Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)

Sparton Corporation (NYSE:SPA)

F2Q13 Earnings Call

February 7, 2013 11:00 am ET

Executives

Michael W. Osborne – Senior Vice President - Corporate Development

Cary Wood – President, Chief Executive Officer, Board Member, Executive Committee Member

Mark Schlei – Chief Financial Officer

Analysts

Arnold Ursaner – CJS Securities

Kevin Casey – Casey Capital

Andrew Shapiro – Lawndale Capital Management

Steve Shaw – Sidoti & Company

Ross Taylor – Somerset Capital

[No presentation session for this event]

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question comes from the line of Arnie Ursaner with CJS Securities. Please proceed with your question.

Arnold Ursaner – CJS Securities

Hi, good morning. First I have a mechanical math question for Mark, if I can. You had mentioned in the prepared remarks, you had an inventory mark up impact on the gross margin from the Onyx acquisition that would not impact future quarters. And I believe in your prepared remarks you indicated that Onyx had $900,000 of gross profit or 14% to margin but had $200,000 of kind of one-time items. So first my question is the inventory, is that reflected in the $200,000 one-time item?

Mark Schlei

No, the inventory is reflected in the adjusted gross profit.

Arnold Ursaner – CJS Securities

So the $900,000 already reflects the impact from the inventory mark up or that has been adjusted to take that out?

Mark Schlei

It has been adjusted to take that out.

Arnold Ursaner – CJS Securities

Got it, okay. So what are some of the elements of the $200,000 because if I add that back, it’s almost 19% margin, not the 14% we had.

Mark Schlei

Yes that’s correct. Obviously, there are going to be some questions around the first six weeks performance at gross margin being somewhat less than we advertised. And it comes in at roughly where we said it would about 17.5% of their balance.

Arnold Ursaner – CJS Securities

I think the bigger question investors are grappling with today Cary, is your comments regarding the medical space. So the facts are I guess your backlog X to Onyx was down 10% sequentially in the quarter in the legacy medical business. And what you’re saying, it sounds like trends have gotten more challenging, pay at the end of the quarter or post the quarter. Can you kind of reconcile both of those and maybe publish what you’re actually seeing when you talk to customers?

Cary Wood

Yeah, first I would say there is really not disconnect between the backlog you’re seeing and what I’m foreshadowing. Foreshadowing is as a result of that softening. Now, these are conversations, I can tell you that I anticipate that this will be reconciled sooner than later. There just generally is a concern and nervousness in the space that I can hear. Just in the last few days you’ve heard Smith & Nephew, you’ve heard Vetronic, you’ve heard Covidein, you’ve heard Boston Scientific; all make substantial lay offs and attributed to in part the excise tax as well as concerns for federally funded programs and the concerns for this frustration is impact.

It’s not just in the medical space but also the defense space. We’re hearing it in both spaces. I think it’s more a matter in my view of coming to the near term milestone of action or lack of action and the potential implication. So my guess is as good as anybody else, but I think generally we’re optimistic on our fourth quarter. We maintain conversations around what that order pattern might look like. But I think there’s going to be potentially a deferral on things from third to four.

Arnold Ursaner – CJS Securities

Excellent, thank you...

Cary Wood

Thanks.

Operator

And our next question comes from the line of Kevin Casey with Casey Capital. Please proceed with your question.

Kevin Casey – Casey Capital

On the slow down in the [Nano clinic] you talk about the – is it slowing down the pace to new wins, is it slowing down the ramp up of new wins? And then longer-term, could this actually be a positive because the company with the reduced cost, they might actually outsourcer them in the medical space?

Unidentified Company Representative

Yeah, I mean your thesis there is, as we talked about, Kevin, a number of times that the outsourcing traffic is going to be more opportunistic for us as a contract manufacturer with specialty capabilities. I think that’s going to play well to us over time. This is not a one or two quarter investment thesis. This is a multi-year plan and we’ve suggested as much for a good number of years.

Now that said, to go back to the first half of your question, it’s hard to discern whether or not this is more about ramp up of new product or legacy product. It’s a mixed bag. We had a number of upticks in medical demands from customers in our second quarter. Our largest customer by example, but we also had a number of vacancies and hold off even in our second quarters.

So we saw some of it traffic its way into Q2. And I’m not so sure that that’s not going to have implications for Q3. And that’s really what I’m kind of tipping my hat towards. And that is that I think there are going to be some softening in Q3 that will be deferred into Q4. And I think more the conversation is around, let’s wait and over the next several weeks and find out what happens with these various issues and how we’re going to work through. I think that’s the crux of it.

I think there’s another – find another and you hit on it Kevin and I’m sorry I didn’t answer that, the forward look on new businesses. The funnel is still very, very sound meaning the new business targets that we’re working towards, the opportunities to win new business all of that has gotten substantially stronger. And I think the business development effort that we put in play about a year ago in a substantial way has continued to yield more and more in our Q. So I continue to be real bullish and optimistic there.

Kevin Casey – Casey Capital

And then year-over-year or how many people are in the business development group including Onyx now versus a year ago?

Cary Wood

I want to say the total in medical is…

Mark Schlei

We’re up four from a year ago total. We’ve switched from being segment specific to having our business development, managers be able to sell into the complex systems just mostly industrial, as well as the middle arrow piece. So it’s a national business development organization that’s cross selling. Four, additional resources from a year ago; three of those come on board within the last couple of quarters.

Kevin Casey – Casey Capital

Okay, thanks.

Cary Wood

Thanks, Kevin.

Operator

And our next question comes from the line of Andrew Shapiro with Lawndale Capital Management. Please proceed with your question.

Andrew Shapiro – Lawndale Capital Management

Hi, a financial cleanup and then a few questions here in DSS. So you mentioned the earning was just about $200,000 inside of Onyx above and beyond the inventory, that wouldn’t be considered non-recurring costs and adjusting that up, put your Onyx margins where they were. Are there any additional costs within Onyx? I don’t think, but in addition, costs that we’re incurred that are in Sparton’s – I guess it would be SG&A and not COGS, that relate to transaction costs, financing related costs with the transaction, your other acquisition search costs, if you would be deemed to be non-recurring, because this transaction and others are now done or fallen by the way so?

Cary Wood

Well, rough estimates on deal related expenses that would have SG&A implications as roughly $250.000. And that’s related specifically to this deal. Now, there are other non-Onyx deals that brought costs. But they’re probably defined more as immaterial than not and I don’t want to get in the habit of excusing them.

I do think that for the next year or two, that’s going to be a part of our expense. And well, it’s an opportunity out in year three or four potentially to soften it. I just don’t think I’m going to see that go away anytime soon. I mean, we’re looking at businesses, we start initiating professional services. We walk away for all the right reasons when we do.

Andrew Shapiro – Lawndale Capital Management

Acquisition is being a recurring thing for you for now.

Cary Wood

Correct.

Andrew Shapiro – Lawndale Capital Management

On the DSS if you could, so when I looked at your DSS segment breakouts, you had a huge increase in your DSS backlog. And I was wondering if you could discuss that in the context of a few questions that I have. First off, is this DSS backlog jump all Sonobuoys or is there anything else as substance?

Cary Wood

It is almost exclusively Sonobuoy.

Andrew Shapiro – Lawndale Capital Management

Okay. And we understand you have Navy approval time lags to directly announce your Sonobuoy contract wins. However, since the Department of Defense press office releases are a matter of public records. So can you confirm or clarify whether all the contract wins that have been announced by the DOD press office up to today are reflected in your Q3 backlog, or if there’s any recent announcements that are not yet in your backlog?

Cary Wood

No, that’s the case. Our backlog fully reflects everything that’s out there.

Andrew Shapiro – Lawndale Capital Management

Okay. And of your sizably larger Sonobuoy backlog, can you quantify and breakout what portion is of the higher margin foreign order type versus last quarter or last year?

Cary Wood

Well, percentage wise, just a minute here; it’s a smaller percentage – well, it’s in the same range as last year. But you’re dealing with a much higher denominator. So on a dollar basis, it’s slightly up.

Andrew Shapiro – Lawndale Capital Management

Okay.

Cary Wood

But as a matter of the total percentage, it is slightly down. As you mentioned we’ve got a much larger backlog number now. So I think it’s safe to say, it’s relatively flat year-over-year.

Andrew Shapiro – Lawndale Capital Management

Okay. And your DSS – the Navy’s first new P-8 Poseidon squadron has just been announced to be going combat ready in Jacksonville this month and other squadrons are becoming operational next year. So when should we expect the first Navy Sonobuoy procurement contracts for the new higher altitude and presumably higher margin Sonobuoys to start – the RFP starting to be announced, or the awarding on RFPs that are already out there, the awards to start to be announced?

Cary Wood

I know the awards are a matter of public record and certainly the press associated with the P-8 and some of the successful flights are out there as well. But we’re expressly prohibited to talk about that kind of timing. I can’t tell you what’s out there in public record, it has been expressed in other IR initiatives is that with the 2014, 2015 timeframe is where we expect there to be ramp up in demand to be more about tie out to choosing that.

Andrew Shapiro – Lawndale Capital Management

Okay. And that would be when the awards would be granted is the fiscal 2014 period, which means they have probably the RFPs asking for your bids and all that are out there now?

Cary Wood

Correct, and keep in mind that’s the government fiscal 2014, but yes.

Andrew Shapiro – Lawndale Capital Management

Okay, government fiscal 2014. Great. I have other questions, I’ll back out in the queue, please come back to us.

Cary Wood

Okay.

Operator

(Operator Instructions) And our next question comes from the line of Steve Shaw with Sidoti & Co. Please proceed with your question.

Steve Shaw – Sidoti & Company

How you guys doing?

Cary Wood

Hi, Steve; good, how are you?

Steve Shaw – Sidoti & Company

Regarding funds, I know the orders are usually choppy, was there any specific event that course the region orders this quarter or is it just more of a life cycle and supply issue?

Cary Wood

Yeah, I’ve mentioned in past calls and other investor formats that I’ve been a part of that the line aside of foreign sonobuoy demand is choppy and we don’t have the same type of visibility as we do domestic orders. So it’s a hard thing for us to give you I guess a solid answer to your question.

There wasn’t one specific event. There were no macro events that I know that drove the demand more in the near-term. But obviously they were helpful in our second quarter and certainly I expect that will continue to be a part of our revenue mix as we move forward. But I don’t have a specific answer to why we saw and we have a pattern.

Steve Shaw – Sidoti & Company

Okay, got it. Thanks.

Cary Wood

Sure.

Operator

And our next question comes from the line of Ross Taylor with Somerset Capital. Please proceed with your question.

Ross Taylor – Somerset Capital

Thank you. A couple of questions, actually first in the area of your guidance, it sounds like what you’re talking about is more a feel than the fact at this point in time, am I wrong, how I am reading that?

Mark Schlei

No, I think that’s a fair statement Ross. I have been confused more times and not being more transparent than some of my peers. And whether that’s an accurate criticism or not I think what I am is trying to give as much as I can the fact. So I mean just recently this morning Boston Scientific has revised its outlook for its layoffs, they’re laying off some reason. Smith & Nephew announced just several days ago. These are all customers that we interact with and when we shape or perform.

So the conversation is around jeez, I wonder with excise tax is going to do to us, so we’re going to take some steps in the near-term. I don’t know it is going to change the end market demand. It’s fair for me to as I sit here right now to say it is a general feel, it is a very point of conversation with the good number customers. We saw delay and demand on a number of accounts in our Q2 and well, I don’t have direct implications of Q3. It’s a concern to me, and I would certainly rather telegraph that to not.

Ross Taylor – Somerset Capital

Okay. And so looking at there is the opportunity for many of these companies to do layoffs under the guys of concern about the Obamacare tax. So I guess the question really what are we seeing in the way of end demand it’s a flow through business for you as not?

Cary Wood

It is; it doesn’t mean that they haven’t and could make some changes with near-term demand and manage working capital. But I do think that there is an element of that that what I’m suggesting is that the responding to the opportunity that the excise tax brings and may very well be that the action and the real end market demand isn’t going to change much.

Ross Taylor – Somerset Capital

Okay. You made a comment or comment was made in the prepared remarks about your largest customer size you had a significant increase and demand from your largest customer and then you referenced you had decreases the three customers, one of which had drop the program. I took that one or two drop programs and one had second sourcing. I took that to imply that Siemens, which I had thought was your largest customer is not the company, which gave you the additional business that you would not expected, am I correct in reading that?

Cary Wood

That is correct. Siemens is no longer the largest medical customer. It’s out there and disclosure that Fenwal is currently our top customer and that’s were some of our growth has come from. We’ve been able to help them penetrate the service side and the larger degree than we had in the past and that’s been helpful to our revenue stream has of the last quarter. Siemens has dropped, I can’t comment and what our future is going to look like with them.

It would be pure speculation. But we’ve seen some drops this year that were in line with our expectations. Actually, they came in slightly – but we saw drops. And then there were two other customers that while they weren’t material implications and frankly we didn’t expect them when we made the acquisition of Byers Peak to stay with us and they did for period of time. They ultimately sunsetted and at least in one case, there was not a replacement of product.

Ross Taylor – Somerset Capital

Okay. There has been a lot of concern among investors about the Fenwal relationship, when you’re at conferences, you get a lot of questions and alike about the strength in that relationship given an acquisition that they made. Does one read into the facts that they kicked up business with you fairly significantly in the last quarter as a positive comment about the nature and status of that relationship?

Cary Wood

I think that’s absolutely correct. I would say that we immediately were in contact with Fresenius. Actually, we’re already in dialogue with Fresenius prior to the acquisition. I think we have a very close and dependent relationship with Fenwal meaning that they depend on us greatly given that the manufacturing assets are as what ours are.

It is a very solid relationship. It’s one that I think is only going to be further aided by the Fresenius acquisition and we’ll have to see how that plays out. But yes, generally I think we feel very positive about it.

Ross Taylor – Somerset Capital

Okay. And since I’m going to abuse my right to one question, they always have a lot of comments on – commas instead of pauses. The Navy has a much higher forecast of expected sonobuoys demand than you have been carrying as your public estimates.

Unidentified Company Representative

Yeah.

Ross Taylor – Somerset Capital

Could you give us an idea of an order of magnitude of the difference there? And if perhaps some of the Navy’s expectation is driven by the fact that we do appeared to be seeing certain users of submarines becoming much more aggressive such as the Russian have become much more aggressive in the use of submarine to outside of their territorial waters?

Cary Wood

Yeah, first the guidance and it’s out there on a line item basis and future DOD budget estimates. The sonobuoy line item, order magnitude increases is almost 50% on domestic demand. Now I’ve been talked about foreign demand, if you know, but I think there are some changes that could come to foreign demand in trailing years given the fact that the thesis of redeploying P-3 is more likely than not.

Now that said, we discounted that future look by almost half. So I think we’re being very careful and prudent in our forward revenue guidance on that business. I can also say that we’ve got a little obvious that is very actively engaged in conversation and what times and not has been accurate in making revisions to outlook. And this happens to be some of the guidance that we’re getting.

And so order magnitude, 50% up. We’ve handicapped it by half. I still believe that there is a good business to be had by the P-8 thesis and you certainly commented on what’s going on with some of the macro end markets with the Russians, the North Koreans, the Chinese Navy, all of those are opportunities that are going to come our way. Certainly, it’s going to force the redeployment of a much larger percentage of the Navy to Pacific Room Theater.

Ross Taylor – Somerset Capital

Will you comment quickly, I know you can’t speak to specific numbers? But an idea of the level of usage today versus what it was back in the peak periods of the Cold War, are we operating at 50% of what we were doing then, at 10% of what we were doing then?

Unidentified Company Representative

I don’t have that history in front of me Ross. I’d be going from memory, frankly and I don’t want to misspeak. I’ll build that into future investor relations conversations. So it’s out there in other FD environments. But I know I’ve seen it. I know we’ve discussed it. I don’t have the answer, I said to you, Ross.

Ross Taylor – Somerset Capital

Okay. It seems so that sonobuoy usage is down precipitously from what it had been 10, 15 years ago. Specific numbers obviously, I look forward to seeing them. But from what I’m picking up that has dropped substantially and so with sign that the Russians will be increasing their solidity outside of their waters and obviously I think China, Japan, things of that nature. What feat indicates that you could see a pretty big pick up?

Unidentified Company Representative

I think you’re right. I think it’s all a matter of how you book end it. And if you go back to the Cold War Era being as recent as 10 years ago, then I think it’s a fair statement. I want to take things back a bit further and I want to understand the cycle and totality and give a more conclusive response to your question. But I think that what you just said is true. It’s at a level down now compared to what it maybe once it was and I think that presents opportunity as we move forward.

Ross Taylor – Somerset Capital

And my last question is have you been approach by potential buyers of the sonobuoy business?

Unidentified Company Representative

Not formally, I mean, I get folks that make contact with me more informally than not. And as you can imagine, it ranges from private equity to strategics, and I keep in close contact with them. I know a good number of them well at this point and but not formal as ever happened or, nor as the board been approached.

Ross Taylor – Somerset Capital

Can you carve that business out?

Cary Wood

Yeah, I mean we’ve done that with all of our businesses. That was one of the things that we attacked early on, was making sure that we compartmentalize the businesses, so that we operate them well that we could make them transferrable if needed. So we wanted to maximize our options and we work through the worst of our times. And as we said today, we’ve got three distinct business units.

Now, I commented in other environments that there is a good likelihood that we will reconsider the complex segments. And there are a variety of options. I have said in the past that could also include divestiture, but probably at the very least or in internal sales issues that might force us to collapse it into the two other segments, particularly as the medical internal sale starts to increase.

So long answer to your question, but we certainly could carve it out, if that’s what we chose to do.

Ross Taylor – Somerset Capital

Okay. Thank you very much.

Cary Wood

Sure. Thanks, Ross.

Operator

And our next question is a follow-up from the line of Arnold Ursaner with CJS Securities. Please proceed with your question.

Arnold Ursaner – CJS Securities

Sure, a couple of quick follow-ups to Ross’ 10 or 12 questions. On Siemens, is the issue there that, you obviously have been winding down your business with them as a second source. Are you still doing business with them at all?

Cary Wood

We are doing business with them. It’s at a substantially lesser degree than few years ago when we reached the peak of about $35 million, $36 million in total revenue, and that was one of our larger customers at the time. I think it’s fair also to add the conversation Arnie, and this has been mentioned in previous calls that well, dual sourcing is driving a considerable amount of this activity. There is also the issue of product sunsets. And that’s always been there and expected. So there’s nothing new on that front, but what we’ve got now is a combination of the two.

Arnold Ursaner – CJS Securities

Okay. I want to go back on the first question, I asked as I don’t think I actually have the answer, so I look at my notes. You did have an inventory markup that impacted your gross margin; you mentioned that is included in the adjusted amount, but what is the actual amount of the inventory markup?

Mark Schlei

The actual amount was $566,000. And that’s just simply when we add the value of the assets, that’s just the profits that’s in WIP and finished goods, when it gets valued. And that turn itself around in a six weeks we own them. So that will not occur on a go-forward basis.

Arnold Ursaner – CJS Securities

Okay. My last question I guess, I can fully understand the uncertainty in medical, you are hearing some questions from your customers. But I guess I’m a little less clear why the concern or the uncertainty in defense since you have the orders and since the funding appears to be completely in place?

Cary Wood

Yeah, Arnie, you’re right. But I will tell you that there are a couple of things. One, and I’ve said this openly before, I still maintain my confidence around our product and its place in the defense market. I just don’t see it being affected. But I’ve always hedged up by saying, anything is possible and that we’re closer to a sequestration conversation today than we were several months ago.

So I think there is a general hesitation. And I’ve seen that in the last year, it’s a year and a half with the Naval procurement office being more concerned about how to give guidance on demand. That doesn’t change the defense line item projections, it just changes the conversation, but it hasn’t changed the backlog, and hasn’t changed the contract.

So a lot of this is anecdotal conversations around concerns of the, what if associated with sequestration. So your point is well taken. Now, that said there are shifts that have been in demand cycle and we’ve always said that we feel more confident with our back half particularly our fourth quarter then we do our first half. And some of that cyclicality with procurement and testing and schedule testing that happens, and that probably has a whole lot less to do with demand and it does to do scheduling. And that’s certainly could come into play in our third quarter as well.

Arnold Ursaner – CJS Securities

Well, I think that’s what I was really trying to get it. You’ve been pretty consistent saying that this business tends to be back half driven because of (inaudible) it’s not seasonal reason per se, but it kind of is tied to the budget, and I guess what I’m trying to get a better feel for is, are you being told already to deferred things in Q3? I guess we’re all trying to understand the dialogue you’re having that’s causing you to be is cautious as you’re seeing?

Cary Wood

Yeah, there are typically scheduling issues that start to come into conversation about this time. And more times than that, they have worked out so that what we had expected to see in our third and fourth quarter are just what we expect to see, sometimes stronger.

But the conversations of late, I mean they’re all evolving and I think there are concerns around scheduling that we’ll probably have more in the way of fourth quarter implications on the up side, which would translate to me that there are potential implications on the third quarter.

While we’ve not specifically heard, look, we want to defer X into the fourth quarter. It’s been more a question of – these are the circumstances that we’re currently in discussions around. They could have implications on the third and fourth quarter timing of your fiscal year and that’s really the nature of my concern.

Arnold Ursaner – CJS Securities

Okay. And the CS piece of your business is impacted by internal work you do for part of this as well. If you did have a slowdown, should we also expect the inability to maintain the 10% margin in the CS piece of your business?

Cary Wood

I’m still fairly confident of that. We’ve seen other things drive increases on revenue in the CS segment. Year-over-year backlog as you can see in the segment and information that it’s up fairly substantially. And so I’m confident that that will hope to soften kind of any, kind of the internal sales implications, albeit that’s at a lesser margin more typically than that. I think the volume consideration helps to make a whole lot of headway into absorbing the fixed assets there. They’ve been up to this point, fairly underutilized.

Arnold Ursaner – CJS Securities

Thank you very much.

Cary Wood

Sure, thanks Arnold.

Operator

(Operator Instructions) And our next question is a follow-up from the line of Andrew Shapiro with Lawndale Capital Management. Please proceed with your question.

Andrew Shapiro – Lawndale Capital Management

Hi, thanks. A few CS follow-up questions here and then turn to DSS. It appears that the CS segment had about a 90 basis point percentage decrease in operating costs as a percent of sales. And is this due to or is this, I guess cost control measures you’ve employed or is it just overhead absorption and is this cost control in lowered operating cost percentage at a sustainable level?

Cary Wood

On a year-over-year basis, the dollars have exceptionally remained the same. So I think more to your question around absorption. I think that’s the issue in the more recent quarter than that.

Andrew Shapiro – Lawndale Capital Management

Okay. And in the last call, you mentioned about $1.3 million of know demand from one of your CS customers who shifted out into calendar 2013. Did any of this show up here in the current quarter and if not, do you have better visibility in whether it’s going to be just staggered over quarters or it’s coming in one future quarter?

Cary Wood

We’re still confident that volume is going to materialize. But it has yet to start to ramp up in any significant way.

Andrew Shapiro – Lawndale Capital Management

Okay. And when it does, this will be ramp in a staggered apparent or it will be a one…?

Mark Schlei

I think that’s more the case than that.

Andrew Shapiro – Lawndale Capital Management

Okay.

Cary Wood

That’s a ramp up staggered implications.

Andrew Shapiro – Lawndale Capital Management

Right. In your release you said this segment has seven of the 13 new program awards. These new or existing customers, what’s the break out like that? Is it prototyping our design, is there any consistency of the…?

Mike Osborne

This is Mike here. I can give you a little bit down. Complex Systems, it was all manufacturing opportunities. It did have two brand new customers with that; seven medical and one engineering and to many factoring opportunities with existing customers and de-assessed with one engineering and two manufacturing opportunities with existing customers. So the total is...

Andrew Shapiro – Lawndale Capital Management

Thank you for the break out on that. During the December quarter, was the $4.3 million of segment revenue eliminations here in the company is that all inter-company and was it all DSS or what is the medial amount becoming a number amount to be broken out yet?

Cary Wood

We’ll start to break it out as it grows. At this point, it’s still fairly immaterial. I would say it’s in a 10% to 20% range, but it’s growing.

Andrew Shapiro – Lawndale Capital Management

Okay. And are you able to or would you provide capacity utilization by segment at all? And two, a feel for where things stand and if so, is that number inclusive of the Onyx expansion opening?

Cary Wood

Yeah, first, I’ll talk about medical as a whole inclusive of the Onyx footprint is roughly in the 60% range. Now that suggests that there are certain places that have lower numbers than other. But I think we’ve always said that, and so I think that 60% number is about right.

Talking about CS, well, we’ve seen some increases in revenue and demand and growth and backlog is still a business set as opportunity. We’ve certainly grown in Vietnam, but I would say that it is still on the low side utilization probably closer to the 30% utilization, particularly as we start to increase medical device manufacturing there that could change. But right now that will be combined with what we do in Brooksville, I think that’s a segment, that’s still in the 40% to 50% range utilization.

And then as you look at what we’re doing in DSS, and it’s really dependent on how you view, which are overall working capabilities to be generally, I would say that it is 50% to 60% utilize. So we’ve got a good ways to go we would call ourselves at full capacity.

Andrew Shapiro – Lawndale Capital Management

Great. I have some or but I’ll back up in case anyone else ask anything.

Cary Wood

Let you ahead, Andrew.

Andrew Shapiro – Lawndale Capital Management

Okay. On DSS similar observation and question regarding your operating cost as a percentage of sales, but in this instance in DSS looks like about 70 basis points increase as a percent of sales and this junction what kind of increased investment or activity that your operating costs expenditures are focusing on?

Mike Osborne

Yeah, I’ll take that. The majority of that is coming from business development efforts. We’ve added a very specific business development manager in DSS as working with the Department of Defense on new opportunities to bring it from the engineering side and then we’ve also brought a contract specialist as well. So that’s the majority of it.

Andrew Shapiro – Lawndale Capital Management

Okay. That’s going to be a sustainable dollar cost it sounds like in that it was in payroll?

Mike Osborne

Correct.

Andrew Shapiro – Lawndale Capital Management

Okay. And can you talk about the digital compass business and what you might be seeing along that product line whether it would be in navigation oil and gas segments where you getting some traction and your experience with those product launched in 2012 the DC4, GEDC-6, PHOD-1, et cetera and then related to that is the two winning 13 product launch expectations.

Cary Wood

I’ll take their first part of that and just talk a little bit about what the end market look like. As we talked in the past, we’ve had a number of trial samples of our new products going into some opportunities the majority of the end market is in the Mill Aerospace in program as related to unmanned vehicles and other initial navigation opportunities. A lot of those are still in a trial.

Our engineering phase, we haven’t seen anything go to production yet, and I think probably part of that is just whether or not see frustration and what kind of funding is continue at the end of the month as those programs are going to probably be decided at that point in time.

We’re with 60 discrete customers right now, and as we feel bullish about something in that arena will pop it at some point in time in the coming quarters. We also have a pretty robust funnel, again 60 plus opportunity sitting out there. There are manufacturers, reps and business development managers are going after.

And actually this week we’ve got manufacturers, rep training going on down at DeLeon Springs. We’re now talking about the digital compasses and the other initial systems that we’ve got out in the marketplace plus what we will be launching later this year.

We’re also talking about how we generate leads for engineering and manufacturing services without talking to potential customers as these engineering trials potentially turn into realize product. We’re hoping that we’re going to able to gotten some of opportunity within the engineering and manufacturing side as well.

Mike Osborne

And in fiscal 2014, we intend to launch and enhanced version equipped with GPS and then also tracking enhancements, which are really better from land and air, man and unmanned applications. So that’s something we have to look forward to over the course of the next two, three up to four quarters.

Back to the question is kind of summarize it, it’s always tricky to measure success with activity, but the activity that we’ve had with the various compass applications are substantially larger than everywhere. I don’t know that it’s considering guarantee, what is going to translate in the way of revenue? I can tell you that it is tracking roughly what we expect it to be this year. But we’re an important milestone.

We’re into the whole compass thesis about two and half year and will be at a five year business plan on this and we have certain expectations of cash flow, returns and margins, most of those have been achieved in the early years. But they were fairly modest expectations. This is very back-end dependent. So we have to see here as we’re expecting and we’re swinging it now at 60 pitches where we weren’t swing it hardly a few years ago.

Andrew Shapiro – Lawndale Capital Management

Okay. On the medical with regard to the prereduced loss programs, one being Siemens and two just engaged customers. When do these particular programs that were lost in the past or reduced in the past anniversary. So we get a feel for what the Q3 March that we’re currently in headwind is and in our future quarter headwinds from the prior year contributions?

Cary Wood

All of this will start to anniversary by the end of our third quarter this current fiscal year, which will suggest that going into next year, we’ll have some implications in our third quarter compared to this upcoming third quarter. But essentially that’s the anniversary by the end of third quarter.

Andrew Shapiro – Lawndale Capital Management

Okay. And more on a corporate side, in terms of some general questions. You’ve had, I think provided a little bit of guidance before on CapEx in particular invest the company’s investments in ERP was either done or winding up. Can you give with the Onyx acquisition a little bit more, we’ll call it update here now as to your CapEx expectations for the remainder of the year going, or the calendar year going forward. What that’s entails and is the Onyx capacity expansion then placed into service, or is there, because I see there is some construction in progress as of the December quarter. Just to get a hand on one that enters the depreciation and amortization stream et cetera?

Cary Wood

Okay. Let me take the last question about the in-service construction. That will be fully included in our Q3 moving forward. The question of – go back, what was the…

Andrew Shapiro – Lawndale Capital Management

So the overall CapEx is the ERP investment which was kind of carved out as a bigger nut, is that done? Is there any other big nuts in here and what’s the updated guidance with Onyx ongoing maintenance CapEx added to Sparton’s?

Cary Wood

Yeah, okay. We’ll maintain our 1.5 to 2.0 guidance on CapEx and that’s inclusive of Onyx. Now, you’re correct that in previous years, a larger percentage of our year-over-year CapEx was involved in the ramp up and launch of an ERP. With that plan implementation now start behind us as of the second quarter. We’ve now successfully closed our second quarter on a new ERP. There are going to be enhancements opportunities as we move forward.

I don’t know that they’re going to be on the magnitude of the CapEx type of engagement or involvement that we’ve in the past. But we deploy that now towards productivity investments. And that will be a larger percentage of the overall CapEx allocation on a year-over-year basis. But now, we’ll continue to maintain 1.5 to 2 times, 2% rather, that will be inclusive of Onyx.

The ERP thesis is a lesser percentage than it was in the same time last year. We’ve had a fairly good launch of the ERP system as launches go. We’ve got some opportunities to fine tune that might bring some efficiencies as we move forward.

Andrew Shapiro – Lawndale Capital Management

Okay. And similarly with the acquisition of Onyx, the allocation and costs basis and the various things including intangibles and all that and the implementation or operational status of the Onyx expansion, can you give us a bit of guidance here now as to what the updated margin going forward quarterly or annually and amortization and depreciation basically these non-cash charges are going to be?

Mark Schlei

Yeah, well, it’s non-cash. The incremental depreciation expense due to the asset step up is going to reduce prior Onyx gross margins approximately 2.5 points, and so that will bring the Onyx go forward gross profit percentage. Closer to the legacy Sparton, medical gross margin percentages, so as such, the current medical segment gross margins are really in the middle of the guidance range we’ve given in when we spoken about guidance.

So we don’t anticipate any revisions there. But as we go forward, I think it’s important to remember that the 2.5 points is non-cash. So I think it makes sense to start talking about what Onyx EBITDA in relation to legacy Sparton medical EBITDA. And as we view that, the Onyx EBITDA is approximately about 250 basis points higher than our current legacy medical EBITDA.

Andrew Shapiro – Lawndale Capital Management

Great. Well that’s helpful, but let me clarify my question. You given me some guidance here now about what we should expect to see on an annualized CapEx basis and because of the step up and the incremental CapEx that was in Onyx, that’s now going to get amortized.

I’m just trying to get a hand on the – we’ll call it the relative difference of depreciation and amortization from that of CapEx because I would expect to see that the depreciation and amortization in the non-cash charge add back, netting out against CapEx to be a favorable EBITDA. Will there still be favorable cash flow adjustment? So do you have like $3 million, $4 million a year, that’s kind of the ongoing non-cash depreciation and amortization charge rate you had calculated?

Cary Wood

Are you speaking specifically to Onyx?

Andrew Shapiro – Lawndale Capital Management

No, the company as a whole, now the new consolidated level, because the December quarter is only a partial quarter. Clearly, I see what the new consolidated level is at the end of March. But – and I know you don’t give guidance on; we’ll call it business activity revenues and even necessarily guidance on margins. But when it comes to depreciation and amortization, I would think that is an area you can help us analysts project out and put models together to say, okay you can model $3 million a quarter, $1.5 million a quarter and depreciation and amortization on a consolidated post Onyx acquisition and basis.

Cary Wood

Yeah, on a consolidated basis, the depreciation and amortization on a quarterly basis will be somewhere between $1.6 million and $1.7 million a quarter.

Andrew Shapiro – Lawndale Capital Management

Great. That’s what I was looking for. Thank you very much in helping me with that one. And in light of what you’ve said, it doesn’t sound like right now you’re prepared Cary, to do any changes to your segment gross margin estimate ranges.

Do you feel that after you get through what you call this short-term bump in a road potentially, this feeling the potential temporary slowdown, that you would then be able to provide updated segment margin ranges?

Cary Wood

Yeah. You’re correct. I’m not prepared at this point to make any kind of revisions. I know we’re bumping up to the high end of ban on the complex side and right, almost squarely in the middle with DSS and medical. But I don’t want to get too over my skis here and make changes.

I do feel real good about how the balance of this year is going to close out. And then once it does, and I’ve got a bit of a normalized look that I can take into consideration. We may look at it as we go into the next new fiscal year.

Andrew Shapiro – Lawndale Capital Management

Okay. The last question or two here, on the tax benefit, is that entirely a December quarter event or is there any carryover into future quarters and what is the related cash impact and timing of this tax benefit that occurred?

Cary Wood

It is a December only issue. So there will be no future quarter impact as far as income tax expense. And from a cash flow perspective, we’ll expect we’re in a prepaid tax position right now. So we would expect that to unwind over the next couple of quarters.

Andrew Shapiro – Lawndale Capital Management

So we’ll be paying them a little less tax and our cash balances would see the benefit of that.

Cary Wood

Correct.

Andrew Shapiro – Lawndale Capital Management

Okay. And with respect to the cash balances, what’s our interest rate on the book with the $14 million that’s in short-term, current liabilities that we borrowed on this acquisition?

Cary Wood

At the end of the year, the interest rate was 1.7%.

Mark Schlei

1.7% and we are taxpayer right. So that’s 1.7% pre-tax and less after-tax.

Cary Wood

Correct.

Andrew Shapiro – Lawndale Capital Management

Okay. And I guess…

Mark Schlei

In the current quarter, that will go down to about 1.54% just given where we’re going to land as far as the level of pricing. We landed in a little bit of a higher band when we did the agreement because we didn’t have any trailing EBITDA, so we reported and what’s probably level of two band, which was about 25 basis points higher.

Andrew Shapiro – Lawndale Capital Management

Okay.

Mark Schlei

But as we currently sit in this quarter we’re at level one pricing and currently right now we’re locking and fixing the interest rate the one month LIBOR.

Andrew Shapiro – Lawndale Capital Management

Okay.

Mark Schlei

Which is about 20 basis points?

Andrew Shapiro – Lawndale Capital Management

Yeah. When you talk about lock-in and fixing, you make me raise the question of what kind of duration you lock-in and fix for?

Mark Schlei

Right now we’re just going at the one-month increment, the one month option we have. We have an option about lock-in at one, two, three or six months.

Andrew Shapiro – Lawndale Capital Management

Okay, so the next level facility. In light of this very low-borrowing cost and such Cary or Mike, can you update us a little bit more on your focus and successes or near-term items here on acquisitions, because some tell by the wayside I guess, are those dead deals or they just delayed, or what’s the status on your continuing acquisition focus?

Cary Wood

Well, we’re busy. I can say there are lot of activity in the M&A area of our involvement mine in particular, Mike’s in particular. And I would say that the deal traffic remain still fairly solid. We’re pretty disciplined as I think we’ve made that obvious over the last few years, and where an opportunity starts to feel a little bit uncomfortable to us, it’s not much for us to walk away.

And so we’ve done that on a good number of occasions. But there are plenty of things out there. I’m still trying to move us towards opportunities even still yet this current fiscal year. And we’ve got things that are progressing, I don’t know have anything to announce as I sit here today, but I still feel pretty good around the M&A traffic that we got in front of us, the quality of it and a lot of it looks pretty solid.

We want to expand our content, I’ve said that before. We want to expand our content or capability and those of the types of things that we are out looking at in addition to extending our presence in the same end markets and then finding our way into different geographies. These are all the things that have been mentioned in our strategy and right now it’s very much a part of the M&A deal traffic that we’re looking at. We’re pretty busy here just a matter of making that announcement sooner than later I’m hoping.

Andrew Shapiro – Lawndale Capital Management

So with Onyx being your largest acquisition to-date, although the current acquisitions you’re looking at of smaller tuck-in size or are there even deals either as big as or bigger than Onyx that are pleasantly on your play?

Cary Wood

Both, actually, and we’ve seen as a recent couple or good number of tuck-ins that I like. Those obviously are helpful from the standpoint of asset utilization and we’d like to explore those a bit. But I think both end to that spectrum we’ve got, we’ve got larger ones that are big needle movers, and then we’ve got smaller tuck-ins that I think are very opportunistic on the buy-side and could have some incremental improvements to our performance, so a little bit of both.

Andrew Shapiro – Lawndale Capital Management

Okay, thank you. That’s it.

Cary Wood

Thanks, Andrew.

Operator

And our final question for this morning is a follow-up from the line of Ross Taylor with Somerset Capital. Please proceed with your question.

Ross Taylor – Somerset Capital

Real quick. Free cash flow generation over the balance of this year, it looks like you guys start to kick off some pretty good free cash flow. What was the depreciation and other aspects of the acquisition?

Mark Schlei

You’re putting me on a spot with guidance on free cash flow right, and I’m not prepared to do it. I think what we’re saying and I appreciate the optimism that you are – I mean you’re saying as a compliment on the acquisition I think and I you’re right. I think we feel pretty comfortable with how it’s going to play out and you’ll see the enhancements of free cash flow between now and the balance of the end of the year.

Ross Taylor – Somerset Capital

With your stock trading down fairly substantially from recent status today, you know I’m going to ask you this question?

Mark Schlei

You’d have disappointed me had you not asked.

Ross Taylor – Somerset Capital

Well, we had an offer that thought process guidance. I thought not to follow – it might not – I’ve had to ask it.

Mark Schlei

Sure. It’s still something that is being discussed I don’t have a formal authorization as I sit here today. But I think the Board in some of its more recent meetings has gotten comfortable with the concept, and I think it’s more a matter of trying to figure out what we want to do. I think as I said in the past, we’re very M&A minded and we want to deploy correctly, and we want to make sure that the math guides our decisions. And I’m not so sure that a buyback at a lower rate is such a bad option, I think it’s a enhancement to our overall cash deployment strategy. So it’s very much a consideration. I just don’t have an authorization to announce today.

Ross Taylor – Somerset Capital

When is your next Board Meeting?

Mark Schlei

End of April, actually I think it’s the first week of May, but let me make sure I clarify. Getting an authorization for something like that can happen outside of the normal course of the Board Meeting.

Ross Taylor – Somerset Capital

Okay. Thank you very much.

Mark Schlei

Sure, thanks, Ross.

Cary Wood

All right. We will wrap up the call today. I would like to thank all the participants in the call. Again, the call including the question-and-answer period has been recorded and will be posted to our website under Investor Relations sometime later today. Thank you.

Operator

Ladies and gentlemen that does conclude the conference call for today. We thank you for your participation and I ask that you please disconnect your lines.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Sparton's CEO Discusses F2Q13 Results - Earnings Call Transcript
This Transcript
All Transcripts