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Executives

Cary Wood - President and CEO

Mark Schlei - CFO

Michael Osborne - SVP, Corporate Development

Analyst

Arnie Ursaner - CJS Securities

Ross Taylor - Somerset Capital

Tom Kerr - Singular Research

Andrew Shapiro - Lawndale Capital Management

Sparton Corporation (SPA) Q2 2014 Earnings Call February 4, 2014 11:00 AM ET

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Arnie Ursaner with CJS Securities. Please go ahead.

Arnie Ursaner - CJS Securities

Hi, good morning and congratulations on some pretty good results. My question relates to the Sonobuoy piece of Defense & Security, obviously for a while we’ve been talking about a transition to the next generation. You’ve got a mix of domestic and international customers, so I guess the broad question I’m trying to get a feel for is can you update us on the status of the new program. Are you already seeing the Department of Defense start to reduce orders in anticipation of this new program, are you shipping products? Help us walk through the transition over the next 12 to 18 months in this program.

Cary Wood

Yes, we continue to anticipate the announcement of a newer longer-term contract just as we had been discussing for many, many quarters. We’d always said we’re very optimistic to hear anything by the end or even the beginning of the calendar year, but we also said that we didn’t expect to reasonably hear anything until probably the late March, early April timeframe. We continue to maintain that outlook.

At the same time, there is a lot of independent information out there that suggests that the defense orders going forward could be enlarged and while I don’t have anything to announce right now I suspect that things haven’t changed dramatically from what that guidance has been prior, so I feel real good about the timing. It’s very much in line with what we’ve been talking about. I still feel guardedly optimistic around what the outlook is for forward looking volumes, that’s certainly something that hasn’t changed in our views.

Prior to the first couple of quarters performance has been about the same as what it was last year with a little bit of a richer domestic mix than foreign mix, the first six months of this year compared to the last, but our outlook continues to be positive. I think our readiness is exactly where we want it be from an operating perspective. We have long before now been testing and prototyping in a way that we feel confident about the product, but I would also suggest to you just to provide some clarity, the new forward contract is not exclusively about the transition from low to high altitude, it is about a contract engagement that would perhaps address the totality of the purchases, some of which could be high altitude, but will most certainly include low altitude moving forward as well.

Arnie Ursaner - CJS Securities

Okay, if I could ask a clarification, Cary?

Cary Wood

Sure.

Arnie Ursaner - CJS Securities

In your prepared remarks you indicated that H2 should produce results at or above the current performance levels. If in fact that were all that you did, that would be extraordinarily disappointing because typically your second half of the year is much better than the first. So to be clear and maybe clarify it for all of your investors would you remind people of the typical seasonality in second half versus first half and maybe expand on the remark you made in your prepared remarks.

Cary Wood

Yes and I’ll thank you for that, I could see where you might read a little bit into that. We expect as you’ve seen over the course of the last few years with us, a much stronger back half than first half. We don’t expect that to be much different. We’ve typically seen a very strong fourth quarter and the patterns that we’ve been seeing this year are very much in line with that. We expect that our first half will be very robust. We expect that our fourth quarter in the context of Sonobuoys in particular will be very strong and we don’t expect that to be different this year. So, I think for anybody to have assumed that what we were suggesting was that the second half will be the same as the first half would certainly be disappointing frankly. And I think the back half of our year will be very consistent with the type of patterns we’ve seen prior and be stronger than our first half, so hopefully that clarifies.

Arnie Ursaner - CJS Securities

Excellent, thank you.

Cary Wood

Sure.

Operator

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

Ross Taylor - Somerset Capital

Yes, great quarter gentlemen and I’m confident that you’ll be able to achieve your long run goals, but can you address at the point a couple of things for me. One is where you stand versus that 500 by 15 goal you’ve been laying out. Additionally on the operating margin side, where we should be seeing margins in both healthcare go, but also if you get or when you get this new contract from the navy, given that that facility I believe where it’s constructed to produce far more Sonobuoys that are currently being produced, would the increased volume that runs through it also help the margins in that segment?

Cary Wood

Now let me see if I can peel back those questions first. Thank you for the complement and I appreciate the fact that you see we had a nice execution in not just the second quarter but first half. And I think talking first about the medical space, we feel good that the growth we’ve seen on a legacy perspective, 6% to 9% respectively, 6% in Q2 year-over-year, 9% over the course of the year. We feel very, very comfortable with that type of momentum, if you add in the accretive nature to revenues of the acquisitions we’re seeing roughly 37% increase on a year-over-year perspective and almost 27% in the quarter alone. So we feel really very good about that momentum, we feel very good about the revenue accretion from all of those acquisitions and legacy business. So, that outlook continues to be very optimistic for the space.

I think to add to that, I am very pleased to see that out there in some independent references that the medical outsourcing argument is starting to pop-up in places more frequently than what I have seen previously and that argument and apatheist remains true for us that I think it’s going to be more of an opportunity for us than not.

Now when you talk about to shift gears around our DSS location and its capabilities and what we expect to see in the way of forward looking volume on Sonobuoys. It is facilitated for larger volumes and really without getting too technical we have the ability to flux as needed. And I wouldn’t call that an underutilized facility, that’s all a matter of how you define capacity and I would suggest to you that we are not running around the clock. We are not running third shifts and multiple second shifts. I think that there are opportunities to better utilize those assets. I don’t think, I know that there will not be significant infrastructure adds to accommodate what could be increased volume and I think we are ready for that.

It serves to make sense that if you look at the cost structure and what you are doing is absorbing more of that fixed across in much larger volume with better margins than anything else we have, it serves to make sense that, that could be a good outcome. Hopefully that hits on all those questions, Ross. If I’ve missed one come back to me, I am here.

Operator

(Operator Instructions) We are having question from the line of Tom Kerr with Singular Research. Please go ahead.

Tom Kerr - Singular Research

My questions have actually been answered already. Thanks.

Cary Wood

Very good. Thanks, Tom.

Cary Wood

Our next question comes from the line of Andrew Shapiro with Lawndale Capital Management. Please go ahead.

Andrew Shapiro - Lawndale Capital Management

Hi, good morning. With the Beckwood Services acquisition that puts you into the Northeast, it also included a facility and I wanted to get a feel for its just additional capacity. What the capacity utilization had been in the acquired facility, if this is on a long-term lease or if this is something down the road that’s consolidation opportunity in your manufacturing footprints. And in general where you stand I guess we’ll say overall with your capacity utilization in the Complex System segment in particular?

Cary Wood

As we’ve grown organically, we’ve seen good momentum as of late, not just overall but in particular within the Complex System piece of our business. Obviously it helps to enhance our overall utilization. I would suspect that even though we have made gains, it’s fair to say that there is lots for opportunity for us to absorb the footprint. The Beckwood Services location in the Northeast was a strategic as much as anything type of acquisition getting us into that region.

It’s certainly going to present an opportunity for us to utilize that assets and I don’t want to get too far into the weeds over what those specifics might be. We just acquired it hardly a month and a half ago. It’s still stabilizing into our business, it’s still understanding its roles and obligations as a partner now to Sparton. I certainly don’t want to go too far into all the, what ifs and I think that the one takeaway is that we acquired that business.

We expect that it’s going to be accretive from an EBITDA perspective sooner than later. It is a standalone site. We don’t expect that we are going to have a lot of tricky or high risk integration efforts up there and in terms of its asset utilization more opportunity than not. It gives us into a location with brand new customers, more expanding opportunities with those given our capabilities and reach. But other than that I certainly wouldn’t want to get too far too quickly into all those what ifs.

Andrew Shapiro - Lawndale Capital Management

Okay. As a follow-up and then related, one part of that question didn’t get answered, the facilities in long-term leases and in owned facilities and currently on short-term lease?

Cary Wood

Yes, sorry. It is on a multi-year lease.

Andrew Shapiro - Lawndale Capital Management

Okay. And then related on this capacity utilization, is Vietnam and Complex Systems intercompany sales which historically have been into DSS and then booked through a DSS margins, I don’t know if it’s been anniversaried but in maybe almost a year now that Vietnam has gotten medical manufacturing certification. About how much of your intercompany sales of Complex Systems is now going via the Medical segment rather than the medical margin imputation?

Cary Wood

If I understand the question, it’s generally around how much intercompany medical has made it’s away into Vietnam and what influence it’s had on capacity. We continue to grow more medical in the Complex Systems segment in particular in Vietnam than what it’s had in the past. I think it’s still fair to say that it’s rather immaterial as it starts to scale up. I do know the ambitions of the end-customer and certainly don’t want to get into specific names or tip the hand on what their strategic initiatives are.

But it is to reach more in-region sales of products that have been since transferred there, so I think the opportunity is larger than not, but in the meantime I would suggest that it is still rather immaterial percentage of overall Vietnam sales in Medical, CS overall and intercompany overall. We’re making progress there, I mean the capacity utilization of Vietnam is better than what it it’s been, but we’ve got a long way to go before I think we’re even remotely pleased.

Andrew Shapiro - Lawndale Capital Management

Okay, I have more questions. I’ll get back in the queue, but please come to us.

Cary Wood

Okay, very good.

Operator

We have a follow-up question from the line of Arnie Ursaner with CJS Securities. Please go ahead.

Arnie Ursaner - CJS Securities

Hi, this one should be super quick. In the Sonobuoy piece the government shutdown in October but you have pretty good results in the segment. I assume that the shutdown had no impact on you in the quarter?

Cary Wood

It did, I mean there is always a move in a shift to things here and there for a whole variety of explanations. As I mentioned on a year-to-date basis, we’re up 3.5% compared to we were last year, we are up roughly 4%-4.5% on a comparison to Q-to-Q. The mix was certainly more domestic and foreign was down compared to last year. None of that had much to do with the delays of the shutdown. I do think that the major takeaway and I think most of our investors are aware of this, but the war timing could have been affect by that and got pushed from say a middle March timeframe to early April timeframe. But other than that, there has really not been any impact because of the shutdown.

Arnie Ursaner - CJS Securities

Can you go through a breakdown of the new wins that you had that you announced in the quarter?

Cary Wood

Yes, Mike do you want to handle that.

Michael Osborne

Yes, I got it. So, I’ll do it by segment first and then by manufacturing and engineering. So by segment, we had 9 in Medical. We had 2 in Complex Systems and we have 6 in DSS. And between manufacturing and engineering 10 of those are manufacturing and 7 were engineering so for that comes up the total 17 for the quarter.

Arnie Ursaner - CJS Securities

Okay. And just the accounting treatment, you obviously have some important accruals that are performance -based on the acquisitions you’ve made. Where in the balance sheet or income statement should we look for those?

Mark Schlei

Arnie, this is Mark. Right now we don’t have a provision for any earn outs for the acquisitions. The only acquisition that has a potential earn out is Aydin, and at this point in time, there is no provision has been made for an earn-out.

Arnie Ursaner - CJS Securities

Okay, thank you.

Cary Wood

Thank you.

Operator

(Operator Instructions) We have a follow-up question from the line of Ross Taylor with Somerset Capital. Please go head.

Ross Taylor - Somerset Capital

Okay. First, I thought you danced around my questions, but I’ll let you get away with that Cary. Second, you guys commented on the fact that you had a non-Sparton related supplier issue effecting sales in the quarter, is that something we should expect to come back in this quarter?

Cary Wood

It’s hard to say at this point. That’s not the first time that we’ve seen downstream directed supply become an issue. We’ve seen that almost every year. And we do anticipate that it will certainly come back. I don’t believe that it’s a lost sales opportunity I just think that it underscores a delay in what might have otherwise been a stronger first half of our year as it’s simply it.

Ross Taylor - Somerset Capital

Okay. Second, acquisitions have been an important part of your strategy. Obviously you’ve shown tremendous discipline walking away from deals that didn’t make sense either for economic or cultural purposes. With the market having moved a lot last year, how are you finding the acquisition environment?

Cary Wood

Our pipeline is robust. I mean the deal flow continues to be good. There is always going to be the conversations around the perceived value and what we believe it is worth to be and those types of dynamics have been ever present, they haven’t really changed much. I believe that we still have as many opportunities today as we had. I think the real concern is whether or not you can get them executed reasonably. And I mean the simple answer is it’s really much different for us as we sit here today.

Our capital structure is conducive to continue acquiring, and I think we did dial up the traffic and execution it. As you’ve seen it start to dial up I think we go into all of next year and anticipate that we’ll continue to see deals get executed, that make sense for us. We’ll walk away every single time we need to where it doesn’t make sense, it presents a risk, it’s not strategic, we can’t reach a valuation that we believe is reasonable and fair to our shareholders but other than that I think the deal flow traffic has been just as good as it’s been.

Ross Taylor - Somerset Capital

And are you still -- in the past you’ve worked on about 20% ROIC when you are looking at the acquisition, is that something you are still looking at?

Cary Wood

Yes, we’ve maintained that discipline, if nothing else. It’s return on capital number just the. I am sorry IRR, and just to be sure we’re clear on that. We’ve used that as our internal threshold on cost to capital to make that we far exceeded what our current rate is and we’ve done that. And we’ve stayed disciplined to that. I think if nothing else, we’ve added better disciplines upstream either in our diligence and then ultimately in our integrations. So we’ve enhanced that. We’ve put more resources around it. The discipline by which we put financial analytics are certainly a big part of what drives us to get comfortable with marking the decision.

But then we’ve made or we've added additional metrics that are non-financial to evaluate the risk and the integration efficiency and all the things that we would ultimately expect to get from it. I think we’ve gotten better in that area. We’ve certainly maintained the discipline of the 20% IRR threshold that is absolutely true.

Ross Taylor - Somerset Capital

Okay, great. Thank you. Keep up the good work.

Cary Wood

Thanks Ross.

Operator

Next question is a follow-up from Andrew Shapiro, Lawndale Capital Management. Please go ahead.

Andrew Shapiro - Lawndale Capital Management

Yes, regarding the breakout of the new programs and the engineering and manufacturing mix. An observation and really driving a question, I think you mentioned six programs that were in DSS which seems to be a lot. Is this a function because your main customer in the past has been navy and foreign and been Sonobuoys. Is this a function of digital compass like and hydrophone type of new product developments or is this a function of the acquisition of Aydin which is now in that segment?

Mark Schlei

Right, so it’s not a, NavEx does not have a influence on those numbers, we still haven’t incorporated them into the numbers that we gave you guys out on a quarterly basis. From a NavEx perspective I can tell you that we’re seeing increased opportunities. We just actually realized our first substantial engineering order on the NavEx side where we’re helping a prime contractor, defense contractor, incorporate our system into their system so it’s a huge win for us, which we again still haven’t broken out in the reports.

Specific to the 17 programs and the six coming out of DSS, four of them are engineering development projects that are specific to a new business development management we put in place approximately year ago who is working with the U.S. Navy and other DoD factions and we are seeing some wins for some early developmental opportunities. And then the other two wins which are on the production side are related to foreign Sonobuoy sales, which we do track. We do not track, we do not put in these numbers any of the domestic sales.

Cary Wood

There is a higher number of DARP engagements in this quarter than we’ve had in some of our previous.

Andrew Shapiro - Lawndale Capital Management

Excellent, and regarding the overall number on the 17, about how many of those are related to new customers in the last year or versus these are people coming back?

Cary Wood

Probably three -- I'd say approximately three quarters of new customers.

Andrew Shapiro - Lawndale Capital Management

Outstanding. I’ll get back in the queue. I do have a few more questions on the Sonobuoy side.

Cary Wood

Andrew, why don’t you go ahead, let’s go ahead and finish up.

Andrew Shapiro - Lawndale Capital Management

Okay, so two questions I have on the Sonobuoy side, one of them is last quarter was the rollout of we’ll call it a modernized and I think more stable and appropriate method of revenue recognition on newer production and rather than I guess on the recipient testing end of the Sonobuoys. Did that have a noticeable impact in smoothing anything when it came to this quarter or the first half of the year so far in terms of your observation? And also does it have I don’t know if it would have any impact in your utilization or burn through on our backlog at all. Can you comment about that?

Cary Wood

Michael why don’t you take that?

Michael Osborne

The revenue recognition for the first six months was relatively flat impact on the revenue lines as moved in and out. It really does not -- and the revenue recognition pertains to our domestic Sonobuoys not our foreign, our foreign, we did not change the revenue recognition on the foreign. So the impact on a year-to-date basis other revenue recognition changes is minimal.

Andrew Shapiro - Lawndale Capital Management

Okay. And then the drawdown on the backlog is standard seasonality or is that also tied to potentially kind of the delay or pushback in some timing of contract announcements of the government shutdown or other various issues?

Cary Wood

Yes, you hit it. It’s the timing of the award, we ordinarily would have seen the Sonobuoy award and we’ve seen it is early, it’s February and this time around it’s going to be a whole lot later. I mean in some cases it was before the end of the year. So it certainly had its impact on backlog. So that’s the major driver right now.

Andrew Shapiro - Lawndale Capital Management

Now you mentioned in your answer to Arnie about the idea that the big kahuna the first time the Navy is going with a five year deal instead of its typical two year deals and it was going to include some of the standards Sonobuoys and not just the high altitude ones. Does that also mean potentially a burn down of the backlog because all of a sudden it’s going to come in with one big huge wave?

Cary Wood

It’s hard to say exactly how it’s going to say or how it’s going to come in and I’m not trying to be evasive I would suggest to you that we are still in discussions around how the next year or so could look in the way of orders meaning timing, magnitude, size, mix frankly I don’t want to get too far into that discussion. We’re at a very critical point where we’re getting into those details, and it’s hard to say what’s going to unfold.

I do think, I stand by the fact that the timing is going to be roughly around April, I’m confident of that. I stand by the fact that we feel like all the independent information suggest that some of the numbers that have been guided out there including in our own investor presentation outlooks using the DoDs outlook has remained intact. So, I think there is far more optimism than not. But I certainly don’t want to muddy those discussions up by getting into a lot of what if kind of conversations here.

Andrew Shapiro - Lawndale Capital Management

And again, related on this same topic is the navy has deployed its principle squadron of a new P8 dissidents out to the Pacific, they’re now testing and rolling out we’ll call, what will be in the planes of the next year we doing this. With those P8s flying out there in the China Sea and the Taiwan Straits, et cetera if you’re still negotiating and dealing with the high altitude Sonobuoys I guess the question is those planes right now are having to fly what P3 missions in lower altitude because the only Sonobuoys that are in the navy’s inventory are they legacy Sonobuoys.?

Cary Wood

Well, let’s delineate, I mean first of all the aircraft in and of itself is going through its own type of testing phase. I think they’re 11, or 12 or 13 aircraft into the roughly 113 or so that have been projected to roll-off and I think it’s just reasonable to say that they are all kinds of flight tests that are going on, they’re mutually exclusive of having anything to do with the Sonobuoy device in and of itself.

Could they be deploying lower altitude and if that’s part how they’re going through their testing I think it’s a reasonable assumption. We’ve not been too involved at all in what’s going on with the testing of the aircraft in and of itself. We have been involved in a lot of pre-work in testing of Sonobuoy. So, I think again, just to hit on your question, I think you almost answered it. Yes, I think that they were involved with lower altitude right now that they’re higher altitude devices.

And it’s probably and this is a speculation on my part has a whole lot less to do with whether or not the device is working and has a whole lot more to do with whether or not the deployment, whether it’s low or high altitude is as they had anticipated.

Andrew Shapiro - Lawndale Capital Management

Right. I know they have had their own issues and they had to do testing and get over the humps they got with the raytheon radars and other things, it’s in the…

Cary Wood

It holds true this is going on right now.

Andrew Shapiro - Lawndale Capital Management

Yes, yes. But during this time period of course they got P3s flying all over the world and…

Cary Wood

Correct.

Andrew Shapiro - Lawndale Capital Management

They’re burning up and they’re using their legacy Sonobuoys. So, is when you made the comment about how the big Sonobuoy contract is going to be legacy as well as high altitude, are you telegraphing or do you know and have you bid for the legacy Sonobuoys that would have normally been on replacement cycle et cetera that are being consumed as we speak. Are they all part of the package or are there some other legacy Sonobuoy contract RFPs that you have in the hopper as well.

Cary Wood

I think for right now, I’ll stick with my original answer being that it’s all inclusive right now how it pans out in terms of the mix and percent of high compared to low or vice versa is all on the table in discussions. I’m not telegraphing anything about what’s going on with the timing of high altitude or low altitude for that matter.

I have always said and I’ll go back and reinforce the fact that this will never be and was never anticipated to be by us. The flipping of the switch from low altitude to high altitude they will coexist.

Andrew Shapiro - Lawndale Capital Management

The mission we have P3 low are going to be around for a while?

Cary Wood

I think that’s a fair takeaway.

Andrew Shapiro - Lawndale Capital Management

And lastly I guess it’s a test to this government approved budget during this last quarter. First time I think they’ve done that in many years. And then in the budget there are obviously subcomponents including the defense budget and including the smaller sub-segment which is the navy’s procurement et cetera and in the past conference call or two you have had slides which showed and talked about the navy’s proposed budgeting for Sonobuoy use and purchases and your own Sparton will call it internal numbers which dialed back the navy’s projected numbers and all that. What was approved by Congress and signed by the President. I know it is only for the next few years et cetera, but were those numbers more in line with the navy’s higher goals or more in line with Sparton’s conservative assessment?

Cary Wood

They were more in line with what DoDs guidance was and has been for the last several years.

Andrew Shapiro - Lawndale Capital Management

Great. Excellent. And that’s only for the next few years though that they went and approved that right?

Cary Wood

Correct.

Andrew Shapiro - Lawndale Capital Management

Okay. So, at least for the next few years it’s quite favorable. Thank you. Very good.

Cary Wood

Thank you.

Michael Osborne

Alright, thank you Cary and Mark. I’d like to thank all the participants in today’s call. The call including the question-and-answer period has been recorded and will be posted on our website under Investor Relations later today. Thank you once again.

Operator

Ladies and gentlemen, that does conclude the call for today. And we thank you for your participation and ask you to please disconnect your lines.

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