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Mercury Systems, Inc. (NASDAQ:MRCY)

Q4 2014 Earnings Conference Call

August 5, 2014 5:00 PM

Executives

Kevin Bisson - SVP, CFO and Treasurer

Mark Aslett - President and CEO

Analysts

Sheila Kahyaoglu - Jefferies

Mark Jordan - Noble Financial

Tyler Hojo - Sidoti and Company

Kevin Ciabattoni - KeyBanc Capital Markets

Brian Ruttenbur - CRT Capital

Operator

Good day, everyone and welcome to the Mercury Systems' Fourth Quarter Fiscal 2014 Earnings Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the company's Senior Vice President and Chief Financial Officer, Kevin Bisson. Please go ahead, sir.

Kevin Bisson

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

We'd like to remind you that remarks that we make during this call about future expectations, trends and plans for the company and its business constitute forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. You can identify these statements by the use of the words may, will, could, should, would, plans, expects, anticipates, continue, estimate, project, intend, likely, forecast, probable, potential and similar expressions.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated. Such risks and uncertainties include, but are not limited to, continued funding of defense programs, as the timing of such funding, general economic and business conditions, including unforeseen weaknesses in the company's markets, effects of continued geopolitical unrest and regional conflicts, competition, changes in technology and methods of marketing, delays in completing engineering and manufacturing programs, changes in customer order patterns, changes in product mix, continued success and technological advances in delivering technological innovations, changes in the U.S. government's interpretation of federal procurement rules and regulations, market acceptance of the company's products, shortages in components, production delays due to performance quality issues with outsourced components, inability to fully realize the expected benefits from acquisitions and restructurings or delays in realizing such benefits, challenges in integrating acquired businesses and achieving anticipated synergies, changes to export regulations, increases in tax rates, changes to Generally Accepted Accounting Principles, difficulties in retaining key employees and customers, unanticipated costs under fixed price service and system integration engagements and various other factors beyond our control.

These risks and uncertainties also include such additional risk factors as are discussed in the company's filings with the U.S. Securities and Exchange Commission, including its Annual Report on Form 10-K for the fiscal year ended June 30, 2013. The company cautions readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. The company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made.

I'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 several non-GAAP financial measures, specifically, adjusted EBITDA and free cash flow. Adjusted EBITDA excludes the following from net income from continuing operations, interest income and expense, income taxes, depreciation, amortization of acquired intangible assets, restructuring expense, impairment of long-lived assets, acquisition costs and other related expenses, fair value adjustments from purchase accounting and stock-based compensation costs.

Free cash flow excludes capital expenditures from cash flows from operating activities. Reconciliation of adjusted EBITDA to GAAP net income and free cash flow to GAAP cash flows from operations are included in the press release we issued this afternoon.

With that, I will turn the call over to Mercury's President and CEO, Mark Aslett. Mark?

Mark Aslett

Thanks Kevin, good afternoon everyone and thank you for joining us. I will begin today's call with the business update. Kevin will review the financials and guidance, and then we will open it up for your questions.

Mercury closed fiscal 2014 with strong momentum, delivering record defense bookings and backlog for the second consecutive quarter. Before we discuss our results in continuing operations however, I'd like to start out by toughing briefly on the decision to seek a divestiture of Military Intelligence Systems. We determined that MIS, which last year produced $9.4 million of revenue, and a pre-tax operating loss of $1.1 million, excluding one time charges, is not aligned with Mercury's current strategic priorities.

MIS provides extremely valuable services to our nation's intelligence community, and we believe, the best way to unlock this value for Mercury and our shareholders, is to explore a divestiture. As a result, for accounting purposes, beginning in Q4, we are showing MIS as a discontinued operation on our financial statements, as we begin to search for a strategic buyer, who can more roughly realize its full potential.

We recorded a $6.7 million goodwill impairment charge, related to MIS in the fourth quarter. We will continue to focus our efforts and prioritize investments on the core of the business.

In terms of fiscal 2014 as a whole, our results from continued operations were significantly stronger year-over-year. Bookings and backlog reached record levels, growing 18% and 28% respectively. We returned the company to growth, as revenue increased 7%, while total adjusted EBITDA more than doubled to 11% of revenue, and we continue to generate positive cash flow from operations.

Looking forward, our forecast for accelerated growth, improved margins and lower operating expenses, puts us in a good position to achieve our target business model for fiscal 2015. I have more to say about the outlook later in my remarks.

Moving to our fourth quarter results from continuing operations; revenue for the fourth quarter was $53.7 million versus our guidance excluding MIS for $50 million to $54 million. Our GAAP net loss from continuing operations of $0.7 million or $0.02 per share, was much improved year-over-year and compares favorably to our guidance, again, excluding MIS, at a loss of $0.09 to a loss of $0.04 per share.

Excluding Q4 restructuring charges, which totaled $1.9 million, Mercury earned $0.01 per share for the quarter, exceeding the high end of our original guidance. Adjusted EBITDA for the fourth quarter was 13% of revenue, more than double year-over-year and well above the high end of our guidance.

For the second quarter in a row, the major highlight was bookings, which came in at $80 million, up 25% year-over-year, with a total book to bill of 1.5. Total defense bookings increased 42% year-over-year, to a company record $76.8 million, driven largely by continued strength in our Mercury Commercial Electronics or MCE business.

Our defense book-to-bill in Q4 was 1.5, which compares favorably to 1.2 in Q4 last year. Defense backlog and total backlog exiting Q4 were up 42% and 28% respectively year-over-year. International defense bookings, including FMS were 22% of total bookings, compared with 24% in Q4 last year.

Given the challenges the industry has and continues to face, and during a period, where many in the industry have been reporting negative growth, our ability to deliver bookings growth at this rate, we believe, is a testament to our strategy and business model. Leveraging this model, we have been able to accelerate the development of innovations that matter, and at the same time, improve affordability that has led to greater outsourcing by our customers.

We have established a leadership position in the commercial development, specialized since the processing subsystems for new platforms, platform modernization, as well as foreign military sales. This reflects the talents of the engineers we employ, the differentiated technology that it developed, as well as the capabilities we have added through acquisitions. As a result, we have significantly expanded our addressable market, and have uniquely positioned Mercury, as the only commercial company with end-to-end sensor processing capabilities, that are designed and made in the USA. In turn, we want some franchise programs that are in the right segments of the defense market.

This quarter, our largest program from a bookings perspective was Patriot with Raytheon. Raytheon has been pursuing a number of patriot opportunities, which translate into business for Mercury in Q4. These include a Patriot U.S. Army, as well as certain foreign military sales. As a result, we set a new program bookings record for the company, booking $39 million in the quarter for Patriot alone.

The other programs that generated significant bookings in the quarter, were Aegis with Lockheed Martin, a naval signals intelligence program with Boeing, and an airborne electronic warfare program with Exelis.

Our total defense revenue for Q4 was $50.5 million, up 10% year-over-year. International defense revenues, including FMS, were 27% of total revenues, compared with 29% in Q4 of FY 2013. Patriot, Aegis, and Gorgon Stare were our largest revenue programs this quarter. Revenues from radar and electronic warfare, accounted for 86% of total defense revenue in the fourth quarter, versus 82% in Q4 last year.

For fiscal 2014 as a whole, radar revenue, which makes up the largest segment of MCE revenue, and which was impacted significantly last year, grew 49% year-over-year; or put another way, MCE continued to rebound up for a challenging fiscal 2013.

From an operations perspective, we continue to make progress this quarter on the final phase of our acquisition integration plan. In effect, we have taken advantage of the industry downturn to retool the business, and create a platform that we can continue to grow organically and scale through future acquisitions.

Reflecting the first of three major components of the plan, facilities consolidation; over the past year, we have built a world class manufacturing facility, our Advanced Microelectronics Center, or AMC in Hudson, New Hampshire. The Hudson AMC provides us with a platform for continued growth in RF and microwave. To-date, we consolidated five smaller facilities into the new plant, including another small former Micronetics facility in the fourth quarter.

Along with G&A reductions in our Mercury Defense Systems business, we also completed the first phase of the Chelmsford headquarters consolidation in Q4. The remaining consolidation efforts are expected to conclude in the second quarter of FY 2015. At that point, we will have significantly reduced our manufacturing footprint, further decreasing our cost structure, and improving our ability to more rapidly drive advanced microelectronic solutions into the marketplace.

Executing on the second part of our plan, we now have a blueprint for common set of core business processes and systems across the company, following our three recent acquisitions. Based upon this blueprint, we are installing state-of-the-art integrated business systems. This will allow us to centralize wherever possible, the administrative and manufacturing operations across the company.

The resulting time and resource savings were enabling us to improve gross margins, reduced G&A expense, and drive greater efficiency throughout the organization. We made good progress on these initiatives in the fourth quarter.

The third and final element in the plans, is to create a sustainable, repeatable engineering site model, that we are calling Advanced Development Centers or ADCs. We are also aligning our engineering resources to where we see the greatest potential for profitable growth, and innovation that drives differentiation. We expect to complete the acquisition integration plan, by the end of Q2 FY 2015, resulting in gross annualized expense reductions at $16 million. Through the end of fiscal 2014, we have completed actions that resulted in gross annualized savings of nearly $13 million, an increase of over $3 million versus fiscal Q3.

In terms of our guidance for fiscal 2015, we expect to achieve our target business model for continuing operations for FY 2015 as a whole. We expect the year to play out in similar waves of fiscal years 2013 and 2014, with our overall results weighted to the second half, largely due to the expected timing of the defense budget approval.

Our current forecast, excluding MIS, has revenue to be in the range of $224 million to $236 million, which at the high end would represent 13% year-over-year. On the bottom line, we expect to return to our target level of adjusted EBITDA as a percent of revenue.

Adjusted EBITDA is currently forecasted in the range of $37 million to $43 million, at the high end, this represents 18% of revenue, and in dollar terms, up more than 8% year-over-year.

With our record opening backlog, we believe that we are well positioned to deliver stronger revenues in FY 2015. We expect this growth to be driven by five key programs. The first is Seaward block 2, where we expect to book and ship the remainder of LRIP phase II, which was delayed from FY 2014. Additional contract expansion, and the movement of the program later in the fiscal year, to full rate production.

The second program is Aegis, primarily consisting of FMS related development production. Third is Patriot, where we have already received the bookings with the U.S. only upgrades, as well as certain foreign military sales.

Fourth is F-35, we have received the booking in fiscal 2014, to complete certain technology developments as well as related production, and then finally, [indiscernible] positives in Mercury Defense Systems.

Longer term, we are well positioned to capitalize on the major industry growth drivers. One is the DoD strategic pivot to the Asia-Pacific region, the second driver is platform modernization, and now that relates to FMS and international sales, and finally, outsourcing by the large primes.

These growth drivers translate into opportunities in three main areas that form the basis of our plans of fiscal 2015. The first is open an integrated digital RF and microwave subsystem sales, our RF and microwave acquisitions and the AMC investments, have been very well received by our customers. This opens the door for us to take share competitively, and to grow and expand our content in key programs and platforms.

As an example, during the fourth quarter, we signed an MoU with one of our customers, that could double our RF and microwave business on an existing program. Work on similar agreements is currently underway with other customers. We continue to believe that RF and microwave, as it relates to next generation EW and radar subsystems, will likely become the fastest growing part of our business.

Another near term priority is to capture new opportunities in specialized server-class computing beyond the sensor, including mission computing, combat systems, and other specialized applications. These are parts of the market, that historically we haven't played in. The way we can now expand our presence on existing programs and platforms, with unique and differentiated technology.

Our opportunity stems from the fact, that the industry is moving from commodity commercial computing, as more and more of that design and production to have moved offshore. As a result, Mercury is now positioned as the leading U.S. owned domestic designer, developer and producer, and specialized embedded server class processing to defense and intelligence applications.

This comes at a time when the prominence and integrity of these technologies are increasing in importance.

Our third priority is open electronic warfare subsystem sales by our NDS business. We believe the price and DoD is seeking to purchase more affordable grey box EW solutions, for which our business model and capabilities are very well suited.

So in summary, we continue to believe that Mercury's strategy, technology, capabilities and ongoing programs and platforms align well with the DODs new roles and missions. We remain intensely focused on leveraging our relationship with our customers, to drive bookings and revenue from existing programs, as well as new programs and platforms.

In addition, our strategy going forward will continue to include M&A. That said, our media focus is on completing the integration of our recent acquisitions, and growing Mercury's adjusted EBITDA. This will enhance the liquidity and financial flexibility, and not only to manage the ongoing needs of the business, but also for future M&A purposes when opportunities arise.

Our fiscal 2014 results were much improved over 2013. Looking forward, we believe we are in a good position to return to well above industry average revenue growth. Delivering this growth, while completing the final phase of our integration plan, should enable us to realize the substantial operating leverage that we are building in our business. This leverage should further strengthen Mercury's position to deliver significantly improved profitability, cash flow generation and shareholder value as we move forward.

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

Kevin Bisson

Thank you, Mark, and good afternoon again everyone. Before I review the company's financial performance, I wanted to reiterate Mark's earlier point that the company's financial results for the fourth quarter exclude Mercury Intelligence Systems, or MIS.

MIS' fourth quarter results were classified as discontinued operations within the company's income statement, based on the company's decision during the fourth quarter, to initiate plans for the sale of MIS. In addition, as part of its annual test and its goodwill during the fourth quarter, the company reported a $6.7 million impairment charge related to MIS, that was also included in discontinued operations.

In my remaining remarks, company financial results, forecasts as well as historic and future financial guidance, will be reported and referenced on a continuing operations basis, excluding MIS.

Turning now to our financial results; revenue for the fourth quarter of fiscal 2014 of $53.7 million was $1.9 million higher than revenue of $51.8 million for the fourth quarter of last year, and was at the high end of our state guidance of $50 million to $54 million. The company incurred a GAAP net loss from continuing operations of $0.02 per share, in this year's fourth quarter, compared to a $0.06 per share GAAP net loss from continuing operations, in the fourth quarter of fiscal 2013. This year's fourth quarter loss from continuing operations was substantially more favorable than the company's financial guidance of a net loss of $0.04 to $0.09 per share.

Excluding the impact of restructuring charges, the company generated EPS from continuing operations of $0.01 per share in the fourth quarter of fiscal 2014, compared to a $0.03 per share net loss from continuing operations for the fourth quarter of fiscal 2013.

Adjusted EBITDA for the fourth quarter of 2014 of $7.2 million was $3.7 million higher than last year's fourth quarter. Fourth quarter adjusted EBITDA doubled year-over-year, and significantly exceeded our guidance of $2.6 million to $5.6 million. The company generated free cash flow of $900,000 in the fourth quarter, and ended fiscal 2014 with $47.3 million of cash and cash equivalents, and with no debt.

Reviewing the fourth quarter performance in greater detail, the company followed up an extremely strong third quarter of bookings, with an even stronger fourth quarter. Total bookings for the fourth quarter of fiscal 2014 were $80.2 million, which was $50.9 million or 25% higher than total bookings of $64.3 million for the fourth quarter of last year. Fourth quarter bookings performance was the highest quarterly bookings total in the company's history. Defense bookings for the fourth quarter of $76.8 million were $22.6 million or 42% higher than defense bookings of $54.2 million for the fourth quarter of last year. This performance established a new record as well, for a company that had been previously set in the third quarter.

The substantial increase in fourth quarter bookings compared to the fourth quarter of fiscal 2013, was due mainly to the Patriot program. Patriot bookings of $39 million for the fourth quarter, represented the single largest quarterly program booking in the company's history. The bulk of the Patriot program bookings for the quarter, related to upgrades for the U.S. Army, with the remainder dedicated to foreign military sales. The company anticipates most of the fourth quarter Patriot bookings to be shipped in fiscal 2015.

From a revenue standpoint, total revenue for our largest operating segment, Mercury Commercial Electronics or MCE for the fourth quarter of fiscal 2014 was $47.6 million, which was $2.4 million or 5% higher than the $45.1 million of MCE revenue generated in the fourth quarter of fiscal 2013. The increase in revenue between years was due mainly to higher Patriot program revenue, increased revenue from an electronic warfare program with Exelis, and higher revenue from a signals intelligence program with Boeing. Partially offsetting these program revenue increases was lower SEWIP and commercial program revenue.

Revenue from the company's Mercury Defense Systems or MDS operating segment was $9 million, which was $500,000 lower than the $9.5 million of MDS revenue for the fourth quarter of fiscal 2013. The decrease in revenue between years, stemmed mainly from lower Gorgon Stare and [indiscernible] related program revenue. It should be noted that operating segment revenue for the fourth quarter of fiscal 2014 does not include adjustments to eliminate $2.8 million of intercompany revenue.

Total company defense revenue, including MCE and MDS for fiscal 2014's fourth quarter of $50.5 million was $4.5 million or 10% higher than the $46 million in the fourth quarter of fiscal 2013. As mentioned earlier, the year-over-year increase in defense revenue was due to higher patriot program revenue, together with other program revenue from Boeing and Exelis.

Defense revenue for the fourth quarter of fiscal 2014 accounted for 94% of total company revenue for the quarter, compared to 89% for the fourth quarter of fiscal 2013. Of the total defense revenue in fiscal 2014's fourth quarter, $14.4 million or 29% came from international customers, compared to $15 million or 33% in the fourth quarter of fiscal 2013. Revenue from international customers includes foreign military sales or FMS through our prime customers, as well as direct sales to non-U.S. based customers. The year-over-year decline in international revenue reflected lower Aegis FMS revenue, that was partially offset by higher Patriot FMS revenue.

Commercial revenue for the fourth quarter of $3.1 million was approximately half of the $5.8 million of commercial revenue in the fourth quarter of fiscal 2013, due primarily to lower revenue from a telecommunications equipment customer.

Mercury's total book-to-bill ratio for the fourth quarter of fiscal 2014 was an impressive 1.5, which was significantly higher than the 1.2 book-to-bill ratio in the fourth quarter of fiscal 2013. Defense book-to-bill of 1.5 for the fourth quarter was similarly well ahead of the 1.2 defense book-to-bill ratio recorded in the fourth quarter of fiscal 2013.

The company ended the fourth quarter of fiscal 2014 with another record total backlog of $174.1 million, which was $38 million or 28% higher than the $136.1 million of total backlog at the end of fiscal 2013. Of the total ending backlog at the end of fiscal 2014, $144 million or 83% is expected to be shipped within the next 12 months. $168.8 million or 92% of the total ending fourth quarter backlog, relating to defense, which was $47.9 million or 42% higher than the defense backlog at the end of fiscal 2013.

From a bottom line perspective, the company incurred a GAAP loss from continuing operations of $700,000 or $0.02 per share in the fourth quarter, compared to a GAAP loss from continuing operations of $2 million or $0.06 per share for the fourth quarter of fiscal 2013. Excluding the impact of restructuring charges incurred in both quarters, the company generated income from continuing operations of $500,000 or $0.01 per share for the fourth quarter of fiscal 2014, compared to a loss from continuing operations of $900,000 or $0.03 per share in the prior fourth quarter.

Improved operating performance for the company in the fourth quarter of fiscal 2014 compared to the previous fourth quarter, derived principally from a five point improvement in gross margin. Consistent with the last few quarters, the fourth quarter's increased gross margin benefited from a higher proportion of higher margin digital signal processing revenue, as the year-over-year recovery continued for this product line.

In addition, savings associated with facilities consolidation, as part of the company's acquisition integration plan, was also a key factor and improved gross margin performance.

Adjusted EBITDA of $7.2 million or 13% of revenue for the fourth quarter was more than double for $3.5 million of adjusted EBITDA for the fourth quarter of fiscal 2013. Due primarily, to the improved gross margin performance of the business between years.

Relative to our stated financial guidance for the fourth quarter, excluding MIS, we are pleased to report the company was at or above the high end of its adjusted guidance for all key financial measures. Fourth quarter revenue of $53.7 million was at the high end of our adjusted guidance of revenue between $50 million and $54 million. Gross margin of 46% for the fourth quarter was three to five points higher than our adjusted guidance, due to a more favorable program mix, centered on our higher margin, digital signal processor product line.

Reported GAAP loss per share from continuing operations of $0.02 per share for the fourth quarter was favorable, to our adjusted guidance of a loss from continuing operations of $0.04 to $0.09 per share. Finally, adjusted EBITDA of $7.2 million for the fourth quarter, significantly exceeded the company's adjusted guidance of $2.6 million to $5.6 million.

Turning now to the balance sheet, the company ended fiscal 2014 with cash and cash equivalents of $47.3 million and no debt, which was $1.6 million higher than the $45.7 million of cash and cash equivalents at the end of the sequential third quarter. The company generated $900,000 off cash flow during the fourth quarter, as $2.5 million of operating cash flow driven by the quarter's cash earnings, was partially offset by $1.6 million of capital expenditure.

The company continued to execute on time and on budget, relative to its acquisition integration plan that was initiated in January. As noted previously, the company estimated that the plan would generate gross annualized expense savings of $16 million upon completion by the end of the second quarter of fiscal 2015. During the fourth quarter, the company completed actions that generated approximately $3 million of the planned $16 million of gross annualized savings.

Together with the actions completed in the third quarter, the company has cumulatively completed actions totaling nearly $13 million or 80% of the $16 million of planned annualized savings. Fourth quarter actions primarily focused on the first of two phases, related to facilities consolidation at our Chelmsford, Massachusetts headquarter. The closure of our Ewing, New Jersey facility, and headcount reductions at MDS related to systems consolidation.

Consistent with our statements last quarter, the company plans to realize the remaining $3 million of annualized savings during the first half of fiscal 2015, with actions centered on the completion of the Chelmsford facility's consolidation, and the completion of several business systems' integrations. As a result, the company expects to incur approximately $3 million of restructuring charges in fiscal 2015, with $1 million forecasted to be incurred in the first quarter.

Coming off a very difficult fiscal 2015, that saw an industry induced revenue decline, with a significant bottom line impact, the company rebounded nicely from a financial standpoint during fiscal 2014. Beginning with bookings, the company generated record bookings of $246.8 million for fiscal 2014, which are $37.1 million or 18% higher than total bookings in fiscal 2013.

Clearly, the Patriot program was a key driver of bookings growth in fiscal 2014 compared to fiscal 2013. Other programs that contributed to the record company bookings included Aegis, F-35, F-15 electronic warfare, Global Hawk, Gorgon Stare, and Seaward programs.

From a top line perspective, the company returned to growth in fiscal 2014, with revenue of $208.7 million, which was $14.5 million or 7% higher than fiscal 2013's revenue. The Aegis and Patriot programs were significant contributors to revenue between years.

The company shaved its loss from continuing operations by 70% during fiscal 2014, from a loss of $13.8 million or $0.46 per share in fiscal 2013, to $4.1 million or $0.13 per share in fiscal 2014. The substantial improvement in operating results compared to fiscal 2013, stems principally from a five point improvement in gross margin, due to a more favorable program mix, tied to recovery in the company's higher margin core digital signal processing business.

In addition, incremental savings in connection with the company's acquisition integration efforts, contributed to the improved operating performance. It should be noted, that excluding restructuring charges, the company's loss from continuing operations for fiscal 2014, was $500,000 or $0.02 per share, compared to a net loss of $9.2 million or $0.31 per share for fiscal 2013.

Based on the improved fiscal 2014 operating results, adjusted EBITDA for fiscal 2014 of $23.5 million was more than double the $9.9 million of adjusted EBITDA for fiscal 2013.

As stated earlier, from a balance sheet standpoint, the company ended fiscal 2014 with $47.3 million of cash and cash equivalents, and $8.2 million increase from cash and cash equivalents at the end of fiscal 2013. Free cash flow of $7.5 million in fiscal 2014 reversed the $5.8 million of negative free cash flow of fiscal 2013, due mainly to substantially improved cash earnings and lower working capital.

Turning now to our financial guidance, the company entered fiscal 2015 in its best financial position in several years. As noted earlier, the company ended fiscal 2014 with a record backlog of $174.1 million on the heels of two record-breaking bookings quarters in the second half of last year. In addition, the company completed actions that generated 80% of the $16 million of annualized expense savings, as part of its acquisition integration plan.

Finally, while the defense appropriations bill has not been finalized for government fiscal year 2015, the Ryan-Murray bipartisan budget act signed last December, provided improved clarity on total budgeted DoD expenditures for government fiscal years 2015.

With all this in mind, the company believes it can achieve its target business model of adjusted EBITDA of 18% to 22% of revenue for fiscal 2015. The company's full year financial guidance in support of achieving this objective, includes forecasted revenue of $224 million to $236 million. At the upper end of this guidance, the company anticipates a return to above industry average double digit revenue growth, fueled by increased SEWIP, Patriot and F-35 program revenue compared to fiscal 2014.

Additional comfort [ph] for this full year revenue guidance relates to the level of forecasted fiscal 2015 revenue, that is covered by existing backlog. As mentioned earlier, of the company's total backlog at the end of fiscal 2014, $144 million is expected to be shipped within 12 months. This backlog amount would cover between 61% and 64% of the company's forecasted revenue range for fiscal 2015. As a point of comparison, backlog coverage for fiscal years 2014, 2013 and 2012 was 52%, 43%, and 31% respectively.

From a bottom line standpoint, the company is projecting fiscal 2015 GAAP earnings per share from continuing operations in the range of $0.21 to $0.32 per share, excluding forecasted restructuring charges, EPS from continuing operations is anticipated to be between $0.27 and $0.38 per share. the primary drivers for the substantial improvement in forecasted operating performance between years, is due mainly to sales volume related margin improvement, and gross margin and operating expense savings relating to the completion of the company's acquisition integration plan.

Adjusted EBITDA for fiscal 2015 is projected to be between $37 million and $43 million, which represents an approximate 60% to 80% improvement from fiscal 2014. At the upper end of this range, the company would generate adjusted EBITDA of 18% of revenue, which is commensurate with the company's target business model.

As Mark mentioned in his remarks, the company expects fiscal 2015 to largely mirror the last two fiscal years, with a stronger second half of the year compared to the first half. The trigger for this assumption is the timing of Congress' passage of a defense appropriations bill, which has been enacted in the second half of the company's fiscal year for the last two years. We believe this scenario is likely to be repeated for fiscal 2015. With this assumption in mind, the company's financial guidance for fiscal 2015's first quarter, assumes a more favorable financial performance as the year progresses. As such, we are forecasting first quarter total revenue to be in the range of $50 million to $55 million. The estimated revenue range for the quarter assumes year-over-year strength from the Patriot, Aegis and SEWIP programs.

Consistent with prior quarters, we expect the split in first quarter revenue to be approximately 90% defense and 10% commercial. Within our stated guidance, we are forecasting gross margin of between 42% and 43% for the first quarter, which is below the 46% generated during the fourth quarter of fiscal 2014. The sequentially lower gross margin is largely due to program mix, as the first quarter revenue forecast includes a greater proportion of RF and microwave program revenue, and carries a lower gross margin than digital signal processing program revenue.

Operating expenses, inclusive of $1 million of estimated restructuring charges, are forecasted to be $24 million for the first quarter, which is slightly below fourth quarter fiscal 2014 expense levels. From a bottom line standpoint, we anticipate a net loss per share from continuing operations, in the range of $0.01 to $0.06 per share from the first quarter, based on an estimated weighted average share count of 31.6 million shares.

Excluding restructuring charges, the range is estimated to be between EPS of $0.01 per share and a loss of $0.04 per share. The loss per share forecast assumes an income tax benefit of approximately 35% for the quarter. Consistent with prior quarters, the loss per share range includes an approximate $0.04 per share impact from the amortization of intangible assets.

Adjusted EBITDA for the first quarter is estimated to be between $4.2 million and $7 million, we anticipate ending the first quarter with cash and cash equivalents between $48 million and $49 million. Operating cash flow, derived from cash earnings and lower receivables related working capital are expected to be partially offset by capital expenditures.

First quarter capital expenditures are likely to be higher than the fourth quarter of fiscal 2014, due mainly to planned facility consolidation efforts at our Hudson, New Hampshire facility.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from the line of Sheila Kahyaoglu of Jefferies. Your line is now open.

Sheila Kahyaoglu - Jefferies

Hi, thank you for taking my question, and appreciate the detail on the call. I guess, can you give us some idea, you are now 80% through your restructuring and your planned integration process, what capacity utilization looks like within your facilities, and if there is more room in terms of -- how should we be thinking about that?

Mark Aslett

Yeah. So we have got a lot of opportunity for continued growth in the New Hudson AMC facility, which is the larger of the two manufacturing facilities that we have. We are currently only running one shift in that facility, which gives us plenty of opportunity to continue to grow that part of the business Sheila.

Sheila Kahyaoglu - Jefferies

Okay, got it. and then it seems like SEWIP block 2 isn't currently in other phase. When should we be expecting that to ramp, and also, in terms of block 3, what's the process on that, if you could give us some clarity there? And then I guess in just terms of recent awards, are you participating at all in Lockheed Space Fence?

Mark Aslett

Okay, well let me quickly answer the last question first. Yes, we are participating, you know, in part of a Lockheed on Space Fence in the RF and microwave domain, so we are very pleased to be part of that team on that program.

Let me step back a little bit and kind of answer the SEWIP question, because I think you asked actually multiple questions; so when we talk about SEWIP, we talk about, if its actually one program, but its not. Actually SEWIP, given what we are involved with, is actually three separate programs; block 2, a derivative program, but is distinct from the original block 2 program with the smaller ships, and then block 3. So let me kind of walk through each of those in turn, given that is such an important program for us, in terms of its size and potential for growth.

The biggest, I think thing that we are most excited about, is really the progress that we have made, not only in terms of Q4, but also throughout fiscal 2014, firming up our content expansion opportunities on SEWIP block 2. And I think we have been able to do this, because we have been providing Lockheed's not only better performance, but also improved affordability. In actuality, it has actually led us to displace several incumbent suppliers on the program for different parts of the system. And this in turn, is really a direct result of the acquisitions that we have done, as well as the investments in the new AMC up in Hudson.

So if you look at the expansion itself that's related to block 2, what we have seen over the past several quarters, is that as a result of our efforts, the value for block 2 and content expansion is now actually at the higher end from a possible value range, from what we have talked about before. And block 2 in the content expansion range, is anywhere from $329 million to $465 million, a possible value to Mercury over time. And so we are towards the high end of that range now.

In terms of just the short term, we expected, block 2 LRIP phase 2 booking to occur in Q1. As you maybe aware, this actually was delayed from fiscal 2014, so it will be good to get that one in the back.

From a production perspective, we currently anticipate that block 2 will move to full rate production at the end of our current fiscal year. So net-net, when you boil it all down, we expect that SEWIP will be a 10% program for Mercury in fiscal 2015, excluding block 3.

If I move to the SEWIP block 2 derivative, which is where basically, we are going to take a derivative of the existing block 2 system, scale it down and actually use that capability on smaller ships. We believe that we have been selected by Lockheed for that particular program, which again is very distinct and separate from the larger block 2 program.

Lockheed currently expects that AMD award by the end of this calendar year, and if you look at the value of that particular program, its currently in the range of $104 million to round about $166 million of possible value to Mercury.

Block 3, what we are hearing associated with that, is that the award is expected some time during Q2, probably October, in terms of just the latest information that we have heard, that's another program, that as a result of the acquisitions that we have done in our investments in the AMC, we have been able to actually expand our content on that particular part of SEWIP. So if Lockheed and Raytheon win, we believe that again, like block 2, the value associated with block 3 will likely be at the higher end of the range that we previously discussed, which is in the $161 million to $334 million range. So we feel pretty good about that. Block 3, however given that its competitive, is not part of our current fiscal 2015 plan.

So a lot of detail in that, but I think it was important to basically outline the fact that, there are really three separate programs going on in parallel, all three of which were actually in different phases. But we have done a pretty good job, as a result of the acquisitions and the AMC investments, basically growing our content significantly over the past year.

Sheila Kahyaoglu - Jefferies

That was very helpful. Thank you so much Mark. And I guess, can you give us an idea of what SEWIP contributed in 2014 in terms of sales?

Mark Aslett

From a revenue perspective --

Kevin Bisson

In fiscal 2014, it was less than $5 million.

Mark Aslett

Bookings were $10 million and revenue was less than $5 million.

Sheila Kahyaoglu - Jefferies

Okay. Thank you so much. I will jump back in the queue.

Operator

Thank you. Our next question comes from the line of Mark Jordan of Noble Financial. Your line is now open.

Mark Jordan - Noble Financial

Good afternoon gentlemen. Mike, could you just talk a little bit about Aegis, which is obviously continuing to be very good for you. Could you talk about how you see that transitioning to us next generation, and is it correct that that remains -- should it remain at a high level for you through fiscal 2016, and then how should it behave? And secondly, is there any retrofit or upgrade opportunity for the installed base out there, that may go beyond shipments to new installs?

Mark Aslett

You're [indiscernible] straight line Mark. So I think Aegis continues to be a really important program for us. I think during the year, we booked over $27 million and $7 million alone in Q4. We are currently working with Lockheed, basically on new technologies and capabilities, future technology refreshes, as well as tech insertions, that we believe is going to extend the life of the program as we know it today. As well as actually potentially, increase the program's remaining possible value.

So we think there is a lot of opportunity still residing around Aegis, probably even more than what we have talked about historically.

In addition, one of the things that we are pretty excited about, is that given some of the investments that we have made in terms of new processing capabilities, we also see the opportunity of expanding out beyond the radar processing, into different parts of the Aegis system, which again could provide some good opportunities for the company going forward. Like we said with SEWIP, we currently expect Aegis to be approximately a 10% program again for fiscal 2015.

Mark Jordan - Noble Financial

Okay. Do you have kind of a CapEx estimate for full year 2015?

Kevin Bisson

I think we did about $7 million mark in fiscal 2014, and I think that's a roundabout estimate for fiscal 2015. If you recall that, if you look back in fiscal 2012, that's around the same level of capital expenditures we had then. That was a more normal year. So I would expect it to be around that level again in fiscal 2015.

Mark Jordan - Noble Financial

Okay. And given the obviously stronger adjusted EBITDA expectations you have for the year. Do you have a range of potential free cash flow generation in fiscal 2015 to compare the $7.5 million in 2014?

Kevin Bisson

Well certainly, it will be higher. At this stage, I don't think we want to give a precise estimate, but I think you can assume that, given the higher levels of adjusted EBITDA, it will be well ahead of the $7.5 million this year, or last year.

Mark Jordan - Noble Financial

Okay. Thank you very much.

Kevin Bisson

Yup.

Mark Aslett

Thanks Mark.

Operator

Thank you. Our next question comes from the line of Tyler Hojo of Sidoti and Company. Your line is now open.

Tyler Hojo - Sidoti and Company

Yeah hi. Good evening Mark and Kevin. So I wanted a little bit more detail on the MoU that you mentioned Mark, in your prepared remarks. Did you say that you had a current customer MoU that could double your current RFM micro business, and if that's the case, kind of what are the gating factors and timing surrounding that?

Mark Aslett

So it wasn't double the RF business in total with that existing customer, it was double the RF and microwave business on a specific program related to that customer. Now, there are some -- so that's sort of production perspective, and as part of the MoU there is certain development work that we are going to do, that would basically take us into different parts of the system as well. But net-net, we will basically start to see that existing business on our existing program, double, beginning in fiscal 2015 as part of our plan.

Tyler Hojo - Sidoti and Company

Okay. That sounds good. And maybe just a little bit more detail on the AMC buildout. I know, you can't talk specifics, but maybe you could just -- maybe kind of comment on the pace of customer conversations in regards to kind of the new capabilities there?

Mark Aslett

Sure. So I think we continue to enjoy a lot of interest in the new facility. I think I gave this about last quarter, but this quarter, we are in total, cumulative, we had over 30 customer visits. We did sign that MoU this quarter, and there are several other MoUs that we are currently working on, that should continue to allow us to grow that part of the business going forward.

As we have talked about in the past also, and as I outlined in terms of my remarks regarding SEWIP, the AMC is also really important facility, to be able to deliver against our program commitments on existing programs that we won, and where we continue to grow more content. So we feel very good about the new facility, its state-of-the-art feedback has been fantastic, and you know, we are working on additional agreements, Tyler.

Tyler Hojo - Sidoti and Company

Okay, that sounds great. And then just lastly for me, kind of a strategy question for you all. I know over the last year, just given the lack of visibility, kind of the focus has been on running the business to generate cash. Coming off of a really strong bookings quarter and seemingly improved visibility for you all, is there going to be more of a focus or more of a shift on trying to drive more book-and-ship type revenues in your upcoming fiscal 2015?

Mark Aslett

Maybe. In actuality though, I think given our bookings and backlog and how that translates into revenue. We probably don't need to drive as much book-ship business, which translates into better operating efficiency. So I think we are very-very pleased. We just saw bookings performance in the second half, and where we ended fiscal 2015 from a backlog perspective.

Kevin Bisson

I think also, the more we can rely on backlog to satisfy our revenue requirements, the healthier our cash position is, the healthier our working capital performances, and obviously the more predictable the business is. So I think there is a lot of benefits, obviously from the standpoint of running the business with more of a reliance on backlog, and I think it has helped us.

Mark Aslett

It has, and it is till, although I think we are doing much better than many companies right now, in terms of just our reported results, the industry is still somewhat challenging, and I think operating from backlog, basically helps buy down that risk. And go back to what Kevin said in his prepared remarks, we ended fiscal 2013 with 31% of the year in backlog. This year we are in much-much better position and probably the best position we have been in, in the past several years. So we feel really good about that.

Tyler Hojo - Sidoti and Company

Yeah. Okay, that's all I had. Thanks a lot.

Kevin Bisson

Thanks Howard.

Operator

Thank you. (Operator Instructions). Our next question comes from Kevin Ciabattoni of KeyBanc Capital. Your line is now open.

Kevin Ciabattoni - KeyBanc Capital Markets

Good afternoon guys.

Mark Aslett

Hey Kevin, how are you?

Kevin Ciabattoni - KeyBanc Capital Markets

Good. Thanks. So two quarters here of very solid bookings, something was driven largely by Patriot and Aegis in the fourth quarter. Just kind of wondering what we can expect at the bookings line as we had in FY 2015 here, maybe based on kind of what you've seen in the trends since the close of the quarter, or in terms of programs? I know last quarter, you were able to mention that you are expecting some pretty big bookings from Patriot in 4Q, so maybe some thoughts there?

Mark Aslett

Yeah, so probably the one we are anticipating and excited about getting, is the second phase of LRIP 2 for SEWIP block 2. That should have -- according to our original forecast, occur during fiscal 2014. It got delayed, and so its looking like its going to be in Q1.

So overall, I think we are anticipating a book-to-bill round one, for both the quarter, as well as above one for the year as a whole. So we had a very-very good year in fiscal 2014, driven by Patriot in the fourth quarter. But we have got a number of really important programs that we think will continue to be important for us, not least of which is SEWIP that we have talked about and the content expansion, the move to full rate production. We have got JSF or F-35, we got Aegis, it will continue to be a strong contributor. We see growth opportunities in our Mercury Defense Systems business around some of that DFM related programs.

So net-net, I think we have got some great programs that we are pleased to be a part of Kevin.

Kevin Ciabattoni - KeyBanc Capital Markets

Good color. Thanks. And then, I was surprised to see international and FMS sales down year-over-year in the quarter. It sounds like that was primarily on Aegis sales, is that correct, and then kind of, if you can talk a little bit about what you expect to see from the FMS side in 2015?

Mark Aslett

Yeah. Its lumpy. So FMS is notoriously difficult to predict, and so I think on [indiscernible], we have been in the low 20s. I don't see that -- I mean, its probably going to be up a little bit, but its probably not going to start with the three.

Kevin Ciabattoni - KeyBanc Capital Markets

Okay. And then last question for me. Just looking at the adjusted EBITDA margin for next year, I mean, can you talk a little bit about what the impact of pulling MIS out of that is? I mean, it seems like it should be pretty accretive, moving that over to discontinued ops? Just curious?

Kevin Bisson

Yeah I think we meant -- I think Mark mentioned in his early remarks that, from a bottom line standpoint, MIS generated a loss of about $1 million. So using that as a proxy, yes it is accretive, but I don't think its going to drive the needle that much.

Kevin Ciabattoni - KeyBanc Capital Markets

That $1 million loss is for the full year, 2014?

Kevin Bisson

Yes.

Kevin Ciabattoni - KeyBanc Capital Markets

Okay, thanks. That's all I have.

Kevin Bisson

Yes.

Mark Aslett

Thanks Kevin.

Operator

Thank you. And our next question comes from the line of Brian Ruttenbur of CRT Capital. Your line is now open.

Brian Ruttenbur - CRT Capital

Thank you very much. Couple of questions. I just -- if it’s a repeat, I apologize. The restructuring charges left to go in fiscal 2015, how much was that, and how much is that cash?

Kevin Bisson

Its about $3 million, most of it is cash relating to, call it lease costs that we will be incurring over time, that we are pulling forward based on vacating those facilities.

Brian Ruttenbur - CRT Capital

Okay. Timing of the sale of MIS, is that something that you anticipate wrapping up in the next six months to nine months, at least fiscal 2015, is that the goal?

Mark Aslett

Unclear from a timing perspective, just given that we are getting going in the process, Brian. So its hard to forecast out in time, but we will certainly keep people apprised, as things develop.

Brian Ruttenbur - CRT Capital

Okay. So barring any bidders coming in, given that's unprofitable division at least how it fits right now, would -- if you don't have suitable betters, would you just shut that division down?

Mark Aslett

We think there's a lot of value potentially in the business. I think they have done some pretty valuable work in the testing space. They have got some very interesting intellectual property and early beta product around -- inside the threat detection, using some cloud-based techniques, which I am sure, given this environment, someone will find of interest. But even beyond that, the [indiscernible] certain programs, they have got a wonderful classified facility, as well as some highly cleared [ph] personnel. So I think for the right strategic buyer, there is definitely value there, and I think they could accelerate the unlocking of value. But in the meantime, we think the best thing for Mercury and shareholders, is to explore a sale?

Brian Ruttenbur - CRT Capital

And then last question. You guys were for sale. You have put that on hold. Is this going to be a situation, where potentially down the road, you're interested in selling yourselves again, or maybe, talk about your vision? I understand you are in the middle of a turnaround, or near the end of that turnaround?

Mark Aslett

So we don't comment on industry rumors and speculation Brian, like pretty much every other public company. We are very pleased with our performance this year. We delivered 7% revenue growth, record bookings, record backlog. We see our opportunity basically increasing our revenue growth rates, delivering strong bookings and you know, very strong performance in adjusted EBITDA. And we are focused on growing the business, I think that's what we are paid to do.

Brian Ruttenbur - CRT Capital

Okay. Thank you very much.

Operator

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

Mark Aslett

Okay. Well thanks very much for listening, we look forward to speaking to you all again next quarter. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Have a great day everyone.

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Source: Mercury Systems' (MRCY) CEO Mark Aslett on Q4 2014 Results - Earnings Call Transcript
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