Seeking Alpha
Research analyst, growth, value, long/short equity
Profile| Send Message|
( followers)  

There has been a paradigm shift in measures taken by both national governments and private bodies with regard to security. Intelligence has become the most important aspect of national security. Mercury Systems (MRCY) is one of the leading best-of-breed providers of commercially developed, open sensor & Big Data processing systems, and software & services for critical defense and intelligence applications.

The company's results have been shaky over the recent past, especially for Fiscal Year 2013. Nonetheless, Mercury's future appears solid with the growing need for security intelligence and various digital solutions that the company produces. Mercury operates in two main business units, Mercury Commercial Electronics [MCE], and Mercury Defense and Intelligence Systems [MDIS].

The company's Big Data processing systems segment has a big future ahead, and still provides room for scalability to new markets, other than government defense.

Over the last three fiscal years ended June 30, 2013, 2012 and 2011, a majority of Mercury's revenues came from three defense prime contractors, including Lockheed Martin (LMT), Raytheon (RTN), and Northrop Grumman (NOC). Revenues from these three companies represented 37%, 54% and 51% in 2013, 2012 and 2011 respectively. the drop from 54% to 37% illustrates why the company's revenues fell in 2013.

However, the company's recent quarter results have shown good signs of improvement from last year's results. If this is replicated on the next three quarters, then Fiscal 2014 should deliver better results, along with significant savings from its restructuring process.

Overview

For Fiscal 2013, the company's net revenues declined substantially by nearly 15%. This came after the company's cost of revenues grew by about 15.6% from last year. In the company's most recent quarter [F1Q14], revenues increased by 9%, but this did not prevent it from making a GAAP loss of $0.07 per share. However, this indicates a significant improvement compared to F1Q13 GAAP loss of $0.24 per share.

The massive dip in overall revenues was due to a decline in defense revenues, which accounted for 88% of the company's net MCE revenues for Fiscal Year 2013 compared to 93% in 2012. MCE revenues accounted for 73% of the company's overall net revenues. This meant that the 38% growth reported from the MDIS segment was well offset due to weighting, hence the overall decline of 15%.

The company made key acquisitions over the last two years, including the purchase of Micronetics, KOR Electronics and LNX Corporation to expand its Microwave and RF (Radio Frequency) line-up. The expansion of the Microwave and RF product line-up puts the company in a strategic position as the markets targeted by this business unit remains solid with scalability options.

With ~0.0x debt/equity ratio and nearly $40M in total cash from the most recent quarter, Mercury appears financially stable. This is also boosted by a current ratio of 5.30, while its price to book value also looks attractive at 1.00x.

Strategically Positioned

Mercury Systems is strategically positioned to capitalize on the changing trend in warfare. Over the years, governments invested heavily on kinetic weapons as a majority of the warfare was fought on the ground. However, the trend is now changing towards distance warfare, which requires a lot of investments in surveillance and intelligence. This may not be totally new, but my understanding is that several governments are now focusing to invest in electronic surveillance systems to monitor potential threats. It is no longer about a few countries.

Additionally, the investment in sophisticated systems is also growing as governments seek to boost intelligence in a bid to curb various terror threats. The U.S government has over the years demonstrated its commitment to fighting the war against terror. We have seen the government engage various countries in a bid to boost intelligence and international security a fact that has resulted in massive spending in defense and weaponry related costs.

This is not going away anytime soon. If anything, it is expected to go higher as rogue nations' missile programs remain a threat to several countries. Therefore, investment in new electronic weapons and ballistic missile defense capabilities is becoming everyone's business, and not just the U.S. This subjects the U.S government to invest even more on better defense mechanisms as it seeks to stay ahead of the rogue nations.

Therefore, Mercury Systems may be facing short-term slowdown in revenues due to uncertainties in government spending, but one thing for sure is that the government needs to spend more going forward. Will Mercury Systems be around to capitalize on this when the time comes? Well, that is the goal.

Mercury Systems' CEO, Mark Aslett stated in a recent investor conference that the company is well positioned to capitalize on these emerging trends in defense mechanisms.

We are going to need more sophisticated electronic warfare and electronic countermeasures on both the platforms themselves. It's not all about kinetic weapons anymore, it's going to about who dominates the electromagnetic spectrum and that's where electronic warfare comes into play and we feel that we are very well positioned there.

As noted earlier, Mercury Systems is also very active in big data systems. There is a huge opportunity in this market, especially considering Mercury Systems' defense systems, as real-time surveillance grows from a mere add-on in security and intelligence to a necessity. The U.S government is processing huge amounts of data on a daily basis to monitor security threats, which are traceable via various means such as cyber-tracking, and other forms of communication as recently revealed by a former CIA employee, Edward Snowden.

Once again this type of surveillance is becoming even more sophisticated as technological advances continue to usher in new forms of communication. Mercury Systems' big data systems, which leverage on various cloud-based applications and analytics processes position it well to continue providing best-of-breed technologies for defense applications. Additionally, the company could also capitalize on the growing market in big data applications, with various private bodies and research centers also making use of big data analytics. The company could easily scale its business in this segment to generate additional revenues, without making major capital investments.

Mercury Systems has made key strategic acquisitions over the last 2-3 years, which will be key in its plan for sustainable growth. For instance, the acquisition of KOR Electronics allows Mercury to provide its prime contractor customers with even more capabilities across the sensor processing chain. KOR is a leader in RF simulation and jamming technology, and its acquisition could also result in various operational synergies, thereby improving the company's margins. Mercury Systems has highlighted its mercury and RF division to be one of the key drivers of organic growth.

The company is also looking to capitalize on the growing demand for various electromagnetic weapons and defense mechanisms from global markets. As noted earlier, rogue nations have made it necessary for various countries to advance their internal security and defense mechanisms.

This means that they would have to invest in electromagnetic weapons as well and boost their ballistic missile defense capabilities. This opens more opportunities for Mercury Systems by widening its addressable market. According to the company's CEO, some governments are actually willing to finance the R&D for various electromagnetic platforms and defense mechanisms in order to upgrade their systems. This can also be classified as an incentive to continue growing its business, by addressing demand from such nations.

"..International customers are willing on fund some of the R&D cost to basically upgrade the platforms themselves. So, it's basically a double benefit.

In general, Mercury Systems' strategy is centered around three key catalysts. The changing trend in warfare and defense mechanisms, which fits in well into Mercury's business model, while big data is becoming a key aspect in surveillance and intelligence as governments embrace real-time monitoring. Additionally, the company is also presented with an opportunity overseas, with various governments also adopting the new trends, while others seek to upgrade their systems. All these are boosted by the fact that the company has made key strategic acquisitions over the last few years, which open it to larger addressable market while integration could also result into various synergy benefits.

Let's also not forget that private security bodies are adopting new surveillance measures, which to some extent utilize some of the subsystems offered by Mercury Systems, especially in big data analytics.

Risks

The U.S government has been Mercury's biggest customer over the years. Over the last few quarters, sales from this unit have slowed due to what the company termed as political dysfunctions. This type of risk is likely to subsist for some time, despite the enormous opportunity in investing in defense mechanisms. Mercury CEO placed an estimated $500B plus, in market value in DOD purchases.

However, the uncertainty over budget allocations has made this opportunity appear more like a mirage. Therefore, until stability in government allocations is achieved, the value placed on this customer carries a significant amount of risk, if recent results are anything to go by.

Additionally, government purchases are made on a contractual basis, and politics are always present in deciding the supplier the government opts for. Therefore, even the overseas sales are likely to be pegged on the relationship between the U.S government and the various countries. Additionally, the battle in the electromagnetic warfare requires a lot of discretion. This means that some countries may opt to purchase their supplies from domestic companies, rather than from companies of "rival" nations.

Valuation

Since Mercury started acquiring companies, little seems to be priced in its valuation. In fact, the company seems to have shaded much of its value over the last 2-3 years. In April 2011, mercury traded in low $20s, right now, its current price is less than half of that, and yet it has made strategic acquisitions over the last two years. The company also completed a restructuring program, which saw it incur $7.1 million in costs. However, it expects to make at least $22M in annual savings following the restructuring. This adds to its impressive financial position as noted earlier. This also sets it well to implement its next step, which I believe is to integrate its recent acquisitions into its business model in the most efficient of ways.

By just assuming the company's performance for Fiscal year 2014 remains in line with 2013, Mercury would be poised to make at least $8.5M in earnings, or $0.25 per share. To me, this is the worst case scenario. [Note that the company made a loss of $13.5M in Fiscal Year 2013. Therefore, assuming the company makes no ground upwards or downwards, and factoring in the $22M expected annual savings, that guarantees about $8.5M in earnings]. A best case scenario would be realized if the current slowdown in government spending eases, thereby boosting revenues. This could translate to more earnings for the company as it continues to tighten its spending.

Overall, Mercury is trading at its book value despite making a huge loss in the fiscal year ended June 30, 2013. Therefore, if the reported annual savings are realized, then I would expect the company to trade at about 1.5x and 2x in price to book value, the same ranges it traded in 2012 and 2011 respectively. Note that, just over two years ago, Mercury traded above $20 per share, and some time last year, it did trade at mid teens.

The major difference in terms of performance between then and now, is that Mercury was profitable, and there wasn't much uncertainty as there is now over government spending. However, based on its expected savings after the restructuring, the company could soon return to profitability. Additionally, as noted earlier, whether or not the government is willing to increase its spending on defense, this goes way beyond party politics. So I expect the need at hand to win the battle against political obstacles. The issue is, the government needs to increase spending on defense mechanisms, and the sooner it does submit to this fact, the better for Mercury. Therefore, there is a genuine chance for Mercury Systems to return to profitability, in which case, I expect investors to react positively.

Also note that, fiscal first quarter of 2014 has depicted some improvement compared to last year, if this is mirrored in the remaining three quarters, it could render my estimates conservative. Therefore, this tentatively presents at least 50% upside for Mercury's stock.

Conclusion

Mercury Systems has experienced slowdown in the last few quarters, which were tied to government spending. This may continue for a while. However, the slowdown in revenues from DOD should be supplemented by its recent strategic acquisitions and restructuring processes, thereby enabling the company to report better results.

The bottom line is that mercury is not going to suddenly start growing revenues and profits by double digits, but that is feasible in the long-term. However, for now, the company is poised to return to profitability, and things could even get better going forward as government submits to increase investment in electromagnetic weapons and defense mechanisms. Therefore, there is a genuine opportunity here, while shifting trends in warfare and surveillance systems present a solid future.

Source: Mercury Systems Results Shaky, But Future Looks Solid