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With Starboard, Jana Partners holding stakes, Mercury Systems has options for building value

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Mercury Systems Inc. (MRCY).

Business: Mercury SystemsThe company is an American technology company that manufactures and sells components, subsystems, modules and products for the aerospace and defense industry in America, Europe and Asia Pacific. Its solutions and products are utilized in over 300 programs, including 25 military contractors and commercial aircraft customers. You can find components like power amplifiers and limiters as well switches, oscillators and filters. There are also digital and analogue converters. Chips, memory and storage device, modules, and sub-assemblies. Additionally, the company designs and develops digital radiofrequency memory units that can be used in electronic warfare; radar environment simulator and test systems to support defense and intelligence application; signals intelligence payloads; EO/IR technologies and UAV processors onboard for high-resolution wide area imagery; as well as EO/IR technology for smaller UAV platforms. The company also markets and sells products that protect critical electronic systems for national security.

Stock Market ValueShares: $52.10/share

Starboard Value

Percentage of Ownership 7.34%

Average cost: $52.81

Commentary of an activist:Starboard, a highly successful activist investor, has vast experience in helping businesses improve their operational efficiency and profitability. Starboard has also had a track record of success in the industrial sector. In 13 prior engagements, it has a return of 47.53% versus 9.35% for the S&P 500 over the same period.

What’s Happening?

13 Jan. Starboard sent a letterTo the board of the company, asking them to immediately remove the shareholder rights plan that was adopted Dec. 27, 2021. Starboard could request the company, in addition to the complete removal of the rights plan, to (i) increase the ownership threshold to 7.5%, or 10% in case of passive investors, to 15%, and (ii), put the rights proposal to shareholder vote.

Behind the scenes

Mercury Systems manufactures essential components and products and modules. They sell them to the U.S. defense prime contractors and commercial aerospace companies. They are basically making electronics for defense applications. Because they pay for their own R&D, they are not subject to the Truth in Negotiations Act, which requires cost disclosure. They can enjoy margins that are higher than single-digits. The company’s stock has not done well recently — it closed at $79.28 on April 16, 2021 and is now trading in the mid-$50 range. Moreover, over the past 1-,3- and 5-year periods, the stock has underperformed the S&P 500 by -53.9%, -64% and -23.6%, respectively. EBITDA margins are down year over year from 19.27% to 17.67% by 2021. Revenue growth is also slowing from 32.8% in 2019, to 21.7% growth for 2020, to 15.9% in 2021. All the while, R&D continues to increase and is up 65% since 2019.

Starboard is involved in many situations that can lead to value creation. First, there is top line growth. There are four major drivers. First, while there have been concerns about defense spending, the government is expected to continue to have a healthy budget for this – on Dec. 27, 2021, President Joe Biden signed the National Defense Authorization Act, authorizing $770 billion in defense spending. The company’s recent slowdown in growth led to miss earnings and reduced guidance for two consecutive quarters. This was largely due to Covid and supply chain problems. These are temporary problems and should be addressed quickly. The third is that technology keeps getting better and there’s an increased need for Mercury’s technological components. This will help to enhance their penetration. Fourth, defense contractors like Raytheon or General Dynamics, are more willing to use third-party vendors, which could open up more opportunities.

A margin opportunity is another way to create value. The company has had a heavy focus on growth through acquisitions – since 2011, they have acquired 16 different businesses. The company hasn’t been as focused on integration. This is a significant opportunity. Additionally, the company will celebrate its 2021 anniversary on Aug. 3. announced a cost-savings program called 1MPACTIt identified savings of $30 to $50 millions, which is roughly 3% to 5.5% of its revenue. Starboard can often find cost-saving opportunities which are not in line with management’s estimations. For example, aside from the synergies that can be created by integrating the acquisitions, the company devotes more than 12% of revenue to R&D, where peers are more in the 4% to 6% range. Starboard has a history of getting management to look at R&D in a more disciplined manner. The company may have identified cost savings opportunities, but that does not necessarily mean they can execute.

Starboard has a wealth of experience helping companies maximize growth and margins. We believe that Starboard will be able to help the company achieve this goal. Curtiss-Wright’s defense business has 27% EBITDA margins compared with 17.8% for Starboard. Additionally, Curtiss-Wright has a unique type of business which could result in higher margins.

It is unusual that another activist is involved in this situation. Jana Partners filed a 13DOn December 23, 2021, the company received a call from Jana, asking them to consider strategic options, including the sale. They also reported that three industry professionals have been partnered with the company, which could lead to potential nominees for director. The company now has Jana, a Starboard operational activist and a strategic advocate. Although this may be good for shareholders, the company could find it difficult to select the right activist. Although it’s unlikely the company will choose a strategic over an operational option they might prefer Jana’s more vocal directors to Starboard’s.

Jana would prefer to keep pushing for the sale. Starboard will not be urging board members to sell the company. However, the directors are fiduciaries to shareholders and economic animals. Jana should not seek board seats and instead support Starboard’s expected push to get board representation. They have a greater track record in governance-oriented and operational activism and are more likely than Jana to nominate one their principals. This is because they have more experience helping companies increase margins and create shareholder value. Starboard might consider Jana’s business partners to be potential nominees for Starboard’s slate if that happens.  

Ken Squire, the president and founder of 13D Monitor is an institution research service that focuses on shareholder activism. He also founded and managed the portfolio for the 13D Activist Fund which invests in a range of activist 13D investments. Mercury Systems holds a stake in the fund.

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