Mercury Systems Inc (MRCY) Recent Volatility

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Sterne Agee analyst, Peter Arment and Josh W. Sullivan comment on today’s Mercury Systems Inc (NASDAQ:MRCY) volatility in their report dated March 18, 2014.

Mercury Systems’s volatility

News reports that Mercury Systems Inc (NASDAQ:MRCY) could be up for sale through an auction process. While its just speculation as of today, a few key points to consider:

1. Mercury Systems has been positioning the company to exit FY14 as the trough year in sales.

2. Cost cutting from the previous acquisitions should improve the profitability for the long term, with $16 million in annual savings planned by FY16.

3. Defense budgets are viewed more stable now with funding in place.

We continue to rate Mercury Systems a Neutral for the following reasons:

1. Remains vulnerable to contract timing as individual programs delays can have an outsized impact on MRCY’s operations.

2. Valuation premium – Mercury Systems trades at FY15E EV/EBITDA at over 17x at current prices, which is over 2x the defense group average. We would expect any strategic company to pay mid-teens EV/EBITDA, which limits the upside unless the company is will to add back significant adjustments.

Last night Mercury Systems Inc (NASDAQ:MRCY) announced its 2Q14 results of an EPS loss of $0.03 vs. consensus of a loss of $0.08. However, given additional restructuring costs of ($0.10), FY14 EPS has been guided to a midpoint of a loss of (~$0.27) vs. consensus of a loss of ($0.15). Mercury Systems is re-positioning and integrating its operations for a return to growth in core programs in FY15 with a potential of $16 million in gross cost savings in FY16. FY14 is setting up as the trough year.

Mercury Systems’ 2Q14 Results

2Q14 sales were $53.1 million, an increase of $3.4 million year over year (y/y) vs. consensus of $52.6 million. GAAP net income was a net loss of $1.0 million or ($0.03) per share vs. consensus of ($0.08) per share. This includes $0.04 associated with amortization of acquired intangible assets. Mercury Systems’ total 2Q14 backlog was $130.5 million, a $2.7 million y/y decrease. Mercury Systems has two segments: Mercury Commercial Electronics (MCE) and Mercury Defense and Intelligence Systems (MDIS).

MCE Sales Increase 11%

MCE sales in 2Q14 were $45.0 million, representing a 11% increase y/y. 95% of sales were derived from defense vs. 89% in 2Q13. Management reiterated its strategy to manage the business to be cash break-even. MDIS sales in 2Q14 were $11.1 million, a 4.5% sequential decrease and a 24.8% y/y decrease tied to lower Electronic Warfare (EW)revenues.

Mercury Systems announces new restructuring efforts

Mercury Systems Inc (NASDAQ:MRCY) announced new restructuring efforts which will drive $16 million of annual gross cost savings. Mercury Systems anticipates 3Q14 revenues to be in the range of $50 million to $56 million vs. the consensus of $54.3 million. GAAP EPS in 3Q14 is now expected to be in the range of ($0.09)-($0.15) including ($0.06) of restructuring vs. the consensus of ($0.03). FY14 sales are expected to be in a range of $215-$225 million with GAAP net loss per share of ($0.20)-($0.34) including ($0.10) of restructuring. The Street is in print with sales of $216 million and a per share loss of $0.15. Further, Mercury Systems believes core revenues will resume growth commencing in the 2H14 with the potential of 10% y/y growth in FY15.

Key drivers for FY15 are continued core program growth and modest gains in outsourcing with key customers. Mercury Systems Inc (NASDAQ:MRCY) believes once integrated, the restructured/ consolidated assets will see share gains that can leverage the enhanced engineering capabilities bundled with quality high volume manufacturing within the Radio Frequency (RF) and microwave sensor chain.

Adjusting Estimates

We are increasing our FY14 EPS estimate to a loss of $0.28 from a loss of $0.32 but maintaining our FY15 EPS estimate at break-even. We are establishing an FY16 EPS estimate of $0.25, reflecting a modest return to growth coupled with gains from the cost-savings efforts.

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