Charday Penn
On the final days of 2020, I last had a look at shares of Mercury Systems (NASDAQ:MRCY) calling it a stealth M&A play which traded at a big valuation. I concluded that the defense supplier operated a bit under the radar, as it has rapidly built up a strong M&A track record, and with the market recognizing this, valuations were a bit too demanding for me.
Former Take
Founded in the early 1980s, Mercury Systems operates at the intersection of high-tech and defense applications, being an electronic system provider for aerospace and defense markets. A team of 2,000 workers generate some $800 million in sales from sensor processing, platform & mission management, among others, to customers and their programs.
The company operates in a >$100 billion aerospace & defense electronic systems market of which it serves and addresses a substantial part. This includes platform & mission management, communication, radar, command & controls, missiles, and others, as this is of course interesting in today’s world given the renewed political tensions following the war in Ukraine.
The company has essentially tripled sales between 2015 and 2020 to some $800 million, as a result of multiple acquisitions. Shares have risen accordingly, but the aggressive pace of growth has in part been paid for by dilution in the share count. But even accounting for that dilution, the track record has been quite solid. The economies of scale meant that operating margins rose from high-teens to the low-twenties, as earnings per share (adjusted earnings those are) have tripled to $2.30 per share.
The fiscal year of the company ends in July, which means that the fiscal year 2020 results were impacted in the final quarter of the year by the pandemic. Full year sales rose 22% to $797 million, with the backlog actually up 46% to $846 million, equal to more than a year’s worth of revenues. EBITDA rose 21% to $176 million as the company guided for 2021 sales to come in at $860-$885 million, with modest improvements in EBITDA seen as well. Somewhat concerning is that adjusted earnings were seen down ten cents to $2.20 per share, and excluding stock-based compensation expenses, earnings come in around $2 per share.
The 55 million shares traded at $87, for a $4.8 billion equity valuation at the time, or about $4.6 billion valuation if we factor in a net cash position of $227 million. This translated into a 5 times sales multiple and 23 times EBITDA multiple, a bit too high for my taste, despite the announcement of a solid $310 million deal to buy Physical Optics, adding some $120 million in sales at compelling sales multiples while margins were in line with the core operations.
Nonetheless, valuation were far too demanding for me as earnings just over $20 per share translate into very demanding multiple around 40 times earnings, even as the past growth was quite impressive.
Caution Worked
Fast forwarding from the end of 2020, we see shares down to $50 when 2021 turned into 2022, as shares have rebounded to $63 now amidst the backdrop of the political tensions, but even at these levels, shares are down by about a quarter from the price level seen late in 2020.
In August 2021, the company posted its 2021 results with revenues reported at $924 million, far ahead of the guidance on the back of the Physical Optics deal and the acquisition of Pentek, a company acquired at a $65 million price tag in May of that year.
Amidst the revenue beat it were adjusted earnings of $2.42 per share which came in twenty-two cents ahead of expectations, but realistically still came in around $2 per share after backing out stock-based compensation expenses as the company has incurred a modest net debt load following its dealmaking efforts. The company guided for 2022 revenues to just surpass the billion mark, with adjusted earnings seen rather flattish at a midpoint of $2.50 per share.
During the fiscal year 2022, the company embarked on more dealmaking. Last September, Mercury announced the purchase of Avalex, in a deal adding $40 million in revenues. In November, Mercury acquired Atlanta Micro in a deal adding $16 million in sales.
In May 2022, the company announced the third quarter results as the company has seen somewhat softer demand. While the full year sales guidance was largely kept unchanged at a midpoint of $1.01 billion, the adjusted earnings guidance has been cut to $2.39 per share. Dealmaking has resulted in net debt inching up to $360 million, as EBITDA for the nine-month period came in at $129 million. The run rate of around $175 million works down to a roughly 2 times leverage ratio, a reasonable leverage ratio.
And Now?
With shares down 25% over a roughly one and a half year period, it is this stagnation in the share price amidst modest improvements in the business which looks appealing. The issue is that I started looking at the shares at a time when shares traded at a realistic earnings multiple at 40 times, very demanding multiples of course. Right now, earnings per share have hardly moved, and with realistic earnings trending around $2 per share, we see earnings multiples having compressed to 32 times following the share price decline, all while a net cash position has translated into modest net debt.
The mediocre share price performance “attracted” interest from activist investor Jana late in 2021, pushing for a strategic review, as the M&A trajectory has not really resulted in the desired improvements promised upon. While the valuation multiple contraction has been meaningful and activist investors are involved, I simply cannot see the appeal in the shares right now as heavily lifting will need to be done in terms of margins, but margins are not so healthy, and the real growth has to come from organic growth.
Amidst all of this, I see appeal on the increase given the lackluster share price performance, yet I am not yet appealed to the shares here just yet.
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