Sparton Corporation F2Q10 (Qtr End 12/31/09) Earnings Call Question and Answer Session Transcript

Feb.16.10 | About: Sparton Corporation (SPA)

Sparton Corporation (NYSE:SPA)

F2Q10 (Qtr End 12/31/09) Earnings Call

February 16, 2010 11:00 am ET

Executives

Mike Osborne – SVP, Business Development

Cary Wood – President and CEO

Greg Slome – CFO

Analysts

Andrew Shapiro – Lawndale Capital Management

David Wright [ph]

Bruce Baughman – Franklin Templeton Investments

Charles Dierbach [ph]

Question-and-Answer Session

Operator

(Operator Instructions). One moment please for our first question. And our first question comes from the line of Andrew Shapiro. Please proceed with your question.

Andrew Shapiro – Lawndale Capital Management

Hi, good morning. In your costs and your margins here, I just want to get some clarification of what items of note, good or bad, were nonrecurring in the present quarter and if they are in the SG&A or in the cost of goods sold line item?

Greg Slome

Sure, Andrew. I'll take that. Really, as far as the significant nonrecurring things, obviously we had the restructuring expense, which has continued into second quarter, $1 million obviously in operating income, you can see that on the page of the income statement.

The second piece is $250,000 of expense related to the stock options that were granted in November. The options had immediate vesting, so the full charge was taken in the second quarter; once again $250,000 expense item and that went through G&A. Third item I'm pointing out is obviously you can see on the income statement the $2.1 million debt benefit that we incurred related to the carry-back provisions that were changed and we basically reversed out a portion of our deferred tax asset valuation allowance.

Fourth item, we had a true-up of our pension expense, amounting $270,000. We had the final valuations on as of the June 30 asset value and adjusted the estimate that we had booked in Q1. If you remember, Q1, we had a total of about $500,000 of pension expense. The net in Q2 was $225,000. On a go-forward basis, in Q3 and Q4, we expect it to be in the range of $350,000. And most of the pension expense went through gross margin.

Say, the next item, really two things that – really once again, I won't say are nonrecurring, but relate more towards the use of accounting estimates and that really relates to our obsolescence reserves on inventory and also our rework results related to the contract accounting on the U.S. Navy contracts. And once again, we did – the pickup of about $400,000 that went through gross margin related to adjustments to our obsolescence reserve. Most of that was the benefit that we realized from a lot of the foreign sonobuoy orders that we picked up and we actually were able to utilize a lot of our production materials that we had considered to be slow-moving and sequentially obsolete.

And then lastly, similar to last quarter, based on the successful sonobuoy drop tests, we released approximately $400,000 of reserves related to rework. And once again, that, looking forward, is based on our ability to continue to achieve the success levels that we have up to this point. Those are really the major items that I would highlight.

Andrew Shapiro – Lawndale Capital Management

Okay. And with another quarter under your belt and the restructuring, as you said – as Cary said, substantially are completed, can you confirm again or summarize what your long-term gross margin goals are for each of the medical, DSS, and EMS segments?

Cary Wood

First, I want to delineate the difference between what we say and what's to be taken from that statement. We believe that the financial expenses associated with the restructuring are substantially behind us. We still know that there is a great deal more to be done out in the operations, which will lead to what I believe ultimate gross margin performance to be.

I continue to maintain the guidance, Defense & Security Systems being the 15% to 18% and growing more optimistic that our performance that we have seen in the preceding few quarters, particularly in the areas of quality and reduced rework is gaining some level of sustainability and perhaps in a future call, I can adjust that forward-looking guidance. But for right now, I think sustaining the 15% to 18% is where we will remain for now.

From the medical standpoint, I continue to maintain the guidance of between 13% and 15% and we are seeing that, it's up substantially from year-over-year quarters obviously, but I'm also starting to come to appreciate the space and the opportunities in it, but not something that I'm willing to adjust guidance on just yet.

The area where I'm starting to grow a little more confidence in its performance outlook is in the area of our traditional EMS business. While it's reduced substantially in volume, we closed out better than 60% of the footprint capacity. We believe that there is an opportunity to perform at double-digit gross margins that we've not seen.

We've seen hints of that while you don't see monthly financials, you see a quarterly consolidated. We've seen months where it has outperformed our internal guidance substantially and shown promise of double-digit gross margins. And then we'll turn the corner and go into a month where we see inconsistent performance from the standpoint of quality and throughput and cycle time to standard.

So what it tends to me is we will executed, better executed, we can start to move closer to double-digit gross margin. So while we are not comfortable suggesting that it would be a 10% to 12% gross margin performer between now and the close of this quarter or even into next quarter, we are starting to identify specific actionable items that acted upon can start to get us to a level of sustainable form, it's like what we started to see in our Defense & Security Systems.

So I'm not necessarily revising my guidance, but I'm at least giving you some insight as to what kind of progress we are seeing that I think will ultimately lead to a change in our guidance in forward-looking quarters.

Andrew Shapiro – Lawndale Capital Management

Okay, great. I have many more questions, but I'll back out into the queue and let others ask, but please come back to us.

Greg Slome

We'll do.

Operator

Our next question comes from the line of David Wright [ph]. Please proceed with your question.

David Wright

Good morning, Cary.

Cary Wood

Hi, David.

David Wright

Just to frame what's happened to your – a year ago or so, you had a company that was capped out on its line and told to go find another lender. And through a lot of hard work, you turned it into a company with no debt and cash, and I surmise a lot of that came out of balance sheet management and mostly stuff in EMS. You've gone through the three businesses here and I have two questions. The first is on DSS. Is there ever any visibility in terms of a pipeline or do these foreign orders just come along?

Cary Wood

It's a good question. We have obviously great deal of visibility and awarded contracts over a defined time period with the U.S. government for sure. And that's highly reliable and it's typically is 12 months to 15 months in duration and we have sat on anything as high as $60 million to $70 million and we will be announcing that award in the coming days as we work through the approvals of the announcement with the U.S. government and then we feel comfortable that there will be a second award out in the March.

So we think that the backlog that we have seen in the past, while we believe is we will slightly grow, it will continue to be just as visible and hopefully somewhat higher that we've seen in the preceding quarters. Foreign sonobuoy business is a little bit different. It comes through exclusively our ERAPSCO arrangement, which is Sonobuoy Tech Systems (inaudible) and generally, it's not something that we have a great deal of forward-looking kind of outlook on.

We might have a quarter or quarter-and-a-half's worth of outlook. That’s why, as it stands today, I can fairly confidently state that going into the third quarter, our foreign sonobuoy business will be probably half of that, which we've seen in the first two quarters. But beyond a quarter or two quarters, that visibility significantly reduces.

David Wright

And just a question, one A [ph] on that, for the foreign portion, what's a good order from a country? Is it $5 million, $10 million, $2 million?

Cary Wood

Our first half of the year was roughly $9 million worth of foreign sonobuoy sales and our second half, as we have said, that's visible to us is roughly half of that.

David Wright

And that's multiple countries?

Greg Slome

Correct. As you start to now segment that down, you could go anywhere from a $200,000 to $1.5 million. I would generally say the range is between $1.5 million and $3 million on a foreign sonobuoy order. But like I said, you've got some extremes in there, we've got a Spanish order coming up from Spain of $200,000; we've got an order for Norway, which is just short of $2 million; Japan, Taiwan, each of which are slightly in excess of $1 million up to $1.5 million.

So generally, I would say $1.5 million to $2 million is a reliable order from a foreign-friendly source.

David Wright

Okay, that's very helpful. Then, my second question goes to EMS and if you are turning the ship around, you talked about kind of what you would like to get it to, but can you give us a time frame and may be give us one or two slightly broader examples of new opportunities that you think could feed your growth plans?

Cary Wood

Some of the new opportunities kind of come from two sources and I'll give you a longer answer probably than you anticipate. But I think most of our – even current customers were putting us a bit on hold, as reason is three quarters ago, two quarters ago, waiting to see us come out of this financial turbulence. They weren’t sure that we were going to be able to manage through the working capital investments, they weren’t sure that we were going to be able to maintain facilities open that we had ultimately selected for them, and I think in general, they put us on a penalty box.

Aside from they putting us in a penalty box for our financial status, I would also tell you that our performance was waning significantly in the areas of order performance and promise dates on delivery and while those things aren’t often quantified in any of our financials or our analyst calls that are shared with you, I would generally say that most of the customers in EMS were frustrated with our performance and fearful of our financial state and they put us into a penalty box that created a great deal of urgency on our part to explain to them our path where we were headed, what they could expect from us on a quantifiable basis over a defined period and that has started to take hold.

And one of the single biggest examples of that is one of our largest customers in EMS where they've been monitoring closely our delivery and product fulfillment. And that has significantly improved, which has taken us from a red status, which is hold, which gives us no opportunity for new business, to a yellow status, which takes us off of the customer being de-sourced to back into a green status, where they are now starting to consider us for new opportunities. And that example is the same across the board with some of our current customers. So those are opportunities that are now reopening that weren’t available to us as recent as two quarters ago.

In addition to that, we've started to have discussions with folks that we've never done business with; I'm reluctant to call them out by name on this call. But they have visited us because they've been in trouble with some of their current customers and they've asked us to go ahead and run prototype samples of our Sparton Express line, which is in general supposed to have done just what it did and that is attract customers that are otherwise troubled with who they are engaged with, are looking for a quick turnaround, and are hoping that we can provide them some insights as to the speed, cost and those are opportunities that we are aggressively pursuing.

And we've seen more of that just in the last quarter than we have seen two quarters ago. All of those things are going to continue to fill the pipeline. I don't believe that aerospace in and of itself is a bad place for us to be, it certainly attracts large volume opportunities, but we tend to be fairly good and gain ground on getting better at areas where it's low-volume, high-complexity types of opportunities that might be somewhat outside of aerospace. And so we continue to concentrate on those things as well.

So while I don't want to sit here and talk about the many millions of dollars of opportunities that we have worked through and failed to secure in the preceding quarters, I would tell you that there has been a great deal of progress in the last quarter securing customers that had otherwise, like I said, put us in a penalty box.

So long answer a bit to your answer, but where that ultimately, I think, heads us and I'm growing far more confident is that this is a business that can ultimately achieve double-digit gross margin performance and that is our benchmark and we will get there. I don't know that it would be there in a matter of a quarter. I would be very careful not to say that and then under-deliver. I am confident that by the tail end of our fourth quarter, we will start to see some level of sustainable improvement and I would suggest to you that that's the way we are going to go into our 2011 fiscal year planning is that type of performance.

So long answer to your question, David. I hope I hit on the points.

David Wright

Yes. So – well, I guess then just a timeline to surmise off of that is that we could start seeing some improvement from the second – I'm sorry, from the segment in the second half of this calendar year?

Cary Wood

We could. But I'm far more optimistic that if we were to talk like this in a call at the end of our first quarter fiscal '11 that that is the type of operating performance we should be seeing.

David Wright

Okay. Thanks for taking my questions. Keep up the good work.

Cary Wood

Thanks, David.

Operator

Our next question comes from the line of Bruce Baughman. Please proceed with your question.

Bruce Baughman – Franklin Templeton Investments

Hi. Following up a bit on Andy's questions, in the analysis of operating income, the other unallocated, it's a big jump quarter-to-quarter and six months year-over-year. Can you take that apart for us?

Greg Slome

Yes. The biggest driver there is really the shift; I would call, in the makeup of our SG&A.

Really, quarter-to-quarter, when you look last year, this year, and really for the first six months, SG&A overall was flat, which will really guide a shift in the components of that with all the restructuring actions we took, the plant closures, the cost reduction actions in regards to headcount and benefits really see a shift in the makeup from the normal – what we would call ongoing SG&A costs that typically get allocated to our three divisions, being replaced by an increase in legal fees, increase in costs associated with the stock options that were issued, increase in costs related to the short-term incentive plan that was put in place.

The majority of those costs are items that typically don't get allocated to the individual segments and that's really why you see the uptick in the unallocated piece in the current year versus last year.

Bruce Baughman – Franklin Templeton Investments

Does that suggest that these are – these unallocated pieces are ongoing? They all sound like they are going to continue except maybe in the legal fees.

Greg Slome

Yes, most of them are ongoing. The stock option expense portion of it, the $250,000 that was recorded in the quarter, obviously that's tied directly to the issuance of the options in November. From a legal standpoint, in all the professional fees, we have – we are making our best effort going forward to keep costs under control and try to – hopefully, we'll get some reduction there. But overall, outside of the stock option expense, I would claim that most of items are ongoing.

Bruce Baughman – Franklin Templeton Investments

Okay. So we are seeing significant improvement in operating income, but on a – in terms of what gets to the bottom line, there is a bigger hurdle to get over, I guess, is a takeaway.

Cary Wood

I think there is part of – I think that's partly true. You are certainly narrowing in on the issue of SG&A and I think it's fair to say and we've mentioned it today that it is flat from a year-over-year comparison. It's not lost on us and if we were to start to peel that back and put it into three essential buckets, you are looking at an executive team which has replaced what was a lesser bandwidth and we brought about a different degree of competency and that's obviously coming across.

We've also embraced certain kinds of compensation approaches that were not and they are – in the past embraced and they are intended to keep the team and the folks that have a great deal to do with kind of turning this thing engaged and involved in this company for the long haul. So that's certainly an issue for us to manage, but I think it's the right investment.

The second is – will be IT. We are targeting a 2% cost of sales IT environment. It has been slightly higher than that in the past and it has been on old technology with very expensive maintenance related contracts. We feel like we are making some inroads in that area. But just as we make inroads to reduce old equipment, old applications, and we look to reduce the overall staff size, but augment it with better bandwidth, I'm going to see that as we look forward there is probably going to be some level of investment in our IT infrastructure, some of which will come through CapEx, some of it will come through SG&A. But again, our internal target is about 2% where it's been about 2.5%.

And then the last has to do with professional related expenses and fees. And this year, it appears through our first two quarters that essentially we've replaced what we reduced last year, what we disengaged and made some changes and by the time we get done taking those costs out, we've essentially replaced them with both legal and some other outside service related expenses. I would say that the IR initiative has been a fairly successful initiative and it is one that we undertook in the first half of this year and we'll start to slow in just how much we will invest in that in the third and fourth quarter.

Second, we've invested substantially in some outside help in formulating some of our third-person data on our strategic deliverable to ourselves about what our outlook was going to contain and that will start to reduce in the third and fourth quarter.

And then finally, some of the legal related expenses, we are going to have to take a variety of different looks at it and I would suggest that a great deal of it has been associated with the preceding restructuring activities, review of contracts, dealing with potential litigation, all of that has been, I would say, at a much higher level in the preceding two quarters than I would hope, if not anticipate.

So while I don't want to offer specific guidance on our SG&A all the related, I think there is reason to believe that it should start to come down over the course of the next several quarters. So before we conclude that – we've got a ways to go, we don't know how to get there and it's a problem. I would suggest that it's very much under radar, we know what's driving it and we believe we know what the opportunities look like in the next several quarters.

Bruce Baughman – Franklin Templeton Investments

Okay, thank you.

Operator

And our next question comes from the line of Charles Dierbach [ph]. Please proceed with your question.

Charles Dierbach

I'd just like to know why the big drop today, down over 12%. Is there any particular reason?

Cary Wood

Are we talking about in the stock price?

Charles Dierbach

Yes.

Cary Wood

I wish I understood that science of the stock price, to be honest with you. There is a great deal of a reduction – well, there was a good amount of volume from what I saw, a couple of hundred thousand shares, but I'm not sure I can't comment. Again, I've said this in the past to both here and in others venues where I've been asked to comment. I wish I understood it, but I'm not going to spend a lot of time trying to figure that out. I think – in general, we keep doing what we do.

Charles Dierbach

Okay. Okay, thank you very much.

Cary Wood

Sure.

Charles Dierbach

That – that's good. Okay then.

Operator

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

Andrew Shapiro – Lawndale Capital Management

Hi, thank you. I just wanted to get a little – I guess I'm clarifying what you guys discussed with – in Bruce's question. If I look at the income statement, I see a sequential increase from Q1 on SG&A of just shy of $600,000, which may or may not have been the $600,000 he was referring to, but then there is another line item which is called SG&A other – or it's the other one. And that's also $600,000 and coincidentally maybe almost $600,000 from the prior quarter. It looks like from your 10-Q, one of these line items is referring to what's called carrying costs of facilities held for sale.

So if you could at least help me understand what the extra expenses in the SG&A and SG&A other line items were this quarter versus last quarter and to get an handle on, for example, this carrying costs of facilities held for sale, are these costs and levels recurring until those parcels are sold, that would be helpful for me to kind of understand and get a feel for what the fixed costs of this business are.

Greg Slome

Sure, Andy. Well, the SG&A line, the increase from Q1 to Q2, single biggest driver there once again is the stock option expense of the $250,000. And then there was also a bit of an increase that went through that line related to sort of short-term incentive plan and then also bit of an increase in professional fees. So that's really a more traditional SG&A.

The other line within our operating expenses is really associated with the carrying cost of the vacated facilities. In Q1, we – if you thought we were still operating out of debt and it was still ahead of full quarter of production going out of Jackson. And so really those – what we – what now is getting classified as carrying cost in the first quarter was still being pushed through gross margin on the production and the sales that was occurring.

Really going forward, we are probably looking at about $300,000 a quarter that we currently expect as long as the Albuquerque, the London, and the Jackson facilities remain in place and obviously, you have a lot of cost, real estate taxes, some of the maintenance costs going on with it, some of the other items that kind of get backward into that. But that's really going forward as long as those faculties remain in place then we probably get back to about $300,000 a quarter to –

Andrew Shapiro – Lawndale Capital Management

Okay. That will be like a separate line item for those facilities until they are – as each one sells off, that will start coming down.

Greg Slome

That is correct.

Andrew Shapiro – Lawndale Capital Management

Correct? So can you – I'll take the opportunity to follow up on that exact point. Can you update us on the progress of selling these facilities and are they each listed for sale at their book values or I believe from prior calls or public broker listings, they are being offered at higher pricing, for example Coors Road is on the books I think for only $107,000, but I think you said it was offered or appraised for several millions more.

So can you give us an update on the status, what they are – which ones are listed for more than – or offered right now for more than what they are on the books for, obviously if you are offered for less, then you would have impaired them and dropped them down. So it's just an embedded gain.

Cary Wood

Right. Okay, generally, just so everybody – just to remind everybody, we'll talk about four parcels, we are taking about Jackson, Michigan, London, Ontario, two in the Albuquerque area, one referred to as Bluewater and the other one referred to as Coors Road. In all cases, they are either listed or a price being sought out well above the book value. So you are right, there is a bit of an embedded gain there that is opportunistic.

I would say that on each of the parcels, the activity has substantially improved in terms of making a sale. I don't want to get too far into the specifics of each one of these, but I would say that in Albuquerque, we've got a tentative offer on both properties that we'll looking to work through, certainly don't want to make that anymore messy by having conversation here about those and we've got a ways to go, but we'll work through that and certainly the impairment aspect is squarely on our mind.

Secondly is the two other parcels that – one in Jackson, the other in London. We believe that we've got a plan to manage through those sooner than later and my hope is that by the time we close out our third quarter, we've got some news on at least one of the four parcels and by the time we close out the fourth, we could have some news on two of the remaining three.

So I think between now and the end of the year, our objective is to move on three of these, ideally well above the book value, which is what we anticipate to happen and we certainly can use the cash for other opportunities, but just as important, you pointed out, is the operating expense, which is no small issue, on four facilities of which they still require some level of maintenance, oversight, security, these is no small cost and that's certainly a cost that we are anxious to take off the income statement in general.

So I hope that answers the question, Andrew.

Andrew Shapiro – Lawndale Capital Management

No, it answers it real well. Now, the assets held for sale line item though – I was curious about this, I think you have increased in Q2 end of December from the prior quarter and I was wondering what impacts that or what causes it to increase and does that mean it increases each quarter?

Greg Slome

Andrew, that really relates to the reclassification of both the Jackson and the London properties. At the end of the first quarter, we had still held those as part of PP&E and we have now listed them for sale in the second quarter and that drove the reclassification to assets held for sale. So it's nothing more than a re-class between PP&E and the assets held for sale. We do not expect that to change going forward and so we – start to sell the properties.

Andrew Shapiro – Lawndale Capital Management

Okay. Now, your 10-Q also discussed $2.1 million of newfound tax refund opportunity that Sparton is going to file for. Can you discuss the timing you expect to receive this newfound cash and after the related reduction in Sparton's NOL, which I think the 10-Q said it would be a – kind of divided by the tax rate, about a $6 million reduction in NOL. What's your reduction now and what would it thus be at after the collection of those refunds and thus reduction of your NOL?

Greg Slome

Sure. On the tax carry-back, it's really two tax law changes that are creating the $2.1 million. First change is the change in the tax regulations allowing us to backlogs five years and we expect from that to generate roughly $1.5 million out of the $2.1 million. Second change in the provision was an ability to carry back up to 10 years cost related to – associated with both the EPA remediation and workers' compensation. And so we anticipate going through that, that's another $600,000. We anticipate that the actual returns will be completed and filed within the next two months and then obviously it's in the hands of the federal government as to when we actually get the cash back. We are pretty confident that it will be in the near term herein. So we are pretty confident on that.

Andrew Shapiro – Lawndale Capital Management

Okay. And then, what's the NOL at right now?

Greg Slome

We started at the end of June, we were roughly about $25 million. The reduction as we disclosed in the Q related to these carry-backs as just a little bit over $6 million, which would put us down to $19 million and then we would – it would come further based on the taxable income in the first six months of the year. And I don't – that number, I don't have available at this point, but going off of book income pre-tax, probably looking at pulling it down another $3 million to $4 million.

Andrew Shapiro – Lawndale Capital Management

Okay. So it's still got about another $16 million of shield for the rest of this year and going forward?

Greg Slome

Correct.

Andrew Shapiro – Lawndale Capital Management

Okay. And I have a few more questions about your individual divisions, but again I'll back out into the queue in case someone else –

Cary Wood

Andrew, why don't you go ahead and take care of those couple more questions while we've got you now?

Andrew Shapiro – Lawndale Capital Management

Okay, great. So in DSS, you – last quarter, you talked about how there was an expectation or a thought that maybe even 17% – a decent percentage of the overall revenue stream in this fiscal year would be related to various engineering work on developmental contracts the U.S. government or commercial application of existing technologies.

Can you give us a handle on, I guess, the progress and the status of some of that, as well as, in particular, your navigational systems or digital compass and other products you specifically mentioned had some commercial opportunity outside of the defense channel, as well as maybe additional opportunities within the defense channel?

Cary Wood

Wow, lots of questions there. Generally, I would say that our engineering sales as a percentage of revenue is fairly consistent with our guidance and I'm looking at number right now that suggest it's about 18%. So that's pretty much what we had expected.

Secondly, while you didn’t ask it, I would suggest that our gross margin guidance on those types of opportunities are fairly consistent with what we said, 10 plus, typically on a cost plus basis we do have some opportunity to enhance that, but in general, we stay fairly consistent with our guidance on that.

I would also say that – I feel fairly – I'm actually very pleased with the progress we've made there. We brought in some business development talent that we did not have in that arena. I would like to significantly dilute down the sole importance of sonobuoy sales to that business and as we've mentioned, start to bring to the forefront the supporting technology and some of that we've already started to explore opportunities.

For instance, I mentioned port security and while I don't want an opportunity like that to go out to public too specific, we are engaged with a foreign-friendly government that is looking for some specific technology that we feel and they agree is applicable to port security. And we feel if we can get that opportunity both engaged and under our belt as very real, then I think that opens up other like kind opportunities including domestically. And so we feel fairly optimistic about that.

I also talked about the fact that we've got about eight different specific product development opportunities under evaluation, some of which are going to require some internal funding, others requires a bit of time, but it's far more specific R&D related projects other than sonobuoys that were not engaged and/or started that now are.

And while I'm not optimistic, they are going to take hold in the next six months, we are certainly hard at it. Our business development guy is currently all over Asia and Europe and our belief is that over the course of the next 90 days, we will have significantly primed the pump in Defense & Security Systems and started to lay the groundwork for potential opportunities.

So I think we are doing all the right things. I think generally, as we mentioned the takeaway, is that after having been at a penalty box for so long that the upswing on growth is going to take a substantial amount of effort. I think that we have done in medical and being able to make gains in the first and second quarter on a year-over-year sales comparison is fairly good, I feel pretty good about it. I think from the standpoint of what we've gained in the Defense & Security Systems through foreign sales in particular and how that's affected our business from our internal expectations is also fairly good.

What we've seen within EMS is fairly flat and it meets our internal expectations, but I also know what the last quarter and a half has looked like and what's run across Sparton Express and what kind of things our strengthened balance sheet is enabling us to do and talk with potential target customers.

So I think we are making good inroads here. It's certainly not lost on us, that growth is going to be the engine to the next iteration and I think we are doing the things that you've expected us to be doing and over the course of the next few quarters, we'll see some of that stuff start to take hold. But I'm also realistic. I think we are going to have to continue to manage this business as it exists today without a whole lot of expectations on the revenue topside anytime soon, just because of the nature of the other supply chain issues.

So that being said, did I hit on all of them there, Andrew?

Andrew Shapiro – Lawndale Capital Management

You hit on the DSS and medical. A few follow-up questions on EMS.

Cary Wood

Sure.

Andrew Shapiro – Lawndale Capital Management

You mentioned earlier the loss of a certain programs from a fourth customer that you were still engaged with. I'm assuming you can't identify the customer, but if you can, please do. More importantly, the cause of the loss of the program – for example, was is it a completion of the program, did they move manufacturing in-house or did they move it to a competitor and what do you expect your trend with this customer to be?

Cary Wood

Yes. No, it's a fair question. We obviously wouldn't want to disclose who our customer was in that case. But I would suggest to you that it was essentially an expected end-of-life program. So there is nothing about it that I take from it to be concerning and I would go on further to say that this is a customer that has put far more new business opportunities in front of us here more recently to replace that.

The issue is that if you look across the preceding four quarters, a lot of our – even current customers like I mentioned, slowed down opportunities for future business. So that has come to slow and that is starting to kind of regain some momentum and what we will see is we will see some of the preexisting programs fall off like what we just talked about, we will see some of the activities look to replace that, but there will be a bit of a low before that starts back on the upswing. Certainly, a consequence of failed performance in the preceding year.

Andrew Shapiro – Lawndale Capital Management

Okay. And Honeywell sales, what were the Honeywell sales in this Q2 and it sounds as if, please confirm, there are no expected Honeywell sales in Q3 ended March that they finished up in the December quarter and thus that would have a negative impact on margins by having completed Honeywell's restructured contract, right?

Cary Wood

Right. Well, a couple of things there. First we are essentially done with Honeywell going into third and fourth quarter. We had a remainder of sales of about $0.5 million worth in the second quarter. And generally, that issue is come to a close and it's behind us. We don't sit here and plan for changes in any of our Honeywell circumstances and the business that we've been engaged with them. But I certainly know that we are performing far differently and better than we were a year ago and I know we are viable supplier and we are quite capable.

And so I wouldn't discount the possibility of some future engagement, but it will be certainly different in the way that that is being initiated and was ramped up and was agreed to. I wouldn't hold out hope for that anytime soon, but I know that we are a darn good supplier and that that is something that we wouldn't – we wouldn't necessarily discount the potential of happening over time. I don't know, nor do I – I'm sure do I agree that it will have a gross margin impact.

Andrew Shapiro – Lawndale Capital Management

Oh no, it was only $0.5 million in sales. It's not going to be a big deal –

Cary Wood

Yes, it's negligible at best. And our challenge in that business segment as I mentioned is more about operating performance, it's about adding new business opportunities with some value-added kind of margin too, but generally I think we see the opportunities based on our performance in the second quarter, what we should be expecting to see out into the fourth and into the first of next year.

Andrew Shapiro – Lawndale Capital Management

Okay. And carrying over on this EMS, just a final divisional question on EMS is Vietnam. Where are you in the process of determining the viability in that facility, one of your tests was whether the backlog would be growing at a pace and has is grown at a pace that you expected and if not, what's the time frame or milestones you are going to look towards making decisions on that part of the business?

Cary Wood

There is a couple of things there to talk about. First is that our objective was to ship volume to go ahead and see if we couldn't strengthen the absorption of that operation. I think we've done that substantially. Second, I would say the objective was to reduce its breakeven and we've done that substantially.

Third, I would say that it was to prime the pump for new opportunities at a low-cost country footprint might avail itself to and we've seen some substantial activity and while we've not made an announcement on it, I'm reluctant to that here, we have been awarded a substantial cargo contract that will start to layer into our Vietnam operations over the course of the next few quarters. And in doing so, I think that we will not only achieve improved level of revenue, but we will start to see the breakeven be as we had expected and hoped and that has come down I want to say about 20% from two quarters ago.

So generally, I think all the right things are starting to converge. The volume in Vietnam is up almost 120% of the rate it was a year ago. So the plans we've had for Vietnam, we at least are seeing them take hold. I wouldn't discount them being at more than breakeven scenario going into the first quarter of 2011. We've seen shades of greatness in the first quarter on a month-over-month basis and then we turn around and the revenue drops substantially. But we're starting to see some of the aerospace orders start to strengthen, take hold and we are certainly benefitting from that in Vietnam.

Andrew Shapiro – Lawndale Capital Management

Okay. As you are bringing this cash from a tax refund and you bring in the cash for not having to pay taxes because of your NOL, unprofitable operations and as you bring in cash from the sale of assets held for sale and cut out the maintenance and ongoing operating costs of those vacant facilities, what are your thoughts and plans with respect to the cash that would eventually build up here at the Company? Is the thought – what are your prohibitions from conducting a stock buyback for example?

Cary Wood

We've been reluctant to go. We have considered that, we've obviously had some opportunities to undertake that possibility and we passed on that for a variety of reasons. But I would say, paramount to that was the fact that we had what we believe to be better usage of our cash to our shareholders' benefit.

And specifically, we feel like there are some R&D opportunities that we want to fund within Defense & Security Systems. We think there are some specific M&A targets on the medical side that we certainly wanted to have those cash in avail for that type of an opportunity. And then we knew that this business is still yet in a bit of a turnaround.

While I can't continue to use that, I think it is true that this business is susceptible to opportunities that it kind of falls back to its own way. I think that I'm growing far more comfortable every single period, every single quarter that we've certainly rooted out a lot of operational bad habits. I certainly have a certain comfort level with cash on hand that I would otherwise likely not have if things were performing better than where we are at today and certainly, that's obviously better than it was several years ago.

But in general, I think we want to put our funds to use in places that I think are to our shareholders' best advantage and I think that includes M&A, I think that includes product line extension through internal development, and that's where our focus is for the invested funds. I would also say that we plan to invest fairly substantially going into 2011 in our IT infrastructure, specifically into an ERP and I think that is going to standardize the methods in this company in a way that allow us to scale up effectively as we look ahead.

So I think we've got specific earmarks for our cash. It doesn't include at this time a stock buyback, but it could and it's just not something that has passed either management or Board of Directors' discretion at this time.

Andrew Shapiro – Lawndale Capital Management

Okay, great.

Cary Wood

Andrew, we will take one more question from you.

Andrew Shapiro – Lawndale Capital Management

No, I'm going to actually back out and let someone else ask, if there is.

Cary Wood

Thank you, Andrew.

Operator

And there are no further questions at this time.

Mike Osborne

All right. Well, I'd like to thank all the participants in today's call. We apologize that we could not get to – well, I guess we got to everybody's questions today. Again, today's call includes the question-and-answer period, has been recorded and will be posted on our website on our Investor Relations later today. Thank you.

Operator

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

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