Sparton Corporation (NYSE: SPA), a $218MM LTM revenue company 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, just announced strong Q2 FYE June 2012 results. These results, highlighted by 20% growth in revenues, (up 14% net of this past year's acquisition of Byers Peak) show Sparton has mostly overcome the speed bump in its growth path from reduced sales to one of its large medical customers, Siemens Medical (SI), stemming from Siemens' move to reduce supply risks by adding another company to join Sparton in its manufacturing chain.
Sparton's renewed organic sales growth further confirms 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. Sparton's accretive acquisitions of Byers Peak and the larger August 2010 purchase of Delphi Medical Systems, meaningfully expanding Sparton's medical device manufacturing into the therapeutic device sub-market, additionally position the company for both growth and higher margins in the future.
At February 9, 2012's closing price of $8.60/share, Sparton's $86.5MM market valuation remains around 1.1X book with almost $29MM of net cash at 12/31/12 equal to roughly 1/3 of that market value. While sustainably profitable and growing again, Sparton remains 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. Through the end of January 2012, Sparton has executed on a stock buyback plan announced in August 2011, repurchasing and retiring 338,000 shares for around $2.7MM.
Sparton's current $57.6MM enterprise value ($86.5MM market cap less $28.9MM net cash) is now around 4.2X LTM operating EBITDA of $13.6 (ex impairment charge, property sales gains, etc.) and a low 0.26X LTM revenues of $218.5MM. Note, this revenue rate is already supported by $126.5MM of contracted backlog at December 31, 2011.
Outstanding December Q2 Operating Performance And Substantial Y/Y Improvement
As discussed in Sparton's December 2011 Q2 earnings press release, in addition to the sales growth discussed above, Sparton grew gross profit by almost 16% and adjusted EBITDA 65% from prior year's quarter. For Q2, Sparton reported net earnings of $0.19/share that included a very small gain on the sale of a long-held investment in a private company offset by an even smaller restructuring charge vs. $0.14/share in December 2010 quarter that did not have a full GAAP tax charge. Taking out non-recurring net benefits, (see page 5 of Sparton's recent Q2 FY'12 earnings call slide show) from each year's period, Sparton would have reported $0.18/share pro-forma EPS for this recent December Q2, 80% higher than a fully-taxed $0.10/share in the prior year's December quarter. Thus, earnings not only grew this quarter, but the growth rate accelerated over prior quarters'.
Three Segments, Defense & Security, Medical, And Complex Systems With Differing Margins
Sparton Corp. is currently segmented into three business units: Defense & Security Systems ("DSS"), Medical Devices, and Complex Systems (formerly Electronics Manufacturing Services "EMS") with substantially differing gross margins. Sparton also 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. For now, this start-up NavEx unit remains within the DSS segment results.
As illustrated in slides 6-8 of Sparton's recent Q2 FY'12 earnings call slide show, Sparton achieved gross margins in each of its segments at or near its guided target ranges for FYE June 2012 as follows (actual December Q2 margins in parenthesis): DSS: 20%-25% (19%), Medical 13%-16% (14%), and Complex Systems 7%-10% (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:
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 generating profitable organic growth, making complementary and compatible acquisitions, and fixing or divesting underperforming lines of business. Slides 12 and 13 of Sparton's June Q4 FY'11 earnings call slide show are quite helpful to understanding Sparton's three prongs to achieve the growth targeted by management's ambitious vision above.
Profitable Organic Medical Segment Growth Has Overcome Siemens Move To Dual Sourcing
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, 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 Navigation & Exploration unit, 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 has not disclosed any large customer names yet.
In Sparton's June Q4 and FY'11 press release, the company 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 manufacturing chain on two programs, which annually generated $28MM of Siemens' $36MM in total business with Sparton. Sparton continues to sole source other programs of Siemens that are not expected to be dual-sourced due to these product programs' more limited remaining life and the costs to obtain regulatory certification of an additional supplier. At the time, Sparton estimated Siemens' move to dual-source certain programs might negatively impact Sparton's annual sales by between $12MM to 16MM.
Over the course of the first half of this FYE June 2012, as the reduction in sales to Siemens has ramped in, Sparton has been able to more than offset this segment revenue decline with increased sales to other medical customers. This is best illustrated by the table in slide 11 of Sparton's recent Q2 FY'12 earnings call slide show showing other medical segment sales rising by $10.3MM from the 2nd half of FY'11 to the 1st half of this FY'12, while Siemens sales on its dual-sourced programs dropped by $7.9MM. Sparton's introductory script of its Q2 conference call gave guidance that Sparton expects this $7.9MM pace to only decline further to around $4.5-$5.5MM in the 2nd half of FY'12 and that it "will be fully offset by increased sales with existing customer programs coupled with new business awards."
Other Profitable Organic Growth Opportunities
During the recent December Q2 FY 12 earnings conference call question & answer session, Sparton management not only highlighted a continuation of expected growth in the Medical segment but across all segments. This not only included Complex Systems, where Sparton is having success with its new prototyping service offerings, but also included the DSS segment, despite overall US defense spending cutbacks.
In particular, in Sparton's introductory script of its Q2 conference call, management highlighted potential Defense Department increases in that "Congress appropriated $95 million, an 8% increase from the prior year's budget, for the line-item where sonobuoy product purchases are covered." Increased Foreign sonobuoy sales at higher margins are also expected. Also, Sparton and its sonobuoy joint venture, ERAPSCO, has received substantial defense-related research & 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. Finally, according to slide 10 of Sparton's recent Q2 FY'12 earnings call slide show, the company expects, in the March or June quarter, contracts for the SSQ-101 ADAR sonobuoy and the new SSQ-125 sonobuoy. (See also my article entitled, "Sparton: Ready to Cash In on the Naval Arms Race".)
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's Medical segment has moved into the therapeutic device market, specifically targeting Cardiology, Orthopedic, and Surgical segments via the two highly accretive acquisitions of Delphi Medical and Byers Peak, mentioned, above. These acquisitions provided not only a new and diversified customer base but also expanded Sparton's geographic reach into the western US. (For greater detail on the Delphi acquisition, see my article entitled, "Sparton: Delphi Medical Acquisition Should Be Highly Accretive".) While the Byers Peak acquisition closed in March 2011, it wasn't until the end of November 2011, 2/3rds into this most recent quarter, that manufacturing consolidation into Delphi's Frederick, Colorado facility was completed. Thus, additional margin benefits may still result from this successful acquisition.
From several answers given on the recent December Q2 FY 12 earnings conference call, it is clear that larger synergistic acquisitions are a main focus of management.
Fixing Or Divesting Underperforming Lines Of Business As discussed more fully in my November 8, 2011 article entitled "Sparton Corp.: Strong Q4 Operating Results Bode Well For Q1", after my firm, Lawndale Capital Management, launched a proxy fight in 2008 that successfully resulted in board and management changes, Sparton removed huge costs from its operations, while jettisoning unprofitable contracts, and shuttering grossly under-utilized and inefficient manufacturing capacity over the past few years. For example, in Sparton's Complex Systems (formerly EMS) segment, these improvements continued into FY June 2011 with gross margins rising from only 4% in FY'10 to 10% in FY'11, where this improved gross margin has remained in FY'12's first half as well. During the recent December Q2 FY 12 earnings conference call question & answer session, management confirmed that some legacy contracts remain not optimally priced and would be improved upon as contracts roll over. In addition, on the call, in response to one of my questions regarding DSS segment sonobuoy quality improvement costs, management said that recent increased costs peaked in the most recent December quarter and, in addition to these on-going costs declining, and they should pay off in the future with fewer rejected lots and less rework expense.
In Conclusion
With the bump in the road from diminished sales to Siemens now quickly overcome, and further organic growth and margin improvements on the horizon for Sparton, the current market valuation of SPA shares is a compelling risk/reward investment opportunity worth researching further. Future planned acquisitions and investments in R&D and business development make the opportunity even more compelling.
Disclosure: I am long SPA.
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