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Executives

Kevin M. Bisson – Senior Vice President, Chief Financial Officer and Treasurer

Mark Aslett – President and Chief Executive Officer

Analysts

Tyler E. Hojo – Sidoti & Co. LLC

Peter J. Arment – Sterne, Agee & Leach, Inc.

Sheila Kahyaoglu – Jeffries LLC

Brian W. Ruttenbur – CRT Capital Group LLC

Jonathan F. Ho – William Blair & Co. LLC

Michael F. Ciarmoli – KeyBanc Capital Markets, Inc.

Mercury Systems, Inc. (MRCY) F1Q 2014 Earnings Conference Call October 29, 2013 5:00 PM ET

Operator

Good day everyone and welcome to the Mercury Systems First Quarter Fiscal 2014 Conference Call. Today’s call is being recorded. At this time for opening remarks and introductions, I’d like to turn the call over to the company’s Senior Vice President and Chief Financial Officer, Kevin Bisson. Please go ahead, sir.

Kevin M. Bisson

Thanks, Mary, and good afternoon, everyone, 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 we issued earlier this afternoon, you can find it on our website at www.mrcy.com.

We’d like to remind you that remarks that we 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, potential 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 programs as well as the timing and amounts 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 the 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 and restructurings 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 system 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, 2013. The company cautions 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 statement 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.

With that, I’ll turn the call over to Mercury’s President and CEO, Mark Aslett. Mark?

Mark Aslett

Thanks, Kevin. Good afternoon, everyone, and thanks 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. Despite continued industry headwinds, Mercury performed well in the first quarter. We delivered results at or above the high end of our guidance across all of our key metrics.

Total revenue for the quarter was $54 million versus our guidance of $48 million to $54 million. Our GAAP loss from continuing operations was $0.07 per share versus our guidance of a loss of $0.14 to $0.08. Adjusted EBITDA was 7% consistent with last quarter and above the high end of our guidance and we continued to generate positive cash flow. In addition, we made good progress in our most important programs and we continued to see good growth in the value of our design wins.

Looking specifically at our defense business, total defense revenues were down 7% sequentially from Q4 to $46.4 million, but were up 4% versus the first quarter last year. Total defense bookings were down 25% sequentially to $43.6 million, but increased 19% year-over-year. The sequential decline in bookings was primarily due to the exceptionally strong bookings performance we delivered in Q4. The increase year-over-year was largely due to the continued recovery in our MCE core compute business.

In the first quarter, MCE core compute defense bookings in 12 months backlog grew 54% and 42% respectively versus the same period last year. In total, including Micronetics, MCE defense bookings grew 8%, defense revenues 16% and 12-month backlog 34% versus Q1 last year. This evidence suggests to us that our strategy of managing the MCE business differently in this challenging industry environment is working well.

Our total book-to-bill increased to 0.87 from 0.83 in Q1 last year. Our book-to-bill in defense improved to 0.94 from 0.82 year ago. Defense backlog exiting the first quarter was down 2% sequentially. Year-over-year, however, defense backlog was up 6% and total 12-month backlog was up 13%. From a bookings perspective, our largest program this quarter was Aegis with Lockheed Martin, which continues to do well.

Our other key bookings this quarter include a classified airborne program with Northrop, an order for U.S. Army Patriot with Raytheon, Predator/Reaper radar upgrades with General Atomics, and additional orders for existing and next-generation EW products in our MDIS segment.

From a revenue perspective, Patriot, B-1B, SEWIP, F-16 and Aegis were important contributors during Q1. Foreign military sales and international sales continued to show strength. International defense revenues including FMS were 23% of total defense revenue during the first quarter, compared with 30% in the sequential fourth quarter.

From an award perspective, the first quarter started out well. Our customer Northrop was selected for the U.S. and Taiwanese F-16 AESA Radar upgrades. This win along with future FMS pursuits by our customers could be worth $50 million to $100 million to Mercury over time. However, Lockheed failed to win the EMD phase of AMDR, the next-generation Aegis radar replacement program.

Although, this was disappointing for us from a long-term perspective, the AMDR EMD phase was strictly an upside to our plan for fiscal 2014. The LRIP phase isn’t expected to begin until government fiscal year 2016 and production in 2020. As such, we’ll be managing the business in the ordinary course, keeping in mind that we currently expect Aegis to continue for another five or six years at historic run rates. Additionally, Lockheed is since protested the AMDR award to Raytheon. We expect further information on the outcome of that protest early next quarter.

In the near-term, our portfolio of ongoing programs provides us with a strong foundation for bookings and revenue growth. The most important of these programs is SEWIP Block 2, which only recently moved into the LRIP phase. In addition to realizing LRIP on production revenue from the content on SEWIP Block 2 that we have currently, we’re focusing on winning additional design win content on that program, which will increase our revenue per shipped set. A scaled down version of SEWIP Block 2 could provide additional opportunity as well and finally, there is SEWIP Block 3.

In addition to our existing programs, which is Aegis and SEWIP Block 2, SEWIP Block 3 is one of the group programs that we believe will be important to Mercury longer-term. Among these other future programs, the E-2T Hawkeye, F-16 Radar upgrades and U.S. Army Patriot. These are franchise and programs for Mercury that in aggregate could represent hundreds of millions of revenue potential over their lives.

We won some important new designs during the first quarter, although design wins overall were impacted by the industry macros. We received a total of nine design wins, eight of them in defense. This compares with nine design wins in the majorly proceeding quarter.

Our design wins continue to focus on radar, electronic warfare and electro optical/infrared. The five-year probable value was approximately $94 million, compared with approximately $42 million in Q4. The major design wins this quarter were for F-16 radar upgrades with Northrop and EW subsystem to [indiscernible] RF and microwave capabilities for excellence and a refresh of its second subsystem for Raytheon.

The new procurement environment has created a difficult set of business challenges for the primes. How can they keep their existing programs sold, while at the same time, investing to grow in line with the DoD’s new defense roles and missions to [indiscernible] and should be maintained the resources required to address the complexity, speed and cost of innovation and the way to develop solutions, while at the same time, moving to exportable open architectures.

We continue to believe that Mercury’s strategy, technology, capabilities in ongoing programs and platforms align well with the DoD’s new priorities and those of the primes. We’ve reshaped the compute side of our business over the past five years and has completely refreshed our product portfolio. As a result, we now have a state-of-the-art significantly differentiated product line.

These products enable new war fighting technique intelligence capabilities that can be readily deployed today. They will allow our customers not only to win new awards, but also to keep their existing programs sold in an increasingly competitive environment. We also have exportability features that can help our customers accelerate their foreign military and international sales, which has become a key focus area for the industry.

On the RF and microelectronic side of the business, there were series of acquisitions over the past three years. We have positioned Mercury as the better alternative with truly end-to-end capabilities for advanced sensor processing. These recently acquired assets are proving to be critical as the primes work to develop and manufacture the DoD’s next-generation EW and electronic countermeasures subsystems. RF and microelectronics is an area where we see greater opportunities for growth on programs such SEWIP Block 2 and 3 and other EW programs that we are pursuing.

I talked last quarter about the new advanced microelectronic center or AMC we’re opening in New Hampshire. The buildout and systems implantation are well underway, and we are currently on track and on budget. The AMC provides us with significant infrastructure in terms of clean room manufacturing space and our customers with a new level of microelectronics capability in the northeast. Combined with our existing center in New Jersey, wee see the AMC as both a scalable and redundant design in manufacturing solution, that allows us to provide customers a second source manufacturing site internally for the first time.

Now that we have this internal second source capability, will increase our customers’ confidence in outsourcing work to us that they may have previously planned on doing in-house. The investments we’ve made in our people and facilities have positioned Mercury as a trusted outsourcing partner to the primes. We believe that longer term, RF and microwave, as it relates to next-generation EW and radar subsystems will likely become the fastest growing part of our business. We expect this growth to be driven by existing programs such as SEWIP Block 2 and future programs such as SEWIP Block 3 should the Lockheed Martin and Raytheon team win this competition.

Let’s turn now to conditions in the industry. Unfortunately, from the macro perspective, we are in a remarkably similar situation to where we were a year ago. The politicians continue to argue over raise in the debt ceiling and we are now operating under another short-term CR. In mid January, the second wave of sequester reductions is expected to kick in unless a broader spending and revenue deal can be forged before that. The net result is that spending at the end of government fiscal 2013 was slow and will likely remain at this pace until the 2014 Defense Appropriations bill is approved.

The services also appeared to be operating under the assumption that sequestration or a derivative is here to stay as they prepare their forecast and budget submissions for government fiscal 2015. These issues continue to cloud our visibility into FY14. There remains a potential for delays in orders and associated revenues in new program starts or programs transitioning between phases as well as risks to program timing, funding levels or cancellations.

The difference between this year and last year for us is that we are now more than a year into managing in this environment. We saw the advanced impact of sequestration very early on in our FY13. We responded immediately and proactively, and for the past four quarters, we’ve been managing the business very differently than in the past. Not only did we significantly reduce our expenses to continue to generate positive cash flow, but more importantly, our focus on building backlog has put us in a much better position at this point in our fiscal 2014 than we were a year ago. The fact that we ended our FY13 with our backlog up 34% year-over-year was part of our strategy to help manage that what we believe will be [indiscernible] 2014 that was remarkably like the year we’ve just been through.

Looking forward, barring major unforeseen changes in national priorities and resources, the U.S. defense budget will be small and spent differently in the future. Even so, defense is likely to remain a $500 billion industry for years to come. Within that $0.5 trillion of annual spending, our myriad of opportunities waiting to be exploited, as long as differentiated and affordable solutions are available.

To the primes, delivering this affordability means incorporating a higher level of variable cost in their business models, which we anticipate will lead to greater reliance on outsourcing to prudent suppliers. We believe that Mercury is well positioned to capitalize on these dynamics over the longer term. For the near term, our top priority is to leverage our relationships with the primes and drive bookings and revenue from existing programs as well as new programs and platforms.

At the same time, we continue to manage the business through a conservative revenue and income statement forecast. We remain focused on execution in areas that are within our control and managing with an eye on maximizing our cash and continue to build backlog. Meanwhile, we have 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. We're committed to the financial targets and our long-term business model and are confident that we can follow through on that commitment.

Given our focus on cash management and recent expense reductions, we believe that we’ve created substantial operating leverage in our business. We believe this will lead to a significant improvement in Mercury’s profitability, cash flow generation and enterprise value over time.

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

Kevin M. Bisson

Thank you, Mark, and good afternoon again, everyone. Turning to our financial results. Revenue for the first quarter of fiscal 2014 of $53.9 million was $4.5 million or 9% higher than revenue of $49.4 million for the first quarter of last year and was at the upper end of our stated guidance of $48 to $54 million. The company incurred a GAAP net loss of $0.07 per share in this year’s first quarter, which was substantially smaller than the GAAP net loss of $0.24 per share in the first quarter of fiscal 2013.

Last year’s first quarter net loss included a significant restructuring charge and Micronetics related acquisition costs that together contributed $0.12 per share to the reported net loss. Adjusted EBITDA for the first quarter of fiscal 2014 of $3.6 million was $2 million higher than the adjusted EBITDA of $1.6 million for the first quarter of last year and exceeded our stated guidance of $100,000 to $3.2 million. The company generated free cash flow of $1.1 million in the first quarter and ended the quarter with $40.1 million of cash and cash equivalents and with no debt.

Reviewing first quarter performance in greater detail, total revenue for our largest segment, Mercury Commercial Electronics or MCE, was $44.6 million, which was $7.8 million or 21% higher than the $36.8 million of MCE revenue generated in last year’s first quarter. The year-over-year increase in first quarter revenue was driven mainly by higher Patriot, SEWIP, and B-1 bomber program revenue that was partially offset by lower Joint Strike Fighter program revenue. Revenue from the company’s Mercury Defense and Intelligence Systems or MDIS operating segment for the first quarter was $11.1 million, which was $4.7 million lower than the $15.8 million of MDIS revenue for the first quarter of fiscal 2013.

The lower revenue between years is derived mainly from lower Gorgan Stare revenue, as development efforts wind down for this program, as well as lower digital radio frequency memory or DRFM jammer revenue due to customer funding delays that were recently resolved and lower MIS revenue. It should be noted that operating segment revenue for the first quarter of fiscal 2014 does not include adjustments to eliminate $1.8 million of intercompany revenue.

Total defense revenue, including MCE and MDIS for the first quarter of $46.4 million was $1.9 million higher than the defense revenue of $44.5 million for the first quarter of last year. As mentioned previously, the increase in year-over-year defense revenue was primarily due to higher Patriot, SEWIP and B-1 bomber program revenue that was partially offset by lower Gorgan Stare revenue. Of the total defense revenue in the first quarter, $10.8 million or 23% derived from international customers, compared to $9.1 million or 20% in the first quarter of fiscal 2013.

Revenue from international customers includes foreign military sales through our prime customers as well as direct sales to non-U.S. based customers. The key programs driving international revenue in this year’s first quarter were the Patriot, F-16 and Digital Electronic Warfare Suite or DEWS programs.

Commercial revenue for the first quarter of $7.6 million was $2.7 million higher than the $4.9 million of commercial revenue generated in the first quarter of fiscal 2013. The year-over-year increase in commercial revenue was mainly the result of higher product shipments to a telecommunications equipment customer for product that was designated as end of life.

Defense bookings for the first quarter of $43.6 million were $6.9 million or 19% higher than the $36.7 million of defense bookings in the first quarter of last year. The significant increase in defense bookings between years was due primarily to higher bookings from the Aegis, Patriot and two DRFM jammer programs that was partially offset by lower bookings related to the DEWS program for the F-15 platform.

Mercury’s total book-to-bill ratio for the first quarter of fiscal 2014 was 0.9, which exceeded the 0.8 book-to-bill ratio for the first quarter of last year. Defense book-to-bill of $0.9 for this year’s first quarter was similarly above the 0.8 ratio generated in the first quarter of last year.

The company ended the first quarter of fiscal 2014 with $133.3 million of total backlog, which was $13.1 million or 11% higher than the $120.2 million of backlog at the end of last year’s first quarter. Of the total ending backlog in the first quarter, $116.1 million or 87% is expected to be shipped within the next 12 months. $114.7 million of the ending first quarter backlog relates to defense, which is $6.8 million higher than last year’s first quarter defense backlog.

From a bottom line perspective, the company incurred a GAAP net loss of $2.3 million in this year’s first quarter, that was substantially smaller than the GAAP net loss of $7.2 million in last year’s first quarter. It should be noted that the company incurred a pre-tax restructuring charge of $5 million in last year’s first quarter in connection with headcount reductions that addressed the rapid slowdown in bookings and revenue tied to the threat of sequestration.

Absent the restructuring charge and Micronetics related transaction expenses, a $1.6 million or approximately 40% improvement in bottom line results in this year’s first quarter, compared to last year’s first quarter stem from higher sales volume and product mix related gross margin. The favorable product mix derived from higher year-over-year revenue from the company’s core digital signal processing business, which carries gross margins that are accretive to the company’s overall gross margin.

Adjusted EBITDA of $3.6 million for the first quarter of fiscal 2014 was $2 million higher or more than double the $1.6 million of adjusted EBITDA generated in the first quarter of last year, largely due to the smaller operating loss in this year’s first quarter. Relative to our stated financial guidance for the first quarter, we are – we are pleased to report that the company was at or above the high end of its guidance for all key financial measures.

First quarter revenue of $53.9 million was at the high end of our guidance of revenue between $48 million and $54 million. Reported GAAP loss per share of $0.07 for the first quarter was favorable to our guidance range for a net loss of between $0.08 and $0.14 per share. Finally, adjusted EBITDA of $3.6 million for the first quarter, comfortably exceeded guidance of $100,000 to $3.2 million.

Turning now to the balance sheet, the company ended first quarter of fiscal 2014 with cash and cash equivalents of $40.1 million and no debt, which was $1 million higher than the $39.1 million of cash and cash equivalents at the end of the fourth quarter of fiscal 2013. The company generated $1.1 million of free cash flow during the first quarter as $2.2 million of operating cash flow driven by the quarter’s cash earnings, was partially offset by $1.1 million of capital expenditures.

Turning to the second quarter guidance for fiscal 2014, while the company has seen an improvement in defense procurement activity and hence its financial performance since the first half of the last fiscal year, industry uncertainty, remains prevalent.

The DoD will be operating under a continuing resolution or CR for the U.S. government’s fiscal 2014 until mid-January with all of the limitations of CR that were outlined by Mark in his remarks. The mid-January data is also important, because it marks the timing of the next round of sequestration cuts that will occur unless a broader agreement is reached by Congress and the President to replace or reduce the impact of the sequester.

None of the fiscal 2014 budget submissions among the President, the House and the Senate factor in the legally mandated sequester budget levels for the DoD. Finally, the politicians at Washington will need to deal with raising the debt ceiling again, by the February-March timeframe in calendar year 2014, which may in fact implicate the DoD budget as a consequence to a potential resolution to this issue.

With this DoD budgetary uncertainty seemingly recurring theme, the company believes the prudent course of action as to continue managing the business conservatively. This entails forecasting revenue principally for backlog in order to minimize the buildup of working capital and ultimately, preserve liquidity. As such, we are continuing the practice from the last several quarters of providing only quarterly financial guidance.

With that in mind, for the second quarter of fiscal 2014, we are forecasting total revenue to be in the range of $48 to $54 million, which is comparable with the last several quarters. The estimated revenue range for the quarter assumes continued strength from the Aegis program, based on prior quarter bookings and the finalization this quarter of anticipated product shipment dates from our customers.

Consistent with previous quarters, we expect the split of second quarter revenue to be approximately 90% defense and 10% commercial. Within our stated revenue guidance, we are projecting gross margin to be in the range of 43% to 44%, which is one to two percentage points higher than this year’s first quarter and a healthy eight to nine percentage points higher than the second quarter of last year. The forecasted year-over-year improvement in gross margin is due to a recovery in the core digital single processing business with particular strength from the Aegis program.

Operating expenses are forecasted to be $27 million for the second quarter, which is largely in line with first quarter operating expenses. From a bottom line perspective, we are targeting a GAAP loss per share in the range of $0.06 to $0.12 per share for the second quarter, based on an estimated weighted average share count of 31 million shares. The loss per share forecast assumes an income tax benefit of approximately 36% for the second quarter, which is comparable to the first quarter. The loss per share range forecasted for the second quarter also includes an approximate $0.04 per share impact from the amortization of intangible assets.

Adjusted EBITDA for the second quarter is estimated to be between $400,000 and $3.5 million, which is slightly higher than the forecasted range the company provided for the first quarter. In terms of liquidity, we anticipate ending the quarter with cash and cash equivalents slightly higher than the $40.1 million at the end of the first quarter of fiscal 2014.

Operating cash flow generated from cash earnings and lower working capital is expected to be offset by a higher level of capital expenditures than prior quarters due to the buildout and equipment purchases related to the new Hudson, New Hampshire facility.

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

Question-and-Answer Session

Operator

Thanks. (Operator Instructions) Our first question comes from Tyler Hojo from Sidoti & Company. Your line is open.

Tyler E. Hojo – Sidoti & Co. LLC

Yes. Hi. Good evening everyone.

Mark Aslett

Hi, Tyler.

Tyler E. Hojo – Sidoti & Co. LLC

Hi. So just firstly, when we look at the top line guidance, I guess you’re kind of looking for things to be kind of where they were in Q1. I’m just wondering, is there any sort of swing factor to get you to the high end of the range, any sort of program that needs to both book and ship or something that you don’t have in hand today to get there?

Mark Aslett

Well, I think, we will have some book ship revenue. What we’ve been trying to focus on is, reduce the amount of book ship revenue that we – we’ve seen any particular quarter and that’s been tied to our focus on growing backlog. So we will have some book ship. however, I think overall, we feel right now, Tyler, that the risk level this quarter is actually probably less than what we anticipated last quarter. Probably, the biggest deal that we have in Q2 is related to Aegis, so which we feel is in pretty good shape right now.

Tyler E. Hojo – Sidoti & Co. LLC

Okay, great. and just some regards to R&D, it was up; I think about 24%-25% sequentially in the quarter. Anything to call out there and maybe, if could just, I know you’re not giving full-year guidance, but maybe you could just directionally talk about expectations for that line item.

Mark Aslett

Yes, Tyler, the increase sequentially is largely due to the fact that our level of customer funded development dropped in Q1 compared to the prior quarters and that’s largely due to the wind down of the Gorgan Stare development efforts that, as you know, the company has undertaken over the last several years. In terms of moving forward, I think our expectation is that over the course of the next several quarters, we have plenty of design wins that we have announced both this quarter and in prior quarters that we expect will be start – will start up that will absorb some of the lack of customer funding that we saw in Q1 and our expectation is that that will move forward in terms of absorbing that incremental cost.

Tyler E. Hojo – Sidoti & Co. LLC

Okay, great. And just maybe lastly from me, a question on AMDR, so I guess, we all know kind of where you were positioned, but if we look at Raytheon, is there any opportunity to perhaps gain a position on their team, my understanding is that they were using a proprietary offering, but just wondering what your perspective was?

Mark Aslett

Yes, I think it’s – I think the answer is yes, potentially, Tyler, probably more on the RF and the microwave side of things, but that said, it’s still very early days. So I think we’re clearly going to pursue it and we’ll see how the things evolve

Tyler E. Hojo – Sidoti & Co. LLC

Wonderful. I’ll hop back in the queue. Thanks a lot.

Mark Aslett

Okay.

Operator

Thank you. Our next question comes from Peter Arment from Sterne Agee. Your line is open.

Peter J. Arment – Sterne, Agee & Leach, Inc.

Yes, good afternoon, Mark, Kevin.

Mark Aslett

Hi, Peter.

Kevin M. Bisson

Hi, Peter.

Peter J. Arment – Sterne, Agee & Leach, Inc.

Mark, I appreciate the design win color you gave [indiscernible] defense. Given your kind of commentary talking about that 2014 looks like it’s going to be a kind of a mirror image of 2013 from a budget standpoint, when do you think the primes are going to act more aggressively on kind of the outsourcing, because it seems like that we’re not really seeing any sort of movement at least from this front or maybe you could just give us some color that maybe you are seeing some signs that you’re well positioned?

Mark Aslett

No, I think we are, Peter, in particular, if you look at say SEWIP Block 2, which is probably the largest program that we have in production right now, we see substantial opportunities associated with more outsourcing on that program, so basically, picking up more content per shipped set and basically taking over work on derivatives of the program. So I think there’s actually two levels of outsourcing going on simultaneously; one is in the, our traditional business, where the primes are outsourcing more of the development type work for the compute associated with sensor processing subsystems, but the other area that we’re actually seeing increased activity is in the RF and the microwave dimension and that’s one of the major reasons that we’re investing in the new Advanced Microelectronics Center in New Hampshire.

Peter J. Arment – Sterne, Agee & Leach, Inc.

Okay. And do you view that opportunity set in the RF to be bigger than the traditional development business?

Mark Aslett

I think right now, it’s going to be the fastest growing part of our business as we see it based upon either the expansion opportunities on the programs that we’ve won or new potential pursuits and I think it’s directly tied to what I said in my prepared remarks, which is in my mind the RF and microelectronics industry structure is somewhat broken and our customers or the primes, they’re looking for better alternative and the investments that we’ve made in terms of engineering resources, as well as this new MCE is actually. they seemed very excited about it and they’re looking for opportunities to outsource more work to a company like Mercury as a direct result of that. So I think it’s probably going to be the largest area of growth for us going forward.

Peter J. Arment – Sterne, Agee & Leach, Inc.

Okay. and then just lastly I guess where is your desire on obviously managing the business for break-even and to kind of preserve backlog and build that when you can, but still you want to take the manage of – these M&A opportunities, how are you viewing with that given a year forward from where we were last year?

Mark Aslett

Sure. I think it hasn’t really changed. We have clearly finished Phase I of our M&A agenda and we built we believe a very, very unique outset. With the only commercialized company that we know well in the defense electronics industry that’s truly got the end-to-end capabilities to build the next generation of sensor processing subsystems. What we don’t believe would be the right thing for us to do right now, although we have the facility in place is to lever up in our financial risk on top of industry risk.

So we have really focused on integrating the businesses that we have acquired and gaining the efficiencies as a result of that integration and we see additional opportunities for efficiencies going forward, particularly as we bring the new AMC online and start to merge different facilities together. So we’re really focused on integrating what we have and we’ve prepared for the next phase, but we don’t think in this industry environment period, it makes sense to kind of lever up.

Peter J. Arment – Sterne, Agee & Leach, Inc.

Okay, thank you.

Operator

Thank you. our next question comes from Sheila Kahyaoglu from Jeffries. Your line is open.

Sheila Kahyaoglu – Jeffries LLC

Thank you. good afternoon, everyone.

Mark Aslett

Hi, Sheila.

Kevin M. Bisson

Hi, Sheila.

Sheila Kahyaoglu – Jeffries LLC

Could you comment on what organic revenue growth was in the quarter?

Kevin M. Bisson

Yeah Sheila, I think we – as you know, Micronetics was acquired in the first quarter of last year.

Sheila Kahyaoglu – Jeffries LLC

Yeah.

Kevin M. Bisson

So we’ve effectively – included it as in total with MCE and frankly, it’s not that meaningful given the fact that we had Micronetics for most of the first quarter of last year. so for all kinds of purposes, it’s not really a meaningful number.

Sheila Kahyaoglu – Jeffries LLC

Okay. so you’ve turned the corner at about 9% organic growth rate and I mean going back to, I think Peter’s question in terms of a break-even, it seems that I mean what will keep you from going to a break-even at this point? is it just the higher R&D this quarter or was there anything else, because now that – I guess you had a $55 million run rate, what else do we – what are the next steps from here?

Kevin M. Bisson

So I would say, Sheila, that we are committed to achieving our target business model over time. and I think we can get there on a number of different ways, depending upon the assumptions that we make regarding kind of the budget environment, the performance of ongoing programs, some of the content – the opportunities for growth around content expansion combined with some of the efficiencies related to the ongoing integration activities that I’ve just spoken about.

So we do believe, we can get back to profitability. We do believe we can get back to significant levels of growth, but given the industry backdrop, it could take sometime, but we’re committed to achieving the target model.

Sheila Kahyaoglu – Jeffries LLC

Okay. I understand and maybe, can you comment about what’s there is in maintenance activity look like in the quarter just to get a sense of the shorter cycle activity?

Mark Aslett

It was consistent with what we’ve seen in prior quarters.

Sheila Kahyaoglu – Jeffries LLC

That was up 20% last quarter?

Mark Aslett

So, roughly flat.

Sheila Kahyaoglu – Jeffries LLC

Okay, got it. And I – can you just give me a sense of what headcount was that for the quarter?

Mark Aslett

Yes, came in it at 752, which was down 1%.

Sheila Kahyaoglu – Jeffries LLC

Yes, yes. Got it, okay. Thank you very much.

Mark Aslett

Yes.

Operator

Thank you. Our next question comes from Brian Ruttenbur from CRT Capital. Your line is open.

Brian W. Ruttenbur – CRT Capital Group LLC

Great, thank you very much. Can you first of all go over the logic that you used on switching teams from Raytheon to Lockheed on AMDR, I know that didn’t pan out in other time, I’m sure it has, but just kind of go through the logic with us on why you did switch and would you redo it now in hindsight or was it a good decision, I’m just trying to understand the logic behind it?

Mark Aslett

So we didn’t switch Brian, I think we were partnered with Lockheed on obviously, Aegis as well as the bidden proposal for AMDR. Clearly, they weren’t successful and the protest at the award and we’ll see what happened to the result of that. I think the question that I got asked is, is there opportunities potentially going forward working with Raytheon, and I don’t think to say, we’ve seen opportunity in the area that we’re working with Lockheed, which is largely in the traditional compute part of our business. but maybe there’s some opportunity going forward on the RF and microwave side of things, although as I say, it’s very, very early stages and there’s a lot of water that’s going to pass under the bridge between now and then. So hopefully, that cleared out your question.

Brian W. Ruttenbur – CRT Capital Group LLC

Okay. And then final question, I think it’s been asked from a couple of different angles, but you mentioned that target business model and you talk about being a target business model, what is that target business model, is it $55 million in revenue and break-even, I just don’t recall it?

Mark Aslett

Okay. so we haven’t updated the target business model. It’s the prior model that we’ve had as probably over a year now and it’s calling for an adjusted EBITDA in the 18% to 22% and if you recall we achieved in fiscal year 2012 during more normal industry conditions at 20% adjusted EBITDA.

So we do believe there is some of the more traditional programs start to come – kick into gear and if the industry conditions improve and if some of the larger programs that were involved with start to move into production. We can get back to the levels that we were previously.

Brian W. Ruttenbur – CRT Capital Group LLC

Great. Thank you very much.

Mark Aslett

Okay. Thanks, Brian.

Operator

Thank you. Our next question comes from Jonathan Ho from William Blair. Your line is open.

Jonathan F. Ho – William Blair & Co. LLC

Good afternoon, guys.

Mark Aslett

Hi, Jonathan.

Kevin M. Bisson

Hi, Jonathan.

Jonathan F. Ho – William Blair & Co. LLC

So just wanted to start out on, did you guys see any unusual activity around the end of the September budget flush in terms of maybe programs that you expected to come in, but you look to sit out or I mean any sort of surprises around the budget flush activity?

Mark Aslett

I don’t think there was much of a budget flush actually this year or in – I think as we’ve said in prior years, Jonathan, given our position in the industry, we typically don’t see that as the time that other companies, prime contractors that are operating at a higher level than we typically see. So I don’t think we saw anything unusual. I think the government towards the back-end of 2013, it’s continued into 2014, is spending at a lower rate, largely because I think they don’t want to repeat that what they saw during government fiscal 2013, where they were spending in the first part of the year at a rate that was consistent with the budget submissions, but due to the Budget Control Act, less money was available, and the Army, in particular, saw some shortfalls. I don’t think they’re going to repeat that this year, and so I think they’re taking a more measured approach. But for us, we haven’t really noticed a material difference in the overall environment. I think it’s very similar to what we’ve been operating under in the past three or four quarters and we feel that we actually have learned a lot how to operate effectively in this environment.

Jonathan F. Ho – William Blair & Co. LLC

Got it. And just relative to AMDR and your expectations, I mean, with that program, maybe diminishing value or maybe no longer available, can you give us a sense, does that impact your perspective in terms of your ability to grow at 10% or better on the top line or is it something that you can definitely sort of power through with other activity overtime?

Mark Aslett

Sure, it’s a good question. If you look at the timing on AMDR, the LRIP wasn’t expected to go into – the program wasn’t expected to go into LRIP until government 2016, with full production until 2020. So it’s a fair amount of time away in terms of its ability to impact the growth of Mercury kind of in the short-term. I think there are other opportunities that we feel very significant in terms of our ability to continue to grow the top line, and in particular, I think we see a lot of opportunity in SEWIP Block 2.

It’s largely as a result of the acquisition of Micronetics that we did and largely as a result of the investments that we’re making in the new Advanced Microelectronics Center and we’ll talk about the opportunity that we see there at our Investor Day in November. But that’s a very important program for us, and as you know, it’s really just moved into the low rate initial production phase, it hasn’t even yet hit production. So we do feel that we’re going to grow and not only with SEWIP Block 2 and Block 3, but as you know, this quarter, we also won the F-16 SABR award with Northrop Grumman. So we’ve got a portfolio of programs. Yes, I’m disappointed that we didn’t win AMDR, but it’s a number of programs – it’s one of the number of programs that we’re involved within at the ceiling.

Jonathan F. Ho – William Blair & Co. LLC

Great, thank you.

Operator

Thank you. (Operator Instructions) Our next question comes from Michael Ciarmoli from KeyBanc. Your line is open.

Michael F. Ciarmoli – KeyBanc Capital Markets, Inc.

Hey. Good evening, guys. Thanks for taking my questions.

Mark Aslett

Hi, Mike.

Kevin M. Bisson

Hi, Mike.

Michael F. Ciarmoli – KeyBanc Capital Markets, Inc.

How are you guys?

Mark Aslett

Great.

Michael F. Ciarmoli – KeyBanc Capital Markets, Inc.

Just to follow-up on the other side of Tyler’s question with the guidance for next quarter. We’re one month into this quarter, it sounds like you’re managing through it quite well. The impacts of the shutdown, I guess, didn’t have too much of an influence. So help me understand what would drive a sequential 11% decline in the coming quarter to get you down to that low end of the guidance?

Mark Aslett

So I think overall, just the timing of deals, is it enough to kind of [indiscernible], I think that is the difference between the high end and the low end. It’s not like last quarter specifically, where we said the difference between the top end of the range and the bottom end of the range was the specific Aegis shipment that we’re expecting that we haven’t yet locked down the dates with the customers. So I think we’re just trying to be conservative, Mike, to make sure that we can deliver our numbers as we’re guiding them, so…

Michael F. Ciarmoli – KeyBanc Capital Markets, Inc.

Yes, totally appreciate that work. What about – on the topic of the target model and given this environment, I mean, they are grumblings out there that we might stay in the sort of continuing resolutions, sequestration type environment through potentially the 2014 elections or maybe even the 2016 presidential election. I mean, what would you guys have to change? It sounds like you guys have gotten ahead of this to some extent, it sounds like you’re getting your lags with this over the last couple of quarters. I mean, would that create incremental kind of headwinds for you guys or would it just be kind of more of this similar operating environment?

Mark Aslett

I think we took a very conservative approach to the way in which we plan fiscal 2014, and I think it’s a direct result of what we experienced during fiscal 2013. I think, as you know, we were probably one of the first to see the impact of kind of the – our customers preparing for the potential of sequestration and did have a material impact on the business.

To us, I think we figured out how to operate in this environment. I think we figured out also how to plan more effectively in this environment, and so I don’t see a material change to the business. I think we’re operating it very effectively. Most of the planning that we’re doing and what we’re planning from a growth perspective is basically around programs that’s either or already in production or have transitioned into production and that we’ve already won. And so we feel pretty good about our position and our ability to be able to manage through things given the turbulence that we see down in DC. I think if anything I would kind of summarize to say that right now we feel there’s more upside opportunity than what there is downside risk in the business.

Michael F. Ciarmoli – KeyBanc Capital Markets, Inc.

Could you, and I’m not asking for longer-term guidance, but if this environment persists, given the portfolio of programs you have and what’s going to be ramping, can you get into the target EBITDA range in this current environment if it persists through, let’s say, worst case scenario, the 2016 presidential election?

Mark Aslett

I think the answer to that we believe is, yes, and it’s clearly based on a lot of assumptions regarding what happens with the budget environment, what happens to our existing programs, our ability to capture additional content on some of the programs that we’re already involved with, but we’re pursuing new design wins as well as our ability to capture the synergies associated with the ongoing integration as the businesses that we’ve acquired. But as I said on the call, we are committed to achieving our target business model and we believe that under a realistic set of assumptions, we can get there in a reasonable period of time.

Michael F. Ciarmoli – KeyBanc Capital Markets, Inc.

Fair enough. And if I’ll just sneak one more in here and I’ll jump out of the way.

Mark Aslett

Sure, Mike.

Michael F. Ciarmoli – KeyBanc Capital Markets, Inc.

I think you mentioned on SEWIP, you’ve got the opportunity to pick up or increase your shipped set content taking on more work, what’s driving that or is that just primes outsourcing more to you, are you displacing some other suppliers, can you maybe just elaborate there?

Mark Aslett

Sure. I think, first of all, we’ve got a lot more capability to offer the direct result of the acquisition of Micronetics. So we were involved in the program previously and as we’re going through the due diligence with Micronetics, we were pretty excited about the potential of taking some of their capabilities into our existing customer base. And this is probably the primary example and we see a lot of potential upside opportunities as the result of that acquisition.

We also see that in the RF and the microwave domain, the industry structure we believe is somewhat broken and it’s kind of a hourglass shaped industry structure, where you’ve got a couple of companies at the top, one of which, in particular, is competing with our customers and many of them are trying to move away from that particular supplier. We’ve got other companies that are emphasizing defense less and more industrials and kind of scientific parts of their business, and we see opportunities of basically taking share from both of those companies.

In the middle, you’ve got a number of or kind of a dearth of companies and we are kind of positioning ourselves as that federal alternative of that go to company and what characterizes that is not only the engineering development capability, but the ability to be able to manufacture in volume and that’s really where that AMC – the new AMC that we’re building comes into play and I think we are very well positioned there to basically pickup more work either with companies above us or companies that are below us that don’t have the ability to scale, and so we are pretty excited actually about the potential that we see in the RF and the microwave domain.

Michael F. Ciarmoli – KeyBanc Capital Markets, Inc.

Okay. Great. Thanks a lot guys.

Mark Aslett

Okay.

Kevin M. Bisson

Thanks, Mike.

Operator

Mr. Aslett, it appears there are no further questions. Therefore I’d like to turn the call back over to you for closing remarks.

Mark Aslett

Okay. Well, thank you all very much for listening and for joining the call here today. We hope to see you at our Investor Day in early November. Thanks very much. Bye-bye.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program and you may all disconnect at this time.

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