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

Business: Mercury Systems is a technology company, engaged in the manufacture and sale of components, products, modules, and subsystems for aerospace and defense industries in the United States, Europe, and the Asia Pacific. The company’s products and solutions are deployed in approximately 300 programs with 25 defense contractors and commercial aviation customers. It offers components, including power amplifiers and limiters, switches, oscillators, filters, equalizers, digital and analog converters, chips, monolithic microwave integrated circuits, and memory and storage devices, as well as modules and sub-assemblies. The company also designs and develops digital radio frequency memory units for various modern electronic warfare applications; radar environment simulation and test systems for defense and intelligence applications; and signals intelligence payloads and EO/IR technologies for small UAV platforms, as well as onboard UAV processor systems for real-time wide area motion imagery. In addition, it designs, markets, and sells products intended to protect electronic systems that are critical to national security.

Stock Market Value: $2.9B ($52.10 per share)

Percentage Ownership: 7.34%

Average Cost: $52.81

Activist Commentary: Starboard is a very successful activist investor and has extensive experience helping companies focus on operational efficiency and margin improvement. Starboard also has a successful track record 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.

On Jan. 13, Starboard sent a letter to the company’s board, requesting that they immediately eliminate the shareholder rights plan adopted on Dec. 27, 2021. Alternatively, if the company is unwilling to fully remove the rights plan, Starboard would expect the company to, at the very least, (i) raise the ownership threshold from 7.5% (or 10% in the case of a passive investor) to 15% for all shareholders and (ii) thereafter put the rights plan to a shareholder vote.

Mercury Systems is a manufacturer of essential components, products, modules and subsystems and sells them to defense prime contractors, the U.S. government and original equipment manufacturer commercial aerospace companies. Essentially, they are making the electronics that go into defense applications. Because they pay for their own R&D, they are not subject to the Truth in Negotiations Act, which requires cost disclosure. This allows them to have better than single-digit margins. 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 have declined year-over-year from 19.27% in 2018 to 17.67% in 2021, and revenue growth has also slowed from 32.8% growth in 2019 to 21.7% growth in 2020 to 15.9% growth in 2021. All the while, R&D continues to increase and is up 65% since 2019.

As we usually see with situations where Starboard gets involved, there are multiple paths for value creation here. The first opportunity is for top line growth and there are four main drivers for this. 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. Second, the company’s growth has slowed recently leading to missed earnings and cut guidance two quarters in a row, largely because of Covid and supply chain issues. Both are transient problems that should be resolved in the short term. Third, as technology continues to get upgraded, there is increased demand for Mercury’s technological components, helping to improve their penetration. Fourth, larger defense contractors, such as Raytheon and General Dynamics are becoming more open to using third-party vendors such as Mercury which should provide more opportunity.

The other area for value creation is through a margin opportunity. The company has had a heavy focus on growth through acquisitions – since 2011, they have acquired 16 different businesses. However, there has not been as much of a focus on integration, a meaningful opportunity for the company. Additionally, on Aug. 3, 2021, the company announced a cost-savings program called 1MPACT, in which it identified $30 million to $50 million in savings, roughly 3% to 5% of revenue. However, Starboard generally can find cost improvement opportunities beyond management’s estimates. 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. Moreover, just because the company identified cost saving opportunities does not mean that they will be able to execute.

Knowing Starboard’s extensive experience in helping companies optimize growth and margins, we think having them involved here will not only make it more certain that the company executes on this goal but will also give the company the opportunity to exceed their goal. As a reference, the defense business of Curtiss-Wright has 27% EBITDA margins, compared to just 17.8% for the company. Moreover, the company has a more proprietary type of business, so it could have even higher margins than Curtiss-Wright’s.

This is a unique situation in that there is already another experienced activist involved here. Jana Partners filed a 13D on the company on Dec. 23, 2021, urging the company to evaluate strategic alternatives including a sale, and reporting that they have partnered with three industry experts, who could presumably be potential director nominees. So, the company now has a strategic activist in Jana and an operational activist in Starboard. This appears to be a good thing for shareholders but could backfire in that the company is in a position in which it can choose the activist it wants to work with. While it is unlikely that the company chooses a strategic option over an operational option, they may prefer Jana’s less vocal directors over Starboard’s.

The best outcome here would be for Jana to continue to push for a sale of the company. While Starboard is not urging the board to sell the company, they are economic animals with a fiduciary duty to their investors and would certainly support a sale at the right price. If the board is unwilling or unable to sell the company, the best thing that can happen for shareholders is for Jana to not pursue board seats for their directors and support Starboard in their expected push for board representation as they have a better track record at governance-oriented, operational activism, are more likely to nominate one of their principals than Jana and have more experience in helping companies improve margins and create value from the board level. If that does happen, Starboard may even want to look at Jana’s industry partners as potential nominees on Starboard’s slate.  

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments. Mercury Systems is owned in the fund.