2 for Tuesday: Mercury Rising

We all watched on television as U.S. special forces leapt out of planes in the middle of the night onto the rough Afghan terrain. Sophisticated reconnaissance and radar pinpointed where the soldiers were dropped and tracked their whereabouts as they roamed the countryside in search of al Queda fighters. Those reconnaissance, surveillance and radar systems wouldn't be possible without Mercury Computer(MRCY).

Despite the likelihood that defense spending will increase solidly over the next several years, particularly in electronics (where Mercury is strongly positioned), this company has been suffering lately. Mercury's revenue and earnings declined 17% and 45%, respectively, in the September quarter (the first quarter of this fiscal year, which ends June 2002). Then, on Jan. 3, Mercury preannounced that its second quarter would be similarly weak.

I believe the earnings shortfall is a temporary setback related to the defense budget, one that provides a great opportunity to get into Mercury's shares at a good price. With roughly $180 million in annual sales, Mercury makes very high-end proprietary digital-signal processing (DSP) and image processing systems, primarily for the defense and medical-imaging markets.

These systems can instantly process high volumes of continuous data streams -- signals received from sensors in either radar, sonar or medical-imaging equipment like magnetic resonance imaging (MRI) machines. The data, then, can be converted into an audio or visual signal that can be easily interpreted by battlefield commanders or surgeons. Over the past four years, Mercury has grown sales and earnings per share at a compound annual rate of 29% and 46%, respectively.

Almost two-thirds of the company's sales are to defense contractors; Mercury has captured a dominant 40% to 50% market share of this business.

Not surprisingly, the defense contractors as a group have performed well over the past year, particularly since Sept. 11. Lockheed Martin(LMT), General Dynamics(GD), Northrop Grumman (NOC) and Raytheon (RTN) are, on average, up more than 17%.

But Mercury has not fared as well; its shares are down 22% since Sept. 11, and down 39% from its 52-week high of $59.

The sales shortfall over the past six months was driven by a combination of factors. These include a new administration in Washington that made a late transition, a preoccupation with Afghanistan and the delayed passage of the Defense Department's fiscal 2002 appropriations bill. About 50% of Mercury's business is dependent on current funding, for areas such as research and early stage development, which has been held up by budget delays.

Even Defense Secretary Donald Rumsfeld complained about the length of the budget process during his first year in office in a press briefing on Dec. 27, saying, "We've had to prepare, since I've been here, something like five-plus or -minus budgets of sorts." Bush's team is likely to get to work immediately in 2002 to get the budget process back on schedule for next year.

The Stock Mercury Computer (MRCY:Nasdaq)
Recent Stock Price:	$34.78
52-Week Range:	$24.40-$58.95
P/E Ratio:	29.32
Market Capitalization:	$764.0 million
Float:	20.4 million shares
Short Interest Ratio:	1.89
Institutional Ownership:	73%
Source: Yahoo! Finance

Even if we put aside budget delays, the current emphasis in defense spending has understandably been to support the war on terrorism, which means bombs and bullets rather than modernizing weapons systems. (Hence, the incredible 74% rise in the shares of Alliant Techsystems(ATK), a maker of conventional munitions.)

But soon the focus will shift to fulfilling the administration's long-held goal to "digitize" the battlefield and tighten homeland security with increased intelligence, surveillance and reconnaissance -- all of which should incorporate Mercury's real-time signal processing systems. Mercury's systems are already used widely on surface ships, aircraft, submarines and drone vehicles, such as the unmanned Predator and Global Hawk and U2 reconnaissance and surveillance aircraft programs.

Another 25% of Mercury's sales are to the medical-imaging industry, where the company has won a leading share of the MRI and computed topography (CT) markets. This year will likely be a slow one for medical imaging, however. Many of Mercury's products have matured and are now growing more in line with their end markets, at about a mid-single-digit rate. But new digital X-ray design wins are just starting to ramp up, and revenue growth from these products should start contributing meaningfully during the next 12 to 18 months.

The Stats
Year	Revenue (in millions)	EPS
2000	$140.94	$1.10
2001	180.49	1.33
2002*	173.53	1.01
2003*	217.35	1.71
*Thomson Financial/First Call estimates. Source: Company reports

The real wild card in the Mercury story is its next growth frontier: third-generation (3G) wireless, the technology that will enable high-speed wireless Internet access. The company's DSP systems could help service-providers get more efficient use of the spectrum and also improve the transmission range of cellular base stations, allowing providers to maintain the same level of service with half the number of base stations -- a potential savings to capital spending budgets.

Although 3G is unlikely to make a meaningful contribution to Mercury's revenue any time soon (particularly because most service providers have delayed the buildout of these systems), the company still anticipates wining one major wireless contract by June of this year.

Mercury will be reporting its earnings Jan. 16, and will Webcast its conference call with the investment community at 5 p.m. EST that day. Company representatives told me Mercury's earnings guidance for fiscal 2002 will be updated at that time. I would wait to listen to the call before buying the shares.

But even at $35, the stock is trading at a P/E ratio of just 20 on analysts' estimates of $1.71 for 2003 (ending June). That is a good deal for a market leader with proprietary technology growing its earnings 25% per year.

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