This article was originally posted on SeekingAlpha (August 29th, 2011) by Andrew Shapiro. Andrew is PM of Lawndale Capital Management, an investment advisor that has managed activist hedge funds focused on small- and micro-cap companies for over 18 years. His full profile and archive of articles can be found here.
Sparton Corporation (NYSE: SPA) is a company ($183MM LTM revenue) that designs, develops and manufactures complex electronic and electromechanical products and subassemblies (and provides related services) for the Medical, Military & Aerospace, and Industrial & Instrumentation markets. This month’s substantial sell-off in Sparton’s stock price, during an information “vacuum”, has created a compelling risk/reward valuation and time sensitive window of opportunity for investors before Sparton’s management discuss current results.
Over the past 30 days, Sparton’s stock price is down >25%, far greater than the broad market, including small- and micro-cap indices. This decline is likely the result of undeserved investor anxiety from the lack of meaningful company news during a time of great broad market turmoil.
Sparton has yet to report its June quarterly results as its fiscal year ends in June. According to the Investor Relations page on Sparton’s website, the company’s earnings release and next-day conference call for discussion of Q4 and a successful FY2011 ended June, will occur on September 7-8, 2011. Following this release, Sparton’s proven management team (which has displayed commendable investor relation’s skills) will be able to speak to the investment community about Sparton’s most recent results and growth plans for the coming FY2012.
With sustained profitability and over $23 million or 30% of its current market value in net cash, Sparton still is in a valuation catch-22, lacking meaningful analyst coverage and the trading liquidity and expanded price multiples that such coverage generates.
No Negative News From Sparton To Motivate Its Stock Price Decline
Sparton’s stock price is now down over 30% below its 52-week high of $10.88/share, set only 3 ½ months ago in May, when its last quarterly report (a strong one) was made. All the news releases from the companysince this earnings announcement have been positive, reflecting new product introductions, reduction of board size through the retirement of legacy (pre-2008) directors, and upcoming investor relation’s presentations. Below is a list of those headlines:
- AUG 22: Sparton’s Complex Systems Exhibiting at LandWarNet 2011
- AUG 16: Sparton Defense And Security Launches New & Advanced Navigation Sensors And Hydrophone Products
- AUG 16: Sparton Corporation To Present at Midwest IDEAS Investor Conference
- AUG 4: Sparton Announces Board of Director Change
- JUN 28: Sparton Announces Board of Director Changes
- MAY 18: Sparton To Present at the B. Riley Investor Conference
- MAY 10: Sparton Corporation Reports $0.25 EPS for Fiscal 2011 Third Quarter; Net Sales Increase 30%
Sparton’s Valuation Now At Even More Attractive Levels
At present prices, Sparton’s $75MM market valuation is not only down to near present book value but also, with its over $24MM of net cash, its $51MM enterprise value is <5X LTM EBITDA and an amazingly low <0.3X LTM revenues of $183MM. Note, this revenue rate is already supported by $122.4MM of contracted backlog at March 31, 2011.
Sparton Continues Positioning For Growth And At Higher Margins
Sparton is moving from a successful turnaround into a growth story with a stated vision as follows:
Become a $500 million enterprise by fiscal 2015 by attaining key market positions in our primary lines of business and through complementary and compatible acquisitions; and will consistently rank in the top half of our peer group in return on shareholder equity and return on net assets.
Management’s vision of higher revenues at higher rates of returns involve transitioning Sparton from a traditionally defined ‘contract manufacturer’ to a higher margin full service developer, designer, and manufacturer of complex & sophisticated electromechanical devices. This transition is being achieved by a combination of fixing or divesting underperforming lines of business, making complementary and compatible acquisitions, and generating profitable organic growth.
Sparton Corp. is currently segmented into three business units: Defense & Security Systems (“DSS”), Medical Devices, and Complex Systems (formerly Electronics Manufacturing Services “EMS”) of differing gross margins. For FY2011, the company’s target gross margin range by segment was DSS: 20%-25%, Medical 13%-16%, and Complex Systems 5%-8%. Sparton also recently launched a new fourth business unit,Navigation & Exploration, commercializing some of Sparton’s defense technology in digital compasses and hydrophones into non-military products.
As discussed, below, Sparton management has outlined and begun delivering on its plan by growing its two higher margin segments, DSS and Medical, while shrinking the low-margin Complex Systems segment into improved profitability to either earn an adequate return or eventually divest it.
Sparton’s return on equity and return on assets has already greatly improved due to a very favorable shift in segment revenue mix from FY’09 (DSS 19%; Medical 29%; Complex Systems 52%) to FY’11 plan (DSS 32%; Medical 49%; Complex Systems 19%)
Fixing Or Divesting Underperforming Lines Of Business
After 3 years of consecutive quarterly operating losses and a liquidity crisis, board and management changes at Sparton in 2008 and early 2009 led to substantial restructuring actions (and charges) during FYE June 2009 and part of FYE June 2010. These cathartic changes removed huge costs from Sparton’s operations, while jettisoning unprofitable contracts and shuttering grossly under-utilized and inefficient manufacturing capacity. (See also, “Sparton: Turnaround Team Returns Micro-Cap Manufacturer to Profitability” by Adam Sues) “Sparton: An Undiscovered Turnaround” by John Rolfe.) In the most recent Q3 FY’11, Sparton’s continuous improvement activities further improved its Complex Systems segment gross margins to 11%, up from only 5% in Q3 FY’10.
Making Complementary And Compatible Acquisitions
In addition to Sparton’s plan to improve the Medical segment’s market share within the in-vitro diagnostics market through geographic expansion and new & increased vertical offerings, the company has moved into the therapeutic device market, specifically targeting Cardiology, Orthopedic, and Surgical segments via two highly accretive acquisitions.
First, in August 2010, Sparton purchased the assets of Delphi Medical Systems, which meaningfully catapulted Sparton into the therapeutic device market, providing not only a new and diversified customer base but also expanding Sparton’s geographic reach into the western US. (For greater detail on this acquisition, see my article entitled, “Sparton: Delphi Medical Acquisition Should Be Highly Accretive”.)
Most recently, in March 2011, Sparton acquired the assets of Byers Peak, another therapeutic device manufacturer located very near Sparton’s Delphi facility. These operations are being consolidated into the Sparton’s existing facilities, likely making this acquisition nicely accretive.
Generating Profitable Organic Growth
Over the last few years, Sparton has made meaningful new investments in sales & marketing and research & development to engage new customers as well as enhancing relationships with key existing customers that have included – in the Medical segment: Siemens Medical (SI), Fenwal, and NuVasive (NUVA), in the DSS segment: the US Navy, Northrop Grumman (NOC) and BAE Systems, and in the Complex Systems segment: Goodrich (GR), Raytheon (RTN), and Parker Hannifin (PH).
Sparton recently launched a new fourth business unit, Navigation & Exploration, commercializing some of Sparton’s defense technology in digital compasses and hydrophones into new products for oil & gas exploration, sea floor mapping and port security applications.
Sparton and its joint venture, ERAPSCO, has received substantial defense-related research & development contracts toward new sonobuoy designs and applications to assist high altitude anti-submarine warfare (HAASW) and Communications at Speed and Depth (CSD) programs. (See also my article entitled, “