Executive Summary / Key Takeaways

The CPA-Driven Margin Inflection: Mercury Systems is executing a fundamental shift from low-margin custom development to high-margin production of its Common Processing Architecture (CPA) platform, with Q1 FY26 gross margins expanding 260 basis points to 27.9% and management targeting low-to-mid-20% EBITDA margins over time as production scales and legacy programs burn off.

Competitive Takeaways Through Open Architecture: The company's open-standards CPA, now enhanced with Star Lab cybersecurity software, is winning head-to-head against larger competitors like Curtiss-Wright (CW) and L3Harris (LHX), evidenced by $26 million in competitive takeaways in Q1 and a $36.9 million ground-based radar win in Q4—wins that embed Mercury deeper into multi-year defense programs.

Cash Flow Transformation in Progress: Working capital has decreased $105.7 million year-over-year, and free cash flow has exceeded $130 million over the trailing four quarters, proving that Mercury's operational improvements—automation, site consolidation, and production discipline—are converting earnings into cash despite negative net margins.

Legal Overhang Creates Asymmetric Risk: While a $32.5 million securities class action settlement and an internal investigation into 20-year-old test certifications create headline risk, resolution of these issues could remove a significant overhang; the larger risk is execution missteps on the CPA ramp, not historical liabilities.

Valuation Balances Turnaround Execution vs. Defense Tailwinds: At $70.59 per share (EV/Revenue 4.72x), the stock prices in successful margin expansion but offers optionality on unmodeled upside from European ReArm initiatives and U.S. Golden Dome missile defense funding, neither of which is reflected in management's conservative low-single-digit FY26 revenue guidance.

Setting the Scene: Mission-Critical Processing at the Edge

Mercury Systems, incorporated in 1981 and headquartered in Andover, Massachusetts, has spent over four decades building what it calls the Mercury Processing Platform—a comprehensive stack for mission-critical processing that spans from radio frequency (RF) front ends to human-machine interfaces. The company makes money by selling three tiers of products: basic Components (power amplifiers, switches, converters), integrated Modules and Sub-assemblies (processing boards, RF tuners), and complete Integrated Solutions (sensor processing, avionics computing, C4I systems). This ladder determines margin profile: components are commoditized, modules offer leverage, and integrated solutions command premium pricing when they solve specific mission problems.

The aerospace and defense electronics industry is an oligopoly dominated by vertically integrated primes like Lockheed Martin (LMT) and Northrop Grumman (NOC), with mid-tier specialists like Curtiss-Wright ($3.2B revenue), L3Harris ($20B+ revenue), and Kratos (KTOS) ($1.3B revenue) competing for subsystem contracts. Mercury, at $912 million in annual revenue, occupies a niche position but has carved out a defensible moat in open-architecture, standards-based processing subsystems that integrate across vendor ecosystems. This positioning is increasingly valuable as the Pentagon mandates interoperability standards like SOSA and CMOSS , forcing legacy proprietary systems into obsolescence.

Mercury's current positioning emerged from a series of strategic acquisitions that built the processing platform, but also from a painful recognition that its historical model—custom development for specific programs—was structurally unprofitable. The company spent fiscal 2025 shedding headcount (230+ employees) and restructuring operations to align with a production-heavy mix, setting the stage for the margin inflection visible in Q1 FY26. This wasn't a simple cost-cutting exercise; it was a deliberate pivot from engineering services to product manufacturing, with all the working capital and margin implications that shift entails.

Technology, Products, and Strategic Differentiation

The Common Processing Architecture (CPA) is not just another product line—it is Mercury's strategic bet that defense electronics can be productized like commercial semiconductors. CPA provides a modular, open-standards-based processing backbone that can be configured across multiple platforms (ground radar, electronic warfare, satellite systems) without redesigning the core architecture. CPA fundamentally changes Mercury's economics: instead of billing engineering hours for custom solutions, the company sells repeatable hardware modules with software-like margin scalability.

The tangible benefits are quantifiable. In Q1 FY26, modules and sub-assemblies revenue surged 44.5% to $66.2 million, while integrated solutions remained flat at $113.5 million. This mix shift drove gross margin expansion of 260 basis points, as production modules carry higher margins than custom integration. More importantly, CPA enables competitive takeaways: management highlighted a $26 million RF subsystem win for a U.S. missile program where the incumbent couldn't meet security requirements. CPA's open architecture with embedded anti-tamper and cybersecurity features creates switching costs once designed into a platform, locking out competitors for program lifecycles that can exceed a decade.

The Star Lab acquisition, completed in early Q4 FY25, layers cybersecurity software onto CPA hardware, creating a bundled solution that addresses the Defense Department's top priority: secure, resilient processing at the tactical edge. This integration allows Mercury to capture software-like margins on the security layer while maintaining hardware production scale. In Q4 FY25, $36.9 million in ground-based radar awards specifically leveraged CPA and Star Lab software, demonstrating that the acquisition is already driving incremental revenue. The differentiation against pure-hardware competitors like Curtiss-Wright is stark: Mercury offers a secure, upgradable platform; they sell components.

R&D spending decreased 28.3% to $13.2 million in Q1 FY26, not because Mercury is starving innovation, but because the innovation phase is giving way to production execution. The company redirected engineering resources from new development to CPA ramp and automation initiatives, including a 50,000-square-foot highly automated factory in Phoenix coming online in Q3 FY26. This is the right strategic move for this stage—Mercury has built the platform; now it must scale it efficiently. The risk is that underinvestment in next-gen technology could create a gap for competitors, but management insists they are "still moving innovation along" while focusing on production.

Financial Performance & Segment Dynamics: Evidence of Strategy Working

Q1 FY26 results provide the first clear evidence that Mercury's strategy is working. Revenue grew 10.2% to $225.2 million, but the composition tells the real story. Modules and sub-assemblies—the CPA-heavy segment—grew 44.5%, while components grew only 1.4% and integrated solutions declined 0.2%. This is exactly the mix shift management promised: higher-margin production revenue replacing lower-margin custom work. The 260-basis-point gross margin expansion to 27.9% was driven by favorable program mix and lower manufacturing adjustments, proving that scale and automation are translating to profitability.

The working capital story is equally compelling. Net working capital decreased $105.7 million year-over-year, a 18.8% reduction from peak levels in Q1 FY24. Billed receivables fell $31.9 million, unbilled receivables dropped $23.4 million, and inventory decreased $10.8 million. This shows Mercury is converting its backlog into cash rather than tying up capital in long-term contracts. Management explicitly noted that accelerating deliveries on high-priority programs allows them to "invoice and collect cash" even as revenue recognition slows on older contracts with large unbilled balances. The result: free cash flow exceeded $130 million over the trailing four quarters, turning a historically cash-consumptive business into a cash generator.

Adjusted EBITDA jumped 65.8% to $35.6 million, with margin expanding to the mid-teens trajectory management targets. This leverage demonstrates the operating leverage inherent in the production model—once CPA programs reach full rate, incremental revenue drops directly to the bottom line. The $200 million share repurchase authorization, announced in November 2025, signals management's confidence that this cash generation is sustainable and that the stock is undervalued relative to the transformation's potential.

Segment performance validates the strategic focus. C4I revenue surged $26.2 million, driven by CPA adoption, while electronic warfare and radar declined $5.3 million and $3.6 million respectively. This is intentional: Mercury is prioritizing programs where its open architecture creates competitive moats, even if it means walking away from commoditized radar components. The European defense business grew 15% over the trailing twelve months, reaching primes directly and via Foreign Military Sales, positioning Mercury to capture ReArm Europe budget increases that could triple aggregate spending to $1 trillion.

Outlook, Guidance, and Execution Risk

Management's FY26 guidance frames a deliberate, conservative path. They maintain low single-digit annual revenue growth, with the first half flat year-over-year and volume increasing sequentially in the second half. This embeds two key assumptions: first, that the $30 million of revenue pulled forward into Q4 FY25 from FY26 creates a headwind that will pressure Q2 comparisons; second, that factory capacity will be allocated to programs with unbilled receivable balances, driving cash flow but minimal incremental revenue.

The EBITDA margin outlook—approaching mid-teens for the full year, with low double-digit margins in the first half and Q4 as the highest of the year—assumes successful execution on the CPA ramp and continued working capital optimization. This is achievable but fragile. Any delay in bringing the Phoenix automation online in Q3 FY26 could constrain margins, and if legacy programs require more resources than expected, the margin progression could stall. Management's comment that they "expect to incur an additional $2.4 million in restructuring charges in Q2 FY26" for 42 international positions shows the transformation is still ongoing, adding execution risk.

The most significant upside asymmetry lies in two areas management explicitly excludes from guidance: Golden Dome and European defense acceleration. Golden Dome, the U.S. missile defense initiative, requires processing capabilities across space, airborne, tracking, interceptor, and ground-based layers—exactly Mercury's architecture. While management notes the FY26 outlook "does not yet incorporate any impact from Golden Dome-driven acceleration" due to early pipeline phases, they also express "optimism that they may have a positive impact on our demand environment if funding is allocated." This is classic conservative guidance with embedded optionality.

Similarly, European ReArm initiatives are "still in early pipeline phases" but represent a potential doubling or tripling of addressable spend. Mercury's 15% growth in European business before these tailwinds kick in suggests they are well-positioned. For investors, the guidance floor is conservative, and any clarity on funding timing could drive meaningful upside to both revenue and margins, as these programs would be CPA-based and carry higher margins than legacy work.

Risks and Asymmetries: What Can Break the Thesis

The securities class action settlement, while covered by insurance, highlights a history of aggressive accounting that investors must monitor. The $32.5 million settlement, recorded as a receivable, resolves the 2023 lawsuit alleging revenue recognition improprieties, but the internal investigation launched in September 2025 regarding "potentially inaccurately reported test results and certifications" over 20 years for a $15 million revenue program is more concerning. Management cannot estimate the cost or loss, and "any determination that the Company's operations were not in compliance with laws or regulations such as the False Claims Act could result in civil or criminal fines" that are material. This is a tail risk that could derail the transformation if it expands beyond the disclosed scope.

Execution risk on the CPA ramp is the more immediate threat. Mercury is "ramping the full rate production" and expects capacity to be "fully available as we move through the back half of the year," but defense production is notoriously difficult to scale. Supplier issues, quality control problems, or customer acceptance delays could all compress margins and delay the margin inflection story. The workforce reduction of 82 positions (40 in Q1, 42 in Q2) is designed to align costs, but if it cuts too deeply into program management talent, execution could suffer.

Customer concentration remains a structural vulnerability. The top five customers represent roughly 50% of revenue, and the $24.5 million Defense Department satellite program win, while significant, shows the lumpy nature of defense contracting. A program cancellation or shift to a competitor could create a revenue hole that takes quarters to fill. The federal government shutdown risk, while currently "minimal" according to management, could delay new bookings if it extends, particularly for programs requiring new starts.

On the positive side, the balance sheet provides resilience. With $305 million in cash, an $850 million revolver extended to 2030, and net debt to EBITDA of just 0.18x, Mercury can weather execution stumbles or legal settlements without diluting shareholders. The $200 million buyback authorization, while modest relative to $4.25 billion market cap, signals management's confidence and provides a floor for the stock.

Competitive Context and Positioning

Mercury's competitive position is best understood as a niche specialist with technology advantages against larger generalists. Curtiss-Wright, with $3.2 billion in revenue and 37.4% gross margins, dwarfs Mercury in scale and profitability, but its proprietary approach creates lock-in that primes increasingly reject. Mercury's open-architecture CPA can integrate across vendors, reducing program risk for customers. Mercury can win as a second source on CW programs, taking share without having to match CW's scale. However, CW's vertical integration and manufacturing depth mean it can undercut on price for commoditized components, forcing Mercury up the value chain into software-enabled solutions.

L3Harris, at over $20 billion in revenue, competes directly in EW and radar processing but moves slowly due to bureaucratic scale. Mercury's ability to "take share in this attractive market segment based on our technology leadership position"—as evidenced by the $26 million missile program takeaway—stems from its nimble engineering and security-first design. LHX's gross margins of 25.6% are actually lower than Mercury's 28.5%, suggesting that scale doesn't automatically translate to profitability in specialized subsystems. Mercury's disadvantage is LHX's prime contractor relationships and ability to self-source components, but its advantage is speed and open standards.

Kratos, growing revenue at 26% to $1.3 billion, represents the agile upstart threat. Kratos focuses on attritable systems and low-cost microwave assemblies, competing on price where Mercury competes on performance. Mercury's 28.5% gross margins vs. Kratos's 22.9% reflect this differentiation: Mercury sells reliability and security, Kratos sells cost-effectiveness. The risk is that defense budgets could shift toward disposable platforms, but the trend toward reusable, upgradeable systems with long lifecycles favors Mercury's modular approach.

The broader threat is vertical integration by primes. Lockheed and Northrop are increasingly bringing subsystem design in-house to capture margin and control supply chains. Mercury's moat—its 40-year processing platform and security clearances—defends against this, but only if it continues to innovate. The Star Lab acquisition and CPA platform are designed to make Mercury indispensable, but a prime could still decide to build competing capability, eroding 5-10% of revenue over time.

Valuation Context

At $70.59 per share, Mercury trades at an enterprise value of $4.40 billion, or 4.72x trailing revenue of $912 million. This multiple is a discount to Curtiss-Wright (6.36x) and Kratos (9.64x) but a premium to L3Harris (2.92x), reflecting Mercury's growth potential but also its smaller scale and execution risk. The EV/EBITDA multiple of 55.7x is elevated but misleading given the company's transition; using management's target of mid-teens EBITDA margins on FY26 revenue implies a forward multiple in the 20-25x range, more reasonable for a defense electronics company with growth tailwinds.

The company is unprofitable on a net income basis (-3.5% margin), but this is the wrong metric for a business in transition. Free cash flow of $119 million over the trailing twelve months yields a price-to-free-cash-flow ratio of 31.3x, which is reasonable for a company generating 15% FCF growth and targeting 50% conversion of EBITDA. The balance sheet is strong: net debt to equity of 0.18x, current ratio of 3.37, and $305 million cash provide flexibility to invest in automation or weather legal issues.

The key valuation driver is margin expansion. If Mercury achieves its target of low-to-mid-20% EBITDA margins and grows revenue at 8-10% (in line with defense electronics market growth), the stock would trade at approximately 15-18x forward EBITDA, a discount to peers given its niche leadership. The market is currently pricing in successful execution but not the upside optionality from Golden Dome or European defense acceleration, which could add $50-100 million in high-margin revenue if funded.

Conclusion

Mercury Systems stands at an inflection point where a decade of platform development and recent operational restructuring are converging to drive margin expansion and cash generation. The Q1 FY26 results provide tangible evidence: gross margins up 260 basis points, working capital down $105.7 million, and competitive wins validating the CPA platform's differentiation. Management's conservative guidance masks significant optionality from Golden Dome and European ReArm initiatives, neither of which is reflected in the low-single-digit revenue growth outlook.

The investment thesis hinges on two variables: successful execution of the CPA production ramp and resolution of legal overhangs. If the Phoenix automation comes online in Q3 FY26 as planned and CPA programs reach full rate production, EBITDA margins should expand toward the mid-teens in FY26 and low-20s thereafter, justifying the current valuation and providing upside. Conversely, execution missteps or expansion of the internal investigation could derail the transformation.

Relative to larger competitors, Mercury's open architecture and cybersecurity integration create a defensible moat in mission-critical processing, allowing it to punch above its weight in competitive takeaways. The stock's valuation at 4.72x revenue balances turnaround execution risk against defense tailwinds, offering a favorable risk-reward for investors who believe the margin inflection is real and sustainable. The next two quarters will be critical in determining whether Mercury can deliver on its target profile and cement its position as the processing platform of choice for the defense electronics upcycle.