Mercury Computer Systems, Inc. F3Q10 (Qtr End 03/31/10) Earnings Call Transcript

| About: Mercury Systems, (MRCY)

Mercury Computer Systems, Inc. (NASDAQ:MRCY)

F3Q10 Earnings Call

April 27, 2010 5:00 pm ET

Executives

Bob Hult - Senior Vice President and Chief Financial Officer

Mark Aslett - President and Chief Executive Officer

Analysts

Tyler Hojo - Sidoti & Company, LLC

Stephen Levenson - Stifel Nicolaus

Jonathan Ho - William Blair & Co.

Jim McIlree – Merriman

Mark Jordan – Global Financial Group

Mike Ciarmoli - Boenning & Scattergood

Operator

Good day and welcome everyone to the Mercury Computer Systems Inc. third quarter fiscal year 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.

Bob Hult

Good afternoon. Thanks 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, you can find it on our website at www.mc.com. I’d like to remind you that the remarks we may make through this call about future expectations, trends and plans for the company and its business, constitutes forward-looking statements which involve risks and uncertainties. They 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 earnings press release we issued this afternoon reporting the company’s third 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 obligations to update any forward looking statements.

I’d also like to mention that in addition to reporting financial results in accordance with general accepted accounting principles or GAAP, 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 EBIDTA to GAAP net income from continuing operations is included in the earnings press release we issued this afternoon.

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

Mark Aslett

Thanks Bob. Good afternoon and thank you for joining us. I’ll begin with an update on our business for the third quarter. Bob will review the financials and discuss our guidance and then we’ll open it up for your questions.

We’ve refocused Mercury’s business to benefit from the fundamental changes taking place in defense electronics technology and procurement as evidenced by our results in the third quarter. Total revenue exceeds the high end of our guidance range by [$9.6] million. We reported GAAP earnings from continued operations of $0.16 per share compared with guidance of an $0.11 to $0.15 loss.

We did not record any revenue from the $27 million missile defense radar order that we received in Q2. However, the GAAP earnings outside this quarter did reflect a high defense revenue from other programs. Earnings were also driven by higher gross margin associated with favorable changes in our business mix.

Adjusted EBIDTA for the third quarter fiscal 2010 came in at $4.2 million compared with our guidance of a negative $1.1 million to a positive $100,000. Operating cash flow grew to $4.5 million from $2.5 million in Q3 last year. Total bookings for the third quarter were $49.9 million down 11% sequentially because of an over achievement last quarter relating to a large missile radar defense order we received.

Bookings in our ACS commercial business more than doubled sequentially driven by a strong performance in [semi]. On a year-over-year basis total bookings for the third quarter were down 14% from the unusually strong Q3 in fiscal 2009 when we booked a large defense order in ACS and its stronger bookings in our Mercury Federal Systems business.

Our total book to bill for Q3 was 1.14, total backlog is up 32% year over year and our 12 month backlog is up 44%. Looking specifically at our defense business, total defense revenue in the third quarter, including ACS and Mercury Federal, declined 1% sequentially and by 9% year over year to $34.2 million. Defense bookings in Q3 were $29.4 million.

Both bookings and revenues this quarter reflect the top sequential and year over year comparisons I just mentioned. Our book to bill in defense for the third quarter fiscal 2010, including ACS and MFS was 0.86 down from 1.38 in the sequential second quarter and 1.25 in Q3 of fiscal 2009.

Our backlog in defense for Q3 decreased 4% sequentially but increased 33% for the same quarter last year. Looking over defense bookings from a broader perspective, last fiscal year the second half was stronger than the first. This trend reversed in fiscal 2010 as we had a very strong first half and I anticipate a weaker second half.

For fiscal 2010 we currently anticipate reporting a book to bill of approximately 1:1. We expect defense bookings to be down from last year. This is largely due to the near term trends we’re seeing in our sales and systems integration business in ACS as well as in MFS. I’ll speak to those trends in a moment.

Overall we expect to return Mercury to growth and to report solid defense revenue growth for the full fiscal year 2010. This reflects the progress we’ve made in restructuring, refocusing and strengthening our core business.

First a quick update on our strategic positioning in defense electronics. We refocused our business in specific markets where funding should continue to grow over the next several years. Airborne intelligence surveillance and reconnaissance or ISR is the largest of these markets and represents about 50% of total defense electronic expending.

One particular area we’ve targeted is airborne persistent ISR which we believe to be an important segment going forward. Looking ahead we’re strengthening our product road map for this segment to include [EOIR] processing for full motion video applications.

Anti-ballistic missile defense is second to the key markets we’ve targeted. The Mercury is providing crucial radar signal processing technology for two key BMD programs. With the military’s emphasis on improving and expunging the nation’s mobile BMD capabilities we believe these programs will continue to be a Defense Department priority into the foreseeable future.

The Navy’s Aegis ballistic missile defense capability has become our largest single program. Our bookings in Q3 included an additional $3 million in the Aegis orders. As anticipated previously, we do expect to see significant revenue from this program in Q4 which is reflected in our current guidance.

A second major BMD program is Patriot, the mobile ground-based missile defense platform. We expect to see continued growth in Patriot foreign military sales through Raytheon over the next several years. In total, revenues in our radar business for the first nine months in fiscal 2010 grew 17% year over year and bookings were up 40%.

Our third growth market is electronic warfare or EW. This market encompasses electronic, signal and communications intelligence processing or ground-based naval and aerial platforms. We are working hard to penetrate a number of emerging EW opportunities.

One all of them, Encounter ID has become large enough to be considered a growth market in its own right. The DOD has challenged the defense electronics community to deliver technology that can effectively detect and counter roadside bombs and Mercury is engaged in this effort. We’ve been [down] selected by two primes to work on a next generation counter ID program of record. While still in the early phase, this program could generate significant revenue for us long-term.

If the program is funded, it could ultimately lose its production. In addition to funding levels, there are two other key factors to consider in the defense procurement environment and both represent advantages for Mercury. First, it’s part of a long-term re-prioritization. The DOD is shifting its emphasis from making new weapons systems development to upgrade to the existing programs and platforms. These upgrades focus on four key areas: improved sensors, more advanced signal processing and computing, enhanced algorithms and better communications on and off the platform. These are all areas of strength for Mercury.

Second, the DOD is deeply committed to long-term broad-based procurement reform, shifting more emphasis to our quick reaction capabilities or QRC as well as more firm fixed price contractor awards. Fixed price elevates risk for the primes. To mitigate this risk, they’re outsourcing some of their capabilities or technologies to best of breed companies in those particular areas. We create our service and systems integration business within ACS and our MFS business to capitalize on these opportunities.

Given these market dynamics, there are five factors that we believe will drive our growth over the next several years. One is the potential for re-growth in ACS commercial and I’ll start there.

In the third quarter fiscal 2010, revenue from our commercial business was down 28% year over year at 10% sequentially. Through the third quarter, the decline was in part related to the overall weakness in the semiconductor industry. But the largest of our decline in revenue came from our end of life medical business which we do not expect to recover.

On the other hand, bookings and commercial rebounded strongly in Q3 and were up 147% sequentially and more than 90% year over year. The bookings growth was driven largely by a sharp increase in semiconductor where sales to KLA Tencor grew due to an increase in product lead times and product transition as well as a strong overall demand.

At KLA Tencor we’re roughly half way through their current product cycle and expect the related production revenues to continue into fiscal 2011. Our visibility however, with respect to our involvement in the next generation system, is less clear at this point. At ASML, our opportunities are primarily related to a major design win which occurred in fiscal 2009 on the next generation platform.

Although we’ve begun receiving production revenues from ASML, it’s still in the early phases of their new product introduction cycle. Our business with them will take time to accelerate especially since it seems most of that growth to date was in their lower range and existing product line at which Mercury not a part. As a result, we don’t expect to see the same level of commercial bookings growth sequentially in Q4 as we saw in Q3.

Given the underlying volatility we continue to see in our commercial business, we remain cautious in the near term and are modeling roughly flat commercial revenue year over year for financial year ‘11.

The outlook for growth in our defense business, however, couldn’t be more different. This brings us to the second of our five growth drivers, increasing the number and body of our design wins in defense. Mercury won 14 new designs in the third quarter 2010, ten in defense and four in commercial which compares with a total of nine design wins all of them in defense in Q3 of last year.

Probably the most significant win this quarter was for another system on the Aegis B&D platform which could potentially result in tens more millions of dollars for us in the years ahead.

For the first nine months of fiscal 2010 the total five year probable body of our design wins declined 11% from the same period last year to $140 million. In defense specifically, fiscal year to date, the five year probable value is up 13% year over year to $121 million. Our success in winning new designs reflects the impacts of the restructuring and refocusing of our business over the past two years.

We dramatically improved our R&D leverage first in hardware and now moving on to software. As a result we’ve refreshed both our signal processing and multi-computer product lines by increasing our product velocity. Faster product velocity aligns us with the government’s demands on the primes of QRC.

By shortening our product development times we’ve been able to quickly launch the great products we need to win new designs for the primes and ultimately drive bookings and revenue. The DOD is also putting more emphasis on rapid product customization using open standards.

This is another area where we’ve aligned Mercury with the available needs of the primes. Mercury led the industry working group developing the next generation of embedded system standards called Open VPX. And we’ve positioned ourselves as first to market by developing a broad range of new Open VPX solutions. Open VPX is important because it enables the primes to obtain both high performance and highly customized solutions using open standards for the first time.

With the government driving the primes towards open systems, QRC, and fixed pricing, we believe the industry is heading towards more commercial items, architectures like Open VPX and more complete value added signal processing sub-systems instead of boards. This is our third growth opportunity and the reason why we developed our services and systems integration business within ACS.

In the third quarter, services and systems integration revenues more than doubled year over year to $7.2 million. On a sequential basis revenue for Q3 grew 6%. For the first nine months of fiscal 2010, services and systems integration revenue grew over 200% versus the same period last year.

However, this is still a starter business for us. Comparatively, bookings and services and systems integration for fiscal 2010 will likely be lower than 1. This is due to a very strong year in fiscal 2009 and the number of programs that have pushed out due to the timing and availability of funding.

As a result, we’re likely to be heading into fiscal 2011 with a lower backlog in this business then we had going into fiscal 2010. And this is likely to be reflected in lower fiscal 2011 revenues. That said, we remain very confident that our services and systems integration business as well as MFS are very important parts of our business model and have positioned us as the ideal partner for the primes going forward. That is as a best of breed provider of open, application ready multi and sub systems and services for the ISR market.

MFS is the fourth in our list of five business opportunities. The hybrid business model that we created within Mercury Federal enables us to leverage our main expertise in high end embedded computing by providing services directly to the end customer at the front end of the design and development process. This can open the door to design opportunities for our ACS business in areas beyond the commercial item defense and electronics market that historically we wouldn’t have been able to address.

The capabilities we’re building in MFS clearly differentiate us from our competitors. They better position us to serve as the architects for advanced signal, image and sensor processing subsystems or next generation ISR programs and platforms. Q3 bookings at MFS grew sequentially to $2.7 million from $400,000 in Q2. The decline year over year from the record of quarterly bookings of $5 million were reported for Q3 in fiscal 2009.

A major program in MFS is for the image processing subsystem for the next generation persistent ISR capability on a tactical unmined aerial vehicle. This platform will collect and transmit wide area motion imagery directly to the analysts and soldiers who need it on the ground in time for the information provided by these images to be actionable. In the near term, MFS bookings and revenue are likely to remain highly concentrated and will continue to be driven by the single large program whose timing and funding particularly for fiscal 2011 is still being determined.

Under the leadership of Dave Martinez who joined us early last month as President of MFS, we are optimistic about the prospects of this new business. We expect that long term, he will become an increasingly important part of our overall revenues. However, growth in FY ‘11 may be challenging given our short-term bookings outlook and likely year-end backlog for MFS.

Business opportunity number five is growth through acquisitions. We continue to look for opportunities in three areas. First are the opportunities to strengthen our ISR domain expertise and MFS. Second is increased access to the most promising next generation ISR platforms and programs. Thirdly is technology and products so that we can expand our platform content footprint.

So to sum up, we restructured, strengthened and refocused Mercury in ways that align the business with key tech trends and defense procurements. As a result, we have created a solid momentum in our core ACS defense business where we expect further strong growth in financial-year ‘11.

Our commercial business, on the other hand, will likely continue to face challenges. In the longer term, we see the potential for additional growth in our new services and system integration and MFS businesses. We look forward to capitalizing in the opportunities that we have created in defense and continue to achieve our growth and profitability goals in Fiscal 2010 and beyond.

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

Bob Hult

As a reminder, I will be discussing our results on a GAAP basis. Please note that commencing with FY ‘10 our non-GAAP measure for reporting financial fulfillment 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 that I will be discussing will relate only to continuing operations. Total revenue for the third quarter of fiscal 2010 was $43.6 million above the high-end of our guidance range of $41 million to $43 million. This compares with $50.6 million in revenue for the third quarter of fiscal 2009.

Please note that in Q1 of fiscal 2010, Mercury elected to adopt a new EITF08-1 revenue arrangements with multiple deliverables. Mercury was not required to adopt this guidance until Q1 of fiscal 2011. We elected to only adopt as the company feels this guidance allows for the recognition of revenue for the arrangement of multiple deliverables more closely mirrors 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 with multiple element arrangements. In Q2 and Q3 we recognized a net $2.3 million and $3.2 million respectively for FY ‘10 year-to-date incremental revenue amount of $7.5 million.

GAAP income from continuing operations from the third quarter of fiscal 2010 was $3.7 million with $0.16 per diluted share of approximately 2 million shares outstanding. The upside from our Q3 guidance of negative $0.15 to negative $0.11 reflected three factors; higher revenue, higher gross margin driven by product mix, and reduced other costs of goods sold and discrete tax items leading to a lower estimated tax rate for FY ‘10.

For last years’ third quarter, Mercury reported GAAP income from continuing operations of $4.7 million or $0.21 per diluted share. Looking at our revenues by operating unit, revenue in ACS including both defense and commercial for the third quarter fiscal 2010 was $42.2 million, down by $7.3 million from $49.4 million in Q3 last year.

Year-to-date ACS revenues is $132.2 million compared with $138 million for the comparable period in fiscal 2009. Our services and systems integration business within ACS posted another quarter of strong growth, year-over-year, delivering $7.2 million in revenue compared with $3.3 million in Q3 last year.

Our Mercury Federal Systems business again performed well as revenue increased to $2.3 million from $2.0 million a year ago. On a sequential basis MFS revenue declined from $3.2 million in Q2. We are continuing to deliver solid results in our core defense business. Total defense revenue for the third quarter, including ACS defense and MFS, declined 9% year over year to $34.2 million from $37.5 million in the third quarter of fiscal 2009.

Sequentially defense revenue is down by 1 %. However, for the 9 months year-to-date, defense revenue totaled $109.7 million, up 5% over the $104.9 million for the comparable period last year. Commercial revenue for the third quarter of fiscal 2010 was $9.4 million, down 28% from the $13 million reported in Q3 last year. Sequentially commercial revenue declined 10% from the $10.5 million that we reported for Q2.

Mercury’s total book-to-bill ratio for the third quarter, including ACS and Mercury Federal was 1.14 compared to 1.24 in the sequential second quarter and 1.14 in Q3 last year. Mercury’s Q3 total backlog, including the third revenue, was $116.6 million. This compares with backlog of $110.4 million for the sequential second quarter and $82.3 million in Q3 of fiscal 2009.

Approximately 85% of our current backlog relates to defense. In addition, $94.4 million or approximately 81% of our total Q3 backlog relates to shipping schedule within the next 12 months. This is up by $6.2 million from Q2 and by $29 million year-over-year. As that backlog continues to grow, not only does our near term visibility revenue need to improve, but our ability to execute future quarters in a more linear shipping fashion should also improve.

Mercury’s adjusted EBIDTA for the third quarter of fiscal 2010 was $4.2 million. This compares with $8.4 million in our first quarter fiscal 2009. Please be reminded that third quarter fiscal 2010 results include a $2.2 million tax benefit compared to a $0.1 million of tax expense in the third quarter of fiscal 2009. We will discuss the drivers of the tax benefit shortly.

The adjusted EBIDTA for Q3 2010 excludes the impact of approximately $0.5 million in charges as follows: $0.2 million in interest income, $0.2 million in interest expense, $2.2 million tax benefit, $1.3 million in depreciation, $0.9 million in stock-based compensation charges, $0.4 million in amortization of acquired intangible assets, $0.1 million in impairment charges. Our adjusted EBITDA margin remains strong at 10%. This compares with 12% in the sequential second quarter and 17% in Q3 of ’09.

In the first 9 months of fiscal 2010, our adjusted EBIDTA margin improved from $16.9 million or 12% in the comparable period last year to $17.4 million or 13% against a longer term pro forma target of 17% and 18%. The reconciliation of adjusted EBIDTA to GAAP net income of continuing operations is included in the earnings press release that we issued this afternoon.

As I’ve mentioned, we have a $2.2 million tax benefit for the third quarter, including certain discrete items. We expect that estimated tax rate to be approximately 7 % for the full fiscal year FY ‘10. This estimate reflects our latest view with regard to maintaining the valuation allowance on our deferred tax assets and our ability to utilize the DTAs in future periods.

If, based on information available to us at the end of this fiscal year, we believe that we can utilize that deferred asset and the evaluation allowance would be reversed. Subsequently, we would then expect to evidence a more normalized estimated tax rate in the range of 35% to 37% for FY ‘11. Our Q2 results, again, demonstrated the leverage of our business model. Gross margin was 56.9 %. It is a little bit better than our guidance range of 50% to 51%. Our favorable gross margin continues to be driven by three factors. First, the higher revenue, second, favorable product mix; and third, lower fixed manufacturing costs and other costs of goods sold.

In addition, as I mentioned last quarter, our investments and engineering methodologies and supply chain capabilities is continuing to drive product quality and time to market benefits. As a result, we are continuing to see declines in warranty costs, inventory provisions and scrap. Operating expense for the third quarter of fiscal 2010 was $23.7 million down modestly from $24.4 million in Q3 last year and $24 million last quarter, underlying our guidance of $25 million.

We are continuing to make good progress improving the underlying operations of the business in terms of our supply chain infrastructure and our working capital and 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 grow Mercury’s revenues. Inventory was up sequentially $20.1 million up from $16.9 million in Q2. The increase was entirely related to our pre-positioning of material to support the large radar shipments we are expecting to make in Q4.

Inventory returns for the third quarter were 3.7. DSOs were 63 days, up from 62 in the sequential second quarter. Mercury generated $2.4 million in positive free cash flow in Q3 compared with $3.2 million in Q2 and $1.5 million in Q3 last year. For the fiscal year-to-date, free cash flow totaled $7.4 million up from $4.6 million for the first 9 months of FY ’09.

Turning to the balance sheet, cash equivalents and marketable securities at the end of the third quarter of FY ‘10 totaled $92.9 million. As a reminder, our auction rate securities agreement with UBS entitles us to full repayment of our outstanding ARS portfolio at par on June 30, 2010. During Q3 we experienced $11.2 million of early calls on our auction rate securities at par. This leaves us with a $38 million balance that will be redeemed at par on June 30 and subsequently set up for cash, one day later, on July 1, 2010. In the interim, we have a $25 million zero cost loan from UBS. At the end of the third quarter our total employee headcount, excluding contractors, was 540 compared with 525 at the end of Q2.

Moving on to guidance, for the fourth quarter of fiscal 2010, we currently expect a revenue range of $58 million to $60 million. Delivering the midpoint of this range would be consistent with the full year FY ‘10 revenue guidance we provided last quarter of $195 million. As a reminder we’ve provided this full year revenue guidance last quarter including the timing of the shipments for the ACS radar order. We do not expect to continue the practice on a regular basis going forward.

Turning to the other guidance metrics, we anticipate reporting Q4 margin of approximately 55%. Our fourth quarter operating expenses are currently anticipated to be approximately $46 million. CapEx for the fourth quarter of fiscal 2010 is projected to be approximately $2.8 million. We expect to report Q4 GAAP income for continuing operations in the range of $0.45 to $0.28 on approximately 23.3 million shares outstanding.

Turning to Mercury’s adjusted EBIDTA for the fourth quarter of fiscal 2010, our estimate excludes the following approximate amounts: depreciation of $1.5 million, $1.2 million in stock-based compensation costs, $0.4 million in amortization of acquired intangible assets, interest income of $0.2 million, and interest expense of $0.1 million.

As I said, our estimated tax rate for fiscal 2010 is expected to be approximately 7%. As a result, adjusted EBIDTA for Q4 FY ‘10 is currently expected to be in the range of $9.3 million to $9.9 million. With that said, I have one closing comment. At this point in the year, the focus is increasingly turning to FY ‘11. Although I am not making it a practice to provide annual guidance, I would like to remind you that we do have a target business model that we believe remains relevant for our planning horizon over the next two or three years.

We are clearly having a strong FY ‘10 fueled by elevated gross margins due to a favorable product and business mix and the benefits of our focus on quality resulting in lower other costs of goods sold. However, our target model for gross margin remains in the 54+% range over the planning period.

We have also been very successful holding down operating expenses in FY ‘10. We continue to expect operating expenses to grow at a slower rate than our revenue will. Although our budget for FY ‘11 is not complete at this point in time, we do anticipate upward pressure on OpEx for FY ’11. This is mainly related to cost of living and merit pay increases and selective hiring. Though, again, we would point to our target model as an accurate indication of where we see Mercury’s business trending going forward.

With that we will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Tyler Hojo – Sidoti & Company, LLC.

Tyler Hojo – Sidoti & Company, LLC

Just on that $28 million ACS order, has any of that shipped so far in the fourth quarter?

Mark Aslett

No it hasn’t. We expect to ship approximately $20 million of the $28 million or $27 million in Q4 split over two shipments; one in May and one likely in June.

Tyler Hojo – Sidoti & Company, LLC

Okay. Has that expectation gone down a little bit for the fourth quarter?

Mark Aslett

No it has not. It is pretty in line with what we were anticipating in Q3.

Tyler Hojo – Sidoti & Company, LLC

Okay, very good. Then maybe, if you could just talk about… What is the risk here if that is pushed out? How much confidence do you have in that stuff shipping in the quarter?

Mark Aslett

Well at this point we feel pretty comfortable. We are in constant dialogue with our customer. They are in the final processes of negotiation and documenting their contract with the government. So we expect it to occur as I just described in Q4 and it is in our guidance for the fourth quarter.

Tyler Hojo – Sidoti & Company, LLC

Okay. I mean you commented in the prepared remarks just about seeing some perhaps incremental strength in some of your other defense programs in the quarter. I was just wondering if you could perhaps elaborate on that at all.

Mark Aslett

Well I think longer term, as I said in my prepared remarks, we believe that the Patriot program is going to be an important driver of growth for us longer term. I think today we received a single PO for a single country, from Raytheon.

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and Swanson sat on the Raythoen call. They’re obviously pursuing multiple countries such as Saudi, Turkey, Japan, etc., and as we know, Congress recently approved the sale of major new weapons systems including the Patriot to Taiwan. So I think overall, yes, we do expect Patriot’s MFS sales through Raytheon to be an important growth driver for us going forward. So, Aegis and Patriot I think are going to be important ones for us Tyler.

Tyler Hojo – Sidoti & Company, LLC

Right, right. I was more getting at just in the quarter. I mean, you exceeded the high end of the guidance range—

Mark Aslett

Yes.

Tyler Hojo – Sidoti & Company, LLC

Go ahead, I’m sorry.

Mark Aslett

Yeah, so no, clearly we did. I mean I think we saw strength in Global Hawk I believe this quarter… and it was one of the major ones.

Tyler Hojo – Sidoti & Company, LLC

Okay, that’s fair enough. And then just one last quick housekeeping question for me. Was Merc Fed profitable again this quarter?

Mark Aslett

No Merc lost several hundred thousand dollars in the quarter.

Tyler Hojo – Sidoti & Company, LLC

And the guidance for 4Q, what’s the expectation for performance in that segment?

Mark Aslett

Well we don’t typically forecast at a segment level on a go-forward basis, so…

Tyler Hojo – Sidoti & Company, LLC

Understood, but I mean maybe if you could directionally comment on trends in either sales or where the business is currently running from a profit perspective.

Mark Aslett

Yeah, I mean, it’s hovering around breakeven to, you know, losing a little bit of money. I mean, it’s highly sensitive on the revenue given the fixed expense that we’ve got. So it could be up a little; it could be down a little.

Operator

Our next question comes from Stephen Levenson – Stifel Nicolaus.

Stephen Levenson – Stifel Nicolaus

Just a question – how many 10% customers do you have this quarter and were they all in defense?

Bob Hult

Steve, we had one, and it was in defense. Year to date we actually had three and they are also all in defense.

Stephen Levenson – Stifel Nicolaus

Okay thanks. And one of the things I was curious about, with the focus on airborne, one of Mercury’s advantages in the past has been form factor and heat dissipation. How does that play into what your plans are now in going forward?

Mark Aslett

Form factor and…? I didn’t hear the second part of the question Steve.

Stephen Levenson – Stifel Nicolaus

Heat dissipation.

Mark Aslett

Clearly we believe that size, weight and part are still very important factors in not only the airborne, but pretty much all mobile defense applications and I think what we try to do is lead the industry going forward by actually authoring the next-generation embedded system standard which is OpenVPX. So, where we’re going is kind of heading up market to focus more on application-ready subsystems that are size, weight and part constrained, so… You know, we think that those… You know the space and thermal dissipation, etc., is still pretty important for us.

Stephen Levenson – Stifel Nicolaus

Okay thanks. There’s recently some talk about the platforms that are planned that include everything from big jets like JSTARs down to the Project Liberty planes and then the UAVs. Based on what you’re hearing are those potentially common? I know it’s not a common platform, but will it be a common payload? That if you’re in one, you’re likely to be in all?

Mark Aslett

It very much depends. You know, if you look at, say, on the radar side, the Air Force is got the MP-RTIP program which is a multi-platform radar capability. If you look on the SIGINT side there are payloads such as ASIP that span across different platforms. You know, we believe that we’re pretty well positioned on some of the more important ones going forward Steve, but I don’t think you can make a truly broad statement to say that everything is going to be around one or two standards.

Operator

Our next question comes from Jonathan Ho of William Blair.

Jonathan Ho – William Blair & Co.

Just a quick question, I didn’t know if I heard this correctly or not, but did you guys say that your expected bookings in the back half of the year to be a 1:1 ratio, implying down in the fourth quarter?

Mark Aslett

So we’re expecting for the year, our book to bill to be approximately 1:1. I think in the prepared remarks, it suggested that we had a stronger first half than what we’re seeing in the second half. And you know, we don’t think there’s anything particularly happening there, it’s just the way in which the business laid out this year.

Jonathan Ho – William Blair & Co.

Great, and can you talk maybe a little bit about the supplemental and the 2011 budget and some of the good things that you’re seeing there? And maybe give us sort of your high level thoughts on, you know, how that would translate into sort of a benefit for Mercury’s programs?

Mark Aslett

Yeah, so I mean, I think overall if you look at the budget on a year over year basis, it’s going to be up – base budget up – roughly 3%. And we kind of see those levels looking forward out over a five-year time horizon. When you step back and you look at the recently completed quadrennial defense review, you know we definitely believe that we’re well positioned within the areas that are going to continue to see growth and good bonding from a government perspective.

Like Airborne ISOL, BMD, Encounter ID, et cetera. So, just some of the things that we picked up from a budget perspective is clearly… You know, we’re expecting pretty good growth in terms of tactical UAVs in particular. Program Reaper, the dollars associated with those on an ’11 basis versus ’10, we’re up 58%.

You know, we’re seeing additional funding for a dollar perspective with Global Hawk, with those numbers expected to go up on a dollar basis, 7% year over year. And of course, I think when you look at the budget overall, Aegis continues to be well funded and I think they’re looking at adding additional ships in the ’11 budget. So overall, I think we feel that we are in the right spots, you know, from a defense budget perspective, looking at the base budget as well as the overseas contingency.

Jonathan Ho – William Blair & Co.

Great, and just one final question on the commercial side of things. Can you give us a little bit more color on exactly what’s happening with KLA? I know you guys said that you’re on the current system and the next-generation system competition… What’s your thoughts there in terms of being able to keep that program and approximate timing in terms of when that’s going to be decided?

Mark Aslett

Okay, so if you look at our semi business was obviously very, very strong from a booking perspective this quarter. Bookings were up around about $13.6 million in semi; we’re up 162% year over year and up 187% sequentially. The first was obviously increased demand; however we did see additional orders associated with increased product lead times as well as the product transition.

The other two which we don’t expect to occur on a go forward basis. Looking forward, if I kind of project into FY ’11, we’re probably halfway through their existing current products cycle and we expect the revenues associated with that to continue into FY ’11. At this point we’re still kind of determining how far into the year. Our best guess at this point is probably 9 months. So that’s kind of an assumption we’ve got. As our budgeting cycle improves, then the visibility will hopefully go up.

With respect to our involvement in the next generation system, again, things are a little unclear at this point and as such, we’re basically modeling KT to be down in financial year ’11.

Operator

Our next question comes from Jim McIlree – Merriman.

Jim McIlree – Merriman

Can you help me understand why gross margins would be down quarter to quarter when you have such a large revenue increase quarter to quarter?

Bob Hult

Good question. The big driver there is pretty much the way it has been the past few quarters. It’s going to come down to product mix within the quarter. Though we have driven our [inaudible] down quite well and I think that’s your point. We get more volume across items that behave, at least in the short term as fixed costs, so that’s a plus up for us, no doubt about that. Our current view on the mix for the fourth quarter would indicate to us that our guidance around 55% is more or less correct.

Jim McIlree – Merriman

Just the math on it implies that the Aegis orders have a lower margin than the corporate average, is that correct?

Bob Hult

I wouldn’t go there. Aegis certainly as a program does not have a lower margin than our overall. Don’t forget, we just had a great booking quarter with Commercial and that’s a precursor to a pretty strong revenue rebound for Commercial, particularly semi in Q4. There we do have a lower margin than we experienced typically on our defense programs.

Jim McIlree – Merriman

Then on the outback side, what’s the driver for the increased OpEx quarter to quarter?

Bob Hult

It’s mostly engineering where we keep working on our product roadmaps. We do have some external spending associated with new product development, specifically prototype spending, so that’s a driver.

Mark Aslett

It’s really timing, if you look at we were down a little bit this quarter. Things can move either side of the quarterly boundary so it’s more timing than anything in Q4.

Jim McIlree – Merriman

Lastly, I just want to make sure I understand your comments on commercial. You said that fiscal ’11 commercial is likely to be kind of flattish with fiscal ’10 is that correct?

Bob Hult

Yes.

Jim McIlree – Merriman

How much of the end of life medical do you expect to have in fiscal ’10 that you won’t have in fiscal ’11?

Mark Aslett

I’ll give you the numbers on a year over year basis . In fiscal year ’09 through the first three quarters we did approximately $7.2 million in revenue. In the first three quarters of financial year ‘10 we’ve done approximately $1.4 million. So we’ve seen a pretty substantial drop off in terms of our medical business.

If you step back and you look at it we’re cautious in both the short term and modeling roughly flat revenues in ’11. KLAs are mentioned we’re roughly half way through there and their existing and current product cycle. There’s still another huge amount of visibility in terms of how far that product cycle is going to continue into ’11 and then the uncertainty around the next generation.

With ASML we feel good but we’re at the start of their new product introduction cycle. Then, to date, most of the growth that they’ve seen has been in relation to their lower existing product line of which Mercury is not a part. We do expect long-term growth. In fact, we’re modeling good growth for ASML in ’11 but it’s kind of [inaudible] there.

Looking at the other segments, you were expecting declines in certain commercial communications and other legacy customers and then clearly in the end of life legacy business, our medical business. Given that we are cautious and that’s why we’re modeling roughly flat revenues in commercial in ’11.

Jim McIlree – Merriman

This Aegis order that you have, that you’re expecting, I think you said $20 million in Q4, you don’t have PO’s yet from Lockheed? That May, June delivery is when you’re expecting them, is that correct?

Mark Aslett

No, that’s not correct. We actually received a $27 million PO in Q2 and it’s our expectation that we’ll ship $20 million of that in the fourth quarter. We really are waiting for ship signals from Lockheed at this point.

Jim McIlree – Merriman

So I misspoke. You have the PO but you don’t have the delivery timetable yet?

Mark Aslett

That is correct.

Operator

Our next question comes from Mark Jordan – Global Financial Group

Mark Jordan – Global Financial Group

If you were to at the end of the fourth quarter flow through all of the valuation allowance on deferred tax assets, how big a number would that be?

Bob Hult

The flow through that is not currently reflected in our forecast and ETA, is that what you’re asking Mark?

Mark Jordan – Global Financial Group

That’s correct. If the accountants were to say eliminate all of the valuation allowance this quarter what kind of number would that be flowing through?

Bob Hult

We’ve got about $14 million in deferred tax assets on the books with a $13 million valuation allowance against it. Essentially a full valuation allowance. If it gets flipped at the end of the year, about $6 million of that is going to flip. The remaining $7 million or so is associated with NASA and deep tax credits that we’re never going to be able to use.

Mark Jordan – Global Financial Group

So the $6 million figure would be what you would see flowing through?

Unidentified Executive Male

Incremental to what we forecasted.

Mark Jordan – Global Financial Group

Subsequent to that you would normally see just a normalized tax freed option [inaudible]

Unidentified Executive Male

We are estimating that to be in the range of 35% to 37%. Pretty much right out of the gate, rough Y ’11. I think you do raise a good point, obviously we’re going to have a very low rate apparently estimating 7% for FY’10 and if we stay on track here and do what you’re suggesting, we’re going to have a 35% to 37% rate next year. That’s going to have to be normalized when we do the comps next year and year over year.

Mark Jordan – Global Financial Group

If you’re going to have a 7% rate then that implies that your guidance again, exclusive of any singular tax benefits that may be realized, that if you’re talking 25% to 30% tax rate in the fourth quarter?

Unidentified Executive Male

If you’re asking if there’s potential for other discreet items to hit in the fourth quarter, other than the flip of the value allowance, we do not see any at this point in time.

Mark Jordan – Global Financial Group

I missed the 9 month commercial revenue number. Can I get that please?

Mark Aslett

The revenue for commercial through the [inaudible] Legacy Medical?

Mark Aslett

$26.5 million through the first three quarters of financial year ’10 and $35.6 million through the first three quarters of financial year ’09.

Mark Jordan – Global Financial Group

A final question relevant to ages, deliveries. Obviously you’re having a big surge [inaudible] If you just step back and say Aegis and the navy program are scheduled out and are growing but should run us, just looking at 2011 and say that Aegis should be up year-over-year and do you have any sense as to how lumpy that should be in fiscal ’11? We’re obviously skewed to the fourth quarter here in fiscal ’10?

Mark Aslett

I don’t think Aegis revenues are going to be up in ’11 over ’10. We’re having a very good year in financial year ’10 so I think the way in which we’re currently thinking about it is it’s going to be roughly 10% of our revenues. This financial year the numbers are going to be higher than that. We’re still kind of putting the budget together and working with Lockheed on figuring out what the calendarization of those shipments and revenues will look like, so at this point it’s probably a little bit too early to tell you.

Operator

At this time we have one question left in queue and that comes from Mike Ciarmoli - Boenning & Scattergood.

Mike Ciarmoli - Boenning & Scattergood

With regard to the backlog on the defense side, obviously Aegis is a big contributor. Are there any other major programs making up the balance of that backlog?

Bob Hult

Patriot is still in there to a degree [inaudible] shift all of that.

Mike Ciarmoli - Boenning & Scattergood

[inaudible] thing about it, Aegis is probably 20%, 25%, is there anything else –

Bob Hult

Yes, with that $27 million booking in December, that’s the biggest single item in backlog.

Mark Aslett

There’s nothing that comes even close.

Mike Ciarmoli - Boenning & Scattergood

Fair enough. I may have missed this, but did you guys disclose an operating margin number for ACS?

Bob Hult

No.

Mike Ciarmoli - Boenning & Scattergood

Would you be able to do that?

Bob Hult

We really haven’t done that in the past. What period are you talking about?

Mike Ciarmoli - Boenning & Scattergood

Current quarter.

Bob Hult

We can dig it out for you.

Mike Ciarmoli - Boenning & Scattergood

Then maybe while you’re just digging that up, I guess Mark, you talked about I guess 10 design wins. Can you elaborate where some of those wins are? Are they from kind of just a scopic expansion on some of your current programs? Are they entirely new platforms for you?

Mark Aslett

We got 10 design wins in the fourth quarter, 4 in commercial, 10 were in defense. We got a design win in semiconductor wafer inspection for a company over in Japan. It’s not huge but it’s kind of in the same space. We got another design win in next gen baggage scanning in commercial. They were probably the two main ones in commercial. In defense, I would say the most significant for us was the fact that we’re likely to get over time another system within Aegis utilizing the same technology that we’re providing as part of the signal processing system for the radar, so that has got pretty good upside potential over the planned period. We were really pleased about that.

Another important one that I think we won was with another customer for their next generation [figgen] platform. It’s kind of an architecture that is their next generation architecture that was kind of baked into.

I think we had some nice ones this quarter. Felt pretty good about the results, Mike.

Repeat your other question please?

Mike Ciarmoli - Boenning & Scattergood

Operating margins for the ACS segment in the current quarter.

Bob Hult

I’m looking at our detailed backup sheets and we have not disclosed that at this point in time. You’ll pick it up when we file the Q but it’s typically not been ready right now for this call.

Operator

At this time there are no further questions. I will turn the call back over to our moderators.

Mark Aslett

I just wanted to come back quickly to the question that you asked. The major programs that drove revenue for us this quarter were JSF, Patriot, Aegis, and F16.

So Operator, thanks very much, and thank you all for listening. We’d like to close down the call and we’ll speak to you again next quarter.

Thanks very much.

Operator

This does conclude today’s conference call. We thank you for your participation and have a wonderful day.

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