Sparton Sell-Off Presents Attractive Valuation And Rebound Opportunity

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:

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 businessmaking 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, “Sparton: Ready to Cash In on the Naval Arms Race”.)

In Conclusion

Assuming Sparton simply maintains its prior quarter’s improved profitability and carries that over to its most recent March, 2011 acquisition of medical device maker, Byer’s Peak, the currently depressed market valuation of SPA presents a compelling risk/reward investment opportunity. This opportunity may also be time sensitive for investors due to the company’s investor communication efforts and ability to begin speaking of this most recent quarter and FY’12 growth plans in the very near future.

 

 

Disclosure: At the 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.