This article was originally posted on SeekingAlpha (November 8th, 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 (SPA) is now a $203MM LTM revenue company that designs, develops and manufactures complex electronic and electromechanical products and subassemblies (and provides related services) for the medical, military and aerospace, and industrial and instrumentation markets.
Strong Q4 FYE June 2011 results, announced a little over a month ago, show a company that continues positioning for both growth and higher margins in the future, with an upcoming Q1 earnings announcement and conference call this week. The upcoming results are sure to further confirm Sparton’s repositioning to sustained profitability by an outstanding turnaround team that has already proven itself capable of making tough cuts when, and if, necessary, as well as investments in both R&D and business development and highly accretive acquisitions.
At present prices, Sparton’s $88MM market valuation is less than 1.2X book with almost $23MM of net cash equal to over one-fourth of that market value. With sustained profitability, Sparton still is in a valuation catch-22, lacking meaningful analyst coverage (only Sidoti formally covering and B Riley informally commenting) and the trading liquidity and expanded price multiples that such coverage generates. Sparton hasrecently authorized its first stock buyback in many years.
Sparton’s current $65MM enterprise value is now around 5.1X LTM operating EBITDA (ex impairment charge, property sales gains, etc.) and a low 0.3X LTM revenues of $203.4MM. Note, this revenue rate is already supported by $137.3MM of contracted backlog at FYE June 30, 2011.
Outstanding Operating Performance And Substantial Y/Y Improvement – Ex Non-Recurring Items
For Q4, Sparton reported a $0.07/share net loss resulting from a $16.8MM of non-cash goodwill impairment and writedown on assets acquired by prior management in a 2006 medical segment acquisition. Absent this writedown, (as page 4-5 of Sparton’s recent Q4 FY’11 earnings call slide show, also illustrate) Sparton would have reported $0.28/share pro-forma EPS for Q4. Also, stripping out prior year’s one-time gain on sale of PP&E, Sparton’s, “apples to apples” pro-forma “clean” June FY’11 of $0.64/share was 60% higher than $0.40/share pro-forma June FY’10.
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:
“… to 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 and 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 and Security Systems (“DSS”), Medical Devices, and Complex Systems (formerly Electronics Manufacturing Services “EMS”) of differing gross margins. As illustrated in my August 29, 2011 article entitled “Sparton Sell-Off Presents Attractive Valuation And Rebound Opportunity,” and now the recent Q4 earnings call slide show, for FY June 2011, the company’s target gross margin ranges (and actual) by segment were DSS: 20%-25% (22%), Medical 13%-16% (13%), and Complex Systems 5%-8% (10%).
For FY June 2012, management guidance maintained target gross margin ranges for both the DSS and Medical segments at 20%-25% and 13%-16%, respectively and increased the Complex Systems segment margin range guidance to 7%-10%. Sparton also recently launched a new fourth business unit, Navigation and Exploration, commercializing some of Sparton’s defense technology in digital compasses and hydrophones into new products for oil and gas exploration, sea floor mapping and port security applications.
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 (DSS 34%; Medical 48%; Complex Systems 18%).
Fixing Or Divesting Underperforming Lines Of Business
After three years of consecutive quarterly operating losses and a liquidity crisis, my firm Lawndale Capital Management, launched a proxy fight in 2008 that successfully resulted in board and management changes in Winter 2008/Spring 2009. These changes, and almost complete replacement of former Sparton senior managers, led to substantial restructuring actions (and charges) during FYE June 2009 and part of FYE June 2010 that 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.) These improvements continued into FY June 2011 in Sparton’s lagging Complex Systems (formerly EMS) segment with gross margins rising to 10% in FY’11, up from only 4% in 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 and 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 U.S. (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 in Colorado, where the Byers Peak operations are being consolidated.
Q4 results clearly illustrate that these acquisitions have been and should continue to be nicely accretive. Slide 11 of Sparton’s recent Q4 FY’11 earnings call slide show, show substantial gross margin improvement from 5.4% to 14.5% for Q4 ended June and from 3.5% to 13.3% for the full FYE June. With Delphi only acquired in March 2011, there should be additional year-over-year improvements coming from this facility in Sparton’s Medical segment.
Generating Profitable Organic Growth
Over the last few years, Sparton has made meaningful new investments in sales and marketing and research and 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 U.S. 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 and Exploration, commercializing some of Sparton’s defense technology in digital compasses and hydrophones into new products for oil and gas exploration, sea floor mapping and port security applications.
Sparton and its joint venture, ERAPSCO, has received substantial defense-related research and development contracts toward new sonobuoy designs and applications to assist a new high altitude anti-submarine warfare (HAASW) mission equipping Boeing’s (BA) new P-8 Poseidon jet, including a September 2011 $8.9MM subcontract to modify existing sonobuoy models. (See also my article entitled, “Sparton: Ready to Cash In on the Naval Arms Race”.)
Slides 12 and 13 of Sparton’s recent Q4 FY’11 earnings call slide showare quite helpful to understanding Sparton’s three prongs to achieve the growth targeted by managements ambitious vision, above.
Overcoming Bumps On The Path – Siemens’ Move To Dual Sourcing
In the Q4 and FY’11 press release, Sparton disclosed that it had received notice from its large medical customer, Siemens, of Siemens’ plan to reduce its supply risks by adding another company to join Sparton in its chain. Siemens continues to be a Sparton customer and is not expected to even begin second sourcing its products until the December quarter at the earliest. In the Q4 conference call transcripts, Sparton’s management said the company would be able to offset potential revenue losses from Siemens’ dual sourcing with other incremental revenue in fiscal 2012.
They further supported this answering a conference call question asking whether maintained gross margin guidance for the medical segment included potentially lost Siemens’ sales. They answered affirmatively and highlighted Siemens business is lower margin. Present backlog for medicalwas actually up vs. prior year so any headwinds from potential diminished revenues have not yet been encountered. The long lead time to add a second source will provide time for Sparton management to make any necessary cuts and production allocations to shorten and minimize this potential “bump” in Sparton’s cash flow growth.
Bumps in the path can sometimes also turn into opportunities. For example, Sparton customer Goodrich has entered into an agreement to be acquired by United Technologies (UTX). UTX’s management is considered very forward thinking and, as such, has moved to outsource manufacturing more aggressively than Goodrich. Sparton should have an opportunity to expand its business opportunities with Goodrich’s new parent.
Assuming Sparton simply carries this past year’s improved profitability over to both the recently acquired Byer’s Peak and future planned acquisitions, while reaping modest benefits from its R&D and business development investments, any bump in the road from diminished sales to Siemens, discussed, above, will be fairly quickly filled, making the current market valuation of SPA a compelling risk/reward investment opportunity.
Disclosure: At time of writing, author and/or funds author manages hold a long position in this issuer and is a 13D filer. Author and the funds may buy or sell securities of this issuer at any time.