Description

Mercury Systems (MRCY – NYSE): Defense Electronics Platform Benefiting from DoD Modernization Efforts

1) Thesis Description

Mercury Systems (MRCY) is a manufacturer and supplier of secure sensor and mission processing subsystems for defense applications in the Sensor/Effector and Command/Control/Comms/Computers/Intelligence (C4I) submarkets. The Department of Defense (DoD) is undergoing a paradigm shift concerning electronic subsystems; reforming procurement standards, requiring secure domestic supply chains and increasing budget allocations to electronic improvements for new/existing programs, all with the intent to accelerate technological capabilities. This shift in DoD emphasis is forcing defense Primes to outsource subsystems to suppliers such as Mercury to take advantage of specialization in leading edge electronic systems. Mercury is poised to grow given a durable market expansion despite low single digit DoD budget growth, while utilizing their platform and unleveraged balance sheet to inflect growth in acquired smaller Tier 3 suppliers unable to scale domestic manufacturing capacity.

The thesis is as follows:

1)      At the current price of $67.04/share, the market ascribes no value to future organic growth/M&A, and little value to margin improvements. Valuation ranges from $48.25/share to $237.50/share over five years, with scenarios ranging from no growth/no M&A to ~25% market share of the Sensor and C4I end markets.

2)      An opportunity is available due to several reasons:

a.       Mercury inappropriately characterized as a typical defense supplier as opposed to a specialized electronics manufacturer to the defense industry. Mercury differs from a standard Tier 2 defense supplier in several ways including its commercial revenue model, pre-integrating subsystems, utilizing open architecture software and domestically manufacturing microelectronic components. Typical Tier 2 electronics suppliers provide subsystems to Primes via cost-plus contracts, a lower margin but externally funded R&D model. Primes then have to integrate the Tier 2’s proprietary components to government or Prime IP. By internally sourcing and pre-integrating many of the components together, Mercury is capable of manufacturing subsystems at a lower cost than competitors but with superior margins, while streamlining time to market for Primes and therefore disintermediating typical Tier 2 suppliers. Further, by creating a domestic microelectronic manufacturing base capable of securing and utilizing the latest semiconductors, Mercury is able to build subsystems with more advanced processing capabilities than competitors. Given the uniqueness of this business strategy and domestic manufacturing capability, it would be more appropriate to compare Mercury to commercial electronics/semiconductor manufacturers who have higher barriers to entry in growing markets (17.5x-22.5x normalized EV/EBITDA), than regular defense Primes/suppliers (10x-15x normalized EV/EBITDA).

b.       Investors overly discount Mercury’s long-term growth prospects even as Primes increasingly outsource, sub-scale Tier 3’s are acquired, and DoD accelerates digital/electronic modernization. During the past decade, Primes acquired multiple traditional Tier 2 suppliers, leaving a vacuum in the marketplace. Mercury advantageously started acquiring smaller players in FY’16 to elevate their standing in the industry and effectively compete in a depleted Tier 2 field. Additionally, the Primes simultaneously diluted R&D efforts of their targets, and over time have been unable to internally create cost competitive electronics even as the DoD pushes electronic modernization efforts and supplier cost optimization. As such, the Primes have increasingly outsourced capabilities to Tier 2 suppliers from 10%-15% in FY’16 to ~20% of the total market in FY’20. The top 30 DoD programs have exhibited 45%-50% outsourcing. The U.S. Tier 2 markets targeted by Mercury comprise of the ~$17.5B sensor/effector market and the ~$22.5B C4I market. The company currently generates ~$500M in the sensor/effector market and ~$205M in the C4I market, ~12.5% and ~5% in outsourced market share, respectively. Notably, MRCY has grown ~25% per annum since FY’14 and only entered the C4I market in FY’18. With DoD emphasis on leading edge electronic content and hundreds of Tier 3 suppliers, the company should have strong organic growth and meaningful inorganic growth opportunities at potentially competitive prices.

c.        Market participants misinterpret the company’s platform business model as a simple consolidation strategy. Mercury’s strategy is underpinned by above-market organic growth from increasing electronic content on DoD programs (new/existing), and M&A activity focused on capabilities coupled with integration benefits. Targets are mostly Tier 3 suppliers who are unable to scale up or do not have substantive access to multiple DoD programs. Mercury integrates these acquisitions and leverages its platform to drive untapped organic growth/margin expansion from manufacturing, personnel and sales/marketing scale. Notably, MRCY’s culture and care of employees have made the company an acquirer of choice, dovetailing nicely with acquisitions from mostly founder-owned or private companies. A strong organic growth trajectory, manufacturing/sales scale coupled with an M&A strategy focused on inflecting growth at competitively priced acquisition targets creates a compounding effect that goes beyond a simple consolidation of market share.

d.       Competition should be mitigated as barriers to entry in domestic secure-microelectronic manufacturing limit new entrants. As a Tier 2 supplier Mercury has seen less competition than at its previous Tier 3 level, given the Tier 2 consolidation over the past decade by the Primes. The company’s value-add at Tier 2 depends on its ability to cost effectively source components for its subsystems which it then sells to Primes/DoD. This has led to Mercury acquiring multiple Tier 3 suppliers, creating capabilities to internally manufacture entire subsystems. With the DoD pushing for domestic supply sources for these microelectronics, the company has built a scaled domestic manufacturing base capable of securing commercial semiconductors for their subsystems. Notably, Mercury is one of four Tier 2 suppliers with a Defense Microelectronic Activity (MDEA) certified manufacturing facility, a certification process which is laborious and time consuming. To date, the only new entrants are Curtis Wright and Rada Electronics, who have attempted to duplicate Mercury’s capabilities, both of which are not currently DMEA certified. The DoD mandates and Mercury’s DMEA manufacturing scale both increasingly force out smaller competitors and limit new entrants.    

e.       Concerns of DoD budget constraints/cuts due to coronavirus stimulus and a possible Democratic administration fail to take into account the need for defense modernization. Defense spending at ~$740B, amounted to ~15% of all federal spending prior to the pandemic, below its 20-year average (~18.5%). With trillions of dollars being spent to mitigate the pandemic’s economic fallout, defense spending becomes a smaller part of the budget, which makes defense cuts both politically unsavory and de minimis in improving the U.S. fiscal situation. All the while, increasingly outdated military platforms need modernization or retirement/replacement by newer systems that are technologically superior. Further, Democratic defense initiatives, as stated by the presidential candidate, point to a refocus on “near-peer” powers with spending priorities on cyber/IT and unmanned aircraft as well as a more generalized focus on innovation in emerging technology. This outlook is in line with both Republican and DoD thinking. Given the increasingly necessary modernization of the military and bipartisan support for DoD technology spending, Mercury is poised to benefit once those initiatives are put on paper by either administration.

3)      The largest micro risks in the name is execution issues with manufacturing expansion/utilization, M&A execution issues and potential lost program bids. The largest macro risks are DoD budget cut risks (fiscal constraints or political philosophy-related), semiconductor supply chain issues and reversal of Prime defense contractor outsourcing efforts.

2) Business Analysis

A Brief History – Strategy Change in FY’16 Led to Platform Business Model Now In Mid-Innings

Mercury Systems was founded in 1981 as Mercury Computer Systems by Jay Bertelli, in Andover, MA, and focused on providing electronic components to Tier 2 defense contractors. In 1998, the company went public and through 2012 acquired four electronics companies, while remaining at the Tier 3 supplier level. However, starting in FY’16 Mercury changed their business strategy, realigning their sales process to increase customer touchpoints and started acquiring specialized defense electronics manufacturers to expand into adjacent markets and to grow into the uncrowded Tier 2 level of the defense supplier market.

Among the eleven acquisitions since FY’16, three stand out in both size and market focus. The carve-out of Microsemi’s defense electronics segment in FY’16 for $300M (~10.5x EBITDA excl. synergies), gave Mercury a scaled microelectronics manufacturing base in the embedded security, RF and microwave submarkets. The purchase of CES Creative Electronics Systems in FY’17 for $38M (~9x EV/EBITDA excl. synergies) for access to international markets and entry in the C4I submarket. Lastly, the acquisition of Themis Computers in FY’18 for $180M (~13.7x EBITDA excl. synergies) gave the company a significant footprint the C4I submarket.

The majority of the company’s acquisitions are from founders or private entities. Only two of the last ten were from private equity owners, and one was a carve-out from a public company. Since FY’16, the company has acquired eleven businesses for ~$800M at ~7.5x EV/EBITDA with ~25% in realized cost savings. Upon closing these acquisitions, Mercury accelerates the targets growth via its sales channel, while at the same time increasing R&D investment and expanding its manufacturing scale. On average, the company is able to accelerate the businesses from 3%-5% to low-double digit annual growth within a year to two. This is the company’s virtuous cycle.

The company has several domestic Advanced Microelectronic Centers throughout the U.S. As a full integrator, Mercury is finalizing its consolidation of manufacturing facilities on the West Coast from recent acquisitions.

Notably, the Phoenix AMC is a Defense Microelectronics Activity (DMEA)-certified facility with a surface mount capability and should have a new clean-room built out by July. The facility is one of 30 DMEA certified manufacturers (excl. Primes/Labs) and one of four amongst Tier 2 competitors, which allows an assured chain of custody from initial design through assembly and test for classified military programs requiring high-performance microelectronics. With the facilities expansion, Mercury should be able to create specifically tailored chiplets for the defense industry, expanding its reach beyond integrated electronic subsystems and into semiconductor manufacturing. 

Lastly, the BuiltSecure System in Package (SiP) platform, adds Mercury security features (physical and digital) commercial FPGA’s and in-house built chiplets for use in military applications, in effect ‘securing’ them.

Mercury has two main market segments: Sensor/Effectors and C4I.

Components include switches, amplifiers, IC’s and memory devices. Subassemblies/Modules include processing boards, Ethernet boards, multi-chip modules, integrated radio frequency/microwave multifunction assemblies and transceivers. Integrated subsystems include multiple modules with a backplane and software to enable a solution, typically integrated within a chassis with power/cooling elements.

In FY’19, revenue comprised of ~60% Sensor/Effector and 25%-30% C4I and 10%-15% Other. Geographically, revenue comprised of ~90% in the U.S. and ~10% in International. Additionally, ~80% of revenue has distinct performance obligations, while ~20% is tied to long-term contracts.

Sensors and Effectors

Mercury’s Sensor and Effector segment contains products for electronic warfare, radar systems, video cameras (thermal/optical), acoustic systems (sonar) and missiles/munitions. For RF/Microwave applications, Mercury provides amplifiers, filters, switches and integrated multifunction assemblies. Additionally, the company has mixed signal processors, sensor signal processing subsystems. Additionally, the company provides RF microelectronics for smart munitions.

The largest programs in this segment include: F-35 (~10% of revenue), F-16, C-130, LTAMDS, Aegis, Triton, Global Hawk, Reaper, Buzzard, SEWIP, Stormbreaker, PGK, Paveway, MALD-J and SM2/3/6.

C4I

The company’s C4I segment contains products for avionics/vetronic mission management, command and control/battle management information processing/exploitation and dedicated communications. For these applications, the company provides rugged rackmount servers, small form factor computers, high density secure memory and mission computing subsystems.

The largest programs in this segment include: the JLTV, WIN-T, KC-46, A330 MRTT and Aegis.

Other

Mercury’s other products include legacy computer components, information assurance software/cryptography and professional engineering services.

Management History – Minimal Insider Ownership (<5%), Key New Hires for Next Step in Company Evolution

Mark Aslett, CEO, joined Mercury in late ’07. Prior to that, he was CEO and COO of Enterasys Networks from ’03-’06.  Aslett’s compensation comprises of a ~$675K base salary, a cash bonus of ~$1M and a stock bonus of ~$3.8M or ~70% of total compensation (part annual part long-term compensation plan). He is required to own 5x his base salary in shares, owning ~0.5% of shares outstanding.

Michael Ruppert became Mercury’s CFO in ’18 though joined the company in ’14 as Senior VP of Strategy and Corporate Development.  Prior, he was a co-founder of RS Partners, an A&D boutique advisory and Managing Director of Investment Banking for Aerospace and Defense at UBS. Mr. Ruppert’s compensation comprises of a ~$400K base salary, a cash bonus of ~$445K and a stock bonus of ~$1.25M or ~60% of total compensation (part annual part long-term compensation plan). He holds ~0.25% of shares outstanding.

Key hires include Bill Conley, Chief Technical Officer and Matthew Grosshans, Senior Director of Global Operations.

Bill Conley was the Director of Electronic Warfare at the DoD from ’15-’19 and a Program Manager at DARPA from ’13-’15. His knowledge base and close contacts with high-ranking DoD officials would be highly beneficial.

Matthew Grosshans was VP of Flight Display Systems, Director of Business Transformation/Improvement and Direct of Quality at Honeywell implementing Lean Operating Systems (similar to Toyota Production System) to improve manufacturing outcomes. As Mercury expands its microelectronic manufacturing, Mr. Grosshans experience becomes critical.

The executive team and insiders own ~2% of MRCY.

Customer Dynamics – Outsourcing of Integration Efforts and R&D by Primes to Defense Electronics Manufacturers like Mercury Create Strong Partnerships

The company sells its products to Prime defense contractors or directly to the DoD and typically engages with them early in the design process. Notably, Lockheed, Raytheon, Northrup and L3Harris comprise ~42% of revenue. Mercury utilizes a commercial business model, wherein the company is partly compensated for R&D expenditures by customers and prices are fixed rather than traditional cost-plus contracts.

The defense primes have increasingly outsourced their subsystem manufacturing to Tier 2 firms, from 10%-15% in FY’16 to ~20% in FY’20 of a ~$40B market. The top 30 DoD programs have exhibited 45%-50% outsourcing.

Outsourcing is largely due to DoD cost cutting initiatives and desire to integrate more commercially-available advanced electronics coupled with Primes unable to cost effectively provide such components with their entire organization structured under a cost-plus model. For the DoD, procurement reform initiatives allow for greater competition through direct interaction with lower level suppliers, while decreasing vendor lock in order to lower prices. Additionally, the DoD is pushing these reforms to keep pace with rapidly evolving electronic/digital threats as well as a need to project force with less materiel/personnel.

Primes are forced to deal with a select number of specialized suppliers to stay competitive on costs and time to market as in-house R&D efforts have been diluted across multiple business units from years of Tier 2 supplier acquisitions. Additionally, the low-volume, high-mix of increasingly complex electronic components result in higher manufacturing/integration costs and diseconomies of scale for Primes. Ultimately, Primes are focused on becoming program designers/integrators, not subsystem manufacturers, and Mercury’s method of pre-integrating components, eases Primes integration efforts/costs while streamlining their supply chain.

In effect, the company partners with customers on R&D creating a close relationship exhibiting moderately high switching costs once a program is in full production. Further, Mercury’s fixed cost contracting and pre-integrated subsystem model provides customers with lower cost subsystems, while accelerating the time to market.

Supplier Dynamics – Proprietary IP to Secure Commercial Silicon Creates Technology Advantage While Mitigating Input Price Pressures

Mercury’s inputs comprise of supplies from large semiconductor manufacturers and some smaller Tier 3’s for custom designed ASICs, DRAM, FPGAs, microprocessors and other third-party chassis peripherals, a majority of which are currently available only from a single source or from limited sources. The largest suppliers are Intel, Microsemi, NXP Semi, Micron, NVIDIA and Xilinx.

The defense industry currently amounts to less than 1% of volumes for semiconductor manufacturers and the costs/barriers to DMEA certification creates pricing power for the defense-oriented suppliers, even while the DoD pushes for domestic sources of silicon. For most defense contractors with no ability to internally secure third-party semiconductors, DMEA-certified Tier 3 suppliers fill in the gap but with small volumes. Larger volume sources of secure semiconductors still come from the DMEA facilities of Intel, On Semi, Microsemi et al. Though, commercial semiconductor manufacturers typically shy away from large investment in defense markets, given international traffic in arms regulations (ITAR) limiting the available market outside of the U.S., so costly leading-edge semiconductors typically do not reach the defense market. Notably, several Primes have DMEA-certified facilities but are dedicated to design and not foundry, packaging/assembly/testing.

Mercury is one of four DMEA-certified manufacturers at a Tier 2 level able to utilize its proprietary IP to insert anti-reverse engineering and other security features in commercial semiconductors. By accessing the volumes of the commercial semi market (~99% of volume), the company is able offer the latest in technology while mitigating supplier pricing pressure that most other defense contractors are exposed to.

Competitor Dynamics – Mercury’s Business Model Takes Advantage of Current Industry Structure and DoD Initiatives, Displacing Incumbents

Over the past 10 years, Primes have acquired multiple Tier 2 suppliers in an effort to consolidate their supply chain, leaving a vacuum in the marketplace. The company advantageously started acquiring smaller Tier 3 players in FY’16 to elevate their standing in the industry and effectively compete in a depleted Tier 2 field. With hundreds of Tier 3 suppliers, Mercury has a plethora of substantive M&A opportunities given its current size. Further, the company is able to acquire Tier 3 suppliers at a competitive price as they would otherwise be unable to scale, accretively adding to MRCY’s capabilities and increasing their competitive standing. 

In an effort to reduce costs and speed adoption of Commercial-Off-The-Shelf (COTS) electronic components, DoD procurement reform using commercial contracts as opposed to cost-plus contracts disadvantages traditional Tier 2 suppliers, both independents and ones acquired by Primes. Mercury benefits from this as its commercial contracting model allows it to compete on price, while providing the latest in technology.

Additionally, DMEA certification and ITAR concerns keep defense electronics and commercial semiconductor competitors from a substantial entrance into Mercury’s market. Lastly, the current investment in its DMEA facilities for chiplet-level design should enable the company to internally create specialized semiconductors.

Market Trends – Mercury End Markets Expected to Grow Above Top Line DoD Budget Growth

Sensor and Effector

In ’19, the Tier 2 Sensor and Effector market grew ~4% to ~$17.5B of which ~20% is outsourced by the Primes. Through ’24, the market should grow by ~4.5% per annum to ~$22B with outsourcing of ~25%, according to RS Advisors. The total U.S. market for Sensors/Effectors equated to ~$41.5B in ’19.

C4I

In ’19, the Tier 2 C4I market grew ~3.5% to ~$22.5B of which ~20% is outsourced by the Primes. Through ’24, the market should grow by ~4% per annum to ~$27B with outsourcing of ~25%, according to RS Advisors. The total U.S. market for C4I equated to ~$82B in ’19.

Defense Budget and Long-Term Initiatives/Focus

In ’20, the DoD budget, with a complete funding bill, should grow over ~7% y/y to ~$740B though should expand only ~2% per annum through ’24. The Top 30 DoD programs have exhibited 45%-50% outsourcing by Primes. Of the RDT&E segment of the DoD budget, C4I spending has increased ~12.5% per annum from ~$6.5B to ~$12B.  

Given the impacts to the government budgets from coronavirus mitigating stimulus and lower tax revenues, the DoD budget is likely to maintain current levels the next 1-2 years before ‘peanut butter’ style cuts, though cuts are more likely fall on older programs given the need for advanced technical capabilities.

Modernization efforts on almost all existing programs is ongoing in order to maintain equal standing to smaller more nimble threats, whether nation-state or insurgent. With these threats adapting evermore quickly, aided by use of technology, the DoD is responding in kind by adapting its procurement model and shifting its funding locus to acquire superior digital capabilities more quickly and more cost-effectively. Further, the growing number of sensors on military platforms is increasing the demands on data storage and processing. Additionally, the DoD is focused on ensuring its defense platforms are protected against digital attacks, both cyber and electronic component manipulation, as such it’s mandating that the electronic supply chain become domestically sourced.

This ultimately puts pressure on the traditional acquisition model as gains in defense superiority goes from pure hardware advancements, utilizing an industrial design/build/produce cycle, to more software/data management advancements, requiring an iterative off-the-shelf acquisition model.

Semiconductors

In ’20 before coronavirus impacts, the global semiconductor market was expected to grow ~12% to $475B following ~12% contraction in ’19. Beyond ’20, the market should grow ~12% in ’21 and slow to less than 5% growth through ’23 at ~$555B. Military applications comprise less than 1% of global semiconductor volumes.

3) Why now?

Mercury is in the mid-innings of its growth trajectory and currently trades at ~16.25x EV/FY’22 EBITDA based on consensus revenue growth of ~10.5% and ~9% growth in FY’21/’22, respectively. However, the company is in the early stages of developing a platform in the C4I market, has only ~$225M in cash, no debt and ~$975M in liquidity to effect an acquisition. If the company grows at a more probable ~20% in 2H/’21 and FY ’22 with M&A, its multiple drops to a more enticing ~13.5x on FY’22 EBITDA. We advocate entering into a position as concerns over DoD budget pressures and political change discount the company’s share price to a level that almost entirely ignores highly probably future growth.

A few key points below illustrate the company’s value potential at this point in time:

1)      Strong Organic Revenue Growth as DoD Pushes Electronic Modernization and Primes Outsource, Amplified by Accretive M&A: Since shifting its business strategy in FY’16, Mercury has grown its total revenue ~25% per annum, ranging from 20%-50% depending on the level of M&A. Supporting total revenue growth is an average ~10.5% of organic growth per annum, accelerating from ~9.5% in FY’17 to ~13.5% in FY’20. This is partly due to market share gains, large programs reaching production stage and increased outsourcing by Primes. Notably, the Primes have increased the amount of outsourcing from ~10% of the Tier 2 supplier market in FY’16 to ~20% in FY’20. Ultimately, we anticipate the Primes outsource ~50% as procurement reform as DoD emphasis on technology and the Primes system integration complexities remain in place. The company has a ~12.5% and ~5% market share in its respective Sensor/Effector and C4I markets, and only recently entered the C4I market. Notably, the DoD’s RDT&E procurement for C4I has increased ~12.5% per annum since FY’16. Additionally, international sales only amount to ~10% of revenue, while NATO and other Allies are pressured to increase their defense spending. Going forward we anticipate Mercury grows ~20% per annum slightly below their long-term guidance, comprising of ~10.5% organic and ~9.5% inorganic growth.

2)      Acquiring Sub-Scale Competitors at Economically Accretive Prices While Inflecting Organic Growth Profile: Mercury is not merely a serial acquirer as it follows a formula tailor-made for its competitive environment. A highly fractured Tier 3 defense supplier market and solid reputation as a consolidator of choice allows Mercury to acquire firms at below-market valuations, while at the same time applying their platform and manufacturing scale to profitably inflect growth to the acquired entities. A typical acquisition is a founder-led/private company, with defense electronic capabilities that complement Mercury’s own portfolio, an inability to scale manufacturing capabilities, EBITDA margins of 15%-20% and growth of ~5%. Since FY’16, the company has acquired eleven businesses for ~$800M at ~7.5x EV/EBITDA with ~25% in realized cost savings and increased organic growth from 5% to almost 10% after one to two years. Once the acquired entity is growing at Mercury’s standard ~10% organic growth, the valuation multiple paid equates to 6-6.5x EBITDA. Given the company’s stellar reputation, and a multitude of potential targets due to a fractured Tier 3 market along with the ongoing generational shift in privately-held companies spurring founder exits, we anticipate Mercury’s M&A strategy going forward to have similar effectiveness as in the past.

3)      Flexible Balance Sheet Creates Large M&A Optionality; C4I Market Should Exhibit Greatest Emphasis/Growth: The company assiduously manages its balance sheet, peaking at ~2.5x debt to EBITDA in FY’16 with the acquisition of Microsemi’s defense business. At present, Mercury has ~$225M in cash, no debt and $750M of available revolver, ~$975M in total liquidity. This is more available capital at a single point in time than the $800M that has been deployed since in FY’16. This capital is likely to be deployed in the C4I market, where Mercury has a smaller footprint and where the DoD is increasing spending ~12.5% per annum versus DoD topline growth of ~2%. Greater revenue share of the faster growing C4I segment could result in an organic revenue growth rate in excess of our expected ~10.5% per annum.

4)      Modest Operating Margin Expansion from Manufacturing Scale and New Programs Reaching High-Margin Annuity Phase:  In early ’18, the company opened its DMEA-certified facility in Phoenix and began in-sourcing its production, phasing out contract manufacturers, which should result in margin improvement from manufacturing scale/vertical integration over time. Mercury’s consolidation of its acquisition targets manufacturing sites has amplified the scale effect. Notably, the high mix, low volume characteristics of defense electronics makes the company’s domestic manufacturing base one of the largest in the industry, though below the threshold of diseconomies of scale observed at the Prime level. Further improving the company’s margin profile is the shift from lower-margin early design/manufacturing to higher-margin low volume production across multiple programs. As such, Mercury’s EBITDA margins have expanded from ~14% in FY’16 to ~22% in FY’21, ~160 bps per annum. Modest coronavirus mitigation costs at manufacturing facilities and investment in growth have put near term pressure on margins including FY’21. Going forward, we anticipate the company expands margins to ~26.5% by FY’25, ~100 bps per annum.

5)      Disciplined Management, Unique Culture and Key Hires Ensure Greater Market/Mind Share with DoD and Primes: Key to any company strategy requiring M&A is the skillset of management to execute accretive acquisitions and maintain the cultural environment after integration. Mr. Aslett, the CEO, prizes work culture as much as business performance. Acquisitions are not executed if the price is not attractive and the business culture is not similar to what has been developed at Mercury. This unique culture also shows up in the fact that over 35% of new hires in FY’20 came from employee references. Additionally, other channel checks validate the positive sentiment within Mercury’s workforce. Further, the new CTO coming from a key DoD position should give Mercury more entre to the DoD and an edge up in understanding future C4I technical requirements for new programs. As the company grows in size and stature, its importance to the Primes and DoD should grow in conjunction.

4) Concerns/Thesis Pressure Points

DoD/Government Budget Risk

Top line DoD budget pressure comes from both cost-savings and political initiatives. Over the years the DoD has been working to lower costs via procurement reform and politicians have pushed to lower spending/troop levels. Further, political turmoil over the years has meant Continuing Resolution bills signed at the last minute, adding to defense industry volatility. Mercury has missed revenue/earnings estimates only a few times in the last few years due to this dynamic. Even pro-defense industry administrations appear to see the political expediency of curtailing spending at the DoD.  However, Mercury is exposed growing segments of the DoD budget that deal with delivering force projection with minimal materiel. Coronavirus impacts are expected to lower government revenues and increase sovereign debt levels in the future, which would pressure defense budgets for all allied governments.  Though notably, recent voting on maintaining U.S. defense spending levels was bipartisan and future cuts unlikely to result in a repeat of ’13 defense cuts (~25% across the board). In a more hostile spending environment, Primes would likely increase outsourcing to lower cost providers like Mercury to mitigate decreased earnings.

Concentrated Customer Risk

Mercury sells to a limited number of Primes, who are increasingly selective over who is a part of their supply chain. Lockheed, Raytheon, Northrup and L3Harris comprise ~42% of revenue, each 10% or more. Given the customer-funded R&D model, Mercury is more insulated from concentration risks as it’s viewed as a partner and competes effectively on cost.

Semiconductor Supplier Risk

As a manufacturer of electronic subsystems, Mercury requires supplies of semiconductors and other small components. Their unique model of utilizing/securing commercial semiconductors allow them access to greater volumes and more advanced technological capabilities, though could be subject to the overall industry’s cyclicality.

Manufacturing Execution Risk

The company’s manufacturing of mission-critical military components/subsystems requires high quality control. Any issues in production would be highly detrimental. Additionally, the manufacturing base represents a floor on fixed costs, should utilization become challenged operating leverage would create amplified pressure on margins.

M&A Funding/Execution Risk

Over-priced or ill-suited acquisitions and/or integration issues would detrimentally impact Mercury and large equity issuances would dilute current shareholders. Since FY’16, the share count has grown ~45% from ~39 million shares to ~56 million in FY’20, contrasted to a ~200% increase in share price. Additionally, as the company gets larger it may have difficulty gaining scale through accretive acquisitions and large M&A deals would carry greater risk. However, at present the company is small enough in that many Tier 3 companies would still have a substantive effect on operations, and the multitude of them should keep purchase prices competitive.  

Competition Risk

The company’s competitive environment is fairly benign at the Tier 2 level, as many former Tier 2 suppliers were acquired by the Primes, and Tier 3’s lack scale. Going forward, several competitors should try to compete at the same level as Mercury which could put downward pressure on prices or siphon off key personnel. Though pricing pressure should be mitigated as the company’s pre-integrated subsystem strategy already makes it the lower cost provider in the marketplace. Additionally, the company’s DMEA-certified manufacturing scale and unique culture should keep competition from recreating Mercury’s advantage.

5) Business Valuation

Mercury should exhibit double digit organic growth over a number of years as the company focuses on the most important submarkets of the defense industry. Additional top line revenue growth should come from acquisitions given the plethora of M&A opportunities in the Tier 3 defense electronics market. The company generates revenue through the manufacture and sale of specialized electronic subsystems to the Prime defense contractors and DoD.

A summary of the Base Case assumptions for the company is below:

1)      Short-Term Guidance FY’21: Total Revenue Growth: 7%-11% y/y, Organic Growth: 7%-11% y/y, EBITDA margin: ~22%, Capex: 5%-6% of revenue.

2)      Long-Term Guidance: Total Revenue Growth: ~25% per annum, Organic Growth: ~10% per annum, EBITDA Margins: ~26%, Capex: ~3% of revenue.

3)      Total revenue should grow ~16% to ~$920M in FY’21 with M&A activity returning in 2H/FY’21, and 20% per annum to ~$1,900M by FY’25 assuming ~10.5% organic growth, remainder is inorganic.

4)      M&A metrics assume the gap between 20% and our organic revenue growth forecast is attributable to acquisitions with ~19.5% EBITDA margins purchased at pro forma acquisition multiple of ~6.35x (assumes ~25% cost synergies and organic revenue growth of ~10% realized year one).

5)      EBITDA margin of ~22% in FY‘21 should improve to ~26.5% by FY‘25, a ~100 bps expansion per annum. Taxes increase from 21% to 28% in '21.

6)      Capex: ~6% of revenue in FY’21, stepping down to ~3% of revenue over three years.

7)      ~22x normalized EV/EBITDA multiple for Mercury. Reasoning behind the multiple is in the Peer Analysis section below.

8)      Discount rate at ~12.5% (mid-cap).

Five-Year Operating Model

A simple five-year operating model is utilized to determine value.

Base Case:

Base Case assumes the company grows ~20% per annum from 2H/FY’21 through FY’25 and expands EBITDA margins to ~26.5%.

-           Base Case Valuation: $119.25/share.

Upside Case:

Upside Case assumes the company grows ~25% per annum (~13% organic growth) through FY’25 and captures ~25% of a ~$25B end market assuming ~50% outsourcing by Primes.

-           Upside Case Valuation: $237.50/share.

Downside Case:

Downside Case assumes the company does not grow or conduct M&A and is valued at ~15x EV/EBITDA, ~30% below our normalized valuation.

-           Downside Case Valuation: $48.25/share.

Peer Analysis – Trading Comps

Mercury has no direct public comparables, as it’s one of the only defense electronics pure plays with scale. The list of comparables below consider firms which exhibit similar characteristics as to end market dynamics, products and competitive positioning. Analysis below utilizes a normalized EV/EBITDA metric to account for the margin implications of business model shifts.

Public Comparables – EV/EBITDA

1)      AeroVironment (AVAV) – ~22.5x normalized EV/EBITDA; currently at ~19.75x FTM.

2)      Inphi Corp (IPHI) – ~19.5x normalized EV/EBITDA; currently at ~23x FTM.

3)      MACOM (MTSI) – ~18.5x normalized EV/EBITDA; currently at ~20.5x FTM

4)      Teledyne (TDY) – ~15.5x normalized EV/EBITDA; currently at ~20.25x FTM.

AeroVironment is a manufacturer of Unmanned Aircraft Systems (UAS) to the DoD and other allies defense departments (50%+ of revenue) as well as commercial customers. While not a competitor to Mercury, AVAV does sell to the same end customer and provides unique electronics to aid in modernizing military ops, projecting power with less personnel. The company does have some commercial markets exposure, ~20% of revenue. Growth is expected to average ~15% per annum over the next three to five years.  For AVAV only, we lowered the normalized valuation multiple by ~25% to ~22.5x given the more speculative nature of the company and to err on the side of conservatism.

Inphi is an analog/mixed signal semiconductor manufacturer for communications and datacenter markets. While not having exposure to defense, the company has many semiconductor products which encounter no to minimal competition given high barriers to entry. Growth should average 20%+ per annum over the next three to five years.

MACOM is a manufacturer of high-performance RF, microwave and analog ICs for data center, telecom and defense applications. Additionally, the company has a DMEA-certified semiconductor foundry. The firm’s exposure to the DoD is 40%-45% of revenue. Growth should average ~9% per annum over the next three to five years. This is arguably Mercury’s closest comparable company.

Teledyne is a manufacturer of high-performance instrumentation, imaging, and other electronics for a wide range of industrial and defense applications. Additionally, the company has a DMEA-certified electronic design/assembly facility, competing with Mercury in the Tier 2 space. The firm’s exposure to the DoD is ~25% of revenue. Growth should average 3%-5% per annum over the next three to five years.

The group’s normalized EV/EBITDA multiple equates to ~19x and has ranged between 12x-28x from ’15 to ’20 and currently trades at ~20.75x FTM assuming ~6% per annum revenue growth. Mercury currently trades at ~18x FY’21 and ~16.25x FY’22 EV/EBITDA (consensus 10.5% and 9% revenue growth, respectively) and since its strategy shift in FY’16 has averaged ~24x EV/EBITDA with a 25%-30% revenue growth CAGR.

Peer Analysis – EBITDA Margins

EBITDA Margins

1)      AeroVironment (AVAV) – ~15% normalized EBITDA margin; currently at ~16% FTM.

2)      Inphi Corp (IPHI) – ~35% normalized EBITDA margin; currently at ~33% FTM.

3)      MACOM (MTSI) – ~20% normalized EBITDA margin; currently at ~18% FTM

4)      Teledyne (TDY) – ~20% normalized EBITDA margin; currently at ~19% FTM.

Aero’s operating margins have increased ~180 bps per annum since FY’15 and are expected to normalize over the next five years as R&D and SG&A have reached scale. Capital expenditures have averaged ~3.5% of revenue.

Inphi’s operating margins have increased ~200 bps per annum since ’15 and are expected to expand 170 bps per annum for the next three years given operating leverage. Capital expenditures have averaged ~9% of revenue.

MACOM’s operating margins have decreased from FY’18 to FY’19 due to a semiconductor downcycle and should return to its ~20% normalized margin by FY’21.  Capital expenditures have averaged ~6% of revenue.

Teledyne’s operating margins have increased ~75 bps per annum since FY’15 and are expected to expand less than 50 bps per annum for the next five years as gross margin fractionally improves. Capital expenditures have averaged ~3% of revenue.

Mercury’s comparable group generates ~20% normalized EBITDA margins, underpinned by operating margin expansion of ~110 bps per annum. Mercury generates ~22% EBITDA margins and has expanded margins ~160 bps per annum from FY’16 to FY’21.

Peer Analysis – Conclusion

For Mercury, a ~22x EV/EBITDA normalized valuation appears reasonable based on a ~15% premium to its more representative comparable group of faster-growing defense names and specialized electronics/semiconductor manufacturers given its superior margins, strong organic/inorganic growth and a highly competent management team. Further, this valuation multiple equates to a ~10% discount to the company’s historical average since FY’16 (~24x) to accommodate minor compression in light of a higher probability for defense cuts in the next five years. Scarcity value of MRCY’s growth in a pressured defense industry underpins confidence in the multiple. Notably, we did not include a strategic acquirer analysis as we anticipate the company being more valuable as an independent company and a generally poor fit for Primes given contrasting business models.

6) Market Expectations/Perceptions

Mercury’s is covered by 11 analysts with an average price target of ~$93/share. Eight analysts have a Buy rating and three have a Hold. A highly capable management team and belief in the company’s growth trajectory is generally acknowledged by market participants. Though with higher probabilities of DoD budget pressures, many consider milder growth prospects in the future.

Notably among market participants is the comparison of MRCY to either traditional defense contractors or pricing power consolidators like Transdigm. Mercury is unlike almost every defense contractor, both in terms of strategy and business model thus making for a poor comparison. Additionally, despite being an active acquirer, the company does not have/flex pricing power on its customers, opting for a win-win partnership and does not utilize considerable financial leverage like TDG. As argued above, Mercury is closer to an electronics/semiconductor manufacturer in a growth market with higher barriers to entry.

Consensus forecasts ~10.5% revenue growth for FY’21 slowing to ~5.5% in FY’23, and EBITDA expansion of 50 bps per annum to ~23% in FY’23. The market’s growth forecast appears anticipate slowing of organic growth, while not including inorganic growth opportunities or margin expansion. Given the multitude of potential acquisitions and the DoD’s focus on improving its electronic/digital capabilities, we believe these inorganic/organic growth expectations are the largest disconnect between reality and markets. Underpinning the growth disconnect is the concern over defense budget austerity in the future resulting in a bear market for defense names, though this underemphasizes the DoD’s advanced electronics mandate and Mercury’s role in modernization as well as its low cost provider standing.

7) Downside Protection – Where’s the Margin of Safety?

The company’s downside is well protected as Mercury provides crucial components to many top DoD programs and alternative products are few and far between despite the DoD’s best efforts to open up competition. Additionally, any fiscal austerity that takes place following the coronavirus outbreak may actually accelerate the adoption of advanced electronics at the DoD and outsourcing by Primes, underpinning Mercury’s growth and value to the defense industry.  Further, MRCY’s domestic manufacturing base for microelectronics should maintain a solid barrier to entry with many newly domesticated semiconductor firms disincentivized to invest in DMEA facilities given minimal cross-selling or reinvestment opportunities at their level of scale.

At ~$65/share, the market assumes revenue does not grow after FY’21 and values MRCY at its current ~18x EV/EBITDA level. At ~$75/share the market assumes only ~2% growth per annum, below end markets, assuming the company is valued at our expected ~22x normalized EV/EBITDA multiple. Given the current investment opportunity set and the company’s stable operations, a share price drop into the $50’s should be fleeting as this implies no growth and a valuation equivalent to traditional Prime contractors (10x-15x EV/EBITDA), both of which we believe are unrealistic assumptions.

8) Conclusion       

Mercury is a well-run defense electronics company with a long growth trajectory, numerous reinvestment opportunities, higher barriers to entry, minimal competition and a misunderstood value proposition by a noticeable portion of the investment community. The company’s strategy and market positioning enable it to create an electronics platform unlike any in the defense industry with durable competitive advantages which would only be amplified in an increasingly tech-focused DoD.

In this environment, Mercury continues to operate as normal and concerns over future DoD budget cuts in light of fiscal constraints fails to account for the necessary electronic modernization of the military. Additionally, MRCY has no debt and ~$975 million in liquidity, more than at any point in company history, and an increasing number of potential acquisition candidates.

As of September 10, 2020, the name is trading at $67.04/share. With a Base Case valuation of $119.25/share, we believe there is ~80% upside, equating to ~12% annualized IRR over five years.  

Catalyst

·         Substantive M&A transactions

·         Continued strong organic growth (C4I, Prime outsourcing)

·         International expansion

·         Funding Bills for DoD vs. Continuing Resolutions