industry is dealing with an ongoing shortfall in government contracting personnel. We're also beginning the new fiscal year under a defense budget continuing resolution. This means the contracting environment will likely remain challenging in the short term. We're not expecting a defense appropriation bill until after the midterm elections. On a positive note, once that bill is passed, the GFY '23 budget is currently expected to increase year-over-year. That said, given inflation, the real defense spending and buying power increases could be far less. So overall, the demand environment is strong and appears to be getting stronger. Although the industry is dealing with headwinds, we believe that they're temporary. We expect to see a shift to tailwinds as defense spending grows and supply chain conditions improve. Turning to Slide 6. At the Mercury level, the supply chain environment remains challenging but stable. Although we're still seeing supply delays and isolated quality issues, we're experiencing fewer supply decommits compared with Q4. Lead times overall have not increased but are extremely long for high-end semiconductors. Mercury's sophisticated end-to-end processing platform powers some of the most critical A&D missions. High-end processing represents about 70% of our business and it's where Mercury likely has the largest opportunity to grow over the next five years. It's also where the global supply chain has been most disrupted. High-end semiconductors are at the heart of many of our offensive and defensive weapon systems and have rapidly become the long lead time for defense development and production. Prior to the pandemic, semiconductor processor lead times were 10 to 12 weeks. They increased rapidly in the second half of fiscal '21 and now range from 52 to 99 weeks. Putting this in perspective, this means that high-end semiconductor material orders that we're placing today support revenues in our third and fourth quarters of fiscal '24. It's not until this point that we believe lead times and availability will begin to improve. Throughout this multiyear period, we've used the strength of our balance sheet to invest in working capital to mitigate supply chain risk as best we can, positioning Mercury to deliver stronger and more consistent results over time. When the supply chain conditions normalize, we expect a significant release of cash related to inventory and unbilled receivables from our balance sheet. We also continue to deal with semiconductor-related inflationary pressures. Semiconductors equate to 38% of our direct supply spend far more than our peers', we believe. We've taken aggressive steps to maintain the strongest possible margins in this environment and they're working. These include repricing standard products and incorporating price adjustment mechanisms in our rates-based businesses and multiyear proposals. We've also shortened the validity of our quotes to capture any near-term inflationary effects. Given the short-cycle nature of our model, it's likely that the impacts of supply chain inflation will begin to diminish over time as these actions result in more of the business being priced at market rates. We're making good progress in managing the industry headwinds through our 1MPACT program. Much like our approach to sequestration, we're laying the foundation for Mercury to achieve its full growth and profit potential over the next five years. We've seen tremendous changes since we launched 1MPACT at the beginning of fiscal '22. We began by simplifying and streamlining our organizational structure and strengthening the leadership team and we continue to do so. Mitch Stevison, our former Chief Growth Officer, who joined us from Raytheon 12 months ago, recently took the helm as President of our Processing division which accounts for approximately 70% of total company revenue. Mitch knows Mercury well and has hit the ground running in his new role. We also have focused 1MPACT on margin expansion initiatives in fiscal '22 and we're now pushing their execution deeper into the business. Effective October 3, Alan joined us to accelerate these efforts as our Senior VP of Execution excellence. Alan was previously at Raytheon in their missiles and defense division. He'll be responsible for supply chain, operations, engineering and program management reporting to me. We're pleased to welcome Alan to the team. As the environment became more challenging in fiscal '22, we pivoted 1MPACT towards those areas that could help mitigate risk and deliver the most immediate financial benefits. This year, in addition to pricing, we continue to focus on supply chain risk mitigation, working capital burn down and accelerated cash release. Another initiative is R&D investment efficiency and returns, building on the progress last year. Our digital transformation initiatives and engineering and operations will help improve our cost structure and performance over the long term as well. We're also making good progress in our facility footprint strategy. In Q1, we consolidated two engineering teams and a new center of excellence in Fremont, California. We're on track to consolidate our Mesa, Arizona facility into the Phoenix site in the second quarter and we expect to release two additional buildings in California by the end of fiscal '23. As it relates to M&A, 1MPACT is about leveraging our proven ability to integrate and grow acquired businesses but at a greater scale going forward. The environment continues to be active and will remain focused on our existing M&A themes. With that, I’d like to turn the call over to Mike. Mike?

Thank you, Mark and good afternoon, again, everyone. As usual, I'll start with our first quarter results and then move to our Q2 and fiscal '23 guidance. As Mark has discussed, Mercury's first quarter results exceeded our guidance across all metrics, despite the supply chain and inflationary headwinds. Exiting Q1, from a demand perspective, we have excellent visibility into Q2 and the second half. As a result, we're raising the low end of our fiscal '23 guidance and expecting a cash flow positive year. Turning to our Q1 results on Slide 7. Bookings were $267 million, up 34% compared to Q1 '22. Our book-to-bill was 1.17 compared to 0.89 in Q1 '22. For the last 12 months ended Q1 '23, our book-to-bill was 1.14. The rebound in our book-to-bill indicates the positive demand environment. Our backlog at the end of the quarter was a record $1.08 billion, up 22% from Q1 '22. Our 12-month backlog was up 25% compared to last year and up 7% compared to last quarter, providing us good visibility into the remainder of fiscal '23. Coupled with bookings on key programs that we expect to receive in Q2, we're optimistic about our results for H2 and the full year. Revenue in Q1 increased 1% year-over-year to $228 million, exceeding the top end of our guidance of $215 million to $225 million. Organic revenue was $216 million and acquired revenue which included Avalax and Atlanta Micro was $12 million. Gross margins for Q1 were down approximately 500 basis points year-over-year. As expected, we had a smaller proportion of higher-margin production revenue in the quarter. Q1 gross margins also reflected material and labor inflation. As we move through fiscal '23, we expect to see higher gross margins as a result of program mix and a gradually stabilizing macroeconomic environment. Adjusted EBITDA for Q1 was $31.2 million, above our guidance of $27 million to $30 million. Our adjusted EBITDA margins were 13.7% for the quarter, down 330 basis points from 17% in Q1 fiscal '22 and primarily driven by gross margins. Adjusted EBITDA margins exceeded our Q1 guidance range. As I'll discuss shortly, free cash flow for the first quarter was an outflow of approximately $73 million. This was primarily due to award timing and continued supply chain disruption. We also observed delayed payment behavior across our customer base. Slide 8 presents Mercury's balance sheet for the last five quarters. Our balance sheet remains strong with significant capacity under our $1.1 billion revolving credit facility. Driven by the anticipated strong cash flow generation in H2, we expect to be well positioned to delever the balance sheet while continuing to invest in the business. We ended Q1 with cash and cash equivalents of $52 million and approximately $512 million of debt funded under our revolver. The sequential increase was primarily related to the free cash outflow. During the quarter, we swapped $300 million of our floating rate debt to fixed rate. We now have fixed SOFR at 3.79%. At our current leverage levels, that implies approximately 5% interest on a majority of our funded debt which positions us to continue to allocate capital at attractive rates. As a result of the macroeconomic environment, over the last five quarters, we've invested approximately $250 million in working capital to support performance obligations to our customers and ensure delivery on critical programs. This investment primarily consists of accelerated material purchases to mitigate the risks associated with the supply chain volatility and contracting delays that Mark discussed. This has resulted in increased unbilled receivables and inventory. The majority of these material purchases are for programs that are aligned with the DoD's strategic priorities and on which Mercury is a sole source supplier. As supply chain conditions normalize and our customer performance obligations are completed, we expect unbilled receivables and inventory to convert to cash and decrease substantially as a percentage of annualized sales. Turning to the specifics. Accounts receivable in Q1 were $495 million, a $47 million increase from Q4 '22. Within that increase, billed receivables were up approximately $20 million primarily as a result of customer payment behavior. Unbilled receivables increased approximately $27 million. with our intentional strategic shift to more integrated subsystems which meet the criteria of over time revenue recognition, our unbilled receivables have naturally increased. At the same time, macroeconomic conditions across the contracting environment, supply chain, and to a lesser extent, labor market are impacting our ability to complete program building milestones and putting further pressure on unbilled receiving. We continue to take a disciplined and proactive approach to unlocking unbilled receivables, including negotiating legacy contract terms to incorporate progress or performance-based payments. We're including these payment structures in all new contract awards. We expect these actions to drive unbilled receivables down as a percentage of annualized overtime revenue throughout fiscal '23 and fiscal '24. Inventory increased approximately $17 million in Q1 '23 compared to Q4 '22. Semiconductor lead times range from 52 to 99 weeks as Mark discussed. We continue to lean forward on accelerating raw material purchases to support customer delivery schedules and mitigate supply chain risk in future quarters. Additionally, as with unbilled receivables, shortages in key parts have hindered our ability to deliver finished goods to our customers. We're working with our supply partners to accelerate deliveries of key components in order to deliver finished goods to our customers. Turning to cash flow on Slide 9. Last quarter, we forecasted a free cash outflow in Q1, driven by lower net income, one-time payments as well as working capital build associated with continued supply chain constraints. However, the outflow was larger than expected at $73 million, primarily due to customer contracting delays within the quarter. Reflecting the proximity of award receipts to quarter end, expected billings and cash collections in the quarter were lower than expected. We expect the majority of these Q1 delays to result in billings or cash collections in Q2. We also observed delayed payment behavior across our customer base in Q1, with payments due as of quarter end, not being paid until the first weeks of Q2, resulting in an increase in billed receivables. Although it wasn't used in Q1, we've put an accounts receivable factoring facility in place to address this in the future, if necessary. As Mark said, we believe Q1 was the low point of fiscal '23 free cash flow. We expect free cash flow to improve in Q2 and grow through the second half, leading to positive free cash flow for the year. Looking forward, we believe that our financial results for fiscal '23 will reflect the early impacts of a potentially substantial longer-term release of working capital from our balance sheet especially as the supply chain headwinds subside. I'll now turn to our financial guidance, starting with Q2 on Slide 10. Forecasting the current environment remains challenging. Our guidance incorporates to the extent we can, potential impacts associated with ongoing supply chain constraints and material and labor inflation as well as a continuing resolution in a midterm election year. For Q2, we currently expect revenue in the range of $225 million to $240 million. This is approximately 6% growth at the midpoint compared to the second quarter last year. We currently expect gross margins to increase from Q1, so we continue to be cautious with regard to supply chain variability and material inflation. In the second half of fiscal '23, we expect gross margins to increase as we complete several of our lower-margin development contracts. The revenue growth in H2 is expected to be driven by higher-margin production programs. We expect adjusted EBITDA for Q2 to be $38 million to $42 million, representing 17.2% of revenue at the midpoint. This is approximately 350 basis points higher than Q1 and in line with Q2 fiscal '22 actual margin. For Q2, we currently expect free cash flow to be near breakeven to slightly positive with Q1 marking the low point in fiscal '23. I'll now turn to our guidance for full year fiscal '23 on Slide 11. In Q1, the team worked to mitigate risks within our control, resulting in Mercury exceeding the high end of guidance. Our updated full year guidance builds on the Q1 overperformance but remains cautious based on our risk outlook for the remainder of the year. The near-term outlook for the industry and the macroeconomic environment remains far from certain. However, the demand environment continues to improve and we believe our strong Q1 will be, in retrospect, Mercury's low point for organic growth and margins in fiscal '23. As a result, we're raising the low end of our previous guidance for revenue and adjusted EBITDA for the year. Driven by 34% year-over-year bookings growth, we ended Q1 with a 12-month book-to-bill of 1.14 or backlog. For fiscal '23, we expect double-digit growth in bookings and improved bookings linearity, leading to continued growth in our backlog and greater visibility to our forecasted revenues. We also expect a positive book-to-bill for the year. From a revenue perspective, we now expect total company revenue of $1.01 billion to $1.05 billion in fiscal '23. This represents 2% to 6% growth year-over-year and approximately flat to 4% organic growth. While this organic revenue guidance is still below our target business model, we're beginning to see the rebound driven by the strong bookings momentum over the last 12 months. We continue to expect fiscal '23 to be second half weighted. Based on the midpoint of our guidance ranges, we expect approximately 45% of revenue in H1 and 55% in H2. And with organic growth accelerating in H2 and into fiscal '24. As I mentioned, our current backlog and expected Q2 bookings should provide strong visibility and backlog coverage as we enter H2. Adjusted EBITDA for fiscal '23 is expected to be in the range of $202.5 million to $215 million, up 1% to 7% from fiscal '22. Adjusted EBITDA margins are expected to be approximately 20% to 20.5%. The increase in our EBITDA guidance for fiscal '23 is driven by Mercury's outperformance in Q1. Like revenue, we expect adjusted EBITDA and EBITDA margins to be heavily weighted towards the second half. As revenue ramps through the year, we expect an increase in gross margins and operating leverage to lead to adjusted EBITDA margin expansion. From a free cash flow perspective, we're targeting approximately 30% of adjusted EBITDA in fiscal '23. This estimate assumes the current R&D capitalization tax laws delayed or repealed. As I've said, we expect cash flow to begin to normalize in H2, driving improved conversion for the full year. With that, I’ll now turn the call back over to Mark.

Thanks, Mike. Turning now to Slide 12. We believe that Mercury couldn't be better positioned strategically. We entered fiscal '23 with a record backlog and strong new business momentum. We anticipate strong bookings, a positive book-to-bill and a return to organic growth, with revenue reflecting $1 billion for the first time. We expect to deliver improved margins, better working capital efficiency and positive free cash flow. This should lead to improved fiscal '23 results, positioning us for a stronger year in fiscal '24 as the supply chain headwinds begin to recede. Looking further ahead, our plan for the next five years remains intact. Mercury's fundamentals are strong and with 1MPACT should improve over time. Defense budgets domestically and internationally are poised for rapid growth. We believe that we're well positioned to continue benefiting from industry trends, including supply chain delayering and reshoring as well as increased outsourcing at the subsystem level. We anticipate that a greater percentage of the value associated with future defense platforms will be driven by electronic systems content where Mercury participates. We're building the company we set out to create from a capability perspective and our addressable market continues to expand as a result. This has been driven in large part by our strategic move into mission systems and the potential to deliver innovative processing solutions at chip scale. Our model is at the intersection of high tech and defense positions us well. We believe that Mercury can and will continue to grow at high single-digit to low double-digit rates organically as the current headwinds diminish. In addition to organic and M&A-related growth, our five-year plan includes continued margin expansion driven by 1MPACT, leading to stronger adjusted EBITDA as well as improved working capital efficiency and cash conversion. Executing on our long-term strategy over the past decade, we've improved margins by growing the business organically, supplemented with disciplined M&A and full integration. As a result, we created significant value for our shareholders and expect to continue doing so. In closing, I'd like to recognize the entire Mercury team for a tremendous effort during these challenging times, my sincere thanks to all of you. With that, operator, please proceed with the Q&A.

Your first question today comes from Jonathan Ho with William Blair.

One thing I wanted to understand a little bit better, can you maybe help us understand how your pricing actions maybe flow through for the balance of the year? And what that could mean in terms of either improvements to gross margins or on the cash flow side?

Sure. So we've done a fair bit, Jonathan. As part of 1MPACT, we had two major initiatives: one related to procurement, where we stood up a procurement organization and seeking to purchase things more efficiently; and then the second is that we stood up a pricing team to initially be able to price our products more in line with the value that we provided. Both of those areas have actually ended up really helping to offset some of the inflationary pressures that we're seeing. And I think we're actually being pretty successful doing that. So in our microelectronics business, at the very start of the year, we actually did pretty much across-the-board price increase associated with our commercial products. And then in our noncommercial business, we have also pretty aggressively looked at passing on the costs associated with the inflationary pressures to all of our customers as well as actually addressing contracts going forward to make sure that we’re capturing the inflationary pressures on a go-forward basis as well. So Mike, I don’t know if you’d like to maybe comment further from a financial perspective.

No, I think you hit it, Mark. Jonathan, the only thing I would add is that as you look at our guidance, we do have some inflation pressure embedded in our guidance. But at the same time, as we said, we're working to offset that through pricing. So there is some in there but we're mitigating the piece of it in our guidance as well.

Great. And then just as a quick follow-up. When it comes to some of the customer behavior around payments, do you have any concerns at all around collections, quality or receivables? And when does that sort of maybe start to normalize in terms of the cash conversion?

Yes. So I'll take that one. So Jonathan, we feel very good about the quality of the assets that are on the balance sheet and the collectibility of both the unbilled receivables to billed receivables as well as the inventory. Because if you step back, the majority of that is material purchases that we've made for programs that are aligned with the DoD's strategic priorities that we were designed in on. And so it really is just a matter of time as the balance sheet unwinds once we deliver on those final performance obligations to our customers.

Mike, I want to emphasize the importance of taking a step back and exploring this matter in greater detail. Most of our challenges concerning working capital and cash flow are primarily linked to the difficult supply chain environment, and we anticipate that these issues will persist throughout 2023. We have noted some improvements; for instance, the in-quarter supply decommits have shown some recovery compared to the fourth quarter, which we appreciate. However, we are still facing significant challenges due to extremely long lead times for semiconductors, especially for high-end products, along with a general shortage of these components. We are also experiencing more rapid and frequent end-of-life cycles for older devices, which poses a particular challenge in the defense sector, given the nature of their life cycles in the context of rising material and labor costs. This situation has impacted us more than others, as 70% of our business is tied to processing. To clarify, in fiscal '22, 45% of our revenue was recognized as point-in-time revenue, meaning that we only recognized it upon delivery of the product, which is a higher percentage than most companies in our industry. The rest of the revenue is recognized over time, and unfortunately, our revenue recognition methods are determined by accounting rules outside our control. Let me explain how our business model affects our cash flow to provide a clearer picture of the underlying issues and why our cash flow has been temporarily impacted. In our point-in-time revenue structure, we usually purchase inventory to fulfill future customer orders based on our manufacturing lead times, which have historically been quite short. This model has worked effectively in the past and allowed us to handle variations in product mix and revenue fluctuations from quarter to quarter. This adaptability is one reason our guidance has historically been strong, as we could manage obstacles that arose periodically. Looking back to 2021, that year saw a sudden and significant increase in semiconductor lead times, disrupting our model and impacting the entire industry. Unlike many of our customers, we don’t generally receive multiyear contracts, which made these longer lead times a challenge last quarter and has continued into this quarter, affecting many customers' financial performance. The reality is that the roots of this issue were sown several quarters ago, likely in 2021, and it has taken time for the effects to ripple through to the prime contractor level. The trend towards short-term contracts in the defense and industrial sectors is a result of defense industrial policy that clearly needs to adapt if we aim to build a more resilient supply chain. Regarding Mercury, the inventory we are purchasing often relates to defense programs where we have designed solutions and are typically the sole source. These programs are generally in low rate initial production or full rate production stages. For such programs, the lengthening semiconductor lead times during the pandemic required us to procure additional inventory earlier than usual to meet our customers' expectations and our financial obligations. Furthermore, the semiconductor industry expedited the discontinuation of outdated components, necessitating inventory buildup in that area as well. As noted by others during this earnings season, semiconductor part shortages have delayed product deliveries, contributing to increased work-in-progress inventory. Thus, cash consumption has primarily been tied to raw materials and work-in-progress, driven by changes in the semiconductor industry. We view this as an investment in our future and that of our customers, despite it consuming cash in the short term. Conversely, regarding unbilled or overtime revenue recognition, this represents the remaining manner in which we record revenue, which is common in our industry and serves as the default for many clients. We have utilized this model appropriately, successfully winning larger subsystem contracts that have fueled our growth. Here, we are procuring inventory tied to specific programs. However, supply-related challenges, including quality issues, labor shortages, and extended semiconductor lead times, persist. Additionally, some of our legacy contracts prevent us from collecting cash until we ship the final units, resulting in partially completed units that tie up working capital. We believe that cash tied up in inventory and unbilled receivables will begin to free up over time, significantly improving our cash flow and conversion rates. It was essential for us to provide this detailed context to help clarify the situation. Thank you for your question, Jonathan.

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

It's actually Scott on for Sheila. But Mark, you talked about some of the importance of M&A for kind of 1MPACT initiative. I mean given the movement in rates we've seen year-to-date, how is the M&A environment shifted? And how are you kind of thinking about any change to the return profile you're looking at?

Mike, do you want to take that one?

Yes, Scott. We've definitely observed a shift in rates over the past few weeks, months, and quarters, which has affected the industry. Valuations in the sector may decrease due to higher discount rates, but there is a shortage of good assets available. This means that quality assets will still command strong multiples, and we've seen evidence of this recently. From our side, we plan to continue with our current strategy, maintaining discipline in our approach to mergers and acquisitions. We are cautious with our underwriting and valuations, especially given the uncertainty in today's environment. We believe we have a strong capability in M&A. Additionally, as I mentioned earlier, our $1.1 billion revolver provides us with ample capacity to pursue M&A opportunities at favorable rates when the right moment arises.

And then maybe just a quick follow-up on 1MPACT. I mean, you’re over a year into it now. I mean, what successes have you really been able to point to? And are there any areas where it’s maybe been a little more challenging than you had previously expected?

Yes, that’s a great question. I believe we have made significant progress. We started by simplifying and reorganizing our business structure, which has greatly enhanced our leadership team. We then concentrated on key areas, one of which was procurement, by establishing a centralized procurement organization to leverage our scale. We implemented an AI and machine learning-based procurement tool that has proven very beneficial in the current challenging supply chain environment. Our pricing organization has also allowed us to price our products more effectively. These two initiatives have helped us manage the 10% to 20% increases we are experiencing due to semiconductor inflation. Additionally, we have worked hard to improve the efficiency of our R&D investments, reviewing projects and eliminating those with low returns to ensure we are focused on the right ones. We've had success in employee engagement and retention, particularly in the context of the difficult labor market and the great resignation, allowing us to retain our workforce and hire the talent necessary for growth. We have also made significant strides in optimizing our facility footprint, having reduced the number of facilities significantly over the past year, with more reductions expected by the fiscal year's end. Furthermore, we have invested heavily in digital transformation, completing the rollout of a new digital manufacturing execution system and migrating our engineering tools to the Amazon Gulf high Cloud, which will enhance productivity, scalability, and efficiency over time. While we have accomplished a lot, we are not yet seeing the full benefits due to ongoing productivity and supply chain challenges. However, we anticipate substantial margin expansion and improved cash flow generation and yield over the next five years.

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

Mark, I know you’ve focused a lot on free cash flow. However, I’m curious about the issue of customers delaying payments. Are we specifically talking about the prime contractors? I’m trying to understand how this situation works, where they are withholding payments while you are simultaneously investing in inventory and working capital to support these programs. It seems like you’re taking on all the risk on your balance sheet regarding cash flow, while they are using their funds to buy back stock. How does this dynamic play out among the customers?

Yes, it's a good question. Let me kind of maybe touch on it at a high level and I'm sure Mike will contribute. So we did see some holdback at the end of the quarter. So I'll give you an example, right? One particular customer paid us for two things. And then the third which was also June, we got paid on the first day of the new quarter, right? So it's not like that we're holding for long periods of time but we definitely saw some holdback at the end of the quarter. The other thing affected us, Mike, I was also just the timing of specific orders. And in particular, our three largest orders in the first quarter all ended up moving to the right and taking the revenue and the cash associated with those outside of the cash window. So it's a number of things that's going on. But look, I think the last two quarters, at an industry level, Mike, in terms of revenue and top and bottom line have been challenging overall. And I think we're seeing some changes in behaviors associated with that. So Mike, I don't know if you would like to maybe add to that.

Yes. No, I think you hit on it. I mean, Mike, the only thing I would add is that the business models and market spend a good bit of time going through it between us and our prime customers are different and he just talked about that. We are doing things to change the dynamic, especially around unbilled receivables. So we’re negotiating with customers now to get more favorable milestones and progress payments on new and existing programs. We’ve got updated processes internally. So we’re trying to change the way we contract with customers. So it’s not all of our balance sheet being used to support these programs. And so that’s why we think we’re going to see some unwinding of the working capital to going forward.

We are concentrating on several key areas regarding cash management. Our primary goal is to enhance cash conversion while reducing unbilled receivables and inventory without jeopardizing revenue generation or timely deliveries. We’ve improved our demand planning processes and implemented effective tools to better assess demand signals and identify necessary material commitments early on, especially given the extended lead times. Another critical area is negotiating payment milestones with customers, particularly for legacy contracts where we did not have performance or progress payments in place. We are actively addressing this to secure upfront cash. Additionally, we are prioritizing our labor resources to effectively reduce unbilled balances, recognizing the importance of staffing in this effort. Lastly, as we pursue larger proposals and strengthen our position in the industry, we are focused on enhancing our bid proposals to secure better terms and protections for Mercury moving forward. We believe that cash flow is likely to stabilize in the first quarter and improve in the second quarter as the year progresses.

Got it. That’s helpful. Just one quick follow-up on this topic. Regarding the budget dynamic and the continuing resolution, in your internal planning, do you think we will see a full bill passed before the end of the year? Or if there is a complete turnover based on the midterms, do you believe that the signing of the bill would need to wait until the new Congress is seated? Would that push things into the end of January or February?

I think our assumption right now is that we will receive the bill before the end of the year, but it’s uncertain what the election results will be and how that might influence things. We are anticipating a relatively short continuing resolution, which we have factored into our guidance.

Your next question comes from the line of Austin Moeller with Canaccord.

Just my first question here. Do you expect that pressure on some of the NATO European allies due to the economy and inflation could delay new orders for modernization programs by maybe a year or more relative to the U.S.?

Yes, it's a good question. I think my instinct is probably not. The situation in Ukraine and the current threat environment typically influence both the level and timing of defense spending. Given that we are nine months into this situation, it’s clear that things are not ideal. I believe we will continue to see increased spending in Europe. Whether that happens immediately or takes a bit longer remains to be seen, but I think there is a strong sense of urgency.

Okay. That makes sense. And can you call out any specific key program deliveries in the second half that you anticipate will support the step-up in free cash flow?

So in the second half, I think we've got some pretty significant programs. Just kind of rattling through a few off the top of my head, we've got Filthy Buzzard. That is beginning to ramp again. We're expecting a very large IDIQ this quarter as well as delivery orders ramping up as the year progresses. I think F-16 will be a significant contributor. The large new EO/IR program, the large microelectronics program. So there's a number of programs that we expect to ramp in the second half of the year.

Yes. And Austin, the only thing I would add on that too is from a working capital release perspective, while there’s orders that we need to drive revenue and bookings. There’s other things that we’re working on from a release of working capital perspective. And we’ve seen unbilled and programs being delayed because of supply chain delays because of contract definitization. And as we work through those in the second half, that will also help the working capital in addition to the growth programs that Mark just described.

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

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