Mercury Systems Inc (MRCY) September 9, 2026 Conference Transcript

Thank you so much. Good morning, everyone. For those on the webcast, I'm Sheila Kayalu with the Jefferies Aerospace Defense and Airlines Equity Research Team, and thank you for starting off our morning and our conference, actually, with Mercury. We have Bill Ballhaus here, who's chairman and CEO, and David Bornsworth, who's CFO. This has been a long transformation, and Tyler Hojo, who's in the audience, who's Investor Relations, in case you need to reach out. I think it's been three years in the making, plus. These firesides used to be a lot different a decade ago, so thank you, Bill and David, for being here. Maybe just to start off, can we talk about the transformation that's ongoing at Mercury, and where are you in that process?

Yeah, and maybe I'll start, Dave, and then you can chime in. We are, you know, companies go through journeys, and we are definitely in a new phase of our journey that is centered on organic growth, accelerating organic growth, margin expansion, and a lot of potential tailwinds in the market that we haven't yet factored into our outlook. If you think about how we got here, the company went through a phase of growth through M&A. There's 15 acquisitions over a 10-year period of time. We had a large portfolio of development programs that were all kind of progressing toward the end of development and the riskiest phase of those programs. And then you fast forward three years to today. We basically have executed through a bunch of development programs, and now we're seeing what you would expect to see, which is the follow-on production awards and the transition to top-line growth, margin expansion that you would naturally expect to see in a portfolio that is shifting from a high development mix to a high production mix. But then you layer it on top of the last three years, our work to really drive synergies out of the acquisitions over a 10-year period of time. We're seeing not only the top-line growth with the transition to production, and not only the margin expansion that you would expect to see as you move from development to production, but we're seeing massive operating leverage because we've taken a ton of cost out of our cost structure over the last three days, or last three years. So as we're at three days, it's continuous, we're doing it daily. So as we sit here looking forward, that's what our outlook is. And we just communicated a revised outlook where our target profile is double digit top line growth, EBITDA margins in the low to mid 20s and free cash flow conversion of 50%. And that really reflects the transition in our portfolio, the margin expansion as we transition to production, and the operating leverage that We see in the business. What it doesn't include and what I think is really exciting is the tailwinds that we see in the market, and we have very broad exposure to tailwinds, and what I mean by that is increased quantities in things like munitions, space, our common processing architecture, airborne assets, and missile defense, none of which have we incorporated into our outlook. So we're sitting here at a place where we feel really good about this next phase of the journey, accelerating growth, margin expansion, and with a lot of upside potential to what we put out there in terms of our outlook.

That's great to hear. Maybe just on that, you reported the end of your fiscal year recently, and as we think about the first half of 2027, top-line growth of double digits, maybe that's the multi-year visibility. How do we think about the specific catalyst driving the double-digit growth?

Well, I think the number one catalyst is our backlog. We have had record performance in terms of bookings over the last year. I think three of our last five quarters have been new records. And in our fourth quarter, we booked $660 million of new orders, which was nearly twice our prior record. The last two quarters, we've booked a billion dollars. It's largely all production awards. And if you look at how that transitions to coverage over the next few years, we have visibility over the next few years, unlike anything that we've had in our history. So for, you know, the next 12 months, our $2 billion backlog, about a billion of it is for the next 12 months. That grew 23% year over year. And beyond 12 months, outside of 12 months, that part of our backlog grew 60% year over year. So we've got a visibility over the next couple of years that's very strong. And again, largely all of those bookings have been production. So it's good visibility, but also good predictability in terms of being able to optimize across our supply chain and really drive efficiencies.

And I think what I would add, Bill, is that, you know, a good illustration that ties both things together is when, you know, three years ago, we spent every Monday talking about what technically we needed to do to keep moving, and now three years ago, or three years later, what we focus on every Monday morning when we get together is how can we convert the backlog more efficiently? So it is the growth is completely tied to that backlog and our focus is on, you know, maximizing, you know, economically and efficiently that growth.

Maybe if we could talk about the fiscal Q4 orders of $660 million, 2.2 times book to bill. You know, how do you think about what drove that? Was there any pull forward in like the short term benefits that you're seeing? And if you could kind of break down the short-term orders as well as the long-term orders, that's 60% outside of the 12 months.

Yeah, I mean, you can see in what we disclose around the duration of our backlog how the bookings over the last couple quarters in particular have driven growth in the next 12 months, but even more growth in the period of time outside of the next 12 months. And again, that just points to not only higher growth rates but with better visibility. When it comes to Q4 specifically, I would say this. When you break down the $660 million, we had three – none of that includes any of the strategic agreements or increases in quantities tied to munitions or any of those tailwinds that you hear about in the market because those agreements are being put in place with the primes. Funding is following that, and then eventually after a couple quarters, it will flow to us. This is all centered on the transition of Mercury's specific portfolio moving from this high concentration of development programs to production. I'd say the one tailwind, if you want to call it a tailwind, is we have seen customers, given the funding environment, being willing to lean into multi-year commitments. And so we had three large orders in the 660 that I would say fall into that category. One was on LTAMs where we got partial funding on the next couple of years that'll take our production through FY29 and into 30, I believe. We had a relatively large last-time buy on an older version of memory, and then we had a large order for our common processing architecture, which is an area that we're really excited about, has huge growth potential and a lot of room to run. But if you take those three orders and you subtract them off the 660, the balance was still near a record bookings quarter, which just shows the strength in orders across our entire portfolio.

Maybe if you could talk about just the $2 billion of backlog you have. How do you think about execution on that? You mentioned that every Monday morning you're focused on executing on that. What are you seeing as the biggest constraints, whether it's supply chain or labor?

When he says Monday morning, by the way, he means from 8.30 until 6 o'clock at night. That's morning for Bill. Go ahead.

Yeah, I think, you know, for us, we don't really have facility constraints. We have enough capacity within our facilities. You know, we spent a bit of energy this past year pulling together some extra space in our Phoenix facility. You know, so right now for us, it's about getting the material in line so that we can spin the factories as fast as possible. And so you've seen that we've actually, you know, added a bit to our inventories. That was intentional. You know, over the past couple of years, we focused the company on reducing our networking capital, And we've been really successful in that, bringing almost $250 million out of our networking capital. Our balance sheet is really strong, so we feel good about going out and spending a little bit of cash, not a lot, you know, to position ourselves to be able to execute, as I said, as efficiently as possible on the backlog. We don't have any customer constraints. They are open to getting deliveries as fast as we can get them to them. So it really is about just getting the material in place to be able to do it. We're not seeing any bottlenecks at this point from the supplier community. This is just our ability to spin faster. And we knew it would take a couple of quarters to swing that pendulum back from just in time to having it early enough and to be able to, you know, convert faster. So that's what we're in the process of. We saw a good example of that in the fourth quarter, and we expect to keep going at that same pace as we go through the year to be able to bring in material.

Just to highlight what Dave said, three years ago when we had the development programs and we had a large buildup in our networking capital, we had to pull on some levers to address the situation. One lever was get through the development programs, which we've done. The other was to swing our material all the way to the right to just in time. And that ended up being the right thing to do in a low-growth mode. Actually, we were declining organically as we were working through those development programs. But over the last several quarters, we've been moving our supply chain to the left. So it's not like we have significant governors on our growth tied to one supplier that's constrained by quantities per year or anything like that. We're still working our way through pulling our supply chain to the left so that we're scheduling material to come in ahead of need date so that we have degrees of freedom so that we can optimize our backlog conversion. But as Dave said, we've seen really good evidence of that. We had a record revenue quarter in Q4. We had the largest overtime revenue quarter in 15 quarters, and that's driven primarily by material coming in. And we've communicated expectations for Q1 free cash flow being negative because we can see the material coming in that we're very quickly going to transition into production and delivery. One other point on capacity to emphasize, we're built up through 15 acquisitions over a 10-year period of time. The footprint of the company looks nothing like what you would architect from a clean sheet of paper. We have plenty of capacity in order to execute on our backlog, and in fact, we're rationalizing our facilities at the same time. So we think we can handle our backlog and drive further efficiencies, if anything, drive to two shifts across our operations if our demand signal were to double. So we feel like we're in a really good place from a demand standpoint and being able to execute on the demand.

Can I ask you, you said overtime quarter, the largest in three years. What does that mean?

So our revenue – well, you should – you're CFO. You should explain this one. We have point-in-time revenue and overtime revenue, and Dave will explain the nuances.

I thought you were going to keep going. I better not. So think of it very simply as, you know, we have two different models. Point in time just means we recognize revenue when we ship or deliver a product. No revenue recognized until then. Overtime is as you make progress on a program. So the primes typically, everything they do is overtime. They recognize revenue every month for the progress, every quarter for the progress we've made. We have some programs that are overtime, some programs that are point in time. It's like half and a half. And why is that a good thing? It's not a good or a bad thing, but why is it a good thing that overtime was so high? Because that shows that the material is actually coming in, that you get to recognize that progress that you've made. It shows, to Bill's point, that you're making significant progress on all those programs.

Largely on those programs, if you look at the total cost, it's 80% bill of material, and then the rest is labor. So to see the revenue progress on those programs, it's primarily driven by material and then just a little bit of labor. And on our production activity, we saw a lot of material volume that led to the overtime revenue being the highest in 15 quarters. And so we think that's a positive indicator that we're working our supply base to the left.

And the other thing I would mention about the supply base is one of the things you're seeing in this industry for I haven't seen in a long time is the primes are coming out and giving longer term projections to the base about what they see quantities and everything else. And we're doing the same thing with our suppliers, you know, being able to go out and talk about, hey, here's what we see as quantities going forward. And so we actually had a supplier forum and went – met with all of our suppliers to talk about this is what we're going to need in the future.

Can we talk about just maybe some of how you convert your backlog, whether it's just – two ways, I guess. One, you have a new program, how you have it go from development to production, and also as you think about the framework agreements, working the agreements with the primes, those becoming funded, and then converting to orders for Mercury.

Yeah. Well, I mean, the first thing I'd say is when you look at our $2 billion backlog today, it is not exclusively, but almost exclusively production follow-on orders. And so the conversion on that is very quick. And it's, you know, it's driven by the timing of the programs. It's driven by staging of material. And as we said, we have very few factory constraints. Now, we have a nice, healthy mix of new design wins that we've won over the last few years that we've talked about in our earnings calls. But typically, it takes two to three years before those transition into material production runs. And in fact, we largely, in our outlook of double-digit growth, we're primarily talking about our existing portfolio of production programs and how they're transitioning to higher rate production. So they were development programs that have been in some phase of low rate to medium rate production, still need to transition to full rate production. But we're not including in that outlook any of the development programs that we have won and how they may contribute. And we certainly haven't captured or included any of the potential tailwinds in the market, which is why we feel really good about our outlook. And hopefully, Sheila, you and others have seen over the last few years that when we put a stake in the ground and talk about here's what our expectations are, we crank on every lever available to us to outperform that. And as we sit here today with our backlog, the outlook we put out there, we feel like we have more degrees of freedom to outperform that outlook than we ever have in the last three plus years.

I think when you think about the framework agreements and those kinds of things, we haven't included any of that in our outlook, but when you look at it, the framework agreements lead the primes to come to the supply base and say, hey, here's what we think we're going to need. You know, if we do it as a multi-year, it looks like this. If we do it one year at a time, it looks like this. These are the range of quantities. So we've all been proposing those things, telling them, hey, if you do it this way, this is what it will cost if you do it that way. That takes them to the point of where they're negotiating the final contracts and getting funding. And as they get funding for us, they'll finish that definition and say it's going to be X. You know, for makeup, you know, Heyon Tomahawk, this is going to be a seven-year program. We're going to fund it all up front. We're going to fund it, you know, every year. These are the quantities. And so once they do that, we'll incorporate it in our outlook. But we haven't incorporated those things in our outlook yet. And what would happen is the primes will get their funding. You should expect a quarter or two lag between when the primes get their funding and when we do. There can be a bit of an exception to that, where they may come to us and say, hey, go buy some of the long lead stuff early, and we'll give you the funding to do that. And so that can happen ahead of even their funding. So, you know, it runs the gamut across all the primes because we have so many different programs that run across. And we've said before, you know, we're kind of agnostic as to where the funding goes, because in any case, it's a good thing for us. You know, so as we look at it, we've always said, hey, we expect this to be the end of the calendar year, kind of for us to see much of that. We saw a very small amount, fractional, in the fourth quarter, but, you know, we expect it to ramp up as we get through this latter part of the calendar year.

To explain what Dave just said about how we're almost agnostic to where funding flows, let me talk about the tailwinds that we see in the market. There's a lot of conversation about layered defense networks, Golden Dome, increased quantities, increased capabilities going on platforms, etc. Understanding where we sit. So we provide mission-critical processing at the edge. What that looks like is behind the back end of an antenna, we handle the signal processing, down conversion, the compute, the data management, and the storage, then the signal processing back out to a display, an effector, or an antenna. So think of that chain as where we operate. We sell components, modules, and subsystems along that chain or within that functional block diagram. Those capabilities sit on satellites in a tracking layer, on airborne assets, on interceptors, on ground systems, on radars, and subsystems on ships. And so in today's environment where there's budget, whether it's $1.1 or $1.3 trillion, whatever it is that's flowing into those assets, it's going to funnel down to a provider like us that has the mission-critical processing capabilities and delivering it to the edge. So when Dave says we're almost agnostic, if the funding flows to the satellite tracking layer where we have a footprint, great. If it flows to airborne assets, great. If it flows to munitions where we have a presence, great. If it flows to missile defense and advanced radars and increased quantities, great. Great. So we have dozens of opportunities like that on existing programs where we're in conversations with customers, and if any subset of those were to hit, it would be meaningful upside to the target profile that we put out there. So hopefully that clarifies that agnostic comment.

Can we talk about, just since you mentioned budgets, how you're thinking about planning for budgets, the CR, and what drove your outlook?

Well, our outlook does the best that we can to incorporate all of it. In terms of a CR, when you look at our next 12-month backlog of a billion and the commentary that we communicated of roughly $1.1 billion for revenue next year, we essentially have all of next year in backlog. And with respect to a CR, even if a CR were to be in place, a lot of our programs and what's in our outlook are production programs. And in a CR, the government has the ability to continue to allocate funding. So any additional funding beyond the billion that's in our next 12 months that would cover FY27 still can flow to us. And then in this world, the administration has a lot more degrees of freedom in how they allocate funding in the CR. So I don't think we're too concerned about a CR and any disruption from a CR flowing to us. I think even more broadly from a budget standpoint, we feel really good about how our programs and where we sit align with the priorities of the administration. So in a world where $850 billion has increased to $1.1 trillion and an increased allocation of it has gone away from government procuring services and more into acquiring technology and capability like ours, potentially going to $1.1 or $1.3, I think we're indifferent because we sit toward the top of the priority list. And if the waterline is being drawn down here, we think our programs are going to be pretty well funded.

That makes sense. I guess how much of the double-digit top-line growth would you say is production programs versus new design wins, and how you think about some of those new design wins and what potential they could bring?

We're thinking about our new design wins as upside to that number. So that literally captures what we see from our backlog, largely production in nature and rolling that forward.

Can you talk about those design wins at all? And I know Tyler's more than generous with the facility visits, so we always appreciate how you think about growing content, or is it adjacencies and expanding on existing programs?

Yeah. I mean, this is a super exciting part of the Mercury story that has yet to get a lot of visibility. So I talked about the cost synergies that we've been able to extract over the last few years associated with the 15 acquisitions. What's more exciting are the top-line synergies as we look across that functional block diagram I talked about earlier and how we can combine elements of it and drive performance up and size, weight, and power down by stitching together capabilities from across our portfolio. Over the last three years, we have realigned our organization in a way that makes capturing those kinds of synergies much more doable. When you're 15, you know, largely isolated companies, it's hard to get that kind of connectivity, but we've organized into a couple product businesses, a subsystems business, and we have an advanced concepts group that on our new pursuits is focused on leveraging Mercury's capabilities to develop a differentiated solution. We've done it in a number of areas. I think one of the places where it's most evident is in the growth in our space business, which has been organic, where we've taken components and modules from different parts of the company and integrated them into subsystems and won new design wins with both traditional space crimes and new entrants. And you've seen us announce some of those orders in our earnings calls. Yeah, it's cool.

But I think the thing about it is there's both traditional development going on with the government on new kind of capabilities going forward. We're doing our own development, you know, in our commercial kind of products business and certainly on smaller form factors and everything else. But at the same time, like what Bill described in space, there's new kinds of development that don't take a year or two years. When we did a couple of the space activities that we did, you would have called it development. It lasted like 90 days. And then you had to develop and have product together. And we had the capability to do that because we were able to pull existing components from across the business and put them together in a system to solve a problem. And when you're looking at some of the non-traditional players, that's what they're interested in. They're not interested in two, three years of development. They've got a problem. They want a solution. They want it now. Yeah.

You know, another area that might be worth highlighting is in our common processing architecture, where, I don't know, three years ago, it was pretty visible to the outside that we were having challenges with that technology and being able to produce it at high yields. Basically, what this is, think about it as a server in which we incorporate the latest of commercial technology. It's ruggedized, but then the special sauce that we provide is a multi-level security architecture that's both software and physical and electromechanical to protect the IP should it get into the hands of foreign adversaries. And you can imagine a whole world of applications where that's relevant. What we do, nobody else in the world has been able to do. We struggled with building it at high volumes. We fixed that problem, and it took a while, and we had to – that was Mondays, Tuesdays, Wednesdays, Thursdays, Fridays, getting to ground truth, understanding the physics of it, and controlling the processes so we could build these at high yield. What followed was exactly what we expected, huge demand, unlocking new orders, and we had record CPA bookings in the fourth quarter. One of our biggest awards was CPA, et cetera. So that continues. New program opportunities are emerging with customers saying, hey, we need that capability on these assets that are going in to this part of the world. And now we're layering on top of that our own internal development with customer interest to potentially participate in fund, taking that to a smaller form factor. So all of a sudden opening up a new addressable market for that technology with new platforms that are slightly smaller with the same kind of mission needs to protect assets if they got into the hands of foreign adversaries. So it's a different flavor on the development question, but I think it's a nice evolution of our existing roadmap and something that we're really excited about.

Can we ask about your international business? It's only 15% of sales, but you've seen a transition in your Switzerland facility. Just give us an update there.

Yeah, the thought process there was we see a great opportunity in Europe in particular. We actually have record backlog in that part of our business right now. We think that in order to expand over time, it'll be important for us to be able to manufacture in different countries. And rather than on our own investing in a number of subscale sites spread out across Europe, we transitioned our operations to a contract manufacturer that has the footprint. So as the business opportunities come up, we can work with them to move manufacturing into whatever country is necessary and be able to scale efficiently. We ran into some bumps along the way as we were transitioning to the contract manufacturer, which in my experience isn't unusual in outsourcing IT or contract manufacturing or anything like that. We're a few quarters into working through the issues, and I don't expect to be talking about it in a couple quarters. But we're super excited about the opportunity. We have a very strong backlog. We've got great channels to market direct to the primes and with our domestic primes and FMS. So a very big opportunity for us.

Can we talk about profitability, just how you're thinking about achieving your EBITDA margin targets of high teens in fiscal 27? You're anticipating about $200 million of EBITDA on an adjusted basis. Maybe if you could just walk us through the bridge on volume, productivity, any headwinds.

Yeah, we've been talking about this. It's Bill's, one of his best things he likes to talk about, so I'm surprised he's letting me talk. But it really isn't complicated. You can literally model it, and he says this, so I actually had to go do it to prove that I could do it. But on a four-line kind of model that just talks about what's our revenue growth, you know, if you look at our kind of direct margin, you know, does that, that's been increasing because you look at margin and backlog, and we've talked about our margin and backlog has been increasing every quarter. We talk about, hey, is it above what we need to achieve our target model? And we've talked about, hey, it's been above. It's been above for quarter after quarter after quarter. So we do see that that's getting to the right kind of level. So if you just vary that and you hold our op expense relatively constant, because we've shown that we can do that, could it take up a little bit in terms of absolute dollars? Yes, but not in terms of percentage of revenue. It's been decreasing in terms of percentage of revenue. And we expect that to continue as we get more leverage. You know, so if you just do the math, it's pretty straightforward. You can see that, you know, with us, you know, the increase we're talking about in revenue, which is double digit growth in revenue and above market and markets in the 10% range. So if you see us above market in revenue growth over the next couple of years, and when you see us at holding our OPEX, and if you just increase the direct margin slightly, you can see that you can get to the low to mid-20s pretty easily, pretty quickly.

Yeah, I mean, our outlook basically reflects low double-digit top line and 2.5 to 3x that on the bottom line. And the way that we're getting there is from incremental gross margin improvement as the portfolio is transitioning more to high-rate production and then keeping our OPEX in a very tight box in the positive operating leverage. And so for folks that are new to the Mercury story and may not know much about the company, you might be sitting there wondering, wait, how can this defense technology company have access to all this upside with expanding margins and positive operating leverage without significant investment? You have to appreciate the phase we went through. Significant investment in M&A and then the opportunity to extract synergies that we're into, but we're not all the way through. Massive investment in development programs that really challenged our P&L and we had a big buildup in our working capital associated with those. But we've unwound that, and now we're seeing the fruits of that investment with the transition into production, and we're nowhere near our potential in terms of full rate production, with then broad exposure to a bunch of tailwinds in the market that we're not factoring into our outlook. And so if you take that and you kind of run it through that four-line model, it explains our focus on value creation right now. It's very different than what it was three years ago where we had to clean up the networking capital and get the cloud removed over the business. It's captured the tailwinds. Just experience the gross margin that's going to happen as we transition to higher rate production. And we're focused on Mondays on the things that drive gross margin as you move from low rate to medium to high rate production. And then keep our OPEX in a vice. If we do all of those things, we're going to see massive acceleration on the bottom line.

I have three more questions and three minutes to go, so I'll make it quick. Dave, what's the supply chain item you're keeping your eye on closest to? Sorry, I'm putting you on the spot. You said I could ask anything.

Yeah, no, that's okay. Like everybody in the industry, we have a pretty keen focus on memory. We've got largely everything that we need for 27 is already on order. And we've got a lot in our inventory. You can see the level of our inventories. A good deal of that was already paid for in our deferred revenue. You can see that, you know, hey, customers have already paid for it, but until we use it, it stays, you know, you have to net those things. You know, I think that's probably the biggest thing, and it's just the timing of that and how we're actually, you know, bidding that into new contracts given the volatility in the market and won't, you know, and how we're working with the primes on that I think is the biggest thing.

I think the broader thing we're looking at is optimizing and sequencing our supply chain so that we can optimize our backlog conversion, and that's some of the insight that we're starting to get from Palantir.

Okay. I didn't even ask about Palantir, but I got one minute and two more questions to go.

Hey, you're time for it.

You're shrinking.

Free cash flow conversion. What's the right level that we should be looking at?

Yeah, I think we've talked about that, and 50% of EBITDA is the right level for us. We've had way above that for a couple of years as we were burning down our networking capital, but we feel good about where the balance sheet is. Bill would argue that we still have room to go in working capital. I think that's true, but right now, I think it's for the value of the company for our shareholders. I think the right thing to do is to capture these tailwinds, and if I've got to invest $10 or $15 million in inventory or in working capital, it's a good tradeoff for us. It makes perfect sense.

Okay. Last question since I'm out of time. Bill, how many energy drinks does Dave have during your Monday morning meeting?

We cap him at one because he's effective at one and annoying after one. I mean, there's like four cups of coffee in each one of those.

Thank you guys for joining us. Thanks so much.

Appreciate it.