Mercury Computer Systems, Inc. F3Q09 (Qtr End 03/31/09) Earnings Call Transcript

Apr.28.09 | About: Mercury Systems, (MRCY)

Mercury Computer Systems, Inc. (NASDAQ:MRCY)

F3Q09 Earnings Call

April 28, 2009, 5:00 pm ET


Bob Hult – Senior Vice President and CFO

Mark Aslett - President and CEO


Mark Jordan - Noble Financial

Tyler Hojo - Sidoti Company

Jonathan Ho - William Blair

Stephen Levenson - Stifel Nicolaus


Good day and welcome everyone to the Mercury Computer Systems, Incorporated third quarter fiscal 2009 earnings results conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the Senior Vice President and Chief Financial Officer, Mr. Bob Hult. Please go ahead, sir.

Bob Hult

Good afternoon and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett, and our Vice President and Controller, Karl Noone.

If you have not received the copy of the earnings release, you can find it on our website at We would 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 which involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated. Additional information regarding forward-looking statements and risk factors is included in the press release we issued this afternoon reporting the company’s third quarter results and in the company’s periodic reports filed with the SEC.

We caution listeners of today’s conference call not to place undue reliance upon any forward-looking statements, which speak only as of the date of this call. We undertake no obligation to update any forward-looking statements.

In addition to reporting financial results, in accordance with generally accepted accounting principles or GAAP, we will also be discussing non-GAAP financial measures adjusted to exclude certain charges which we will specifically identify.

Management believes these non-GAAP financial measures assist in providing a more complete understanding of the company's underlying operational results and trends and management uses these measures along with their corresponding GAAP financial measures to manage the company's business, to evaluate its performance compared to prior periods in the marketplace, and to establish operational goals; however, they are not meant to be considered in isolation or as a substitute for financial information provided in accordance with GAAP. A reconciliation of GAAP to non-GAAP financial results discussed in today's conference call is contained in the press release we issued this afternoon.

Finally, we will also briefly remark on our proposed option exchange program, which is described in our proxy statement dated April 13, 2009. We have not commenced the exchange program. If the exchange program is approved by shareholders, we will provide eligible participants with written materials explaining the full terms and conditions of the program and will also file these materials with the SEC.

When these materials become available, participants should read them carefully, because they will contain important information about the program. Once file, the materials will be available free of charge at and by contacting our investor relations department at 978-256-1300.

I am now pleased to turn the call over to Mercury's President and CEO, Mark Aslett.

Mark Aslett

Thanks Bob. Good afternoon everyone and thanks for joining us.

I'll begin with an update on the business. Bob will review the financials and discuss our guidance for the fourth quarter, and then we'll open it up for your questions.

As part of our strategic turnaround, we’ve been working toward the goal of divesting Mercury’s unprofitable non-core businesses by the end of fiscal 09. In fiscal 2008, we shut down AUSG and sold the ESPS business.

Earlier this fiscal year, we sold the assets and IP have sold our pharmaceuticals. On our Q2 conference call, January 27, we announced the sale of our largest non-core business, VI, which generated the majority of our operating losses.

The sale of our last remaining non-core business, the Visualization Sciences Group, will conclude this process. We have moved VSG into discontinued operations this quarter and anticipation of the sale, which we currently expect to close by the end of this fiscal year.

This will be another milestone for Mercury as we work to focus the company and position ourselves for renewed growth.

We’ve also treated VI as a discontinued operation in this quarter’s financial statements. As a result, from a reporting standpoint, we have finally unmasked the true profitability we’ve been delivering in our core business.

Overall this was another successful quarter for Mercury. Our total revenue and non-GAAP earnings both exceeded the high end of our guidance range. From a revenue perspective, we guided $48 to $50 million for the quarter, which excluded VI, but included VSG. Excluding VSG would have adjusted our guidance to $45 to $47 million. Revenue, excluding discontinued operations came in at $50.6 million for the quarter, which was substantially above the high end of this adjusted guidance. Our non-GAAP earnings of $0.20 a share were also well above the high end of our range.

We continue to generate healthy levels of free cash flow in Q3 and have paid down all but $5 million of our $125 million convertible senior notes. We ended the quarter with a strong cash balance of $85.6 million and as we announced in March, we plan to redeem the remaining $5 million of the convert in May.

Returning the company back to profitability in the third quarter was a major achievement. When we put our divestitures fully behind us, we will have also successfully refocused the business in a very challenging M&A environment. Now, the priority is to grow the business. Our focus is clearly on defense where we’ve been making steady progress, not only in driving bookings and revenue, but also in terms of operating profit.

In the third quarter, total defense revenue including ACS and Mercury Federal increased 11% sequentially and by $2.2 million dollars or 6% year-over-year to $38 million.

Revenue at ACS Defense was up 11% sequentially and 3% year-on-year. The ACS business as a whole produced a non-GAAP operating income margin of 14%.

We also continued to improve the underlying operations of the business. From a supply chain perspective, we’ve made substantial progress around improving work in capital. Our cash conversion cycle is down significantly and inventory has declined from $28.6 million to $18.9 million in a year, which is a dramatic reduction.

Margin work in capital will continue to be an area of focus for us going forward. Our goal is to make sure that we have a business model that’s efficient, allowing us to generate the cash we need to scale a business profitably as we capture the growth opportunities ahead of us.

Looking at where Mercury stands today, we’re well prepared to emerge from our turnaround phase. This phase focused on restoring total company profitability, rationalizing the portfolio, and improving operations.

The next phase is focused on continuing to strengthen our core defense business and growing the business on both the top and bottom lines.

We’ve been increasingly successful in producing this growth. Although the commercial business in ACS is still contracting due to the macro economy, revenue in ACS Defense was up 17% year-on-year in fiscal 08 and more than 9% year-to-date in fiscal 09.

Going forward, our growth in defense will come from four sources. Number one, from growth in the number in value of our design wins. Two, it will come from a larger role for systems integration and services business in ACS. Third, it will come from Merc Fed and then longer term potentially from acquisitions.

Starting with design wins, the key to winning new designs is having new products. We’re now in the midst of the most ambitious new product development cycle in Mercury’s history, encompassing both our signal processing and multi computer product lines. Our main focus over the past four quarters has been to create significant hardware design leverage in the business and to refresh our product line.

Fiscal 2010 will be the year we focus on software leverage. We’re in a high mix, low volume customization business and if you can’t bring customized new products to market quickly and efficiently, you’re not in the game, whereas if you can do it through substantial design reuse and leverage, you can win a larger number of new designs that will ultimately fuel growth on the top line.

We received a total of 18 design wins in the fiscal first half of 09 and now there are another nine wins in Q3. All of our wins in Q3 were in defense. The five-year probable value for the nine wins is approximately $59 million, an increase of $26 million or 78% compared with design wins in Q308.

Year-to-date, looking specifically at defense, the probable value of our design wins increased significantly from $60 million to $107 million over the same period last year.

We believe this demonstrates not only the success we’re having in proving our engineering leverage, but also the fact that we are now better in tune with the market and our customers’ requirements.

In terms of bookings, we expect ACS Defense to report a stronger second half of the fiscal year as planned. Defense bookings were strong in Q3 and we closed the quarter with a book to bill in Defense of $1.21. We booked a $13 million dollar contract for airborne sonar dipping application, as well as a multimillion dollar deal related to an important grand base electronic warfare application.

I’m pleased to report that Q4 is also off to a great start. Within the first three weeks of the quarter, we’ve already received two PO’s totaled $30 million. One is an $18 million contract for a grand base radar program, missile defense, with one of the major primes. It’s one of the largest single bookings in Mercury’s history with good revenue potential going forward.

In addition, about ten days ago, we received a $12 million PO related to an airborne radar on a next generation phyto platform. With two months to go in the fourth quarter, we’re already in a good position to deliver strong second half bookings that we’ve previously discussed.

Let’s now turn to our second growth driver. A larger role for the systems integration and services business in ACS. The total adjustable market in defense electronics is roughly $3 billion dollars annually. Our broad based hardware business addresses about a third of this market with the other two billion being systems integration and services business. Our goal over the longer term is to capture a greater share of this larger market. Strategically, our plan is to transition ACS Defense from the hardware centric model we currently have in our cost board business to a complimentary systems integration and services model focused on Intelligence Surveillance and Reconnaissance or ISR.

We’ve been involving our organization, our business model, and product roadmap in support of this strategy. The centerpiece of the strategy is a next generation converged sense network or CSN platform architecture. We believe CSN will position Mercury as a leader in the ISR space over time.

Shifting our ACS Defense business into the systems integration and services domain has the potential to help scale the business faster than a hardware based business alone. The key is to position Mercury as a trusted partner for the primes with domain expertise in ISR. Early in fiscal 09, we set about creating a dedicated systems integration business and we’re starting to see some very good progress.

The Q4 grand base radar program for the theatre missile defense that I mentioned earlier is a significant systems integration and services component. Mercury will play a key role in providing additional signal processing architecture for this next generation platform. If this program develops as we think they can, they could be significant revenue drivers for Mercury.

These contracts are good examples of how the systems integration and services model works. In our position as a trusted partner to the primes, we’re capturing more of the content within the platform. Moving up the volume chain for playing at the board and sub system level to providing more of a complete solution than we’ve done historically.

We’re also getting paid for work that we previously would have expensed through our own P&L.

Systems integration and services bookings grew 167% sequentially to $2.4 million in Q3. Revenue was up 229% to $2.3 million in the quarter. Our objective is to grow this part of our defense business both this year and next.

We’re talked in the past about the broader military electronics market, which at $30 billion dollars is ten times larger than the cost market we’re addressing at ACS Defense.

This is growth driver number three. The opportunity we’re pursuing with our Mercury Federal Services business, Merc Fed. Our goal for Merc Fed is to create a hybrid business model that will lead to faster revenue growth, reduce R&D expenses, and mitigate the risks that we have elsewhere in our business model.

Merc Fed positions us to be perceived by the government as their key trusted partner for Smart Processing. This opens the door to being selected as the prime subcontractor to pull together the entire signal processing and computing architecture, the new programs and platforms. Merc Fed also offers us the potential, to where appropriate, subcontracting developing work to ACS Defense.

Merc Fed’s total bookings in Q3 grew from $1.2 million in the sequential second quarter to $5 million, the best quarterly performance since its inception. The largest of our Q3 deals was for the second phase of important next generation persistent ISR program. Structures is a professional services contract. It’s an example of how Merc Fed is getting us closer to the application and closer to both the primes and the end customer, which enables us to track funding flows and gain greater insight into DOD priorities.

As a result, even at this early stage, Merc Fed is establishing us in markets like TN much earlier than we could have done through ACS Defense alone.

To put the great progress Merc Fed has made this year in perspective, in fiscal 08, Merc Fed’s first full year in business, bookings were $400,000 for the entire year. Through the end of Q309, Merc Fed had booked $10.2 million year-to-date, which is a great showing for start of business in an early stage of development.

Merc Fed’s Q3 revenue totaled $2 million and operating profit was $116,000. We’ve been able to focus Merc Fed very rapidly into a space where we think there is a significant potential. It’s a space where we can fully develop a hybrid business model that clearly differentiates us from our competitors.

From a longer term perspective, we feel Mercury did well into the re-prioritization announced by defense earlier this month.

We are only minimumally involved on the air force F22, which is one of the platforms and programs facing cuts or being scaled back.

In addition, we have no exposures to others in this category, such as the navy’s DDG1000 zoom world class destroyer and the army’s future combat system.

There are four main areas in the Gate’s proposal that Mercury will benefit from. It includes an additional $4.4 billion dollars in fiscal 2010, which encompasses 30 additional F35 aircraft, while we have a presence in the radar.

It increases spend by $900 million on theatre missile defense. This includes the EBS program along with Fad, another grand base missile defense program where Mercury participates.

Third, it increases R&D spending by an additional $2 billion dollars. This is among other things to field sustain 50 UAVs to meet high demand in Iraq and Afghanistan and we’re also on Predator.

Fourth, Gates has also proposed a high level of funding for [IAD] technology.

Our positioning relative to the DOD’s new priorities demonstrates that we have a strong install base in ACS Defense. It encompasses a wide range of high priority military platforms and programs at various stages of development and deployment.

This creates a low potential risk profile for us as we pursue new programs and platforms to drive growth going forward.

Before I hand it over to Bob, I’d like to briefly note the special meeting of shareholders scheduled for Friday, May 8. As outlined in our April 13 proxy statement, the purpose of the meeting is to approve exchange program, which we feel is critical to employee retention as we execute in our turnaround. The program is structured to provide our employees with meaningful performance incentives, while it’s also being shareholder friendly in its design. Bob will provide some of the details in few minutes. We encourage those of you who are shareholders to vote your shares in favor of this proposal.

As we approach the end of a turnaround year, we’re making good progress driving growth in our defense business through new design wins by expanding our ISR systems integration and services in Acs, as well as through Merc Fed.

Looking specifically at Q4, although we continue to face challenges in our commercial markets, it’s shaping up to be another strong quarter for defense bookings and revenue. We expect to exit the year with a solid momentum positioning Mercury for renewed growth in fiscal 2010.

Bob, over to you.

Bob Hult

Thank you, Mark. As a reminder, I will be discussing our third quarter results and fourth quarter guidance on both a GAAP and non-GAAP basis. In addition, as Mark said, both VI and VSG are treated as discontinued operations in our financial statements for the third quarter. So the numbers I will be discussing relate only to continuing operations.

Mercury executed well this quarter. Total revenue was $50.6 million, coming in above the top end of our guidance range of $48 million to $50 million, which included VSG. We have run VSG through discontinued operations and after subtracting VSG’s actuals, our Q3 guidance would have been $45 to $47 million.

On that basis, we substantially exceeded our original revenue guidance.

Non-GAAP earnings for the third quarter were $0.20 per share, also above the high end of our guidance range, which was $0.05 to $0.09 per share.

We seen good success in growing bookings, revenue, and operating profit and our third quarter results reflect this progress.

We’re also continuing to do well from an operations perspective.

Operating income in our ACS business was up by $2.1 million year-on-year and $4.1 million sequentially.

Mercury generated $1.5 million in free cash flow for the quarter. We redeemed $119.7 million of our convertible senior notes on February 4, 2009 and we notified the holders that we would be redeeming the remaining outstanding $5.3 million of notes at par plus accrued interest on May 1, 2009.

Now that we divested four of our non-core businesses and treated the remaining VSG as discontinued operations, our income statement clearly reflects the value at the core of the enterprise and we now have a clean and incumbent balance sheet.

Breaking down our $50.6 million in total revenue, ACS revenues for Q3, including both defense and commercial were $49.4 million dollars, up 12% from the sequential second quarter and down 2% from Q3 of fiscal 2008. For the nine months, year-to-date, ACS total revenue was down 1% to $138 million from $139.2 million in the comparable nine month period a year earlier.

We reported revenue in ACS Defense for Q3 of $36.4 million dollars, an increase of 11% sequentially and 3% year-on-year.

Defense revenues represented 74% of ACS total revenue in the third quarter, up from 70% in Q3 last year.

In ACS commercial, revenue was $13 million, up 17% sequentially, but down 13% year-on-year. The sequential increase resulted from two main factors. First, a large commercial radar order in the quarter, and second, the expected modest bump-up we’ve seen in Legacy Medical. Some of our medical business customers are extending their support for existing Mercury equipment in the field, because their customers are slowing down on purchasing new equipment.

Semiconductor remains our largest commercial market. We continue to believe that any future rebound in ACS commercial will be driven mainly by semiconductor, which is in the midst of an extended downturn. As a result, we expect our commercial bookings and revenue to be down sharply both sequentially and year-over-year in the fourth quarter.

Our long-term target is for the relationship between the ACS defense and commercial businesses to stabilize around the 80/20 level; however, this split is likely to continue fluctuating from quarter to quarter, primarily driven by conditions in the macro economy and the impact on commercial bookings.

Our Q3 book-to-bill ratio in ACS as a whole was 1.1 times, down from 1.12 in Q3 last year, but up from 0.9 in the sequential second quarter.

Commercial bookings in ACS were up 44% sequentially, but down 10% year-on-year. ACS Defense bookings for Q3 were up 36% sequentially and down 1% year-on-year.

We closed the quarter with a book-to-bill in ACS Defense of 1.21.

Mercury Federal had an outstanding quarter reporting $2 million dollars in revenue, In essentially its first year of operations, Merc Fed has grown significantly, reporting year-to-date bookings and revenues of $10.2 million and $3.4 million, respectively.

Book-to-bill for Mercury as a whole, including ACS and Merc Fed, was 1.14 for the third quarter and 1.03 for fiscal 2009 year-to-date.

Mercury’s third quarter backlog, including deferred revenue, was $82.3 million, an increase of $7.2 million from the sequential second quarter and a decrease of $5 million from Q3 last year.

Of the current total backlog, $65.4 million or approximately 80% relates to shipments scheduled within the next 12 months. Note that backlog has also been adjusted for discontinued operations.

Moving down the income statement, third quarter GAAP net income from continuing operations was $4.7 million or $0.21 per diluted share. This compares with a GAAP loss of continuing operations of $2.2 million or $0.10 per share for the same period last year.

Third quarter GAAP operating income was $4.7 million and includes approximately $1.9 million in charges as follows. $1.2 million in stock base compensation costs, $500,000 in amortization of acquired intangible assets, and $200,000 in restructuring expenses.

On a non-GAAP basis, excluding the impact of these charges, third quarter non-GAAP operating income was $6.7 million as compared to $3.2 million in Q3 last year.

We used a non-GAAP tax rate of 34% in FY09 and 30% in FY08.

Depreciation was $1.5 million dollars.

EBIDTA for the third quarter was $6.9 million. Adjusted EBITDA, which excludes Faz123 charges in restructuring was $8.3 million dollars.

Our non-GAAP gross margin for the quarter was 57.9%, within our guidance range of 57 to 58%. Our non-GAAP operating expenses for the third quarter were $22.5 million. This compares with $23.4 million in the sequential second quarter and $26.2 million in Q3 last year.

Discontinued operations have been excluded for all periods. We can clearly see the benefit of the cost reduction actions we took previously.

Turning to the balance sheet and cash flow statement, cash, cash equivalents, and marketable securities at the end of the third quarter were $85.6 million, compared to $197.9 million at December 31, 2008.

As previously mentioned, we redeemed $119.7 million of convertible senior notes in the quarter.

As we reported last quarter, as part of a settlement with UBS concerning our auction rate securities portfolio, we received a line of credit at no net cost to Mercury. We were advanced approximately $31.4 million dollars under the line of credit in December.

We borrowed an additional $1.9 million, again at no cost, in the third quarter raising our total borrowings to $33.3 million.

Our settlement with UBS also entitles us to full repayment of our auction rate securities portfolio at par on June 30, 2010.

As I mentioned earlier, we generated $1.5 million of free cash flow this quarter. This compares with $1.6 million in the sequential second quarter. Free cash flow year-to-date is $4.6 million.

There were three elements in our turnaround strategy for Mercury. The first, which should be complete by the end of FY09, is to rationalize our portfolio by divesting our non-core businesses. The second is to improve the underlying operations in our business and we’re also making progress in this respect.

The third element is to strengthen and grow our core defense business and we are clearly making progress there.

As Mark discussed, we’ve been able to significantly improve the hardware design leverage in our business and we’re now focused on comparable gains in the software design area. We’re also been focused on improving the work in capital in our business by strengthening the overall supply chain capabilities, reducing inventory, and improving our performance in cash collections.

Third quarter day sales outstanding were 60 days, compared to 46 in the sequential second quarter.

Accounts receivable was up from $26 to $34 million sequentially. Collections this quarter were negatively effected by two drivers. The first being an unfavorable end of quarter shipment SKU. The second driver was an increase in unbilled receivables associated with a large contract being accounted for under the percentage of completion method.

Inventory turns improved in Q3 to 4.5 from 3.8 in Q2 and inventory declined by 11% to $18.9 million from $21.3 million in the sequential second quarter.

Since Q308, inventory is down by nearly $10 million or 34%. At the end of Q3, our total employee headcount excluding contractors was 576, compared with 634 at the end of Q2, and 745 a year ago.

The 576 figure for Q3 excludes 64 employees of VI, but still includes VSG 54 employees. Although was have run VSG through discontinued operations in anticipation of a sale, which we currently expect to close by the end of this fiscal year, we continue to include VSG’s personnel in our headcount until the deal has closed.

I’d like to call your attention to a couple of important corporate items before we get to guidance. First, earlier today we filed a $100 million dollar universal shelf registration statement as stated in our form S-3. Any proceeds raised through the sale of securities under the shelf are intended for general corporate purposes, including to fund potential acquisitions.

Second, is a recently proxy statement related to our proposed stock option exchange program for employees. Mark discussed the reason for the proposal earlier. I’ll expand briefly on the mechanics, which we believe are shareholder friendly in their design.

Our executive offices and board of directors are not eligible for the program. It has been structured as a value for value exchange for the participants. So it’s Faz123 neutral to the extent practicable with minimal impact on the P&L and it only includes stock options with exercise prices that exceed the 52-week high price of our stock.

In addition, assuming full participation by the eligible participants, the program would represent approximately a 1.3% net reduction in the company’s equity award overhang. We believe the program is in the best interest of all of our shareholders and we encourage you to vote in favor of the proposal.

I’ll conclude with guidance for the fourth quarter of fiscal 2009. We previously said that Mercury will exit the fiscal year as a more focused and profitable enterprise and our guidance bears this out.

We’ve made steady progress enhancing the leverage in our business model, increasing our cash flow, expanding the size of our addressable defense market, and capturing a share of that larger opportunity.

As Mark said, we’re expecting Q4 to be a strong quarter for bookings. We also expect defense revenues to remain strong. Although we expect decline in commercial revenue, we expect Mercury to remain solidly profitable in the fourth quarter. For the fourth quarter 2009, we currently expect a revenue range of between $46 and $48 million.

We anticipate reporting Q4 gross margin of approximately 52 to 53%. This is down sequentially from 58% in Q3 and 57% year-to-date, due to product and business mix.

This reflects our expectation that Q4 will have a larger share of systems integration and services projects. We expect gross margin for the full year to come in around 56%.

Operating expenses are currently anticipated to be approximately $23 million on a non-GAAP basis. CapEx for the fourth quarter is projected to be approximately $1 million, and depreciation approximately $1.5 million.

Mercury’s GAAP earnings per diluted share are currently expected to be in a range of $0.04 to $0.08 on approximately 22.5 million shares outstanding.

On a non-GAAP basis, our earnings estimate for the fourth quarter 2009 excludes the impact of approximately $200,000 in stock base compensation costs, approximately $500,000 for amortization of acquired intangible assets, and the difference between expected GAAP and non-GAAP tax rates.

Our non-GAAP tax rate in Q4 is expected to be 34%. As a result, fourth quarter 2009 non-GAAP earnings per diluted share are currently expected to be in a range of $0.05 to $0.08 on approximately $22.5 million non-GAAP shares outstanding.

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

Question-and-Answer Session


Thank you. (Operator Instructions). We will take our first question this afternoon from Mark Jordan with Noble Financial.

Mark Jordan - Noble Financial

I’d like to talk a little about the capital structure here and see if I understand your position. You said you ended with $40.6 million in cash and you have the adjusted rate securities which you’ll receive applaud for the middle of next year. Against that, you have the line of credit of 33.4. So in essence, we were looking at your company, it’s fair to say you have cash or quasi-net cash of about $52 million and therefore don’t have any immediate financing needs. Is that a proper view?

Bob Hult

That’s a very proper view, Mark. We certainly feel that we’ve got sufficient cash to run the business.

Mark Jordan - Noble Financial

So while you have that shelf in place, there is no need to do anything unless it’s on an opportunistic basis?

Mark Aslett

The shelf we feel is just a good tool to have in the corporate finance tool kit and a prudent thing to do, you know, hence the filing.

Mark Jordan - Noble Financial

Stock comp has come down in the third quarter. Obviously the discontinuance has helped that, but you’re looking for $200,000 the fourth quarter. Is there a change in philosophy for the use of stock for compensation and what type of stock comp expense might be reasonable for 2010?

Mark Aslett

I think overall you have seen a decline in the stock compensation expense. We’ve had a number of senior executives leave the business over the last year as we kind of rebuilt the management team. In addition, as you state, we have divested ourselves four of the non-core businesses at this point that clearly reduce that number also.

I think, you know, what are trying to do or how we using our equity? We believe that from an employee perspective, we’re trying to focus that equity to get the best return from an employee perspective. So we are looking to see some changes. From a stock comp expense going forward, I’ll hand that over to Bob.

Bob Hult

We have modestly moved our forfeiture rate up here in the third quarter from approximately 9.5% to 10.5%. That’s brought the expense down a few hundred thousand dollars. Mark noted that we’ve had a number of senior executives leave the company this past year. That’s had an equal impact on bringing the overall expense down.

Looking forward, I think I’d like to hold off on that until the July call. I think a rough takeaway at this point would be our stock base compensation expenses have been moving down this past year, compared to FY08. They should move down a bit again in FY10, but I want to stay away from the numbers for the moment.

Mark Jordan - Noble Financial

Looking at the commercial business, clearly you’re expecting a decline sequential from the $13 million in the third quarter. Where and when do you think that commercial businesses is going to bottom out?

Mark Aslett

I think a big piece of it, Mark, is dependent upon what’s going on with the overall macro economy. As we said, in the prepared remarks, the largest part of the commercial business today is semiconductor, which as we all know is in the midst of a pretty significant downturn.

There appear to be some potentials or glimmer of hope looking forward. I think there was an interesting article in the Wall Street Journal about maybe the memory market, one of the earliest parts of the semi market that would recover. So maybe it’s a leading indicator.

The customers that we’re dealing with are still clearly down substantially, but they’re feeling a little bit better. Whether or not that translates into bookings and revenues the next couple of quarters, it’s still a little bit early to tell.

I think as we’ve said overall for our commercial business to really recover, we do need a rebound in that sector. We had a couple of pretty substantial design wins. One with KLA10 core in terms of their next generation design. And two, pretty substantial wins with ASML.

So we need that part of the market to recover before we start to see a recovery in commercial.

Mark Jordan - Noble Financial

As you develop your systems integration business, how do you manage the potential for channel conflict with the prime?

Mark Aslett

We’re not actually competing with the prime. If anything, I think the primes want Mercury to take on more of the complete system. So this program I mentioned, this grand base radar program, working closely with one of the big primes. They basically came to us and asked us to take over more of the systems integration activities.

So I think there’s an opportunity for us. We’re not looking to compete with our customers; we’re looking to provide more value add.


We’ll take our next question from Tyler Hojo with Sidoti Company.

Tyler Hojo - Sidoti Company

What was the gross margin implied in your guidance? Was it 56% for the fourth quarter?

Bob Hult

No, for this next quarter, fourth quarter, it’s a range of 52 to 53%. We said that we felt that the full year would come in at 56%. We’ve had very strong gross margins throughout the year. 56, 57, 58%. 52-53% for the fourth quarter. So full year will be 56%.

Tyler Hojo - Sidoti Company

Clearly these results were at least much stronger than I was looking for. Did most of that come from the commercial side?

Mark Aslett

The decline in commercial, quarter over sequential, we did have the large commercial radar booking that wouldn’t repeat on a quarter-over-quarter basis. In addition, we did get some pick-up I think as we’d been talking about in Legacy Medical business where the large medical OEMs are actually looking to extend the life of the equipment that they have in their field on behalf of customers, because customers aren’t buying used stock.

So, that we may benefit, but probably not to the extent that we did this quarter. So that’s really the dynamic that’s occurring along with a slight decline in semiconductor sequentially and then we actually had a good quarter in defense again.

Tyler Hojo - Sidoti Company

I get all that, but what I guess what I’m trying to understand is what specifically is driving the margin down from the 58-59% we saw in the first three quarters of the year.

Mark Aslett

So this quarter coming up, Q4, there’s a high percentage of services in systems integration business than we’ve had historically. So it’s really a product and business mix this quarter.

Tyler Hojo - Sidoti Company

Would you expect this to be a more normalized business mix on a go forward level or too early to tell?

Mark Aslett

I think it is lumpy, but this quarter, we’ve got more of that type of business than we’ve had historically.

Tyler Hojo - Sidoti Company

The really solid performance in Merc Fed, obviously $5 million in bookings and a huge increase sequentially in revenue. If you could talk about what your near term expectations beyond this quarter are for that business?

Mark Aslett

We think that we got three major growth drivers in the business. One is the number and the value of the design wins. I think we’ve been putting some pretty good numbers up on the board there.

The second is around systems integration and services and we believe that we can continue to grow that business going forward and it’s certainly an important part of us adding more value to the primes and scaling the ASC business potentially faster than we have been.

The third as you mentioned is Merc Fed. We had a really good quarter in Merc Fed this quarter. The largest booking that we had was the second phase of what we believe to be a next generation persistent ISR platform. We’ve had some early bookings in 2009 associated with that. This was the second phase.

Looking forward, we believe that we’re going to continue to grow that business. Q3 was particularly strong. So we don’t expect the same sort of number in Q4, but when you look at it from a year-over-year perspective and you say 400,000 of bookings for the whole of 08 to over 10 through the first three quarters of 09. It’s a pretty impressive performance.

Tyler Hojo - Sidoti Company

What was the operating margin in the ACS business?

Mark Aslett

14% non-GAAP this quarter.

Tyler Hojo - Sidoti Company

Was the big swing factor there the Legacy Medical?

Mark Aslett

No, it’s largely product and business mix. The gross margin has been increasing over the last few quarters. We’ve got a lumpy business depending upon what’s in there kind of affect our gross margins. This was favorable this quarter.


We’ll take our next question from Jonathan Ho - William Blair.

Jonathan Ho - William Blair

How scaleable is the Merc Fed business? Is this mostly a boots on the ground type of a business? Is this a good sort of proxy in terms of lead generation for future hardware and software sales?

Mark Aslett

The Merc Fed, the way in which we’re approaching our business is to really look at scaling it profitably. A number of businesses we didn’t scale profitably. We were sucking a lot of profit out of the business. So we’ve taken a more conservative approach with Merc Fed. We’re kind of winning the business and having the resources as appropriate. We believe that we can continue to scale it going forward.

As it relates to how we’re using Merc Fed. Merc Fed, because they’re doing business, largely directly with the government but then also a prime subcontractor as it relates to the smart processing, it gives us the opportunity of getting much closer to the funding flows as well as some of the new program starts and getting involved in those programs much earlier than what we would have done historically. So it is a form of BD and we believe it’s having a positive impact on our business model.

Jonathan Ho - William Blair

Are you already seeing the Merc Fed results beyond the systems integration and BD side, but also in sort of these design wins that you’re talking about that. Has that flowed through already at this point?

Mark Aslett

Absolutely. So I think this program that we mentioned, one of the number that we’re pursuing. This one is further along than some of the others, but this one particular contract is a great example of how the hybrid business model works.

Merc Fed is actually doing the upfront work and there’s a subcontract with some of the engineering work back into the ACS business. So it’s kind of proving out at a very early stage that this hybrid business model is actually we feel the right way to go and take the business going forward.

Jonathan Ho - William Blair

In terms of the margins, can you talk about the differences or just give us a rough ball park ranges between the services margins versus your more traditional product margins?

Mark Aslett

Clearly it’s a different pro forma business model. Merc Fed looks more like a prime model in terms of the costs are really in the O-cogs line as opposed to the operating expense line. From an operating income level, both businesses will be double digit we believe.

Jonathan Ho - William Blair

My last question is on the software leverage opportunity for 2010. Can you give us more color on how you see that developing?

Mark Aslett

Mercury I think had lost a lot of the design leverage. We were designing specifically for customers, programs and platforms with very little design reuse. It’s a pretty inefficient way of doing it.

So what we’re doing is now doing much more modular base design where you kind of lay out a computer process or architecture and be able to reuse that technology across multiple different platforms, markets, and programs.

We’re going to do the same thing on the software side of things, which is it’s basically designed reuse. If you do it effectively, it allows you to be more efficient from an R&D expense perspective, but probably more importantly going forward, it allows you to go after more design wins which is clearly a focus for us as we’re trying to scale a top line.

So we think it’s the right approach and we demonstrated that we can do this in the hardware side of things and 2010 we’re going to do it in software.

Jonathan Ho - William Blair

Defense Secretary Gates talks about changing the current model to favor more fixed price contracts. How do you think about that shift and whether it’s beneficial to Mercury?

Mark Aslett

We believe it is beneficial. I think clearly the cogs model makes sense when you’re trying to contain costs. We’re developing the majority of the technology on our own nickel, which the government can benefit from.

As we’ve seen this part of Secretary Gates’ reprioritization, we believe that we try to sidestep the programs and platforms that were cut and were net beneficiaries of the increases such as missile defense and the increase in more generally in ISR.

So we feel pretty good about how we’re positioned, that we’re on the right programs, we’re on the right platforms, and in the right sectors.


We’ll take our next question from Stephen Levenson - Stifel Nicolaus.

Stephen Levenson - Stifel Nicolaus

Did you have any ten percent customers this quarter and if so, how many?

Mark Aslett

We did. We had four, all in defense.

Stephen Levenson - Stifel Nicolaus

On the design wins that you’ve captured, do you think they were more related to processing power, temperature management, price, or was it something else?

Mark Aslett

I think we’ve been working steadily during 09, refreshing parts of our signal processing and model computer product lines. Some of the design wins this quarter were related to the new products that we’re bringing out.

So we feel pretty good about the fact that the products that we’ve been working on are starting to get some traction.

Stephen Levenson - Stifel Nicolaus

With the increased focus on ISR, what do you see as the demand picture for the next year? What’s the competitive landscape like?

Mark Aslett

Clearly I think we feel good about ISR in general. I think if you look at what Gates did in terms of funding, more monies for ISR R&D. We’re a part of that through Merc Fed in terms of the persistent ISR program. It’s kind of a next generation approach. So we feel good that we’re on some of the leading edge there. But then in terms of the platforms that we’re on, programs and platforms such as part of the global haul, the B. platform again will be net beneficiaries.

So I think we see and expect to see increases in ISR as a result of the prioritization and we feel good about the position that we’re in.

Stephen Levenson - Stifel Nicolaus

Competitors, do you see other ones or this is where you’re sort of blocked out?

Mark Aslett

We feel pretty good about where we’re at. I think we’re getting stronger from a product portfolio perspective. I think we’re adding more value from a systems integration perspective. We’re going to have a competitive advantage over time. So actually I feel pretty good about the progress that we’re making.


We’ll take a follow-up question from Mark Jordan - Noble Financial,

Mark Jordan - Noble Financial

Bob, given the dust has settled here on the divestitures, how much of tax benefits do you have or how much pretax profitability can you shelter, on a GAAP basis, you’ll start to show a beating for tax rate?

Bob Hult

Not much. We’ve been carrying things back consistently here the past couple of years. So we’re going to become a tax payer fairly quickly.

Mark Jordan - Noble Financial

Can you pick a quarter in the next 12 months?

Bob Hult

I won’t try to pick a quarter, but it could have in FY10.


Gentlemen, there are no more questions at this time. I’d like to turn the call back over to Mr. Aslett for any additional or closing remarks.

Mark Aslett

Okay. Thanks very much, Brandy, and thanks to everyone for listening. We look forward to speaking with you again next quarter. This concludes our call.


Thank you for your participation in today’s conference call.

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