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Mercury Computer Systems Inc. (MRCY)

F2Q 2013 Earnings Call

January 29, 2013 5:00 p.m. ET

Executives

Kevin M. Bisson – FO & SVP

Mark Aslett – President & CEO

Analysts

Peter Arment – Sterne Agee

Tyler Hojo – Sidoti & Company

Brian Ruttenbur – CRT Capital

Michael Ciarmoli – KeyBanc Capital Markets

Howard Rubel – Jefferies

Jonathan Ho – William Blair

Operator

Good day and welcome, everyone, to the Mercury Computer Incorporated Second Quarter Fiscal Year 2013 Conference Call. Today’s call is being recorded. At this time, for opening remarks and introduction, I would like to turn the call over to Senior Vice President and Chief Financial Officer, Mr. Kevin Bisson. Please go ahead, sir.

Kevin Bisson

Thanks Brian, 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 you can find it at our website at www.mrcy.com.

We’d like to remind you that remarks that we may make during this call about future expectations, trends and plans for the company and its business constitute forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. You can identify these statements by the use of the words may, will, could, should, would, plans, expects, anticipates, continue, estimate, project, intend, likely, forecast, probable and similar expressions.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated. Such risks and uncertainties include but are not limited to continued funding of defense program, the timing of such funding, general economic and business conditions including unforeseen weakness in the company’s markets, effects of continued geopolitical unrest and regional conflicts, competition, changes in technology and methods of marketing, delays in completing engineering and manufacturing programs, changes in customer order patterns, changes in product mix, continued success in technological advances and delivering technological innovations, changes in U.S. government’s interpretation of federal procurement rules and regulations, market acceptance of the company’s products, shortages in components, production delays due to performance quality issues with outsourced components, inability to fully realize the expected benefits from acquisitions, divestitures and restructuring or delays in realizing such benefits, challenges in integrating acquired businesses and achieving anticipated synergies, changes to export regulations, increases in tax rates, changes to Generally Accepted Accounting Principles, difficulties in retaining key employees and customers, unanticipated costs under fixed price service and systems integration engagements and various other factors beyond our control.

These risks and uncertainties also include such additional risk factors as are discussed in the company’s filings with the U.S. Securities and Exchange Commission including its Annual Report on Form 10-K for the fiscal year ended June 30, 2012. The company caution readers not to place undue reliance upon any such forward-looking statements which speak only as of the date made. The company undertakes no obligation to update any forward-looking statements to reflect events or circumstances after the date on which such statement is made.

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 discuss several non-GAAP financial measures, specifically adjusted EBITDA and free cash flow.

Adjusted EBITDA excludes interest income and expense, income taxes, depreciation, amortization of acquired intangible assets, restructuring expense, impairment of long-lived assets, acquisition costs and other related expenses, fair-value adjustments from purchase accounting and stock-based compensation costs. Free cash flow excludes capital expenditures from cash flows from operating activities.

Reconciliation of adjusted EBITDA to GAAP net income and free cash flow to GAAP cash flows from operations are included in the press release we issued this afternoon.

I’m now pleased to turn the call over to Mercury’s President and CEO, Mark Aslett. Mark?

Mark Aslett

Thanks Kevin. Good afternoon, everyone, and thank you for joining us. I’ll begin today’s call with a business update, Kevin will review the financials and guidance and then we’ll open it up for your questions.

Our focus right now is to maximize the result in a difficult environment and Q2 was successful from that perspective. Total revenue for the quarter of $49.8 million exceeded the high end of our guidance range. Our GAAP loss narrowed to $4.8 million or 0.16 per share versus our guidance loss of $0.17 to $0.24 per share.

Adjusted EBIDTA came in slightly above the high-end of our guidance and we were cash flow positive for the quarter.

Probably the highlight of the quarter is that bookings were up substantially from Q1 resulting in a total book-to-bill of 1.3. That said, condition to the defense industry remain challenging and promise to remain so for the foreseeable future.

We faced two key issues in the short-term, first is the increased likelihood that the current CR will be extended for the full government fiscal year, and second, there is the possibility that the recently modified sequence will actually take effect.

At the Mercury level, our biggest risks remain poor visibility, potential delays to expected orders and increased uncertainty on the timing of associated revenue, delays the timing of new program starts and programs transitioning between phases, slow foreign military sales, risks that bonds from the DOD investment accounts are reprogrammed and the risks overall to the timing and level of program funding.

In turn, these risks are and could continue to impact the number of value added design wins as well as result in lower bookings, revenues, profits and cash flow for at least the remainder of our fiscal 2013.

As Washington continues to avoid dealing with sequestration and improving a defense budget for this government fiscal year and now with the potential for FY 2014 Presidential Budget submission to be delayed, our results could be further affected.

Based on the challenging industry conditions and the risks that we face, we made some tough decisions in Q1 that in retrospect were absolutely right. Although total company revenues were in down in Q2 year-over-year, our bookings actually grew 11%.

In an environment so radically change from FY12, the relevant question now is, are we beginning to make progress on a sequential basis. During the second quarter, I believe that we did. We were pleased to see growth in both total company revenues and bookings as compared with Q1.

Turning to defense, total defense revenues grew 2% sequentially to $45.5 million while total defense bookings increased 52% to nearly $56 million. Our book-to-billing defense improved to $1.2 million to $0.8 million in Q1. And as I said, our total book-to-bill was $1.3 million. This compares favorably with $0.8 million in Q1. Our defense backlog exiting the second quarter was up 8% sequentially.

The part of our business that was hit hardest in Q1, the ACS core business had a really good bookings quarter on a sequential basis in Q2, as did Micronetics, the business we recently acquired and reorganized.

Although defense revenue in the ACS core was up just a point sequentially, defense bookings were up 63% and defense backlog increased 7%. We’re obviously very pleased with this progress.

The two major ACS core defense bookings we received during Q2 were Aegis and SEWIP Block 2. The Aegis order is the largest booking for that program that we’ve received since fiscal 2011. Also during the quarter, it’s our understanding that Lockheed received the official SEWIP Block 2 Milestone C signoff which is great news. We believe it’s now likely that the program will begin the transition to low rate initial production.

This signoff then what appeared to be near final contract negotiations between navy and our customer, and what likely triggered our receipt of the seaway border during Q2.

Although Lockheed does not yet formerly provided a shift date, the indication from our customer based upon the recent progress is that we’ll finally be able to shift and recognize our first SEWIP LRIP revenue during our current fiscal quarter Q3 following several quarters of delays.

Looking farther ahead, we continue to feel very good about the relationship we built with Lockheed around Aegis, SEWIP and several other potentially major program pursuits. We continue to expect that both Aegis and SEWIP will be important bookings and revenue drivers for Mercury over the longer term.

Commercial bookings in the ACS core business also increased this quarter, growing 42% sequentially and our commercial backlog was up 45%. This growth was driven by a large booking for a complex networked RF subsystem for security applications.

In addition to the substantial improvement from a bookings perspective in the ACS core business, Micronetics delivered very strong performance in Q2, its first full quarter as part of Mercury. Revenue was up 94% sequentially, bookings were up 48% and backlog exiting Q2 was up 25%.

This booking and backlog growth was largely driven by the single largest booking Mercury received during the quarter for EW system upgrades on the B-1 Bomber.

In terms of our other large ongoing programs and platforms, they continue to produce at lower levels than they have in the past. However, we see this is a reflection of a slow down in activity related to the ongoing budget negotiations in Washington and don’t currently see any of them is being specifically at risk.

The small run rate deals relate to spares, maintenance and repair that we typically receive each quarter also being negatively affected in this environment. However, we were encouraged that the bookings for these deals were also up sequentially, growing nearly 50% for the first quarter.

Unfortunately we didn’t see comparable strength in our design wins in Q2. The ongoing slow down in defense design wins reflects two factors. First, under continued resolution, there are no new program starts. Secondly, we believe that the primes have continued to reduce their internal R&D spending because of the potential for sequestration.

Looking at the second quarter specifically, we had a total of seven design wins, six of them in defense. This compares with six wins, five of them in defense in the immediately preceding quarter. Our design wins continue to focus on radar, electronic warfare, and electro optical infrared. The five-year probable value our design wins in Q2 was approximately $43 million compared with approximately $143 million in Q1.

As we said last quarter, knowing that we can’t control the timing of specific deals, order flows, or revenues in this environment, we’re managing the business differently than in the past focusing only on the things that are within our control. Overall, we’re managing to a more conservative forecast in revenue plan given the industry conditions.

We also believe that managing for caution this environment is the most prudent thing to do. For example, to minimize working capital, we’ve slowed down or in some cases, seized purchasing long lead time materials, ahead of order receipt for programs where the order timing is questionable.

We continue to take at one-quarter at a time, staying ahead of the curve by being as proactive as possible. With two major restructurings since Q4 of fiscal 2012 under our belt, we’re confident that we’ve achieved our goals and reducing our overall expense levels while preserving Mercury’s intrinsic enterprise value.

At the same time, we’ve ensured that we have sufficient liquidity and financial flexibility, not only to manage the ongoing needs of the business, but also for future M&A purposes when visibility and conditions in our end markets are more favorable.

During the second quarter, we closed on $200 million unsecured revolving facility with excellent terms. This facility is available for general corporate purposes, but it is intended primarily for future M&A. Our current focus however is on integrating Micronetics. We take a very cautious view of leveraging this environment, looking to avoid adding financial risk to the high level of industry risk that we’re currently facing.

So in summary, Mercury performed well in the second quarter and we were pleased with our progress. Looking ahead near-term, it appears that the industry is assuming a full-year CR and in light of the march to quest a deadline, the on services are now actively planning to sequestration and have begun to implement pre-sequestration spending thoughts.

We believe that country’s key programs aligned well with the DOD’s new roles and missions and should survive these potential cuts. However, the slow down in defense procurement that we have seen for the last several quarters is expected to continue until Washington resolves the DOD’s future spending authority.

We currently expect to make continued progress in Q3 and in longer term, our outlook for Mercury remains positive. With the product portfolio of refreshing we’ve implemented over the past five years, the programs we have won coupled with the improvements in our operating leverage, we believe we build intrinsic value in our business. We’ve done this despite historic levels of volatility and defense budgeting and contracting and we expect to continue doing so.

During those same five years, we’ve established and secured a competitive standing as the premier commercial ISR subsystem outsourcing partner to the defense primes. When the industry returns to more normal conditions, we believe the pressure to outsource to company like ours will only increase. Mercury is well positioned to capture a significant share of this potential opportunity.

We’re confident that given our cash management focus and recent expense reductions, this recovery will generate substantial operating leverage and this will lead to a significant improvement in profitability and cash flow generation over time.

With that, I’d like to turn the call over to Kevin. Kevin?

Kevin Bisson

Thank you, Mark, and good afternoon again everyone. Turning to our financial results, revenue for the second quarter of fiscal 2013 of $49.8 million was lower than revenue of $68 million for the second quarter of last year, but exceeded our stated guidance of $43 million to $49 million.

Company incurred a GAAP net loss of $0.16 per share in this year’s second quarter compared to GAAP earnings of $0.30 per diluted share in the second quarter fiscal 2012. This year’s second quarter loss per share was smaller than the company’s guidance of a net loss of $0.17 to $0.27 per share for the quarter.

Adjusted EBITDA for the second quarter of fiscal 2013 of $1 million was lower than the $18.8 million of adjusted EBITDA for the second quarter of last year, but exceeded our stated guidance of negative $2.1 million to a positive $700,000 for the quarter. The company generated free cash flow of $800,000 in this year’s second quarter and ended the second quarter with $33.9 million of cash and investments and with no debt.

Taking a look at the second quarter in greater detail, total revenue for our largest segment, Advanced Computing Solutions or ACS was $46.7 million, which was $19.4 million lower than the $66.1 million of ACS revenue generated in the second quarter of last year. The year-over-year decrease was due to $19.6 million decrease in ACS defense revenue and was partially offset by $200,000 increase in commercial revenue. The lower ACS defense revenue was due primarily to unusually high revenue in last year’s second quarter from a classified program with Northrop Grumman and the JSF program that were partially offset by revenue derived in this year’s second quarter from the acquisitions of KOR Electronics and Micronetics.

On a sequential basis, ACS revenue in this year’s second quarter was $4 million or 9% higher than the first quarter of $42.7 million due mainly to higher Micronetics related shipments driven by the B-1 Bomber program and a full quarter’s impact of Micronetics revenue compared to a partial quarter’s impact in the first quarter.

Revenue from the company’s Mercury Federal Systems or MFS’ operating segment for the second quarter was $7.9 million, which was $2.7 million higher than the $5.2 million of MFS revenue for the second quarter of fiscal 2012. The increase in revenue year-over-year was due primarily to the inclusion of revenue from Paragon Dynamics or PDI which was acquired as part of KOR Electronics.

Compared to this year’s first quarter, second quarter MFS revenue declined by $2 million, principally due to lower revenue from the Gorgon Stare program. It should be noted that operating segment revenue for the second quarter of fiscal 2013 does not include adjustments to eliminate $4.8 million of intercompany revenue.

Total defense revenue, including ACS and MFS, for the second quarter of $45.5 million was lower than the $63.9 million of defense revenue for the second revenue of last year. The year-over-year reduction in defense revenue was mentioned earlier system to principally from a significant decline in the company’s organic defense revenue related to JSF and a classified Northrop Grumman program, offset in part by the impact of acquisition related revenue.

On a positive note, defense revenue for the second quarter increased $1 million from the first quarter reflecting increased Micronetics related revenue that was partially offset by lower Gorgon Stare program revenue.

Defense bookings for the second quarter of $55.7 million were $2.4 million or 5% higher than the $53.3 million of defense bookings in the second quarter of last year. More impressively though, second quarter defense bookings were $19 million or 52% higher than defense bookings of $36.7 million generated in this year’s first quarter. The substantial increase in sequential bookings was driven by orders received in the quarter related to the B-1 Bomber, Aegis and SEWIP programs offset partially by the absence of the large F-15 EW upgrade booking received in the first quarter.

Mercury’s total book-to-bill ratio for the second quarter of fiscal 2013 was 1.3, which was significantly above the 0.8 book-to-bill ratio for both the second quarter of last year and this year’s first quarter. Defense book-to-bill of 1.2 for this year second quarter was similarly above the 0.8 book-to-bill ratio generated in the second quarter of last year and the first quarter of this year.

The company ended the second quarter of fiscal 2013 with $133.2 million of total backlog, which was $10.7 million or 9% higher than the $122.5 million of backlog at the end of last year second quarter. Of the total ending backlog in the second quarter, $109.4 million or 82% is expected to be shift within the next 12 months.

$116.2 million of the ending second quarter total backlog related to defense which was $2.5 million lower than last year’s second quarter defense backlog, about $8.3 million or 8% higher than defense backlog in this year’s first quarter.

From a bottom line perspective, the company incurred a GAAP net loss of $4.8 million in this year’s second quarter compared to GAAP earnings of $9 million in last year’s second quarter. The reduced bottom line performance year-over-year was mainly due to lower gross margin resulting from lower revenue and an unfavorable product mix.

Impacting product mix was lower organic defense revenue in this year’s second quarter, which carry higher gross margin that was partially offset by acquisition related RF, Microwave and services related revenue that carry comparably lower gross margin.

Partially offsetting this year-over-year reduction in gross margin were lower operating expenses as the benefits of the restructuring actions completed in last year’s fourth quarter and this year’s first quarter were partially offset by incremental core PDI and Micronetics operating expenses.

On a sequential basis, the second quarter net loss of $4.8 million was $2.4 million favorable to the first quarter net loss of $7.2 million. Lower sequential gross margin due to higher mix of RF and Microwave related revenue was more than offset by the restructuring benefits and the absence of this year’s first quarter restructuring charge.

Adjusted EBITDA of $1 million for the second quarter of fiscal 2013 was significantly lower than the $18.8 million of adjusted EBITDA generated in the second quarter of last year. The reduction in adjusted EBITDA between years is mainly attributable to lower earnings offset partially by a higher year-over-year add back of amortization expense and purchase accounting adjustments related to the company’s recent acquisition.

Relative to our stated financial guidance for the second quarter, we are pleased to report that the company exceeded the high-end of its guidance in all key measures. Second quarter revenue of $49.8 million exceeded our guidance of revenue between $43 million and $49 million. Loss per share of $0.16 for the second quarter was favorable to guidance of $0.17 to $0.24 per share. And finally, adjusted EBITDA of $1 million for the second quarter exceeded our guidance of negative $2.1 million to a positive $700,000.

Now turning to the balance sheet, the company ended the second quarter of fiscal 2013 with cash and investments of $33.9 million and no debt. This was $3.3 million higher than the $30.6 million of cash and investments at the end of the first quarter of fiscal 2013.

The increase in cash and investments for the second quarter stemmed from the release of restrictions on the company’s restricted cash due to the renegotiation of certain company real estate leases. We generated $800,000 of free cash flow for the second quarter as $1.6 million of operating cash flowed due to improved receivables collections was partially offset by $700,000 of capital expenditures.

Consistent with the prior two quarters, the company will be providing only quarterly financial guidance due to the continued lack of clarity relative to defense procurement and the looming threat of sequestration. With that in mind, we are forecasting third quarter total revenue to be in the range of $44 million to $50 million. As Mark pointed out in his remarks, this forecasted revenue range continues our recent policy of placing a much greater reliance on revenue sourced from existing backlog and less reliance on revenue required to be booked and shipped in the same quarter.

We believe that in these unprecedented times of defense industry uncertainty, the appropriate course of action for the time being is to minimize the buildup of working capital and preserve liquidity at the expense of potential revenue upside. Consistent with prior quarters, we expect to split in third quarter revenue to be approximately 90% defense and 10% commercial.

The company’s third quarter revenue forecast also reflects defense revenue that is largely in line with second quarter defense revenue. With the receipt of the SEWIP purchase order in the second quarter and favorable indications from our customer that it will authorize shipment of products shortly. We have included revenue from the SEWIP program in our revenue guidance for the third quarter.

Within our stated revenue guidance, we are projecting gross margin to approximate 35% for the third quarter, which is largely consistent with the second quarter. The mix of forecasted third quarter revenue between the base defense business and the RF and Microwave businesses is expected to approximate the second quarter product mix.

Operating expenses are forecasted to be $26 million for the third quarter, little change from operating expenses in the second quarter. From a bottom line perspective, we anticipate a GAAP los per share in the range of $0.02 to $0.08 per share for the third quarter based on an estimated weighted average share count of 30.2 million shares.

Included in this loss per share range is an unusually high income tax benefit driven by the extension of the federal research and development tax credit retroactive to January 1 of 2012 as part of the fiscal cliff legislation signed in early January.

In effect, our estimated tax benefit for the third quarter will include the cumulative impact of four quarters of R&D tax credits. The lost per share range forecasted for the third quarter also includes an approximate $0.06 per share impact from the combination of intangible amortization and trailing restructuring costs.

Adjusted EBITDA for the third quarter is estimated to be between negative $2.5 million and positive $1 million, which largely tracks our second quarter guidance. Relative to liquidity, we anticipate ending the third quarter with cash and investments between $32 million and $33 million, which is slightly lower than cash and investments at the end of the second quarter as slightly positive operating cash flow is forecasted to be offset by capital expenditures.

With that, we’ll be happy to take your questions. Operator, you can proceed with the Q&A now.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And we’ll take our first question from Peter Arment with Sterne Agee.

Peter Arment – Sterne Agee

Hi, yes, good afternoon Mark and Kevin.

Mark Aslett

Hi, Peter.

Kevin Bisson

Hi, Peter. How are you?

Peter Arment – Sterne Agee

I’m doing well. Guys, question I guess, Mark, on the – the previous cost reductions that you addressed really last quarter and a lot of that was primarily related to integration of Micronetics. Maybe you could just give us an update on how you anticipate some of those savings flowing through and where things stand there and any additional actions you’re taking now that the CR is going to extend then we have this additional uncertainty was clustered?

Mark Aslett

Sure. So we’ve basically done two restructurings to date, one in the fourth quarter and then one in the first quarter. The majority of the auctions that we took in the first quarter were actually expense reductions in the ACS core business, which is where we’ve seen the majority of the slow down. So we did see a significant amount of the benefits this quarter, however, we’ve also either in the full quarter of expense from the recently acquired Micronetics which has provided a partial offset there.

We believe that the expense reductions that we’ve taken to date is sufficient for the environment that we see right now. And obviously we’re taking things one quarter at a time Peter.

Peter Arment – Sterne Agee

Okay. And then, just regarding, just comment your comments about potential reprogram funds. Can you just give us maybe without all the details, but the kind of qualitative like moneys that have obligated but not ultimately released to you and what the risks are for some of that, what that is in terms of reprogrammed funding?

Kevin Bisson

Yeah, we haven’t got it at that level, Peter. I think it’s more just an industry macro level what we hear occurring. If you look at and read with what secretary of navy has said and the secretary of the army, I think both of them are very concerned around the shortfall that they see in particularly in the O&M budget. Now right now I think that under the CR, they have little flexibility of moving monies across and between accounts, but that is a potential going forward. Depending upon what happens with both sequestration as well as the CR. So it’s more a risk that we see as opposed to something that’s very specific right now.

Peter Arment – Sterne Agee

Okay. And then you also mentioned potentially slowing FMS funds. What are you equate to your total international mix as of today?

Mark Aslett

Can you maybe look that up Kevin?

Kevin Bisson

Why not I give you sort of more of a qualitative perspective on that? I think that I was pointing at one specific program which is patriot. So, if you go back and you kind of listen to what Raytheon said on the last earnings call is clearly a lot of opportunity in the Middle East and specifically around Kuwait, Qatar and Turkey. However, if you look at what we booked and recognized from a revenue perspective through the first half of fiscal 2013 is basically zero. So that program is not producing the way in which we would have hoped.

Raytheon did expect a decision on Kuwait in their Q4, but it slipped and they now expect a decision either this quarter or maybe next. Qatar, a ward is currently targeted in the late calendar 2013, so it’s really outside of our current fiscal year. And I think everyone knows what’s happened with Turkey which is basically loaning patriot systems from NATO at this point. So patriot is really important program but we have seen delays on it.

Peter Arment – Sterne Agee

Okay. Now that’s helpful and just one last one. Just the R&D tick down as low as I’ve seen it in a while. Was that just proactively was it just timing, just being additionally cautious as given the backdrop, is that kind of a new run rate there, how should we think of that?

Kevin Bisson

I didn’t hear the question, Peter. Could you just repeat the…

Peter Arment – Sterne Agee

On the R&D it was certainly one of the lower levels that we’ve seen on an absolute and a percentage basis. Is it just your cautiousness or was it just timing. Is that kind of an expected new run rate or how should we think of it?

Kevin Bisson

Yeah, so that’s part of the major cost reduction actions that we’ve taken. If you remember what I said last quarter, in Q1 we really a very significant new product portfolio refresh cycle. And so, as a result of that, but also the weakness that we’re seeing in the ACS defense core, we did take the opportunity of reducing our R&D expenditure in that part of the business. So it’s a good run rate from at this point in time.

Peter Arment – Sterne Agee

Okay. That’s helpful. Thanks. I’ll get back in queue.

Operator

And we’ll take our next question from Tyler Hojo with Sidoti & Company.

Tyler Hojo – Sidoti & Company

Yeah, hi. Good evening guys.

Mark Aslett

Hi, Tyler.

Kevin Bisson

Hi, Tyler.

Tyler Hojo – Sidoti & Company

Yeah, just a first question, just to follow on Peter’s line on the R&D side. I was hoping that maybe you could talk a little bit about the effect on design wins. I mean we’re down a little bit this quarter, and I think that was expected, but maybe you could talk about what you’re expectations are over the next several quarters in light of the kind of declining R&D budget.

Mark Aslett

Sure. I don’t believe that the reductions that we made in the R&D budget impacted our design win activity during the quarter. I think as I said in my prepared remarks, really what has impacted our design wins is the fact that under a continuing resolution there are no new program sides. And in addition, what we’re seeing in this environment, particularly given the potential for sequestration, the primes themselves were actually lowering their internal R&D budget. So I think those are the items that in effect have actually impacted the, both the quantity as well as the dollar value of our design win activities in the second quarter.

So I think we’re going to be sticking, we’re going to be at this level until its clarity around what’s happening with the defense spending environment. But to reiterate again, I don’t believe it’s related to our reductions in our R&D spending, because we believe that we’ve probably got the industry’s most up to date product portfolio given the new product introduction cycle.

Tyler Hojo – Sidoti & Company

Okay, great. Thanks for that clarification. And moving on to something else, you mentioned that the guidance includes some sort of SEWIP shipment in Q3. Two questions on that, first, is that the same order that’s been pushed out here over the last several quarters? And how big is that?

Mark Aslett

So, yes that is the order that has been pushed out for the several quarters. So obviously we feel really good that we finally received that and as I intimated in my prepared remarks, I think the reason that we received it during this quarter is the fact that Lockheed finally received official notification of the Milestone C which signifies the transition to the LRIP production.

In addition, I think they have made pretty good progress in terms of narrowing the gap as it relates to the remaining contractual items that they’re working on. So they send us the PO and we’re pleased to get it. As it relates to the specific magnitude of the order itself, we’re not going to break that out, but it is obviously encompassed in the guidance that we provided.

Tyler Hojo – Sidoti & Company

Okay, that’s fair. Just lastly on free cash flow, obviously it was nice to see the cash generation this quarter, could you maybe expand on, I think you mentioned in the prepared remarks that CapEx was going to lift a little bit in Q3. Could you maybe quantify that and just talk about longer term kind of where you think free cash flow is going to go?

Kevin Bisson

Yeah, so if you look at in the second quarter, Tyler, our CapEx levels were historically low in the $700,000 that’s been the lowest that we’ve had for a while. Now clearly we are managing that in this environment. Its one of the things that we mentioned that is within our control. So we don’t see that up-ticking materially, but there is timing issues and we do see a slight increase quarter-over-quarter. So we don’t expect it to grow substantially as the year progresses.

Tyler Hojo – Sidoti & Company

Great, thanks so much.

Kevin Bisson

Okay.

Mark Aslett

Yeah.

Operator

And we’ll now take our next question from Brian Ruttenbur with CRT Capital.

Brian Ruttenbur – CRT Capital

Thank you very much. I appreciate the opportunity. Couple of questions, first of all, JCREW 3.3, I may have missed this, so what is the status that is it pushed off, what’s the timing visibility? Can you give me a little program update on that?

Mark Aslett

Sure. So, good evening Brian. There is really no official no news on the status or the fate of the program at this time. So it’s pretty much status quo. As we said last quarter, all the program funding that our customer received has been exhausted and our customers actually stopped work on the program. You may recall also that previously we actually removed JCREW A1/B1 LRIP bookings and revenue from our financial year ‘13 plan due to the delays. So at this point, we still believe that the marine core has a need, but it’s unclear as to how it is that the program is going to proceed at this point.

Brian Ruttenbur – CRT Capital

Okay. The other question I have is, on the gross margin in this period, you expect a dramatic uptick in gross margin from second quarter to third quarter. Is that how the earnings are being driven assuming that you said operating expenses are being held essentially flat. So it’s a gross margin increase? Is that right?

Mark Aslett

So in the…

Kevin Bisson

Brian, this is Kevin. Now we had said in our prepared remarks that gross margin is going to be roughly flat between Q2 and Q3 at a roughly 35%. The uptick on the bottom line, a lot of it has to do with an unusually high tax benefit that we’re going to be benefiting from in the quarter largely because of the extension of the R&D tax credit retroactive to January of 2012. So you’re effectively going to get four quarters worth of R&D tax benefits baked into the third quarter. But in terms of the gross margin it’s going to be roughly flat quarter-to-quarter.

Brian Ruttenbur – CRT Capital

Okay. Then, thank you I missed that. I dialed in late, I apologize. So then the fourth quarter, assuming things don’t change then gross margin should be maintained in this level part of going forward as we all have to project beyond one quarter unfortunately. Just thinking on in terms of gross margin, what would impact if you get higher again or back to historical levels?

Mark Aslett

So, what’s going to drive that is really the program mix. But right now as we said in Kevin’s remarks, we’re really sticking with the one quarter at a time guidance Brian.

Brian Ruttenbur – CRT Capital

Okay. And the tax benefit is only for the third quarter or would you automatically carry that out for the fourth quarter as you think about tax benefits. I guess I’m not asking for specific guidance for the quarter, I’m just thinking about taxes.

Mark Aslett

No, I think the large benefit will be this quarter because of the cumulative impact of the R&D tax credits. But moving beyond that, we will certainly get a benefit from R&D tax credits but only the usual quarter-to-quarter, not a cumulative benefit. So in essence it’ll be a lower benefit in future quarters based on the lack of the cumulative feature this quarter.

Brian Ruttenbur – CRT Capital

Right. And then you expect to end, well I’m asking before guiding, I was going to ask about cash. Can you tell us about cash on the year you expect to kind of maintain no matter what kind of maintain $30 million of cash, is that the goal or something like that long-term.

Mark Aslett

Sure. We’re really providing one quarter at a time guidance Brian.

Brian Ruttenbur – CRT Capital

Okay. I appreciate the call, thanks.

Mark Aslett

Thank you.

Operator

And we’ll now take our next question from Michael Ciarmoli with KeyBanc Capital Markets.

Michael Ciarmoli – KeyBanc Capital Markets

Hey, good afternoon guys. Thanks for taking my question.

Kevin Bisson

Hi Mike.

Mark Aslett

Hi Mike.

Michael Ciarmoli – KeyBanc Capital Markets

Just a follow-up, Mark, maybe on Peter and Tyler’s questioning on SEWIP. You’ve got the one quarter guidance laid out, I guess the midpoint $47 million includes SEWIP now. So it’s still down I guess, what I’m looking at is, why is the guidance trending lower? If SEWIP is coming into the fold, is there anything in the current quarter that weakens or that’s lumpy and I’m just thinking to how you stated that you’re sort of managing the business from backlog in hand and not the book ship business? I mean is there anything to read into there?

Mark Aslett

No, I don’t think there is, Mike. The defense business as you know is notoriously lumping and we’re taking a conservative view in terms of what include in our guidance. So I wouldn’t kind of read it as because this is ain’t something else moved out and there is a problem elsewhere that’s not the way in which we constructed the guidance.

Michael Ciarmoli – KeyBanc Capital Markets

Okay, that’s fair. And then just the only other one I had, if you can, as I remember at your Analyst Day you showed I think two pages of kind of your key programs in production and I’m trying to get a gauge out of the programs in your portfolio, what type of risk is there or that you would associate with any IDIQ contracts. I tend to think in this budget environment if you’re going to see cost cuts, the easiest area to cut some of these contracts would be on IDIQs where there is no termination, clauses, or anything. I mean do you foresee any risk in terms of your IDIQ portfolio in the coming months here?

Mark Aslett

We’ve only really got one program that is technically classified as in IDIQ and that is a program called filthy budget and we didn’t name it. It’s enabled program inside of the acquired company KOR Electronics. And if you remember, we actually had a press release in actually this quarter that outlined a new IDIQ that’s being put in place by the navy.

From what we can tell right now, it’s a needed capability, it’s obviously EW EA space which is high priority. So we don’t see any potential risk at this point in time, however, as we discussed on the call, there is still a tremendous amount of uncertainty given the potential of now a full-year CR and the fact that the sequestration is still looming. But that’s the only IDIQ that we have in our portfolio.

Michael Ciarmoli – KeyBanc Capital Markets

Okay, perfect. That’s helpful. Thanks a lot guys that’s all I have.

Mark Aslett

Okay, thanks Mike.

Kevin Bisson

Thanks Mike.

Operator

And we’ll now take our next question from Howard Rubel with Jefferies.

Howard Rubel – Jefferies

Thank you. A couple of things. Could you, Mark, just give us a sense of headcount? Where did you end the quarter and where do you think you’ll be at the end of the next quarter?

Mark Aslett

So we ended Q2 at 769 heads and we are expecting I guess a small increase in heads going forward, but we’ve got a pretty tight grip on expenses right now.

Howard Rubel – Jefferies

You talked about the second quarter kind of being maybe or the third quarter rather being in the range of 50 million and if we assume see we’ve some material, maybe you could give us a little more granularity as you to how you constructed the guidance for the next quarter because it would appear that something is either down or soft or lumpy?

Mark Aslett

Yeah, as we said, I mean we’ve a portfolio of programs not each of them produces at the same level each and every quarter or even each and every year. And so the SEWIP is in our guidance. We’re pleased that it’s in the guidance and I think we haven’t as I said to Mike, we don’t see anything specifically that is at risk. We’re just taking a more conservative approach given everything that’s going on down in DC.

Howard Rubel – Jefferies

Don’t’ believe me, I get that. The other thing is, you kind of look at where you are with headcount and you’re trying to manage that and you could resized R&D and CapEx and all that. What level of volume, I’m sure you’ve done the scenarios, what level of volume do you think you need to get to breakeven?

Mark Aslett

So we sized the business to basically be breakeven roughly on a cash flow basis. That was our goal. We believe that what’s happening in the industry right now is temporary and that we are, at some point, going to see a rebound in some of our major programs that have produced for us well in the past. So it’s a balance between how far do you cut when you think it’s only temporary and we believe that we made the right decisions in light of that.

Howard Rubel – Jefferies

So, we should, I mean you still have GAAP losses but cash flow plus or minus you feel pretty comfortable that you’ve found that level where there is equal puts and takes.

Mark Aslett

That’s basically the way in which we went through the exercise of the reductions, yes.

Howard Rubel – Jefferies

Just two more, one is, when you had nice backlog numbers. How did you sort of evaluate or how would you sort of stack up your bids versus your proposals?

Mark Aslett

So, I mean the overall contracting environment is you could see from our design win activity, right. There wasn’t a lot going on there compared to what we’ve seen in prior quarters or even in prior years. And that again I believe is largely due to the CR no new starts and the primes reducing their internal R&D budget given the potential for sequestration. We had three major bookings in the quarter that I think Kevin talked about is the largest of which was in Micronetics which was a very significant booking to do with upgrades on the B-1 Bomber relating to electronic warfare.

The other two were in the ACS core which was great. The first was Aegis and that was the largest single booking that we’ve had from Aegis since 2011 and then clearly we’re pleased to get the SEWIP border which has been delayed as you know for several quarters. So I think we’re pleased to see the progress in bookings. We had a very substantial book-to-bill of 1.3. The ACS core which was impacted last quarter clearly did much better, but we’re still hesitant and cautious in this environment given everything that’s going on down in Washington.

Howard Rubel – Jefferies

Last thing, is to go back to SEWIP one more time, my guess is, most of it sitting in inventory today and so one would expect that you would actually have a reasonably decent cash flow quarter. First of all you have to do is just ship it at this point.

Kevin Bisson

And collect the cash.

Howard Rubel – Jefferies

Well, I mean Lockheed is a pretty good pair the last time I checked.

Mark Aslett

Yeah. So I think the most of the product is sitting in inventory and we do expect to be able to ship it for revenue this quarter. The collection of the cash is anticipated in the cash flow forecast that Kevin described in his prepared remarks.

Howard Rubel – Jefferies

Thanks gentlemen.

Mark Aslett

Okay, thank you.

Kevin Bisson

Thanks Howard.

Operator

And we’ll now take our last question from Jonathan Ho with William Blair.

Jonathan Ho – William Blair

Hey guys. Just wanted to get a sense at this point looking forward, from a visibility standpoint, when do you think things start to normalize and how do you see that playing out? I guess I’m just trying to wonder whether you guys are seeing a light at the end of the tunnel yet or whether we could be in this for a while longer.

Mark Aslett

Well, I think the visibility has probably gotten incrementally worse quarter-over-quarter, Jonathan, largely because I think the industry is currently anticipating that it’s likely that we’re going to have a full-year CR and the budget control or the sequester that got basically pushed two months to now been triggered on March the 1st, even the services are beginning to undertake some pre-sequestration cut as well as planning that sequestration may actually occur. So until it’s actually clarity around what’s happening with the defense budget itself in terms of the dollar volume as well as improvements in the way in which they’re currently budgeting meaning the process, I don’t think things are going to improve materially. So we kind of – we’re taking it one quarter at a time and hopefully being as bright as we possibly can as we see things occur down in DC.

Jonathan Ho – William Blair

Got it. That’s helpful. And can you talk a little bit about how some of the acquisitions have performed. Now that you had some of these for extended period of time relative to your expectations and just taking into account what’s happened with the environment. Can you maybe grade some of the performance that you’re seeing?

Mark Aslett

I think we’re seeing good performance literally across the entire portfolio that we’ve acquired. Going way back well when the LNX business that we acquired is right in the heart of delivering against SEWIP program which as you know is probably one of the largest single programs that we want as a company to date. If you look at core defense including Micronetics, that business continues to perform well. They recently in this past quarter received $58 million IDIQ for their existing generation of systems and they anticipate getting another IDIQ for their next generation tool probably within the next six month period. So they’re doing well also.

Micronetics, which is the business that we just recently acquired, had another really strong quarter, the second in a row. Bookings were up 48% quarter-over-quarter, the backlog was up 25% sequentially and revenue was up 94%. So all in all we feel pretty good about the businesses that we’ve acquired in terms of their strategic fit, the way in which we’ve integrated them as well as that financial performance to date.

Jonathan Ho – William Blair

Great, thank you.

Kevin Bisson

Thanks.

Operator

And it appears there are no further questions at this time. Mr. Aslett, I’d like to turn the conference back over to you for any additional or closing remarks.

Mark Aslett

Okay, well thank you all very much for listening. We’re pleased with the progress that we made in the second quarter and we look forward to speaking to you all next quarter. Bye-bye.

Operator

And ladies and gentlemen, that concludes today’s conference call. We thank you for your participation.

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