2023-03-06 11:17:34 ET
Summary
- U.S. defense electronics manufacturer Mercury Systems, Inc. is exploring a sale.
- Peer Cobham has recently noted that a potential acquisition of Mercury Systems would be highly strategic.
- Mercury Systems might fetch above $60/share in a sale scenario - a 12%+ upside.
This is a potential company sale brewing up behind the scenes. A number of interesting aspects, including management’s recently announced strategic review, involvement of two reputable activists, and a potential buyer’s public comments, suggest a transaction might materialize in a rather short order. There is also a possibility of a full-blown bidding war breaking out.
Mercury Systems, Inc. ( MRCY ) is a $3.1bn market cap company manufacturing and selling components, products, modules and subsystems to defense contractors, the U.S. government and commercial aerospace companies. At the end of January, MRCY launched a strategic review, aimed at exploring strategic alternatives, including a potential company sale. One day after the announcement, Bloomberg reported that one of the company’s peers, Cobham (privately held), is considering acquiring Mercury, with its chairman noting that the company “would be the perfect fit” if acquired. MRCY’s share price has reacted favorably to these developments, jumping 15% before retracing back to 10% above the unaffected share price. WSJ reported that, based on analyst estimates, Mercury might fetch well over $3.5bn in a sale scenario - a 12%+ upside from current share price levels.
Company sale might be likely given that MRCY’s management seems willing and incentivized to sell the company. The recently launched strategic review comes after the management has yielded to the rather prolonged pressure from two reputable activists Jana Partners (owns 5%) and Starboard Value (7%). After a push from Jana to initiate a company sale back in Dec’21, MRCY’s management promptly instituted a poison pill . The move attracted another activist, Starboard Value, which in Jan’22 urged the management to remove the poison pill.
In an interesting turn of events, the management has since mid-2022 played alongside the activists. In Jun’22, Mercury entered into a cooperation agreement with both Jana and Starboard Value, agreeing to appoint two of their nominees to the board, before recently launching the strategic review. Given the management’s collaboration with the activists, a company sale appears to be a likely strategic review outcome. It is interesting to note that Mercury’s management team would be entitled to rather large pay-outs if their employment is terminated due to a company sale. For reference, according the most recent proxy , the CEO would receive a payment of $33m (largely from severance + accelerated equity vesting) on top of the sale of his 0.9% ownership stake (worth $28m at current share price levels). This would dwarf the CEO’s total pay of $6.3m in FY22 (ending in July). Another interesting aspect is that MRCY’s CFO departed concurrently with the strategic review announcement.
A merger between Cobham and Mercury Systems would make strategic sense for the potential acquirer. The company is a UK defense contractor which owns the advanced electronics business ((CAES)) providing components, modules and sub-systems for a number of applications, including electronic warfare, satellite communications and medical imaging. Importantly, technology of both companies - Cobham and Mercury Systems - is used across a number of common programs, such as F-35 and SEWIP. Similarly to MRCY, Cobham is one of the leading players in the manufacturing of components used in radar applications. Worth noting that since 2020, Cobham has been owned by the large U.S. private equity ("PE") firm Advent ($89bn in AUM). Since the acquisition, Advent has been expanding the company through acquisitions, including buying the UK’s defense electronics supplier Ultra Electronics ($3.4bn, completed in 2022) and acquiring the major satellite imagery supplier Maxar Technologies ($6.4bn, expected to close in mid-2023).
Aside from Cobham/Advent, there is a non-zero possibility of other strategic and/or financial bidders emerging here. Worth noting that in Mar’22 reports appeared that Elliott Management made a bid to acquire MRCY (offer price was not disclosed). Interest from peers and/or PE firms would not be surprising given broader industry tailwinds that Mercury is set to benefit from. Amid the heightened geopolitical uncertainty driven primarily by the war in Ukraine, defense spending in the U.S. and Europe is expected to grow significantly. Renaissance Strategic Advisors ((RSA)) projects that the U.S. defense budget will grow from $757bn in FY22 to over $900bn by FY27, or a 4%+ CAGR (see chart below).
Mercury Systems Investor Presentation, June 2022
Meanwhile, defense electronics - a segment where MRCY operates - is expected to disproportionally benefit from increasing defense bills. This is expected to be driven the electronification trend given the increasing share of electronics share of military platform cost value (see below). The defense electronics market is expected to grow from $40bn in 2021 to $52bn in 2026. Worth noting that Mercury is one of the few remaining independent suppliers of electronics for the defense and aerospace industries.
Mercury Systems Investor Presentation, June 2022
A noteworthy trend in the industry is increasing outsourcing of subsystems by the largest defense contractors to Tier 2 suppliers such as Mercury. This has been driven by a push from the U.S. government, including the DoD procurement reform, for the defense contractors to utilize commercial technology due to resulting cost savings. According to RSA, defense primes currently outsource only a small percentage of their work. This is expected to benefit Mercury, which, unlike typical Tier 2 suppliers, operates under the commercial revenue model (as opposed to standard cost-plus contracts). As of 2020, MRCY held 12.5% and 5% outsourced market shares in its primary sensor/effector and C4I markets (according to this VIC write-up ). In this context, it is not hard to see why private equity firms as well as Cobham and other defense contractors might emerge as potential bidders.
Valuation
Valuation suggests there might be room for some upside in a sale scenario. MRCY currently trades at 18.6x/17.0x TTM/2023E adjusted EBITDA. These multiples are on the lower-end of the historical valuation range of 17.2x-24.5x fetched during FY2016-FY2022.
It is worth noting that MRCY’s TTM and 2023 adjusted EBITDA might not be representative of the company’s long-term earnings power. The business has been severely impacted by increasing semiconductor lead times (up from 10-12 weeks pre-pandemic to 36-72 weeks currently) which the company expects to normalize only in H2’FY24. The management has noted that while customer demand from funded franchise programs remains strong, supply chain issues remain the main culprit. Aside from supply chain delays, $14m in adjusted EBITDA has been shifted from FY23 to FY24 due to a temporary customer program funding delay. Adding back this amount would decrease the forward multiple to 15.6x.
While there are no direct peers with exposure solely to the defense and aerospace markets, one of the most comparable companies is MACOM Technology Solutions Holdings, Inc. ( MTSI ). MTSI manufactures RF, microwave and analog ICs for a number of end-users, including telecom and defense. The peer currently trades at 20.6x TTM adjusted EBITDA. Another competitor, Teledyne ( TDY ) (manufactures instrumentation, imaging and other electronics), is valued at a 15.9x multiple.
Below are a couple of comparable industry transactions:
- FLIR Systems acquired by Teledyne in 2021 at 15.7x TTM adjusted EBITDA.
- Ultra Electronics acquired by Cobham in 2022 at 16.8x TTM adjusted EBITDA.
Mercury Systems
More background on the company can be found in this well-written VIC write-up. Mercury Systems operates across two markets - sensor and effector mission systems and C4I (abbreviation for command, control, communications, computers, and intelligence). MRCY’s products include components (such as power amplifiers and limiters, switches, oscillators, filters, among many others) as well as modules and subsystems. One of Mercury’s competitive advantages is supply of fully integrated subsystems to the defense primes, allowing for lower costs.
The company, which started out in the radar segment of the defense electronics industry, has over time expanded into a number of markets through acquisitions of smaller Tier 3 suppliers (see below). This, coupled with increasing defense spending, has led to rapid topline growth - 28% CAGR from FY14 through FY21. However, impacted by the pandemic, which led to supply chain issues and program/technical delays, the company’s sales growth have slowed in recent years, with rather modest 16% and 7% expansion in FY21 and FY22. This, along with missed earnings and cut guidance (several times), has led to a 50%+ share price decline from 2020 highs to the recent pre-rumor levels.
To address slowing operational performance, in Aug’21 Mercury announced a cost savings program called 1MPACT. The company has pushed for streamlining of the organizational structure and manufacturing facility footprint consolidation, among other measures. The management expects the program to lead to $30m to $50m in annual adjusted EBITDA savings by FY25.
Mercury Systems Investor Presentation, June 2022
Mercury Systems Investor Presentation, June 2022
Risks
- Companies operating in the defense industry are difficult to value as there is generally low visibility into the businesses. However, given secular industry tailwinds and MRCY’s status as of the few remaining independent suppliers of electronics for the defense industry, a potential company sale would likely come at a premium to current share price levels.
- The buyer pool might be limited to private equity firms and other small-/mid-sized defense suppliers (such as Cobham) as opposed to large defense contractors (primes). This might be likely given the expected regulatory pushback on further industry consolidation initiated by the largest contractors. A notable example here is Lockheed Martin terminating its merger with rocket engine maker Aerojet Rocketdyne back in Feb’22 due to antitrust concerns. Rather harsh environment for further consolidation by primes was previously also highlighted by Raytheon’s CEO. Notably, Mercury’s electronic components are used across a wide range of programs managed by the primes, making a potential sale complicated from a vertical integration perspective.
- Another risk is related to MRCY’s high customer concentration. In FY22, 38% of the company’s sales came from the three largest customers - Lockheed, Raytheon and the US Navy. Having said that, the revenues are split across a number of programs for each of MRCY’s customers. Another aspect is that MRCY operates a customer-funded R&D (fixed price) model as opposed to the typical cost-plus contracts. This allows the company to compete on price and thus reduces concentration risks as MRCY is viewed as a supply chain partner.
Conclusion
Mercury Systems, Inc. presents an interesting potential takeover situation. A couple of points, including the management yielding to the activist pressure and initiating a strategic review as well as Cobham’s publicly communicated interest in an acquisition, suggest a merger might be brewing. I would expect a potential transaction to be announced at a premium to current share price levels.
For further details see:
Mercury Systems: Potential Buyout