Description

Summary:

Mercury Systems (MRCY) is a formerly great business with a great CEO on the cusp of completing a turnaround. Numbers have been obscured by the cost of fixing the business, but we expect a solid FY 25 (which begins on July 1). Short interest is high and numbers seem way too low. We believe FY 25 will be the first “clean” year in a while, driving renewed interest and multiple expansion which could eventually drive the stock from $30 to $50+ in 18 months.  

Thesis:

Turnarounds can make tough investments. In general companies take longer than you’d expect to fix, new issues emerge, and the turnaround process can scare off both talent and customers. On the flip side, timing a successful turnaround correctly can be extremely lucrative.

Mercury Systems has basically every quality you would look for in a turnaround:

1. A historically high quality, non-cyclical growth business that achieved a very high multiple
2. Strong customer relationships and products with no substitute and solid bookings
3. A new, Tier 1, aligned CEO and board with a very specific gameplan and timeline
4. No balance sheet issues, with cash flow generated throughout the turnaround
5. After myriad new issues arising, no new issues for months
6. Substantial upside vs consensus expectations, high short interest etc

We believe that after four years of stock price declines (from a high of $90), including a failed sale process, a game of “hide the ball” from prior management, a full board/management turnover and seemingly endless operating issues – the time to buy MRCY shares is now.

What Broke Mercury?

MRCY was a high flying growth stock in 2021, and is now the most popular short in defense. What happened? Obviously, parsing through exactly what has gone on inside the company is difficult given limited disclosures, but we have managed to get a rough picture of the slow motion disaster that was Mercury 2021-2023.

Historically, MRCY has booked two types of business: development and production.

Development business is lower margin (20% gross margins), and time and personnel intensive. Essentially, a Tier 1 defense prime will pay MRCY to develop a specific product for a specific program (a specialized edge processor for threat detection in a new anti-ballistic missile platform, lets say). They will be paid a relatively fixed rate for the development work along a pre-determined timeline. Then, MRCY’s team of scientists and engineers will develop the system/technology and the techniques for larger production runs. The goal of this development is not to earn a huge profit (although it is generally profitable), but instead book much larger production awards on the tail end. In normal times development is 20% of total revenues.

Production business is high gross margin (40-50%), and much more akin to a traditional manufacturing business. They have a contract with their customer, normally with some input cost and labor cost protections, and produce the component or system on a fixed timeline. This is a great business – extraordinarily steady, high margin, and very long cycle. Once designed into a defense program the components will be required for decades. Normally 80% of total revenues.

And so the growth algorithm makes sense, MRCY is constantly developing new products that build their installed base, and the new products coming in outnumber the production programs being sunsetted given the long-cycle nature of the business. They also have pricing escalators or in some cases relatively fixed gross margin contracts.

Mark Aslett, the now former CEO, had run MRCY since 2007 and experienced a period of torrid growth from 2014-2021. The feedback we got on Mark was bad generally across the board, and in an effort to keep up the pace of growth Mark seemingly made a series of errors in the 2020-2021 timeframe that were then meaningfully exacerbated by the post-Covid supply chain challenges.

Delivering on 20%+ topline growth expectations in the defense industry is tough, and as a result Mark i) booked too much new development business and ii) did so on less than favorable development terms with few risk parameters built in.

Essentially management bombarded the company with a whole host of new projects that Mercury had the technical capability to complete, but not under the timelines promised. Throw in a dash of supply chain breakdown and this mistake became significant.

Management then added an additional wrinkle – as the cash flow for these projects ran out as they ran over their allotted timeline, they would book “unbilled revenues” against the time (and often overtime) their employees spent developing, while not even billing their customers. While this can pass accounting muster in a program accounting framework, as you will eventually bill the customer once the project is complete, it patched a hole in revenues when there really weren’t any and extended the runway of this problem for a while.

Long story short, instead of big misses the company had small ones, could not generate free cash flow, and activists intervened and pushed a sales process that failed, I surmise because of the aforementioned issues.

JANA, the lead activist, took over the board (Scott Ostfeld, Partner there is on the board, and Bill Ballhaus, their nominee is Chairman and CEO), ousted Mark Aslett, and Bill became interim CEO. More on Bill below.

Bill spent a few months with the company, realized the issues were serious and the opportunity immense, and took over as permanent CEO. He bought stock. JANA bought more stock (now own 12% of the company). He began re-underwriting every project from the ground up. He stopped all unbilled revenue, focused on working capital and operational improvement, and uncovered all the festering issues, laying them bare to the market and savaging reported EBITDA (not even adding back clear one-time items like inventory writedowns). And that brings us to today. So, why is this a good investment here?

Point 1: Underneath it all, MRCY is a very good business

MRCY is a highly diversified tier 2 technology supplier to the world’s largest defense contractors. MRCY produces a wide range of products, from single components to integrated subsystems, that power the most advanced defense technology on the planet. A few examples of what they do:

• Sensor edge processors within the F-35 that interpret enemy combatant movement and send signal to interceptor systems at extremely low latency
• Radiation tolerant solid-sate, EM-protected data recorders on planes and satellites
• Rugged modular blade servers for forward deployment across air, sea, space
• Variety of processing boards with embedded EM and cybersecurity protection
• Hundreds of other products, many of which are classified

Our research has indicated the end markets where MRCY plays should grow more than 10% per year, with notable excess growth in space (where MRCY is a leader), missile defense (boosted by recent geopolitical events) and EM-protected hardware (now a requirement on many projects).

And historically MRCY was a growth business. Through bolt-on acquisitions and organic growth from 2014 to 2022 Mercury grew revenue 5x, from ~$200m to ~$1bn. Given secular trends in incorporating more automation, encryption, EM-protection, low-latency processing into military hardware, this is unmistakably a growth business. As a kicker, as GPU-related compute/AI becomes an area of deployment for military hardware, MRCY is the leading subsystems player in this nascent market.

Point 2:  Strong Customer relationships with no substitutes

To paraphrase from our contacts within the industry, Mercury is unique in that their customers will essentially wait forever for their products. They are the only player who can produce much of this at scale.

Our research to date has confirmed that what Mercury does is difficult to replicate, but worth a thought experiment: you are building a classified piece of military hardware on a government contract and you need a very specific subsystem. You talk to multiple players and decide MRCY has the best technology. This is not off the shelf – it’s a custom made subsystem built to extremely exacting specifications for a specific program (lets say an EM-harded sensor chip in the F-35). Well, once you’ve chosen MRCY, you are locked in. Defense contractors don’t run simultaneous development projects for the same part at the same time as its just so expensive, so even if MRCY does go over your development timeline by 20%, in the grand scheme of things (remember, this is just one component), as long as the performance characteristics are in line, you are going to order the production run from MRCY.

Moreover, our research indicates that MRCY continues to have very strong relationships with its customers, and fortunately the development issues mentioned above are confined to a relatively small number of programs (19 out of MRCY’s ~300), so its not some company-wide disaster as much as the numbers may make it seem.

Finally, the proof is in the bookings. Despite the challenges book:bill has remained well over 1 for the entire turnaround period and as of right now MRCY has a record backlog and has won some high quality projects recently, recently including a FPGA chip for the Blue Halo satellite program for the US Space Force, and a Swiss F-35 development project.

Point 3: High Quality, aligned CEO with a concrete plan

The number one reason to get involved in MRCY is the new CEO, Bill Ballhaus. The guy has quite the resume. Some highlights:

• Stanford Aeronautics and Astronautics PhD who won the Best PhD Thesis award
• President of BAE’s Network Systems division 2003-2008, a job he got at age 36
• CEO and President of DynCorp, publicly traded defense contractor, which he sold to Cerberus at a 47% premium to where it was trading the day before
• CEO of SRA International (Consulting firm for Governments) from 2011 to 2015 when owned by Providence Equity Partners, who sold it to CSRA
• Chairman and CEO of Blackboard, Inc, an EdTech Company from 2016 to 2021 when it was sold to Anthology

So, just to summarize, a really smart aeronautical engineer who has been CEO of three companies and sold them all. And its not fluff – he’s been PE-backed a majority of the time, he’s a great operator. I don’t think we could have found a better CEO to come in and fix MRCY.

We also have solid alignment:

1. He was granted 934,000 options struck at $42, $43, $46 and $49 a share that vest in 2026/2027 and terminate in 2027/2028
2. He has $5.75m of long-term stock awards that mostly cliff-vest in 3 years
3. He bought $1.5m shares at $37 and got a $3m share grant with similar vesting
4. He bought another $200k at $29.
5. Everything vests if he sells the company.

JANA seems pretty aligned as they own $200m of shares here as well.

To date I think Bill has done a good job with the caveat that it took him a while to get his hands around the issues and the true proof has yet to be seen. But the plan is clear and I believe they are executing the plan:

1. Re-underwrite every development program with a focus on the “challenged programs.” These are programs where MRCY is behind the development timeline and have yet to ship, thereby incurring cash losses.
   1. MRCY has moved from 19 programs identified when Bill joined to now only 8 remaining, with line of sight to all of these being retired in the next 3 months
   2. Notably, no new problem projects in last two quarters
2. Specifically rework the combined architecture set of projects
   1. The biggest problem, a large-scale development and initial production project that went to production too early that Bill stopped and has entirely re-worked
   2. This project has caused the lionshare of the incremental losses and accounting changes that have hammered EBITDA in FY2024
   3. As of FYQ3, the issues have been identified and a new production processes initiated and tested, just working toward getting to a statistically significant number of systems before they can say it is ready to ship to customers
3. Eliminate unbilled revenue and receivables, work towards getting product out the door and turning receivables into cash, fix working capital reliance/balances
   1. As a result, they expect positive free cash flow in FY24 despite the negative EBITDA
4. Continue strong bookings
5. Enter FY25 “with a clear path to predictable, profitable organic growth and strong free cash flow”

We think Bill is on track across this plan, and the market is underestimating how dramatically things can improve when these problem projects go away. More in the economics section at the end.

Point 4: No Balance sheet issues

MRCY has one outstanding piece of debt, a $1.1bn revolver with $616m drawn on it. They have $142m of cash. This matures in February 2027. No other debt.

The net debt/EBITDA in 2022 EBITDA is a bit under 3.0x. While they have reported negative EBITDA in FY24, they have very few covenants (interest coverage ratio only), and their terms allow them to add back many of the items that have taken down EBITDA this year.

I’ve had several direct conversations with them about this and am highly confident they have no covenant issues, even with further setbacks.

Moreover, their focus on working capital will allow the company to be cash flow positive in FY24 and grow cash flow meaningfully in FY2025.

Point 5: No new issues for months

We believe that the final cockroach has emerged from its hiding place, final shoe has dropped, etc. This is why the FY3Q results were very important. In the prior two quarters management had uncovered additional issues, notably in FY2Q removing guidance for the year and essentially pulling production of the combined architecture product, dramatically reducing revenue and EBITDA for the fiscal year.

The third quarter was well within expectations, with only a minor hiccup from an industry-wide supplier issue that impacted a few production products and was resolved during the quarter.

While I wouldn’t describe the quarter as a clearing event, as it still exhibited cost growth and various writedowns associated with the problem projects, we learned a few things:

1. They retired 3 of the remaining 11 problem projects and expect 4 more to be retired by the end of the fiscal year (45 days away so I figure line of sight pretty good)
2. This leaves 4 challenged projects, which are all basically one project tied to the common processing architecture. To quote Bill:

"Where we are with respect to the common processing architecture is, we believe that we've gotten to root cause in understanding what was keeping us from getting to a very specific physical integrity that we need to get to in order for our technology to work as intended. And it's based on our understanding of the material science. And based on that understanding of the material science, we've been able to implement a change in the manufacturing process that allows us to get to the physical integrity that we need.

Now, we're ramping up production, we've moved to initial production after we've done a ton of testing, a lot of analysis, seeing our analysis and the empirical data all match up. So in the fourth quarter, we've done initial builds. We are currently in what we're calling pilot production, which will go through the end of the fourth quarter. And as we exit the fourth quarter, we expect to have pretty solid validation of our corrective action, which will then give us the ability and the indications that we need in order to ramp up to full-scale production.

And really, this is all about getting to a sample size that we think is statistically significant. I mean, the units that we build, all the testing that we've done during the quarter, all indicate that the corrective action we've put in place gets us to where we need to be from a physical integrity standpoint. We want to see that over a much larger sample size to increase our confidence in the corrective action."

                While I’m sure issues can emerge at this stage, a lot of the risk seems to be retired.

3. The bookings have returned to the 80/20 production/development cadence that optimizes growth and margins, which is a leading indicator for revenue
4. No new problem projects for two quarters now

Point 6: Substantial Upside vs Consensus

OK, time to lay out the numbers here.

For some context, the initial guide for FY2024 was for $1bn in revenue, which they subsequently lowered to $800-850m of revenue. This compares to $988m/$974m of revenue in 2022/2023.

The reason this was lowered so significantly was due to removing the unbilled revenues piece from development projects – so they were still incurring the costs, just not booking anything against them – as well as removing all revenue from the common architecture piece discussed above. Finally – and this is a little complex – they began taking cost growth charges that are actually a contra-revenue account, further dinging revenue.

The cost growth is also a non-cash charge. Basically, they had to re-evaluate the economics of some of their challenged projects, most notably the common processing architecture. So, they look at their prior expectations for how much the entire project is going to cost, and then take a charge on higher costs vs expectations. So, in some ways its not actually a reduction in revenue as much as an accounting re-valuation (that hits EBITDA as well). I am confident these types of material adjustments will be confined to FY2024. In fact, they are likely somewhat strategic, lowering the decks for better profitability and growth going forward.

All the while bookings came in fairly strong with a record backlog. So I don’t think that $1bn of revenue has really gone anywhere – I think its definitively possible for FY25, although they might set the bar lower to start. Here are the high level recent financials:

As is clear, the problems began in FY23 and have crushed numbers in 2024. But its worth taking a closer look at the last two quarters. If we use their disclosures to back on the charges associated with the turnaround/challenged projects, there has been a lot of recent improvement:

This is even more notable as Q3 included a significant drag from the aforementioned industry-wide supplier issue, which I have not added back here, even though it is fully resolved.

So, taking the 16.3% EBITDA margin for FYQ3 has a few embedded assumptions:

1. All challenged programs resolved from a cost perspective
2. No incremental revenue from said programs or new bookings
3. No scale benefits from normalized revenue levels
4. No benefits from the Q1 24 restructuring savings maturing

This actually seems very conservative to me. The nice thing about delivering on development programs is that they transition into production programs and become much more profitable. That dynamic is supercharged here as the current development programs are negative gross margin, so the transition can really flick a huge switch once accomplished. The 16.3% margin just ignores that dynamic and assumes the problem projects just disappear vs being converted into real business.

So, lets look at a few scenarios for FY25:

Consensus EBITDA assumes somewhere between a 10-12% margin for 2025, a level this company has never done aside from FY24 turnaround. So, its clear that at least the sell-side is assuming there are additional shoes to drop here, and that Bill will miss on his goal of a clean, growing FY25.

So, taking those EBITDA ranges, the implied multiples today:

At the low end, not cheap, at the high end very cheap. And there are two dynamics here, first is if the ship is turned, the market should start to price in some of the other goals of the business, such as 10% growth and 25% EBITDA margins, which starts to get EBITDA into the $300m range fairly quickly.

But secondly, given the thematic developments in mid-cap defense, particularly in defense electronics relating to missile systems/drones, the comparable multiples are very high:

KTOS: 24x

AVAV: 34x

And then larger cap defense primes all trade around 13-14x EBITDA despite much lower growth.

MRCY’s historical multiple was between 18-25x when the business was producing 20% EBITDA margins. So the market does not yet seem to be pricing in much of a turnaround, even if the stock isn’t extremely cheap on the low-end of my expectations.

I think this will be a situation where the multiple will expand along with EBITDA throughout FY2025 as they execute and the popular short thesis will die, creating a lot of buyers for the stock.

On the upside, if they are executing I expect EBITDA estimates in the $220-240 range for FY2026 (this is not heroic given historical performance, restructuring actions and growth), At 15x, still the low end of multiple ranges, this is a $50 stock.

On the technical side, the stock has 8.5% short interest and is unpopular with the sell side, with sell ratings from Jefferies and Goldman and holds from most other brokers. There is a nice opportunity for shorts to cover and analysts to come around to the story.

Finally, the intention here seems to be to sell the business after the turnaround is complete. Bill has a long track record of successful exits and it’s a much cleaner way for JANA to exit their 12% stake. In February 2023, when this stock was $54 a share, the Chairman of Cobham, a PE backed competitor, said “Mercury would be a perfect fit,” stating that Cobham was studying a deal closely. While there might be FTC/DOD concerns with this particular deal, given the industry growth, low capex, long-cycle nature of the business I expect they find a home for MRCY in the not-too-distant future.

Risks and Mitigants

New Issues Emerge: As with any turnaround, the stock will take a hit if the timeline gets pushed back further. There are many programs here and although we are confident Bill has looked over each with a fine-toothed comb, more issues could emerge that derail the timeline, hurt the FY2025 story, and slow the turnaround. Our view is that Bill has things under control and this is low likelihood and that we are being well compensated for this risk.

Customer Abandonment: One concern we’ve heard from bears is that the lack of execution may lead some of the larger customers to walk from Mercury in the future. While possible, we do not think there is any evidence to date to support this (in fact, the opposite given bookings strength), and I think it over-emphasizes the challenged projects here. These are now just 11 of the over 300 projects Mercury has, so most customers are receiving exactly what they want on time. The challenged projects also haven’t been challenged for that long given the long-cycle nature of the business. But, if new issues emerge, this can become a more significant risk.

Investor Burnout/Credibility: Investors have certainly been burned here, and restoring credibility will take time. I think we are very fortunate that Bill has such a strong track record and is such a straight shooter – I would not be interested in a turnaround run by the ex-CEO, Mark Aslett. In some ways the burnout may work to our advantage, as there are many parties not involved in the stock who may need to own it given the lack of growth opportunities in defense at the moment – assuming, of course, that the turnaround bears fruit.

Disclaimer

This document is for informational purposes only. All content in this report represents the author's opinion. The author obtained all information herein from sources believed to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind — whether express or implied. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any information contained herein. This report is not a recommendation to purchase the shares of any company. The information included in this document reflects prevailing conditions and the author’s views as of the date submitted, all of which are accordingly subject to change. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity. Any or all forward-looking statements, assumptions, expectations, projections, intentions or beliefs about future events included in this document may turn out to be incorrect. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment prior to making any investment decision.

Catalyst

• Announcement of FY25 guidance in August
• Continued progress on turnaround KPIs