Mercury Systems has had an impressive run over the past six months as its shares have beaten the S&P 500 by 24.2%. The stock now trades at $37.87, marking a 34.6% gain. This was partly due to its solid quarterly results, and the performance may have investors wondering how to approach the situation.

Despite the momentum, we're swiping left on Mercury Systems for now. Here are three reasons why we avoid MRCY and a stock we'd rather own.

Why Do We Think Mercury Systems Will Underperform?

Founded in 1981, Mercury Systems (NASDAQ:MRCY) specializes in providing processing subsystems and components for primarily defense applications.

1. Core Business Falling Behind as Demand Declines

In addition to reported revenue, organic revenue is a useful data point for analyzing Defense Contractors companies. This metric gives visibility into Mercury Systems’s core business because it excludes one-time events such as mergers, acquisitions, and divestitures along with foreign currency fluctuations - non-fundamental factors that can manipulate the income statement.

Over the last two years, Mercury Systems’s organic revenue averaged 6.5% year-on-year declines. This performance was underwhelming and implies it may need to improve its products, pricing, or go-to-market strategy. It also suggests Mercury Systems might have to lean into acquisitions to grow, which isn’t ideal because M&A can be expensive and risky (integrations often disrupt focus).

2. New Investments Fail to Bear Fruit as ROIC Declines

ROIC, or return on invested capital, is a metric showing how much operating profit a company generates relative to the money it has raised (debt and equity).

We typically prefer to invest in companies with high returns because it means they have viable business models, but the trend in a company’s ROIC is often what surprises the market and moves the stock price. Unfortunately, Mercury Systems’s ROIC has decreased over the last few years. Paired with its already low returns, these declines suggest its profitable growth opportunities are few and far between.

3. High Debt Levels Increase Risk

As long-term investors, the risk we care about most is the permanent loss of capital, which can happen when a company goes bankrupt or raises money from a disadvantaged position. This is separate from short-term stock price volatility, something we are much less bothered by.

Mercury Systems’s $591.5 million of debt exceeds the $158.1 million of cash on its balance sheet. Furthermore, its 15× net-debt-to-EBITDA ratio (based on its EBITDA of $28.91 million over the last 12 months) shows the company is overleveraged.

At this level of debt, incremental borrowing becomes increasingly expensive and credit agencies could downgrade the company’s rating if profitability falls. Mercury Systems could also be backed into a corner if the market turns unexpectedly – a situation we seek to avoid as investors in high-quality companies.

We hope Mercury Systems can improve its balance sheet and remain cautious until it increases its profitability or pays down its debt.

Final Judgment

We cheer for all companies making their customers lives easier, but in the case of Mercury Systems, we’ll be cheering from the sidelines. With its shares outperforming the market lately, the stock trades at 174.1× forward price-to-earnings (or $37.87 per share). This multiple tells us a lot of good news is priced in - we think there are better investment opportunities out there. We’d recommend looking at TransDigm, a dominant Aerospace business that has perfected its M&A strategy.

Stocks We Would Buy Instead of Mercury Systems

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