Mercury Systems Inc (MRCY) Q4 2023 Earnings Call Transcript

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

Good afternoon, and thank you for joining us. With me today is our President and Chief Executive Officer, Bill Ballhaus. If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. The slide presentation that Bill and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations. Turning to Slide 2 in the presentation. I'd like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's financial outlook, future plans, objectives, business prospects and anticipated financial performance. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2 in the earnings press release and the risk factors included in Mercury's SEC filings. I'd also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles, or GAAP. During our call, we will also discuss several non-GAAP financial measures, specifically adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue and acquired revenue. A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release. I'll now turn the call over to Mercury's President and CEO, Bill Ballhaus. Please turn to Slide 3.

Thanks, Dave. Good afternoon, everyone, and thank you for joining us. In this call, I'll cover three topics: first, introductory comments on recent changes, actions taken at the company and my initial impressions; second, our priorities and focus going forward; and third, expectations for our performance both for FY '24 and longer term. I'll then turn it over to Dave to discuss our results and look forward to wrapping up with Q&A. Before diving in, I wanted to take a moment to recognize the efforts of the Mercury team. Their demonstrated resilience over time and their dedication and commitment to serving our clients in their important missions. As we've discussed throughout the company, with our recent announcements, we are on a very clear path to unlock the intrinsic value of Mercury for our customers, shareholders and employees through enhanced operational focus. As a team, we realized that what we need to do is within our control, and we all recognize that's a great place to be. Please turn to Slide 4. Let me start by summarizing some of the recent changes at the company. At the end of Q4, the Board concluded its review of strategic alternatives and implemented several important changes to put Mercury on a path of enhanced execution of our strategy. Over the past two months, the Board has made positive governance changes, appointing Roger Krone and Jerry DeMuro to the Board, both well-respected industry veterans with CEO experience and appointing Scott Ostfeld to the Board, who brings an important shareholder perspective. I have known these three individuals for a number of years, and I'm delighted to have them on the board. In addition, the Board affected a smooth leadership transition with the valuable addition of Dave Farnsworth, a seasoned defense technology leader as Chief Financial Officer. And with today's announcement, I am humbled and excited that the Board has placed its faith in me to lead Mercury through its next phase of value creation. We have significant work ahead of us, and I'm confident based on what I've seen over the last year as a Board member and more recently as interim CEO that we can and will make tangible progress toward predictable, profitable organic growth with improved cash conversion in fiscal '24 and beyond. I also want to take a moment to thank Bill O'Brien for his 15 years of service to Mercury and for his significant leadership in navigating through this recent transition period as Chairman of the Board. Before I go too far, I'll give you a little background on myself. I began my career as an aerospace engineer designing and building high-powered communication satellites for government and commercial applications around the world, supporting demanding missions and delivering very complex satellite systems. One of my key takeaways from that experience was that as a young engineer, I didn't need to worry about things outside of my control. I realized that if I just came to work every day, focused on solving the customer's hard technical problems better than anybody else, being a good teammate, doing the right thing and delivering programs on cost and schedule, everything else would take care of itself. Customers would be happy, shareholders would be happy, and as employees, we would have a lot of fun outperforming our competitors. That was about the first decade of my career. And over the last 20 years, I've led a number of aerospace, defense and technology businesses. Like Mercury, many of these businesses had great fundamentals, but needed renewed focus to restore and drive strong shareholder returns. In each of these situations, I've worked with high-performing teams to drive a culture of relentless focus on enhanced execution that led to significant value creation and returns for shareholders. This experience, combined with my knowledge of this leadership team and Mercury's superb positioning in the market, gives me the utmost confidence that we will be successful in realizing the inherent growth, profitability, cash flow and ultimately, value of this national asset. Since taking on the interim CEO role on June 26, I spent significant time with the team digging into the details of the business in forming an assessment of Mercury and its value creation potential. Specifically, I have visited our major centers of operation and personally led reviews of our challenged programs and expanded those reviews to include 100% of our current development programs, their estimated cost to complete and any roadblocks or risk to completion. I've engaged with the growth organization to review the health of our new business pipeline and our approach to accelerate organic growth. The leadership team and I have rapidly assessed our cost structure, taking initial actions to rightsize our organization and improve margins in fiscal '24 and beyond. And as a leadership team, we have reviewed our major unbilled receivables balances by program and our inventory in detail to establish burn-down plans and drive improved free cash flow conversion. Please turn to Slide 5. Based on the last year plus that I served on the board and my work recently with the team, here are my initial impressions and takeaways. First impression, Mercury's strategy is sound. We are a national asset in the defense industrial base. At a macro level, we are positioned in an attractive growth market: Defense Electronics. And more importantly, we are situated in the right parts of that market that are experiencing spending growth. At a micro level, we are designed in with sole-source positions on critical defense programs poised for significant electronic modernization. And finally, with enhanced customer focus and execution excellence, Mercury will continue to benefit from increased outsourcing by our defense prime customers. All these factors give me confidence in our ability to grow faster than the market. Second impression, over the past several years, the company grew inorganically into strategically attractive areas, but didn't fully integrate some of the businesses and mature processes and management systems to align with Mercury's evolving business portfolio. In my experience, this is not uncommon in businesses that grow rapidly via acquisitions. At Mercury, though, the immaturity and lack of full integration of key functional areas have led to the serious challenges the company experienced forecasting business performance over the past several quarters. That said, maturing in these areas is doable within our control and underway. My third and most important takeaway is that while our recent results are disappointing, the majority of our business is performing well, delivering predictable and profitable growth. However, this solid performance has been masked by approximately 20 programs that are experiencing unique and outsized costs primarily due to temporary cost growth related to initial development challenges. In fiscal '23, these few programs impacted our financial performance by approximately $56 million. Said differently, our reported margin in 2023 does not at all reflect a structural shift in our margin profile. It is the composite of a very predictable and profitable core business obscured by an atypically large mix of development programs and cost challenges on a subset of programs that are resolvable and temporary in nature. And looking beyond our recent results, I'm encouraged by three factors: first, the majority of our business is performing very well; second, the temporary execution challenges that are masking this performance are occurring on a small subset of programs, most of which are development in nature and are all solvable; and third, the current larger than normal mix of development programs reflects the potential for increased highly predictable and profitable business as the programs transition into production. With those introductory comments, I'd like to now transition to our priorities and focus going forward. So please turn to Slide 6. Our enhanced focus on execution includes four priority areas: first, delivering predictable results through improved execution on challenged programs; second, building a thriving organic growth engine that leverages our unique strategic positioning; third, expanding margins through a rationalized cost structure and improved program gross margins; and fourth, driving improved free cash flow conversion and near-term cash release. These priorities are central to unlocking the intrinsic value in the business. Let me provide some additional color on how we're approaching each of them: first, on delivering predictable results. In assessing our program portfolio, our core business consisting of franchise production programs as well as a large portfolio of performing development programs is healthy and delivers solid gross margins, which gives me a lot of confidence in our long-term business model. Currently, there are two factors that have pressured and added variability to our recent results. First, as discussed in Q3, we have been successful in winning a number of development programs that have led to a shift in our program mix from 20% development programs in FY '21 to 40% development programs in FY '23. We know this mix shift is temporary in nature and a positive leading indicator of future growth as our development programs are a precursor to higher-margin, long-term production contracts. But given that our development programs typically run at approximately 1,000 basis points lower gross margin than our production programs, we have experienced near-term margin pressure tied to this mix shift. Second, as I mentioned earlier, because our management systems and processes have not matured at the same pace as our growth over the last several years to address the complexities inherent in many of these development programs, a small number of programs have become challenged, leading to unanticipated and temporary impacts on our overall performance. In FY '23, execution challenges on approximately 20 programs, a majority of which are development in nature, drove approximately $56 million of impact, or approximately 580 basis points of margin contraction. We are squarely focused on mitigating the effects from the challenged programs, completing them and transitioning them into production. We have strengthened our program reviews on development programs with increased frequency and internal rigor and tightened program management accountability to drive better performance. Two of these programs moved into production in Q4, five more have transitioned or are expected to transition in H1, with the majority completing throughout FY '24. While I can't promise we are done seeing the impacts from the challenged programs on our results, I can say that these execution challenges are resolvable, temporary in nature and the full force of the organization is focused on overcoming them. As we make progress through the year and as we return toward a more typical program mix, I believe the profitability of the core business will begin to become visible as we progress through FY '24. And finally, even at the increased levels of investment associated with the challenged programs, I'm confident that we'll see a high return on those programs as they transition from one-time development to ongoing long-term profitable production runs. Our second focus area, delivering consistent industry-leading organic growth requires the ability to bid and win new contracts at an appropriate level given our scale after years of inorganic growth. Our book-to-bill has averaged slightly above 1.0 over the past eight quarters, which isn't adequate to meet our growth aspirations. Going forward, we are focused on driving a higher book-to-bill, which will help meet our long-term growth objectives and above-market growth rates, reflecting our attractive market positioning. Sizing upward growth engine will take some time, but the good news is that we aren't opportunity constrained given our market positioning. I've had the opportunity to successfully work through similar growth scaling exercises several times in my career to accelerate organic growth. There is a consistent progression associated with targeting pipeline and levels of bid activity as leading indicators to revenue growth. We are beginning that work today led by our growth organization, and while it will take time to translate into revenue, I am confident that a healthy growth engine, combined with Mercury's strong positioning will lead to industry-leading organic growth. Our third area of focus is margin expansion through targeted improvements to both our operating expense and gross margin. As mentioned earlier, we have taken initial actions to simplify our organizational structure, facilitate clearer accountability and align to our priorities, including embedding impact processes and execution into the business, streamlining our organizational structure and removing areas of redundancy between corporate and divisional organizations; and reducing SG&A headcount and rebalancing discretionary and third-party spend. This first set of actions will generate approximately $24 million in annual run rate cost savings, including approximately $20 million to $22 million of net benefit to FY '24. These savings are reflected in our FY '24 outlook, which Dave will discuss shortly. In the near term, we are evaluating additional efforts to drive further efficiencies in SG&A, R&D investment and manufacturing footprint, among others. Our fourth focus area is driving improved free cash flow conversion and cash release. Over the past two fiscal years, Mercury has delivered $333 million of adjusted EBITDA, but generated negative $107 million in free cash flow, which is clearly unacceptable. Since FY '20, working capital has grown from approximately 35% of revenue to approximately 65% of revenue in FY '23. This growth has primarily been driven by increases in unbilled receivables and inventory, and is a direct result of the temporary execution challenges previously discussed. Our focus in this area is as follows: First, resolve execution challenges and ship and bill against legacy program unbilled balances. Second, continue to improve asset efficiency in our new overtime revenue programs through cash neutral or positive terms and tighter alignment of manufacturing cycles with customer deliveries. And third, better align the receipt of inventory with our manufacturing execution cycles and pursue advanced funding for material where possible. We believe these actions will help return the company to historic levels of net working capital representing a future cash release opportunity of approximately $300 million or more over time. With that description of our focus going forward, I'd now like to discuss our expectations for both our long-term business model and guidance for FY '24. Please turn to Slide 7. Looking at our model and focusing on margins considering recent history. With 2023 as a reference point, as we improve our program execution and resolve our challenge programs, we will remove approximately 580 basis points of headwind in our margins, which is partially offset on a go-forward basis by approximately $22 million or 230 basis points related to annual incentive plan bonus that was not paid in FY '23 due to underperformance. Based on recent actions to improve our cost structure, we see another 250 basis points of benefit. We also expect to return to a more normal mix of production versus development programs over time, which will have a natural margin uplift given the 1,000 basis points lower average gross margins on development programs. Assuming we return to our historical 80-20 mix of production versus development programs, we could experience an additional 200 basis points of margin expansion, demonstrating a clear path to 22% adjusted EBITDA margins over time. Beyond that, we have several additional levers to drive margin. We will continue to focus on program execution, not only on our development programs, but on our already profitable production programs to drive gross margin improvement. We're looking at IRAD efficiency through prioritization and return thresholds. And given our unique strategic positioning and focus on growing faster than the market, we should see operating leverage with accelerated organic growth. Netting all of that together, while we have more work to do prior to communicating specific long-term targets for Mercury, I do see a clear path back to predictable organic growth that delivers mid-20% adjusted EBITDA margins and strong free cash flow conversion. I look forward to coming back to investors later in the fiscal year to review our progress to date and provide more insight into our long-term financial targets. Turning now to our outlook for FY '24 on Slide 8. While we have taken and will continue to take actions to improve predictability, organic growth, margins and cash flow, fiscal '24 will be a transition year. Consistent with our go-forward philosophy to deliver on our financial commitments, build credibility and drive long-term shareholder value, we are taking a more conservative approach to guidance for the year. Dave will discuss our guidance in detail, but at a high level, we expect flat revenue at the midpoint with margin improvement throughout the year. While we're not providing quarterly guidance, I will say that Q1, which is a seasonally low quarter, is expected to be below Q1 last year's revenue and adjusted EBITDA with negative cash flow. As we continue to work through execution challenges and enhance our visibility through management system and process improvements, we anticipate improved profitability in the second half and positive cash flow for the year. While we are taking a cautious approach to guidance, I want to reiterate that our business model is sound, and I have not seen any challenges that are not resolvable with proper focus and execution mindset and ultimately, enhanced management processes and systems. With that, I'll turn it over to Dave to walk through the financial results for the quarter and the year, and I look forward to taking your questions.

Thank you, Bill. I'll start with a brief introduction then present our fourth quarter and fiscal '23 results as well as our fiscal '24 guidance. First and foremost, I'd like to thank Michelle McCarthy for serving as the interim CFO for the last six months. I look forward to working closely with her as she steps back into her role as our Chief Accounting Officer. The majority of my career spanning the last four decades was at Raytheon, where I served in numerous finance roles up through Vice President and CFO, Integrated Defense Systems and prior to that, as Vice President and CFO of its Intelligence Information and Services segment. The main focus in those roles was on operational finance, managing programs, developing financial plans and forecasts as well as maximizing return on invested capital with a particular focus on net working capital improvement. It was at Raytheon that I worked with Mercury as a supplier. I gained firsthand knowledge of the unique capabilities the company brings, which are critical to mission success. The ability to design and develop affordable open architecture defense electronic solutions reduces risk and accelerates time to market aligning with the drive towards outsourcing in the defense industry. In my initial weeks here, I have been impressed by the agility and drive of the Mercury team. I would also echo Bill's view regarding the strength of Mercury's long-term business model and the ability to return to above-average market growth and profitability with an enhanced operational focus. As Bill mentioned, our results for the quarter and the fiscal year were disappointing. Our financial performance throughout fiscal '23 and especially the fourth quarter obscures the underlying strength of our core business. In fact, the majority of the more than 300 active programs we are managing are performing well and generating margins in line with historical trends of above 40% across production programs and low to mid-30s across development programs. Our financial performance for the quarter and the year is masked by approximately 20 programs that have experienced unique and outsized cost growth, primarily related to development challenges. Specifically, our financial results were impacted by approximately $29 million in the fourth quarter and $56 million in the fiscal year across these challenged programs. We continue to experience minimal net changes across the rest of our program portfolio. As discussed in Q3, our proportion of development programs and execution has nearly doubled from approximately 20% in fiscal '21 to approximately 40% in fiscal '23. We have realized risks as certain of these programs have entered final stages of test and qualification in the fiscal year. Given nearly 90% of our program portfolio is firm fixed price contracts, incremental labor and material costs result in negative impacts to revenues and margin in the period recognized. Outside of this small population of challenged programs, we continue to experience predictable and profitable performance across the remainder of the program portfolio. We have taken aggressive and immediate actions to ensure enhanced execution and operational focus across programs to mitigate further risk. With that as background, please turn to Slide 9, which details the Q4 results. Demand remains strong as evidenced by bookings of $294 million with a book-to-bill of 1.16 in the quarter, yielding backlog of $1.1 billion and up 10% year-over-year. Revenues for the fourth quarter were $253 million, down $37 million or 13% on a total inorganic basis as compared to the prior year of $290 million. Revenue was below expectations, primarily as a result of cost growth on the challenged programs. As total program costs increased on firm fixed price contracts that are recognized over time, the measure of progress on those programs decreases. This results in a delay and/or reversal of revenues in the period that the costs are recorded. To a lesser extent, award and material timing also impacted program execution in the quarter. Gross margin for the fourth quarter decreased to 26.6% from 41.3% in Q4 '22. Gross margin contracted primarily as a result of over 1,150 basis points or approximately $29 million of impact from challenged programs in the quarter. This reflects the reduction in revenues, coupled with incremental charges associated with loss accruals as well as deferred program cost recognition. The remaining contraction in gross margin is a result of the higher than historical mix of lower-margin development programs as well as unfavorable manufacturing variances and reserves. GAAP net loss and loss per share in the fourth quarter was $8.2 million and $0.15, respectively, as compared to GAAP net income and earnings per share of $16.9 million and $0.30, respectively, in the prior year. The year-over-year decrease was a result of approximately $29 million of impact from challenged programs. The fourth quarter operating expenses also included a reduction of approximately $7 million for the forfeiture of stock-based compensation related to the departure of our former CEO. Adjusted EBITDA for the fourth quarter was $21.9 million compared with $71.6 million in the prior year. The decrease was primarily due to lower gross margins resulting from the impact of challenged programs as well as reduced operating leverage. Free cash flow for the fourth quarter was approximately $4 million, including the second payment of $7 million related to the R&D tax legislation and better than our view of breakeven entering the quarter. Turning to our full year results on Slide 10. Fiscal '23 was a solid year for bookings. Our book-to-bill was 1.10 compared to 1.08 in fiscal '22, yielding backlog of over $1.1 billion. This backlog supports a high level of visibility as we enter fiscal '24. Fiscal '23 revenues were $974 million, down 1% in total and 3% organically. Our fiscal year revenue decline was primarily a result of production award delays due to execution challenges across several development programs. In addition, incremental cost growth delayed progress and therefore, revenue recognition on certain programs. Gross margin for the fiscal year decreased to 32.5% from 40% in the prior year. Gross margin contracted by approximately 580 basis points as a result of approximately $56 million of impact from challenged programs incurred in the year. The remaining contraction in gross margin is a result of the higher mix of lower-margin development programs as well as unfavorable manufacturing variances and reserves. GAAP net loss and loss per share in fiscal '23 was $28.3 million and $0.50, respectively, as compared to GAAP net income and earnings per share of $11.3 million and $0.20, respectively, in the prior year. The year-over-year decrease was a result of approximately $56 million of impact from challenged programs. Adjusted EBITDA for fiscal '23 was $132.3 million compared with $200.5 million in the prior year. The decrease was primarily related to lower gross margin and reduced operating leverage. Free cash flow for the fiscal year was an outflow of approximately $60 million, including payments of $26 million related to the R&D tax legislation. The remaining outflow is reflective of growth in both unbilled receivables and inventory as a result of execution delays across our challenged programs. Slide 11 presents Mercury's balance sheet for the last five quarters. We ended fiscal '23 with cash and cash equivalents of $72 million. We have $511.5 million of funded debt under our $1.1 billion revolver, which provides us with significant financial flexibility. Turning to cash flow on Slide 12. Our billed receivables remained flat, while unbilled receivables increased approximately $6 million quarter-over-quarter. During the quarter, we successfully resolved a critical technical challenge dramatically improving our yields on a product platform common across many of our programs. We began final shipments and converted approximately $20 million of long-standing unbilled receivables to billed receivables on these programs during the quarter. This reduction was more than offset by new unbilled balances recorded in the quarter. More importantly, the resolution on this common product platform will enable the conversion of an additional $50 million of long-standing unbilled receivables over the course of fiscal '24. We also leveraged our receivables factoring arrangement at levels similar to the prior quarter. Inventory decreased for the first time in eight quarters as we improved our processes and management systems to better align procurement of materials with manufacturing cycles. Other noncash items, net and other operating assets and liabilities primarily reflect the activity within our tax accounts related to the R&D tax legislation. Working capital continued to grow as a percentage of sales, largely driven by increased unbilled receivables and inventory. We expect continued progress towards the completion of challenged programs to serve as a catalyst for the start of a significant reduction of unbilled receivables. The follow-on production awards associated with these programs will consume inventory, resulting in improved asset efficiency and cash flows beginning in fiscal '24. I'll now turn to our financial guidance for the full year fiscal '24 on Slide 13. We have shifted our guidance approach in fiscal '24 to guide annually rather than quarterly. While we have taken steps to improve predictability, fiscal '24 will be a transition year. As such, we're taking a more conservative approach to guidance for the year. Given our attractive positioning within the defense technology market, our existing franchise production programs and the sole-source nature of approximately two-thirds of our portfolio, we expect the demand environment to continue to support strong bookings. As a result, we expect a positive book-to-bill in fiscal '24. Our fiscal '24 guidance for total company revenues is $950 million to $1 billion. This represents flat growth at the midpoint. Our backlog entering fiscal '24 supports a high level of revenue visibility, providing more than 70% forward coverage over our revenue range. This exceeds historical levels of forward coverage entering a fiscal year. We expect improved revenue linearity between the first and second half of the year as compared to prior years. Gross margins in the first half of the fiscal year will approximate those of fiscal '23 as we transition through the challenge programs and balance the potential for unknown risks that may materialize through final stages of completion. Gross margins will increase throughout the year as we receive and execute on the expected follow-on production awards and begin to shift from the higher mix of lower-margin development programs. GAAP results are expected to be a net loss for fiscal '24 in the range of $13.7 million to $5.9 million with GAAP loss per share of $0.24 to $0.10. GAAP results include approximately $9 million of restructuring charges related to the cost savings efforts announced today. We expect fiscal '24 adjusted EBITDA in the range of $160 million to $185 million, up 30% at the midpoint from fiscal '23 and reflecting adjusted EBITDA margins of 16.8% to 18.5%. Adjusted EPS is expected to be in the range of $1.14 to $1.48 per share. Adjusted EBITDA and adjusted EBITDA margins reflect a marked improvement in gross margins, although not a full recovery to the historical levels, reflecting the potential for unknown risks materializing as we transition through the final stages of execution on our challenged programs, specifically in the first half of the year. As such, our adjusted EBITDA and adjusted EBITDA margins in the first half will be below the comparative period in fiscal '23. In addition, adjusted EBITDA and adjusted EBITDA margins reflect net cost savings of $20 million to $22 million associated with the workforce reduction as well as reductions in discretionary and third-party spend announced today. These cost-saving actions will result in annualized net savings of approximately $24 million. We expect positive cash flow for the fiscal year, inclusive of a full year of cash outflows related to R&D tax legislation. Cash flow will be second half weighted as we complete the majority of our challenged programs, ship and build final product and convert unbilled receivables to billed receivables and then to cash. We expect improvement in net working capital by the end of the year as we begin to see reductions in unbilled receivables and inventory with more meaningful reductions over the longer term. Looking beyond fiscal '24, Mercury is well positioned for stronger growth, margin expansion and improved working capital. We expect our current backlog and strong slate of existing programs, coupled with increased defense spending to drive a return to above industry average revenue growth. On the bottom line, as we complete our challenged programs and our mix transitions from the current weighting of development programs to higher-margin production programs, we expect to see a natural uplift in gross margins beginning in fiscal '24. In closing, our strategy remains sound. The organization is centered around four priorities: enhancing execution to deliver predictable performance, building a thriving organic growth engine, addressing our cost structure to improve margin expansion and driving free cash flow release and improved conversion. Executing on those priorities will not only enable a return to historical revenue growth and profitability but will also drive further margin expansion and cash conversion, demonstrating the full potential of our business model. With that, I'll now turn the call back over to Bill.

Thanks, Dave. Operator, please proceed with the Q&A.

Your first question comes from Seth Seifman with JPMorgan.

Bill, could you share what gives you confidence that Mercury is a national asset? Additionally, regarding outsourcing, which the company has mentioned previously, I'd like to know your perspective on this opportunity. Do you discuss with senior management at defense primes about their interest in outsourcing more of their cost structure, or is it typically addressed on a case-by-case basis? How do you view this opportunity over time?

Yes, Seth. So thanks very much for the question. And just as a reminder, I've been in and around this space for a few decades. So when I speak to some of the trends that I see that are relevant to Mercury, many have been in place for a while or been in work for a while. And I've also having been on the Board for over a year, had a perspective coming in. And I'd say that, that perspective coming in was I've always felt like Mercury was in an outstanding position strategically in the market from a macro standpoint, based on major funding trends around defense electronics, the growth rates the opportunity to bring capability enhancements to platforms on time constants that matter, make a difference today in missions and serving men and women in uniform and having a difference in their lives. So I knew coming in that Mercury was well situated, favorable tailwinds from a funding standpoint, market growth standpoint and had established program positions on franchise programs with long duration run rates. With respect to outsourcing, that's been a trend that's been in work across aerospace and defense and across contractors who have supported the federal government for decades. In our space, we certainly see it with the Tier 1 primes, who are really forced to focus on what are their core strengths and where are they going to focus? And in turn, where are they going to rely on the supplier base. And that's where I think we bring a very unique angle with our commercial model of investing in products that have relevance across platforms. It also drives our margin profile along with it. And so I think it's a trend that's here to stay. It's been in work for a long time and it's certainly relevant to Mercury and our positioning. So I've had a chance to see that over time from the outside to think about it certainly coming in when I joined the Board a year ago and now to see it up close and personal, while I've been in the interim role over the last couple of months.

Your next question comes from the line of Ken Herbert with RBC Capital Markets.

Maybe, Bill, to start off, as we consider the fiscal '24 guidance and the transition on the EBITDA from 132 to the midpoint of the guidance range, how much improvement is expected from the $56 million headwind caused by the 20 programs in '23 compared to the growth of the core business and other cost actions? It would be really helpful if you could provide some details on the key components affecting the EBITDA transition.

Yes, Ken, I'll start, and then Dave can add in. If we use Slide 7 as a reference, thinking about FY '24, I can provide a sense of our perspective. We have conservative assumptions regarding the program mix shift over time. We're anticipating a gradual shift throughout FY '24, with the possibility of a more favorable mix by the end of the year, but still holding to conservative expectations for the gradual change. Regarding cost reductions, we expect to benefit significantly from these reductions, although not reaching the full run rate, and we will see normalized comparisons. This gives you an overview from the right side of the chart of how we approach the midpoint of guidance, considering the unknown factors associated with development programs as we proceed with executing those programs in FY '24.

Okay. So I guess, just to summarize then, obviously, the guidance implies a fairly conservative view on the improvement on the impact of the challenged programs, which theoretically could be where you could see perhaps the most upside of the guide as we think about '24?

I think that's an appropriate way to look at it. And again, I would take as a backdrop, our view on guidance this year, recognizing it's a transition year, and we've got some moving pieces as we're executing on the back portions of these development programs, we think that's a prudent way to be thinking about guidance.

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

Congratulations on the new opportunities. My first question is regarding the program execution challenges; why has it taken this long to resolve some of these issues? Can you provide any additional details? Also, what gives you confidence that you'll be able to overcome the remaining challenges, especially considering the significant number of them?

Yes, Jonathan. To provide some context, the challenged programs that are affecting the overall performance of the business are actually few in number. We are looking at around 20 programs among over 300 in our portfolio, most of which are performing reliably and profitably, indicating a robust business that is being overshadowed by these isolated issues. In the last 45 days, we gathered our senior team from various functions, including engineering, manufacturing, and program management, to review every development program. We started with the initial 11 discussed in our Q3 call and expanded our review to include any programs identified as having a risk profile that needed attention, as well as those that were considered low risk. By the end of this process, we had examined every development program and scrutinized the activities and estimates for completing each one. This analysis is reflected in the growth of our estimates at completion and cost growth reported this quarter. Our acquisitions have provided strategic advantages and valuable development programs, which we believe will yield excellent returns and lead to predictable and profitable production runs. However, our engineering and program management processes have not advanced at the same pace as our acquisitions, which we are currently addressing. We have implemented detailed cross-functional reviews of our programs and their completion costs on a monthly basis to quickly identify and resolve any emerging issues. While I cannot guarantee that there will be no further development program challenges, I am confident in the thoroughness we've applied to our cost assessments and the involvement of our experts in evaluating what it will take to complete these challenging programs.

If I may add, Jonathan, the thoroughness of these reviews allows us to receive earlier warnings about risks. When these risks begin to emerge, it provides us with more time to address them. Recognizing these issues sooner and being able to respond is crucial to our strategy moving forward.

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

I guess just one quick one. And then I guess, for the past 12 to 24 months, we've heard an extremely large amount of detail about supply chain impacting this business. And I think here we are on this call, no one's brought up supply chain. So has that been a factor at all in some of the negative performance? And then the second one I wanted to ask, you've got $760 million of backlog that's shippable, can you give us any color on the margin profile there? Are some of these challenged 20 development programs critical to getting that product out the door?

Yes, Michael, thank you for your question. I'll begin with the second part. The answer is yes. We have conducted a thorough review of our inventory and our unbilled, which represents the majority of the increase in working capital over the past couple of years. Our ability to generate cash is primarily linked to the execution of these development programs. As we carry out these programs, deliver hardware, and initiate the production phases, we will be able to reduce both unbilled receivables and inventory. Our current focus is on releasing cash that has been tied up in the company. The increase in working capital you mentioned is mainly due to unbilled receivables and inventory. We are concentrating on shipping hardware program by program to enable invoicing and cash collection to reduce unbilled receivables. The inventory has grown over time, but it will decrease as we move our development programs into production. We initially purchased inventory in anticipation of timely project completions, but as these projects have extended, the inventory has remained while we await the start of production programs to utilize it.

And Jonathan, this is Dave. If I could just add a couple of thoughts. From a supply chain standpoint, the reason we're not focused on discussing that much here is that we've actually seen it start to normalize in terms of lead times. Where we had significant risk in the past, we talked about and had extended our purchasing to an earlier time. We're starting to go back and revisit all of those lead times, working with our suppliers to ensure we're not bringing in material too early to help us manage our inventories as we move forward.

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

So much to digest in your script, and I appreciate all that you've put together. I just maybe wanted to step back from all this and I hate the sort of question, but what do you think went wrong? Was it just simply acquisitions we integrated, and the company grew too quickly, not caring for margins? Do you think this is more structural or a process-oriented problem? And how do you think about the processes you'll fix if it is that over the next 12 months?

Yes. I think big picture, the company has scaled up and inorganically moved into areas that I think are very attractive areas to be in but require processes that are mature in areas like program management, system engineering, et cetera. And I think we're seeing the growing pains associated with that on some of these development programs. So to answer your question directly, I don't think it's so much structural. I think it's more process-oriented. And these aren't challenges that companies or leaders that have taken on development programs haven't seen before. They're very fundamental process type issues. So we have a team in place that is squarely focused on these development programs, not only on executing the ones that we have in-house but maturing our processes so that we can execute more effectively on development programs in the future. So I would characterize it more as a process maturity challenge that we are laser-focused on and already have maturing processes underway than anything that's more structural in nature.

And I guess just on the processes over the next few months, how will you change it? How do you make the systems more mature, so there are checks? And have you found anything wrong with the contract structures on the development side that might need to be changed?

Yes. I think on the process maturity, that's a journey. But like I said, it's already well underway. So when it comes to reviewing our development programs. We're doing it with a higher frequency right now, I would say, with more rigor because of the people that we have involved in those processes. And we're getting very granular when it comes to things like burning down our unbilled in our inventory and literally looking at it program by program every week. So hopefully, that gives you a sense of some of the maturing in our processes.

Sheila, I would add to that when you talk about the structure of some of the contracts that we've had in the past firm fixed-price contracts with billing at delivery, and we've been working with our customer set to ensure that we have milestones that are better aligned with how we're spending money on these programs. So we're working through that. And at the same time, we're working with our customers to ensure we have really solid alignment in our contracts around the scope of what's being performed.

Your next question comes from Jan Frans Anglebrooke with Baird.

I'm stepping in for Peter today. I have a question regarding the previous release where we mentioned 12 development programs that were primarily responsible for the issues, with 4 of those linked to a specific technology. However, today's release highlighted 20 programs facing challenges. Could you clarify if this means there are 8 new development programs, or do they include existing ones? I would appreciate some guidance on how we transition from 12 to 20.

Yes. So if we put it in the context of the impacts in the fourth quarter, where we saw a difference from guidance to our actual EBITDA of about $33 million. About $29 million of that was incremental program costs that we saw. And I'd say about a quarter of that were tied to the programs that were discussed in the third quarter call. The balance of that was tied to about an equivalent number of programs that were separate from the programs that were discussed last quarter. And so I think that gives you a sense of the programs last quarter as they're working their way through development stabilizing and then also the rigor of the review that we put in place across the rest of our portfolio and all of the other development programs in our portfolio. I think I would characterize it that way. Dave, anything to add.

No, I agree, Bill. The 20 programs include the 12 from the previous quarter. I would say that among those initial ones, about a third of the growth is driven by a very small subset of the original programs. The majority of the problems have been resolved, the programs are on track, and there has been no further increase in the program costs.

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

I wanted to follow up on the revenue guidance. Looking at the midpoint, we are not anticipating growth in 2024 and expect sales to be down in the first quarter compared to last year. Could you explain what aspects of the portfolio are hindering growth this year? I understand there are execution issues with certain programs, but growth-wise, we're observing that your customers, mainly major contractors, are experiencing revenue increases, while your revenues seem to be lagging. Why isn't Mercury benefitting from the industry growth we're seeing? Particularly since the limited growth we noted in Q4 this year appeared to be impacted by negative EACs, which I assume will not occur again.

Yes. Yes, I appreciate the question. And I will say that one of the benefits of this increase in mix that we have of development programs, we've talked about the fact that historically, it's been in the range of 80-20 and more recently, we shifted to 60-40, 40% development programs. I think implicit in that, our expectations of future growth tied to completing those development programs and then turning on the production programs that go with those that become long-running, predictable and highly profitable. To get there, we have to execute on and finalize the development programs. And that's really what's in front of us in '24. And more effectively, we're able to get through the development and turn on production, the sooner we'll be able to see the inflection point in the benefit of those long-run production programs in our organic growth rate. So I think we're taking a fairly balanced view of our execution in FY '24 across these development programs and the transition to turning on the production program.

And I would add, as Bill said, we're focusing our resources on these challenged programs and getting them done because the sooner we get those done, the sooner we turn on those production awards, which is going to help us across the board from a growth standpoint, from inventory, from working capital in general. And those programs where we're focusing resources are programs where incrementally, the revenue was not that great in the beginning part of the year, but it will turn into something much larger as we go forward.

And on the production portion of those programs, are those contracts established and signed? Or will you now go ahead and when the development is done then negotiate and sign production contracts with your customers on these programs?

Yes. They're not signed and they're typically dependent on the development programs being executed. But I think we view the conversion of those development programs to production programs as a very high rate. And in some cases or in many cases, we're the sole source provider. So it really comes down to just finalizing the development, delivering those first few units so that the production contracts can be awarded.

Can you discuss the significance of LTAMDS in this context? While 20 programs may seem small in relation to the company's total number, it's substantial for a single program. Did LTAMDS play a major role in the challenges you've faced, and how beneficial will it be for freeing up some working capital? Or should we see it as just one of several elements without expecting it to have a significant impact?

I would think about it more going forward as a program that we're very excited about as opposed to one that's been a major contributor to our challenged programs.

This concludes our question-and-answer session for today. I turn the call back over to Bill Ballhaus.

Well, thank you very much. I'd like to thank everybody for joining us this afternoon, and I look forward to talking during our Q1 earnings call. Thank you.

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