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Mercury Systems, Inc. (NASDAQ:MRCY)

F2Q 2014 Earnings Conference Call

January 28, 2014 17:00 ET

Executives

Mark Aslett - President and Chief Executive Officer

Kevin Bisson - Senior Vice President and Chief Financial Officer

Analysts

Kevin Ciabattoni - KeyBanc Capital

Jonathan Ho - William Blair

Tyler Hojo - Sidoti & Company

Peter Arment - Sterne, Agee

Mark Jordan - Noble Financial

Brian Ruttenbur - CRT Capital

Sheila Kahyaoglu - Jefferies

Operator

Good day, everyone and welcome to the Mercury Systems’ Second Quarter Fiscal 2014 Earnings 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. Kevin Bisson. Please go ahead, sir.

Kevin Bisson - Senior Vice President and Chief Financial Officer

Good afternoon and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you have not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at www.mrcy.com.

We would 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 and technological advances in 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 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 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 will turn the call over to Mercury’s President and CEO, Mark Aslett. Mark?

Mark Aslett - President and Chief Executive Officer

Thanks, Kevin. Good afternoon, everyone and thanks for joining us. I will begin today’s call with a business update. Kevin will review the financials and guidance and then we will open it up for your questions.

Despite challenging conditions in the industry, Mercury performed well in the second quarter. Total revenue for the quarter was $53 million versus our guidance of $48 million to $54 million. Our GAAP loss from continuing operations was $0.03 per share favorable to our guidance of a loss of $0.12 to $0.06 and much improved both sequentially and year-over-year. Adjusted EBITDA was 10% of revenue, up substantially from last quarter in Q2 last year and well above the high end of our guidance. Cash flow also exceeded our plan due to higher than expected collections at quarter end. We continue to make good progress on our most important programs.

Total revenues in our defense business for the second quarter increased 10% sequentially from Q1 to $50.8 million and were up 12% versus the second quarter last year. Total defense bookings increased 10% sequentially to $47.9 million. Our total book-to-bill was 0.9 compared with 1.3 in Q2 last year. Our book-to-bill in defense was 0.9 flat sequentially and down from 1.2 a year ago. Defense backlog and total backlog exiting the second quarter were both down 2% sequentially. From a bookings perspective, our largest programs this quarter were for F-15 EW upgrades with BAE, Aegis with Lockheed Martin as well as ASIP, the airborne signals intelligence program and a classified airborne program both with Northrop.

International defense bookings, including foreign military sales were 49% of total defense bookings compared with 17% in the sequential first quarter. From a revenue perspective, Aegis, ASIP, Gorgon Stare and Predator/Reaper were important contributors during Q2. International defense revenues, including FMS, were 16% of total defense revenue compared with 23% in Q1.

Moving to the operations, over the past two quarters, we successfully laid the groundwork for the second and final phase of our acquisition integration strategy, which begins in Q3. Our goal over the next 18 months is to create a fully integrated business that we can continue to profitably grow organically and scale through potential acquisitions established some background.

Over the past several years, our top priority had been to leverage our relationships with the primes and drive bookings and revenue from existing programs as well as new programs and platforms. We collectively and successfully built out Mercury’s portfolio with best-in-class products and capabilities across the entire sensor processing chain. We achieved this through a combination of ongoing work in our existing businesses and strategic acquisitions in RF, microwave and electronic warfare. These acquisitions, which we think of is Phase 1, were all about aligning our business with the needs of our customers as well as positioning ourselves with sustainable growth in the long-term. This phase culminated with the acquisition of Micronetics and through a lot of hard work, we have created a commercial company that I believe is second to none in the defense electronics industry.

The second phase integration, which is underway consist of three key initiatives: first, facilities consolidation around our two Advanced Microelectronics Centers; second, standardizing business processes and systems across the enterprise; and third, realignment of our engineering resources. Successful execution of these Phase 2 initiatives over the next 18 months should result in approximately $16 million of annualized expense reductions when complete. Kevin will discuss the financial aspects of the restructuring in his prepared remarks.

Looking at the plan in more detail, the first of our priorities is to take full advantage of the investments we have made in our Advanced Microelectronics Centers. These facilities position us as a world-class player in the RF and microwave industry. With the AMC Centers of Excellence concept in place and with the New Hampshire AMC up and running in Q2, we can now begin to consolidate where appropriate other non-four facilities in New Hampshire. This consolidation will enable us to further reduce our facility footprint and expense space over time. It will also help make us more efficient and more effective in driving Advanced Microelectronic solutions into the marketplace. In addition, we are expected to drive margin improvement as certain programs moving to full rate production.

The second element of Phase 2 involves standardizing our common set of core business processes and systems across the Mercury Enterprise. Three acquisitions since 2011 have let us with a desperate array of processes and systems that have increased our costs and reduced efficiencies. This is something that happens at virtually all companies engaged in acquisition driven growth and something we planned for in our M&A strategy.

For the past six months, we have been working methodically to address this issue. The result is a blueprint for common set of core business processes and IT systems that will allow us to centralize wherever possible Mercury’s administrative functions and manufacturing operations. We believe these initiatives which are well underway in proceeding on time and on budget will also make Mercury an easier company to do business with. At the same time, the resulting savings in time and resources should significantly lower our G&A expense and improve gross margins.

The third and final integration plan component is to align and rebalance our engineering resources. Our goal is to create sustainable repeatable engineering site models based on what we are calling Advanced Development Centers or ADCs. We began employing the ADC model internally last year by outsourcing our remaining digital manufacturing. This will allow to start particular facility to focus exclusively on engineering development and low volume new product introduction. Going forward, Mercury’s high volume digital production will continue to be performed by our contract manufacturing partners and in the case of RFs and microwave in one of our own AMCs.

We see the AMC and ADC concepts as models that we can sustain and replicate as we continue to grow and scale our business. The realignment of engineering resources is designed to sustain our lead over the competition in processing, while strengthening high growth areas such as RF and microwaves. Overall, the realignment results in a very modest net reduction to our engineering headcount.

Said another way, the plan I have just outlined is not about scaling back on R&D. It’s about leveraging our acquisitions to make the business more efficient and taking out cost to improve margins and reducing operating expenses. In effect, we are positioning ourselves to achieve our target business model earlier and under more conservative revenue growth assumptions reflecting the prevailing industry conditions. Assuming approximately 10% annual revenue growth next year, the normal program mix and reduced operating expenses from our Phase 2 integration, we currently expect to achieve our target business model for fiscal 2015.

Moving to the industry, we are encouraged by the recently enacted two year federal budget which we believe will reduce the short-term impact of sequestration. We were also pleased to see the approval of the government FY ‘14 defense appropriations bill earlier than last year. These should help to solidify the growth in bookings, revenue and EBITDA we have forecasted for the second half of FY ‘14 and should also position us well for fiscal 2015. With this in mind, the guidance that Kevin will discuss today includes our expectations of both the third quarter and the full fiscal year.

We are anticipating mid single digit to low double digit revenue growth in the second half driven largely by Aegis, SEWIP Block 2, LRIP, Patriot and JSF. I have said in the past that RFs and microwaves as it relates to next generation EW and radar subsystems will likely become the fastest growing part of our business. The investments in our RF and microwave capabilities that we have made over the past two years are clearly bearing fruit.

Our second half guidance suggests an improvement in top line growth compared to the industry with the potential to accelerate this growth in fiscal 2015. We invested significantly during the good times and now we are reaping the benefits of that. Mercury’s strategy, technology, capabilities and ongoing programs and platforms aligned well with the DoD’s new roles and missions. As a result we are positioned to win new business and to take share from the competition in next generation processing opportunities. These opportunities include the Pacific pivot, the upgrade of aging military platforms as well as growth in foreign military and international sales. In addition as a leading outsourcing partner to the primes we have the potential to capture significant upside from defense procurement reform.

Looking ahead, SEWIP is the largest of the group of programs that we believe will be important to Mercury longer term. These other programs include Aegis and Patriot, upgrades to the Predator/Reaper, F-15 and F-16, (indiscernible), JSF, E-2D Hawkeye as well as Filthy Badger and Buzzard. These are a franchise set of programs in Mercury that in aggregate could represent hundreds of millions in revenue potential over their lives. If we can continue to deliver growth despite the prevailing industry conditions while continuing to execute on the second and final phase of our integration plan, we should benefit from the substantial operating leverage that exists and that we continued to drive in our business. This leverage should further strengthen Mercury’s position to build a significantly improved profitability, cash flow generation and shareholder value as we move forward.

With that, I would like to turn the call over to Kevin. Kevin?

Kevin Bisson - Senior Vice President and Chief Financial Officer

Thank you, Mark and good afternoon again everyone. Turning now to our financial results, revenue for the second quarter of fiscal 2014 of $53.1 million was $3.3 million or 7% higher than revenue of $49.8 million for the second quarter of last year and was at the upper end of our stated guidance of $48 million to $54 million.

The company generated a GAAP net loss of $0.03 per share in this year’s second quarter, which was substantially smaller than the GAAP net loss of $0.16 per share in the second quarter of fiscal 2013. This year’s second quarter loss per share was smaller than the company’s guidance of a net loss of $0.06 to $0.12 per share for the quarter. Adjusted EBITDA for the second quarter of fiscal 2014 of $5.1 million was $4.1 million higher than the adjusted EBITDA of $1 million for the second quarter of last year and exceeded our stated guidance of $400,000 to $3.5 million. The company generated free cash flow of $4.5 million in this year’s second quarter and ended the second quarter with $44.5 million of cash and cash equivalents and with no debt.

Reviewing second quarter performance in greater detail, total revenue for our largest operating segment, Mercury Commercial Electronics or MCE was $45 million, which was $4.5 million or 11%, higher than the $40.5 million of MCE revenue generated in the second quarter of last year. The year-over-year increase in second quarter revenue derived mainly from significantly higher Aegis program revenue that was partially offset by lower RF components and UAV program related revenue.

Revenue from the company’s Mercury Defense and Intelligence Systems or MDIS operating segment for the second quarter was $10.6 million which was $3.5 million lower than the $14.1 million of MDIS revenue for the second quarter of last year. The lower revenue between years was primarily due to lower Digital Radio Frequency Memory, or DRFM jammer program revenues and lower MIS revenue resulting from delays in customer funding. It should be noted that operating segment revenue for the second quarter of fiscal 2014 does not include adjustments to eliminate $2.5 million of inter-company revenue. Total defense revenue including MCE and MDIS of $50.8 million for the second quarter was $5.3 million or 12% higher than defense revenue of $45.5 million for the second quarter of last year.

As mentioned previously the year-over-year increase in defense revenue stemmed from higher Aegis program revenue that was partially offset by lower revenue at MDIS. Of the total defense revenue in the second quarter $8.4 million or 17% was derived from international customers compared to $9.3 million or 20% in the second quarter of last year. Revenue from international customers includes foreign military sales to our prime customers as well as direct sales to non-U.S. based customers.

The key programs driving international revenue in this year’s second quarter were the Aegis and F-15 Electronic Warfare or EW programs as well as direct sales to a customer in the Asia-Pacific region. Commercial revenue for the second quarter of $2.3 million was lower than the $4.3 million of commercial revenue generated in the second quarter of last year. The year-over-year decrease in commercial revenue was principally the result of lower product shipments to customers in the telecommunications equipment and security sectors.

Defense bookings for the second quarter of $47.9 million were lower than the unusually strong defense bookings of $55.7 million in the second quarter of last year. However, second quarter defense bookings were $4.3 million or 10% higher sequentially from the first quarter defense bookings of $43.6 million as higher F-15 EW and F-35 program bookings were partially offset by lower Aegis program bookings. It should also be noted that second quarter defense bookings included the company’s first order for the Saver Program that was recently awarded by the U.S. Air Force to our customer, Northrop Grumman. Lower year-over-year defense bookings were primarily due to decreased SEWIP, B-1 Bomber and Aegis program bookings that were partially offset by higher F-15 EW program bookings.

Mercury’s total book-to-bill ratio for the second quarter of fiscal 2014 was 0.9, which was below the 1.3 book-to-bill ratio for the second quarter of last year, but matched this year’s first quarter. Defense book-to-bill of 0.9 was similarly below the 1.2 book-to-bill ratio generated in the second quarter of last year, but matched this year’s first quarter.

The company ended the second quarter of fiscal 2014 with $130.5 million of total backlog, which was $2.7 million lower than the $133.2 million of total backlog at the end of last year’s second quarter. Of the total ending backlog in the second quarter, $101.4 million, or 78% is expected to be shipped within the next 12 months. $112.6 million of the ending second quarter total backlog is related to defense, which was $1.7 million lower than last year’s second quarter defense backlog.

From a bottom line perspective, the company incurred a GAAP net loss of $1 million in this year’s second quarter that was substantially smaller than the GAAP net loss of $4.8 million in last year’s second quarter. The stronger financial performance between years was mainly due to a 12 point improvement in gross margin driven by a recovery in the company’s higher margin digital signal processing business. Fueling this recovery was year-over-year revenue improvement from the Aegis F-35 and various UAV related programs, which carry gross margins accretive to the company’s overall gross margin this quarter. Partially offsetting the increased gross margin were higher operating expenses compared to last year’s second quarter due principally to lower customer funded development work and higher prototype expenses.

It should be noted that the company’s gross margin of 47% in the second quarter was 3 to 4 points higher than the stated guidance for the quarter. This increase in gross margin compared to guidance is attributable to previously forecasted RF and microwave program revenue, which carries lower than historical margins slipping to the third quarter and being replaced by digital signal processing program revenue, which carries higher margins that was originally forecasted for the third quarter of this year.

Adjusted EBITDA of $5.1 million from the second quarter of fiscal 2014 was considerably higher than the $1 million of adjusted EBITDA generated in the second quarter of last year due largely to the overall improved operating performance between years.

Relative to our stated financial guidance for the second quarter, we are pleased to report that the company was at or above the high end of its guidance in all key financial measures. Second quarter revenue of $53.1 million was at the high end of our guidance of revenue between $48 and $54 million. Reported GAAP loss per share of $0.03 for the second quarter was favorable to our guidance range for a net loss of between $0.06 and $0.12 per share. And finally, adjusted EBITDA of $5.1 million for the second quarter comfortably exceeded guidance of $400,000 to $3.5 million.

Turning now to the balance sheet. The company ended the second quarter of fiscal 2014 with cash and cash equivalents of $44.5 million and no debt, which was $4.4 million higher than the $40.1 million of cash and cash equivalents at the end of the first quarter of fiscal 2014. The company generated $4.5 million of free cash flow during the second quarter as $7.4 million of operating cash flow driven by the quarter’s cash earnings and lower working capital due to improved receivables collections were partially offset by $2.8 million of capital expenditures.

Before providing financial guidance for the third quarter, I want to spend a few moments discussing the financial implications of the Phase 2 integration efforts that were outlined in this afternoon’s earnings release and Mark’s earlier comments. The Phase 2 integration plan encompasses actions that began this quarter with further actions to be completed over the next 18 months or by the end of fiscal 2015. Upon completion of Phase 2, the company anticipates generating annualized gross savings of $16 million. Third quarter actions that were recently completed are estimated to achieve $9 million of the $16 million of gross annualized expense savings. This development further demonstrates that the savings associated with the company’s Phase 2 integration plan are heavily front-end loaded. Forecasted gross savings for the third quarter resulting from the third quarter actions are estimated to be $1.6 million, with $400,000 relating to manufacturing and the remainder split evenly between SG&A and R&D.

Total restructuring charges for the third quarter are expected to amount to $3.4 million. For the second half of fiscal 2014, Phase 2 actions are forecasted to generate $4.3 million of gross savings as compared to first half expense run-rates with $1.2 million related to manufacturing, $1.6 million related to SG&A, and $1.5 million related to R&D. Total restructuring charges for the second half of fiscal 2014 are expected to be $4.9 million.

For fiscal 2015, integration actions for Phase 2 are estimated to produce an additional $9 million of gross savings as compared to total forecasted expenses for fiscal 2014. The breakout of these savings includes $4 million related to SG&A, $3 million related to manufacturing and $2 million related to R&D. The company anticipates incurring $4.2 million of restructuring charges in fiscal 2015. With the anticipated completion of Phase 2 integration actions by the end of fiscal 2015, the full $16 million of gross annualized savings as compared to current expense run-rates is expected to be realized in fiscal 2016.

Now, turning to third quarter financial guidance, we are forecasting total revenue to be in the range of $50 million to $56 million, which is higher than the revenue guidance the company has provided over the last several quarters. As Mark alluded to in his remarks, the passage of the Bipartisan Budget Act in December by Congress and signed by the President provides better defense spending clarity for government fiscal years 2014 and 2015. In addition, with the enactment of a defense appropriations bill for the remainder of government fiscal 2014, the company is seeing some loosening of procurement activity from its prime customers leading us to raise our revenue guidance this quarter as compared to previous quarters.

The estimated revenue range for the quarter assumes continued strength from the Aegis, SEWIP and UAV-related programs as well as a classified Northrop Grumman program. We expect a split in the third quarter revenue to revert to the more normal 90% defense and 10% commercial split as compared to the 95% defense and 5% commercial split seen in the second quarter.

Within our stated revenue guidance, we are providing gross margins of between 38% and 40% for the third quarter, which is below the 47% gross margin generated in this year’s second quarter. The reduction in gross margin is mainly due to product mix as the second quarter as described earlier included a greater proportion of higher margin digital signal processing revenue that had not been previously anticipated. The third quarter is now expected to include a greater proportion of RF, microwave and commercial revenue that carry gross margins lower than the digital signal processing business.

Operating expenses are forecasted to be $28 million for the third quarter, which is slightly higher than the second quarter operating expenses. Excluding the restructuring charges, operating expenses for the third quarter are forecasted to be $24 million, which is $3 million lower than the second quarter due to savings from the integration actions and higher customer funded developments.

From a bottom line perspective, we anticipate a reported GAAP loss per share in the range of $0.09 to $0.15 per share for the third quarter based on an estimated weighted average share count of 31 million shares. Excluding restructuring charges, the loss per share for the third quarter is estimated to be in the range of $0.03 to $0.09 per share. The loss per share forecast assumes an income tax benefit of approximately 36% for the third quarter which is comparable to the second quarter. This forecasted tax rate assumes no benefit for the remainder of fiscal 2014 from the federal research and development tax credit, which expired on December 31, 2013. Consistent with the second quarter the loss per share range forecasted for the third quarter includes an approximate $0.04 per share impact from the amortization of intangible assets.

Adjusted EBITDA for the third quarter is estimated to be between $1 million and $4.1 million, which is slightly higher than the forecasted range the company provided for the second quarter. Relative to liquidity we anticipate ending the third quarter with cash and cash equivalents between $43 million and $45 million which is slightly lower than cash and cash equivalents as compared to the end of the second fiscal quarter. Operating cash flow from cash earnings is expected to be offset by higher receivables related working capital due to the unusually high second quarter collections and capital expenditure levels that are estimated to be comparable to the second quarter.

With improving top line visibility from our customers, stemming from the Bipartisan Budget Act and 2014 defense appropriations bill the company will now be providing full year financial guidance. For all of fiscal 2014 the company is forecasting revenue in the range of $215 million to $225 million. At the midpoint of this range fiscal 2014 revenue would represent an approximate 5% growth rate from a year ago. In addition, we expect gross margin to be between 42% and 43%, which is slightly below the first half gross margin due to a more favorable product mix in the second quarter and its adverse impact on forecasted third quarter gross margin. Operating expenses are forecasted to be approximately $107 million for fiscal 2014. Excluding restructuring charges fiscal 2014 operating expenses are expected to amount to $102 million.

Forecasted GAAP loss per share for fiscal 2014 is in the range of $0.20 and $0.34 per share. Excluding restructuring charges the loss per share is anticipated to be between $0.10 and $0.24 per share. Achieving the favorable end of the latter loss per share range would result in profitability excluding restructuring charges for the second half of fiscal 2014. Adjusted EBITDA for all of fiscal 2014 is projected to be between $14 million and $20 million. At the high end of this range the company would generate adjusted EBITDA of nearly 10% of revenue for fiscal 2014.

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

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question comes from Kevin Ciabattoni from KeyBanc Capital.

Kevin Ciabattoni - KeyBanc Capital

Hi, good afternoon guys.

Mark Aslett

Hi Kevin.

Kevin Ciabattoni - KeyBanc Capital

Just looking at the target model, you say you hope to achieve it by ’15 is that something you expect to be able to achieve on a full year basis or is it something we are more likely to see as the tail end of the year just kind to trying to figure out the ramp there?

Mark Aslett

Yes, so we anticipate achieving it full fiscal 2015 Kevin.

Kevin Ciabattoni - KeyBanc Capital

Okay, great. Any color you can give us on amortization for next year I know you gave the restructuring number Kevin that that was helpful?

Kevin Bisson

Yes, I think it’s similar to the quarterly rate we are seeing right now, somewhere between $1.9 million, $2 million a quarter.

Kevin Ciabattoni - KeyBanc Capital

Okay. And then some report is out there that the F-16 upgrade programs in doubt with the ‘15 budget, any thoughts on what you are seeing there and how that might impact the business going forward?

Mark Aslett

Sure. So I truly argued early today, to me when I read it, it looked, it looked more like propaganda. I think it’s still speculator as to what actually going to happen from a funding perspective for the U.S. fees, but from what we know right now Taiwan looks like its in great shape, its going ahead and we have received our first order for the Saver Program during Q2. So I guess we are going to have to wait and see, more information around cape to see whether or not the radar upgrades are going to be done as part of that or separately. So I haven’t heard anything official Kevin.

Kevin Ciabattoni - KeyBanc Capital

Okay, thanks. And then just one last one from me, just wondering if you could give us any color on what your seeing in terms of the level of outsourcing from the primes and whether you have seen any change since you have been able to get the new Hampshire, the new Hampshire facility kind of up and running just in terms of overall outsourcing?

Mark Aslett

Sure. Yes, I would love to. So we feel very excited about the opportunity in RF and microwave. I think as we said on the last call, we spent a tremendous amount of time looking at the industry structure and the way in which we described it at Investor Day was basically said it was an hourglass. Net, net what we see is our customers are looking for a better alternative of either the companies that are their traditional suppliers on the high end or the small companies that they are working with. And what we have done through the acquisitions that we have made in the space that, the most recent was Micronetics and now the investments in the AMC, we are providing an alternative, so a couple of different data points.

During the quarter that was done with one of our customers and that’s provides a lot of capabilities in the EW space. And literally as a direct result of bringing the new AMC facility online, the investments that we have made in our existing AMC as well as the additions that we have made to the engineering team in RF and Microwave they are going to outsource substantially more work to us than what they were previously planning on doing, which I think is great. We hired pretty much all of our major customers throughout the new AMC facility in Hudson, New Hampshire. The feedback is being overwhelmingly positive to the extent that, at least two of them are actually approving us as a strategic supplier in RF and microwave for more advanced RF and microwave subsystems. And one of the other customers that we are dealing with today where we are not actually doing much at all in RF has given the available commitments that we are going to get some business for them and they have seen us as a strategic partner going forward. So I couldn’t be happier with the progress that we are making and I think it’s a substantial opportunity for growth for us going forward Kevin.

Kevin Ciabattoni - KeyBanc Capital

Great, thanks. That’s good color. That’s all the questions I have.

Mark Aslett

Thank you.

Kevin Bisson

Thanks Kevin.

Operator

Thank you. And our next question comes from Jonathan Ho from William Blair. Your line is open. Please go ahead sir.

Jonathan Ho - William Blair

Good afternoon. Just wanted to see if you could give us a little bit more color on how each of the components that you outlined in your cost savings plan is going to contribute to that $16 million in aggregate savings and maybe a little bit more color in terms of how we should be modeling the savings to come in to the model over time?

Kevin Bisson

Yes, I think we were, Jonathan, I think we were fairly explicit about that. I think we, in terms of the second half of this year we outlined that we would expect roughly $4.3 million in savings. And I think if you do the numbers I think it’s about $1.2 million for manufacturing and $1.5 million for R&D and $1.6 million for SG&A, another $9 million in fiscal ’15 over compared to fiscal 2014’s expense levels. And again I think the splits there are roughly $4 million in SG&A, $3 million in cost of sale or manufacturing, the rest in R&D. And then because we have actions planned probably towards the end of ‘15 where the savings won’t be achieved until ’16, the remaining $2 million, $2.5 million of savings we would expect to be in ’16. So I think if you add those three together and I think it comes pretty closely to $16 million of savings. Again…

Jonathan Ho - William Blair

Got it.

Mark Aslett

As far as high level Jonathan it’s roughly 40% of the savings are in manufacturing, 40% are in SG&A and 20% of that $16 million in R&D. But just to put a fine point on it, this is not about a reduction in our research and development. When you look at the number of heads that we have reduced this quarter, it was 17 and we are done with that option. Most of the activities that we are talking about going forward are really about the fact that now that we have got the new AMC up and running, we can consolidate more of our or other non-core facilities over time. And given that we have got an operating model in place with the business, we can standardize on a common set of core business processes and systems that in particular will allow us to actually centralize our manufacturing operations as well as our general and administrative functions and that’s really where you see the big, big overall savings.

Jonathan Ho - William Blair

Got it. And just as a second question, just want to understand from a confidence perspective, now that you guys have offered toward the 10% perspective on 2015, can you remind us, which are the programs you expect to sort of support that visibility? Are there any potentially at risk or with the budget visibility that’s there now, do you feel pretty good about sort of the potential for those programs to happen?

Mark Aslett

Sure. The numbers that we gave you are not necessarily guidance per se, we are trying to put the context of the integration plan that we announced and the potential impacts that we see in the business model. Net-net, I think as a result of the activities that we have taken, in essence what it does is it brings in the attainment of the target business model and allows us to attain that target business model range at a lower revenue run-rate than what we previously anticipated. So in essence, what supports from a programmatic perspective is the fiscal ‘15 kind of outlook as it were, will give more firm guidance on the fourth quarter call fiscal ‘14. It’s really around SEWIP Block 2, the LRIP as well as some production as well as increased content on SEWIP Block 2 that we talked about in Investor Day.

I think Patriot has the potential to see increased revenues in fiscal ‘15 associated with both foreign military sales as well as the fact that the U.S. Army Patriot upgrades particularly for the radar processor got very good funding in the overall budget. We expect Aegis to be an important revenue contributor not necessarily a growth program, but an important contributor overall. And then I think I would finally I would say Filthy Badger and Buzzard in our Mercury Defense and Intelligence Systems operating segment and as well as JSF. So programmatically, those are the drivers. From a business model perspective, I think I would kind of boil it down to really two things. We are anticipating continued strong rebound in the more traditional processing part of our business and continued strength in RF and microwave.

Kevin Bisson

Jonathan, I would add to put some numbers behind it. If you took the high end of our revenue guidance for the second half of the year and annualize that, you are probably looking at a 70% growth rate year-over-year. So kind of puts into perspective what a 10% year-over-year growth rate would mean for us.

Jonathan Ho - William Blair

Got it, got it. And just one final question on the environment, now that we have got sort of the budget passage and some of the visibility towards ‘14 and ‘15, I mean do you feel sort of a normalization in terms of your contacts with the prime contractors, their confidence level and visibility order flow, just want to get a sense for you how the environment feels at this point?

Mark Aslett

Yes, I think overall people feel much better than say where we were during fiscal ‘13. In essence, the budget deal eliminated sequestration and traded off reduced spending levels, but the spending levels for fiscal ‘14 and ‘15 are somewhat baked at this point flat to what was enacted in fiscal ‘13 at $500 billion a year. So they have taken away that uncertainty surrounding sequestration, which in our mind was one of the big issues that were causing the delays in funding and contracting to occur. So I think it’s really positive overall. I think people feel better about that we have got at least some short-term clarity from the overall budget environment. And the 2014 defense appropriations bill was singed earlier than it was last year. So we are not out of the woods, but I think things are heading in the right direction and we generally feel better about it.

Jonathan Ho - William Blair

Great, thank you.

Operator

Thank you. And our next question comes from Tyler Hojo from Sidoti & Company. Your line is open. Please go ahead sir.

Tyler Hojo - Sidoti & Company

Yes, hi Mark and Kevin.

Mark Aslett

Hi, Tyler.

Kevin Bisson

Hi, Tyler.

Tyler Hojo - Sidoti & Company

Yes, just a follow-up on the last question when you talk about seeing kind of business normalize what you had been talking to us about was being really conservative in terms of how you had been running the business, really running it for cash and kind of stepping away from some of the book and ship opportunities that you have traditionally gotten. So in context with what you have said about seeing some normalization, do you get a little bit more aggressive? And then maybe as a follow on to that, do you need to get more aggressive in order to get accounted to that 10% growth bogie?

Mark Aslett

So if you look at say the high end of guidance for H2 that would suggest a 10% revenue growth rate. And given the integration plans and the reduction in operating expenses that would lead to a huge improvement in terms of adjusted EBITDA over the first half of the year and that’s somewhat consistent in terms of what we saw during fiscal ‘13 if you can remember back that far, Tyler. When the defense appropriations bill was actually approved in the second half of fiscal ‘13, we actually saw a 12% increase in bookings and a 10% increase in revenues. And in essence at the high end of the range, we are kind of forecasting that to occur again. At the full year level again at the high end of the guidance range, we are basically delivering revenue growth or forecasting to deliver revenue growth that’s in the high single-digits. So as you project forward really into fiscal 2015, it’s not too much of a stretch to see how we can achieve a target business model given the integration plan that we just outlined, given the growth rates that we are potentially forecasting for fiscal ‘14 and given some of the things I talked about from a program perspective. So look, we are trying to give you some perspective on what we see the outlook for the business being going forward in the context of the integration plans. And obviously as we exit this fiscal year, we will give firmer guidance for fiscal ‘15, but we are just trying to putting context what we see in the net result that the actions that we are taking.

Tyler Hojo - Sidoti & Company

Yes, I know and it’s definitely appreciated to kind of lay something out for us as we start thinking about fiscal ‘15, but when you think about your comfort level, I mean, do you still run the business pretty conservatively today until you see maybe a little bit more improvement or are you at the point where you think you could be a little bit more aggressive going after those book and ship type orders?

Mark Aslett

Well, we must be feeling somewhat better, because we are kind of returning back to full year guidance and the guidance that we are giving for Q3 is higher than the guidance that we have given for probably the last three or four quarters. So yes, I mean I think we do anticipate that we are going to see higher growth in revenues and substantially higher bookings in the second half. Are we going to let that ball flow through to the top line? Probably not, we still want to continue to grow the backlog, but we are probably prepared to take a little bit more risk than what we have done over the past several quarters.

Tyler Hojo - Sidoti & Company

Got it, okay. Well, I do appreciate that commentary. And maybe just moving to one other item, if you look at the R&D spend this quarter, it was up a bit – quite a bit on a year-on-year basis and up sequentially and if we look at achieving the target business model in ‘15, it’s going to grow quite a bit next year as well. So how do we think about that in context with kind of some of your commentary in regards to the reduction in R&D?

Mark Aslett

Yes. So we are not going to get into the specifics at the line item detail level, Tyler, for fiscal ‘15. Yes, because again what we are trying to do is really provide more context around how it is that we could get back to the target business model not necessarily give you guidance on each and every line item. I think net-net, we feel like we have made a very small reduction on a net basis to the hedge in engineering. What we are going to do is actually add back in certain areas where we see the potential for growth. And I think much of that is in the RF and microwave space whereas – where we see the potential for our customers transitioning to a better alternative supply which is the way in which we position the company. So we feel can we get back to the target business model, we believe that we can under reasonable set of growth assumptions given the actions that we have taken, but I don’t want to get into too much detail regarding the specific expense line items.

Tyler Hojo - Sidoti & Company

It makes sense, well, that’s all I had, so thanks a lot.

Mark Aslett

Okay. Thanks.

Operator

Thank you. And our next question comes from Peter Arment from Sterne, Agee. Your line is open. Please go ahead sir.

Peter Arment - Sterne, Agee

Yes, good afternoon Mark and Kevin.

Mark Aslett

Hi, Peter.

Kevin Bisson

Hi Peter.

Peter Arment - Sterne, Agee

Mark I hate you circle back on this 10% growth kind of number that you put out there, but I just want to another way of looking at it is that, is it seen like you are getting, you are just going to get better lift from some of these core programs you outlined and we haven’t really, that’s not really even factoring in kind of the ultimately the share gains that you are going to get from this new AMC centers and all the efforts that you are putting out there for the longer term?

Mark Aslett

Yes, so it’s a continued rebound in the core processing part of our business which was somewhat depressed during fiscal ‘13 and clearly we started to see a rebound there and some pretty good growth. But in particular as I outlined earlier, we have got some programmatic drive as this well with various programs at different stages that are transitioning as well as different funding profiles of programs that we think can have an impact next year. So yes, so I think it’s a mix of different things. But when you look at the growth rates at the high end of our H2 forecast which is 10% which is really what we delivered in H2 of fiscal ’13 or for full year fiscal ‘14 being in the high single digits, it’s really not too much of a stretch to look out an additional 10% as we move into fiscal ‘15. So again directionally we are trying to give you a perspective on how and when we might achieve that target business model versus what potentially could have looked like prior to the second and the final phase of our integration activities.

Peter Arment - Sterne, Agee

Okay and so that’s appreciative very much. Kevin did you mentioned what the international sales were in the second quarter, I thought I wrote down 16%, it was that the right number?

Kevin Bisson

Yes, correct.

Mark Aslett

Yes, so bookings were actually – bookings this quarter were 48%, international and defense bookings were 48% but total defense bookings in the quarter and international and defense revenues was 16% as Kevin said as defense revenues.

Peter Arment - Sterne, Agee

Yes Mark, how do you see the international sales mix transition for the full year ’14?

Mark Aslett

So we haven’t broken it down in terms of giving guidance, but I think we are seeing strength in foreign military sales internationally. In this quarter it was being driven by the F-15, EW upgrades. It was driven by Aegis. I think going forward we think that Patriot is going to be strong contributor in foreign military sales. The only challenge that we see there is that they are actually notoriously difficult to predict the timing of them. So I think they are going to continue to grow because I think we are well aligned with our customers as they are pursuing growth overseas, but I am not going to ahead (indiscernible) forecast fiscal ‘14 from a international defense perspective at this time.

Peter Arment - Sterne, Agee

Okay, that’s all I had. Thanks for all the color.

Mark Aslett

Alright, thanks.

Operator

Thank you. Our next question comes from Mark Jordan from Noble Financial. Your line is open. Please go ahead.

Mark Jordan - Noble Financial

Good afternoon, gentlemen. The question is relative to the guidance on 2015, does the obtaining the business model, does that include or exclude the restructuring charges that you will flow through in 2015?

Kevin Bisson

Mark that would exclude that.

Mark Jordan - Noble Financial

Okay and if I am looking at the right presentation suite, your business model for operating income 12% to 13%?

Kevin Bisson

Correct.

Mark Aslett

Yes, I think when we are thinking along the adjustable EBIDTA lines, which is kind of the metric that we are using.

Mark Jordan - Noble Financial

Okay. And then was if I am looking at the right target 18% plus?

Mark Aslett

Correct.

Kevin Bisson

Right.

Mark Jordan - Noble Financial

Okay. Looking at your guidance for this quarter I guess for that matter last quarter you had about $6 million spread, given a lot of the contractual nature of your business, is that wider range of function of the incremental book and ship business that can come or is that dependent upon last minute adjustments of delivery schedules by your customers?

Mark Aslett

So it’s more the latter, but the range hasn’t actually changed. We have kept with the same spreads as you called it then it’s been that way for probably four quarters now or more. The guidance range is consistent look.

Mark Jordan - Noble Financial

Okay. And looking at the savings that you expect to be able to realize in 2015 with the restructuring, will those be spread equally through the year or weighted in one period or another?

Mark Aslett

They all spread out throughout the year according to the auctions that take place. So at this point, we are not going to get into the specifics of what actions in what quarter. We’ll really we feel that we’ll guide that on a quarter by quarter basis, but we have given you the high level savings on a per year basis for you to kind of put your models to go out.

Kevin Bisson

And also as I mentioned earlier, Mark, the actions we took in Q3 of the $16 million of annualized savings, $9 million of it has already been achieved for the actions we took in Q3. So we have got a good chunk of it done right away. And as Mark said, we have got a phased approach going forward in terms of the remaining actions in the associate savings.

Mark Jordan - Noble Financial

Thank you very much.

Mark Aslett

Yes.

Operator

Thank you. And our next question comes from Brian Ruttenbur from CRT Capital. Your line is open. Please go ahead.

Brian Ruttenbur - CRT Capital

Thank you very much. Very encouraging. A couple quick questions. In fourth quarter 2014 what were the level of charges that you stated? Were there any?

Kevin Bisson

Yes, we have – we said well, you compare it’s 1.5 million we are anticipating in Q4 for a total of…

Brian Ruttenbur - CRT Capital

Okay, okay, that was perfect. I just want to make sure there was a lot of numbers getting turnaround. And then the charges in fiscal 2015, what were the total on that? What was the total on that, excuse me?

Kevin Bisson

It’s estimated to be about 4.2 million.

Brian Ruttenbur - CRT Capital

And how is that, by first quarter, second quarter or is there equal or is it all front end loaded?

Mark Aslett

Yes, we are not giving – Brian, we are not getting into that level of detail at this point. I think it’s as we get closer to the end of this fiscal year we will get into fiscal ‘15 guidance with more clarity.

Brian Ruttenbur - CRT Capital

Okay. So as I understand fiscal ‘15 what you stated is high single-digit growth charges of around $4 million, gross margin should go to back to ideal, which is in the high 40s. SG&A should drop by how much in ‘15, I heard ‘16 but I didn’t it was a little confusing how much ‘15 was going to rock by?

Mark Aslett

So the gross savings in fiscal ‘15 approximately $9 million, so but again what we are not doing here is kind of guiding exactly what our expense structure is going to be, because we are going to have some potential add backs between now and then. So net-net, if you look at the what we are assuming on the top line and then what we said is we feel that we can achieve our target business model for fiscal ‘15. So we are not going to guide the individual line items, Brian, because we are trying to give a framework and context of the integration plan, not specifically give ‘15 guidance on this call.

Brian Ruttenbur - CRT Capital

Great, thank you very much.

Mark Aslett

Alright.

Operator

Thank you. And our next question comes from Sheila Kahyaoglu from Jefferies. Your line is open. Please go ahead.

Sheila Kahyaoglu - Jefferies

Thank you. Good afternoon. Less progress and clearly some productivity, how are you ensuring that you are keeping the cost savings when you are not giving it back to the customer?

Mark Aslett

So we actually feel pretty good about that, Sheila. I think as we talked about in the past a measure of the value that we deliver to our customers is really in the gross margin line. And I think we have historically the processing part of the business, had very strong gross margins. We are not seeing a ton of pressure there largely because I think the economic benefit to our customers is where they outsource more work to us in an engineering level and we can do it much more quickly and much more cost effectively. And so, in essence we are a commercial item company. We are selling off a commercial price list. And we are investing heavily in the R&D and our customers are getting the benefit of it.

Sheila Kahyaoglu - Jefferies

Great, thanks. And can you provide us an update on timing of SEWIP Block 3 and perhaps the reminder of what your current content is on Block 2 and if you are expecting any additional content there?

Mark Aslett

Yes. So Block 3, I think the timing at this point is that the award is likely going to be made in the second half of this fiscal year for us so over the next six months. And from a content perspective on SEWIP Block 2 and Block 3, we kind of lay that out in detail in our Investor Day presentation in November and things haven’t changed since then, Sheila.

Sheila Kahyaoglu - Jefferies

Are you bidding on any additional content there or it’s sort of it?

Mark Aslett

So we – I mean, we are always looking for new business, but I think the content expansion opportunity is that we have been pursuing a laid out in the investor presentation in November.

Sheila Kahyaoglu - Jefferies

It sounds good. Thank you very much.

Mark Aslett

Okay, thanks Sheila.

Kevin Bisson

Thanks.

Operator

Thank you. And Mr. Aslett, it appears that there are no further questions. Therefore, I would like to turn the conference back over to you for any closing remarks.

Mark Aslett - President and Chief Executive Officer

Okay. Well, thank you for your interest in Mercury. We enjoyed the call, look forward to speaking to you next quarter. Bye-bye.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may all disconnect and have a wonderful day.

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