Sparton Corporation (NYSE: SPA), a $220.8MM LTM revenue company that designs and manufactures complex electronic and electromechanical products and subassemblies, recently announced profitable Q1 FYE June 2013 results followed by an informative conference call that communicated the temporary nature of weaker y/y comparisons and maintained guidance of y/y growth over a strong FYE June 2012. This growth guidance was before taking into account Sparton's newly announced definitive agreement to acquire Onyx EMS, LLC. If successfully consummated, the Onyx acquisition will be Sparton's largest to date with the potential to be highly accretive to earnings.
September Q1 FYE 2013's less than expected profits stemmed from two unrelated product production/acceptance delays, (discussed below) which have partially been made up already in the first part of the current Q2. Absent these delays, September quarterly results would have added to the impressive growth Sparton generated during the preceding fiscal year ended, June 2012. Even using what are now 'depressed' trailing 12-month operating results (at least until the shortfall is reversed by delivery of the delayed products), Sparton's market value remains quite attractive.
With November 12, 2012's closing price for SPA of $12.74/share, Sparton's almost $41.4MM of net cash at 9/30/12 is equal to almost 1/3 of the company's $130.4MM market valuation. Sparton's current $89.0MM enterprise value ($130.4MM market cap less $41.4MM net cash) is now around only 5.8X LTM operating EBITDA of $15.4MM (adjusted to exclude one-time gains) and 0.4X LTM revenues of $220.8MM. Note, this revenue rate as a base for future growth is already supported by contracted backlog from September 31, 2012 of $156.1MM.
Three Segments: Defense & Security, Medical, And Complex Systems
Sparton Corp targets customers in the Medical, Military & Aerospace, and Industrial & Instrumentation markets via the following three business segments, each with substantially differing gross margin ranges:
- Defense & Security Systems ("DSS") 20-25% gross margin
- Sparton Medical 13-16% gross margin
- Complex Systems 7-10% gross margin
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, port security, and other unmanned air, land and sea applications. For now, this start-up NavEx unit remains within the DSS segment results.
Outstanding Full FYE June 2012 Operating Growth and FY 2013 Guidance
As discussed in Sparton's Q4 and FYE June 2012 earnings press release, Sparton delivered strong performance in its most recently completed fiscal year. Sales grew 10%, fueled by a combination of organically grown and acquired revenues. Gross and operating margins expanded in all three segments. Slides 8-10 of Sparton's Q4/Full Year FYE June 2012 earnings call slide show illustrate how Sparton achieved gross margins in each of its segments within or above its guided target ranges. Slide 7 of the same slide show illustrates how comparably adjusted FY '12 pre-tax Income grew by 39% vs FY '11's results. Sparton reported adjusted net earnings of $0.91/share for FYE June 2012, up from an adjusted $0.64/share in FY 2011.
On Sparton's Q4 and FYE June 2012 earnings conference call, management provided guidance that FYE June 2013's results would be even better than the recently completed strong year.
… the progress we have made should provide for year-over-year increases in revenue and profitability with the second half of fiscal 2013 being stronger than the first half as experienced in the previous two fiscal years.
September Q1 FY 2013 Misses Y/Y Growth From Product Delays That Are Already Reversing
While the FY 2013 guidance called for a stronger second half of FYE 2013 than Q1 and Q2, Sparton's recently reported profitable September Q1 FY 2013 results were still less than expected. Despite medical segment revenues enjoying 2.2% y/y growth and expanded margins, Sparton's overall Q1 sales declined $2.8MM or 5.4%, contributing to a y/y operating profit decline of $1.0MM. Temporary product acceptance/order delays in the DSS and Complex Systems segments deferred $3.5MM and $1.3MM in revenues, respectively, along with their associated profits.
The $3.5MM DSS segment revenue shortfall resulted from two sonobuoy lots that failed drop tests conducted by the Navy in the final weeks of September under conditions which were outside of the product's design specifications. As discussed on the September Q1 FY 2013 results conference call as part of management's prepared remarks and Q&A, already one of these two lots has been accepted and the second lot is expected to be accepted as early as a week or two from now by waiver or within the current Q2 if by retest under contracted conditions.
Had the sonobuoy drop tests been originally conducted according to contract and passed, Sparton's revenues for the quarter would have been up y/y and profits closer to prior year's strong quarter. It is no wonder that on the conference call management maintained guidance for FY 2013 to exceed 2012 and added that Q2 will now exceed prior year as well.
In the meantime, according to Sparton's September Q1 FY 2013 10-Q, the company's backlog at the end of September grew to $156.1MM, up 7% y/y and also up 6% from prior quarter. Complex Systems segment backlog reached its highest level in 3 years and greater than 10% of DSS segment's $77.9MM backlog is again comprised of higher-margin foreign sonobuoy orders.
Sparton Positioning To Double Its Revenues And At Higher Margins
Sparton management has published a vision statement 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.
This 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 17 and 18 of Sparton's Q4 Fiscal 2012 investor road show presentation are quite helpful to understanding Sparton's three pronged approach by segment to growth investments: Internal R&D, Business Development and Strategic M&A.
Already, 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), Fresenius Medical Care/Fenwal (NYSE:FMS), and NuVasive (NUVA), in the DSS segment: the US Navy, Northrop Grumman (NYSE:NOC) and BAE Systems, and in the Complex Systems segment: Goodrich (NYSE:GR), Raytheon (NYSE:RTN), and Parker Hannifin (NYSE:PH). As discussed, above, Sparton also launched its Navigation & Exploration unit, commercializing some of Sparton's defense technology in digital compasses and hydrophones into new products.
Acquisitions Are Key; Onyx EMS adds new region, products, customers, AND EARNINGS
In order for Sparton's management to be able to achieve its ambitious growth goals, it not only has to grow "legacy" Sparton organically, but it has to also successfully acquire several businesses that it also grows. So far, the company's management team has proved capable of that task.
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.") Then, 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 have now been consolidated.
On November 6, 2012, Sparton announced a definitive agreement to acquire Onyx EMS, LLC, for $43.5MM in cash. Onyx, with sites in Watertown, South Dakota and Minneapolis, Minnesota, manufactures medical devices for OEM and emerging technology companies, including products for cardiovascular diagnostics, hearing assistance, patient temperature and warming, point-of-care diagnostics, and surgical equipment used in intraosseous medicine. The company also has a presence in the industrial market, providing products such as precision measurement instruments for monitoring air quality and pollution, commercial fire and smoke alarm systems, sensing tools, test fixtures, and complex LED assemblies.
Onyx will initially provide Sparton an incremental $50MM of annual revenues at 18% gross margins, higher than Sparton's current medical segment. The acquisition will provide Sparton further geographic expansion regionally into the Minneapolis medical device corridor and further diversification of Sparton's customer base through both existing programs and a strong business development pipeline. Additionally, Onyx existing customers will be able to utilize Sparton's expanded list of service offerings such as its full engineering design capabilities and low-cost country footprint in Vietnam, which was recently given FDA clearances.
Taking $43MM of Sparton's cash that has been earning very little in interest income and acquiring substantial cash flow that is likely to grow will be accretive to SPA's earnings - potentially VERY accretive. Sparton's press release on the Onyx acquisition was restricted by terms of the purchase agreement from disclosing too much specific information until the deal closes. However, during the Q1 FY 2013 conference call I specifically asked about management's IRR requirements for acquisitions like Onyx. The low end of the range management answered was 20%. 20% on a $43MM purchase calculates out to $8.6MM pre-tax and, assuming a 35% tax rate, $5.6MM net of tax - or $0.55/share annually.
Stock price weakness in SPA shares resulting from September Q1 FYE 2013's less than expected profits present a temporary window of purchasing opportunity. The product acceptance/order delays, causing the earning miss, have already begun to reverse themselves. In addition, the successful completion of the large Onyx EMS acquisition at the end of November followed by required financial disclosures will provide information making future sizable earnings accretion clear to all who read such documents.
With further organic growth of existing and newly acquired businesses 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.
Additional 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.