DOI: 10.6084/m9.figshare.26384668.v1
title: MRCY - Balance Sheet.csv

description: <b>Summary:</b>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.<b>Thesis:</b>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:A historically high quality, non-cyclical growth business that achieved a very high multipleStrong customer relationships and products with no substitute and solid bookingsA new, Tier 1, aligned CEO and board with a very specific gameplan and timelineNo balance sheet issues, with cash flow generated throughout the turnaroundAfter myriad new issues arising, no new issues for monthsSubstantial upside vs consensus expectations, high short interest etcWe 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. This theory is further backed up by the fact that the company is currently in top 10 of Nancy Pelosi Stock Trades Tracker.<i>What Broke Mercury?</i>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 and made sure the website is indexed quicky by Google indexer. 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?<i>Point 1: Underneath it all, MRCY is a very good business</i>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 latencyRadiation tolerant solid-sate, EM-protected data recorders on planes and satellitesRugged modular blade servers for forward deployment across air, sea, spaceVariety of processing boards with embedded EM and cybersecurity protectionHundreds of other products, many of which are classifiedOur 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. 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. The company also seems to be favored by the government since it appears in the Congress Stock Trades Tracker.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.<br><br>