Mercury Computer Systems Inc. F2Q10 (Qtr Ended 12/31/09) Earnings Call Transcript

Jan.26.10 | About: Mercury Systems, (MRCY)

Mercury Computer Systems, Inc. (NASDAQ:MRCY)

F2Q10 Earnings Call

January 26, 2010 5:00 pm ET

Executives

Bob Hult - Senior Vice President & Chief Financial Officer

Mark Aslett - President & Chief Executive Officer

Analysts

Mark Jordan - Noble Financial

Steve Levenson - Stifel

Tyler Hojo - Sidoti & Co.

Jonathan Ho - William Blair

Michael Ciarmoli - Boenning & Scattergood

Operator

Good day, and welcome everyone to the Mercury Computer Systems, Inc. second quarter fiscal 2010 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, Mr. Bob Hult; please go ahead, sir.

Bob Hult

Good evening 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 release, you can find it on our website, 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 second quarter fiscal year 2010 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. I would 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 a non-GAAP financial measure, specifically adjusted EBIDTA.

Adjusted EBIDTA excludes interest income and expense, income taxes, depreciation, amortization of acquired intangible assets, impairment of long lived assets, stock-based compensation costs and restructuring expense. A reconciliation of adjusted EBITDA to GAAP net income from continuing operations is included in the press release we issued this afternoon.

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

Mark Aslett

Thanks, Bob. Good afternoon, everyone, and thanks for joining us. I will begin with an update on our business for the second quarter. Bob will review the financials and discuss our guidance for the third quarter and then we will open it up to your questions. This was another quarter of very solid progress for Mercury. On our Q1 call, I noted that we expected a large missile defense radar order to push from Q2 to Q3.

I’m pleased to report that the receipt of this $28 million order during the quarter led to a very strong bookings performance. Defense bookings combining ACS and Mercury Federal grew year-over-year by 43% to $47.8 million. Total revenue for the second quarter exceeded the high end of our guidance range by more than $3 million. We reported GAAP earnings of $0.10 per share compared with guidance ever a $0.04 to $0.08 loss.

Our adjusted EBIDTA margin increased from 8% in Q2 of ‘09 to 13% this quarter and operating cash flow grew to $5.2 million. Total bookings for the second quarter were up 37% from Q2 of fiscal 2009 and 15% sequentially to $56.1 million. This included the missile defense booking I just mentioned which was the largest single purchase order in Mercury’s history.

Although we have the PO in hand, the timing of deliveries for this booking is still being determined with our customer. This uncertainty will be reflected in our guidance, which Bob will cover in his prepared remarks. Our book-to-bill in defense for the second quarter of fiscal 2010 was $1.37 up from $0.93 in the sequential first quarter and $0.99 in Q2 of fiscal 2009.

Year-over-year, our total backlog is up 47% to $110.4 million, and our defense backlog increased to 55%. In addition, as we expected, our 12 month backlog reversed the decline we have seen for the past few quarters, rising 41% sequentially from Q1 and 33% year-over-year to $88.2 million. Total defense revenue in the second quarter, including ACS and Mercury Federal, declined 15% sequentially and grew by 3% year-over-year to $34.8 million.

Looking at our results for the first half of the fiscal year, our defense revenues and bookings grew 12% and 27% respectively, evidence of the progress we’ve made in strengthening and growing our core business.

For the first half of fiscal 2010, Mercury’s total bookings were up 20% year-over-year and total backlog is up 47%. Our results for the first half also demonstrate our success in improving Mercury’s underlying operations. Revenue for the first half grew 3% year-over-year reflecting the weakness in our commercial business, but gross margin is up a full two percentage points from the first half last year, driven mainly by a favorable business mix.

GAAP earnings were up from $0.01 per share in H1 of fiscal ‘09 to $0.30 per share for the first half this year. Our adjusted EBIDTA margin has improved from $8.6 million, or 10% in the first half last year to $13.8 million, or 15% against a longer term pro forma target goal to 17% to 18%.

We’ve developed our strategy for driving growth and profitability in the business with an eye toward the fundamental changes taking place in defense procurement. Against an expected backdrop of essentially flat overall spending for the next several years, the DoD is clearly shifting its priorities from major new weapon systems development to upgrades of existing programs and platforms.

At the macro level, these upgrades largely revolve around four areas, better sensors, better signal processing and computing, enhanced algorithms, and better communications on and off the platform. The DoD is also in the midst of broad based procurement reform, shifting more emphasis toward quick reaction capabilities or QRC and more firm fixed price contracting.

As these changes take hold, the primes are beginning to outsource more to best of breed companies like Mercury. We’ve refocused our business to grow and prosper in this new environment. Mercury is now strongly positioned in several areas within the defense electronics market that should continue to be well funded in the years ahead.

The first of these markets is airborne ISR, which represents about 50% of the military's total spending on defense electronics. Within the airborne ISR space, among the platforms seeing the most robust growth in funding are unmanned platforms such as the Global Hawk, Reaper and Predator UAVs.

We’ve leveraged our historically strong position in the radar domain to drive significant bookings growth related to the SAR or synthetic aperture radars on these platforms as well as important EW signals intelligence upgrades. Longer term, we’ve been investing in new products to grow the EO/IR application segment, given the importance of full motion video in the persistent ISR market.

Looking forward, the DoD is also likely to upgrade the Radar on other airborne platforms to AESA type radars or Actively Electronically Scanned Arrays. AESA radars allows the platform to track more targets at a much greater distance, while still maintaining a self profile.

Longer term, Mercury should benefit from these types of upgrades as well. The second of our key markets is missile defense where Mercury’s radar signal processing is positioned on two of the preeminent BMD programs: the first is Aegis, the naval ballistic missile defense capability, which should soon be in production and which is Mercury’s largest single program.

The second is Patriot, the ground based missile defense platform, which is clearly seeing a resurgence. Aegis and Patriot have been thoroughly covered by the news media in recent months. The Obama administration has decided to deploy a combination of Aegis and Patriot, to protect our Euro zone allies from a potential ballistic missile attack by Iran instead of using fixed ground based missile defense.

At the same time, Aegis equipped ships in the Pacific are playing an increasingly important role as the first line of defense against a potential missile attack on our allies in Asia by North Korea. Revenues and bookings in our radar business for the first half of fiscal 2010 were up 14% and 56% respectively.

Our third growth market is electronic warfare, encompassing electronic, signal and communications intelligence processing. EW is an area of growing strength and importance to Mercury on the ground, at sea and in the air. A good example of ground based EW is counter-IED. This is Mercury’s fourth growth market in a space where we are creating a strong position for ourselves longer term. As you probably know, improvised explosive devices or IEDs are one of the most serious threats being encountered by our soldiers in Afghanistan.

The DoD has mobilized the defense electronics community around a push for technology that can effectively detect and counter roadside bombs. Mercury has been down selected by two primes to work on the next generation counter-IED program of record. Longer term, this could be a major opportunity for us if the funding for production volumes comes through as we expect it will.

With this as a background on our market opportunities, let’s look at the opportunities from a business perspective. We believe there are five key factors that will drive the expansion of our business on both the top and bottom lines over the next several years. The first of these factors is the potential for re-growth in ACS commercial.

On a call last quarter, I said that it looked like our commercial business might be bouncing along the bottom. This seemed to be the case in the second quarter also. Revenue in the commercial business was down 7% year-over-year, but up 57% sequentially. This growth was largely driven by our business with Artiza Networks for test equipment in the 4G wireless communication space.

Commercial bookings were $8.3 million, up 11% year-over-year, but down 23% sequentially. If growth in our commercial business does materialize, it will likely be driven by our key semiconductor customers, KLA-Tencor and ASML. These companies are at different stages in their new product introduction cycle. We remain hopeful for a rebound in the second half of fiscal 2010.

The second growth driver is increasing the number and value of our design wins. One of the key elements in defense procurement reform is the DoD’s increasing pressure on the primes for QRC. This in turn puts more pressure on us to increase our product velocity in order to win new designs.

To accomplish this, we’ve been executing on a major refresh in both our signal processing and multi computer product lines. At the same time, we’ve been creating significant hardware design reuse and leverage in the business. We are working to enhance product velocity even further in fiscal 2010 with more design and reuse and leverage in the software side of our model.

The DoD’s new approach to procurement also puts more emphasis on open standards. Our focus for this effort is Mercury’s leadership in the industry and in the working group developing the next generation embedded systems standard called OpenVPX. OpenVPX was recently ratified and we have positioned ourselves as first to market by developing a broad range of new OpenVPX products.

As we announced back in October, one of the major primes awarded us the industry's first OpenVPX order valued at $6 million for advanced signal processing in a major radar system upgrade. Mercury won eight new design wins in the second quarter of 2010, five in defense and three in commercial, compared with a total of 10 design wins in Q2 last year.

The total five year probable value grew from $63 million in Q2 of fiscal ‘09 to $69 million this quarter. In defense specifically, the five year probable value more than doubled from $31 million in Q2 last year to $66 million. Defense electronics is a high mix, low volume business, where the key is not only product velocity, but also product customization.

Historically, there was no way for the primes to obtain both high performance and highly customized solution using open standards. Mercury’s OpenVPX solutions makes this possible for the first time. OpenVPX will also help us capitalize on our third business growth opportunity, developing our service and systems integration business within ACS.

From a strategic perspective, our goal for this new business is to penetrate the two thirds of the defense electronics market that in the past are focused on hardware alone has prevented us from addressing. This opportunity stems for another aspect of defense procurement reform, preventing cost over runs by shifting towards more firm fixed price contract awards.

One consequence of fixed price is that it could elevate the risk level for the primes. To mitigate this risk, the primes are outsourcing the capabilities or technologies, where they lack strength to best of breed companies in those particular areas.

Our services and systems integration business is a way to capture this opportunity. We believe that QRC and fixed price procurement will continue to change the industry structure over time towards more commercial items, open systems architectures like OpenVPX and more complete solutions instead of boards [ph].

We also believe that procurement reform will create a strong preference for partners who can provide more value added signal processing signal subsystems. This added value will come from a combination of ISR domain expertise and faster time to market through improved product velocity

With our service and systems integration business, as well as Mercury Federal, we have positioned ourselves as the ideal partner for the primes in this new market, a best of breed platform independent, ISR systems and services company, with a specialty in high end digital image, signal and sensor processing.

In the second quarter, services and systems integration revenue grew from $1.4 million in Q2 last year to $6.8 million, nearly a four fold increase. On a sequential basis, revenue for Q2 grew 37%. The fourth on our list of five business opportunities is growth in federal services through Mercury Federal.

Mercury Federal takes the capabilities we have in the services and systems integration business to the next level, so we can begin penetrating the broader defense electronics market that we haven’t previously addressed. We believe this potential is ten times larger than the commercial item defense electronics market that our ACS business has targeted in the past.

The American military has made substantial progress, essentially digitizing the battlefield by putting computers on everything from weapon systems to the soldier to the ordinance itself. The resulting time to information gap is a critical challenge being address virtually everywhere in the DoD's technology budget and nowhere more intensively than in ISR.

The hybrid business model we created with Mercury Federal enables us to address this challenge by serving as the architects for advance signal image and sensor processing subsystems on next generation ISR programs and platforms. Following a strong first quarter of 2010, Mercury Federal's Q2 bookings was sequentially at $400,000 while the revenue came in slightly high sequentially at $3.3 million.

The growth to date is primarily being driven by our major program, Gorgon Stare, where we are providing the image processing subsystem. Gorgon Stare represents a breakthrough providing Reaper UAVs the ability to collect and transmit wide area motion imagery directly to the analysts and soldiers who need it in time for it to be actionable.

I’m very pleased to announce that Dave Martinez has accepted the role of President of Mercury Federal and will join us in early March. Dave formerly was responsible for an organization with 330 people and a budget of a $140 million dollars, serving as the head of ISR systems and technology division at the MIT Lincoln Laboratory. We are thrilled to have someone of Dave’s stature in ISR community joining the Mercury team and helping to grow our newest business. The fifth on our list of business opportunities is growth through acquisitions.

As we begin to explore this potential, we will be looking to accomplish three things. Number one, strengthen our ISR domain expertise in Mercury Federal. Second, grow our core defense business by improving the timing and/or access to the most promising next generation ISR platform and programs; and thirdly, increase our overall footprint through increased platform production content.

To sum up, we believe that Mercury is well positioned to benefit from the DoD strategic commitment to ISR and its procurement focus on best of breed commercial items and open systems architectures in the image, signal and sensor processing domain. We are improving our product velocity and winning new designs in our key defense markets.

In addition, our commercial business appears to have stabilized with potential upside from a rebound in the semiconductor market. We have made good progress in our growth and profitability goals in the first half of fiscal 2010 and we are looking forward to extending our progress in the second half and beyond.

With that, I will turn it over to you, Bob.

Bob Hult

Thank you, Mark. As a reminder, I’ll be discussing our results on a GAAP basis. Please note that commencing with FY 2010, our non-GAAP measure for reporting financial performance is adjusted EBIDTA. We believe that GAAP combined with adjusted EBIDTA is consistent with practices in the defense industry. In addition, now that we’ve divested all of our non-core businesses and treated them as discontinued operations, the numbers, I will be discussing relate only to continuing operations.

Total revenue for the second quarter of fiscal 2010 was $45.2 million, well above the high end of our guidance range of $40 million to $42 million. This compares with $45.1 million in revenue for the second quarter of fiscal 2009. Please note that in Q1 of fiscal 2010, Mercury elected to adopt a new EITF 08-1 revenue arrangements with multiple deliverables.

Although, Mercury was not required to adopt this guidance until Q1 of fiscal 2011, we elected to early adopt as the company feels that this guidance allows for the recognition of revenue for an arrangement with multiple deliverables to more closely mirror the economics of the arrangement. As a result of this adoption, in Q1 of fiscal 2010, Mercury recognized $2 million that would have been deferred under the previous guidance, EITF 00-21 for multiple element arrangements.

In Q2 of fiscal 2010, we recognized a net $2.2 million for a year-to-date incremental revenue amount of $4.2 million. GAAP income from continuing operations for the second quarter of fiscal 2010 was $2.4 million or $0.10 per diluted share on approximately 22.9 million shares outstanding.

The upside from our Q2 guidance of negative $0.08 to negative $0.04 per share was driven by two factors. Higher revenues and higher gross margins primarily driven by reduced other costs of other goods sold. For last year’s second quarter, Mercury reported a GAAP loss from continuing operations of $1.2 million or a negative $0.05 per share.

Looking at our revenues by operating unit, revenue in ACS, including both defense and commercial for the second quarter of fiscal 2010 was $43.8 million, basically flat from $44.0 million in Q2 of last year. Our services and systems integration business within ACS posted another quarter of strong growth, delivering $6.8 million in revenue, compared with $1.4 million in Q2 last year.

Our Mercury Federal Systems segment also turned in another excellent quarter as revenue increased to $3.3 million from $1.1 million a year ago. We’re continuing to deliver solid results in our core defense business. Total defense revenue for the second quarter, including ACS defense and MFS, grew 3% year-over-year to $34.8 million from $33.9 million in the second quarter of fiscal 2009. Commercial revenue for the second quarter of fiscal 2010 was $10.4 million, down 7% from the $11.2 million reported in Q2 last year.

Mercury’s total book-to-bill for the second quarter including ACS and Mercury Federal was 1.24 compared with 1.03 in the sequential first quarter and 0.91 in Q2 last year. Mercury’s Q2 total backlog including deferred revenue was $110.4 million. This compares with backlog of $99.4 million for the sequential first quarter and $75 million in Q2 of fiscal 2009. Approximately 94% of our current backlog relates to defense.

In addition, $88.2 million or approximately 80% of our total Q2 backlog relates to shipment scheduled within the next 12 months. This is up significantly compared with Q1 and year-over-year and is a reversal in the trend towards lower numbers we’ve seen for the past several quarters. As our backlog continues to grow, not only does our near term revenue visibility improve, but our ability to execute future quarters in a more linear shipment fashion will also eventually improve.

Mercury’s adjusted EBIDTA for the second quarter of fiscal 2010 was $6.1 million. This compares with $3.5 million for the second quarter of fiscal 2009. Adjusted EBIDTA for Q2, 2010 excludes the impact of approximately $3.7 million in charges as follows: $0.2 million in interest income, $0.1 million in interest expense, $0.4 million in taxes, $1.2 million in depreciation, $0.4 million in amortization of acquired intangible assets, $0.2 million in impairment charges and $1.5 million in stock-based compensation charges.

A reconciliation of adjusted EBIDTA to GAAP net income of continuing operations is included in the press release we issued this afternoon. We used a tax rate of 15% for the second quarter of fiscal 2010 and expect 16% to be our estimated tax rate for the full fiscal year. This reflects our latest view on the release of the valuation allowance on our deferred tax assets and our ability to utilize them in future periods.

We do expect to evidence a more normalized estimated tax rate in the 36% tax range for FY ‘11. Our Q2 results again demonstrate the leverage in our business model. Gross margin improved to 58.5%, significantly better than our guidance range of 52% to 53% driven by three factors. First, a higher revenue, second, a favorable product mix; and third, lower fixed manufacturing costs and other costs of goods sold.

In addition, as I mentioned last quarter, our investments in enhanced engineering methods and supply chain capabilities continue to improve product quality and time to market. As a result, we are seeing declines in warranty costs, inventory provisions and scrap. Operating expenses for the second quarter of fiscal 2010 were $24 million, inline with the assumptions underlying our guidance of approximately $23 million to $24 million.

In Q2 last year, operating expenses were $26.2 million. We are continuing to make good progress, improving the underlying operations of the business in terms of our supply chain infrastructure and working capital and in our ability to generate cash from operations. We continue to believe we are well positioned to close in on our target business model as we expand Mercury’s addressable market.

Inventory was up by $2.7 million in Q2 from the sequential first quarter, but down year-over-year by $3.6 million. Inventory turns were 4.3 down from 5.5 sequentially but up from 3.7 a year ago. Second quarter DSOs were 62 days, compared to 67 in the sequential first quarter. Mercury generated $3.2 million in positive free cash flow in Q2, up from $1.8 million in Q1 and $1.6 million in Q2 last year.

Turning to the balance sheet, cash, cash equivalents and marketable securities at the end of the second quarter of FY ‘10 totaled $96.6 million. This compares with $94 million at the end of the sequential first quarter. As a reminder, our auction rate securities settlement with UBS entitles us to full repayment of our ARS portfolio at par on June 30, 2010. In the interim, we continue to have a $33 million zero cost loan from UBS. At the end of the second quarter, our total employee headcount excluding contractors was 525 compared with 519 at the end of Q1.

Moving on to guidance, for the third quarter of fiscal 2010, we currently expect a revenue range of $41 million to $43 million. These estimates do not include any revenue associated with the large missile defense radar order received by Mercury in the second quarter of fiscal 2010. We anticipate reporting Q3 gross margin of approximately 50% to 51% down from Q2 due to business and product mix shifts and lower volumes across our fixed manufacturing costs.

Our third quarter operating expenses are currently anticipated to be approximately $25 million. CapEx for the third quarter of fiscal 2010 is projected to be approximately $2.5 million. We expect to report a Q3 GAAP loss from continuing operations in the range of negative $0.15 to negative $0.11 on approximately $23.1 million shares outstanding.

Turning to Mercury’s adjusted EBIDTA for the third quarter of fiscal 2010, our estimate excludes the following approximate amounts: $1.2 million in stock-based compensation costs, interest income of $0.1 million, interest expense of $0.1 million, $0.4 million in amortization of acquired intangible assets, and depreciation of $1.4 million.

As I said, our estimated tax rate for fiscal 2010 is expected to be approximately 16%. As a result, adjusted EBIDTA for Q3 FY10 is currently expected to be negative $1.1 million to a positive $100,000. Again, these anticipated Q3 results do not include any revenue from the large radar order we received in Q2. Should a portion of this order ship for revenue in the third quarter of fiscal 2010, we will promptly update these estimates and our guidance.

Because of the circumstances related to the timing of the shipments for this order, and since Mercury does expect to ship and recognize revenue on a portion of this order in fiscal year 2010, we have decided to provide you with a revenue estimate for the full year fiscal 2010. For the full year, we currently expect Mercury’s total revenue to be approximately $195 million. Mercury does not expect to provide full year revenue guidance on a regular basis going forward.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Jordan - Noble Financial.

Mark Jordan - Noble Financial

I’d like to talk a little bit about the revenues and see if I understand what you’re talking about here. Given the full year model and we should be in sort of $42 million range in Q3, that would imply about $60 million in the fourth quarter. Given the $28 million contract, if you were to say your normalized run rate is about 45, that would imply about $15 million sort of extraordinary benefit in the fourth quarter.

So should we assume that roughly about half of that contract in essence you’re estimating ships here in the current fiscal year, primarily right now in the fourth quarter?

Mark Aslett

Mark, we’re not being specific in terms of the actual amount. Because as we said on the call, in the prepared remarks, we do anticipate a portion of that $28 million being shipped for revenue in the second half of the year.

Mark Jordan - Noble Financial

It is not my thought process of maybe half of that’s realized to boost you to that 60 is not an unreasonable guesstimate on my part?

Mark Aslett

We’re going to ship a portion of this to revenue in the second half of the year.

Bob Hult

Your thought process is correct. No question there. You do the math.

Mark Jordan - Noble Financial

Just from a duration standpoint if in fact, that one contract tends to inflate quarters as it’s executed, should we assume that that’s all shipped, the incremental amounts will be shipped in the first and second quarters of next year?

Mark Aslett

The $28 million will play out over the remaining part of FY10 and also FY11. That said, we do expect to get additional bookings associated with this program over the coming quarters. So this is not the only booking that we’ll see.

Mark Jordan - Noble Financial

Can you talk a little bit about sort of the M&A marketplace, you clearly just say on a net basis you’ve got about $68.7 million worth of cash, or near cash when the UBS transaction settles out. Plus you have the $100 million shelf. How realistic is it and really where are you looking in terms of acquisitions that would be something that we should count upon say in the next 12 months?

Mark Aslett

Let’s start with what we’re looking for and hopefully we’ve been pretty consistent there in terms of the major emphasis. First of all, we’re looking to strengthen our ISR domain expertise particularly in Mercury Federal. We believe that the migration from boards to systems with more domain specific content in the ISR space will be important differentiator over time.

Secondly, we are looking to grow the core defense business by improving the timing in our access to these next generation ISR programs and platforms, and thirdly, it is about increasing our overall footprint from a production content perspective going forward.

So we really got three goals in mind. I think that we are still at a relatively early stage in terms of the acquisition process. We are out there talking to companies and I think there are companies that fit within the three goals that I have just outlined.

Mark Jordan - Noble Financial

Can you talk a little bit about the commercial marketplace and some of our semiconductor customers? We have tended to see an improvement in some of the fortunes for some of the semiconductor manufacturers here over the last six months or so. I was wondering what signs that you have seen that gives you a sense of support or hope that you are going to see improved business levels out of your two primary semiconductor customers in the second half of fiscal 2010?

Mark Aslett

Let’s start with really what happened with semiconductor in Q2. Year-over-year, semi bookings at $4.7 million were up 48%. They were down slightly 3% on a sequential basis. For H1, on a year-over-year basis, semi bookings at $9.6 million were up 27%. I think we already are starting to see a little bit of pick up. Clearly our customers are feeling more confident in terms of seeing increased demand. However, that said, we have got two different customers at two different stages in their new product introduction cycles.

In addition to that, the two customers that we have are actually in different parts of the semi-cap space which could cause a timing difference in terms of the demand pick up to Mercury. I think the last point on that is we are current -- one of our customers in particular is seeing more growth in their existing product line which is much more price sensitive versus the newly introduced high end system of which we are a part. So I think overall, the customer base is definitely feeling better about what they are seeing but we have got some differences in terms of the two customers themselves.

Operator

Your next question comes from Steve Levenson - Stifel.

Steve Levenson - Stifel

A couple questions on programs that you were talking about, one is Gorgon Stare. I don’t know if you can say how fast those units are supposed to go out. I am also curious as to if you are selling directly to the prime or are you selling to one of the subs?

Mark Aslett

Gorgon Stare is a next generation wide area motion imagery capability that is likely to be deployed in Afghanistan during 2010. We haven’t been specific in terms of the number of systems that’s likely to be deployed, but we do believe it's going to be an important capability that’s going to reduce the time to information for our troops on the ground in a very, very different scenario from a environment perspective than what we saw over in Iraq.

In terms of who we are selling to, we are selling to a QRC prime. It is one of the primes that specialize in rapidly bringing new capabilities into theater. Mercury was chosen as the best of breed image signal and sensor processing company. So we are actually doing the entire signal processing for that new platform.

Steve Levenson - Stifel

Is that customer a 10% customer now?

Mark Aslett

No, it’s not, no.

Steve Levenson - Stifel

Are there, or maybe I should ask how many 10% customers there were this quarter?

Mark Aslett

There are -- we had one 10% customer this quarter, Steve, and it was a large prime. We were across multiple programs with them, all large programs.

Steve Levenson - Stifel

One other question, there’s been some news out that the U.K. is going to retire its Nimrods and pickup some even older RC-135 Rivet Joint, which I imagine will need a lot of upgrades. Do you expect to be involved there or is that something that’s going to use mostly U.K. hardware?

Mark Aslett

We are on the River Joint platform and we’ve actually, we think we’re well positioned for some of the signals intelligence upgrades to the River Joint platform going forward. And commenting specifically on the Nimrods, I haven’t seen the article, Steve.

Operator

Your next question comes from Tyler Hojo - Sidoti & Co.

Tyler Hojo - Sidoti & Co.

Just to go back to the commercial ACS, good color in terms of the prepared remarks, but just trying to get a better understanding of how that tracks. I mean, obviously, you are up almost $4 million sequentially in that business and I don’t know if this was the right read through. Are you anticipating perhaps a little bit of a dip back down or how should we look at that?

Mark Aslett

No, I don’t think we’re anticipating a dip back down. I think what I’m saying is that the rate of increase in the semiconductor space will differ on a per customer basis, dependent because of the fact that we got customers at a different stage in their new product introduction cycle and also because of the fact that the two customers that we sell into are actually in different parts of the semi-cap space.

So, there’s an expectation that say the radical inspection space will probably see some increases prior to the lithography growing. So that’s kind of what I was trying to get at. I think there’s some concern out there that I have read, and also sort of listening to some of the other company’s earnings calls regarding the potential for a double dip scenario, but we haven’t heard directly anything from our customers at this point in relation to that.

Tyler Hojo - Sidoti & Co.

Was I correct in understanding that the sequential increase this quarter was largely driven from something outside of semi?

Mark Aslett

So semi-bookings were actually down 3% sequentially.

Tyler Hojo - Sidoti & Co.

Just on the services and systems integration piece, good progress there again on a sequential base, just wondering, what your expectations for that are in terms of the back half of the year?

Mark Aslett

We expect to see continued growth in that part of our business going forward.

Tyler Hojo - Sidoti & Co.

In terms of Merc Fed, was that segment profitable this quarter?

Mark Aslett

Actually, Merc Fed was profitable in Q2.

Tyler Hojo - Sidoti & Co.

Last question, if you do not get any of the AGS orders in the third quarter of your fiscal year, would you still expect to be free cash flow positive?

Mark Aslett

Yes.

Operator

Your next question comes from Jonathan Ho - William Blair.

Jonathan Ho - William Blair

Just a couple of quick questions, first, with regard to sort of the implied contribution in the fourth quarter, how do we think about modeling out the potential margins in the fourth quarter, given sort of the size of the increase in the revenue and the potential leverage that is in the model?

Bob Hult

So Jonathan, you’re trying to do guidance out one quarter, the way we [ph] prefer to do it. I think you’ve seen the target business model that we have put out there and the progress we’ve made moving towards it. I don’t know if there is anything else to say with regard specifically to Q4.

Jonathan Ho - William Blair

I mean, is there any sort of hint there, because I mean with that type of an increase in revenue, I would expect the operating income and EBIDTA margins to move up substantially. Is that a fair characterization?

Mark Aslett

Sure. I mean if you go back to the math that Mark Jordan did, suggesting what Q4 revenues would have to be to hit the 195 for the full year. You can work from that, but please use the target business model. We called out a 54% plus margin on a longer term basis. We’ve been operating above that in recent quarters.

We certainly expect that to continue. We’ve noted that there’s a lot of operating leverage available to the company going forward. So we don’t expect operating expenses to move at a rate that is anywhere commensurate with the kind of revenue growth we would see in that particular quarter. Am I zoning it in for you here?

Jonathan Ho - William Blair

Can you talk about the risk that the order falls out of 2010 on a fiscal basis into 2011 or are you pretty sure you’re going to at least see a portion of that in Q4?

Mark Aslett

I think first of all, we’re thrilled obviously to be in receipt of this large PO, I mean it’s the largest PO in Mercury’s history. Let me talk a little bit about the program. It’s the Navy’s most important program. It’s the centerpiece of the new administration’s BMD strategy and Mercury’s just delivered a brand new signal processing system that’s performing very, very well in the trials. The likelihood of us not being able to ship a portion of that order for revenue in the second half is very low. We believe it’s a matter of timing at this point.

Jonathan Ho - William Blair

You guys talked a little bit about 4G testing as being a driver on the commercial side. How do we think about that given the investments that are happening in the 4G networks today? Is this future growth opportunity, or is this a little bit more of a one off type situation?

Mark Aslett

No, I wouldn’t say it was one off. We do expect to see continued business from that, but it could be lumpy. We do see this future opportunity associated with it as 4G networks continue to be built out.

Operator

Your next question comes from Michael Ciarmoli - Boenning & Scattergood.

Michael Ciarmoli - Boenning & Scattergood

Just if you can, Mark, if you can elaborate on your opportunities for the counter IED programs? What are you thinking there? It seems like you've been down, you said you've been down selected? What are you thinking in terms of timing and if you even can characterize what sort of revenue opportunities you’d be looking at there?

Mark Aslett

Yes, so we have been down selected by two primes on the next-generation program of record for counter IDs. In terms of the timing, I think understanding at this phase is that, we’d probably start to see revenues in 2011. From a sizing and magnitude perspective, not sure I want to go there at this point, other than to say that there are 26,000 crew vehicles out there. If they are upgraded, if they’re substantially upgraded, then the revenue associated with that program could be very, very large for us.

Michael Ciarmoli - Boenning & Scattergood

You mentioned some of the design wins that you guys had in the quarter earlier. In terms of those wins, you’ve talked about I guess, the total revenue opportunity increasing seemingly year-over-year. Is that because you are grabbing more content on these design wins or are these just bigger programs and there’s more units? I’m trying to get a sense if you guys are executing on that plan of increasing your content per platform.

Mark Aslett

We absolutely are executing against the strategy of increasing our footprints and hence the amount of content on the platforms. We’re also looking to expand out beyond Mercury’s historic areas of strength. So the counter ID is a great example, right. Mercury is very strong in the airborne domain today.

We haven’t done a lot on the ground, but if you look at two of our major design wins, one for Patriot and then another one for these counter-IED opportunities, they are both ground opportunities. So we’re actually expanding our addressable market by going after more opportunities also.

Michael Ciarmoli - Boenning & Scattergood

Then just on the operating expenses, looking at kind of where you’ve been running here in terms of SG&A, what the rest of the year is going to look like, again versus your target model, which I think is in the low to mid 20s, is there a lot more that you guys have add here, or are you going to get to a point where you’ve got enough kind of quarterly spend where that top line can continue ramping and you’re not going to see the added SG&A?

Bob Hult

Mike, simplistically, we don’t have to add much in the substantial sense to grow the top line. You will note for instance, our guidance for Q3, we’re talking about a very modest sequential increase, $1 million compared to the way Q2 executed and frankly, all of that in the primary is going into fuel, our engineering designs, getting more new products into market faster.

Mark Aslett

It’s really new product introduction.

Operator

Your final question comes from Mark Jordan - Noble Financial.

Mark Jordan - Noble Financial

You said an interesting comment that the $28 million relates to major Navy missile defense contract. I guess that led me to the question, is this, or the Navy accelerating the rollout of the 4.0 or next generation, and if so, does this really, the $28 million represent nine to ten ships are only about half of the installed base. So that’s where your comments said that there should be a following on, which would be again upgrading of more ships in the fleet?

Mark Aslett

The $28 million is really a mix of new installations, upgrade to existing systems as well as spares. So it kind of covers the gambit. The new signal processing system that we just delivered is recently being tested in v4.01 of Aegis platform and the results of that signal processing system as well as new discrimination algorithms, I think it went very, very well.

So I think overall, the schedule, all the upgrades that we know haven’t changed. They’re still looking to upgrade the same number of ships. That being said, we do think that Aegis has the potential of increases going forward, whether it would be due to more ships, FMS sales or Aegis grand.

Mark Jordan - Noble Financial

My belief that 4.0 was scheduled to rollout to the fleet in 2012, so does this imply that it’s been successful, I guess that the Erie was involved in some of those tests off Hawaii that they may be accelerating the rollout of the next generation?

Mark Aslett

My understanding, and I probably need to go away and do a fact check, but my understanding is that it’s 2011.

Operator

As there are no other questions coming in the queue at this time, I’ll turn the call back over to Mr. Aslett.

Mark Aslett

Thank you very much for joining us this quarter and we look forward to speaking to you next. Thank you.

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