Mercury Systems Faces Challenges Amidst Recent Earnings Report

Shares of Mercury Systems (MRCY), a small-cap defense company, took a tumble this past week following their quarterly earnings report. Despite management's preferred profit measure, adjusted Ebitda, showing a decline of 94% from the previous year, the company reported $2 million in earnings. This fell significantly short of the anticipated $29 million. Additionally, revenue for the quarter was $181 million, a 20% decrease compared to the consensus estimate of $219 million. The disappointing results came as a blow to investors.

We were also impacted by this downturn, having recommended buying Mercury stock back in September when it was trading at $38. At that time, Mercury was already in the midst of a turnaround story, with its unique aerospace and defense business specializing in the manufacturing of electronics and chips used in advanced military programs. Their components are utilized in various cutting-edge systems like F-35 fighter jets, Predator unmanned aerial vehicles, and Patriot surface-to-air missiles, among others.

Mercury had undergone significant research and development efforts in recent years, as well as pursuing an acquisition-based strategy to transition from components to entire subsystems. While this move promised higher sales and profit margins, it introduced complexities beyond the simplicity of their previous products, such as circuits, switches, and sensors.

However, the transition has not gone without its hurdles. Over the past two years, Mercury has faced challenges due to supply chain disruptions caused by the pandemic. They have also encountered activism from shareholder investors and experienced unsuccessful attempts at selling the company. As a result, they have redirected their focus towards turning things around under new leadership provided by their current CEO and management team. The company has identified 20 "challenged" programs out of approximately 300, significantly impacting their cash flow and profit margins during the research and development phase.

Unsurprisingly, these setbacks have taken a toll on Mercury's stock performance. After reaching a peak of $93 in 2020, the stock dropped to a low of $31.50 in June. Despite a brief rally, the disappointing earnings report caused the stock to fall back below $32.

Progress Amidst Challenges

Despite the challenging numbers, there are promising signs of progress for Mercury. The company has successfully completed two out of its 20 troubled programs. Additionally, it plans to complete at least three more in the current quarter and six or more by the end of the fiscal year. This highlights the management's proactive approach in addressing the issues at hand and suggests a significant improvement in the second half of the fiscal year.

A Time for Patience

Investing in a small-cap company like Mercury requires patience. Although it may seem like we've caught a falling knife with our stock pick, it is crucial to remain patient. The current trading valuation of the shares is more pessimistic compared to previous years, offering a compelling entry point. With a valuation multiple of 23 times forward earnings, as opposed to over 30 times in 2019 and 2020, this presents an opportunity for potential investors. Despite the current predicament, Mercury's management, led by CEO Bill Ballhaus, is staying focused on their messaging, and progress is slowly but surely registering externally.

According to Raymond James analyst Brian Gesuale, the challenges faced by Mercury are fixable, but the pace of their resolution remains uncertain. Gesuale expresses confidence in Mercury's future by giving the company an equivalent of a Buy rating on its stock, with a $40 price target—a 25% increase. If Mercury executes its plan effectively, achieves earnings growth, and secures a premium valuation multiple, there is potential for the stock's value to double over the next three years.

Timing is Key

For investors looking to capitalize on Mercury's potential, getting in early is crucial. Although it may seem that we entered the market prematurely, the bullish thesis remains intact.

Stay updated with Mercury's progress as it navigates through its turnaround journey.