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Mercury Computer Systems, Inc. (NASDAQ:MRCY)

F4Q09 Earnings Call Transcript

August 04, 2009 at 5:00 pm ET

Executives

Bob Hult - Senior Vice President and Chief Financial Officer

Mark Aslett - President and Chief Executive Officer

Analysts

Tyler Hojo - Sidoti & Company

Mark Jordan - Noble Financial

Stephen Levenson - Stifel Nicolaus

Philip Friedman - PW Partners

Operator

Good day and welcome everyone to the Mercury Computer Systems fourth 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 Company's Senior Vice President and Chief Financial Officer, 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.

If you have not received the copy of the earnings release, you can find it on our website at www.mc.com. 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 fourth quarter and fiscal year 2009 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.

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 thank you for joining us.

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

On our call 12 months ago, we said fiscal 2009 would be a pivotal transition year for Mercury and it was. We executed successfully on each of the three goals on our turnaround strategy. We refocused the business and completed the divestiture of our non-core businesses in a very challenging M&A environment. We improved the underlying operations of the business and return the Company to profitability and we developed a strong and growing position for Mercury in the defense, intelligence, surveillance and reconnaissance or ISR space.

As a result, we exited fiscal 2009 a more focused and profitable enterprise. From a financial reporting standpoint, we have finally unmasked the two profitability and potential in our core business. Now, it is all about growth.

The progress we made in fiscal 2009 positions us well to expand our business on both the top and bottom line as we begin the new fiscal year. We are in a design-win led business so if you look at the factors that we believe will drive our growth going forward, the first is growth in the number and value of our design wins. Fiscal 2009 was a great year in this regard as the five year probable value of our defense design wins increased 51% from fiscal 2008.

The second growth driver will be growth and complementary ISR related services and systems integration business in ASC. We also made excellent progress in expanding this part of our business in fiscal 2009 delivering year-over-year revenue growth of 157%.

Our third growth driver is Mercury Federal Systems. The defense electronics market as a whole is 10 times larger than the commercial item defense electronics market that ACS has targeted in the past. Fiscal 2009 proved that the Mercury Federal model can work and worked well.

Revenue in Merc Fed first real operating year grew to $5.7 million from essentially zero in fiscal 2008 on $11.9 million in bookings. Be on defense or our ACS commercial business, the recession driven erosion continued in the fourth quarter. Commercial revenue was down 34% year-over-year for the fourth quarter and down 24% for the full year.

Our return to growth in commercial will primarily depend upon the timing of any eventual rebound in the semiconductor space. At this point, the signs of improvement in that industry are inconsistent and as a result, we expect to see further declines in our commercial bookings and revenue in the first quarter of fiscal 2010.

Looking ahead however, we have laid the groundwork for re-growth in this part of our business as well with significant semiconductor design wins in FY09. I will touch more on the growth outlook in a few minutes, but first on comments on our fourth quarter results which clearly were better than anticipated.

On a continuing operation spaces, revenue and non-GAAP earnings both exceeded the high end of our guidance range coming in at $48.4 million and $0.13 per share respectively. Mercury continued to generate solid free cash flow in Q4 and we complete our divestiture assets on schedule by successfully selling the VSG business. As a result, we paid down the remaining $5 million of our $125 million convertible senior notes and we ended the quarter with a healthy cash balance.

Total defense revenue in the fourth quarter including ACS and Mercury Federal grew 7% sequentially and by $3.3 million or 9% year over year to $40 million. The fiscal 2009 as a whole total defense revenue increased by $14.5 million or 11% from the prior fiscal year.

In terms of bookings, on our call last quarter we said that Q4 was off to a fast start. Within the first three weeks of the quarter, we had already received two POs totaling $30 million; one for ground-base radar program to see the missile defense with one of the major primes, and the other for radar technology on the DoD's next generation fiber platform. Including additional radar on electronic warfare bookings that came in later in the fourth quarter, bookings in ACS defense increased 106% year on year to $58 million.

Including Mercury Federal, our defense bookings grew 108% year over year in Q4. For fiscal 2009 as a whole, defense bookings grew 20% from fiscal 2008 representing the largest bookings year ever in Mercury's defense business. We closed the fourth quarter with the book-to-bill in defense of 1.49 up from 1.25 in the sequential third quarter and 0.78 in Q4 of last year.

In summary, we worked hard in fiscal 2009 to strengthen our core defense business and focus on high growth areas in the defense electronics market. Our bookings in the fourth quarter reflect the progress we have made to date.

Let us come back now to the growth drivers in our business starting with design wins. Winning new designs requires new products. In both our signal processing and multi computer product lines, we are in the midst of the most comprehensive technology refresh cycle in Mercury's history. As a result, we have positioned ourselves within the defense prime contract community as the leading in high end digital signal processing.

The new products coming out of our pipeline enable the primes to deliver new capabilities to their customers and ultimately to the war fighter. In this environment, the key is product velocity; the faster we can bring new products to market, the faster we can increase the volume and the value of our design wins. We have been focused for more than a year now on creating significant hardware design reuse and leverage in the business as the way to enhance our velocity and product development.

As a result, we are better positioned to respond to the government's increasing focus on [curiosity] of quick reaction capability. Design requirements are revolving rapidly and we are positioning Mercury as a company that can rapidly react and bring new technologies to market to meet the new requirements. Looking ahead, we will be focused on reinforcing this position by improving the software design reuse and leverage in our model.

Defense electronic is a high-mix, low-volume business where the key is not only product velocity but also product customization. Enhancing our software design reuse and leverage will allow us to be faster and more efficient in the ways which we deliver this customization. Defense Secretary Gates has been quoted to say that he would rather have a 75% solution in months than a 100% solution in years. Through improve hardware and software design leverage and reuse; we are playing directly into this new philosophy.

As we begin fiscal 2010, we believe that Mercury's is well positioned in each of the three key areas within the overall ISR market: radar, electronic warfare and electro optical infrared or EOIR. We had only one 10% program in ISR in fiscal 2009 and we have established a broadly diversified presence on the right programs and platforms.

In terms of the numbers, we received a total of 27 design wins in the first three quarters of fiscal 2009 and added another ten wins in Q4 and all of the Q4 wins were in defense. The five year probable value for the ten wins is approximately $53 million. On a fiscal year basis, the five year probable value of our design wins totaled $211 million, an increase of $38 million or 22% compared with design wins in fiscal 2008.

Looking specifically at defense, the probable value of our design wins increased 51% from a $106 million in fiscal 2008 to $160 million this year. Turning now to the second growth driver, a larger role for our services and systems integration business in ACS, our goal is to capture the two-thirds of commercial item defense electronics market that in the past our focus on hardware has left untouched.

Transitioning from a hardware centric focus to a complementary service and systems integration model aligns Mercury with the biggest challenges faced by the large primes today, the government's demand on them to get more war fighting capability into theater more rapidly and at a lower cost. The government is clearly frustrated with proprietary close systems, significant schedule slippages and huge cost overruns. A new best of breed model is emerging which embraces open systems architectures and that include greater use of commercial items.

We play directly into this trend in both Mercury Federal and in the ACS services and systems integration business. Mercury is in the best position to integrate signal processing sub system because this is our specialty, it is what we do. Expanding our role as an ISR sub-systems integrator for the primes has the potential to help scale our business faster than the hardware base business alone.

Mercury is recognized as the best of breed in high end digital signal processing and the leader in commercial item technology through the defense market. In fiscal 2009, we took this leadership a step further and led the development of the next generation embedded systems standard VPX with what we called open VPX. This standard is now in the process of being adopted by the industry standard body that supports the defense electronics industry.

Open VPX positions Mercury as the key architecture partner to the primes in that performance migration to open systems. Historically, they could not have both high performances in open standards. Today, they can while using Mercury's new approach. Our plan for 2010 is do the same thing from a software perspective. In terms of both hardware and software, our objective is to use open VPX systems as the pass to the design reuse and standardization and fast to deliver a more complete solution in the more cost effective and timely manner.

The Q4 bookings to the theater missile defense ground base radar program are a good example of how the services and systems integration model is enhancing and growing our business. Our role in this program started out as the traditional $6 million booking to provide hardware for the radar. We then generated another $6 million in bookings with custom engineering and prototype delivery representing the services element.

Finally, by bringing together the complete radar processing subsystem which is the systems integration piece, we have raised our total bookings to approximately $18 million.

In terms of our fourth quarter results, ACS services and systems integration bookings were $4.9 million and revenue increased 112% sequentially to $7 million. The fiscal 2009 ACS services and systems integration bookings were $13.6 million and revenues of $13.2 million, both significant increases over fiscal 2008 levels. We feel good about the performance and trajectory of this part of our business as we begin fiscal 2010.

Let us go now to the third driver, Mercury Federal. Mercury Federal hybrid business model positions us well to be selected as a best of breed QRC subcontractor to develop and coordinate the entire ISR signal processing and computing architecture for upgraded or new ISR programs and platforms. Clearly, we demonstrated the value of this model in fiscal 2009 as bookings increased to $11.9 million from $400,000 in the prior fiscal year.

Sticking with Mercury Federal and touching only the defense budget for a second, we believe that looking forward; the DoD and intelligence community budgets will demonstrate very modest top line growth. However, we foresee continued robust support for increasing investments in command and control and intelligence, surveillance and recognizance assets, Mercury's sweet spots.

We are seeing additional monies being applied to procure more airborne ISR systems that offer significant improvements in finding, tracking and engaging multiple individual, high-value targets over hundreds of miles in various urban and mountainous environments. As an example, in the FY09 and FY10 budgets, the DoD allocated $2.4 billion in procurement funding for an additional 137 medium altitude ISR unmanned systems such as the Reaper and Predator and $2.8 billion for an additional 12 global high altitude platforms. Today, Mercury is providing the processing hardware and software to these platform’s radar sensors.

In FY09, Mercury Federal was awarded an important contract by a rapidly growing prime as the best of breed subcontractor to pull together a new processing system for the Reaper aircraft that supports multiple sensors configured in a single pod. This new ISR processing systems that we are developing for the [Golgan Stare] Reaper unmanned aerial system includes the hardware and software capabilities of our converged central network architecture.

For the first time, this system will allow multiple operational assets to receive timely relevant information over the large areas of interest. Indeed, Mercury's new advance processing solutions address the DoD’s principal airborne ISR challenge of quickly processing large data sets and getting meaningful information to many tactical uses in a timely manner. Perhaps Lieutenant General Deptula of the Air Force summed up this challenge best by stating last week that – “We are going to be swimming in a sea of sensors and drowning in data.”

Today, we are also aggressively working with our prime partners on options to upgrade existing [man's] ISR platforms with our converged sensor network architecture capabilities in order to improve the operational utility of these deployed assets. Based on our experience this past year, we feel really good about Mercury Federal's growth prospects going forward and its ability to significantly enhance our competitive position within the ISR space.

As we mentioned last quarter, in conjunction with our Shelf Registration, we are also at an early stage and beginning to explore acquisition opportunities. We have a single goal in mind for any potential acquisition. That goal is to strengthen our ISR domain expertise and grow the core by increasing our assets to and content on the most promising ISR platforms and programs.

Wrapping up, the fourth quarter was the solid conclusion to a successful turnaround year for Mercury. Although we currently expect that our commercial markets could remain challenging for some time to come, the progress we have made in strengthening and expanding our defense business positions us well to deliver renewed growth in fiscal 2010 and beyond.

Bob, over to you.

Bob Hult

Thank you, Mark. As a reminder, I will be discussing our fourth quarter and fiscal year 2009 results and first quarter guidance on both a GAAP and non-GAAP basis. In addition, now that we have divested all of our non-core businesses and treated them as discontinued operations, the numbers I will be discussing relate only for continuing operations. Also note that we replaced non-GAAP earnings with adjusted EBITDA as one of our guidance measures.

Starting on the top line. Total revenue for the fourth quarter of fiscal 2009 was $48.4 million, slightly above the top end of our guidance range of $46 million to $48 million. This compares with revenues of $50.6 million for the sequential third quarter and $49.6 million for the fourth quarter of fiscal 2008. For fiscal year 2009 as a whole, Mercury's total revenues were $188.9 million, down 1% from the prior fiscal year.

Non-GAAP earnings from continuing operations for the fourth quarter of fiscal 2009 were $0.013 per diluted share, also above the high end of our guidance range, which was $0.05 to $0.08 per share. For the full year, non-GAAP earnings from continuing operations were $0.49 per diluted share compared with $0.51 for fiscal 2008.

Looking at our revenues by operating unit, revenue in ACS including both defense and commercial were $47.2 million, down 4.5% from the sequential third quarter and down 4.3% from Q4 of fiscal 2008. For the full year fiscal 2009, ACS revenue was down by 1.7% to $185.3 million from $188.5 million in fiscal 2008. Our Mercury Federal system segment had an outstanding year. Revenue increased from $200,000 in FY08 to $5.7 million in FY09.

Mercury's total book-to-bill ratio, including ACS and Mercury Federal for the fourth quarter, was 1.33 and for the full year, 1.11. Our fourth quarter total backlog, including deferred revenue, was $98.2 million, an increase of $15.9 million from the sequential third quarter and up by $20.6 million from the fourth quarter last year.

Of the current total backlog, $69.7 million or approximately 71% relates to shipments scheduled within the next 12 months. In addition, $93.8 million or approximately 96% of our total backlog relates to defense. Note that backlog has also been adjusted for discontinued operations.

Moving down the income statement, fourth quarter GAAP income from continuing operations was $3.1 million or $0.14 per diluted share. This compares with a GAAP loss from continuing operations of $900,000 or $0.04 per share for the same period last year.

For the full year, GAAP income from continuing operations increased to $7.9 million in fiscal 2009 from a loss of $4.4 million in fiscal 2008. Mercury's fourth quarter GAAP results include approximately $1.4 million in charges as follows; $1 million in restructuring expenses, $45 million in amortization of acquired intangible assets, and a negative $0.1 million in stock-based compensation charges.

On a non-GAAP basis, excluding the impact of these charges and the difference between GAAP and non-GAAP cut rates, fourth quarter non-GAAP net income from continuing operations was $2.9 million or $0.13 per diluted share. This compares with $2.4 million in Q4 last year. We used a non-GAAP tax rate of 34% in FY09 and 30% in FY08. Depreciation was $1.3 million in the fourth quarter of 2009.

For full year fiscal 2009, non-GAAP net income from continuing operations was $11 million or $0.49 per diluted share compared with $11.1 million or $0.51 per diluted share last year. Adjusted EBIDTA, which excludes FAS 123 charges, was $4.9 million dollars for the fourth quarter. For full year fiscal 2009, adjusted EBITDA was $21.1 million.

Reflecting the steady progress that we have made in enhancing the leverage in our business model, gross margin for the fourth quarter of 2009 was inline with our forecast while operating expenses were slightly lower. Our non-GAAP gross margin for Q4 was 53.4%, slightly above the high end of our guidance range of 52% to 53%. For full year fiscal 2009, non-GAAP gross margin was 55.9%. This compares with our non-GAAP gross margin of 58.4% in fiscal 2008.

Gross margin has declined from previous levels due to a change in business mix. Gross margin was also adversely impacted this past year by abnormally high inventory reserves associated with the slowdown in our commercial business. At the same time, the actions we have taken to lower our cost over the past year are clearly evident in our result. Non-GAAP operating expenses for the fourth quarter of fiscal 2009 were $22.0 million. This compares with $22.5 million in the sequential third quarter and $23.9 million in Q4 last year.

Discontinued operations have been excluded for all periods. For the fiscal year as a whole, non-GAAP operating expenses declined to $89.2 million from $99.9 million in fiscal 2008.

Turning to the balance sheet and cash flow statement, cash, cash equivalents, and marketable securities at the end of the fourth quarter fiscal 2009 totaled $91.9 million, compared to $85.6 million at end of a sequential third quarter.

As previously mentioned during the fourth quarter, we redeemed the remaining $5.3 million balance on our convertible senior notes. In addition, we received net proceed of $9.1 million from the sale of VSG. Mercury generated $2.4 million in the free cash flow in Q4. This compares with $1.5 million in the sequential third quarter. The fiscal 2009 as a whole, free cash flow was $7.1 million.

As a reminder, our option rate securities settlement agreement with UBS entitles us to full repayment of our ARS portfolio at par on June 30, 2010. In the interim, we have a $33 million zero cost loan from UBS. As Mark discussed, we have been focused on improving the ongoing operations of the business. Our goal is to make our business model more efficient so we can generate the cash necessary to scale a business profitably.

Working capital is key to this effort and we have executed on initiative to strengthen our overall supply chain capabilities, managed down inventory and improved our performance in cash collections. Inventory decreased by $2.1 million sequentially in the fourth quarter of fiscal 2009. The FY09 as a whole, inventory is down by $7.4 million from fiscal 2008. Fourth quarter DSOs were 53 days compared to 60 in the sequential third quarter.

Accounts receivable were down to $29 million from $34 million in Q3. The cost and challenge we faced is the lack of shipment linearity with any given quarter in our business. We have been adjusting this in conjunction with our customers but we still have work to do. Nonetheless, we feel good about the progress we have made on working capital overall and the Company's ability to generate cash from operations.

At the end of the fourth quarter, our total employee headcount excluding contractors was 517 compared with 522 at the end of Q3 and 530 at the end of fiscal 2008. All these figures exclude employees associated with discontinued operations.

Before we move on to guidance, I would like to note that our $100 million universal Shelf Registration went effective May 20th. As stated in our Form S3, any proceeds raised through the sale of securities and with the Shelf are intended to general corporate purposes including funding potential acquisition.

In addition, I would like to extend our appreciation to Mercury shareholders regarding the favor of our stock option exchange program for employees. Option holders exchange 431,000 underwater stock options for 154,000 non-vested shares. The exchange program was largely across neutral and reduced our overhang by 1.1%.

Let us move on to our guidance for the first quarter of fiscal 2010 which incorporates a new non-GAAP measure of financial performance adjusted EBITDA. We will be using adjusted EBITDA going forward because we believe that it is more in keeping with the practices in the defense industry than our previous non-GAAP earnings measure.

Our guidance for Q1 reflects the operational and market momentum driving our defense business as we begin the new fiscal year. Although we expect commercial revenues to continue declining, we expect to report strong growth in defense revenues and as a result, another quarter of solid profitability for Mercury.

For the first quarter of fiscal 2010, we currently expect a revenue range of between $43 million and $45 million. We anticipate reporting a Q1 GAAP gross margin of approximately 56% to 57%. GAAP operating expenses are currently anticipated to be approximately flat both sequentially and year over year. CapEx for the first quarter of fiscal 2010 is projected to be approximately $2.5 million and depreciation approximately $1.3 million.

On this basis, GAAP earnings from a continuing operation to Q1 are currently expected to be between $0.03 and $0.08 per diluted share on approximately $22.6 million shares outstanding. As I mentioned commencing with Q1 of fiscal 2010, our non-GAAP measure of financial performance was changed to adjusted EBITDA. Our estimate for the first quarter of FY10 excludes the following approximate amount; $1 million in stock-based compensation cost, net interest income of $100,000, $400,000 in amortization of acquired intangible asset and depreciation of $1.3 million.

Our GAAP tax rate for FY10 is expected to be approximately 27%. As a result, adjusted EBITDA for the first quarter of fiscal 2010 is expected to range from $3.5 million to $5 million.

I would like to conclude by announcing that coincident with preparing our FY10 strategic operating plan, we have updated our pro forma target business model to better align with our current operation. The model consists of two segments; the first is our advance computing solutions or ACS business. ACS includes our core defense business including services and systems integration and our commercial business. The second segment consists of Mercury Federal Systems.

Now that we have divested our non-core businesses, we focused ACS on high growth defense market and develop Mercury Federal Systems. Looking at Mercury in terms of these two segments provides more insight into the underlying performance of our business.

Prior to our portfolio rationalization, Mercury's consolidated target model reflected a blend of businesses including the high gross margin, software driven VSG and VI unit which have since been divested. The historical model targeted a 58%+ gross margin and a 15% non-GAAP operating margin. We are resetting the target model that continued to reflect a 14% to 15% operating margin on a non-GAAP basis without an expected lower gross margin of 54%+. This is based on Mercury's target to profitability within the next two to three years excluding an acquisition in the expected mix in that timeframe between our ACS and MFS businesses where MFS contributes between 10% to 15% of overall corporate revenues.

The ACS unit continues to drive high margin and we are targeting 55%+ gross margin and 15% operating profit in this larger part of our Company. This gross margin target is slightly down from currently reported gross margin levels due to the faster growth in services and systems integration offerings that we expect over the next two to three years. Mercury Federal Systems being a value added service provider for the primes and federal government agencies has targeted a more typical 20% gross margin in a 10% to 12% operating profit.

In addition, our new target business model will deliver an adjusted EBITDA margin in the 17% to 18% of revenue range. Mercury concluded fiscal year 2009 as a more focused and profitable enterprise and we believe this new target model lines well with our new and stronger positioning.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Tyler Hojo - Sidoti & Company.

Tyler Hojo - Sidoti & Company

I was hoping maybe you could talk a little bit more about the systems integration and services business and ACS. Last quarter, I think you gave us a number just in terms of what that contributed in revenue in the quarter and I am hoping that you can start maybe the dialogue by giving that again.

Bob Hult

Okay, so the revenue in services and systems integration this quarter was $7 million.

Tyler Hojo - Sidoti & Company

Okay, that is more than double what it was in the third quarter. Can you maybe talk about what drove that and what your expectations are for that little niche in the segment as we move in to fiscal 2010 and beyond?

Mark Aslett

Yes, so if you look at what we are trying to do at a corporate level, we are really positioning the Company as an ISR subsystems integrator that kind of building upon our expertise in high performance signal processing and adding complementary services and systems integration to increase the size of the deals that we are going after. So, what we are starting to see is more and more opportunity for deals that are within our existing pipeline to provide more of those types of services to our existing prime defense contract to customers.

So, that is kind of what we are trying to do and I think we expect good growth out of that business going forward.

Tyler Hojo - Sidoti & Company

Okay, great and maybe you could just comment on, I am not sure if you are familiar with, I imagine you are familiar with the OCI clause in the new defense procurement legislation and I am just wondering if you think this impacts basically the business model going forward and if potentially put some risk to some of the things we are trying to accomplish here.

Mark Aslett

Okay. Let me start out by talking about the rules as they stand today. I mean we have done a pretty thorough OCI review and through that review, we determined two things that currently we have no work or plan projects that trigger the current OCI rules and secondly, the way in which Mercury and Merc Fed work together does not trigger the existing OCI rules. So, I think we believe that we are fine today.

Looking at the new pieces of legislation of which these two, the National Defense Authorization Act as well as the Weapon Systems Acquisition Reform Act, over the next 12 months, that could result in the definition of new best practices or changes of the defaults. Our best view of it is that the primary focus area of the government is likely to be the large primes under the definition and potential conflicts associated with being classified as the lead systems integrator, neither Mercury nor Merc Fed is the lead systems integrator.

So, basically we do not believe we got a problem. What we are going to continue to do is basically monitor any potential changes and make sure that we are in compliance with it going forward, Tyler.

Tyler Hojo - Sidoti & Company

Okay that sounds good and just lastly for me, on the R&D side, I think you were down somewhere in the mid teen sequentially. Obviously, you are up sequentially in design wins. I mean just on the R&D front obviously part of the story has been trying to leverage those R&D dollars but I mean, is this downward trend something to expect going forward or have you kind of bottomed out here?

Mark Aslett

If you look at the R&D, yes, it can be lumpy quarter to quarter depending upon things like the timing of prototype deliveries, etc. Our expectation is that R&D will remain relatively flat overall for FY10 and so, that is our expectation. It may be up a little or may be down a little on the quarterly basis.

Operator

Your next question comes from the line of Mark Jordan - Noble Financial.

Mark Jordan - Noble Financial

Just following up a little more explicitly on the R&D, it is flat year over year. You did say that you saw op expenses being flat sequentially so that would imply probably a little bit higher R&D in the out quarters of fiscal 2010?

Bob Hult

Mark, it is Bob. We are really trying to stand firm on not getting into the business of forward guidance beyond the next immediate quarter but going back to Mark Aslett's point on R&D, there is operating leverage in our model so we are not looking at much growth across OpEx as we grow into our model with top line growth over the next couple of years.

Mark Aslett

So that is kind of consistent with what we said in terms of our pro forma model structure.

Mark Jordan - Noble Financial

Relative to that, just to make sure that I heard things properly on your revised model, you said on a blended basis, you are looking for 14% to 15% operating margins on a non-GAAP basis, is that correct?

Bob Hult

That is correct, on a non-GAAP basis and we believe that will deliver…

Mark Jordan - Noble Financial

Will the GAAP adjustment be crudely a 150 to 200 basis points if you were to look at that on a GAAP basis?

Bob Hult

It is in that range but the big adjustment there is really depreciation to get from an EBITDA. I would rather go to EBITDA, Mark, if you know what I am saying.

Mark Jordan - Noble Financial

Yes.

Bob Hult

I think what we are trying to do is to provide guidance on a GAAP basis going forward in an EBITDA basis. I reset the model on a non-GAAP basis so that you could compare yesterday's Mercury model to tomorrow and I think our big message is yesterday's model had a non-GAAP operating percentage of 15 and we are ranging at 14 to 15 now.

Mark Jordan - Noble Financial

Just because of the succession you see in Merc Fed.

Bob Hult

It is really coming down to mix with Merc Fed over the planning horizon next two or three years becoming 10% to 15% of our total revenues and that will run with 10 to 12 points on the bottom line, again non-GAAP. So, if you want to adjust our non-GAAP down to a GAAP, you will probably going to have to take some of the historical charges that you got in your model and attempt to model those going forward. I am going to try to stay away from that.

Mark Jordan - Noble Financial

Okay. Two more questions if I may, one, your restructuring charge was up to almost a million dollars, was that kind of clean up case and what should we look for in sort of moving forward…

Bob Hult

Yes, sure.

Mark Jordan - Noble Financial

And then secondly, will you be reporting a tax rate in the upcoming year? You did say that you had adjusted; you had a tax rate of 27% assumed in some of your calculations. When will your results reflect a reported tax?

Bob Hult

Let me just quickly hit the tax rate. Our best estimate right now is that we will average at 27% rate for 2010. Onto restructuring, we did incur about a million dollar restructuring expense in the fourth quarter. It was a little bit more than clean up frankly. We sold our final non-core asset in the June quarter which gave us the opportunity to reorganize our corporate functions and that is primarily what that charge is all about is a more focused Mercury going forward, ACS and Merc Fed, having sold five businesses in the last 18 months.

So, we took advantage with that opportunity in the fourth quarter restructured. We do not expect much in the way of restructuring charges going forward.

Operator

Your next question comes from the line of Stephen Levenson - Stifel Nicolaus.

Stephen Levenson - Stifel Nicolaus

On you ISR subsystems integration efforts, where do you think you are going to run into and how do you think you are going to beat them?

Mark Aslett

I think if you look at our traditional competitors given what we have done, we are not looking to branch out into other areas of technical capabilities. We are still focusing very much on the digitalization, signal processing, and compute capability for the platforms that we are selling into. So, I think our competitor set remains relatively stable. What we are starting to see really is the primes looking to outsource more of the stuff that they themselves may have done historically and this ground base radar program to see the missile defense is the great example.

The last time around, in terms of this particular program, the primes themselves did much of the work. This time around, they have outsourced it to Mercury.

Stephen Levenson - Stifel Nicolaus

Second, on the sales mix. I do not know if this is something you have but it will be helpful. Can you break it out between the upgrade and reset work that you are doing and what you are doing on new platforms?

Mark Aslett

No, we have not got that information, Steve.

Stephen Levenson - Stifel Nicolaus

Okay, if you wanted to take a guess, do you believe it skewed heavily one way or the other?

Mark Aslett

I would say the majority of the work today is on upgrades to existing platforms, specifically in ACS. If you look at Merc Fed, they are more focused on new starts in the ISR space and the Golgan Stare program that I mentioned is a very good example of a next generation ISR platform and system that start into incorporate in our converged sense of network architecture capability.

Stephen Levenson - Stifel Nicolaus

Okay, if you can say, is the customer there General Atomics is the maker of the aircraft or Sierra Nevada, the maker of the sensor package?

Mark Aslett

We are not at liberty to say which one it is.

Stephen Levenson - Stifel Nicolaus

Okay and I guess last is, do you think the mix is going to stay this way at least for fiscal 2010?

Mark Aslett

In terms of upgrades versus new?

Stephen Levenson - Stifel Nicolaus

Right.

Mark Aslett

Yes, because I think if you look at the focus on much of the defense budget today, it is providing, upgrade that capabilities onto existing platform. So, yes my belief is that that mix would remain relatively stable.

Operator

(Operator's instruction) Your next question comes from the line of Philip Friedman - PW Partners.

Philip Friedman - PW Partners

I got two questions. Do you know about what percent of last year's continuing ops backlog of the shippable? Was it comparable to the 71% going into this year?

Bob Hult

Phil, all the backlog numbers we have given has the discontinued operations taken out of them.

Philip Friedman - PW Partners

Alright. Okay, so the question is maybe I missed it when you reported it, therefore, this year's number; you said I think was 71% is shippable for the next 12 months so going into next year that helps us. So I am trying to figure out what the percent shippable was last year or into the next 12 months.

Bob Hult

Yes, I can do a quick calculation. It was much higher, Phil, 90%+.

Philip Friedman - PW Partners

Okay.

Bob Hult

Now, quick reminder there, total backlog is up over $20 million year on year and I think what I want to make sure you are understanding here is good example is the program that Mark was just talking about where we are doing engineering services and systems integration work and the program that he broke down there, it is an $18 million program with the hard purchase order. Three chunks, $6 million products, $6 million engineering services and another $6 million with systems integration. That plays out over a greater than 12-month period. So, I think it is good news is what you are observed in the numbers.

Mark Aslett

There is one other point that if you look with the commercial business being down, there is a much greater percentage of the backlog associated with the defense business this year than last.

Philip Friedman - PW Partners

Okay and then just the second last question is a follow up to the margin question on the 14% to 15%, just to help frame it, the Q1 guidance you gave, the amortization I think of $400,000, the depreciation of $1.3 million and the stock-based comp of $1.0 million, those were really the three items, right, that would be excluded from a reported GAAP EBIT margin, right?

Bob Hult

That is correct.

Philip Friedman - PW Partners

Okay, so if I take that $2.7 million and very simplistically multiply it times four and again $10.8 million, I am not sure if that is all close to reasonable and say, you guys you have typically go at the high end or better of your revenue numbers of 45 and 180. You have simply take 200, my number not yours, right. So that would say the numbers closer to 550 basis points close, not the 150 to 200 of the prior questionnaire so is my math wrong or…?

Bob Hult

Well, you have put yourself in the annual guidance business there for 2010 and we are trying to stay out of that but…

Philip Friedman - PW Partners

But is my logic of annualizing those items wrong?

Bob Hult

No, you are dealing with the correct item but you need to find obviously an algorithm to annualize them. I will go back to Mark Jordan's question, he took a non-GAAP target bottom line of 14% to 15% and he was trying to get it down to GAAP and without parsing all the individual pieces but you have itemized them for us or enumerated them, it is two to three points…

Philip Friedman - PW Partners

But then I am off in the stock based compensation or is that more first quarter loaded?

Bob Hult

No, stock-based compensation is past year. Total year run about $5 million and it will run somewhere in a similar range next year.

Philip Friedman - PW Partners

And same thing though with the amortization and depreciation should be fairly linear I would think.

Bob Hult

Depreciation will not move around too much and a note on the amortization of intangibles, you set this up when you acquire companies and the intangibles that we have been amortizing relate to acquisitions that Mercury made back in the 2004 and 2005 timeframe, not the ones we sold, the ones we still have like our Equitech business in Huntsville. These tend to run out variably depending on what the asset is in the three, four and five timeframe. So, they burn off all the time.

So, we do have some moving parts there. I think you should stick with two or three points with some variability, adjust non-GAAP down to GAAP in terms of a target business model. I would also encourage you to stay on point and we are pretty comfortable looking at in adjusted EBITDA which is go in the other way of 17% to 18% as a target business model and I think you will find that easier to work with as a comparable to other companies.

Operator

You have a follow up question from the line of Tyler Hojo - Sidoti & Company.

Tyler Hojo - Sidoti & Company

I was just wondering if you had the operating margins for the segments or do I have to wait for the 10-K.

Bob Hult

I think we should wait for the K to get filed.

Operator

And it appears there are no more questions at this time. I would like to turn the conference back over to our speakers for any closing remarks.

Mark Aslett

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

Operator

That does conclude today's conference. We thank you for your participation.

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Source: Mercury Computer Systems, Inc. F4Q09 (Qtr End 08/04/09) Earnings Call Transcript
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