Mercury Systems Inc (MRCY) Q3 2023 Earnings Call Transcript

Good day, everyone and welcome to the Mercury Systems Third 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 Senior Vice President and Interim Chief Financial Officer, Michelle McCarthy. Please go ahead, Ms. McCarthy.

Good afternoon and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you have 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. Turning to Slide 2 in the presentation. I would like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's 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, Michelle. Good afternoon, everyone and thanks for joining. I'll begin with the business update. Michelle will discuss the financials and guidance and then we'll open it up for your questions. First, a quick note about the review of strategic alternatives we announced last quarter. The review is continuing, and we don't intend to disclose any new developments on the call today. As Michelle and I will discuss, we're running the business in the ordinary course as this process unfolds and continue to execute on our strategic plan. With that, let's turn to the third quarter. Revenues above the high end and adjusted EBITDA came in at the midpoint of guidance for Q3. Bookings were in line with our expectations and our book-to-bill was 0.93, following 1.18 in the first half and 1.10 over the last 12 months. Q3 backlog grew 10% year-over-year. Our largest bookings programs in the quarter were V-22, F-16, Aegis, AH-64, and a classified CSfC program. We are positioned for strong bookings growth sequentially in Q4 as planned, given the timing of the awards. Q3 total revenue increased 4% year-over-year as organic revenue. Our largest revenue programs were V-22, Aegis, F-16, F-35, and a classified CSfC wide program. GAAP net income and GAAP earnings per share for the third quarter exceeded our guidance due to a higher-than-expected tax benefit. Adjusted EPS and adjusted EBITDA declined year-over-year as expected to be cashflow positive, excluding the R&D tax impact. Looking forward to our results of the year level, we expect to deliver record bookings for fiscal '23 and a positive book-to-bill. Revenue is now expected to be flat to slightly up year-over-year, $30 million below the midpoint of prior fiscal '23 guidance due to award and supply chain delays. Organic revenue is expected to be approximately flat year-over-year versus a 5% decline in fiscal '22. On the bottom line, we're lowering the range for GAAP net income and adjusted EBITDA by $34 million and $44 million at the midpoint. Free cash flow is expected to be around breakeven in Q4 and negative for fiscal '23. We expect lower cash outflows year-over-year, excluding the R&D tax. Turning to Slide 4, we are now in the fourth fiscal year dealing with the derivative effects of the pandemic on the business. We've seen impacts in prior years on bookings and organic revenue. This year, the bottom-line impact is primarily driven by lower margins. We're experiencing temporary margin degradation for two reasons. The first is a significant shift toward development programs in our business mix. The second is the pandemic-related impacts on product and program execution, especially related to certain development programs. Over the last several years, we've won a significant amount of new business, both organically and through acquisitions. These wins decreased the ratio of production to development stage programs from approximately 80:20 to about 60:40 in fiscal '23, corresponding with a doubling in customer-funded R&D revenues. A typical performance period on programs pre-pandemic was approximately 18 months, far shorter than many of our customers given where we sit in the value chain. Over the course of the pandemic, this period increased to about 30 months, driven in part by delays in development programs. In the initial phase, development programs typically carry gross margins in the low to mid-30s on average; in comparison, more mature production programs have gross margins above 40%. Although this elevated ratio of development stage programs has pressured margins over the past couple of years and more significantly in fiscal '23, these programs will drive Mercury's future growth as they transition into production. We expect to see a meaningful margin expansion as they transition and our mix returns to pre-pandemic levels. The second contributor to margin degradation, as I mentioned, is pandemic-related impacts on execution. Supply chain delays and inefficiencies, long semiconductor lead times, tight labor markets, and inflation have resulted in cost growth impacting both direct costs and R&D. In terms of R&D, Mercury leverages a commercial investment model focusing on developing sophisticated new technologies and products. These highly differentiated capabilities are then used across multiple DoD programs. The cost growth we're experiencing is associated with certain new technology developments nearing completion, and new product introductions are taking longer than planned. The higher costs are related to both labor and materials driven by labor and supply chain inefficiencies, manufacturing constraints, and inflation. Approximately a dozen or so of our 300+ active programs have been affected, and all but two of the affected programs are more than 90% complete in terms of the total expected costs incurred. The good news is that once we complete the development and new product introduction activities, multiple programs will quickly benefit due to our product program leverage model. We expect these programs to complete over the next two to three quarters and transition to production-based contracts thereafter. This transition should lead to stronger fiscal '24 results, not only improving gross margins and adjusted EBITDA as cost pressures diminish but also lowering working capital as we quickly relieve unbilled receivables through shipment invoicing and cash collections. As I said previously, our challenges are not related to end-market demand, which remains strong. They're largely timing and cost-related. They're short-term, and they're not unique to Mercury. We're focused on controlling what we can in this environment given the technologies that we developed and the programs that we won. Structurally, our business model and financial outlook are sound, and we're very optimistic about the future. We expect margins to naturally return to pre-pandemic levels as we overcome current execution challenges. And as supply chain conditions continue to normalize, further margin expansion will follow as the late-stage development programs transition to production and as we return to a more normal 80:20 business mix over time. Turning to Slide five. We now have Alan Kutcher on board as Head of Execution Excellence, Mitch Stevison now leading our Mission Systems Business and Roger Wells continues to lead Microelectronics. Under their leadership, we're driving continuous improvements in new product development, supply chain operations, and program execution. New leadership was instrumental in clarifying the magnitude and timing of our late-stage development challenges. We're making progress on the engineering development challenges and manufacturing yields began to improve by the end of the third quarter. We expect this progress to continue in Q4 in fiscal '24, allowing for final program execution. In addition, we are through the first phase of our business systems integration in Torrance, California, the former POC. This was delayed largely due to COVID-related travel restrictions and is on track to be completed in the fourth quarter. Completing these integration activities will increase our visibility across the business, especially regarding program execution and related labor and material costs, as well as working capital. The platform systems business we built through a series of acquisitions over time, of which Torrance is the largest part, has some amazing capabilities. In addition to the work that we've done around our secure processing and trusted microelectronics, we expect it to deliver long-term growth in the business. Although we made progress on the income statement in Q3, we still have more work to improve our balance sheet and cash flow. We expect that our impact program, together with improved execution, will lead to increased margins or a reduction in inventory and unbilled receivables, resulting in improved cash flow. Turning to Slide six and the industry operating environment, which continues to improve incrementally. Employee hiring at Mercury continues to outpace attrition in Q3, and the supply chain is beginning to flow more smoothly. We saw fewer supplier issues this quarter, with some suppliers delivering ahead of plan. Semiconductors are still affecting program timing and efficiency, although to a lesser extent. Semiconductor processor lead times peaked in Q1 of fiscal '23 at 52 to 99 weeks, and now range from 13 to 78 weeks. Prior to the pandemic, the average was 10 to 12 weeks. Although current lead times on average are getting shorter, constraints in certain areas are still affecting new product developments and program execution. We don't expect a significant improvement in lead times until the second half of fiscal '24. Semiconductor inflationary pressures remain a challenge also. In the third quarter, for example, we made approximately $10 million of end-of-life related semiconductor purchases, where the prices increased nearly 9 times. Our impact program launched in early fiscal '22 continues to evolve with positive results. We've streamlined our organizational structure and significantly strengthened our leadership team. We push margin expansion and working capital efficiency initiatives deeper into the business. In this inflationary environment, we're passing on higher costs wherever we can, and we've raised prices across the board on the commercial microelectronics side of the business. We're improving R&D investment effectiveness and consolidating our manufacturing facility footprint. Our digital transformation efforts in engineering, operations, and the back office should also help improve our cost structure over time. Turning to Slide seven, we believe that the defense spending outlook remains positive. The defense appropriations bill approved last year, as well as the President's budget request, targets substantial spending growth related to national security issues, as well as continued support for Ukraine. An extended budget continuing resolution appears to be the base case scenario for government fiscal '24, including the potential for a full-year continuing resolution. However, given the geopolitical environment, there appears to be strong bipartisan support for increased defense spending. Domestic and international defense spending is expected to grow in both the short and longer term, and we believe that Mercury is well positioned to benefit from secular industry trends. We've seen continued growth in demand for compute capability on board military platforms, and an ongoing push for platform electronification. We also stand to benefit from supply chain delayering and reshoring as well as increased outsourcing by our customers at the subsystem level. Our addressable market has increased substantially, largely driven by our strategic move into platform systems, and the potential to deliver innovative processing solutions at chip scale. Our model sitting at the intersection of high-tech and defense positions us well. As we announced in March, Christine Fox Harbison has joined us as Chief Growth Officer to help capture these opportunities. Christine has an impressive track record of driving growth, developing new markets, and building successful partnerships in defense and commercial technology businesses. We're very pleased to welcome Christine to the Mercury team. With that, I'd like to turn the call over to Michelle.

Thank you, Mark, and good afternoon again, everyone. I'll start with our third quarter results and then move to our fiscal '23 guidance and Q4 guidance. Please turn to slide eight, which details the Q3 results. Mercury's revenue and net income exceeded the high-end of our guidance, while adjusted EBITDA came in at the midpoint. Total bookings for Q3 were $245 million, yielding a book-to-bill of 0.93 as expected. Bookings linearity was still weighted heavily in the third month of the quarter but improved versus the first half. Our total backlog was up 10% and 12-month backlog was up 9% compared to Q3 last year. We're entering the fourth quarter with forward coverage of over 80% and solid visibility of the remaining bookings required to achieve our forecasted Q4 revenues. Q3 revenue was approximately $263 million, up $10 million or 4% on a total inorganic basis, compared to $253 million in Q3 '22. Avalex and Atlanta Micro are now included in organic revenue, having completed their fourth full fiscal quarter since being acquired. Gross margins for the third quarter decreased to 34.3% from 39.4% in Q3 last year. The decline was partially offset by savings in operating expenses, primarily within R&D, as a higher proportion of engineers continue to incur direct labor on development programs. As Mark mentioned, over the last several quarters, we've consistently cited two key drivers of lower gross margins. First, a higher concentration of development program revenues in our mix. And second, the derivative effects of the pandemic resulting in program execution delays. There is a close correlation between these two drivers that warrants a finer point. In fiscal '19 through fiscal '21, we achieved a significant level of design wins, both organically and through acquisition, especially in relation to the Physical Optics Corporation acquisition. These design wins were predominantly within secure processing, and mission avionics, two of our key strategic growth areas and translated into development contracts in our backlog. The onset of COVID in fiscal '20 and the transition to remote work added latency to our development efforts. Shortly thereafter, supply chain delays began to limit availability of critical components, followed by the great resignation, which created labor constraints across a number of our program execution functions. We began to see some margin reductions in fiscal '21 and fiscal '22, partially offset by lower R&D expenses, as more engineers charged labor directly to these development programs. This resulted in increased levels of unbilled receivables, as discussed in many of our prior earnings calls and public filings. The higher engineering labor content, coupled with the low unit volume on most development programs, contributes to average gross margins in the low to mid-30s on these programs. This compares to average gross margins of above 40% across our production programs. As Mark mentioned, our proportion of development program revenue has nearly doubled from approximately 20% in fiscal '21 to approximately 40% in fiscal '23. While the mixed shift alone created initial pressure on gross margin, the derivative effects of the pandemic created concurrent execution delays and inefficiencies. The delays resulted in many of our largest development programs entering final testing and qualification in fiscal '23. We have encountered technical challenges as is typical for this stage, across a dozen or so of our development programs. The resulting cost growth has a compounding impact on gross margin, given that many of our active development programs are predicated on firm fixed-price contracts. Remediating these challenges requires incremental labor and material, both of which have experienced inflation over the last several years. More specifically, the cost growth incurred in the testing and qualification stage of these development programs resulted in higher scrap charges, as well as more senior engineering labor charges when the unit did not yield as expected. In accordance with GAAP, we continuously reassess our estimates to complete on these programs, based on changes in facts and circumstances. Changes in estimates are applied retrospectively, and adjustments to estimated contract costs are identified. Such revisions require a cumulative catch-up of prior program margin performance. This resulted in an outsized impact in the quarter in which the changes in estimate were identified across these development programs. As Mark mentioned, nearly all of the dozen or so development programs that have contributed to the fiscal '23 cost growth are nearing completion in the next two to three quarters. Completing these programs will not only rebalance our revenue and margin profile as we shift back to a production and weighted contract mix but will also reduce susceptibility to cost growth across our program portfolio. As a frame of reference, historically, we experienced minimal changes in our cost-to-complete estimates. During Q3, outside of these dozen development programs, we continue to experience the same trend of minimal changes in these estimates across the nearly 300 other active programs we manage. As we complete these development programs over the next two to three quarters, we will apply the lessons learned to the follow-on production contracts, as well as development programs in our backlog to support more stable cost-to-complete estimates going forward. As such, we expect to see an improved gross margin, not only from the mix shift to production-based contracts but also due to recovery from cost growth specific to these programs. In addition, where possible, we are seeking cost-plus fixed fee structures on new development programs, partially mitigating the impact of cost growth on future program execution. From a working capital perspective, these dozen or so programs have been a significant primary and secondary source of growth in unbilled receivables. We expect their completion in the next two to three quarters to allow the billing and cash collection of nearly $30 million. Even more importantly, we have many other programs that leverage the same underlying technology or product or otherwise require the same specialized engineering resources currently consumed by these development programs. Therefore, as they are completed, manufacturing yields will improve across the shared technology or product, and engineering resources will be redistributed across multiple other programs. We expect this to allow for the billing and cash collection of an additional $60 million of unbilled receivables. In summary, our fiscal year '23 gross margins have been pressured by both the proportion of development programs in our mix, as well as execution challenges across a dozen or so of these programs, nearly all of which will complete in the next two to three quarters. We expect that overcoming these challenges will not only return us to a more normal, higher margin production contract mix, but also improve execution across multiple other programs. As a result, we expect to see improved gross margins, as well as the release of over $90 million in unbilled receivables, resulting in improved cash flows and overall working capital level. Q3 GAAP net income increased to $5.2 million or $0.09 per share, and $4.1 million or $0.07 per share in Q3 last year, due to a tax benefit of over $10 million in the quarter. We calculated Q3 income taxes using the discrete method, a more appropriate methodology given our year-to-date and expected fourth-quarter results. Our third-quarter operating and pre-tax results are lower year-over-year, due to the lower gross margins just discussed, as well as higher interest expense. Adjusted EBITDA in Q3 was $43.5 million compared with $52.5 million last year, again due to lower gross margin. Our adjusted EBITDA margin was 16.5% in the quarter. Free cash flow for the third quarter was an outflow of approximately $13 million, including the first payment of $19 million related to the change in R&D tax legislation. Excluding this, free cash flow would have been an inflow of nearly $7 million better than our expectations of near breakeven entering the quarter. Slide nine presents Mercury's balance sheets for the last five quarters. From a capital structure perspective, our balance sheet remains strong. We ended Q3 with cash and cash equivalents of $64 million. We have $511.5 million of funded debt under our $1.1 billion revolver, which provides us with significant financial flexibility. We observed a 30% reduction in supplier decommits in Q3. While this is a positive indicator of stabilization in the supply chain, it resulted in material receipts of $20 million more than planned for the quarter. This is reflected in the growth in unbilled receivables, as well as inventory for the quarter. To some extent, it is also driving an increase in accounts payable, given the timing of certain receipts later in the quarter. Turning to cash flow on Slide 10. Although we saw more timely customer payment patterns, reducing our billed receivables, this was more than offset by growth in our unbilled receivables, primarily as a result of development program execution challenges. In addition, some of the snapback with suppliers I just mentioned resulted in higher Q3 cash outflows. We leveraged our receivable factoring arrangement at a level similar to the prior quarter to help offset these impacts. Working capital continues to grow as a percentage of sales, largely driven by increased unbilled receivables and inventory. As discussed, we expect continued progress toward development program completion over the next two to three quarters which should serve as a catalyst for the start of a significant reduction in unbilled receivables, and improved cash flow extending to fiscal year '24. In addition, with the supply chain beginning to normalize, and various impact initiatives progressing, we expect to have greater visibility, predictability, and control over inventory. As a result, we continue to believe an appropriate target for working capital as the percentage of sales is 35%, consistent with pre-pandemic levels. I'll now turn to our financial guidance starting with full fiscal year '23 on slide 11. The demand environment was strong in the first nine months of fiscal '23 and is getting stronger as we begin the fourth quarter. To reiterate, we expect record bookings in a positive book-to-bill for the year. Entering the fiscal year, we expected the completion of these development programs in the first half, with the follow-on higher-margin production awards throughout the second half, this supported higher revenues, improved gross margins, and strong operating leverage in the second half and especially in the fourth quarter. Based on the development program execution challenges and related cost growth experienced to date, we're adopting a more cautious outlook for the remainder of fiscal '23. Our fiscal '23 guidance for total company revenue is now $990 million to $1.01 billion. This represents flat to 2% growth year-over-year and approximately flat organic growth compared with a 5% decline in fiscal '22. The reduction from our prior revenue guidance reflects award and funding delays, including follow-on production awards associated with our development programs, as well as continued supply chain delays. GAAP results are now expected to be a net loss for fiscal '23 in the range of $19 million to $11.1 million, with GAAP loss per share up $0.34 to $0.20. We now expect fiscal '23 adjusted EBITDA in the range of $160 million to $170 million, down 18% at the midpoint from last year. Adjusted EPS is now expected to be in the range of $1.36 to $1.50 per share. We now expect negative free cash flow for the fiscal year both with and without approximately $30 million of cash outflows related to R&D tax legislation. I'll now turn to our fourth quarter guidance on Slide 12. For the fourth quarter, we currently expect revenue in a range of approximately $269 million to $289 million. At the midpoint, this is a decline of about 4% year-over-year. The revenue forecast for the fourth quarter is well supported by our existing backlog, with over 80% coverage entering the quarter and a strong line of sight to the remaining Q4 bookings. We expect gross margins to increase in Q4 as we complete certain of the late-stage development programs we've discussed. We also expect to see improved operating leverage on higher revenue. We expect Q4 GAAP net income to range from $1.2 million to $9.1 million. We expect fourth quarter adjusted EBITDA to be $49.6 million to $59.6 million, representing adjusted EBITDA margins of approximately 20% of revenue at the midpoint. Looking ahead to fiscal '24 and beyond, Mercury is well positioned for stronger growth, margin expansion, and improved working capital. We expect our current backlog and strong fleet of existing programs, coupled with increased defense spending, to drive a return to high single-digit to low double-digit revenue growth. On the bottom line, as our mix transitions from the current weighting of development programs to the higher margin production contracts, we expect to see a natural uplift in gross margin throughout fiscal '24. In addition, as the margin headwinds from certain of our existing development contracts subside, we expect to see further improvements in gross margins. At the same time, continued supply chain normalization will position us to begin rebalancing the timing of material receipts with the availability of labor, allowing us to meet our customer performance obligations in a more efficient manner resulting in improved working capital levels. Finally, we expect continued impact savings to support margin expansion and improved cash flows in fiscal '24 and over the longer term. With that, I'll now turn the call back over to Mark.

Thanks, Michelle. Turning now to Slide 13. Demand is strong and getting stronger as we begin the fourth quarter of fiscal '23. For the year, we expect to deliver record bookings and a positive book-to-bill. We are positioned for continued progress and a rebound in fiscal '24, as we push our development programs across the finish line and transition to production. Overall execution improves, and the supply chain conditions continue to normalize. Driven by stronger growth, higher EBITDA margins, and substantially improved working capital and cash flow, we believe next fiscal year will begin a longer-term period of improved financial performance for Mercury. Looking at over the next five years, we're well positioned to benefit from increased defense spending, both domestically and internationally. As a result, we believe that Mercury can and will continue to grow organically at high single digits to low double digits. In addition to growth, our five-year plan includes margin expansion, driven by better execution as the supply chain conditions normalize, the shift in maximum development to production, as well as continued improvements through our impact program. These tailwinds should lead to stronger profitability, as well as greater working capital efficiency and cash conversion over time. In closing, I'd like to extend my appreciation to the entire Mercury team, which is committed and working extremely hard to deliver improved results. My sincere thanks to all of you. Before we turn it over to Q&A, I ask that you please keep your questions focused on our earnings results. With that operator, please proceed with the Q&A.

Thank you. Your first question comes from the line of Peter Arment with Baird.

I guess, I appreciate the details you kind of explained development mix growing and kind of the derivative effects of the pandemic and what you've talked about, just what I'm trying to understand is that a lot of those things were kind of known three months ago that your development mix was growing. And you were still dealing with all these lingering effects. And then just trying to understand like kind of the change from what the implied guidance was of potentially 31% adjusted EBITDA for the fourth quarter, three months ago to now 18% to 21% just help me try to understand at least bridge kind of a dynamic, sir. Thanks.

So big picture, I think, as we were coming into the year, we were expecting that these development programs would be further along than what we currently are, right, as a result of some of the technical challenges. And we've experienced the cost growth associated with that. And as a result of the delays, Peter, we've also seen some follow-on award delays of high-margin business. So it's really kind of the two things, right, the later than expected completion on the development programs with higher costs, plus a knock-on impact for higher-margin production awards that we're expecting in the second half. So those are the two main drivers. The other one is that I think we also have seen some supply chain availability constraints that have affected certain businesses in the fourth quarter as well.

Just as if I could as a follow-up Mark, does this change how you approach just sort of bidding on some of these larger development programs in the future? Just because it sounds like these were technically challenging. What's your approach there? Thanks.

So yes, I mean, if you look at our model, Peter, right, we've got a product program, commercial investment leverage model. And prior to the pandemic, right, we've done a really good job, I think, in developing new capabilities quickly and cost-effectively, and then sharing those capabilities over multiple programs. What we're experiencing here is a very small fraction of the overall program portfolio. So as Michelle mentioned, it's about a dozen programs or 300 active programs that we are currently managing. The products go into multiple programs. So when you've got one issue, it'll affect multiple things. So it's the opposite of the leverage that we have when things are working well. Yes. That being said, we are nearing the late stages in terms of the development test and qualification. And yes, we do believe that once we get through it, you'll start to see things move much more quickly. Today, most of the types of contracts that we have are actually firm fixed-price contracts with only about 10% being cost-plus fixed fee. And so where possible, and where it makes sense on new development programs, we will clearly seek to move towards the cost-plus fixed fee structure. But it really does need to make sense depending upon the type of business and the actual business that we're pursuing, largely because of our investment models. So we're far along on them. It's unfortunate that it's happened, but the critical capabilities are tied to really important programs.

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

I guess Mark, can you tell us maybe, I don't know if it's only a dozen programs, maybe the top five or six programs that are driving this.

So we're not going to get into the specifics because the capabilities that we're in the final stages of development are specialized in nature. And we don't want to specifically link them to known DoD programs. But it is a very unique set of capabilities that we're producing. And I think they're very, very important in terms of the programs in which they enter. So unfortunately, I can't really disclose too much, Seth.

Okay. So they're classified programs?

They are not classified, but linking certain technologies into programs, just given what we're doing is not something that we would normally disclose.

Okay. And then maybe just the last point on this pass along is, in terms of these programs moving towards production, as Mercury kind of finishes its work on the development, presumably, you're supplying it to a prime contractor? Is there further technical risk on these programs that's out of your hands, as to when the customer is going to call on you to get going on production once you guys have executed on your part of the development work?

No, I don't believe so, Seth. But I think, as soon as we can ship these products, our customers are going to take them because they need them for the work that they're doing. So I don't believe that there's any additional risk or delays associated with that. We've literally just got to get through the finishing up the development efforts and ramping up new product introduction yields, which we began to see at the end of Q3. So hopefully, on the ones that are most important, we're already seeing progress.

Your next question comes from the line of Ken Herbert with RBC. Your line is open.

Maybe, Mark, just to stay on these, as you think about the progress in terms of retiring the risk on these development and other development programs. What's your assumption, again, for the sort of working capital release in fiscal '24? I mean, how much of a tailwind can this be? Is it possible to quantify that prior to official '24 guidance, but I think the impact on cash I think would be very important as we think about the next year.

It's a good question, Ken. Let me explain the issues and what we're doing. Then I’ll pass it over to Michelle, who can discuss the potential positive impact regarding unbilled receivables. At the working level, there are two late-stage products in development along with new product introductions that, due to our product program leverage model, are influencing multiple programs. The first product has unique capabilities that are utilized across several programs. In the second and third quarters, we conducted an extensive root cause analysis, and our customer in the U.S. government agreed with our findings and the corrective actions we've taken. Currently, we are monitoring the effectiveness of our options and making adjustments as necessary to enhance product yields and throughput. We are now gradually ramping up production. To give you an idea of our progress in Q3, although it came later than we hoped, we've increased our yield on this product from 0% to nearly 90% in alignment with program requirements. We are also on track to build tensor systems in the first half of the fourth quarter. As Michelle mentioned, we are applying lessons learned to prevent these issues in the future. The technology is very sophisticated and unprecedented, so we are in a strong position with it. Regarding the second product, our collaboration has enabled us to resolve some manufacturing problems, and we have returned to full production. However, we faced another issue at the end of Q3 with one of the variants that affects multiple programs. We anticipate deploying a software fix for this issue in Q4. Overall, we are in the final stages of development, which will allow us to proceed with production, deliver the products, and collect cash. With that background, I'll hand it over to Michelle, as these programs have the potential to generate significant unbilled receivables right now.

Yes, thanks, Mark. Hi, Ken. Yes, from a working capital perspective, the completion of the dozen or so programs that we referenced will result in a reduction of about $30 million, coming out of unbilled as we ship that product. And we think some of that release will occur in Q4, but occurring much later than we had originally expected, obviously, coming into the quarter. So we're going to see that cash convert, more likely in Q1 of '24, and Q2 of '24. But almost more importantly, is just when we complete the dozen or so programs, because of that either shared technology product or need for those same specialized engineering resources across multiple other programs. Those other programs are essentially waiting in line, right? And so there's another $60 million of unbilled receivables that's waiting for release. So once we can resolve the technology issues, or the common product issues, and redistribute those engineers to these other programs, there's another $60 million that we can convert to cash, which we believe will convert also in fiscal '24. So really, where you're going to see that working capital impact across these programs, is around that unbilled release. And we take that $90 million and think about what it means from a working capital perspective, it's a 10% reduction when you're looking at kind of trailing 12-month revenue.

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

I guess one thing I wanted to understand a little bit better is that in terms of the program dependencies, and specifically around the yield issues that you've been experiencing, like how do you think about sort of the ability to remediate this? And then, maybe what gives you the confidence that in FY '24, we'll actually see these issues resolved, as opposed to maybe a continuation? Just want to get a little bit more clarity around this?

Yes. As I mentioned earlier, we are making significant progress. We have identified the root cause of the most impactful issue, and our customer is in agreement. We have already started to increase production in phases, and we saw a dramatic improvement in yields during the third quarter. While we wish this had happened earlier, the delays in delivery have affected the timing of some follow-on awards. Regarding this product, we have already begun ramping up one variant in production, and we are now waiting for a software fix for another variant, which is scheduled for the fourth quarter. We are confident we understand the status of these programs and the technologies that are interconnected. We will be shipping products to the programs that our customers need in the first and second months of the quarter, which boosts our confidence. Additionally, two of the programs mentioned by Michelle are over 90% complete in terms of expected costs, and we anticipate completion of these programs within the next two to three quarters. Overall, I believe we are in a solid position. This is the first instance we have encountered this level of volatility, and despite that, we have historically seen very little turbulence over the past three years. It's a combination of factors and complex technology, but we feel we are nearing resolution.

Your next question comes from the line of Scott Wylie with Jefferies. Your line is open.

Hey, it's Scott on for Sheila. Mark, we always thought of Abaco as one of your closest competitors in the space and Advantech reported this morning. And like they point into Abaco's seeing pretty strong growth with margin expansion. I guess a natural question from that is, is there any market share shift happening in the market? And I know, it's difficult to comment on other businesses. But is there any color you might have into what's driving that delta and performance?

Yes. So as we said, Scott, right, it's really related to this dozen or so sets of programs where we're developing highly sophisticated technologies and capabilities that span out over multiple programs. It really ties to two things: just the development, engineering, developmental delays associated with the capabilities and then ramping those new products into production. So we don't think it's related to anything with respect to erosion of margins with respect to competition or anything like that. It's literally related to cost growth on the programs as we are going through these specific challenges. Michelle, if you want to add anything to that.

No, I would just highlight the continued strong demand that we have, you can see it through our bookings. Although Q3 was below one, it was as expected, and year-to-date we're above one, as we have been for quite some time in several of the last few quarters.

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

Mark, I just got to go back to Peter's first question. I still don't understand how EBITDA got cut 45% in 90 days. I mean, you're talking about these 12 programs, things you thought in the beginning of the year, but I mean, this was just 90 days ago, you had given us this implied fourth quarter. I mean, is there anything else happening? Was that just an aggressive view? And I guess more on the EACs, are they captured in here? Can you tell us what the negative EACs were?

Sure. So if you go back to it, as I mentioned, right entering fiscal year, we'd expect the development of these programs in the first half of the year with follow-on higher-margin production awards expected in the second half. It's this set of circumstances that basically supported the higher revenues, improved gross margin and strong operating leverage that we forecasted in the second half and especially in the fourth quarter. The challenges we've had have obviously been taking us longer to get the development effort across the goal line. That's not only affected the estimates from the fourth quarter, which was the cumulative catch-up. But as a result of those delays, it had an impact on follow-on awards also expected as higher-margin follow-on awards in the fourth quarter, which combined is roughly two-thirds of the overall drop; the other is related to supply chain availability on other programs. So Michelle, if you want to talk about why the impact was so large in the third quarter, and just from an accounting perspective, how it is that you actually got a team to account for the changes in estimates in a particular period?

Yes, sure. So, Mark, as you said, the drop is really a function of the execution delays on the development program. So it's pushing those follow-on production awards outside of the fiscal year and into '24. And then, the incremental costs that we are expecting, not all of the programs specific at this point, the planning for unknown unknowns in some cases, right? That is just a one-for-one drop-through right to adjusted EBITDA, because again, it's a cumulative catch-up. And then, as you said, supplier commitments have put kind of critical material receipts needed for the quarter outside of the required window. So we are in constant communication with suppliers. And although we have seen some level of reduction in decommits, we are constantly getting updates from those suppliers. In some cases, what we found was that those commitments were pushing out to a point where we could not complete the product or progress it to a point where we would be able to recognize the revenue.

But I guess on January 31, I mean, this seems like a pretty risky forecast you gave us expecting all this to get across the finish line. I mean, all of this just manifested in the net the last 90 days, though?

We faced challenges during development, and while our team was making progress, we encountered issues as we transitioned into the New Product Introduction stage. The yield was lower than anticipated due to the complexity of the technology, which hindered our ability to pass through the production processes as expected. Although the engineering development was completed, we struggled with production yield, starting at 0% unexpectedly, which none of our teams anticipated. However, by the end of Q3, we improved from 0% yield to 90% on one of our main products and capabilities. We also ran into issues with other product variants, including a software problem, as we began to ramp up production. This experience of late-stage development and new product introduction led us to reassess our forecasts based on the information available at the time, which resulted in adjustments as we faced these challenges and pushed timelines back.

Yes, Mike. I would also just add one of the examples that Mark just went through, we had execution underway earlier in the year. But because we got to that kind of testing and qualification point, we didn't meet performance specs. The nature of the units meant that we had to scrap them in their entirety; there was no salvaging of the units. And these are pretty meaningful scrap events, tens of thousands of dollars every time they occur with every unit. So there was significant rework needed at that point. We have the most senior engineers on our team working through it. And so as you can imagine, higher labor costs because of the seniority of those engineers, and then the material costs that are needed to recover are actually at inflated cost values because they're more recent material purchases. So it's very dynamic in terms of how the issues are being resolved. And as Mark said, we can make our best estimate in terms of what yield will be, but again, it's very dynamic, and it has changed throughout Q3, and it's the new facts and circumstances that are now reflected in our results for the year.

So if you go back to the model, right, that's the product program model. It's got a tremendous amount of leverage associated with it. And it's part of the reason that customers really want to work with Mercury, right, we're spending high levels of our own money on internally funded R&D to develop these capabilities. That is amortized or used over multiple programs. The good news in that model when it works is that we are able to deliver technologies and capabilities far more quickly and affordably than if it was on a per-program model. The challenge that you've got is that, in this particular instance, and it's probably the first time that I can recollect in my history at Mercury this has actually occurred, it's just given the sophistication of the technology, where we've had challenges and again, some of them were related to the effects of the pandemic and the challenges that are on execution. And we're now getting negative leverage, meaning that a couple of these technologies or products are actually holding up multiple programs. Now, once we get through the development and the NPI activities, which will close, the multiple programs will quickly benefit, meaning that will actually begin to make rapid progress, we believe, which is less cost growth in terms of the income statement, and we'll be able to ship systems at higher margins. Once we start to ship the systems, we'll obviously be able to invoice and collect the cash. And yes, we've got a significant amount of unbilled receivable tied up right now, as Michelle mentioned. So, yes, we're not done, but we've made a lot of progress in Q3, just unfortunately with slower progress than what we had previously anticipated.

This concludes our Q&A portion of today's call, and I will turn the call back over to Mark Aslett for closing remarks.

Okay. Well, thanks very much, everyone. Appreciate you joining the call today. Thank you.

This concludes today's conference call. You may now disconnect.