MRCY Q1 Earnings Call: Revenue Beat Expectations, Margins and Cash Flow Improve Amid Backlog Transition

Aerospace and defense company Mercury Systems (NASDAQ:MRCY) reported revenue ahead of Wall Street’s expectations in Q1 CY2025, with sales up 1.5% year on year to $211.4 million. Its non-GAAP profit of $0.06 per share was $0.01 below analysts’ consensus estimates.

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StockStory’s Take

Mercury Systems delivered revenue above Wall Street expectations in Q1, driven largely by strong execution on production and development programs. Management pointed to disciplined operational changes and a shift toward higher-margin contract wins as the primary factors behind the quarter’s results. CEO Bill Ballhaus highlighted that the company’s focus on predictable performance led to improved program management and reduced costs, while CFO Dave Farnsworth emphasized progress in lowering net working capital and accelerating hardware deliveries.

Looking ahead, management indicated that the transition to a higher-margin backlog and ongoing operational streamlining would be key drivers for the remainder of the year. Ballhaus stated that the company expects steady improvement in adjusted EBITDA margins, with recent bookings supporting this trajectory. However, he also noted that the pace of margin expansion will depend on the gradual replacement of legacy lower-margin contracts with new business at targeted profitability levels. The company plans to provide more detailed commentary on expectations for next year in its next update.

Key Insights from Management’s Remarks

Mercury Systems’ Q1 results were influenced by operational improvements, a focus on production contracts, and proactive management of working capital. The company’s explanations for the quarterly revenue beat centered on contract execution and backlog quality, with management emphasizing several internal and external factors that shaped performance:

• Production Contract Momentum: The company received significant production contract awards, including $40 million for its common processing architecture and a $20 million follow-on order for the F-35 program, reflecting customer trust in Mercury’s technology.
• Shift to Higher-Margin Backlog: Management stressed that the backlog composition is improving as lower-margin development programs are completed and replaced by new bookings at targeted margins, supporting longer-term profitability goals.
• Operational Efficiency Gains: Reduced operating expenses resulted from consolidating and streamlining operations, including actions such as the planned divestiture and outsourcing of the Switzerland manufacturing operation.
• Improved Cash Flow and Working Capital: Free cash flow improvement was attributed to better program execution, hardware delivery, and just-in-time material procurement, with net working capital at its lowest level in several years.
• Strategic M&A and Competitive Positioning: The acquisition of Star Lab, a cybersecurity software provider, is expected to enhance product differentiation, while management also highlighted strong recent wins against competitors and favorable market trends in defense technology procurement.

Drivers of Future Performance

Management’s outlook for the remainder of the year is anchored by the ongoing transition to a production-heavy, higher-margin backlog and continued operational discipline. The broader theme is that margin expansion and free cash flow improvement will depend on both the pace of legacy backlog replacement and the company’s ability to sustain efficiency gains.

• Backlog Margin Progression: The shift toward new bookings at targeted margins is expected to gradually raise overall profitability as legacy contracts are completed.
• Operational Streamlining: Ongoing efforts to simplify operations and reduce costs are anticipated to support positive operating leverage and sustained cash flow conversion.
• Industry Demand and Defense Budgets: Management noted constructive trends in defense spending and technology acquisition, but acknowledged that any delays or changes in government priorities could affect future growth trajectories.

Top Analyst Questions

• Peter Arment (Baird): Asked about the LTAMDS program’s impact as it moves into production. Management confirmed it remains a key growth driver and expressed optimism about scaling with the customer’s schedule.
• Michael Ciarmoli (Truist Securities): Inquired about optimal net working capital levels and future free cash flow conversion. CFO Dave Farnsworth reaffirmed the goal of 50% free cash flow conversion from EBITDA and a working capital target of 35-40% of revenue.
• Rockwell Collins (for Seth Seifman, JPMorgan): Questioned the sequential revenue change and impact of accelerated deliveries. Management explained that early hardware deliveries in the previous quarter shifted timing but did not change full-year expectations.
• Ken Herbert (RBC Capital Markets): Sought details on common processing architecture contract trends and competitive positioning. Management noted significant wins and increased differentiation from the Star Lab acquisition.
• Noah Poponak (Goldman Sachs): Probed the timeframe for eliminating low-margin backlog and achieving targeted margins. Management clarified that margin improvements will occur gradually over several quarters as higher-margin bookings replace older contracts.

Catalysts in Upcoming Quarters

In the upcoming quarters, the StockStory team will closely monitor (1) the pace at which Mercury Systems transitions its backlog to higher-margin, production-oriented contracts; (2) progress in reducing net working capital and achieving the company’s free cash flow conversion targets; and (3) the integration and impact of the Star Lab acquisition on product differentiation and market share. Developments in defense spending and program awards will also be critical indicators for sustained growth.

Mercury Systems currently trades at a forward P/E ratio of 65.8×. Is the company at an inflection point that warrants a buy or sell? See for yourself in our free research report.

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