Mercury Systems specializes in electronics and chips for the aerospace and defense industries of the United States and its allies.
Courtesy of Mercury Systems
Text size
Everyone goes through growing pains and defense contractor
Mercury systems
suffers from it in a big way. Now a new CEO has a chance to help the struggling company mature into what management and investors have always envisioned.
Headquartered in Andover, Massachusetts, Mercury (ticker: MRCY) specializes in electronics and chips for the aerospace and defense industries of the United States and its allies. Mercury says it has more than 300 programs with about 25 defense contractors, and its products are found in F-16, F-18 and F-35 fighter jets; Predator and Reaper unmanned aerial vehicles; AND
RTX
‘S
(RTX) Patriot surface-to-air missiles, to name just a few.
Where it once specialized in simpler circuits, switches and sensors, Mercury Systems has shifted the value chain from components to entire subsystems, a transition that requires spending billions on mergers, acquisitions and research and development. The company has made 14 acquisitions since 2016, including companies that make aircraft display systems, radio frequency components, rugged computers and servers, and flight control units.
Mercury’s plan on paper was to combine disparate components into larger subsystems to sell to its defense contractor customers, increasing sales and profit margins.
“It’s a good strategy because when you’re a subsystem supplier, it’s a more complicated business than just selling individual components,” says Randy Gwirtzman, co-manager of the $1.4 billion company
Baron Discovery
fund (BDFFX), which owns Mercury shares. “So it was a smart move, it just wasn’t executed as well as we hoped.”
Mercury may have bitten off more than it can chew as supply chain disruptions caused by Covid-19 worsened the situation. Earnings in its latest fiscal year fell 54%, to an adjusted dollar a share, while revenue was nearly flat, at $974 million.
Mercury shares, meanwhile, tumbled from a closing high of $92.80 in April 2020 to $44.74 at the end of 2022, before slumping to $31.50 in June after the company announced a sale attempt, initiated at the behest of activist investors Starboard Value and Jana Partners, would end without a deal.
This is where the new management comes in. Jana pushed to add Bill Ballhaus, a trained aerospace engineer with a career with several major defense contractors, to Mercury’s board last year. He took on the roles of CEO and president on an interim basis in June, positions the company made permanent last month.
Mercury also has a new chief financial officer, David Farnsworth, formerly of Raytheon, and several new board members. It will be their job to remediate programs under development that are tying up resources and weighing on overall profits.
| Headquarter | Andover, Mass. |
|---|---|
| Recent price | $37.99 |
| 52 week changeover | -20.2% |
| Market value (billion) | $2.2 |
| 2024E sales (mil) | $976 |
| Net profit 2024E (mil) | $77.8 |
| 2024E EPS | $1.33 |
| 2024E P/E | 28.6 |
E=estimate. Note: The fiscal year ends in June.
Source: Bloomberg
“[Ballhaus] has an exceptional track record of executing turnarounds and driving shareholder value, comes with a head start having been on the board for a year, and is highly aligned with shareholders with his compensation plan,” says Scott Ostfeld, managing partner and portfolio manager at Jana and a member of Mercury’s board of directors since July.
Ballhaus calls fiscal 2024 a “transition year,” with revenues largely stable but profits and cash flow steadily improving over the period. “In my experience, this is not uncommon in companies that grow rapidly through acquisitions,” he said in August at the company’s fiscal fourth-quarter earnings call. “At Mercury, immaturity and lack of full integration of key functional areas led to severe challenges the company faced in forecasting business performance in recent quarters. That said, maturing in these areas is doable, under our control and ongoing.”
Discover all the stocks we are bullish and bearish on
These operational improvements should begin to manifest in the coming quarters. Sales won’t grow much in the new fiscal year – management forecasts call for revenues of $950 million to $1 billion in fiscal 2024, and the Wall Street analyst consensus splits the difference – but profits are expected to rebound by 33%, to $1.33 per share. This is due to tighter integration and oversight of Mercury’s acquired operations and other cost-cutting measures, which will help reduce expenses by approximately $21 million this fiscal year and improve profit margins, the company says .
The key to the turning point, however, will be to get programs in difficulty back on track. Just 20 programs took about $56 million from Mercury’s adjusted earnings for fiscal 2023 before interest, taxes, depreciation and amortization, or Ebitda, which without them would have been $188 million.
These programs also resulted in a drain on cash flow due to a build-up of inventory, with the company’s working capital totaling 65% of revenue last fiscal year, compared to 35% in fiscal 2020. Once these programs—and the dollars spent on research and development on them—start generating sales, Mercury can free up that working capital into free cash flow. Margins are also expected to expand, and management is targeting a return to low-to-mid 20% adjusted Ebitda margins “over time” – their words – after a decline to 14% in fiscal 2023.
The market doesn’t seem to give Mercury much credit for its ability to figure out its engineering hurdles and grow. The shares, at $37.93, currently trade for about 28 times trailing 12-month earnings, a discount from the more than 30 times it received in 2019 and 2020, despite what is expected to be the bottom line in profits. It wasn’t long ago that Mercury was racking up earnings at a double-digit rate and overwhelming the market and the stock performance of its competitors.
It’s not hard to imagine a world in which Mercury matures, and if it does, stocks could double over the next three years, especially if they follow higher earnings growth and regain their premium valuation multiple.
Growing up can be painful, but Mercury Systems stock should be worth it.
Write to Nicholas Jasinski at nicholas.jasinski@barrons.com