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Mercury Systems Inc  (NASDAQ:MRCY)
Q2 2019 Earnings Conference Call
Jan. 29, 2019, 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, everyone, and welcome to the Mercury Systems Second Quarter Fiscal 2019 Conference Call. Today's call is being recorded.

At this time, for opening remarks and introductions, I'd like to turn the call over to the Company's Executive Vice President and Chief Financial Officer, Mike Ruppert. Please go ahead, sir.

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Good afternoon, and thank you for joining us. With me today is our President and Chief Executive Officer, Mark Aslett.

If you've not received a copy of the earnings press release we issued earlier this afternoon, you can find it on our website at mrcy.com. The slide presentation that Mark and I will be referring to is posted on the Investor Relations section of the website under Events and Presentations.

Please turn to slide two in the presentation. Before we get started, I would like to remind you that today's presentation includes forward-looking statements, including information regarding Mercury's financial outlook, future plans, objectives, business prospects and anticipated financial performance. These forward-looking statements are subject to future risks and uncertainties that could cause our actual results or performance to differ materially. All forward-looking statements should be considered in conjunction with the cautionary statements on slide two, in the earnings press release and the risk factors included in Mercury's SEC filings.

I'd also like to mention that in addition to reporting financial results in accordance with Generally Accepted Accounting Principles, or GAAP, during our call we will also discuss several non-GAAP financial measures, specifically adjusted income, adjusted earnings per share, adjusted EBITDA, free cash flow, organic revenue and acquired revenue. A reconciliation of these non-GAAP metrics is included as an appendix to today's slide presentation and in the earnings press release.

I'll now turn the call over to Mercury's President and CEO, Mark Aslett. Please turn to slide three.

Mark Aslett -- President and Chief Executive Officer

Thanks, Mike. Good afternoon, everyone, and thanks for joining us. I'll begin by providing a business update, Mike will review the financials and guidance and then we'll open it up to your questions.

Mercury delivered solid results in the second quarter of fiscal 2019, building on the momentum from Q1. We finished the first half of the fiscal year strong coming in above the high-end of our Q2 guidance for revenue, adjusted EBITDA and adjusted EPS.

In addition, we're announcing today the acquisition of GECO Avionics as part of our continued push in the C4I market. We've now completed five C4I acquisitions over the past two fiscal years that have significantly expanded our capabilities and addressable market. I have more to say about the GECO transaction and our C4I strategy later in my prepared remarks.

Turning to the numbers. Revenue for the second quarter was a record, an increase 35% in total and 11% organically. We now expect 9% to 10% organic growth for this fiscal year, which is up to 2 percentage points to 3 percentage points from fiscal 2018. Our largest revenue programs in the quarter were F-35, Filthy Buzzard, Predator, an next-generation missile system and DEWS.

We continue to perform well from a bookings perspective also. Total bookings for Q2 increased 29% year-over-year to $173.2 million. Our largest bookings programs included the UAV mission computer and the next-generation ground-based radar. We also booked large orders for F-35, AIDEWS, and MALD. Our book-to-bill for the quarter was 1.09 and backlog was a record $522 million, up 39% year-over-year.

On the bottom line, adjusted EBITDA was up a strong 39% from Q2 of fiscal 2018. Free cash flow increased 279% year-over-year and was in line with our target yield a 50% of adjusted EBITDA.

Turning to slide four. Mercury's ability to win new business has never been stronger. We're in a period of significant new design win activity in new program starts. The level of pursuits and design win continues to be the highest I've seen since joining the Company.

Our continued growth demonstrates that Mercury is well-aligned with DoD budget priorities and the need for modernization. We're targeting the C4I in Sensor and Effector Mission Systems markets. Both segments continue to grow faster than the overall defense market. Sensor and Effector Mission Systems accounted for 56% of total Q2 revenue, increasing 5% from the second quarter last year.

The C4I market is far larger than the Sensor and Effector Mission Systems market, and looking at the estimated lifetime value of our top 30 programs, we've rapidly created $800 million of potential C4I opportunity. We've done this through the investments that we've made and the deals that we've completed. A critical component of this potential growth is the recent acquisitions of Themis and Germane. Here we're in the process of integrating these businesses to create an industry-leading rugged server business. For the second quarter, C4I revenue increased 249% year-over-year to 30% of total revenue.

Since fiscal 2013, we've seen the estimated lifetime value of our top 30 programs and pursuits grow significantly. This growth reflects our M&A strategy, as well as the impacts of three industry trends that we've discussed in the past. The first trend is what we believe to be the largest secular growth opportunity in defense, which has increased outsourcing by our customers at the subsystem level. Second is the flight to quality. The primes the seeking to deal with fewer, more capable suppliers, suppliers like Mercury, who are prepared to co-invest in internal R&D, have trusted domestic manufacturing assets and have invested significantly in cybersecurity. Third is supply chain delayering by the government and the primes. We've transformed mercury into a Tier 2 Company over the past several years. We've moved up the value chain and positioned ourselves to capture more subsystem content as the delayering trend involves.

As we benefit from these three fundamental trends, we're also continuing to take share from competitors. This is largely because of the significant and focused investments that we've made in R&D, as well as building out our trusted domestic manufacturing capabilities. As you can see on slide five, we've made solid progress in these areas during the second quarter, thanks to another great effort by the Mercury team. Our R&D strategy has been focused on positioning Mercury as the leading US supplier of secure and safety critical processing subsystems for aerospace and defense applications. This is based on our belief that over time more and more of the technology that goes into US military platforms will need to be designed and produced domestically. We believe this represents a significant opportunity for Mercury. We're executing against this strategy by investing significant internally funded R&D to develop secure hardware and software technologies. These technologies offer our customers choice and an industry-leading range of secure embedded and enterprise computing solutions, all developed and produced domestically.

We're very pleased that six Mercury products in trusted computing, software and C4ISR were recently recognized by Military and Aerospace Electronics Magazine' Annual Innovators Awards Program. This recognition underscores the power of our business model to embed innovation deeply into our product development and commercialization processes.

In addition to our IRAD investments, we have funded the capital dollars necessary to build out a trusted digital SMT manufacturing facility in Phoenix, Arizona. The in-source digital production capabilities we've created in Phoenix are crucially important to our ability to continue growing the business. We've largely completed the Phoenix build out as planned and was substantially complete in our initial manufacturing in-sourcing plan. Now, under the leadership of Amir Allahverdi, who joined Mercury in Q2, our goal is to continue to optimize all of our internal and manufacturing operations, including Phoenix over the coming years.

The consolidation of our West Coast RF manufacturing locations is progressing. We received planning permission and will soon begin to build out of the leased facility adjacent to our existing Oxnard, California plant. Completing this build out will then allow us to consolidate our remaining West Coast RF operations.

We'll continue to make good progress integrating Themis and Germane, and migrating both businesses to Mercury systems and processes, which we currently expect to complete by fiscal year-end. The combined Themis and Germane leadership team and structure is now fully deployed. Both businesses are performing well, and combined, they're generating revenue and cost synergies in line with our expectations.

When we acquired Themis and Germane, our strategic goal was to insert our own domestically designed and produced secure processing capabilities into their rack server solutions over time and for certain applications. This activity is well under way and the capability has been well-received by customers. The feedback is that we've created a unique business and set of capabilities in line with the trend in need for secure and trusted compute solutions. We've already won two important new design wins with Themis and Germane been part of Mercury.

While expanding our secure processing product portfolio, we've also invested significantly over the years to build out the best-in-class cybersecurity capability to protect our own infrastructure, critical technologies and information.

Turning now to slide six, our business outlook remains strong. We've seen an acceleration in defense spending this government fiscal year. This is leading to a high-level of new design win activity, a strong book-to-bill and an increase in our projected organic revenue growth rates.

Over the longer-term, our baseline forecast is for overall defense spending to increase at low-single-digit rates. Mercury's goal is to continue delivering organic revenue growth at a rate that exceeds this industry average. As I mentioned earlier, we now expect to deliver 9% to 10% organic growth of fiscal 2019. This is an increase from what we anticipated last quarter and above the 7% organic revenue growth we delivered in fiscal 2018. We're well positioned to continue supplementing this high-level of organic growth with smart strategic M&A. Our pipeline is strong and we continue to see interesting opportunities of various sizes, all of them are well-aligned with our strategy.

Including the deal that we announced today, the acquisition of GECO Avionics, over the past three years we've completed eight acquisitions totaling more than $650 million of capital. These transactions share a common strategic rationale, they're expanding our addressable markets and broadening our customer offerings as well as our program base. At the same time, the cost and revenue synergies that generate and contributing to our strong financial performance. We intend to remain active and disciplined in our approached to M&A. We'll continue to look for deals that are strategically aligned, have the potential to be accretive in the short-term and promise to create long-term shareholder value. We will seek to continue to acquire and grow within the Sensor and Effector Mission systems and C4I markets as we have in the past.

As outlined on slide seven, we currently have two M&A themes under way in the C4I market. The first is secure rugged rackmount servers. Here, we've created one of the largest players in the space by the acquisitions and integration of Themis and Germane. Our second theme in C4I is avionics processing subsystems. We began building this business in November 2016 when we acquired Creative Electronic Solutions, or CES. We followed this up with a further acquisition of Richland Technologies, or RTL, in July 2017.

The GECO Avionics acquisition continues that journey. The $36.5 million purchase price is approximately 10.5 times LTM adjusted EBITDA, net of the expected tax benefits. GECO is based in Mesa, Arizona and has more than 20 years of experience designing and manufacturing affordable safety critical avionics and mission computing solutions. Their technologies are deployed on a range of military platforms, including Boeing's Apache attack helicopter and KC-46 Pegasus refueling tanker.

Our goal is to combine GECO with CES and RTL to create an industry-leading avionics business. We view this combination as another platform on which we can and will likely continue to build by looking for deals in this space.

An example of the opportunities we pursue in this market organically is the Q2 design win when we announced on January 3. Our team in Geneva, Switzerland, the former CES, secured a $40 million 10-year contract from a large aerospace and defense company to develop a set of advanced, safety certifiable flight computers.

Turning to slide eight, in summary. Mercury remains on track for another year of strong performance in fiscal 2019. Our strategy and business model are working extremely well. We're growing the business substantially faster than the industry overall. Our planned manufacturing and M&A integration synergies are materializing. We're expecting another year of double-digit growth in revenue and adjusted EBITDA, as well as strong cash flow generation.

We remain confident that we can achieve the high-end of our adjusted EBITDA target model over time by continuing to execute our plans in four areas. First is to drive high single-digit, low double-digit organic revenue growth, supplemented by acquisitions. This is consistent with the 20% compound annual growth we've delivered over the past five years.

Second, we're focused on manufacturing in-sourcing and driving operational improvements across all of our manufacturing locations. The goal here is to enhance margins and improve working capital efficiencies over the coming years. Third, we're creating stronger operating leverage in the business by ensuring that organic operating expenses grow more slowly than revenue. And finally, we're fully integrating the businesses we acquire to generate cost and revenue synergies. These synergies combined with three other elements should produce attractive rates of return for our shareholders.

Given our results in Q2, our record backlog and our current business outlook, we expect to report continued strong performance in the third quarter. We're also raising our full year of fiscal 2019 guidance and Mike will take you through those numbers in detail.

Before Mike begins, I'd like to note that Barry Nearhos, a partner at PricewaterhouseCoopers was elected to Mercury's Board of Directors and appointed to the Audit Committee in late November. Barry has a rich history of providing global corporations with audit and assurance services along with strategic business advice on M&A, corporate governance, and finance. We welcome Barry to Mercury's Board and look forward to benefiting from his expertise as we continue to execute against our business objectives.

With that, I'd like to turn the call over to Mike. Mike?

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Thank you, Mark, and good afternoon, again, everyone. Q2 was another great quarter for Mercury. Bookings, revenue, adjusted EBITDA and adjusted EPS increased substantially from Q2 of fiscal 2018. Gross margin exceeded our Q2 guidance, and free cash flow was up 279% year-over-year. We concluded the second quarter with record backlog and solid growth momentum. As a result, we're anticipating strong financial performance in the second half of fiscal 2019 and we're increasing our fiscal 2019 guidance for revenue, adjusted EBITDA and adjusted EPS.

In addition to our organic growth, our strategy of acquiring businesses that fit with our strategy and integrating them into Mercury is delivering results as planned. Our recent acquisitions, Germane and Themis, are continuing to perform well on both the top and bottom lines. The acquisition of GECO Avionics, which closed today is another example of our strategy and action. As Mark said, it's another important step forward in our plan to expand our presence in the C4I market. With approximately 70 employees and approximately $20 million of revenue, GECO continues to add scale to the avionics business we've been growing over the past two years.

Turning now to the metrics on slide nine. Mercury's total bookings for Q2 increased 29% year-over-year to $173.2 million, driving at 1.09 book-to-bill ratio. We ended the quarter with record backlog of $522 million, up 39% from Q2 fiscal 2018. Backlog expected to ship within the next 12 months increased 25% from Q2 last year to $389.1 million. Q2 was a strong quarter for revenue growth. Total revenue increased 35% year-over-year to a record $159.1 million, exceeding our guidance of $151.6 million to $156.6 million. Organic revenue was up 11%, and as Mark mentioned, we now expect 9% to 10% organic growth for the year.

Gross margin for the second quarter was 44.6% above the high-end of our guidance of 43.9% to 44.5%, largely due to favorable program mix. This compares with 45.9% in Q2 last year, reflecting this quarter's inclusion of Germane Systems. Excluding Germane, Q2 gross margin would have increased year-over-year. The integration of Germane into Themis and Mercury is progressing well. The teams are already working together effectively, and we're on track to deliver our expected cost synergies. Over time we expect to see the combined Themis-Germane achieve EBITDA margins consistent with our target business model. In addition, we're already seeing revenue opportunities that neither company would have seen on a stand-alone basis.

SG&A for Q2 increased 31% from $21.2 million in Q2 2018 to $27.8 million, driven by the inclusion of Themis and Germane, as well as the organic growth in the business. As a percentage of sales, SG&A decreased from 18% in Q2 last year to 17.5% this quarter, highlighting the operating leverage we're creating as we continue to grow sales faster than expenses.

GAAP net income and GAAP EPS in the second quarter increased by 36% and 37% year-over-year, respectively. Adjusted EPS for the second quarter was $0.47 per share, up 68% from $0.28 per share for Q2 last year.

Adjusted EBITDA for Q2 increased 39% year-over-year to $37 million, exceeding our guidance of $31.7 million to $34.5 million. Adjusted EBITDA margin was 23.2% for the quarter. This compares to 22.5% in Q2 fiscal 2018 and exceeds our guidance of 20.9% to 22%. The increase was driven primarily by favorable program mix.

Finally, free cash flow, which we define as cash flow from operations less capital expenditures, increased from $4.8 million in Q2 last year to $18.2 million.

Slide 10 presents Mercury's balance sheet for the last five quarters. We concluded Q2 well-positioned to continue executing on our capital deployment strategy, supporting future growth organically and through our acquisitions. Driven primarily by Mercury's strong free cash flow, cash and cash equivalents at the end of Q2 totaled $93.9 million, up $21 million from $72.9 million at the end of Q1 and up $61.9 million from $32 million in Q2 fiscal 2018.

Inventory in Q2 increased by $5.2 million quarter-over-quarter and inventory turns were flat.

Accounts receivable increased $14.4 million quarter-over-quarter, while DSOs improved slightly compared to last quarter.

From a capital structure perspective, we've maintained flexibility and good access to capital. At the end of the quarter, we had $240 million of debt. Following the $36.5 million purchase of GECO Avionics, which we funded under the revolver, we now have $276.5 million of debt. Post the GECO acquisition, our balance sheet remains conservatively levered at approximately 1.4 times net debt-to-adjusted EBITDA.

Earlier this month, we entered into a floating to fixed rate interest rate swap. This fixes $175 million of our $276.5 million variable rate debt at a fixed LIBOR rate of 2.54%. Meaning that approximately 60% of our debt is now locked in at a very attractive rate. At current leverage levels, our interest rate is LIBOR plus 125 basis points, implying a pre-tax cost of debt of 3.79% on the fixed portion of the debt.

Turning to cash flow on slide 11. Free cash flow for Q2 was $18.2 million, representing 49% of adjusted EBITDA. For the first half of fiscal 2019, free cash flow was at 50% of adjusted EBITDA, up 275% from the first half of fiscal 2018. Operating cash flow for the second quarter increased to $25.3 million from $8.8 million in Q2 last year.

Working capital was $3.4 million use of cash compared with a $4.5 million use of cash in Q1, and a $14.6 million use of cash in Q2 last year. Capital expenditures in Q2 were $7.1 million or 4.4% of revenue and $10.8 million or 3.6% of revenue in H1. We expect CapEx to increase in H2 as we continue to integrate recently acquired businesses. Although this will reduce free cash flow in H2, our cash flow for fiscal 2019 will be up significantly compared to fiscal 2018.

I'll now turn to our financial guidance for Q3 and fiscal 2019. This guidance includes the impact of GECO Avionics. Starting with Q3 on slide 12, you can see that we're forecasting consolidated total revenue in the range of $162.7 million to 167.7 million, an increase of 40% to 44% compared with Q3 last year.

Q3 fiscal 2019 gross margins are expected to be 43.6% to 44.1%. The decrease from Q3 last year is primarily driven by lower margin revenues from our recent acquisitions, as well as the higher proportion of new development programs in our mix.

Q3 GAAP net income is expected to be $10.8 million to $12.3 million, or $0.23 to $0.26 per share.

Adjusted EPS is expected to be $0.43 to $0.46 per share, up 43% to 53% compared to Q3 fiscal 2018.

Finally, adjusted EBITDA is expected to be $34.8 million to $36.8 million, representing approximately 21.4% to 21.9% of revenue.

Turning to slide 13. Our guidance for the fiscal year reflects both the strong organic growth and the inclusion of GECO Avionics. We're raising our previous full year guidance for revenue, adjusted EPS and adjusted EBITDA. For the full fiscal year, we now expect revenue of $631 million to $646 million, representing growth of 28% to 31% from fiscal 2018. This is a significant increase from our previous guidance of $607 million to $625 million. At the top-end, the $21 million increase from our previous guidance reflects approximately $15 million of incremental organic revenue, driven by new program design wins, as well as an anticipated $6 million of revenue from GECO Avionics.

Consolidated gross margin for fiscal 2019 is currently expected to be 43.4% to 43.9%. Our gross margin outlook reflects new design win activity and the inclusion of Germane and GECO Avionics.

Consolidated operating expenses for fiscal 2019 are expected to be $203 million to $207.6 million, including an estimated $27.5 million of amortization expense. The increase from our previous guidance reflects an incremental investment in our products and our people in the second half of the year.

In Q2, we exceeded the high-end of our adjusted EBITDA guidance by $2.5 million. Given the opportunities we see in the market, we're modestly increasing R&D spend in the second half of the year. Our strong financial results in the first half allow us to invest for the future, while still raising our full year guidance for adjusted EBITDA.

Interest expense for fiscal 2019 is now expected to be approximately $9.6 million. This reflects the estimated additional debt associated with GECO for five months of the year.

Total GAAP net income on a consolidated basis is expected to be $42.6 million to $46.1 million, or $0.89 to $0.96 per share.

Adjusted EPS is expected to be in the range of $1.72 to $1.80 per share, an increase of 21% to 27% compared to fiscal 2018 results.

Our fiscal 2019 guidance for adjusted EBITDA is $138.6 million to $143.5 million on a consolidated basis, or 22% to 22.2% of revenue. This is an increase of 21% to 25% from fiscal 2018 and up from our previous guidance. We expect adjusted EBITDA margins to increase over time as we integrate Germane and GECO Avionics and recognize the anticipated synergies.

In addition, we expect to gain further operational efficiencies and we anticipate continued improvement in operational leverage as revenues grow. We also expect gross margins to improve over time as early stage development programs move into production. As we discussed at Investor Day in November, this should lead to EBITDA margin expansion over the coming years.

Finally, we expect CapEx for fiscal 2019 to be approximately 5% of revenue, up from approximately 3% last year. This increase is driven by continued investment and the consolidation of our West Coast RF manufacturing locations and is weighted toward the second half.

Turning to slide 14, in summary. Mercury delivered a strong second quarter, setting us up for another year of strong performance in fiscal 2019. We concluded the quarter with a 1.09 book-to-bill and record backlog. Total revenue was up 35% and organic revenue grew 11% year-over-year. Net income and adjusted EBITDA exceeded our guidance. We delivered solid operating and free cash flow, while also completing our eighth acquisition in the past three years. The outperformance that we've seen in the first half of the year is allowing us to invest in the business, while also allowing us to raise our full year guidance.

With that, we'll be happy to take your questions. Operator, you can proceed with the Q&A now.

Questions and Answers:

Operator

Thank you. (Operator Instruction) Our first question comes from Peter Arment of Baird. Your line is open.

Peter Arment -- Robert W. Baird -- Analyst

Good afternoon, Mark. My congrats on the quarter.

Mark Aslett -- President and Chief Executive Officer

Thanks, Peter.

Peter Arment -- Robert W. Baird -- Analyst

Mark, you mentioned C4I is now 30% of revenues and then that continues to progress, obviously. And you mentioned an $800 million kind of opportunity. Can you maybe talk a little more color about, I guess, the market and what you're seeing and some of the success that you're having early on?

Mark Aslett -- President and Chief Executive Officer

Sure. So, I think there are a number of different opportunities that we're seeing. The growth in the C4I is really broken down into two major areas, as I kind of described a little bit on the call. The first is, in the secure rugged rackmount server domain, and here we've obviously acquired Themis and Germane, and grouping those or combining those two businesses together. We've seen opportunities and upgrades associated with upgrades in the naval subsurface fleet, as well as the naval surface fleet, as well as in airborne applications for those types of capabilities.

The second area that we've seen opportunities is in the avionics processing subsystem domain and that's really the primary rationale behind the acquisition of GECO that we announced this evening. And that really follows on from the other acquisitions that we've done in the space, those being RTL and CES. And so, there we're going after opportunities and upgrades in mission computers, as well as avionics processing subsystems. And one of the unique things that we bring to the table is our ability to be able to combine together the safety certifications and embedded security, and where we're seeing the opportunities for that is particularly in the shift toward more autonomous system.

So, net-net, I think the shift into that space, the C4I market, which is a much larger market than we've traditionally played in, I think is presenting a significant amount of opportunity for us, Peter.

Operator

Thank you. And our next question comes from Jon Raviv of Citi. Your line is still open.

Jonathan Raviv -- Citi -- Analyst

Hey, good afternoon, everyone.

Mark Aslett -- President and Chief Executive Officer

Hi, Jon.

Jonathan Raviv -- Citi -- Analyst

Hey. On the organic growth, certainly appreciate the view 9% to 10% organic growth this year, some of your customers are growing almost at that rate, not quite. But given new design wins, which is around -- you're talking about now increasing R&D a bit more. What's the prospect for double-digit organic growth at some point in the future?

Mark Aslett -- President and Chief Executive Officer

So, as I said in the prepared remarks, I think the range of organic growth that we're now giving for the year is 9% to 10%. So, at the high-end of that, we'd already be at double-digit rates. We are expecting, I think, a stronger performance in the second half in bookings, and with some quite significant potential. So we'll see how things evolve, but right now we feel pretty good about the increase that we've just made and our outlook for the remainder of the year, Jon.

Jonathan Raviv -- Citi -- Analyst

Understood. And then in terms of the margin for this year, just looking at your, again, full year FY'19 adjusted EBITDA margin guidance ticked down a little bit from the last -- from three months ago call. Is that mostly due to GECO or how much of that is from GECO versus R&D versus some mix changes with the higher growth? If you could just sort of level set us on the contributors to the lower margin expectation for this year? Certainly appreciate the EBITDA numbers are higher, but just on the percentage number (Multiple Speakers).

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Yeah. Sure, Jon. I mean, I think if you look at the guidance that we had before, the midpoint of the EBITDA was about 22.4%. If you look at the midpoint of our EBITDA margin now, it's 22.1%. GECO doesn't really has a major impact on that. It's about kind of 0.1%. It's small. So, you're looking at -- though, going from 22.4% down to kind of 22.2% on the margin decline, that's really driven by the additional R&D investment that we're making in the second half when you compare it to our previous guidance, and that's about -- that's just a couple million, but it has a small impact on the margins, probably 0.3%, something like that. So, it's really the R&D, a little bit GECO, but it's really the additional investment. And remember that the CRAD that we've talked about in the past can impact gross margins, but that's offset by the internal R&D. So that's not driving any changes to EBITDA from our previous guidance.

Jonathan Raviv -- Citi -- Analyst

Okay. And then just -- and I have a quick follow-up on that idea of the CRAD versus IRAD, just wanted to understand how they're sort of two pieces or two slices of the same pie. But with your increased IRAD plans for second half, does that change at all your CRAD wins expectations, so to speak, or CRADs running high but this IRAD happen to be picking up a little bit as well?

Mark Aslett -- President and Chief Executive Officer

So, we're increasing IRAD to really accelerate the development to some of our own secure and trusted motherboards associated with the acquisitions of Themis and Germane. So, we see an opportunity of continuing to capture new design wins and we have made the decision to spend a little bit more money in the second half to accelerate that.

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Yeah. And to get -- Jon, to get it back into our target model, I mean, you'll see because of all the CRAD, our IRAD in the first half was about 10.3%. And what we want to do is, for the opportunities that Mark just mentioned, increase our R&D in the second half to get it back into the range because we're seeing a lot of opportunities.

Mark Aslett -- President and Chief Executive Officer

Yeah. Right. So, I mean, the level of new design win activity, as I mentioned, is literally the highest I've seen since joining the Company. CRAD alone is up 62% in Q2 on a year-over-year basis. So, there's a lot of new activities under way and we're well positioned to capture those, which is again part of the reason that we're actually raising our total revenue guidance organically beyond the acquisitions that we just announced.

Jonathan Raviv -- Citi -- Analyst

Understood. Thanks guys. I'll hop back in the queue.

Mark Aslett -- President and Chief Executive Officer

All right. Thank you.

Operator

Thank you. And our next question comes from Sheila Kahyaoglu of Jefferies. Your line is now open.

Sheila Kahyaoglu -- Jefferies & Company -- Analyst

Hi, good afternoon, Mark, Mike. Thank you for the time. Just on the avionics market, how could we categorize how big it is the addressable market for you? And then when we look at the combination of the three deals, how they should contribute to the top line?

Mark Aslett -- President and Chief Executive Officer

Sure. So, the overall C4I market is slightly over $17 billion off the top of my head, Sheila, I haven't got the actual breakdown between the various elements, the C2I, the comms market and the mission computing. But we see opportunities really across all three of those submarkets, and we're actually growing the business substantially in all of them. So, it's an area that we focused on strategically. It's an area that we're pretty excited about. As I mentioned in the prepared remarks, we created over an $800 million opportunity pipeline in the deals that we've done to date and we expect to continue to grow that over time.

Sheila Kahyaoglu -- Jefferies & Company -- Analyst

Is there any way to think about how big your business is within that?

Mark Aslett -- President and Chief Executive Officer

In terms of the revenue today by market segments, let's have a quick look. So, C4I in the second quarter is 30% of total revenue on an LTM basis, it's around about 27%. So, we created a pretty significant business in really a pretty short space of time. And the good thing about it is that we're obviously able to sell into same customers on existing programs, as well as into existing customers on new programs. And I think we would bring in the dimension of being able to add security into those solutions. So, our customers are pretty excited about the opportunity there.

Sheila Kahyaoglu -- Jefferies & Company -- Analyst

Sure. And then...

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Yeah. And, Sheila, I would just add if you're looking just at the avionics, it's really, as Mark said in his prepared remarks, in addition of the whole C4I, it's really CES that is -- that we bought a couple years ago and that's really growing well.

Mark Aslett -- President and Chief Executive Officer

That's doubled in size since we bought it.

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Doubled in size. Richland Technologies, which is a smaller acquisition but gave us really important technologies. And then GECO today, which we said was about $20 million of revenue. So, it's -- we're building up mass in that business, but there is a long way to go and a huge market opportunity.

Mark Aslett -- President and Chief Executive Officer

Yeah.

Sheila Kahyaoglu -- Jefferies & Company -- Analyst

On GECO, who competes with that product line? Would you come against like somebody like a Harris or is it tech companies, who is competing with those guys?

Mark Aslett -- President and Chief Executive Officer

Yeah. It's not really our customers. I mean, we're selling into the same customer set, where we're not looking to compete with our customers directly. But as we've seen elsewhere, many of our customers are actually looking to outsource more of the work that they're currently doing in-house at the subsystem level and they're focusing on being able to pull together more of the complete solution. So that's the trend that we have at the ceiling, and we're now pursuing it in the C4I market, as well as in the Sensor and Effector market, which is where we've been historically. So same trend, just different types of computers on both the platforms.

Sheila Kahyaoglu -- Jefferies & Company -- Analyst

Sure. And the last question, I think, Mike you said second half free cash flow decelerates, is that right or did I misunderstand?

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Yeah, no. So, free cash flow is still solid, and we still think that free cash flow target of 50% overtime is reasonable for H1, we're right at that level. Working capital as a percentage of revenue is down, so we're happy with where the free cash flow is coming out. What I did say is that, we do expect increased capital spending in the second half of the year, that's driven by the consolidation of our West Coast facilities. We're looking at 5% CapEx as a percentage of revenue for the year. We were down to mid-3% for the first half, so that implies 6% in H2.

So we'll have some headwinds, so we might be a little below 50%, but we continue to be happy with how the business is generating cash, and over the long-term we still believe that 50% free cash flow to adjusted EBITDA is a good target for us. But we do have some expansion CapEx in the second half.

Sheila Kahyaoglu -- Jefferies & Company -- Analyst

Thank you.

Mark Aslett -- President and Chief Executive Officer

Associated with the acquisition integration, which is really what drives the changes in CapEx on a period-to-period basis.

Sheila Kahyaoglu -- Jefferies & Company -- Analyst

Thank you.

Operator

Thank you. And our next question comes from Seth Seifman of J.P. Morgan. Your line is now open.

Seth Seifman -- J.P. Morgan -- Analyst

Thanks very much. Good evening. Just a couple of quick questions. When you think about that facility consolidation and the work you're doing on the West Coast there, can you layout kind of the timeline and, I guess, maybe some of the tail on that and whether it has in the past is there some excess inventory that comes with a consolidation that kind of would need to get burned off into the next year just so we can kind of model that out?

Mark Aslett -- President and Chief Executive Officer

So we expect the activity to be complete by back-end of this year, early next from an RF perspective. So we've got to build out the facility and then basically move into and consolidate some of the operations. We've already gone from three sites down to two. So we closed an additional site, how long was that, some three quarters ago?

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Yeah.

Mark Aslett -- President and Chief Executive Officer

And so, this is kind of the final phase. We don't expect any inventory write-offs or anything like that associated with it. It's literally just building out capacity on the West Coast to be able to absorb the growth that we see in the business.

Seth Seifman -- J.P. Morgan -- Analyst

All right. Okay. Thanks. And then, apologize if you've addressed this, but the additional R&D that you're adding for the second half is focused on which area?

Mark Aslett -- President and Chief Executive Officer

So we're investing pretty modestly. It's kind of a couple of million dollars to really accelerate the development of our own additional secure and trusted motherboards associated with the acquisitions of Themis and Germane.

Seth Seifman -- J.P. Morgan -- Analyst

All right. Okay. Great. Okay. Thanks very much.

Mark Aslett -- President and Chief Executive Officer

Okay.

Operator

Thank you. And our next question comes from Pete Skibitski of Alembic Global. Your line is now open.

Peter Skibitski -- Alembic Global Advisors -- Analyst

Yeah, nice quarter guys. Hey, Mark, the $40 million flight controller contract that you won, it looks like a really nice win, and it sounds like maybe that gave you some upside to get to revenue guidance this year. Can you give us any more detail in terms of whether that's a military platform or commercial platform? And one thing I wasn't clear about the $40 million over 10 years, is that just design or is that -- or is there a production opportunity on top of that as well? (Multiple Speakers) on that.

Mark Aslett -- President and Chief Executive Officer

Yeah. So it is a military platform. It's a medium altitude UAV, where we've won the flight controller or mission computer, as well as the ground segment. It's working with a non-US prime to do that. And that really stemmed from the acquisition of the CES business back a couple of years ago. So, we're working on the development of that, and over time the program will go into production. So it does have a production element associated with it. It's not really the primary driver of the growth that we're seeing this year. I think the primary driver of the increase in the forecast beyond the acquisition is some of the work that we have won on some next generation missile systems.

Peter Skibitski -- Alembic Global Advisors -- Analyst

Okay. Understood. And then just, sorry if I missed this, but GECO, is it going to be accretive to GAAP EPS this year, or are they a money losing operation, could you give some more color on that?

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Yeah. No, it's small, so it's effectively on an adjusted EPS basis just slightly accretive. So $20 million of revenue run rate, but for the year our guidance has $6 million of revenue. It's about 15% EBITDA margins in there. So a little less than a $1 million of EBITDA. And when you look at the expenses, it's really just interest expense. So it's making money but for us it's relatively immaterial on the EPS line. From a GAPP EPS standpoint, there is, I think, about $700,000 of amortization that's in the numbers. So it might be ever so slightly dilutive there. But on an adjusted EPS basis it is slightly accretive.

Peter Skibitski -- Alembic Global Advisors -- Analyst

Okay, that's helpful. Thank you. The last one for me, just on CRAD, one thing I'm not clear about. What's the percentage of your CRAD revenue maybe like in 2018 or in 2019 basis? And, I guess, should we assume it's going to be down in fiscal 2020?

Mark Aslett -- President and Chief Executive Officer

So we actually haven't broken out specifically how much it is as a percent of total revenue, but it has increased, particularly I would say in the last two years, as we've seen kind of the increase in the budget and focus on our customers modernizing with their customers various systems. And we're obviously participating heavily in those upgrades. So CRAD is up 62% in Q2 and it's up 53% on an LTM basis through the end of Q2.

So, I think it's going to continue in the short-term. I mean, hard to predict exactly what the growth rate is going to be, but we are seeing a tremendous amount of new design win activity really in a number of different areas, significant opportunities in the missile defense domain, where we're seeing upgrades at various ground-based radars and new radars coming online that we're participating in. We're seeing upgrades associated with various EO/IR systems, associated with A2/AD capabilities. We talked about a little bit about the opportunity that we see in the C4I space around rugged servers, and avionics, significant opportunities in EW to deal with kind of some of the emerging threats that we see, as well as some small form factors.

And then two other areas that have been pretty rapid growth for us, albeit off a smaller base is in the smart munitions domain. And then finally space, where we've got some very interesting technologies and we're starting to see some new design win activity. So, we're involved in a lot of things. We've got some amazing technology that we've been investing in for a period of years now and our customers see that and they're supplementing R&D with some of their own to rapidly adapt that technology to those new and emerging opportunities.

Peter Skibitski -- Alembic Global Advisors -- Analyst

Okay. And just one clear, guys, CRAD comes through as either a zero margin revenue or like low-single-digit margin revenue, is that right?

Mark Aslett -- President and Chief Executive Officer

It's lower margin and the lower end of the kind of the target model that we have for gross margins, but it's not zero margin.

Peter Skibitski -- Alembic Global Advisors -- Analyst

Okay. Thanks very much.

Mark Aslett -- President and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from Ken Herbert of Canaccord. Your line is now open.

Kenneth Herbert -- Canaccord Genuity -- Analyst

Hi, good afternoon.

Mark Aslett -- President and Chief Executive Officer

Hi, Ken.

Kenneth Herbert -- Canaccord Genuity -- Analyst

Hey, Mark, just wanted to ask first, if I look at the either the quarter 11% organic growth or the full year sort of 9% to 10%. Is there any way to parse that out by what you're calling out as the drivers, I mean, how much of that would be end market sort of fundamental growth versus either share gains you're seeing or as part of the secular trends you've identified? I mean, is there any way to quantify some of the unique opportunities to Mercury relative to the broader industry growth?

Mark Aslett -- President and Chief Executive Officer

Yeah. Not necessarily kind of numerically, but we are seeing broad growth over the -- in terms of the two major markets, Sensor and Effector and C4I overall. And then kind of beneath the covers, if you look at the submarkets, we're pretty much seeing growth across all of our major market segments, and with pretty strong book-to-bills expected in them also. Beyond that, I do believe that the trends that we've mentioned around outsourcing is alive and well. If you look at the growth in our subsystems revenue in Q2, it was up 109% year-over-year and our LTM subsystems revenue was up 62% through the end of Q2, which is obviously driven some of it by the acquisition, but a lot of it is also just organic growth where we're capturing share at the subsystem level, either through outsourcing or by taking share.

We're clearly taking share from a technology perspective in two different areas. One is in RF, where we've talked about historically where there's really a flight to quality, where our customers are struggling with a number of different companies and we've been quite successful at taking away some of that business. Some of it is next-generation, some of it is business that is beginning to move into production. And then the other area is in secure and trusted computing, where we're now on our fourth generation of embedded security. And what we're seeing is a wave of activity there and we believe that secure computing is now really beginning to cross the chasm, and Mercury is -- got some industry-leading technologies and other companies don't, and we're beginning to take share in that space as well.

Kenneth Herbert -- Canaccord Genuity -- Analyst

Okay, great. That's helpful. And then as I look at Themis and Germane, have you talked about or can you provide any more detail on when you expect with the ramp there and the improvement that they start to hit sort of company margin levels? What should we expect or how should we view that sort of headwind to taper down over the next few quarters?

Mark Aslett -- President and Chief Executive Officer

We haven't been specific, right, about the actual timing of it, but I tell you that the integration of those two business is progressing extremely well. I would say we're actually slightly ahead of where we thought we were going to be in terms of our integration activities of Themis into Mercury and then Germane into Themis and Mercury as a whole. So, there's a lot of work under way, the team is performing extremely well, we're seeing a lot of opportunity.

I don't know if you would like to comment on that, Mike.

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Yeah. Ken, what we did say is when we announced the Germane acquisition which was on our Q4 earnings call. So we closed it in July that we expected a run rate of $5 million of cost synergies and that we would hit that full rate by the end of fiscal 2020. So that can provide you some guidance in terms of looking at their revenue and those synergies, when we think they're going to get back to the EBITDA range, but we haven't provided a specific quarter, but we're on track to hit the synergy plan that we announced and talked about on that call when we announced the transaction.

Mark Aslett -- President and Chief Executive Officer

Yeah.

Kenneth Herbert -- Canaccord Genuity -- Analyst

Hey, great. Thanks, that's very helpful. And just one final question. You've talked, Mark, a few times you've mentioned that bid and quote activity seems to be the highest you've seen it in quite some time. Have you seen any acceleration now into sort of fiscal 2019 and is there any sort of any reason to expect that that elevated level of activity wouldn't sort of maintain at least through calendar 2019?

Mark Aslett -- President and Chief Executive Officer

So I don't see a reason why wouldn't continue. I mean, I think, as I said in the prepared remarks, we upped our organic revenue growth target 2 to 3 points versus last fiscal year. Now, kind of expected in the range of 9% to 10%. There's a lot of a new design win activity and a good example of that or a metric that you can point to is just that increase in CRAD that I just went through the statistics on earlier. So, we feel really good about the position. We feel really good about our capabilities, the markets that we're in and our ability to continue to take share.

Now, given the some of the early stage of those design wins, they're obviously not going to go into production for some time because we're working on some next-generation capabilities, but there's a lot of new activity under way.

Kenneth Herbert -- Canaccord Genuity -- Analyst

Great. Thank you very much.

Operator

Thank you. Our next question comes from Michael Ciarmoli of SunTrust. Your line is now open.

Michael Ciarmoli -- SunTrust Robinson Humphrey -- Analyst

Hey, good evening, guys. Thanks for taking the questions. Nice quarter. Mark, just to maybe stay on the topic, I mean, you've guys have talked now, I mean, there has been a lot of Q&A here about the design wins, the bid and quote activity, you just covered being so high. I mean, what are your thoughts on the pending fiscal 2020 budget? I mean, you've got to feel pretty good here, I mean, that kind of gets complimented, I guess, with the missile defense review, where some of your big programs seem to be getting even more priority. And maybe even if you can talk about, is there going to be any potential opportunity for you guys on the radar and sensors that are going to be needed for both the hypersonic strike and counterstrike systems?

Mark Aslett -- President and Chief Executive Officer

Sure. So, multiple questions there. I think on the budget side, we'll see what ends up playing out for fiscal year 2020, obviously, it is a kind of range of what the alternatives might be. We continue to believe that, if you look over a multi-year period, we're still going to be operating in kind of a low-single digit growth on a compounded basis depending upon what your starting point is. We also believe, however, that our ability to grow above that as we have been doing remains very strong.

We are seeing opportunities in missile defense, so we're seeing a, I would say, probably three or four upgrades, as well as new potential missile defense systems. And I think with our processing capability, we are well-positioned in a number of those. We're also involved in a number of next-generation missile systems. I'm not going to mention which ones they are, or what type of weapons they are. But a big reason for -- or a primary driver of actually the increase in organic revenue this fiscal year is being driven by one of those new design wins that is moving relatively quickly.

So, I think we see a lot of opportunity in missile defense, in missile systems, whether it'd be the replenishment or new technologies and capabilities that need to be added to those systems. We're seeing a lot of work that is under way related to dealing with anti access capabilities that will lead to investments in new EO/IR systems. We're also seeing similar investments in EW, where we think that we're pretty well-positioned. So, I really like how we're positioned right now with respect to how the world is evolving and where we think the monies are going to flow, Mike.

Michael Ciarmoli -- SunTrust Robinson Humphrey -- Analyst

Got it. It makes sense. And then maybe just one last one here and shifting gears. I think you commented around opportunities for working capital efficiency. I mean, is there anything else you guys are looking at a longer supply chain, what could be in-sourced? I know you've kind of talk about that already in prior calls. But maybe talk more about what you can do to optimize and create more efficiencies in working capital?

Mark Aslett -- President and Chief Executive Officer

Sure. It's not just working capital. So, I think, as I mentioned in my prepared remarks, right, in Q2 -- early Q2, Amir Allahverdi joined the Company. Amir ran operations for Meggitt, and had a very expansive set of factories on a global basis across the world. And Amir was really responsible for introducing what became Meggitt Operating System, which is what ended up kind of leaning out their manufacturing operations. One of the biggest changes that's occurred to Mercury or occurred inside of Mercury over the last five years is the build up of our own domestic manufacturing capabilities. Some of which were existing that we've expanded in particular in RF. Others are relatively new, such as in the custom microelectronics that we acquired with Microsemi. And then we build out the digital SMT manufacturing facility in Phoenix.

So, as we kind of enter into this next phase, it's all about looking at improving, not only our working capital efficiencies, but the manufacturing operations themselves. And that work is really just beginning, and that's what we brought Amir onboard to do. So we do see an opportunity and we're already seeing some of the results. I'll give you an example, in the USMO, which is our facility -- manufacturing facility in Phoenix, the new one that we've stood up. We had a record output in terms of the amount of cogs that were shipped in the second quarter. And that was a record shipment in terms of the number of boards. We've seen a pretty significant increase in terms of on-time delivery. We've already begin to see a reduction in work in progress.

So, we're on a journey, but it's not just the facility in Phoenix, we're going to go after improvements in all of our manufacturing operations, given that we think that they're strategically important to our ability to deliver what our customers needs in terms of domestically developed and produced technologies. And also that impact they can have on our financials. So, that's where we're currently at, Mike.

Michael Ciarmoli -- SunTrust Robinson Humphrey -- Analyst

Got it. Helpful guys. Thanks a lot.

Mark Aslett -- President and Chief Executive Officer

Thank you.

Operator

Thank you. And we do have a follow-up question from Jon Raviv of Citi. Your line is now open.

Jonathan Raviv -- Citi -- Analyst

Hey, thanks for taking the follow-up. I'll keep it brief. Just on cap allocation, GECO looks good. But any updated perspective on doing something transformative, how you're thinking about equity versus debt funding? And then also, how conversations changed if at all in recent month, as it seems that budget concerns have started to weigh on multiples for the space? Thank you.

Mark Aslett -- President and Chief Executive Officer

Okay. So I'll start it off, and I'm sure, Michael want to chip in. So, we see a very robust pipeline of opportunities, and this particular opportunity we've been in conversations with the owners of GECO for quite some time. It's a proprietary opportunity that we uncovered and we work the relationship -- developed relationship that led to the deal that we announced today.

The way which we think about M&A is really thematic (ph). So, we got, as I mentioned, a couple of different themes under way in the C4I space, those being rugged servers, where we did the two significant acquisitions, Themis and Germane to create one of the industry's leading rugged server manufacturers and developers.

And the other theme is the one in avionics processing, where we prosecuted three acquisitions in the last two fiscal years alone. We're going to continue to acquire in that space, and there are additional opportunities that will expand those themes as they develop, and I'm not going to go into specific details as to the sorts of things that we're pursuing there, but we do see the opportunity to create a potentially significant businesses through future M&A.

We're also going to continue to acquire in the other part of the market, which is Sensor and Effector. We've done a several acquisitions in the RF domain. We are very choosy what type of acquisitions that we do there, and we're looking to, not just gain scale for the sake of it, but additive capabilities that will matter to our customers with a margin profile that matches what we're trying to do.

We've also done work in the custom micro electronics domain, we dramatically grown the business that we acquired from Microsemi under Mercury and we see additional opportunities for us to continue to grow in that domain. And then beyond that there are probably three or four or maybe even more themes that we are considering and potentially pursuing at some point.

So, there's a fair amount of opportunity for us to continue to grow. For Mercury, it always starts with strategy. It's not just about gaining scale, it's about creating value and how we create values through the strategy that we're pursuing.

So, I'll throw it over to Mike to maybe kind to add.

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Yeah. Well, Jon, I'll give you a little bit more. So that's the strategy just from a tactical standpoint. You asked about the pipeline, the pipeline is really active. We're seeing deals of all sizes small, medium, large. We're very active in terms of sourcing new deals on a proprietary basis. GECO is a great example of that because M&A is such an important part of our strategy. We have a very active outreach program. And as Mark said, for us, it's just sticking to our strategy and finding good strategic acquisitions, paying fair prices and then recognizing the cost and revenue synergies.

What we've done a good job at we think is being disciplined in prices we've paid over the last couple of years, even when trading multiples were relatively high or higher than they are today, and acquisition multiples were high as well. So, we passed on quite a few deals over the last couple of quarters and years due to evaluation expectations, and prices ultimately paid. We'll see if the recent rewriting of defense trading multiples impacts transaction valuations at all. From our standpoint, we're just going to keep continuing to do what we've been doing and that's remain disciplined on valuation and acquiring companies that stick with our strategy.

Mark Aslett -- President and Chief Executive Officer

And that where we can also really extract costs down revenue synergies, that's been a really important part of our strategy. We're prepared to pay fair market prices, where we think that we can create value for our shareholders by fully integrating the businesses into Mercury. I think as we outlined at our Investor Day in November, when you look at the gross purchase price versus the net of the acquisitions that we've done over the past four or five years, there is substantial delta there. And then we think our strategy is working, Jon.

Jonathan Raviv -- Citi -- Analyst

Indeed. Thanks a lot guys. Have a good evening.

Mark Aslett -- President and Chief Executive Officer

Thank you.

Operator

Thank you. And Mr. Aslett, it appears that there is no -- or there are no further questions. Therefore, I would like to turn the call back over to you for any closing remarks.

Mark Aslett -- President and Chief Executive Officer

Okay. Well, thank you very much for listening this evening. We look forward to speaking to you all again next quarter. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.

Duration: 67 minutes

Call participants:

Michael Ruppert -- Executive Vice President, Chief Financial Officer and Treasurer

Mark Aslett -- President and Chief Executive Officer

Peter Arment -- Robert W. Baird -- Analyst

Jonathan Raviv -- Citi -- Analyst

Sheila Kahyaoglu -- Jefferies & Company -- Analyst

Seth Seifman -- J.P. Morgan -- Analyst

Peter Skibitski -- Alembic Global Advisors -- Analyst

Kenneth Herbert -- Canaccord Genuity -- Analyst

Michael Ciarmoli -- SunTrust Robinson Humphrey -- Analyst

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