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Mercury Computer Systems, Inc. (NASDAQ:MRCY)

F4Q10 (Qtr End 06/30/10) Earnings Call

August 03, 2010 05:00 am ET

Executives

Bob Hult - SVP, CFO and Treasurer

Mark Aslett - President and CEO

Analysts

Jim McIlree - Merrill Lynch

Tyler Hojo - Sidoti & Company

Mark Jordan - Noble Financial

Kevin Ciabattoni - Boenning and Scattergood

Jonathan Ho - William Blair

Presentation

Operator

Good day and welcome everyone to the Mercury Computer Systems Incorporated Fourth Quarter Fiscal 2010 Earnings Results Conference Call. Today’s call is being recorded. At this time for opening remarks and introduction, I would like to turn the call over to the company’s Senior Vice President and Chief Financial Officer Mr. Bob Hult. Please go ahead sir.

Bob Hult

Good afternoon and thank you for joining us. With me today is our President And Chief Executive Officer Mark Aslett. If you have not received the copy of the earnings press release, you can find it on our website at www.mc.com. We’d like to remind you that remarks that we may make during this call about future expectations, trends and plans for the company and its business constitute forward looking statements 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, should, plans, expects, anticipates, continue, estimate, project, intent and similar expressions. Such forward looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated.

These risks include, but are not limited to general economic and business conditions including un-foreseen weaknesses in the company’s markets. Effects have continued geo-political unrest and regional conflicts, competition, changes in technology and methods of marketing, delays in completing engineering and manufacturing programs, changes in customer order patterns, changes in product mix, continued success in technological advances and delivering technological innovations, continued funding of defense programs, the timings of such funding, changes in US 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 outsource components. Inability to fully realize the expected benefits from acquisitions and divestitures or delays in realizing such benefits. Challenges in the integrating and acquired businesses and achieving anticipated synergies and difficulties in maintaining key customers.

Additional information regarding forward looking statements and risk factors is included in the company's periodic reports filed with the SEC. We caution listeners of today’s conference call not to place undue reliance upon any forward looking statements which speak only as of the date of this call. We undertake no obligation to update any forward looking statements.

I’d also like to mention that in addition to reporting financial results in accordance with Generally Accepted Accounting Principles or GAAP, during our call, we will discuss a non-GAAP financial measure, specifically adjusted EBIDTA.

Adjusted EBIDTA excludes interest income and expense, income taxes, depreciation, amortization of acquired intangible assets, restructuring expense, impairment of long lived assets, acquisition and other related expense and stock-based compensation costs.

A reconciliation of adjusted EBIDTA to GAAP net income from continuing operations is included in the press release we issued this afternoon.

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

Mark Aslett

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

Q4 was the strong financial two year of solid progress for Mercury. On our call a year ago, we said the business was positioned to expand on both the top and bottom lines. We produced consistent growth in revenues from adjusted EBITDA since then.

Total revenue for the fourth quarter is $63.6 million, exceeded the high end of our guidance range by 3.6 million. Total defense revenue including ACS and Mercury Federal, increased 40% sequentially and by 20% year over year to $47.9 million. This growth was mainly driven by the $19 million Aegis missile defense order we shipped as planned in the quarter. This was also a strong quarter for commercial revenue, which grew 87% year-over-year to $15.8 million.

The work we’ve done to restructure, refocus and strengthen our defense business over the past two years, has significantly improved Mercury’s operating leverage. Our GAAP earnings from continuing operations in the fourth quarter of fiscal 2010, was $0.77 per diluted share, compared with guidance of $0.25 to $0.28 per share.

The major variances to guidance were approximately a $0.32 gain due to the partial release of a tax valuation allowance, as well as a $0.14 gain due to higher revenues and lower operating expenses.

Adjusted EBITDA for Q4, increased from $5.9 million a year ago to $12.4 million, compared with our guidance of 9.3 million to 9.9 million.

We ended fiscal 2010 with a positive book-to-bill of 1.03. Total backlog including both defense and commercial is up 6% year-over-year and our 12 months backlog is up 27% year-over-year. We expect this backlog to translate into solid year-over-year revenue growth in fiscal 2011.

Last quarter, I said that we expected weaker defense bookings in the second half of FY’10 which is the way in which things played out. For the full fiscal year defense bookings were down 18% year-over-year and our book-to-bill was [0.9]. Bookings in MFS came in lower due to shifts in the timing and funding of our largest single program in that business and as mentioned last quarter several deals were also delayed in ACS services and systems integration. I will talk more about both of these businesses in a minute.

Finally a major driver was that we were expecting high bookings from certain foreign military sales in ACS that did not occur during the year. One such examples Patriot, we now expect to realize strong Patriot bookings and revenues in fiscal 2011. As Raytheon mentioned on their earnings call last week, international Patriot was a highlight of the recent Farnborough air show. They believe that Saudi Arabia is likely next in line and Turkey could be a labor in the year.

They also mentioned that UAE is going well and you may recall that Congress has already approved the sale of Patriot systems to Taiwan. Despite the delays that occurred in the fiscal year one important take away on our defense business is that we believe nothing fundamentally has changed. We still do expect to report solid year-over-year growth in bookings and revenue in our defense business in fiscal 2011. At the same time, our commercial bookings for the fourth quarter were up more than 400% year-over-year in Q4 and up 82% for FY’10 as a whole.

Our commercial backlog is up 500% entering fiscal 2011 compared to the year ago. These bookings and backlog growth is driven largely by a product transition within KLA-Tencor. Given that we are reaching the end of this product transition, we are not currently expecting additional KLA bookings in FY11.

In addition, our involvement in KLA’s next generation system, that seems doubtful.

Nonetheless, the high commercial backlog going in to the New Year, has improved our visibility and our confidence in continuing to model roughly flat revenue in commercial for fiscal 2011, this compared with FY 10.

We have also begun to see a ramp in production revenues related to the next generation product roll-out with ASML. We expect that overtime; our business with ASML will help compensate for the expected decline in revenue from KLA.

Let’s now turn to the defense business, where we expect to continue seeing solid growth in both the near and longer term. We have re-focused this business in key markets including ISR, ballistic Missile Defense and electronic warfare. Where we believe DOD funding and foreign military sales will continue to grow over the next several years.

We have also aligned our business model with the comprehensive procure reformed which the DOD is firmly committed. We positioned militaries and outsourcing partners who can help the prime succeed in this new procurement environment. I’ll speak to the five factors that we believe will drive our defense growth over the next several years. The first of these growth drivers is design wins, the most significant long-term, leading indicator in our business.

The dollar volumes for any given design win are usually small initially, but our future growth is all about getting on the right programs and platforms and then seeing these wins develop into significant revenue streams overtime.

We have been successful in drawing the number and the volume of our design wins in defense and the fourth quarter was no exception. Mercury won 11 new design wins in the fourth quarter of 2010, all of them in defense. This compares with a total of 10 design wins, all in defense in Q4 of last year. The fiscal 2010 as a whole, the total five year probable value of our design wins increased 3% from last year to $229 million.

In defense specifically, the five year probable value was up 19% year-over-year to 203 million. Our two most significant design wins this quarter were both in electronic warfare one was for our next generation airborne signal (inaudible) capability deployed on a number of manned and unmanned airborne assets. The other key design win which is likely much larger was related to the surface electronic warfare improvement program.

Sea (inaudible) is the Navy's next-generation electronic warfare suit which Lockheed Martin has been selected as the prime. Together these wins represent significant opportunity for Mercury over the years ahead.

Our second growth driver is the governments increasing demand on the primes for more cost effective, more open, more rapid capability upgrades utilizing more firm fixed price contract awards. We created our services systems integration business within ACS to capitalize on this emerging opportunity.

Driven by four large bookings in FY '09, SSI ended fiscal 2010 with a $23 million backlog that resulted in FY '10 revenue growing 85% year-over-year, clearly a great performance.

SSI however is still nascent in somewhat lumpy business and booking in FY '10 were down $7 million year-over-year. Due to lower bookings and a much lower backlog than we had going into FY '10, we are anticipating lower role exercise service revenues in fiscal 2011.

That being said, we will continue to see the benefits from SSI deals well beyond the time when the initial sales as we delivered. Deals previously won in SSI are likely to generate significant production base annuity streams for ACS in fiscal 2011 and beyond. It’s clear to us that we have succeeded in aligning Mercury with the primes, as the best of breed, outsource provider of application ready sub system solutions for ISR. This position exercise to become an increasingly important part of our business model longer term.

Our third and most immediate source of growth is our involvement with programs that are ramping or that are already in production today such as Aegis, JSF, Global Hawk, BAMS, Patriots, F-16 in the Predator and Reaper UAVs.

We expect these programs to continue providing a growing stream of foundational revenue for the company over the next several years. Revenues in our radar business for fiscal 2010 as a whole grew 31% year-over-year, driven mainly by the Navy’s Aegis ballistic missile defense capability, which is our largest single program in FY ’10.

In terms of fiscal 2011 and future years, we expect to see continued growth in Aegis shipments and revenues through Lockheed Martin as well as stronger Patriot foreign military sales through Raytheon.

We believe we are also well positioned for potential upgrades to the radar of the F-16 and in upgrades to the naval surface, (inaudible) capabilities as previously mentioned. For an existing design win perspective, electronic warfare could be almost significant organic growth opportunity, specifically within the counter id space.

Developing technology that can affectively detect and counter road side bombs, has become one of the DOD’s top priorities. We’ve been down selected by two primes who work on the next-generation counter id program of record. We expect the government to decide to move forward with one of these primes in the fall. Then it comes down to the question of whether the program will be fully funded and how quickly will roll out.

Although we stand a benefit in either case, a decision by the government to award the program to a particular prime could ultimately be a game changer for Mercury in terms of our total revenue from programs in production, beginning as early as fiscal 2012.

[Force] knowledge to growth drivers is Mercury Federal or MFS. The hybrid business model we’ve created with MFS enables us to provide services directly to the end customer at the front end of the design and development process. This can open up design win opportunities for our ACS business in areas beyond the commercialized and defense electronics market that historically we wouldn’t have been able to address.

MFS clearly differentiates Mercury from our competitors. It places us in a stronger position to service sub-systems architects, the next generation ISR programs and platforms. Bookings at MFS were down by $4.4 million for FY’10 as a whole, while revenues nearly doubled to $11.1 million. The Q4 specifically, MFS bookings declined 45% sequentially and by 13% year-over-year to $1.5 million. On major program in this business is for the next-generation persistent ISR image processing sub-system on a tactical UAV.

In the near term MFS bookings and revenues are likely to remain highly concentrated and will continue to be driven by the single large program. Longer term, we expect MFS to become a more significant part of our overall revenues.

The phase II of this major program is awarded in development and funding moves ahead this year, as we think it may. MFS bookings could begin ramping soon as we have previously anticipated.

Our fifth growth driver is the potential for acquisitions. We continue to look for opportunities in three areas. First, strengthening our ISR domain expertise in MFS

Second gaining access to most promising ISR platforms and programs. And third, adding technology and products that can expand our platform content footprint.

We begin fiscal 2011 well prepared to pursue these opportunities. We settle the auction rate securities issue with UBS and ended fiscal 2010 with $74 million in cash as expected as well as zero short term and long term debt.

We also strengthened our management team by recruiting a Vice President of Corporate Development who brings experience with a major US bank and defense related M&A.

In addition last month, we announced that Gerry Haines has joined Mercury as Senior Vice President of Corporate Development and Chief Legal Officer. Gerry brings us in-depth knowledge and experience with M&A in corporate finance, as well as an extensive business and legal background.

We also added significant depth of experience to our Board last month with the arrival of George Muellner. George brings to the board a wealth of knowledge in defense contracting and Aerospace technology as well as government acquisition experience and is also a highly decorated US military veteran.

I’ll wrap up simply by saying that we are in a good place with the programs we are on and with our business model. We have aligned Mercury with the fundamental shift that’s taking place towards outsourcing by the primes and towards service based offerings that can lead to production based annuity streams over time.

A couple of our current early phase programs have the potential to become strong revenue catalysts if they are funded and go into production and as I just mentioned, we have laid the groundwork to drive incremental growth through acquisitions as well.

Looking ahead to fiscal 2011 specifically, we are expecting our defense business and Mercury overall to deliver another year of solid growth. We demonstrated this year that we can translate higher revenues into higher GAAP operating income and adjusted EBITDA. We believe more strongly than ever in our thesis that Mercury will grow into its longer term operating model as the business scales.

Bob will have more to say about our expectations for the business going forward. So, with that Bob, I'll turn it over to you.

Bob Hult

Thank you, Mark. As a reminder I will be discussing our result on a GAAP basis. Please note that commencing with FY 2010, our non-GAAP measure for reporting financial performance is adjusted EBITDA, we believe that GAAP combined with adjusted EBITDA is consistent with practices in the defense industry.

In addition since we had divested all of our non-core businesses and have been treating them as discontinued operations since the end of FY '09, the numbers I will be discussing relate only to continuing operations.

Mercury's total revenue for the fourth quarter of fiscal 2010 was $63.6 million, exceeding the top end of our guidance range of $58 million to $60 million. This compares with $48.4 million in revenue for the fourth quarter of fiscal 2009.

For the full 2010 fiscal year, total revenue increased nearly 6% to $199.8 million from $188.9 million in fiscal 2009. Please note that in Q1 of fiscal 2010, Mercury elected to adopt a new EITF 08-1 revenue arrangements with multiple deliverables.

Although Mercury was not required to adopt this guidance until Q1 of FY '11, we elected to early adopt as the company believes this guidance allows for the recognition of revenue for an arrangement of multiple deliverables and will closely mirror the economics of the arrangement.

As result of this adoption, in the first, second, and third quarters of fiscal 2010, Mercury recognized a net $2 million, $2.3 million and $3.2 million respectively. That would have been deferred under the previous guidance EITF 00-21 with multiple element arrangements.

We recognized a net $17.6 million in Q4, the majority of which was from our large Aegis program shipment, resulting in incremental revenue of $25.1 million for full year FY 2010.

GAAP income from continuing operations for the fourth quarter of fiscal 2010 was $18.0 million or $0.77 per diluted share on approximately 23.3 million shares outstanding. This was well above our Q4 guidance of $0.25 to $0.28 due to three factors. First, higher revenue and lower operating expenses accounted for a combined $0.14 of the difference. Secondly, a partial release of the evaluation allowance on our deferred tax assets accounted for approximately $0.32 of the difference. And thirdly, the remaining difference of $0.04 resulted from other tax related items including in FY ’10, effective tax rate true up and certain discrete items.

For the fourth quarter last year, Mercury reported GAAP income from continuing operations of $3.1 million or $0.14 per diluted share. For fiscal 2010 as a whole, GAAP income from continuing operations increased to 28.1 million or $1.22 per diluted share from $7.9 million or $0.35 per diluted share for fiscal 2009. Again, the year’s results were positively influenced by the partial release of our valuation allowance and an FY10 effective tax rate benefit of approximately 5%.

Breaking it down by operating unit revenue in ACS including both defense and commercial for the fourth quarter of fiscal 2010, was $62.6 million, compared with $47.2 million in Q4 last year. For the full fiscal year ACS revenue increased 193.7 million from 185.3 million in fiscal 2009. Revenue on our services and systems integration business within ACS for the fourth quarter of 2010 was $4.7 million compared with 7.0 million in Q4 last year.

For the full year fiscal 2010, revenue in SSI increased to 24.4 million from 13.2 million in the prior fiscal year. In our Mercury Federal Systems business, Q4, fiscal 2010 revenue was flat sequentially in year-over-year at $2.3 million. For the full fiscal year revenue in MFS grew to $11.1 million from 5.8 million in fiscal 2009.

This was a strong quarter for Mercury’s core defense business. Total defense revenue for Q4 including ACS defense and MFS increased 20% to $47.9 million from 40.0 million in Q4 of fiscal ‘09. Sequentially total defense revenue was up by 40% from Q3. For the full 2010 fiscal year total defense revenue was $157.5 million up 9% from 144.9 million in fiscal 2009.

Commercial revenue for the fourth quarter fiscal 2010 increased 87% to $15.8 million from 8.4 million in Q4 last year. Sequentially, commercial revenue was up 68% from the 9.4 million, we reported for Q3. For fiscal 2010 as a whole, commercial revenue totaled $42.3 million down from 44.1 million in the prior fiscal year.

Turning to bookings, total bookings for the fourth quarter of fiscal 2010 was $51.6 million, compared with 64.4 million in Q4 last year. Sequentially, total bookings were up 3% from 49.9 million in Q3.

Q4 was a difficult comparison year-over-year, because in the fourth quarter of 2009, our bookings included two orders in our services and systems integration business that totaled more than $30 million.

Mercury’s total book-to-bill ratio for the fourth quarter including ACF and MFS was 0.81, this compares with 1.14 in the sequential third quarter and 1.33 in Q4 last year. For the full 2010 fiscal year, book-to-bill was 1.03 compared with 1.11 in fiscal 2009.

Our Q4 total backlog including deferred revenue was $104.6 million, this compares with backlog of 116.6 million for the sequential third quarter and 98.2 million in Q4 of fiscal 2009. Approximately 73% of our current backlog relates to defense.

Approximately 85% or $88.4 million of our total Q4 backlog relates to shipment schedule within the next 12 months. This is down by $6 million from Q3, but up by 18.7 million or 27% from the fourth quarter of 2009. Given the year-over-year growth in our backlog, we should see continuing improvement in our near term revenue visibility and then our ability to execute future quarters in a more linear shipment fashion.

In defense specifically bookings for the fourth quarter of fiscal 2010 including ACS and MFS with $27.1 million this compares with total defense bookings of 29.4 million in the sequential third quarter and $59.8 million in Q4 last year. Again Q4 year-over-year defense bookings reflected the difficult comparison as previously mentioned.

Our defense book-to-bill for Q4 including ACS and MFS was 0.57 down from 0.86 in the sequential third quarter and 1.49 in Q4 of fiscal 2009. Our backlog in defense for Q4 decreased to 76.8 million from 98.7 million in Q3 and 93.8 million in Q4 of FY '09. The sequential decline was primarily due to the large easy shipment this quarter.

Adjusted EBITDA for the fourth quarter of fiscal 2010 was $12.4 million, this compares with 5.9 million for the fourth quarter of fiscal 2009. Please be reminded that our Q4 results include a $7.4 million tax benefit derived from the partial valuation allowance redressal against that deferred tax asset.

Adjusted EBITDA for Q4, 2010 excludes the impact of approximately $5.6 million in net benefits as follows: 0.1 million in interest income, 0.1 million in interest expense and $8.4 million tax benefit, 1.4 million in depreciation, 0.4 million in amortization of acquired intangible assets and 1.0 million in stock based compensation charges. We did not incur any restructuring impairment or acquisition and other related expenses there in the quarter.

As Mark said, our results in Q4 reflected continuing improvement in our operating leverage. Our adjusted EBITDA margins in Q4 increased to 20% from 10% in the sequential third quarter and 12% in Q4 of ’09, closing in on our longer term pro forma target of 17% to 18%. For the full 2010 fiscal year, our adjusted EBITDA margin increased to $29.9 million or 15% from 22.9 million or 12% in fiscal 2009.

A reconciliation of adjusted EBITDA to GAAP net income from continuing operations is included in the earnings press release we issued this afternoon. On the tax front, Mercury’s FY ’10 effective tax rate which excludes the impact of the valuation allowance release and other discreet items was approximately a 5% benefit. This was primarily driven by the company’s decision to adopt the EITF 08-1, revenue arrangements with multiple deliverables for book purposes at the beginning of FY’10. We are currently working to request IRS approval to adopt 08-1 for tax purposes affected in FY’11.

In addition, based on information that became available to us at the end of FY’10 we determine that we can release approximately 7.4 million of our valuation allowance relative to our deferred tax assets. Accordingly, we reversed $7.4 million into our Q4 FY’10 tax provision as a benefit.

From additional 7.5 million of deferred tax assets with a full valuation allowance remains on our books. These DTAs our Massachusetts State R&D tax credits which we do not believe we will be able to utilize in future periods.

For FY’11 we expect to evidence a more normalized effective tax rate of approximately 37%. Our gross margin for the fourth quarter of fiscal 2010 was 54.3% slightly below our guidance of 55%. The FY ‘2010 as a whole gross margin was 56.3% up from 55.8% from fiscal 2009.

Our FY ‘10 gross margin was more than 200 basis points higher than our target business model gross margin of 54% plus. Our strong gross margin performance continues to be driven by three factors; first, higher revenue; second, a favorable product and business mix and third, lower fixed manufacturing costs and other costs of good sold.

As I have mentioned on prior calls, our investments and engineering methodologies and supply chain capabilities continues to drive product quality and time-to-market benefits. As a result, we are continuing to see decline in realty class inventory provisions and scrap.

Operating expenses for the fourth quarter of fiscal 2010 were $25.4 million, compared with 23.4 million in Q4 last year and 23.7 million in the sequential third quarter. And below, our Q4 guidance of approximately 26 million.

Operating expenses for the full 2010 fiscal year, declined modestly to $95.2 million from 97.7 million in fiscal 2009.

Moving onto guidance, for the first quarter of fiscal 2011, I’m sorry, I flipped the page and went to back up. So before we go to guidance let me just continue to wrap up on the year end performance.

We continue to make good progress improving the underlying operations of the business in terms of our supply chain infrastructure and working capital and our ability to generate cash from operations.

Inventory for Q4 was down sequentially to $17.6 million from $20.1 million in Q3, when we pre-position material to support the large Aegis Radar shipments that was delivered in Q4.

Inventory turns for the fourth quarter was 6.6. For fiscal 2010 as a whole, inventory turns improved to 5.0 from 4.3 in fiscal 2009.

DSO's in the fourth quarter of fiscal 2010 was 62 days down from 63 in the sequential third quarter. Mercury generated $1.0 million in positive free cash flow in Q4. The fiscal 2010 as a whole free cash flow totaled 8.4 million compared with 7.1 million for fiscal 2009.

Turning for the balance sheet, we repaid our zero cost loan with UBS leaving us debt free. In regards to our auction rate securities, we exercised our rights to sell our remaining securities back to UBS at par on June 30. The transaction settled on July 1 and therefore the company had a receivable from UBS at 630, which is included on our year end balance sheet in marketable securities and related receivables.

I am pleased to report that we have received the cash on July 1, Mercury close fiscal 2010 with total of 74.3 million in cash, cash equivalents and marketable securities including related receivables. We have zero short term, long term debt. At the end of the fourth quarter, our total employee headcount excluding contractors was 523 compared with 540 at the end of Q3.

Now, finally moving onto guidance. For the first quarter of fiscal 2011, we currently expect the revenue range of $48 million to $58 million. Please do remind me that Q1 tends to be our reasonably slow revenue quarter followed by stronger quarters as the year progresses. We anticipate reporting Q1 gross margin in the range of 56% to 57%. Our first quarter operating expenses accounting anticipated to be approximately $26 million.

CapEx at Q1 of fiscal 2011 is projected to be approximately $2 million. We expect to report first quarter GAAP income from continuing operations in the range of $0.03 to $0.06 per diluted share on approximately 23.7 million shares outstanding.

Turning to Mercury’s adjusted EBITDA guidance for the first quarter of fiscal 2011, our estimate excludes the following approximate amount: zero interest income and expense, depreciation of $1.5 million, 0.3 million in amortization of acquired intangible assets, 1.7 million in stock based compensation costs and as I’ve said, an estimated FY ’11 tax rate of approximately 37%. As a result, adjusted EBITDA for Q1 FY ’11 is currently expected to be in the range of $4.5 million to $5.8 million.

In closing, Mercury turned in a strong FY 2010, driven by a 56% plus gross margin and a successful effort to hold down operating expenses. Looking ahead, we believe that our target model for gross margin in the 54% plus range remains valid over the planning period. We expect that operating expenses for FY ’11 will grow at a slower rate approximately 50% of the rate at which our revenue will grow.

Up with pressure on OpEx for FY ’11 is mainly related to cost of living and merit pay increases and selective hiring and engineering and new product development. The restructuring and refocusing of our business over the past two years has strengthened our operating leverage where we expect to make continued progress towards achieving our target business model.

Again, we estimate that our effective tax rate for FY’11 will be approximately 37%, making for difficult year-over-year comparisons to FY’10 where we evidenced a 5% effective tax rate benefit.

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

Question-and-Answer Session

Operator

Thank you. The question-and-answer session will be conducted electronically. (Operator Instructions). And we will go to Jim McIlree with Merrill Lynch.

Jim McIlree - Merrill Lynch

I apologize if you went over this at the beginning of the call. But did you talk about design wins during the quarter? The numbers and the dollar amounts?

Mark Aslett

We actually did mention some of that in my script, so the total design wins for the quarter were 11. We had a 11 in defense which was one more than what we had in the same period last year.

Jim McIlree - Merrill Lynch

And then typically you gave a five year probable value attached to that, did you that as well?

Mark Aslett

Yeah. The five year probable value of our defense design wins on a year-over-year basis in Q4 was up 17%. For the year as a whole the five year probable value of our defense design wins was actually up 19% on a year-over-year basis.

Jim McIlree - Merrill Lynch

About this, does your tax rate assumption assume the R&D tax credit is reenacted or not?

Mark Aslett

The 37% rate for ‘11?

Jim McIlree - Merrill Lynch

Correct.

Mark Aslett

No it does not, should it be and it probably will get another one or two points out of that, so we could move down modestly by one or two points from 37, but we did not plug in to it that rate, we’ll wait till it’s actually done.

Jim McIlree - Merrill Lynch

Why is gross margin up substantially quarter-to-quarter on a sequentially lower revenue anticipation?

Mark Aslett

What’s always the case with us is the product mix was in the given quarter varies according to the program and the business mix Jim.

Jim McIlree - Merrill Lynch

I was hoping you wouldn’t say that but I thought you would.

Mark Aslett

Well product and business so, business being the mix between defense and commercial, it could also be influenced by the SSI business, how large is that in the given quarter, because there is a number of variables there. I think big picture if you look back on it this past year, we kind of modulated around very narrow range and I would expect that for FY’11 we are going to see the same thing but, it’s again mix can change it one quarter to the next.

Operator

We’ll go next to Tyler Hojo with Sidoti & Company.

Tyler Hojo - Sidoti & Company

Through your script there Mark, you kind of mentioned solid growth in fiscal ‘11, I guess several times and, so my question is what is that in context to is that in context to kind of what you have historically done or is that in context to kind of the ISR space as a whole. Can you kind of walk us through that a little bit?

Mark Aslett

My comments were really in relation to what we delivered in financial year ‘10, so it's kind of a year-over-year comparison.

Tyler Hojo - Sidoti & Company

Okay, I see, and maybe you can talk about a little bit about Mercury's growth prospects relative to kind of the market as a whole. Some of the larger players are playing kind of the same space that you guys do have indicated somewhere in the high single digit kind of C4 ISR growth rates on a go forward basis and is it too aggressive to assume that perhaps you could outpace that growth just given your size and some of the platform opportunities you have?

Mark Aslett

Yeah, I think is it unreasonable maybe, maybe not. I think we are kind of looking at the high single digits to low double digits depending on what happens with our major program drivers. I think we feel that we are well positioned within certain areas of the defense budgets and we have talked bit about those being ISR missile defense and EW and then potentially longer term counter ID. So, we think we have dropped the right mix of programs, the programs that we are on it performing well, we think our business model is in line with the acquisition reform that we are seeing out of the administration. So I think we are in a good position to grow, but it all depends on the timing and the funding of certain programs.

Tyler Hojo - Sidoti & Company

Okay thanks for that color. And just on Merc Fed, was that profitable in the quarter?

Mark Aslett

Merc Fed.

Bob Hult

Almost. We’re having around breakeven kind of...

Tyler Hojo - Sidoti & Company

Maybe you could just comment on how the transition in leadership is going there and I guess that you have touched on kind of near term expectations, but maybe if you could just touch on that?

Mark Aslett

So I think Dave and the team is doing a great job. We actually did recruit another individual into the Merc Fed leadership team this quarter to kind of lead the systems and technology push. As we’ve talked about business is highly concentrated around a large single program where you know we are providing a next generation to systemize our image processing sub system, we believe that we’re well aligned for Phase II. If the program is awarded and the development and the funding moves ahead this year as we think it may, then we could start and see a more rapid ramp in bookings in MFS than maybe even more we anticipated last quarter when we spoke. So we’ll see

Tyler Hojo - Sidoti & Company

Okay very good and just lastly from me, if you can perhaps comment on the [e-Mars] program, I know you highlighted it last quarter I think when I asked you the question, but it seems like some of the primes are really starting to talk about that one?

Mark Aslett

We believe that we could be well positioned for [e-mars] in the second side of things. We are one prime in particular so we will have to wait and see how the program progresses but we are part of several [e-moss] bids.

Tyler Hojo - Sidoti & Company

Okay. Several meaning more than two?

Mark Aslett

Not necessarily.

Operator

We will go next to Mark Jordan with Noble Financial.

Mark Jordan - Noble Financial

Question relative to the Aegis program, obviously a significant surge in revenues Q4. Could you give us a sense as to the order of magnitude as Aegis potential for 2011? And how would that program be spread out over the year?

Mark Aslett

Yeah, Aegis as we talked about is we expect it to be roughly at 10% program going forward. We still believe that’s very much the case. That 10% is based around kind of the existing program and the way in which we expect that to play out. As we talked about however though we do see additional upside opportunities around Aegis longer term associated with taking out capability and maybe putting it on to different platforms, additional shifts that maybe funded in the budgets and then maybe taking the Aegis capability and putting it over the shore.

So I think if you stick with the goal of having as approximately 10% program you are not going to be far wrong from a planning perspective. This year total bookings in Aegis actually totaled over 35 million. So we got more business this year, than what the 10% that we have been planning against. As it relates to the timing, again as we find out during this year, it could be somewhat lumpy so we are not I think going to forecast how that may play out on a quarter-by-quarter basis.

Mark Jordan - Noble Financial

Okay, looking at, Aegis is in a early phase of what generation rollout, are you shipping and into fiscal ‘11, third generation product and how does that shift to fourth generation impact your revenue streams?

Mark Aslett

So the products that we are shipping now are part of the 4.01 system, so it’s our latest generation of product that will be going into production.

Mark Jordan - Noble Financial

Okay and could you give a little color as to when the timing or what or dating issues relative to for military sales on Patriot?

Mark Aslett

Yeah, so today we received a PO for a single country which is the UAE and we received that booking in the fourth quarter of FY ‘09, as Raytheon mentioned on that earnings call last week, they are obviously pursuing a number of different countries. What they are highlighting is that they believe that Saudi Arabia is likely next in line and that; they could see Turkey later this year.

In addition, I think as we have spoken about in the past Congress has already approved the sale of Patriot systems to Taiwan. So out of all of the loans that they are pursuing, there are the three that we see in the near term.

Mark Jordan - Noble Financial

And if you were to look at value of ex-award for military sale, Patriot sale announcement from Raytheon is your content in the order magnitude of 10% or can you give us a sense of size on what that might represent?

Mark Aslett

Not, really. We expect that it’s going to be pretty significant for us, as we are going forward, I'm not prepared at this point to kind of put a number on it.

Operator

We'll go next to Kevin Ciabattoni with Boenning and Scattergood.

Kevin Ciabattoni - Boenning and Scattergood

First looking at Boeings acquisition of Argon ST, can you provide us with some color regarding what you see there in terms of opportunities or challenges for Mercury?

Mark Aslett

Argon is clearly an important customer, we think that we have been doing pretty good job for them on some of their most important programs. Yeah, I think as we are looking at the acquisition, we believe that the sale to Boeing is something that will benefit us in the longer term. Argon is being particularly strong in the Navy around their SSEE Increment E and SSEE Increment F programs which were a part and if you look at Boeing’s strength, clearly they are very strong in the airborne domain. So I think one of our beliefs is that Boeing will help transition some of Argon’s SIGINT capabilities more quickly into airborne production platforms and we could benefit as a result of that.

Kevin Ciabattoni - Boenning and Scattergood

Okay, that’s helpful. And then L3 recently received a pretty sizeable order for airport scanners, is that something that you guys are involved in?

Mark Aslett

Not to my knowledge, no.

Operator

We'll go next to Jonathan Ho with William Blair.

Jonathan Ho - William Blair

Good afternoon. Can you just give us sort of your thoughts right now in terms of the timing for ASML's ramp up relative to the KLA I guess wind down and maybe your thoughts in terms of how that’s going to impact the commercial side of ACS throughout the year?

Mark Aslett

Yes sure. I think we’re definitely starting to see the ramp. We saw over 50% increase in terms of the bookings with ASML in the fourth quarter as compared with the third. We do believe that we are going to continue to see that growth as we are looking forward into financial year ’11.

Basically, I think as we said in the past, we are part of both of their next generation systems, and on the call last quarter, we mentioned that we thought that most of their growth to date was coming from their lower end platform, which we are not a part. It looks as if things are shifting more in line with their next generation systems of which we are a part. So I think what we are expecting is the ramp will continue, they had a great quarter in terms of bookings, backlog and have record growth and we believe that we’ll be a part of that. What we expect to have happened is that over time, our business with ASML, will compensate for the expected decline in revenue from KLA Tencor beyond financial year ’11. So that’s kind of where we stand at this point, Jonathan.

Jonathan Ho - William Blair

And on the SSI business, can you guys talk about maybe this sentiment that’s out there. I know some of the other larger defense contractors have pointed to an anti contractor sentiment and some slowing on the services sides. Are you guys seeing that or a potential push outs that are related to some of the ways in the supplemental out there. Just want to get a sense for what's driving the impact to that business?

Mark Aslett

I’m not sure I would tie it to our SSI business per se, but you know I think we did experience some timing issues which related to some bookings in the second-half of the year and in the fourth quarter in particular. Nothing that we were pursuing was lost per se, just kind of moved across quarterly boundaries. So at this point we believe that we are in a good position to basically grow our defense bookings and revenues on a year-over-year basis as well as grow Mercury as a whole.

Jonathan Ho - William Blair

Okay, last question from me is on the Gorgon Stare program, I think you have talked about business being sort of a poster child for some of the defense procurement that’s out there, defense procurement reforms. Can you maybe give us a sense of whether this is, I guess being more broadly implemented by the government or whether you are seeing some changes in the attitude towards contracting?

Mark Aslett

The major program that we are pursuing in Merc-Fed is a persistent ISR program that we talked about in the past. We think that is still a very important program, it’s a QRC program today. We believe it’s likely to transition into a phase II and if that happens the program is funded and the development works out then you know we are expecting to see a pick up in MFS bookings. The way in which the governments has approached the development of that program I think portends to the way in which we see acquisition reform taking place going forward. We talked about a shift towards more best of breed, we talked about spiral upgrade capabilities and that’s exactly what we are doing on this program as a best of breed sub-contractor for the signal processing. So we think it’s an important program, we are expecting additional business from it and we are hoping that it ultimately it becomes the program of record in the budget. So, there is more to go on that and things will unfold over the next year or so.

Operator

And we will take a follow-up from Jim McIlree with Merriman.

Jim McIlree - Merriman.

Mark, relative to that persistent ISR program in Merc Fed you said, that it might ramp up in fiscal ‘11, is that part of the fiscal ’11 budget or is that part of the fiscal ‘10 supplemental that has just passed?

Mark Aslett

It’s likely to be part of the fiscal ‘11 budget, but there is also money is coming from elsewhere and I can’t really go too much into detail.

Jim McIlree - Merriman.

That’s fine. And then again I apologize if you’ve been over this earlier, but Aegis revenue contribution in Fiscal ‘10, have you disclosed what that was?

Mark Aslett

No we did not.

Jim McIlree - Merriman.

Would you like to?

Mark Aslett

The bookings were approximately 35 million in revenue, it’s approximately 15%.

Jim McIlree - Merriman.

Okay great. Any other, any other programs over 10% for the year?

Mark Aslett

No, that was the only 10% program that we had.

Jim Mcllree - Merriman

Okay, great. And then finally, it sounds like commercially you are expecting to be up, fiscal ‘11 versus fiscal ’10, is that a reasonable expectation?

Mark Aslett

No, as I said on the call, we are expecting the commercial revenues in financial year ‘11 to be basically roughly flat on a year-over-year basis.

Jim Mcllree - Merriman

Okay, I misunderstood. All right, so ASML was compensating for KLA decline and that's how you get to flat?

Mark Aslett

Yes, So KLA we had huge bookings in the fourth quarter, but it’s really in relation to the product transition, so in effect we were getting earlier bookings than what we were previously anticipating. So the revenues is going to kind of play out throughout the year and when you kind of net everything out it hasn’t really changed the picture and we are expecting roughly flat revenues on a year-over-year basis.

Jim Mcllree - Merriman

And is that roughly equally divided between the four quarters or is it going to be skewed in any particular quarter or half of the year?

Mark Aslett

No, I don’t see there is a particular skew, it’s going to kind of play out the way in which the business typically plays out which is smaller getting larger as the year progresses.

Jim Mcllree - Merriman

Then my last one, I think Bob you said that you are looking for OpEx to be 26 million?

Bob Hult

Correct.

Jim Mcllree - Merriman

In the first fiscal quarter?

Bob Hult

Right.

Jim Mcllree - Merriman

I'm trying to understand what are you spending it on? It’s a pretty significant increase over Q1 of fiscal ‘10 and I wouldn’t call it significant increase over the June quarter, but it’s an increase. Is it SG&A or fee or a little of both or what?

Bob Hult

Well, it is a little bit in the R&D space with regards to our product development but I think the best comparison is to look at it sequentially, I would not go year-over-year. We did have some spending delays in the first quarter of this past year particularly with regard to some of our outside spend also associated with product development. So I would just go sequentially and when you do that, the increase is only a few hundred K and it’s clearly driven by us cost of living, merit increases which we are actually doing this quarter, effective the beginning of the quarter. So not much in the way of hiring, very selective on that front.

Operator

That concludes the question and answer sessions. I would like to turn the call back over to Mr. Aslett for any additional or closing remarks.

Mark Aslett

Ok thank you Celia and thanks to everyone for listening. We look forward to speaking with you again next quarter and this concludes our call.

Operator

That concludes today’s conference; we thank you for your participation.

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Source: Mercury Computer Systems, Inc. F4Q10 (Qtr End 06/30/10) Earnings Call Transcript
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