Mercury Systems, Inc. (NASDAQ:MRCY) Q4 2022 Earnings Conference Call August 2, 2022 5:00 PM ET
Company Participants
Michael Ruppert – Executive Vice President and Chief Financial Officer
Mark Aslett – President and Chief Executive Officer
Conference Call Participants
Pete Skibitski – Alembic Global Advisors
Peter Arment – Baird Equity Research
Seth Seifman – JPMorgan Chase & Co.
Jonathan Ho – William Blair & Company LLC
Austin Moeller – Canaccord Genuity Corp.
Michael Ciarmoli – Truist Securities, Inc.
Sheila Kahyaoglu – Jefferies LLC
Operator
Good day, everyone, and welcome to the Mercury Systems Fourth Quarter Fiscal 2022 Conference Call. Today’s call is being recorded. At this time for opening remarks and introductions, I’d like to turn the call over to the Company’s Executive Vice President and Chief Financial Officer, Mike Ruppert. Please go ahead, sir.
Michael Ruppert
Good afternoon, and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett. If you’ve not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations.
Please turn to Slide 2 in the presentation. Before we get started, I would like to remind you that today’s presentation includes forward-looking statements, including information regarding Mercury’s financial outlook, future plans, objectives, business prospects and anticipated financial performance. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2 in the earnings press release and the risk factors included in Mercury’s SEC filings.
I’d also like to mention that in addition to reporting financial results in accordance with generally accepted accounting principles or GAAP, during our call, we will also discuss several non-GAAP financial measures, specifically, adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue and acquired revenue. A reconciliation of these non-GAAP metrics is included as an appendix to today’s slide presentation and in the earnings press release.
I’ll now turn the call over to Mercury’s President and CEO, Mark Aslett. Please turn to Slide 3.
Mark Aslett
Thanks, Mike. Good afternoon, everyone, and thanks for joining us. I’ll begin with the business update. Mike will review the financials and guidance, and then we will open it up to your questions. Before we begin, I’d like to recognize the entire Mercury team for a tremendous effort through the course of an exceptionally demanding year. Thanks to your strong performance. Mercury delivered record bookings, revenue and adjusted EBITDA for the fourth quarter.
That said, the quarter and the year were more challenging than we anticipated due to lingering pandemic impacts, the extended defense budget delay, continued supply chain disruption, labor market constraints and growing inflationary pressures. Despite these challenges, our bookings increased 27% year-over-year in Q4 to a record $332 million, leading to 1.14 book-to-bill and record backlog exiting the year. We received the large Aegis FMS order that was delayed in Q1, which was larger than we had originally expected.
We also received the funding associated with the F-35 TR3 Block 16 as anticipated among others. Our largest bookings programs in the quarter were Aegis, F-18, F-35, PGK and the SDA Tranche Tracking Layer. Total revenue was up 16% year-over-year and 9% organically. Our largest revenue programs in the quarter were Aegis, F-35, P-8, MH-60, and a classified radar program. We will continue to see high levels of new business activity. Design wins in Q4 totaled more than $680 million in estimated lifetime value. For the year, we received 33 new design wins with an estimated lifetime value of more than $1.6 billion, up 9% from fiscal 2021.
On the bottom line, we delivered adjusted EBITDA margins of nearly 25% in the fourth quarter and a record $71.6 million in adjusted EBITDA, which is up 36% from the third quarter and up 21% from the record set in Q4 last year. For the full-year, we delivered record bookings, which grew 21% for positive book-to-bill and record backlog. Total revenue increased 7% year-over-year, while adjusted EBITDA declined 1%. Our largest revenue programs for the year were MH-60, F-35, the classified C2 program, P-8 and Aegis.
Turning to Slide 4. Notwithstanding these record results, we fell short of our guidance of Q4 on the year primarily as the result of material and order delays has affected the timing of revenue. We continue to see in-quarter supplier de-commits, long lead times for high-end semiconductors and delayed supply and deliveries. In the past, we’ve been better able to mitigate short-term revenue risk that wasn’t possible to the same extent this year, given the supply chain and labor market disruptions. The contracting delays also resulted in the higher accounts receivable and lower in-quarter cash collections, which reduced free cash flow.
Inflationary pressures in large part related to semiconductors became more of a challenge as fiscal 2022 progressed. Semiconductors equate to 38% of our external supply spend and we are seeing double-digit price increases. We expect to see greater impacts on material inflation and to a lesser extent, labor inflation in fiscal 2023. Given the short cycle nature of our business however, we believe these impacts will begin to normalize a decline as our future business is priced in market rates.
Clearly, these were unprecedented times. Mercury sophisticated end-to-end processing platform powers many of the most critical A&D missions and represents about 70% of our business today. High-end processing requires high-end semiconductors and this is where the global supply chain has been most disrupted. That said, it’s also where Mercury likely has the largest opportunity to grow over the next five years.
Fortunately, the issues we are experiencing are not demand-related, they are supply and timing-related, they are temporary, and they are not unique to Mercury. We have a plan to focus on what we can control, and we are very optimistic about the future given our positioning. The demand environment is strong and appears to be getting stronger.
Although the defense industry is dealing with short-term headwinds, we expect to see a shift to tailwinds as defense spending grows and the supply chain conditions improve. We believe that we are well positioned to deliver results more in line with our target model in fiscal 2023. Looking ahead over the next five years, our plan remains intact. We believe Mercury can and will continue to grow at high single-digit to low double-digit rates organically, as the short-term challenges diminish.
The war on Ukraine, the most challenging global threat environment since the cold war will actually result in a sea change in defense spending domestically and internationally. Our advisors estimate that U.S. growth combined with increases in NATO defense spending to 2% of GDP could drive up to $1.5 trillion of additional spending over the next decade. This should lead to higher bookings for Mercury in the electronic systems associated with missiles and munitions, air and missile defense systems, unmanned systems, fixed wing and rotorcraft, ground vehicles and electronic warfare.
The secondary trend benefiting Mercury remains favorable in our view. The demand environment is improving, and is demonstrated by our strong bookings and design wins growth in fiscal 2022. We believe that a greater percentage of the value associated with future defense platforms will be driven by electronic systems content where Mercury participates.
Our addressable market continues to increase, driven in large part by our strategic move into mission systems and potential to deliver innovative process and solutions at chip-scale. Our model sitting at the intersection of high-tech and defense position us well. As a result, we expect our business to continue growing faster organically than overall defense spending over time. In addition to organic growth, our five-year plan includes continued margin expansion driven by our 1MPACT initiatives.
Turning to Slide 5, our expectations for fiscal 2023. The defense budget outlook is improving. We expect to deliver another year of double-digit bookings growth and a positive book-to-bill. Despite the potential for an extended CR due to the midterm elections, the DoD topline budget submitted for FY2023 is up from FY2022. There also appears to be strong bipartisan support for increased defense spending.
Labor market conditions have improved somewhat, and the primary health effects of COVID continue to subside. However, the second order COVID supply chain effects will likely continue in fiscal 2023 and possibly beyond. We also expect to see greater impacts from material and labor inflation for the year.
As I said, we believe that we are well positioned to deliver results more in line with our target model in fiscal 2023. We began the year with the record $1 billion in backlog and much improved forward revenue coverage versus fiscal 2022. We expect double-digit growth and bookings for the year and improved bookings linearity lean to a high backlog, better visibility and reduce risk as the year progresses.
We also expect a positive book-to-bill for the year. At the midpoint of guidance, we are expecting approximately 3.5% year-over-year growth in revenue and adjusted EBITDA versus 6% and 7% increases at the high-end. We expect growth together with improved operating leverage and our 1MPACT initiatives to partially offset material and labor inflation, resulting in similar margins to fiscal 2022. In addition to record adjusted EBITDA, we expect to deliver improved free cash flow.
Our fiscal 2022 booking spreads largely occurred in H2 and as I have said, we have seen longer semiconductor lead times. The high-end semiconductors lead times now range from 36 to 99 weeks, 3x to 5x pre-pandemic norms. As a result, we expect the timing of our revenue and adjusted EBITDA to be back-end loaded in fiscal 2023, with Q1 being the low watermark for the year. The increased backlog we expect as the year progresses should help improve operational execution in this challenging supply chain environment and ease the recent pressure on working capital. This should result in improved cash level over time.
Another year of expected double-digit growth in bookings and another positive book-to-bill in fiscal 2023, give us the confidence that we can and will return to organic growth back in line with our model in fiscal 2024, provided supply chain and labor market conditions normalize. And again, looking ahead over the next five years, our plan remains intact.
Turning to our 1MPACT program on Slide 6. We began the journey a little more than a year-ago with the goal of amplifying the value we create as we scale a business over time. During fiscal 2022, we simplified and streamlined our organizational structure and strengthened the leadership team. We also focused 1MPACT on analyzing and quantifying developing initiatives to drive margin expansion.
As we enter fiscal 2023, we are taking advantage of this progress by pushing the execution of these initiatives deeper into the business. We are using the 1MPACT processes and tools that we’ve developed and matured to deliver on our margin expansion goals over time. We expect 1MPACT to generate $30 million to $50 million of incremental adjusted EBITDA by fiscal 2027. This is later than originally anticipated, given the expected 1MPACT of inflation in the short-term. Over the next five years, 1MPACT should drive significant margin expansion nonetheless.
As fiscal 2022 evolved and things became more challenging, we pivoted 1MPACT towards areas that could help mitigate risk and deliver the most immediate financial results. This focus will continue in fiscal 2023. Through 1MPACT, we are seeking to de-risk the timing and availability of materials in our supply chain, and to better manage inventory. We are implementing processes and tools to make better and more timely pricing decisions. We are also prioritizing our human capital resources to the greatest effect.
To contract the inflationary pressures, we are updating our commercial price list and proactively negotiating existing contracts where possible. Our new contracts were introducing more favorable inflation-related terms and milestones to drive improved cash conversion. Another 1MPACT initiative of fiscal 2023 is R&D investment efficiency and returns following the progress in fiscal 2022.
In addition, 1MPACT is aimed at optimizing our balance sheet by improving our working capital and asset efficiency. Like many others in the industry, as a result of the environment, our unbilled receivables balance has grown. We are using 1MPACT to focus on and improve the timeliness of our receivables cash conversion. Although we’ve made some progress, we have more work ahead to achieve our long-term cash flow objectives.
Our digital transformation initiatives in engineering and operations will help improve our cost structure and performance over the long-term as well. We are also continuing to consolidate and optimize our facilities footprint. As it relates to M&A, 1MPACT is about leveraging our proven ability to integrate and grow acquired businesses, but it is a greater scale going forward. The M&A environment continues to be active and we will remain focused on our existing M&A themes.
With that, I’d like to turn the call over to Mike. Mike?
Michael Ruppert
Thank you, Mark, and good afternoon, again, everyone. I’ll discuss our Q4 and full-year results and then focus on our Q1 and fiscal year guidance. Turning to Slide 7. In Q4, Mercury delivered all-time company records for bookings, revenue and adjusted EBITDA. We exited Q4 with record backlog of more than $1 billion. Our 12-month backlog was up 22% year-over-year providing improved revenue visibility into the next 12 months.
Revenue in Q4 was up 16% and organic revenue up 9% year-over-year. During the quarter, we recognized the revenue that we expected from the large Aegis FMS sale, F-35 TR3 and other key programs that we discussed on last quarter’s earnings call. We did however experienced more supplier de-commits and award delays on other programs, which had a greater than $25 million revenue impact on our Q4 results.
Acquired revenue in Q4 included Pentek, Avalex and Atlanta Micro. As a reminder, Physical Optics Corporation, which we acquired in Q2 of fiscal 2021 is incorporated into organic revenue as of last quarter. Physical Optics continues to perform well despite being impacted by contract delays, labor market and supply chain de-commits like the rest of the industry.
In fiscal 2022, Physical Optics had revenue in line with expectations and had a 1.27 book-to-bill. Overall, a strong performance. The acquisition, which was our largest in history, is a critical component of our open mission systems strategy. As planned, when we bought Physical Optics, we are beginning to transition the business from its historical small business innovation research work to subsystem development and production contracts. We are pleased with the acquisition, its growth and its alignment with our strategy.
Q4 gross margins were up slightly year-over-year. Growth in higher margin production and licensing revenue was partially offset by increased direct allocations engineers to customer funded programs, as well as the impact of material inflation that we were not able to pass through to our customers. As a result of the direct allocation of engineers, our internal R&D was lower as a percentage of sales compared to Q4 last year.
In Q4, we had record adjusted EBITDA up 21% year-over-year. Compared to Q4 last year, our adjusted EBITDA margins increased 120 basis points to 24.7% primarily as a result of improved operating leverage. Free cash flow for Q4 was an outflow, primarily as a result of working capital and one-time expenses, which I’ll discuss further in a moment.
Turning to our full-year results on Slide 8. Fiscal 2022 was a record year for bookings. Our book-to-bill was 1.08 compared to 0.95 in fiscal 2021. This rebound drove backlog higher and increases our visibility heading into fiscal 2023. Fiscal 2022 revenue was up 7% in total and down 5% organically. Our organic revenue was impacted by the external market conditions, including supply chain disruption, labor market constraints, and contracting delays. Despite these delays in fiscal years 2021 and 2022, none of our major programs have been canceled.
Adjusted EBITDA for fiscal 2022 was down 1% year-over-year. Our adjusted EBITDA margins were 20.3% compared to 21.9% in fiscal 2021, primarily driven by program mix and inflation. Free cash flow in fiscal 2022 is an outflow primarily as a result of an increase in working capital as well as one-time expenses.
Slide 9 presents Mercury’s balance sheet for the last five quarters. We ended Q4 with cash and cash equivalents of $66 million and approximately $452 million of debt funded under our $1.1 billion revolving credit facility. Our balance sheet is strong and we have significant financial flexibility to continue to invest in the business organically and through acquisitions.
Accounts receivables increased in fiscal 2022. This was primarily a result of unbilled receivables, which increased approximately $61 million from Q3 fiscal 2022 and $140 million compared to Q4 fiscal 2021. This was primarily driven by the growing proportion of over time or percentage of completion revenues, as we execute on our content expansion strategy.
In Q4, over time revenue increased to approximately 60% of total revenues compared to 44% a year-ago. In addition, unbilled receivables were impacted by supply chain disruptions, which continue to delay delivery milestones and cash collections in the quarter. We expect unbilled receivables as a percentage of over time revenue to return to a pre-pandemic level of approximately 35% as supply chain conditions improve and legacy contracts roll-off.
Inventory increased approximately $11 million in Q4 compared to Q3 and approximately $49 million from a year-ago. This was primarily due to accelerated raw material purchases to support higher demand and mitigate supply chain risk in fiscal 2023. It also reflected decisions by our suppliers, the end of life more key components requiring us to invest in raw materials. We expect to see less of this dynamic in fiscal 2023.
Turning to cash flow on Slide 10. Free cash flow for Q4 was an outflow of $28 million and $47 million for the year. Last quarter, we forecast an expected free cash outflow in Q4 driven by one-time payments as well as working capital build due to the record revenue quarter. The Q4 outflow was further impacted by supplier delays primarily within unbilled receivables.
In addition, in Q4, we had approximately $7 million of one-time cash outflows associated with our 1MPACT initiative, acquisition expenses and shareholder settlement costs. When the supply chain normalizes, we expect our cash conversion cycle to normalize it as well and cash conversion to return to our target levels, which we have set at 50% free cash flow to adjusted EBITDA. We currently expect free cash flow to improve in the second half of fiscal 2023 as net income grows and working capital metrics improve.
I will now turn to our financial guidance starting with the full fiscal year 2023 on Slide 11. As of June fiscal year ended company, we are initiating guidance for the next 12 months in a very fluid environment as such our guidance incorporated to the extent we can, potential risks related to continued supply chain delays and material and labor inflation as well as the potential for another continuing resolution in a mid-term election year. While these uncertainties do pose risk, they are timing related and not related to demand which is strong.
On a quarterly basis, our guidance is second half weighted as a result of the bookings profile and supply chain delays that we’ve discussed. We are entering fiscal 2023 with strong backlog coverage given the record bookings in the second half of fiscal 2022. We also have visibility into the key programs not currently in backlog, but we believe will drive our revenue.
During the year, we expect to receive bookings on programs, such as F-16, F-18, Filthy Buzzard, SEWIP and others. We are designed in and have sole source positions on these programs. For fiscal 2023, we are guiding revenue of $1 billion to $1.05 billion, representing 1% to 6% growth from fiscal 2022. Organically, the high-end of our revenue guidance represents a 4% increase year-over-year. Based on the midpoint of our revenue guidance, we have approximately 63% of our forecast revenue in backlog. This compares to approximately 52% entering fiscal 2022.
Over 90% of our fiscal 2023 revenue guidance is either from backlog or from programs where we are designed in. We expect fiscal 2023 revenue to be H2 weighted, primarily as a result of award timing and supply chain lead times. We expect adjusted EBITDA margins to expand throughout the year as a result of program mix, 1MPACT initiatives and operating leverage. While we always tend to have years waited towards the second half, this year we expect that to be more pronounced as a result of the macroeconomic headwinds. As a result, we expect approximately two-thirds of our adjusted EBITDA in the second half.
Unlike the last two years, we expect our bookings to be spread relatively evenly throughout the year with a strong book-to-bill in H1, providing significant backlog coverage going into H2. Based on our current outlook for bookings, we expect to have nearly 80% of our H2 revenue in backlog driven by the key bookings I mentioned. This is above historical levels of backlog coverage entering the second half of the year, supporting the strong growth we expect in H2.
Our guidance range for adjusted EBITDA for fiscal 2023 is $200 million to $215 million, approximately flat to up 7% from fiscal 2022. At the midpoint, adjusted EBITDA margins are 20.2%. These margins are approximately flat year-over-year as the anticipated impacts of material and labor inflation are offset by 1MPACT initiatives related to procurement and pricing.
We currently expect free cash flow to adjusted EBITDA conversion of 30% to 40% in fiscal 2023. This estimate assumed that the current R&D capitalization tax law is delayed or repealed. We expect a free cash outflow in H1, primarily as a result of continued supply chain disruption with free cash flow returning to target levels in H2, as working capital increases subside. For the year, we are expecting double-digit bookings growth and a book-to-bill above one.
I’ll now turn to our first quarter guidance on Slide 12. Our current revenue guidance for Q1 is $215 million to $225 million. At the high-end, this is flat from last year. We expect Q1 adjusted EBITDA in the range of $27 million to $30 million. Margins are expected to be approximately 13% of revenue compared to 17% in Q1 last year. This is primarily a result of continued supply chain and labor inflation as well as program mix. We expect margins to expand as we move through the year as a result of program mix, operating leverage and 1MPACT initiatives offsetting inflation.
We expect a free cash outflow in Q1 as a result of continued supply chain disruption as well as one-time cash outflows associated with 1MPACT and shareholder settlement costs. While we don’t guide bookings, we are expecting strong bookings in Q1 as I said, with a book-to-bill above one resulting in record backlog at the end of the quarter. So while we expect a challenging environment to continue in the first half, we believe our backlog and expected bookings in H1 will position us well heading into H2 and into fiscal 2024. Over the next five years, we expect strong topline growth as well as margin expansion consistent with our target model.
With that, I’ll now turn the call back over to Mark.
Mark Aslett
Thanks, Mike. Turning now to Slide 13. The timing challenges that we’ve experienced in the past two years are likely to continue at least through the end of fiscal 2023 as we see it today. That said, the demand environment remains strong and we believe that strategically Mercury could not be better positioned. We are entering fiscal 2023 with record backlog and strong new business momentum is expected. We believe this positions us to deliver another year of double-digit bookings growth and a positive book-to-bill with revenue exceeding a $1 billion for the first time while maintaining strong margins.
Our five-year outlook remains intact. We expect increased defense spending through this period to positively impact the business. We are well positioned to continue benefiting from the effects of increased electronic systems, content, supply chain delayering and reshoring and increased outsourcing at the subsystem level. We believe the supply chain constraints and inflationary pressures that we are facing today are short-term in nature. Mercury’s fundamentals are strong and with 1MPACT should improve over time.
Executing on our long-term strategy over the past decade, we’ve improved margins while growing the business organically supplemented with disciplined M&A and full integration. As a result, we have created significant value for our shareholders and expect to continue doing so. We have also added depth to the Board. Continuing [indiscernible], I’d like to welcome Mercury’s newest directors, Howard Lance and Bill Ballhaus, who were elected to the Board on June 24th.
In closing, thanks once again to the Mercury team for your outstanding work and contributions.
With that operator, please proceed with the Q&A.
Question-and-Answer Session
Operator
Thank you. [Operator Instructions] Your first question comes from the line of Pete Skibitski with Alembic Global. Your line is now open.
Pete Skibitski
Hey. Good evening, guys.
Mark Aslett
Hi, Pete.
Pete Skibitski
Guys, if we think about fourth quarter topline fiscal 2023 revenue guidance, can you talk maybe about quantifying what part of the headwind is labor related, what part is supply chain related? And then just maybe – are you seeing it across all of your hundreds of programs or are there a few key programs – sizeable programs that are being unusually impacted?
Mark Aslett
Sure. So why don’t we kind of give the high level and then maybe Mike could kind of fill in some of the details, Pete. So at a high level, we saw greater than $35 million impact on bookings, the two probably biggest impact around the F-18. And then we also saw that SEWIP kind of slipped out of the quarter into Q1. Revenue, I think as Mike said in his prepared remarks was really due to two things, it was largely due to some of the order delays where we were actually expecting the order and to be able to recognize some revenue, SEWIP is a good example of that the product was built. But then also we absolutely saw some supply decommits. So we’re expecting material that ended up not arriving as we’d anticipated. So Mike, I don’t know if there’s anything that you’d like to add there.
Michael Ruppert
Yes. Pete, so Mark said it great. Just in terms of numbers, as we look at the impact on fiscal 2022 associated with the award delays, we estimate that that was about $22 million, and then the supplier decommits and extended lead times about $20 million in terms of the revenue impact in fiscal 2022.
Pete Skibitski
Okay. And are you thinking kind of 50/50 also for fiscal 2023?
Michael Ruppert
So in fiscal 2023, when we look at those two things, what you’ll see is that we talked about in the prepared remarks is that it’s more about timing during the year. And so what we’re seeing is that the award delays that we’ve had this year and the supplier decommits are leading to a lower H1 from a revenue perspective and a margin perspective because of a mix of business and a bigger H2. So we’re really looking at it as a fiscal 2022 impact right now.
Mark Aslett
So Pete, I’d just like to add though, I think it’s an important point, right. So we clearly saw a pretty substantial ramp in bookings in the second half. We thought that was going to occur. We did get some impacts, as I mentioned, just with some orders that didn’t arrive. The good thing is that the actual demand environment and order flow remains pretty strong. We’re actually expecting very strong growth in bookings in the first half, which should actually help improve the linearity as we head into fiscal year 2024. So unfortunately, if you step back, we’re kind of in a multiyear industry event here and the linearity of bookings in both fiscal year 2021 and fiscal year 2022 hasn’t helped us with respect to the timing of revenue and EBITDA. So we’re trying to take that into account as we head into the new fiscal year, just given the challenges that the industry’s experiencing. But overall, I think we’re seeing some improvements around bookings, which we believe is going to help not only in H2, but also next year as well.
Pete Skibitski
Yes, very, very unusual times. And if I could ask just one last one. We’ve had this CHIPS Act pass, but even separate from that, are you guys able to identify additional semiconductor capacity coming online in kind of the near-term that could address the shortages that you’ve had or at least lessen the impact?
Mark Aslett
Yes. It’s a great question, Pete. Yes, I think, as I’ve said in my prepared remarks, as one of our customers said on their earnings call, right, it’s hand to mouth right now, it’s pretty challenging. For high-end semiconductors, the lead times of 36 to 99 weeks. To put that in perspective, that’s 3x to 5x what we saw pre-pandemic, and that’s just for the semiconductor – for the high-end semiconductors. But the increases in the lead times has gone up across mechanicals components [and decommits]. I mean, literally it’s across the entire supply chain. The CHIPS Act won’t help in the short-term, right. I think it’s a strategically and critically important piece of legislation for the nation.
Yes, but that’s really about how do we actually bring back – reassure the chip manufacturing capability to make our supply chain more resilient. And it’s very clear with what the industry is facing right now that that’s the right thing to do. So – but it won’t help us in the short-term. So I think it’s going to take some rollover in demand in the semiconductor space to really to loosen up the challenges around availability. I think we’re already starting to see some of that in certain parts of the semiconductor markets. So memory is generally more available than what it has been in the past.
You’re seeing some freeing up of supply around lower end semiconductors associated with consumer electronics. Unfortunately, that doesn’t really help Mercury because we are producing very sophisticated processing subsystems, which is where we’re still seeing the tightness and the very long lead times. So I think is if the economy starts to slow down and as you start to see some demand softened, I do think you’ll start to see some pick up in terms of availability.
What we’ve also seen in the past is that when there is a scarcity, a lot of companies over order because they’re concerned about the ability to actually get access to the parts. And so we’re hoping somewhat that as demand starts to slow, the effects of the limited supply could actually turn quite quickly. But as we see it today, we don’t see it that occurring and we just don’t have the visibility piece.
Pete Skibitski
All right. Fair enough. Thanks for the color guys.
Mark Aslett
Yes.
Operator
Your next question comes from the line of Peter Arment with Baird. Your line is now open.
Peter Arment
Hey, thanks. Good afternoon, Mark and Mike. Mike, just a clarifying comments first. So do you expect to be free cash flow positive this year? And then Mark or Mike wants to make a comment. Trying to understand just the dynamics a little bit that’s going on with your unbilled receivables. You talk about 60% of kind of overtime revenue and getting back to 35%. What are some of the key things we need to see to begin to see that happen? Is it just availability of the supply chain? Maybe if you could just walk us through a little color, that’d be helpful.
Michael Ruppert
Yes. So Peter, I’m going to start with your first question in terms of free cash flow. So coming into the year, we weren’t facing the same number of supply chain issues that we’re facing today or that we did face during the year. So if you look at fiscal 2022, our free cash outflow was $48 million. Now, we invested in the business, we had about $27 million of one-time cost really associated with 1MPACT and some of the org redesign that we did. And I mentioned some of the other one-time costs in my prepared remarks. But the biggest impact by far has been the supplier and contracting delays, which, we estimate was probably about an $80 million impact on our cash flow during the year in addition to those one-time costs that I just mentioned. So coming into the year, we didn’t expect that working capital increase that was really driven by the supply chain and the contracting delays that I mentioned. And that really shows up in unbilled.
And to answer your second question in terms of unbilled and making sure that I clarify the percentages that we’ve talked about. So if you look at our overtime revenue, it has increased since fiscal 2020 from 27% to 55% in fiscal 2022. So this year 60% that you mentioned was our Q4 overtime revenue or percentage of completion revenue. I mean that’s related to our subsystem work. And that’s a natural growth as we do more subsystems consistent with our customer base.
When we look at what’s the rate metric for unbilled, how do we size it and say what’s the right amount of unbilled because we’re naturally going to have some. The way we look at that is the percentage of our overtime revenue. And so if you look back from fiscal 2019 to fiscal 2021, you’ll see – we average it around 35%. And in fiscal 2022, that number went up to 43%. And that’s what you’re seeing because of the supply chain delays, which delayed milestones, which delayed deliveries. And that’s the number that as we look at normalization of our working capital, we’re really going to drive down. And so that 43% that we ended the year in 2022, we think the good target is 35% over time. And we think that’ll unwind in fiscal – little bit in fiscal 2023, more in the second half and then heading into fiscal 2024.
Peter Arment
Mike, you sort of touch upon – I think the second part of the question was around, do we expect positive free cash flow in 2023?
Michael Ruppert
Yes. I’m sorry about that. Yes, we do. We talked about 30% to 40% free cash flow to adjusted EBITDA conversion for fiscal 2023. That’s going to be second half weighted. As I mentioned in my prepared remarks, we are looking at an outflow in Q1 unless we’re currently forecasting. But for the year, we are looking for positive free cash flow and then that normalized even further as we go into fiscal 2024.
Peter Arment
So it’s just to clarify. So if we get into like fiscal 2024 and say the supply chain availability is much better, then it doesn’t necessarily mean the topline story, but you could actually start seeing a lot of these unbilled receivables unwind. Is that the right way to think about it?
Michael Ruppert
Absolutely. Yes. And it’s also inventory. So if you look at our – in general and step all the way back, you look at working capital as a percentage of sales. You’ll see that before fiscal 2021, and even in fiscal 2021, we’re around 40%, prior to that we’re around 35%. This year on an LTM basis, we’ve jumped up closer to 56%. And that’s the combination of that higher unbilled as a percentage of overtime revenue plus inventory because as we’ve talked about, we invested in inventory to defray some of the risk associated with the supply chain. And we’ve seen inventory increase as we’ve seen contracting delays. So yes, you’re absolutely right. The right way to think about it is, as we get through fiscal 2023 and then into fiscal 2024, you should see working capital as a percentage of sales come down.
Peter Arment
Appreciate the color. Thank you.
Operator
Your next question comes from the line of Seth Seifman from JPMorgan. Your line is now open.
Seth Seifman
Hey. Thanks very much and good afternoon. Guys, I just wanted to ask about the expected EBITDA in the first quarter and that kind of 13-ish percent margin, which even last year, which you would’ve considered kind of a tough quarter for profitability was 17% to 18% margin. I mean it would seem like that’s implying something like a low-30s type of gross margin in the first quarter. Is that because of inflation? Is that because of mix? And to the extent that that is the case, how does that improve through the year? And does that imply some kind of exit rate that’s higher than usual? Or does it imply a quick step-up in the second quarter?
Michael Ruppert
Yes. So you’re right, when we look at Q1 revenue $215 million to $225 million is the guidance range. We don’t guide – as you know, we don’t guide gross margin, but we were 39% in Q1 of 2022. We’re going to be – mix is going shift Seth. So don’t necessarily hold me to this, but that’s going to be about 300 basis points lower in Q1 this year then Q1 last year. So around 36% is what we currently expect. So your number is right. And so what’s driving that. It is two things. First is the result of production slips. So revenues lower and gross margins are down because of the engineering work that we’re looking at in the first half of the year is lower margin. And the reason for that is that the production work, where we’re waiting for supplies has gotten pushed to the second half. So that’s one part of it.
And the second part is inflation. We’ve tried to take into account in our guidance some of the inflation that we won’t be able to pass through. We have at least a 100 basis points impact from inflation in those gross margins, but we’re trying to manage that through 1MPACT and other initiatives. So gross margin is down about 300 basis points and then EBITDA is down 400 basis points because we are 13% at the midpoint of our Q1 guidance. Now we are 17%. In Q1 2022, about 300 basis points is from the gross margin that I just mentioned. And the other 100 bps was associated with the negative operating leverage and labor inflation is the other piece of it. So that is what’s driving Q1.
As you look at the year, Seth, we are going to see gradual increase in gross margins throughout the year. So while we’re – I just mentioned 36% in – that’s what we’re estimating for Q1. We expect that to ramp up, probably be relatively similar, maybe a little higher in Q2. But then in the second half of the year, we have good visibility, as I said in my prepared remarks to the programs that are going to make up the revenue in the second half. And therefore, the margins on those programs too so we see a nice margin mix in the second half of the year. So you get closer to 42%, 43% gross margins that you also benefit from operating leverage because of the higher revenue in the second half.
Mark Aslett
If you step back, Seth, it’s literally what I said, big picture earlier. The bookings really in the last two years have being heavily weighted to the second half of the year. So we had a massive ramp in H2 this year, but with that the timing of those orders combined with long lead times on the materials, even though we’ve pre-purchased inventories wherever we have a strong conviction that the orders and the timing going to come in, push the production revenue and the EBITDA to the right. So it’s not like we’re losing anything, we’re not. But from a timing perspective and the mix of business is skewed towards the back half of the year, like it was in fiscal year 2022.
Now, as I mentioned in Pete’s comment, the good thing is that we saw the ramp in bookings in the second half and that ramp in bookings or that strengthened bookings is actually continuing in the first half of this year unlike last. So we are expecting pretty good growth year-over-year in the first half compared to what we experienced last year. So things do seem to be moving from an order flow perspective, but right now, we are being impacted from a time and mix.
Seth Seifman
Got it. Okay. I’ll stick to one. Thanks very much.
Operator
Your next question comes from the line of Jonathan Ho with William Blair. Your line is now open.
Jonathan Ho
Hi, good afternoon. Can you maybe help us understand or provide a little bit more color on how quickly you can push through pricing and maybe how we should think about that margin progression over the course of that second half of 2023?
Mark Aslett
Yes. It’s a good question. So the biggest area that we’re probably seeing from an inflation perspective is in relation to semiconductors, which I think is, as I’ve mentioned in my prepared remarks, it came for about 38% of our external spend and that’s supporting the 70% of our revenue, which is coming from processing systems. So that’s the biggest impact that we’re seeing. The rated which you can pass through the inflationary pressures varies quite honestly. So it depends upon the mix of business, right. How much is cost plus versus fixed price. How much of it you’ve already got in backlog, when those materials come in. I can tell you though that we’ve got a major focus on it and it’s been a big part of what we’re doing with 1MPACT, multiple different areas we’re focusing on, enhancing both the pricing side of things, our cost estimation, bidding proposal practices to ensure that we’re adequately pricing the effects of inflation.
While looking at the commercial side of the business to make sure that we’re capturing the value associated with the capabilities and the value that we’re providing to customers. So right now, we just implemented a standard commercial product price increase that was effective across our microelectronics portfolio, beginning July 1. Yes, we have got pretty – we’ve narrowed the “validity”. We are controlling discounts. We changed our contract modification authorities internally, leveraging the new pricing tools that we put in place. So as we see materials, we’re able to actually immediately wherever possible flow those actuals into our costs. So there’s a huge amount of work going on. And yes, we’re actually expecting to offset a fair amount of the inflation that we’re seeing in fiscal year 2023, but maybe not all.
Jonathan Ho
Thank you. I will stick to one.
Operator
Your next question comes from the line of Austin Moeller with Canaccord Genuity. Your line is now open.
Austin Moeller
Hi. Good afternoon, Mark and Mike. My first question here, how do you view the discussions that are going on around the new $30 billion F-35 order, it’s for around 375 aircraft, which is 22% lower than the last walk by how would you expect that to impact Mercury relative to maybe what you expected and do you think you could have higher margins on that smaller production lot?
Mark Aslett
Sure. So let me kind of step back a little bit Austin and kind of just give a more general update on the F-35 because I think to some extent it answers the question, but it’s important to understand all the moving parts. So we’re obviously aware of just the production rebase lining and kind of what’s going on. As we said in the past, we’re on multiple parts of the F-35 system across different parts of our product line. And although we experienced a pretty substantial reduction in order flow in fiscal year 2021 as a result of the TR3 development delays and the COVID impacts on manufacturing that resulted in the initial production rebase lining things have improved substantially since then.
Probably one of the more important ones for us is that L3Harris reported on their last call, they successfully completed all of the safety flight testing requirements and delivered the first flight chipset of what is known as the F-35 TR3 ICP. It’s the core processor associated with the F-35. They previously reported that the other elements of the systems that were a part of which is the panoramic cockpit display in the aircraft memory system of also, well down the path.
Lockheed, clearly, was able to actually reach an agreement on lots 15 through 17. And so I think to me, there was some very important events occurred during our fourth quarter that I think not only important for Mercury, but also for the industry as a whole. Stepping back and looking at the F-35 for Mercury at a year level, we saw a very substantial rebound in orders as we’ve expected. So our orders on that F-35 were up 123% year-over-year with 24 million of orders in the fourth quarter. As we’d expected and discussed in our last call, we actually received the lot 16 long lead time funding as expected, following the initial award that we got in the first quarter of 2022. That’s important because it actually supports our revenue plan in fiscal 2023. And right now, we’re actually looking at a partial lot 17 ultra long lead time award in the first half of the new fiscal year.
Stepping back to the question that you asked, right, and the potential or the reduction in terms of the number of units, I think there is another couple of things that are important to understand in particular with Mercury. So we’ve been actually very successful winning new content on the program, actually expanding our content footprint with a couple of different customers in a couple of different sensor suites both of which are moving. So following an initial award on one of them in the third quarter, we actually received additional orders in Q4 that is resulting in our substantially taking share from a competitor and that will turn into future revenues and profits.
On the other customer and capability, we’ve actually completed qualification testing and anticipate an initial order in fiscal 2023. So some of those new design wins are actually coming online and are more than expected to offset any decline in terms of the unit count. So overall for us, I think the content and the ASP continues to grow.
The other thing that I think we are obviously noting is that there’s some – clearly some impact associated with what’s just happened in the Ukraine. There’s far more interest in the F-35 from our NATO ally. So Czech Republic indicated it’s intent to acquire 24 aircraft, Greece is requesting 20 and there’s prospective sales the Canada, Germany, Finland and Switzerland so all of which could help actually offset some of the U.S. declines. So overall, I think we made a lot of progress. The programs playing out the way in which we anticipated. And I think there’s strong demand internationally.
Austin Moeller
Great. And then just a follow-up on the tracking where I know you’d mentioned the SDA constellation. There’s 200 satellites planned for the tracking where 684 satellites planned for the transport where 200 for the deterrence et cetera. And some of these SDA constellations start to scale. Do you perceive that this could maybe become a top 10 program or a more relevant program for Mercury?
Mark Aslett
I don’t think it’s going to hit the top 10 as we see it today. But we were obviously very, very pleased with the wind. We’re providing some of our space qualified solid state drives, and I think there seems to be high interest in that particular area. So we’ll see how the space market evolves from Mercury, but clearly, we are thrilled to be a part of the trucking layer with one of our customers.
Austin Moeller
Fantastic. Thanks for all the details.
Operator
Your next question comes from the line of Michael Ciarmoli with Truist Securities. Your line is now open.
Michael Ciarmoli
Hey. Good evening, guys. Thanks for taking the question. Just to follow-up on Jonathan’s question. Mark or Mike, can you tell us what percent of revenues are under fixed price contracts versus cost plus versus maybe the more commercial catalog book ship where you can get immediate price increases?
Mark Aslett
And if [indiscernible] Mike.
Michael Ruppert
Yes. Mike, the vast majority of our programs are either commercial terms or fixed price. So from a cost plus perspective, that only is about $40 million to $50 million of our fiscal 2022 revenue, so called 5% of the overall business. Commercial still counts for a lot of our pricing probably 50% plus probably around 60%, and then 35% is non-commercial firm fixed price.
Mark Aslett
We talked about last quarter, Mike, right, is the fact that we’ve actually got a relatively short sales cycle, where our customers actually order capabilities from Mercury inline with our manufacturing lead times probably the only time that a short cycle business assists with your ability to be able to pass on those inflationary pressures versus having multiyear agreements, which is really not the way in which the industry works with the sub tiers right now.
Michael Ciarmoli
Yes. I guess that’s what I’m trying to figure out then if 50% is commercial, it seems like there’s more of an outsized impact then for you guys on the inflation where you could be passing along or maybe I’ve got that wrong?
Michael Ruppert
No, we are passing it through. So we’re seeing bigger effects internally then, I think, than what we actually experienced last year in terms of the margin degradation. And I think it’s due to the fact that we’re able to pass the prices on where appropriate as a commercial company or just given the short cycle nature of the business. But it doesn’t mean that we’re immune again, 38% of our external spend is related to semiconductors and we’re seeing 10% to 20% price increases across the board in the different categories so then ultimately becomes a matter of timing. When do you absorb those costs and how quickly can you pass them through? We do believe it’s temporary.
Michael Ciarmoli
Got it. And then just on 1MPACT, I think you guys had already recognized $27 million of incremental kind of savings, but now you’re pushing the – seems like you’re already at that low end. Anything really changing on that incremental adjusted EBITDA there?
Mark Aslett
So no, I mean, I think the 30 to 50 we believe is still a good number. Yes, I think if anything, the pipeline of opportunities associated with the 1MPACT is increasing, we did push out the achievement of the goal a year largely because I think we’re seeing the 1MPACT of inflation at the back end of fiscal 2022 and more so in fiscal year 2023. But overall, I think, 1MPACT should drive substantial margin expansion over the course of the next five years. I don’t know if you want to add anything, Mike.
Michael Ruppert
No, I mean, I think you hit on it. The only thing I would say is the fact that we launched 1MPACT slightly over 12 months ago means we’re really well positioned to face the headwinds that we’ve got. So while we’re delaying things, I think we’re in a good position to offset some of the headwinds that we’re seeing.
Michael Ciarmoli
Got it. Thanks guys. Appreciate it.
Mark Aslett
Thank you.
Operator
Your next question comes from the line of Sheila Kahyaoglu with Jefferies. Your line is now open.
Sheila Kahyaoglu
Hey. Good evening, guys. Thank you. Maybe if we could just summarize some of the comments from prior, whether it was Seth’s question or Mike’s just now. When we think about the fiscal 2023 margins, how much of that comes from inflation? I think you said a 100 bps earlier versus volume inefficiencies and then development programs, and you know, Mark, last time I saw you at a facility, your facilities are pretty good. So how much of the 1MPACT comes from those development programs and what are those programs and when do they transition into production?
Mark Aslett
Yes. So Sheila, let me take a cut at that. In terms of inflation and how we’ve positioned that into our guidance. We have put some inflation headwinds into the guidance that we have. I mean, one thing to remember, is we’re guiding right now in a very fluid environment with the macroeconomic headwinds. And we’re trying to predict what’s going to happen not just over the next six months, but over the next 12 months.
So we’re trying to be conservative on the 1MPACT of the, let’s call it, the unknown unknowns that we try to consider in our guidance. But if you look at what’s in our plan, we do have about 100 basis points associated with inflation and pricing that we won’t be able to pass through as we just talked about with Mike, we’re using everything we can on our 1MPACT initiatives to pass that through. But that’s currently in our guidance.
The rest of it really is around program mix and that goes to what we were talking about earlier, which is a lot of the production programs that we have are pushing production into the second half of this fiscal year or into fiscal 2024. But we’ve got growth programs, we’ve talked about AMCs in the past, which is still in the development phase that in fiscal 2023, that’s still in the development phase probably goes to production sometime in fiscal 2024.
We’ve got other programs within our microwave business. We’ve got a classified space program that’s in development that will go into production in fiscal 2024 and a handful of programs like that. F-18, parts of F-18 that we’re doing are currently in development in the higher-margin production world in that case is towards the second half of 2023. So a handful of things that are driving the lower margin in our guidance. Inflation is part of it, but then the program mix is another part of it which was impacted by the supply chain and contracting environment. So things were pushed to the right.
Sheila Kahyaoglu
Thank you so much.
Michael Ruppert
Let me just step back a little bit because I think obviously, there’s a whole bunch of things hit the industry this quarter. And to me, it feels like we’re in the midst of a multiyear industry event that was precipitated by COVID. And yes, clearly, I think we’re all being managed or being measured in terms of what happens on a quarterly basis. But if you step back, we’re actually – given the guidance that we’ve just given, we’re heading into actually our fourth fiscal year dealing with the primary and the derivative effect of COVID. And actually, each year, it’s had a really somewhat distinct set of characteristics that have actually affected the subsequent year.
And so given the relative short cycle nature of our business versus our customers and the size of their respective backlogs, the effect may not always be is readily apparent depending upon the time frame. And so it’s pretty complex what’s going on when you step back from it. But I think we’re clearly seeing the effects now moving its way up the industry. The supply chain disruption hit the industry pretty hard this quarter. The seasons that were shown many quarters previously. It was just hard to see and even more difficult to forecast. So we began to see the effects of that in our fiscal year 2020 – 2021, sorry.
We got through the initial phase of the healthcare crisis phase of COVID in 2020 pretty much unscathed. But we did see the effects of the order slowdown in 2021. We had a 0.95 book-to-bill. That obviously affected the revenue and the profits associated with 2021. And we’re now clearly seeing the uptick in bookings in 2022, but it was back half weighted. Bookings for the year were up 33%. For the second half of 2022 and for the year as a whole, we’re up 21%. And as I mentioned before, we’re actually expecting a strong bookings cadence in the first half and our customers just had a very strong book-to-bill.
So it’s clearly not a demand issue. But we started to see the effects from a supply chain perspective in the second quarter, and it’s kind of – it’s continued throughout the year. We also saw the effects of the great resignation, meaning it was harder to actually find the right engineering and manufacturing talent that we needed to continue to grow the business. And those changes, I think, became more of an issue as the year progress. And I think that’s what you’re clearly seeing in the industry right now. We begin to see the effects of inflation in the fourth quarter. And as we’re now heading into the full-year 2023, we’re expecting a greater effect.
So I think given the fact that we’re guiding for the full-year and given how this is a multiyear effect, we are somewhat more conservative just in our outlook just given everything that’s going on. There are a lot of unknowns right now that we feel that we need to take into account. So they’re temporary. They’re short-term, we believe, and the outlook looks great going forward. But clearly, the industry has been impacted.
Sheila Kahyaoglu
Okay. Great. Thank you so much.
Operator
Mr. Aslett, it appears there are no further questions. Therefore, I would like to turn the call back over to you for closing remarks.
Mark Aslett
Okay. Well, thank you very much, everyone, for joining us. We look forward to speaking to you again next quarter. Take care. Bye-bye.
Operator
This concludes today’s conference call. Thank you for attending. You may now disconnect.
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