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Executives

Cary Wood – President and Chief Executive Officer

Mark Schlei – Chief Financial Officer

Mike Osborne – Senior Vice President-Corporate Development

Analysts

Andrew Shapiro – Lawndale Capital Management

Arnold Ursaner – CJS Securities

Ross Taylor – Somerset Capital Advisers LLC

Steve Shaw – Sidoti & Company

Sparton Corporation (SPA) F3Q13 Earnings Call May 8, 2013 11:00 AM ET

[No presentation session for this event]

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question coming from the line of Andrew Shapiro with Lawndale Capital Management. Please proceed with your question.

Andrew Shapiro – Lawndale Capital Management

Hi, if you could do some clarifications on your script here, Cary, that would be helpful. With respect to DSS, you have discussed that you have an expectation of greater domestic and foreign sonobuoy shipping, arguably, sales volumes in the fourth quarter that’s going to give you and bring your nine months up to positive year-over-year results. What I just want to get a clarification on in the sonobuoy statement is are you just talking about how Q4 is going to be better than prior year or the full fiscal year end is going to be better than prior year or does it even work out that the answer is yes to both?

Cary Wood

First is a couple of things here, we were down 30% on year-over-year basis in DS in the third quarter. There is a probably a deferral of the exact revenue into the fourth quarter which will obviously enhance but we’d already expected and planned. And so I think it’s fair to say, yes, we expect a solid fourth quarter, at least in part of result to that shift, but also expect that to influence the year-over-year as we said we expect that to outpace last year’s full-year $0.91.

Andrew Shapiro – Lawndale Capital Management

Okay, so the full year in all that. Now so you also didn’t expect foreign as a portion of the mix in the Q4 to be more than foreign was a portion of this Q3’s mix meaning we should see a margin expansion as well in the DSS side?

Cary Wood

We don’t expect foreign influence to be significant in our fourth quarter. We expect it to be as (inaudible) it was the same time last year.

Andrew Shapiro – Lawndale Capital Management

Okay and when you talked about your earnings expectations that DSS is going to drive the earnings pace. When you’re referring to $0.90 – that you’ll exceed the $0.91 for the full-year and your nine months is I think $0.50 somewhat.

Cary Wood

$0.50.

Andrew Shapiro – Lawndale Capital Management

You are guiding that you will about $0.41 for the quarter?

Cary Wood

Yeah, that would be the difference, yes.

Andrew Shapiro – Lawndale Capital Management

Okay, I just want to make sure the math – I got the math right on that. And then one last question before I back out, but definitely come back to us, we have some more. On the performance in the Complex Systems side, you have put together now double-digit revenue growth in margin expansion in three of that segments last four quarters including the last two back-to-back. Can you discuss your thoughts on this segment’s resurgence and whether and why you feel it is sustainable?

Cary Wood

Well, I continue to be optimistic on that segment and as we continue to grow and I think it’s going to demonstrate that this is our very volume sensitive segment, that’s we’d always expect it to be the case. As we go in to our budgeting cycle, which were currently in the mid-start and we solidify what the outlook is for next year I think it will only further demonstrate that we’ve got positive outlook for it. And then perhaps we’ll have some discussions internally about how we might revise our margin guidance outlook from where it was previously.

Andrew Shapiro – Lawndale Capital Management

Because it’s substantial previously and probably still is under-utilized fixed capacity issue meaning you will be able to just amortize that fixed cost and report much better margins?

Cary Wood

Obviously, yes, the absorption will be much enhanced by volume and there has been a good amount of new business activity that goes back to Complex Systems, obviously, the software growth in our previous quarter has stated. And as we move forward, we’ll get some clarity on what the full year’s volume and revenue streams are going to look like, but as I sit here right now, I’m very optimistic.

Andrew Shapiro – Lawndale Capital Management

Yeah, and in that segment, regarding the margins and the utilization, Medical was referenced in the last quarter has just starting to flow through because Vietnam, which is in your Complex segment was certified for FDA approval for medical products et cetera, but you didn’t have much intercompany, if any, I think when we asked you, you said it’s all still be assessed in the quarter ended December. For the quarter ended March, when we take a look at your intercompany numbers that you provided, is all that intercompany numbers still DSS and DSS margin application or what amount of it is now consider medical that we might apply a medical margin to it to kind of get a feel for margin effects?

Cary Wood,

We will realize the medical impact on the Complex Systems segment until well in fiscal 2014. And if the contribution from any of the medical and complex systems is still fairly negligible in the third quarter and most of it has been internal sales to DSS, but also on a growing, fairly strong basis as external sales.

Andrew Shapiro – Lawndale Capital Management

Right. But you always provide in your segment and intercompany line and we either applying that intercompany line at DSS margin or over time we’re going to be reducing that amount to apply a mix of DSS and medical margin.

Cary Wood

Correct. Again, I think the third quarter was a fairly immaterial amount for medical.

Andrew Shapiro – Lawndale Capital Management

Okay. I have more questions. Please come back to me and then I’ll back out and let others get in here.

Operator

Thank you. Our next question coming from the line of Arnold Ursaner with CJS Securities. Please proceed with your question.

Arnold Ursaner – CJS Securities

Hi, good morning. So let me start me start by clarifying Andrew’s question. On DSS revenue, last year you did 72.1% and your gross margin was 23.9%. I just want to be completely clear. You are saying that your full-year revenue will be greater than the 72.1 %, is that a good starting point?

Unidentified Company Representative

Yes.

Arnold Ursaner – CJS Securities

And your gross margin, given you now have more foreign sales in Q4 and hopefully, better utilization, how should we think about your margin in the segment in Q4?

Cary Wood

Well, yeah. I want to maintain the guidance on that. I think the previous span we’ve given has been in the low-to-mid 20, so 20% to 25%. I still want to maintain that span for now.

Arnold Ursaner – CJS Securities

Can you quantify the amount of revenue that was deferred?

Cary Wood

Well, if you base it on Q3 last year to Q3 this year, it’s roughly $5 million.

Arnold Ursaner – CJS Securities

Okay, great. Thanks.

Cary Wood

Yeah.

Arnold Ursaner – CJS Securities

A couple of other follow-ups, you mentioned that in – most of my other questions are going to relate to Onyx and Onyx results, you mentioned in your prepared remarks, they were below your initial expectation. With hindsight, why was that and what steps have you taken to resolve it?

Cary Wood

Well, we saw a pullback across medical, which obviously had its influence on Onyx. There were a good number of customers that help to offset what that impact might have otherwise been because Q3-over-Q3 and year-to-date over year-to-date is actually looks flat in medical within the Onyx. So, obviously, we’ve seen some pullback. but as I mentioned earlier, we’ve also seen some growth in the backlog and a lot of that has come from medical specifically from Onyx, and a lot of the new awards almost, about 50% of the awards came from Watertown and Onyx in and out itself

So we feel really strong around how our fourth quarter is going to look with Onyx, it’s contribution and how well it will match up to our original business plan. And then as we go into our budgeting right now approximately it is going to look very, very strong going into next year, which is really the basis for this. I think the first four months is hard to make too many conclusions – draw too many conclusions. It’s not far outside the EBITDA performance; it just was a little bit softer than what we were preferred and hope for, but not in a huge magnitude. And again, it’s only four months, but I know we’re looking at as we go into our fourth quarter and full-year next year. And I think that’s probably the best explanation I can give you.

Arnold Ursaner – CJS Securities

Okay. You mentioned that eight of the 11 new projects were in medical and that they were all new to Sparton, were they also all new to Onyx?

Cary Wood

They were 11 actually of the 18 that were medical and of those 11, eight were Watertown. And of those eight, I think a significant majority of those would have been either expansion of perm accounts, but as I look through the rest, a good number of them are brand new customers.

Arnold Ursaner – CJS Securities

Okay. And your (inaudible) last few months frankly, because you had caution every one about the softening you saw two, three months ago. And yet now you’re much more enthusiastic or positive about the balance of the year, maybe walk us through what you were hearing two, three months ago and then process of how that has changed in the last two, three months to give you more confidence.

Cary Wood

Well, on the positive side of that, we knew that the Complex Systems segment was going to continue to perform, obviously, a much lower contributor from an overall gross margin perspective. But it was going to have a little bit more of an influence as we move forward with our overall revenue. Now that said, we’re going to see as we expected and did see and it materialize was a bit of a pullback from a good number of customers across medical in totality, that was our Colorado facility, our Ohio facility and moving quite honestly as we saw that across all three. That combined with what we expected to see in the way of some revenue deferral with DSS, which is obviously a much richer performer from a margin’s perspective and there’s a variety of reasons there. We talked a little bit about in the past that some of the testing has fallen outside the agreed upon specifications and we continue to work through those issues.

By the time you sum up a softening in DSS, which materialized on a year-over-year comparison about $5 million and you assume that it was going to be at least at the same pace of last year. And then you see that medical is flat and, obviously, as we mentioned in our remarks that we expected the revenue to be higher with our legacy business, forget about Onyx for the moment. Those two things combined had significant revenue implications. And they were very strong contributor from a margin perspective. And that materialize just as we had kind of mentioned in our last call. And it can’t be offset, it wasn’t offset by complex, even though complex outperformed our internal expectations and pricing continued to show progress. So as we go into our fourth quarter, we expect the DSS this year third quarter to shift in the fourth. we expected a fourth quarter, strong fourth quarter for DSS as it was, as we’ve seen in previous years.

Last year, I think we performed at $0.40. And a lot of that was influenced by DSS. So, generally, the guidance of year-over-year outperforming last year, I think this is based on what we expect to see in DSS, always planned for the deferral revenue from third to fourth and then the resurgence of deferred revenue in our fourth quarter from medical.

Arnold Ursaner – CJS Securities

A quick one on the Vietnam facility, it was pretty underutilized around 50% and yet you’re doing more Complex Systems, you’re winning new orders, why wouldn’t we be seeing more margin improvement given hopefully the increment in the Vietnam facility?

Cary Wood

Are you – you mentioned medical, but then you said Vietnam, Vietnam is reported in the Complex Systems segment, I want to make sure that. So we do expect to, but as I sit here right now, I’m not comfortable making any change in marketing guidance (inaudible) with the medical and complex systems. I think that’s going to come more in the focus, but your point is taken and that is that we move medical device into Vietnam, we are going to expand our interco of medical revenue, that’s going to happen, we hope, a better influence on the complex absorption overall utilization of capacity and thereby it’s going to drop a little bit of margin. We continue to be fairly interested in tuck in acquisitions that could certainly absorb assets there. And you combine that with what we expect across medical. As we move forward here in the fourth quarter, we expect to have pullback in the third quarter to start back up. I think there is a good strong potential for some strengthening of the margins. I’m just not prepared to go and value some information at this time.

Arnold Ursaner – CJS Securities

Okay, thanks again.

Unidentified Company Representative

Sure, thanks.

Operator

Thank you. Our next question coming from the line of Ross Taylor with Somerset Capital. Please proceed with your question.

Ross Taylor – Somerset Capital Advisers LLC

Thank you very much and when follows Arnie and Andy, they’re really onto a lot of questions left to ask, but I welcome with a few. First of all, on the – you reference the idea you had expenses in the quarter due to deals. Are those deals still potentially ongoing and what was the magnitude of the expenses?

Cary Wood

First, let me talk about deal activity. We’ve mentioned it in a number of quarters that what we believe to be a fairly strong deal flow and we’re involved in a good number of opportunities. And I would also suggest that we are a disciplined group and the allocation of capital is certainly foremost with us. So we don’t do bad deals. But it doesn’t mean that we don’t spend a good amount of time in opportunities and certainly at some point we take them further into the process, which starts to translate into audit fees and related legal expense and we show some of that in our third quarter. I don’t know that its going to be at the same level as we move forward, it could be somewhat higher, it could be less, but it’s all somewhat contingent upon what we could evolve.

Those deals currently, some have potential, some don’t, but our expectations as we move forward is that there is going to some level of that. The Onyx deal implications is, I think we’ve mentioned before, we’re roughly in the $200,000 to $300,000 range. We saw other expenses in our third quarter roughly a $100,000. We have some financial reorganization expenses in our third quarter which is roughly $300,000. These certainly are going to pile up, but we expect those things on occasions to be one time non-recurring just in the case of the finance and the deal project. They are going to increase and increase as we go through the year.

Ross Taylor – Somerset Capital Advisers LLC

Okay. You have been fairly conservative on your expectations for 2014 Sonobuoy sales growth. The Pentagon and President of the United States, the current budget they’ve thrown out show about a 70% to 72% increase. My guessing is that’s substantially greater than what you guys are expecting. Can you comment on what they’re looking at and why your thought process is going to come in to be but a small fraction of what the President is looking for?

Unidentified Company Representative

If you remember, and for anybody who is lost, some of our investor presentations, we’ve dedicated at least some of our discussions to the outlook on Sonobuoy sales. And out in 2014 and 2015, something we’ve been talking about for probably close to year if not, even longer has been that there is a projected impact of higher altitude and then some level of co-existence with the legacy business for a number of years. That will have an influenced in government fiscal year 2014 and 2015. Well, it’s been projected prior to the President’s budget proposal was just the last month. It was that internal budgets were giving guidance of – as you mentioned about 70% that was reaffirmed by the budget filed by President just in the last 30 to 45 days.

Nothing has been solidified, nothing has been approved. But what we’ve done in the past and you’ve seen it in investor conferences as you handicap that. So instead of it being generally a 70% to 75% increase, we’ve said it’s probably a 30% to 35% increase and we expect that to materialize over time. What I’ve also said is that I don’t expect it to materialize in a timing that, and again, the President are suggesting that it is. I would also suggest that this is government fiscal year, which doesn’t influence our 2014 fiscal year and sort of tail on. So I think it’s fair to say that there will be a change, I think it’s too soon to get specific about what it is, I don’t expect it to be at the level that we’re talking about at the 70% level, but perhaps at a 50% discount and I think that has a small chance of impacting us in fiscal year ‘14 probably more realistically if we go into fiscal year ‘15.

Ross Taylor – Somerset Capital Advisers LLC

So basically, what you’re saying is you would prepare for issue, we should be looking at perhaps a 35% to 40% increase in sonobuoy sales year-over-year, hitting late next fiscal year and substantially in fiscal ‘15?

Cary Wood

Certainly, what we’re seeing in the way of revenue guidance, until it’s approved on hard-pressed to give that type of guidance, we’re certainly modeling out 30% to 35% increase looking out into fiscal year ‘15.

Ross Taylor – Somerset Capital Advisers LLC

Okay.

Cary Wood

(Inaudible)

Ross Taylor – Somerset Capital Advisers LLC

Okay, also you talked about the fact that there were two customers who reduced medical equipment sales by about $3.6 million is either of those customer a customer we have not spoken about in the past, reducing products they bought from you?

Cary Wood

No, this is the, continuing disengagement from one large customer over a few years ago, that is essentially at pace where we expected it and I think essentially as we go into next year there will be little if any revenue at that customer.

Ross Taylor – Somerset Capital Advisers LLC

Okay. And I do have to congratulate you for taking back my favorite thing to question you about, which is the buyback?

Cary Wood

Thanks. Thank you, Ross.

Ross Taylor – Somerset Capital Advisers LLC

Okay. Take care.

Cary Wood

Thanks.

Operator

Thank you. (Operator Instructions) Our next question is coming from the line of Steve Shaw with Sidoti & Company. Please proceed with your question.

Steve Shaw – Sidoti & Company

Hi, guys. How are you doing?

Cary Wood

Hi, Steve.

Steve Shaw – Sidoti & Company

Going back to sonobuoys in fiscal ‘14, just to cover the foreign side of things, with everything going on politically, what are you guys expecting or forecasting on the foreign side? I know they’re always – yours are always choppy, but do you guys have anything in mind that you’re expecting?

Cary Wood

Well, we’re in middle of modeling out as you would imagine ‘14 and ‘15 not domestically, but also from a foreign perspective. And we’ve talked about it in our investor presentations. The world dynamics are not hurting our business and I think if you look at China and the South China sea, the North Koreans even in the last two to three months, all of those things including the implement recent enough, about four or five months ago prior to him leaving this post, is that a larger percentage of the U.S. naval fleet will be deployed on the pacific rim. I think all of those things suggest that the outlook is strong. And it’s also by default going to be strong with some of our Naval partners. And a good amount of our foreign sales growth goes to South Korea; goes to Japan and I expect that we continue to see strengthening out of those countries. We don’t have a firm numbers, I said here today and I don’t want to go on a whim and suggest that there is going to be a win for revenue going into next year from foreign. I think it’s intuitive to suggest that there are a lot of dynamics that are more favorable that that.

Steve Shaw – Sidoti & Company

With the safer or even too conservative to say that would it be at least, foreign orders would be at least up over fiscal ’13?

Cary Wood

It’s fairly speculative, Steve. As you mentioned earlier, it’s choppy and have the same line of sites. They’re going to sometimes the very short order. Again I think as we go into next year, we expect that we’ll see a good amount of foreign sales, will it be substantially higher than what we’ve seen in some of our peak years, we’ll expect the orders from these to go out (inaudible) with that like that.

Steve Shaw – Sidoti & Company

Okay.

Cary Wood

But I would suggest that it continue to be an important component of our overall DSS revenue next year.

Steve Shaw – Sidoti & Company

All right. Thanks, Cary.

Cary Wood

Thanks, Steve.

Operator

Thank you. Our next question is a follow-up question coming from the line of Andrew Shapiro with Lawndale Capital Management. Please proceed with your question.

Andrew Shapiro – Lawndale Capital Management

Yeah, hi. So you had mentioned about how the engineering DSS, the engineering sales were down in the sonobuoy side in addition to the productions that being down primarily with the foreign side. Is this is an indication that the development work for the high altitude, sonobuoy has now been completed; they were moving into the RFP state for production.

Cary Wood

I wouldn’t say that it’s completed, it’s going to continue to be ongoing, but we’ve obviously seen periods of fine quarters where there has been increased engineering involvement and certainly high altitude has been a part of it. There’s a lot of projects that run through our engineering down in DSS, not just high altitude or even future sonobuoy program. There is a lot of things that make up that engineering revenue. But I do think it’s fair to say that in the previous quarters where we saw heighten potential to prototyping and trials on the high altitude program, which is actually coming out over the course of the next 18 months to 24 months, that’s some of that has subsided for now and some of the testing and validation is now the customer location.

Andrew Shapiro – Lawndale Capital Management

Okay. And with the Navy’s first new P-8 Poseidon squadron going combat ready in Jacksonville this past month, and other squadrons to become operational over the next year, when should we expect the first Navy sonobuoy contracts for the newer high altitude to service them, are they able to or they are going to be operational using the legacy sonobuoys for awhile?

Cary Wood

We expect that – while there’s a couple of things there. We don’t anticipate that we will be providing high altitude sonobuoys an issue that what I projected going out into 2014 to 2015. What you might see is a little bit more on the way of testing in the near-term, prototype testing and deployment.

I think it’s a speculation suggested of using the legacy sonobuoys, that’s really not. The plan is we sit here right now and they are really not compatible. So I think generally what you’ll see over the near-term is the testing and deployment of high altitude in small quantities and you’ll see them continue to dial-in on the PA platform, and we’ll spend the next year doing that.

Andrew Shapiro – Lawndale Capital Management

Okay. I mean arguably they got to train. I mean the whole is very different plan.

Cary Wood

Correct.

Andrew Shapiro – Lawndale Capital Management

Now these high altitude [believes] especially you described them and how they have been rolled out in the involvements of their different animal. Should we be dealing the complexity to be an increased complexity, I can’t imagine they are simpler. If you got to still drop them on the target from higher altitude. So will the pricing and the margin expectations on these new believes be higher than the legacies?

Cary Wood

Well, it’s always tricky to discuss margins and pricing particularly when we are in the midst of contract negotiation. So I defer and getting too far into that.

Andrew Shapiro – Lawndale Capital Management

Okay.

Cary Wood

I would say that the average selling price is certainly going to be affected by the step function of the technological components we are in. Certainly, there is a fundamental differences between 20,000 feet and 5,000 feet. That’s certainly going to drive some changes in the sonobuoy and that’s going to drive changes in the material, material cost, it’s going to expand the average selling price. But for margins right now, I think it’s probably inappropriate time for me to get too far into that discussion.

Andrew Shapiro – Lawndale Capital Management

Yeah, I appreciate that. When should we expect the first Navy sonobuoy procurement contracts for the new sonobuoys to take place? There is – and in conjunction with that in case if it’s different RFP. The Navy has got a new RFP proposal that they initially listed it as what should be in the RFP and then they devised what the RFP is, it’s this whole milestone step they do. But for the first time that I’ve seen, it looked like it was going to be a 4 or 5 year contract instead of your traditional 2-year contract. Did I see the right thing and is there a shift and is that for the new higher altitudes or what’s going on?

Unidentified Company Representative

You are correct. That’s what you saw. It’s generally what’s been under conversation, will certainly change the line of sight we have for our sonobuoy engagement or maybe it’s been in a lesser time duration. It’s been as you mentioned. It looks more of a five year timeframe and again, all of that under discussion.

Andrew Shapiro – Lawndale Capital Management

Right. And then when do you expect that there would be the RFP in terms of – is it three months from now, is it six months from now, when you would be submitting and then the contracts to get less in about a year from today kind of thing or what..?

Unidentified Company Representative

Yeah, I mean I think you’re – you’re in the right – I mean you can book end it that way. We’re certainly internally under discussions right now and we’ve had conversations for the past several months with the Navy over high altitude guidance and the specifications and pricing guidance and on and on. And I would suggest that would like to think that that can materialize to its conclusion sometime this summer with a firmed up kind of contract agreement into the fall if we would be so lucky as to win that.

Andrew Shapiro – Lawndale Capital Management

Okay. And with this kind of change in technology et cetera, that’s always open doors for things. in the past, the Navy’s required bidders to prequalify, that you’re technically capable; you have classified clearance (inaudible). I’m assuming that that step might have already occurred and is Spartan approaching this via its ERAPSCO joint venture and any other parties other than your join venture party that are able to or have already prequalified to be part of the bidding?

Cary Wood

We are moving forward as we have in the past with our joint venture partner USSI to ERAPSCO. As far as other external competitors, I certainly don’t want to be so arrogant as to assume there, those who would like to participate in the space, but I would say that our intelligence suggest that we have obviously an inherent barrier. We’ve got the technology, the capabilities, we’ve got the engineering staff, we’ve got the experience, we’ve got the process, and all of that I think makes it very, very difficult for new player to come on to the scene. I think it’s also fair to say that most of the prequalifying steps had essentially come and gone. So this would be a very tough thing and as we said this before, for an outsider to get involved with as a new entrant, it would be a lot of infrastructure costs, it would be a lot of wait-and-see and it would be based on the speculated volume that may or may not materialize, it’s a very difficult business case to me. I would suggest that we’re in a very advantageous spot. But again I don’t want to be so arrogant as to assume that there are competitors those who’d love to get into the space.

Andrew Shapiro – Lawndale Capital Management

Right. Okay. I’ll back out again. I do have a few more questions, but in case, Sonny or someone else got something?

Cary Wood

Why don’t you finish those up, Andrew?

Andrew Shapiro – Lawndale Capital Management

Okay. So you didn’t talk about how your engineering staffs have been working on these things in your press release. You did cite and qualify about 300,000 this quarter as it’s been many quarters. So you’re doing about $$1.2 million to $1.3 million a year of internal R&D. Can you discuss what the – you’ve already rolled out a bunch of new products in the digital compass site and all that. What is down the milestones with respect to roll out of additional digital compass? And what other things is internal R&D expenditure is being deployed on and the timing of those product rollouts?

Cary Wood

We’re going into budget season as mentioned earlier. So we’ll be evaluating what our technological roadmap looks like within our research and development. I do think that’s it’s fair to say, we’ve seen good, sustained legacy revenue, but we’ve not seen as much as I would prefer, not that it’s way off. We expect it or hope to see stronger revenue demand on some of the programs and products that we launched in the previous 18 to 24 months. The expectations were fairly nominal and we are seeing some. It is a long, lead time item to get specked into major programs. We’ve always built that into our business cases assumptions.

We’re going to take a look this as to what our guidance might be and if you’ve gotten any clarity as to what you might hope to see with some of those programs that we’ve been working with and that will tell us a little bit about what we might want to continue to invest in. And we’ll have a product that will launch in the first quarter of fiscal year ’14. Some are (inaudible) product; it’s an inertial navigation system. But it is basically an enhanced compass and there are specific applications that we’re targeting for that. But again, as we go into our budget, we’ll take a look at what makes good sense for us. And I’d like to see us gain some momentum from the previously expended R&D before we continue to commit at the same level, that’s what we need to do.

Andrew Shapiro – Lawndale Capital Management

Yeah. You come up with all these good hydrophones and compasses with this tweak and that tweak and this capability and that capability, but you haven’t, in press releases, moved the needle enough that you’re breaking out and reporting compass sales and arguably it’s going to take too many compass sales since you’ve described and I’m assuming it hasn’t changed that your compasses have huge margins.

Cary Wood

Yes. Your summary is correct.

Andrew Shapiro – Lawndale Capital Management

Okay.

Cary Wood

I mean it obviously going to have a margin influence in a way that could be fairly substantial, as you’d expect with (inaudible) but we’ve not necessarily seen this hit on any substantial programs in the way that maybe we would have preferred now. Just to be clear, we have negligible expectations in the first two years to allow for the integration period of these long lead time items in the solutions that are out there two, three, four years from now. So I think you culminate all of that together and it’s not a disappointment, but I do think we have to take a careful and long look at what we’re going to do from here forward. If you’re using a five-year business analysis, an IRR threshold that you expect to get, you’re at a pivot point and you’re free, you got to make some decisions and I think that’s why we’re out of this.

Andrew Shapiro – Lawndale Capital Management

Yeah. Because arguably you’re not capitalizing these expenses; you’ve already eaten the expense and threaten at some point you want to payback. You mentioned in the SG&A in the DSS side, increased corporate allocated charges in the current quarter, yet your sales were down in the DSS side. and so what I was trying to understand is, what is the method for allocating the corporate charges if it’s not based I guess on sales, how and in what way does the allocated charges hit that segment greater in the quarter than where you had actually weaker financial activity?

Mark Schlei

Andrew, this Mark.

Andrew Shapiro – Lawndale Capital Management

Yeah.

Mark Schlei

We determined the allocation in our budgeting process. So the allocation is that walking into this fiscal year and we really don’t change the allocation within the year, it just causes a lot of noise within the segments, if we were to do that. So revenue being down…

Andrew Shapiro – Lawndale Capital Management

Your allocated charges went up, that’s what, so you’ve just actually made the point that it doesn’t switch around, but your script talks about how, I would appreciate or understand that it was the allocated, the charge as a percent of sales went up, but I don’t understand why it implied with the actual dollar value of the allocated charge actually shifted?

Mark Schlei

Yeah. year-over-year, the allocated amount of SG&A is up year-over-year.

Andrew Shapiro – Lawndale Capital Management

Okay. All right so, it’s a year-over-year dig on that okay.

Mark Schlei

I mean yeah, an impact of the Onyx fees, the incremental SG&A, which we anticipated or expected, and then we’ve had a three-quarter year-to-date financial realization related expenses, and then we had some deal costs that we’ve talked a little about. By the time, we get finished summing all that up on a year-to-date basis. you’ve got an incremental number that’s been allocated out, and I think the methodology remained the same.

Andrew Shapiro – Lawndale Capital Management

Okay. and with respect to the Onyx deal, you always approached. and so this is a good business you bought versus past businesses, which were more of a turnaround and as a result, you paid a certain valuable for this good business that you acquired and you had a certain expectation of accretion to result and I guess to the end of March, it’s been four months. From your language, your dialog on it, it sounds as is the first four months of this particular acquisition didn’t go as planned. But I did want to get clarification that your view on the acquisition is it, that you will still get the targeted results that got you excited about the acquisition; and secondly, kind of what kind of didn’t occur as you had hoped or thought and what changes to your acquisition strategy if any might that have given you some insight and experience for?

Mark Schlei

This is a sizable acquisition. And it’s gotten a lot of scrutiny, and I can appreciate that and certainly, understand why there are a lot of questions around it. The last two deals obviously, were well priced deals that were probably much riskier deals, in certain respects than what we did with Onyx; obviously, the magnitude of the impact given the allocation of capital is that question. But as we’ve looked at the last four months, the only think I’m disappointed in, and as the industry slow down and pull back in the third quarter that had an impact across our medical at large, which also impacted Onyx.

So we certainly laid out our detailed business case, return on capital scenario, expectations on revenue and contribution along they are in the first four months of our ownership. So we’re certainly going into our new budget year, feeling fairly optimistic about how Onyx is going to contribute. And so there’s nothing about the acquisition that I feel any different about. I still think it is a very sound acquisition. I just don’t have two years of trailing performance to talk to, I have four months. But I do understand that that generally speaking, it’s $43 million and it’s an expected contribution.

and I think we’ve been known to be fairly fast moving and we certainly demonstrated that with the last two deals prior to Onyx. This is a bit of a different animal. I think we’ve built in certain conservatism across our five-year projected outlook. I think we’d expect to get reasonable returns on capital while beyond our current average cost of capital. I think all the right scrutiny, review, planning is adequate, and I think every bit of my outlook remains the same. I think it’s going to be a very, very strong contributor to us, particularly on a cash flow and EBITDA basis for sure.

Andrew Shapiro – Lawndale Capital Management

So when you talked about the overall medical segment, the device segment is slowing a bit and the timing of it, I don’t think it’s just coincidental with the implementation and rollout of the medical device excise tax from Obamacare. Do you feel that that, because you’ve now given some decent visibility and a little bit more favorable or optimistic view in the medical device side that it was a temporary slowdown. Do you feel that your customers were just basically maybe scaling back or adjusting their inventory levels in light of their own uncertainty and now from those lower customer inventory levels, they’re selling along at the pace that they always had been?

Cary Wood

I think that lines up well with kind of the conversation we had last quarter. And that is that we saw it and take pause. It was paused, that was based on the unknown. I think we were fairly quick to respond to it and made the necessary internal changes best we could, and I think that they were obviously managing their working capital. But I don’t know that it changed much on the end market demand. And so as we move into our fourth quarter and certainly what we’ve seen on the – with our new business wins, it would suggest to me that the medical piece that certainly we saw in the third quarter soften as good outlook.

Andrew Shapiro – Lawndale Capital Management

So carrying that question in this dialog a little bit forward, as you obviously have to be aware of, the House has voted to repeal portions of Obamacare and the medical device tax was either a direct target or part of it and the Senate has specifically had a vote now to repeal the excise tax although in a toothless revolution, but there has been some comments now from the administration that if a revenue offset could be found that they are open to scaling back or dealing with that device excise tax if that were to occur, do you have a feel of that there maybe a rebuild and thus a little bit a of tailwind that could occur if and when any reduction or elimination of the medical devise excise tax were to take place?

Cary Wood

Well, I like to think that the relocation of the device tax is going to be more positive than not, as you’d imagine we do sensitivity analysis that suggest there’s upside what that mean to us what’s softening into us and how we manage it. In terms of what the outlook might be, it’s pure speculation, and I appreciate the logic and we’ll be prepared for either/or scenario and my hope is that if the demand dynamics don’t change and if there was relocation of the excise tax that’s only going further pace in the speed of production and we’ll certainly be able to grab it.

Andrew Shapiro – Lawndale Capital Management

Okay. When does your window for the buyback or any other insider transactions are obviously subject to possession of material and public info, when does that open in terms of how many days after the earnings announcement in install?

Unidentified Company Representative

Well, our internal trading policy put about two days, but then it’s always the issue of internal black out that will necessary effect the 10b5 loan that would have been off there and then filed. And as you remember we just lock the board meeting of authorization and then we’re midst of planning how that buyback will be executed.

But we’ll in the market as quickly as we can push together, rather bigger than that. We are certainly going to take advantage of any pull back on the price and change in the trailing 90 day selling price so which is certainly our objective and I think that probably hit on all the questions.

Andrew Shapiro – Lawndale Capital Management

Right, well, because I was mentioned that because the last year this time of the year starting by a fraction missed to cut out for its market cap qualifying for inclusion in to Russell 3000 in particular the Russell 2000 in that subset.

Unidentified Company Representative

And this year’s end of May measurement for the Russell is at least from sell-side brokerage estimates is that a market cap level that is below the company’s current market cap based on your 10-Q shares outstanding and you are just are or did announce. And your current price level. So it looks like there is a very high likelihood Sparton’s stock we’ll make it cut off at the end of May for inclusion at the end of June in to the Russell indexes. So you will be having a bunch of index bind that’s going to come in at the end of June and that’s just something as you evolved your 10b5 plan that’s out there in the public domain anyway. So its not….

Andrew Shapiro – Lawndale Capital Management

I want to make sure you guys know and you keep that in mind so that company’s buyback operations might frankly be there before the index funds are because they have the by regardless?

Unidentified Company Representative

Right we’re mindful of the cut-off, we’re mindful of what the estimated market cap threshold is to be when we sit right now with that and we also obviously excited about the prospect of getting into the (inaudible) how that might avail us to new funds that we’ve not spend a lot of time, and so, yes, we certainly understand the point you make.

Unidentified Company Representative

You don’t have to spend time with the index funds are basically black boxes that have to buy, but the trading volume of Sparton stock, the average daily trading volume of Sparton stock after the huge surgeon purchase for the year for those funds, there is going to be fund inflows and outflows that are basically going to create buying and selling of shares that should nicely increase the average daily volume and hopefully that will assist you guys in getting us some expanded sulphide coverage.

Unidentified Company Representative

Correct.

Andrew Shapiro – Lawndale Capital Management

Great. Well, thank you.

Unidentified Company Representative

Thanks, Andrew.

Operator

Thank you. Our next question coming from the line of Ross Taylor from Somerset Capital. Please proceed with your question.

Ross Taylor – Somerset Capital Advisers LLC

Okay. A couple of follow-ups on somethings that have been talked about prior in this call, one of which is, when you are talking about Onyx and its additive nature of the acquisition, there were some others (inaudible) pushing for the idea of a buyback and a buyback of that size would have added roughly $0.40 a share to earnings and almost immediately on an annualized basis and the talk versus deal would basically be as profitable as that or more profitable than that. I am not sure if I heard you correctly in the call, talking about a window for when we should expect to see that kind of profitability generated by the Onyx deal. What kind of time horizon should we expect to see that comparable earnings power generated out of Onyx that we would have gotten if we just bought back stock, which was riskless and not subject to the Obamacare tax?

Unidentified Company Representative

Sure. Well, first, obviously, it’s a detailed conversation around the assumptions that generate the $0.43 from a straight buyback and certainly, you and I can on a one-off have a very long detailed conversation on how that gets it to over $0.43. I think there are some assumptions around what price you might have got back to stock and just how much you would have ultimately achieved, whether or not, it would have been. So setting that aside for a moment, we’ve spent more of our time evaluating the accretive nature of Onyx, how it stands up to our IRR thresholds and how we get there from here. I think that as we go into our first full fiscal year next year with Onyx.

We expect it to be strengthening revenue, and we’re seeing that going into our fourth quarter, and we expect to see a strengthening of cash, EBITDA in a way that certainly will flip the first four months concerns and questions behind us. so I can’t sit here and tell you that it would be equal to or far above. but I’m certainly knowledgeable to what the business case looks like, what the return on capital is going to be. we expect that to come into full view. I know how that’s factored up against the allocation of our capital to a stock buyback program and how that might have been executed and it looks. So I think we’ve been thorough Ross. And I know you have a very strong opinion about the buyback and may have been done alternatively, but I got to tell you I said here, I’m very, very bullish on what Onyx is going to mean to us over time without question.

Ross Taylor – Somerset Capital Advisers LLC

Okay. But you also know that basically an end game oriented and my thought process is what I want at the stock price to truly reflect the underlying value of the business and I’ve long believed that acquisitions as well as the buyback are important core components of achieving that.

Cary Wood

Correct. And I know even certainly, you’d expect that the management team is mindful of that as well and our board is certainly mindful of that. so there is no question about it, that we’re all driving towards the one goal, M&A as a piece of that, and the stock buyback as you saw in the more recent announcements that something that’s been under discussion on a regular basis and certainly something that we’ll likely you to continue to do. We clearly support the idea.

Ross Taylor – Somerset Capital Advisers LLC

Great. For a while you had in your presentations the idea of a $500 million revenue target for the company. We’ve moved on we are now well in to the time life of that expectation, is that still something that – what kind of time horizon should we be looking at for that $500 million in revenue achievement, I understand it’s basically roughly two-thirds acquisition, the growth is two-third acquisition, one-third internal and I assume some of that acquisition growth also would be the internal growth once it’s put on the balance sheet.

Unidentified Company Representative

Correct. First of all we always said that we expected to achieve $500 million revenue run rate at the end of our fiscal 2015 that continue to be fairly optimistic but that’s achievable. I see the deal flow, but I also want to clarify that as I said before I’ll apologize for falling short of that by $100 million and making sure I make good deal. I am optimistic that there are deals out there that makes sense for us and it will be accretive and they are strategic and they are underwriting moves for us. And we’ll continue to pursue those. So I don’t – as I see here today, you are only differently about where we’ll end up at the end of fiscal year 2015.

Right now the full-year’s legacy is you would have compounded with a reasonable growth rate from last year’s finishing, roughly a $230 million to $240 million legacy piece and then you throw in what we expect to see from our Onyx with some level of growth that’s more bullish than that and I think that you get very much inline with what some of the analytics are for going in to next year which is without the influence of any additional acquisitions. So I think as we go in the fiscal year 2014, you can kind of try and get what we expect the revenue to be I think the analyst guidance is fairly close and in line and we still support that outcome. And we would do a deal or two going into next year, I think that further moves us along the expectations, you’re throwing some organic growth going into 2015 and another deal, I still feel like it is a very optimist outcome that’s very achievable going into the end of fiscal 2013.

Ross Taylor – Somerset Capital Advisers LLC

Okay, good. Now when we get there, what type of EBITDA margin should we be generalize and we get there and I would agree with you, I don’t really care if you fall 100, and rather you not do a bad acquisition and then do a bad acquisition to get the extra $50 million or $100 million in revenues. but what kind of EBITDA margin should we expect to see at this company, by that time, producing the new sonobuoys with having Onyx haven’t been run forward at that point over two years internally with medical products getting passed a lot of the substantial customer and things? When would things get on being upgraded as far as level of capacity, I think that nature, what kind of operating margins you would be looking at?

Cary Wood

Well, we’ve always came to the idea that we were going to see margin expansion that would get us and move us more closer towards a 10% EBITDA range, and that’s generally been our ambitions. Our next close on an EBITDA basis accretive out of the box, has been continued to be from the standpoint of our legacy business from EBITDA. And we think as we move forward with organic growth and tuck-in opportunities to better utilize our current assets, combined with some growth in the Onyx acquisition, some of our other businesses, we’ll continue to see expansion in margins, continue to see the impact EBITDA obviously, and we continue to expect that it’s moving into 2015, we’ll get closer to our 10% EBITDA ambitions.

Ross Taylor – Somerset Capital Advisers LLC

So, basically what you’re saying is on the next 27 months, if you achieve the goals which you have set for yourself and what you believe are achievable. We should be looking at EBITDA numbers are roughly $50 million?

Mark Schlei

Yeah. on a $500 million revenue gain in towards the end of ‘15 certainly given that we’ve kind of guided that, our ambitions are at 10% EBITDA certainly the case, yes.

Ross Taylor – Somerset Capital Advisers LLC

Yeah, your math is inaccessible. Thank you, I mean it sounds like you have tremendous opportunity obviously is coming to our close to executing the starts with that substantial upside and we’ll support what steps you need to take to get there.

Mark Schlei

Thanks, Ross

Operator

Thank you. Mr. Osborne, I will now turn the call back to you. Please continue with your closing remarks.

Michael Osborne

Thank you. And I’d like to thank all the participants in today’s call. Again, the call including the question-and-answer period has been recorded and will be posted to our website under Investor Relations later today. Thank you.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Have a great day.

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