This Highflying Defense Stock Stumbled. That’s a Reason to Buy.

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Mercury Systems specializes in electronics and chips for the aerospace and defense industries of the U.S. and its allies.

Courtesy of Mercury Systems

Everyone goes through growing pains, and defense contractor Mercury Systems is suffering from them in a big way. Now a new CEO has the chance to help the struggling company mature into what management—and investors—always envisioned.

Based in Andover, Mass., Mercury (ticker: MRCY) specializes in electronics and chips for the aerospace and defense industries of the U.S. and its allies. Mercury says it has more than 300 programs with some 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 been moving up the value chain from components to entire subsystems—a transition that requires spending billions on mergers and acquisitions and research and development. The company has made 14 acquisitions since 2016, including firms that make aircraft display systems, radio-frequency components, ruggedized computers and servers, and flight control units.

Mercury’s plan on paper has been to combine disparate components into larger subsystems to sell to its defense-contractor clients—boosting sales and profit margins.

“It’s a good strategy because when you’re a subsystem provider, it’s a stickier business than just selling individual components,” says Randy Gwirtzman, co-manager of the $1.4 billion Baron Discovery fund (BDFFX), which owns Mercury shares. “So it was a smart play—it just hasn’t been executed as well as we hoped.”

Mercury may have bitten off more than it could chew, while Covid-19 supply-chain disruptions made the situation worse. Earnings in its latest fiscal year dropped 54%, to an adjusted $1 per share, while revenue was close to flat, at $974 million.

Mercury’s stock, meanwhile, has 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 that an attempt to sell itself, begun at the behest of activist investors Starboard Value and Jana Partners, would end without a deal.

That’s where the new management comes in. Jana pushed to add Bill Ballhaus—a trained aerospace engineer with a career at a number of major defense contractors—to Mercury’s board last year. He took over the CEO and president roles 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 turn around stalled programs under development that have been tying up resources and weighing on overall profits.

Mercury Systems / MRCY

Aerospace and defense electronics contractor

Headquarters Andover, Mass.
Recent Price $37.99
52-Wk Change -20.2%
Market Value (bil) $2.2
2024E Sales (mil) $976
2024E Net Income (mil) $77.8
2024E EPS $1.33
2024E P/E 28.6

E=estimate. Note: Fiscal year ends in June.

Source: Bloomberg

“[Ballhaus] has an outstanding track record executing turnarounds and driving shareholder value, comes in with a head start having been on the board for a year, and he is highly aligned with shareholders with his compensation plan,” says Scott Ostfeld, managing partner and portfolio manager at Jana and a Mercury board member since July.

Ballhaus calls fiscal 2024 a “transition year,” with revenue about flat but profits and cash flow steadily improving through the period. “In my experience, this is not uncommon in businesses that grow rapidly via acquisitions,” he said on the company’s fiscal fourth-quarter earnings call in August. “At Mercury, the immaturity and lack of full integration of key functional areas have led to the serious challenges the company experienced forecasting business performance over the past several quarters. That said, maturing in these areas is doable, within our control, and under way.”

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Those operational improvements should start showing up in the numbers in coming quarters. Sales won’t grow much in the new fiscal year—management guidance calls for $950 million to $1 billion in revenue in fiscal 2024, and Wall Street analyst consensus splits the difference—but profits are forecast to rebound 33%, to $1.33 per share. That’s due to tighter integration and oversight of Mercury’s acquired operations and other cost-cutting measures, which will help lower expenses by some $21 million this fiscal year and improve profit margins, the company says.

The key to the turnaround, though, will be getting troubled programs back on track. Just 20 programs subtracted some $56 million from Mercury’s fiscal 2023 adjusted earnings before interest, taxes, depreciation, and amortization, or Ebitda, which would have been $188 million without them.

Those programs have also been a drain on cash flow due to a buildup in inventory, with the company’s working capital totaling 65% of revenue last fiscal year, up from 35% in fiscal 2020. Once those programs—and the R&D dollars spent on them—begin to generate sales, Mercury can release that working capital into free cash flow. Margins should expand as well, and management is targeting a return to low-to-mid-20% adjusted Ebitda margins “over time”—their words—after a dip to 14% in fiscal 2023.

The market doesn’t appear to give Mercury much credit for its ability to figure out its engineering roadblocks and grow up. Shares, at $37.93, currently trade for about 28 times 12-month forward earnings, a discount to the 30-plus times that they received in 2019 and 2020, despite what should be trough profits. It wasn’t that long ago that Mercury was compounding earnings at a double-digit rate and trouncing the market and its peers’ stock performance.

It’s not hard to imagine a world where Mercury matures—and if it does, shares could double in the next three years, especially if they follow earnings growth higher and regain their premium valuation multiple.

Growing up may be painful, but for Mercury Systems stock, it should be worthwhile.

Write to Nicholas Jasinski at [email protected]

EMEA Tribune is not involved in this news article, it is taken from our partners and or from the News Agencies. Copyright and Credit go to the News Agencies, email [email protected]

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