Sparton Corp: Strong Q4 Operating Results Bode Well For Q1

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.

In Conclusion

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.




About the Author

AndrewShapiro
Andrew Shapiro is Founder, President and Portfolio Manager of Lawndale Capital Management, an investment advisor that has managed activist hedge funds focused on small- and micro-cap companies for over 18 years. Mr. Shapiro’s proactive ownership approach has been effective in directly creating and unlocking shareholder value in Lawndale’s portfolio companies and has contributed to Lawndale’s activist funds often being ranked among the top event-driven and small-cap value funds in peer databases for long-term performance. In addition to leading Lawndale, Mr. Shapiro has also served as a Director or Observer on portfolio company boards and debt and equity bankruptcy committees. Mr. Shapiro is a member of the National Association of Corporate Directors (NACD) and Lawndale has been a long-time Sustaining Member of the Council of Institutional Investors (CII). Mr. Shapiro has more than two decades of portfolio management and analytically varied experience from a number of "buy-side" positions, employing a rare combination of credit, legal and equity analytic and workout skills. Prior to founding the Lawndale organization in 1992, Mr. Shapiro managed the workout and restructuring of large portfolios of high-yield bonds, distressed equities and risk arbitrage securities for the Belzberg family's entity, First City Capital. Before joining First City, Mr. Shapiro was involved in numerous highly leveraged corporate acquisition and recapitalization transactions for both Manufacturers Hanover Trust and the Spectrum Group, a private equity firm. Mr. Shapiro received his JD degree from the UCLA School of Law where he was an Olin Fellow, an MBA from UCLA's Anderson Graduate School of Management where he was a Venture Capital Fellow and a BS in Business Administration from UC Berkeley's Haas School of Business, where he has taught finance courses and frequently guest lectures. Mr. Shapiro is often quoted on matters of corporate governance, fiduciary duty and activist investing and has been the subject of several articles, including a Business Week article in 2000 calling him “The Gary Cooper of Governance”. He is also a frequent speaker on corporate governance and activist investing issues at a broad range of prestigious forums that include the Council of Institutional Investors, National Association of Corporate Directors, American Society of Corporate Secretaries, SEC Advisory Committee on Small Public Companies, and the Director’s education programs of Stanford Law School, UCLA Anderson Grad. School of Mgmt., the Wisconsin Business School and Yale’s Millstein Center for Corporate Governance, among others. Mr. Shapiro started Lawndale’s funds in 1993 with only $188,000 under management and through performance and added capital has grown the firm’s managed assets substantially. In many of its investments, the firm plays a constructive relational role by actively working with Boards and management teams to help them achieve their strategic and operating goals. In other investments, Lawndale is a direct value-unlocking catalyst, utilizing a range of tools that include aggressively promoting improvements in a company's governance and operational structures, asserting shareowner’s legal rights and taking active roles in restructuring and buyout proposal negotiations.