Mercury Systems: Hold Rating For The Near-Term (NASDAQ:MRCY)

Investment Action

Based on my current outlook and analysis of Mercury Systems (NASDAQ:MRCY), I recommend a hold rating. I have concerns about the EBITDA margin performance in FY24, which I believe will put the stock in rangebound mode until more clarity is provided.

Basic Information

MRCY is a manufacturer of critical aircraft components, products, modules, and subsystems. MRCY’s primary markets are government agencies, commercial aerospace OEMs, and defense prime contractors in the United States. Customers use MRCY products in a wide range of mission-critical contexts, from radar and surveillance to electronic intelligence and avionics, for use in everything from weapons and missile defense to air traffic control. As of the latest financial report (4Q23), MRCY generates the majority of revenue from the US (93.2%). MRCY performance has not been great over the past few years, as revenue has slowed from a growth of 33% in FY19 to a negative 1.4% in the trailing 12 months [TTM]. The slowdown has a massive impact on profits, dragging them down from $134 million in FY19 to $97.1 million in the TTM. As a result of its weakening profit position, MRCY has filed to generate positive FCF over the past 2 years, also pushing the business leverage position (net debt to EBITDA) to more than 6x on the TTM. As of the most recent results, MRCY has total cash of $71.6 million and around $580 million in gross debt.

Review

My overall sense of the business and stock is that they are likely to be rangebound in the near term due to the challenges they face in the supply chain, despite the positive performance in bookings and FCF.

After conducting a comprehensive review, management has identified 20 challenged programs, most of which are development efforts. Development programs generally exhibit lower gross margins, often up to 10 percentage points lower, in comparison to production programs. As one can imagine, any major shift in program mix can result in heavy fluctuations in profitability, and that was what happened in FY23. Adj. EBITDA fell to $132.3 million from $200.5 million in FY22, with margins declining by a staggering 730 basis points to 13.6% as the development program mix went up to 40% in FY23 (double from FY21).

In order for margins to experience a rebound, it is imperative that MRCY successfully conclude its ongoing development initiatives. As of the present, a total of 2 out of 20 programs have successfully undergone transition in the fourth quarter of 2023. Additionally, there are plans to transition five more programs in the first half of 2024, with the majority of the remaining programs expected to complete the transition by the end of the fiscal year 2024. The optimistic perspective in this context is that MRCY has already experienced the majority of the EACs in Fiscal Year 2023. Consequently, as the transition continues, it is expected that the profit margin will improve. However, a source of uncertainty arises in this context, as there is a concern regarding MRCY’s ability to successfully complete the entire production transition within the designated timeframe (FY24) due to the supply chain issues that were prevalent in the fourth quarter of 2023. The weak EAC observed in the fourth quarter of 2023 was attributable to a confluence of factors. Firstly, MRCY encountered technical obstacles during their development endeavors, which resulted in a higher amount of rework and excessive engineering. Furthermore, the presence of immature processes resulted in discrepancies between internal assumptions and the actual costs and scope expansion. Finally, the existence of variations in supplier specifications has resulted in the need for rework. It is unlikely for the situation to turnaround overnight, as parts specifications and processes would require time to rectify. The potential consequence of this situation is an extended delay in the transition of the development program to production, thereby exerting ongoing pressure on the margin profile in FY24.

However, it is noteworthy that in the medium term, specifically beyond the fiscal year 2024, there is a reassuring aspect in the form of consistently robust bookings. This factor contributes to a heightened level of predictability and confidence in the company’s growth trajectory. The company concluded the fiscal year 2023 with a backlog valued at $1.14 billion, exhibiting a 10% growth compared to the previous year. It is anticipated that approximately 63% of this backlog will be fulfilled and shipped during the fiscal year 2024. This corresponds to approximately $720 million in revenue, which represents 73% of the consensus estimates for FY24 revenue as well as the guidance provided by management. Moreover, the appointment of CEO Bill Ballhaus as the permanent CEO is expected to alleviate investor concerns regarding the company’s future growth strategy. I hold a favorable stance regarding Bill’s potential appointment as the Chief Executive Officer, given his extensive background in the aerospace, defense, and technology sectors, which encompasses various leadership positions at the CEO level. The primary factor that instilled optimism in me regarding his suitability as the CEO is Bill’s extensive background in senior leadership roles at prominent organizations such as BAE Systems, Boeing, and Hughes. During his tenure, he successfully oversaw global government and commercial technology enterprises, with a specific emphasis on software and information technology.

All in all, I would round out the current situation at MRCY as near-term uncertainty in terms of EBITDA margins (due to the development and production mix), but the strength of bookings and the new management team give comfort over the medium-term growth prospect.

Valuation

I believe MRCY can grow back to 18% eventually, which is its historical growth CAGR since 2014, where the business recovered from the negative growth performance in 2013. I expect the same trend to repeat here, where MRCY recovers from the negative growth of -1.4% in 2023, albeit with a smaller magnitude given the smaller decline. My model is structured in a way to showcase the difference in short-term expected returns vs. the medium term, where I believe the market is focused on the near-term (FY24) as they await MRCY to print results that indicate a smooth transition of development programs to production. In my FY24 estimates, I modeled a flat EBITDA margin to show the bear case—the transition fails to take off successfully and the margin remains pressured. In this scenario, the risk or reward is not attractive. However, as we move towards the medium term, the return profile gets more attractive as margins revert back to historical mean with development and production mix normalizing. Note that I used a 15x forward EBITDA valuation here, as this is where MRCY is trading today and is in line with historical relative valuations vs. peers.

Overall, while I am optimistic about the medium-term performance, I would await more clarity into FY24 performance before recommending a long.

Final Thoughts

In conclusion, I recommend a hold rating for MRCY in the near term. The company faces EBITDA margin challenges in FY24, which I believe will keep the stock rangebound until further clarity emerges. On the other hand, the company’s strong backlog and new CEO appointment provide confidence in its growth prospects beyond FY24. I anticipate a return to historical growth rates, albeit with a smaller magnitude of decline, and believe that MRCY can eventually achieve an 18% growth rate. Short-term uncertainty remains, but the medium-term outlook is more promising. However, I would await more clarity on FY24 performance before recommending a long position.