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Sparton Corporation (NYSE:SPA)

F4Q2010 Earnings Call Transcript

September 10, 2010 10:00 am ET

Executives

Mike Osborne – SVP, Business Development

Cary Wood – President and CEO

Greg Slome – CFO

Analysts

Andrew Shapiro – Lawndale Capital Management

John Rolfe – Argand Capital

Bruce Baughman – Franklin Templeton

Jack Gulati – Safety Care

Jonathan Haines [ph]

Operator

(Operator instructions).

Mike Osborne

Thank you, operator. Good morning and thank you for participating in Sparton’s fiscal 2010 fourth quarter financial results conference call.

Before we begin the discussion, I will take a few minutes to read the forward-looking statement. Certain statements in this conference call constitute forward-looking statements within the meaning of the Securities Act of 1933, as amended and the Securities Exchange Act of 1934, as amended. When used in this conference call, words such as “believe,” “expect,” “anticipate,” “project,” “plan,” “estimate,” “will” or “intend” and similar words or expressions as they relate to the Company or its management constitute forward-looking statements. These forward- looking statements reflect our current views with respect to future events and are based on currently available financial, economic and competitive data and our current business plans. The Company is under no obligation to, and expressly disclaims any obligation to, update or alter its forward-looking statements whether as a result of such changes, new information, subsequent events or otherwise. Actual results could vary materially depending on risks and uncertainties that may affect our operations, markets, prices and other factors. Important factors that could cause actual results to differ materially from those forward-looking statements include those contained under the heading of risk factors and in the management’s discussion and analysis contained from time-to-time in the Company’s filings with the Securities and Exchange Commission.

Today, Cary Wood, our President and CEO, and Greg Slome, our CFO, will report our fiscal year 2010 year-to-date financial results and 4th quarter segmented operating results, provide an update on the status of our liquidity and capital resources, review the Company’s mission, fiscal year 2011 key imperatives, growth initiatives, and, finally, summarize certain strategic implications of the Delphi Medical acquisition. At the end of the narrative, we will allow our investors and other interested parties to ask questions related to the Company’s financial performance and operations. In fairness to all participants, we will ask that one question be asked at a time with the call ending at approximately 12:00pm ET. I would now like to turn the call over to Cary.

Cary Wood

Thanks Mike. Good morning and welcome to our fiscal 2010 year end conference call. Today, we will review our fiscal year 2010 results.

We are pleased to report a fiscal year 2010 operating income of $5.7 million and net income of $7.4 million, or $0.75 per share, versus an operating loss of $11.3 million and a net loss of $15.8 million or a $1.61 loss per share, for fiscal year 2009. As you know, we launched an aggressive and robust restructuring plan in the second half of fiscal 2009 that was intended to reshape the Company and return it to profitability. The implementation of these actions has led to four consecutive quarters in which the Company has posted pre-tax income, after reporting pre-tax losses for the previous 12 consecutive quarters. Additionally, our ability to accelerate the implementation of these actions has resulted in our ability to outperform our fiscal 2010 internal expectations.

Our consolidated fiscal year 2010 revenue was $174.0 million, decreasing 22% or $47.9 million from the same period in the prior year. The overall drop in revenue was in line with our expectations and reflects the full disengagement from several significant customer contracts within our EMS business in the second half of fiscal 2009 and the first six months of fiscal 2010. This reduction was partially offset by increased sonobuoy sales to the U.S. Navy and other foreign nations within the DSS business.

Despite the overall reduction in sales, our gross profit for fiscal year 2010 was $26.6 million compared to $15.9 million in fiscal 2009. The gross profit percentage improved from 7% a year ago to 15% in fiscal year 2010. The improvement in gross margin was mainly attributable to favorable product mix, improved pricing, the disengagement from certain unprofitable customers and the continued effects of successful sonobuoy drop tests. In addition, margin was also favorably impacted by the reduced overhead costs associated with the closing of three plants in the last 18 months, aggressive cost reduction efforts and the continued implementation of our lean and quality programs. Partially offsetting the increase was the impact of the significant drop in EMS volume combined with a drop in Medical gross margins experienced in the last two quarters as operational right sizing actions that were initiated to off-set the reduction in sales volume began to be realized in the fourth quarter.

While significantly reduced from the last fiscal year, we continued to incur $4.1 million of additional restructuring and impairment charges in the year relating to the restructuring actions which had been previously announced in fiscal 2009 and impairment charges on properties both sold and currently held for sale. We believe that these previously announced restructuring activities have now been completed. Partially offsetting the impact of the restructuring and impairment charges, a gain totaling $3.1 million was recorded in the fourth quarter relating to the consummation of a long-term lease on our Coors Road property in Albuquerque New Mexico. Interest expense in the fiscal year was $0.8 million compared to $1.6 million in fiscal year 2009. The drop primarily reflects the repayment of the Company’s outstanding bank debt in August 2009. Finally, fiscal year 2010 net income includes a net tax benefit of $1.9 million resulting from the release of approximately $2.3 million of the Company’s deferred tax asset valuation allowance due to recent tax regulation changes. Overall, we are pleased with the financial results and operational success achieved in fiscal year 2010 as we outperformed to our internal projections. I would now like to turn over the next portion of today’s call to Greg so that he can update you on our individual segment results from the 4th quarter and year-to-date and our liquidity and capital resources.

Greg Slome

Thanks Cary.

For the Medical business, sales decreased $4.1 million, or 24%, in the three months ended June 30, 2010 as compared with the same quarter last year. While Medical sales remained fairly consistent from a year-over-year perspective, we continued to experience a softening in the second half of the year primarily due to decreased sales to three customers, each of whom experienced certain product related issues, including one customer whose production was placed on hold while the customer resolves a non-Sparton supplied component issue. The gross profit percentage on Medical sales decreased from 15% to 13% for the three months ended June 30, 2010 and 2009, respectively. The gross profit percentage for the fiscal year increased from 12% in 2009 to 13% in 2010. The fluctuations in Medical margins in the fourth quarter and fiscal year reflect the impact of the respective period changes in sales volume and product mix between the two periods, as well as the impact of greater operating efficiencies from the consolidation of manufacturing operations, the Company’s continued implementation of lean practices, and the favorable impact of overhead right-sizing actions which were initiated in the third quarter of fiscal year 2009.

For the EMS business, sales for the three months ended June 30, 2010 decreased $12.8 million or 51% as compared to the same quarter last year, and decreased $69.6 million or 55% in fiscal 2010 compared to fiscal year 2009. The fourth quarter decrease primarily reflects the Company’s disengagement with Honeywell during the three months ended December 31, 2009. The year over year decrease reflects the impact of the disengagements with two additional customers with whom the Company had completed the disengagements by June 30, 2009, as well as reduced sales to a continuing customer resulting from the loss of certain programs. Partially offsetting these reductions in fiscal 2010, we experienced increased sales of $4.4 million to our largest EMS customer. The gross profit percentage on EMS sales was a loss of 2% in the three months ended June 30, 2010 compared to a loss of 9% for the same quarter last year. The quarter over quarter change in gross profit was mainly attributable to the reduced overhead costs associated with the plant closings and the consolidation of EMS operations and improved performance resulting from the continued implementation of lean practices. Partially offsetting the benefits of these actions was the impact of the significant drop in sales volume related to the customer disengagements and improved pricing on Honeywell sales in the fourth quarter of fiscal 2009. The gross profit percentage on a year-over-year basis showed an overall improvement from 1% in fiscal 2009 to 4% in fiscal 2010 which has been in-line with our belief that this business unit could be a 3-6% gross margin performer. The improvement is mainly attributable to the impact of the plant closings, disengagement from unprofitable customers and the performance improvement related to the lean practices.

For the DSS business, sales for the fiscal 2010 fourth quarter were slightly down from the fourth quarter of fiscal year 2009, with an decrease of $1.5 million, or 8%, but overall sales for the fiscal year increased by $21.6 million or 51%. The quarter-over-quarter reduction resulted from a decrease in foreign sonobuoy sales, partially offset by an increase in U.S. Navy product volume and engineering sales. The year-over-year growth reflects higher U.S. Navy product volume due to an increase in the awarded annual Navy contracts in production during the respective periods. Additionally, engineering sales revenue and foreign sonobuoy sales also contributed to the year- over-year increase. As discussed in the past, foreign government sales can fluctuate on a period- to-period basis. The gross profit percentage on DSS sales increased from 22% in the fiscal 2009 fourth quarter to 23% in the current fiscal year fourth quarter and up from 16% for fiscal year 2009 to 25% in fiscal year 2010. While the fourth quarter margins were relatively consistent between fiscal 2010 and 2009, the significant increase in the fiscal year-over-year margins reflects the impact of the significant increase in overall sales volume from the prior year, the continuing reduction ofrework costs resulting from improvements in production efficiency and increased foreign sonobuoy sales which generated higher gross margins in fiscal 2010 due to an improved pricing structure. We believe that the Company’s continued implementation of lean principles has resulted in improvements in production performance which ultimately has increased the success rate of our U.S. Navy drop tests.

I would now like to review our current debt and liquidity positions as of the end of the year. The only remaining debt outstanding at June 30, 2010 is the remaining balance on our Industrial Revenue Bonds with the State of Ohio of approximately $1.9 million. During the quarter ended June 30, 2010, the Company made final payments in relation to its notes payable and final contingent consideration obligations to the former owners of Astro/Sparton Medical of $1.1 and $1.5 million, respectively. Our debt to equity ratio as of June 30, 2010 was .03 to one. As of June 30, 2010, the Company had no outstanding borrowings against available funds on its $20 million revolving credit facility provided in August 2009 by PNC Bank, National Association. The credit facility is subject to certain customary covenants all of which were met at June 30, 2010. At June 30, 2010, the Company had $30.6 million of cash, a $5.7 million decrease from June 30, 2009. During the year ended June 30, 2010, the Company generated $19.9 million of cash from operating activities. Excluding changes in working capital, operating activities generated $10.2 million in cash in fiscal 2010, reflecting the Company’s operating performance during the year and $2.3 million of income taxes recovered from net operating loss carry backs. Working capital provided $9.6 million in cash during fiscal 2010 which was mainly attributable to reduced working capital requirements related to lower sales volume, the closing of facilities and the continued inventory management efforts, offset in part by funding of production on U.S. Navy sales in excess of advance billings received, continued funding of restructuring activities and a pension contribution made in the fiscal 2010 first quarter. Investing activities used $3.6 million in cash, mainly for the payment of the Astro acquisition contingent consideration, funding of the EPA trust and capital expenditures, and $0.5 million from the partial sale of the Company’s investment in Cybernet. This was offset by the $3.1 proceeds received from the long-term lease on the Coors Road property and the liquidation of the equipment and buildings at the idled facilities in Jackson, Michigan and London, Ontario, Canada. Financing activities utilized $21.9 million in cash in fiscal 2010, resulting from the repayment of all of the Company’s bank debt as well as the remaining term notes to the former owners of Astro. As of June 30, 2010, the only remaining property which the Company has classified as held for sale is the Bluewater facility located in Albuquerque, New Mexico. Based on an appraisal performed in conjunction with the Company’s year-end audit, an impairment charge of $1.1 million was recorded in the fiscal 2010 fourth quarter to reduce the carrying value of the property to $3.9 million. I would now like to turn the presentation back over to Cary.

Cary Wood

Thanks Greg. I would like to briefly review our new mission statement, the fiscal year 2011 key imperatives, provide an update to our growth initiatives including the recent acquisition of Delphi Medical located in Frederick, Colorado, and end with a fiscal year 2011 outlook.

During the development of the Company’s 5-year strategic growth plan in the past fiscal year, we created a new mission statement that is more reflective of who we are today, describes the markets that we serve, and the benefit it provides to the Company as we work towards achieving our overall vision. Our mission statement provides that “Sparton is a supplier of complex and reliable electronic and electro-mechanical products, sub-assemblies and related services to the highly regulated Medical, Defense & Security, and Aerospace markets. We do this by leveraging design, prototyping, and manufacturing expertise to be the premier partner in our markets of interest.” This may appear to be a fairly basic statement and it intentionally is. Based on the target business and market segments, the mission statement truly reflects and is a great reminder of everything Sparton is and is not.

The key imperatives developed last year contributed significantly to our successful financial and operational turnaround, as well as provide a renewed focus in the area of growth. After internal review and discussion, the fiscal year 2011 key imperatives will essentially remain the same, but will be enhanced by a number of new key initiatives that have been added for this fiscal year.

In our last two quarterly conference calls, we discussed the many actions being taken to prepare the Company for profitable growth. As you may recall, in fiscal year 2009, business development activities were substantially reduced as the Company worked on diagnosing its operational and financial struggles. In fiscal year 2010, while the turnaround was in process, we addressed specific items that would prepare the foundation for growth, including the development of pricing strategies, pursuing additional developmental engineering opportunities within DSS and Medical, obtaining additional manufacturing opportunities within EMS, introducing SpartonEXPRESS, and increasing business development resources within each operating unit – all of which have been implemented and are contributing to the offset of the EMS customer disengagements. For fiscal year 2011 and beyond, we believe that a solid backlog of $112.7 million as of June 30, 2010, along with deliberate and targeted growth initiatives currently being implemented, will further enhance our growth trajectory. As an example, the business development organization is currently being retooled across the Company and, by the end of this calendar year, we intend to double the number of “feet on the street” who will be focused on new strategic business targets. We are also pursuing strategic partnerships where they make sense. As an example, with DSS’s expertise in the engineering and manufacturing of complex electro-mechanical systems, such as sonobuoys, digital compasses, and acoustic hydrophones, it has allowed us to team with National Information and Communications Technology Australia (NICTA), a premier developer of intellectual property (NYSE:IP) for several advanced security solutions. We believe we can accelerate the growth of this business by partnering with NICTA on key emerging technologies to offer advanced security systems to the global marketplace by providing timely solutions for homeland defense, as well as military, police and civilian customers – all of which will give us a strategic path for growth. Where there have been no active marketing programs at any level for many years within the Company, in the near term, a new marketing initiative will center around identifying our brand and brand position, developing new selling collateral materials, enhancing our trade show image and presence, and modernizing Sparton’s website architecture and technology – all done with a level of professionalism that will fully support and improve the selling effort. We are also excited about the possibilities of unbundling the technology we’ve previously developed that resides in the sonobuoys to create our own proprietary commercial product lines. To help facilitate this portion of our growth strategy, we are planning to make a considerable investment this year for internal research & development activities. Lastly, we will continue to be opportunistic with our inorganic growth plans and the Delphi Medical acquisition is a great example of that. While the immediate focus and effort in the M&A arena is on the successful integration of Sparton’s new facility in Colorado, we will continue to pursue potential targets that are in-line with our strategic direction. Overall, the 5-year strategic growth plan has provided us good in-roads and progress that we believe will provide for year-over-year increases in revenue and profit that will ultimately enable us to increase shareholder value.

Since our last call, we announced on August 6th the successful completion of the purchase of Delphi Medical’s contract manufacturing business. The purchase price for the assets of the business is $8.0 million, including a $2.0 million holdback, and was based on an inventory level of $10 million. An inventory valuation is currently in process, and based on the determination of the final inventory value, a post closing adjustment to the purchase price will result if the final inventory value is above or below the $10 million threshold. If below, the purchase price reduces dollar for dollar and, if above, any additional inventory above $10 million will be purchased at $0.50 on the dollar. The purchase agreement provides further protection related to potential obsolete and excess inventory concerns by allowing for the potential recovery from Delphi of an amount up to $2.0 million for certain excess and obsolete inventory remaining on- hand at the end of the 18 month period from closing. Based on the terms of the acquisition agreement, it is not expected to result in the recognition of any goodwill. Aside from acquiring the business below the asset value, there are also a number of other strategic implications that make this deal attractive to us. We believe that this transaction will provide Sparton with anticipated annual revenue of approximately $32 million with a completely new customer base in the high growth Therapeutic Device market space and provides a western geographic footprint to service West Coast customers.. In-line with our overall growth initiatives previously discussed, we have been able to quickly increase our selling efforts through the addition of a direct selling team and five manufacturing representative agreements. Based on our due diligence efforts and through a 100 day integration plan currently in progress, a number of manufacturing processes and cross- selling synergies with the other business units have been indentified and are being pursued. Overall, we believe that we have consummated this strategic transaction at a reasonable price which will enable us to profitably grow and increase shareholder value.

As we look to fiscal year 2011, much of our focus will be on those items we have already discussed on this call, so I will quickly summarize them. First and foremost, we will continue to focus on sustaining our profitability now that the previously announced restructuring actions and costs have been completed. We will continue to implement our 5-year strategic growth plan. As a reminder, virtually all of our business development activities were halted in fiscal year 2009 as we diagnosed the financial and operational issues within the Company. Due to the financial concerns, many customers would not allow us to bid on new opportunities, but now that we have returned to profitability, we are beginning to see new business come our way. However, the incubation period for these prospects can be anywhere from 3 months to 2 years – depending on the project and related market. We have a moderate pipeline of organic opportunities that we are diligently working towards increasing, as the efforts within our business development organization coupled with new go-to-market strategies begin to take hold – but, the impact in this fiscal year could be modest. The final key action laid out in the strategic growth plan for this fiscal year is our investment in new product development in DSS which will further enhance our ability to organically grow in the future. Lastly, we will continue to look at complementary and compatible acquisition targets and, in the near term, the team will be completing the integration of Delphi Medical with accretive earnings anticipated no later than our fiscal year third quarter.

In conclusion, we are pleased with last year’s operational and financial results as they exceeded our internal projections. With substantially all of the restructuring and turnaround actions complete, the Company’s focus has shifted to profitable growth. As we’ve outlined today, we have begun the implementation of a number of key initiatives that will drive our organic and inorganic growth objectives. I remain optimistic and confident that the actions we have taken position us to achieve our goal of sustained and improved profitability well into the future. Many great things are happening . . . the new era continues and we thank you for your support.

Mike Osborne

Thank you, Cary and Greg. We will now open it up for questions. Operator, the first question please.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And our first question comes from the line of Andrew Shapiro from Lawndale Capital Management. Please proceed with your question.

Andrew Shapiro – Lawndale Capital Management

Hi, good morning, Lawndale Capital Management. Cary, I don't think in the script you guys discussed the remaining net operating loss tax carry-forward, and also, when does that valuation allowance on the deferred tax asset get reassessed for possible readjustment?

Greg Slome

Yes, it’s Greg. So, the NOL that we have at the end of the year that’s still remaining is $15.7 million and now has expiration dates that range from 2027 to 2029, and in regards to valuation allowance, we have at this point with one year of income under our belt, we have not made any changes to reinstate the valuation allowance, but we will continue to leave it there and we will make another assessment probably when we get to the end of fiscal year 2011.

Andrew Shapiro – Lawndale Capital Management

Okay. And as a follow-up with this, is – so with over $30 million of net cash, you have an additional $3 million in the CPA trust on your balance sheet, and you only have a $50 million market value right now; I know you are doing your best to have that improved. Sparton's $20 million net enterprise value versus your sustainable cash flow levels now, and no interest obligations and no taxes arguably to be paid, raises the question of instituting a stock buyback. Has this issue yet been brought to the board and discussed with your bank credit lines, since you are not going to be using it for the near future? And what are your thoughts, Cary, as CEO, regarding the cushion, the comfortableness of I guess small, but steady stock retirements?

Cary Wood

I think we obviously want to keep one eye on maintaining the outstanding, so as not to further dilute and it’s certainly not lost on the management team in the Class B that we want to maintain that. The idea of a stock buyback program wouldn’t be new today. It’s been something we have had regular discussions around and when it would be prudent to institute something like that. I don’t believe that it’s off the table and it’s certainly something that we will consider. I think our circumstances with cash, our competence in our go-forward sustainability of profit probably gives us a little bit more comfort to probably institute something like that perhaps. But I think short of making a commitment about what we might do and when we would do it, I think the best answer is that it has been discussed, it has been considered, and I think we are at a time now where we might be able to consider that even more so now with our cash and sustained profitability. So, we will take a closer look at that and have some discussions around that in future quarters.

Andrew Shapiro – Lawndale Capital Management

Related to that, and I will back out in the queue, but I do have more questions. In light of what you are talking about in terms of your R&D investment and some of these other projects could come and go, and it's happened on the medical, etcetera, I was assuming, but I would like to get your feedback as you think about stock buybacks your views regarding, I guess, instituting a small but obviously something that ends up requiring a more steady dividend policy.

Cary Wood

Yes, I think no difference than the discussion around a stock buyback. It is something that will be on our list of Investor Relation concerns with our Board. I think again with sustained profitability, you know, we have grown more confident in our ability to discuss those a little more directly. I think it’s something that we can discuss in future quarters, but for now, we want to remind ourselves that we have only come through four quarters on the heels of three straight years of losses. We just made an acquisition that we feel very, very confident, will be accretive very quickly, but again, we want to be very prudent about how we might entertain some of these other options that might have cash implications sooner than we might be otherwise ready. So, again, a very good point. I just think (inaudible).

Andrew Shapiro – Lawndale Capital Management

Okay. I have more questions, so please come back to me.

Cary Wood

Okay.

Operator

And our next question comes from the line of John Rolfe from Argand Capital. Please proceed with your question.

John Rolfe – Argand Capital

Hi, good morning guys. A couple of questions for you, not related so much specifically to the quarter, but you guys have recently provided a bit of kind of broad longer-term guidance. I think you mentioned that you would like ultimately to sort of target a $500 million revenue level for the company. Can you talk a little bit about sort of what timeframe you are talking about in regard to that, and then secondarily, how you would sort of see getting there with respect to organic growth versus acquisitions?

Cary Wood

Yes, I think I appreciate the questions. We have been pretty diligent and specific about the roadmap to get us to that ambition. It’s not lost on us that it’s very ambitious, but as we look out into, say fiscal year ’15, we believe that if things would fall as we have kind of laid them out, it certainly is achievable. We believe as we have looked at things, there are several different kind of organic growth and there is the conservative and reasonable level of 3% to 5% and we have certainly kept an eye on what that might look like. Then we think that there is another band that could be dialed up to be somewhere in the areas of 5% to 10%. I think the general economy is going to have to help us with that. And lastly, it was our third band which is we believe to be some level of reasonable acquisition targets and some regular year-over-year basis.

The Delphi acquisition brought us what we have targeted about a $32 million revenue level and layered that on top of, say last year’s fiscal year run rate will kind of get us significant ways towards our year-over-year targets. But as we look ahead, I think what is going to probably underscore is the need to do just as we have laid out in our script and that is that we are going to have to continue to incubate product line extensions through R&D and DSS and start to offer more of that into the market than what we do today.

EMS while seemingly counterintuitive can bring growth opportunities at a different margin level than what we have experienced in the past, but is probably more short-term opportunistic than some of the other two. And medical with us now having a West Coast presence, having acquired a much larger selling group than what we even currently had including a rep network, we think all of those things combined can give us a trajectory towards $500 million by the time we get to the end of our fiscal year ’15, and that’s really our game plan is to hit on all the various things that we have talked about in our script.

To extend DSS, to get geographic extension out of medical, and to take advantage of more near-term growth opportunities in EMS, and I think there is just an organic target of 3% to 5% reasonably. There is some upside to that and then some level of targeted acquisition, and I think that some of those things overtime essentially how it is we see that unfolding.

John Rolfe – Argand Capital

Okay. And in addition, one of your other relatively recent comments was that you hoped or had a target of being in the top half of your peer group for purposes, I think, of return on invested capital as well as return on equity. Could you share with us who you view as some members of that peer group?

Cary Wood

You know, John, it’s a good question. We just had this discussion late yesterday about how comfortable we were laying those peers out there. Obviously, we were most recently rolled into the Russell Index and that’s certainly going to serve as a large pool by which to be compared against. We are somewhat reluctant to kind of lay out who some of our direct competitors to compare and contrast against might be. We provided some internal documents for our Board to kind of benchmark against, so that we are little bit more specific. I think we have conveyed in Investor Relations presentations and some one-off conversations with various funds as to who we see as our comparatives.

Obviously this format, we are a little bit reluctant to kind of lay that out here, but I think it’s safe to say in a much higher level that the Russell Index is an index and a pool of comparatives that will be doing some comparisons against and we made the first step towards identifying what metrics we wanted to use and an index that we wanted to generally compare ourselves against. So, not quiet the specific answer I am sure you were looking for, but certainly we have got our eye on who it is we might want to provide comparisons against and the Russell is at least the start to that.

John Rolfe – Argand Capital

Okay. Great, thanks very much.

Cary Wood

Sure.

Operator

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

Bruce Baughman – Franklin Templeton

Good morning.

Cary Wood

Good morning.

Bruce Baughman – Franklin Templeton

Would you be good enough to talk a little bit more about the opportunity you see in EMS given the margin profile that you described, the 3% to 6% gross margin?

Cary Wood

Yes, obviously the year we have had from fiscal ’10 compared to’09, it was a significant change in operating performance. It was in line with the guidance that we provided, but nowhere near in line with what our expectations are. Very shortly, we are going to be revising in our fiscal year ’11 in Investor Relations discussions that our guidance on EMS is going to be in the 5% to 8% band over the course of this fiscal year. We have also discussed that over the course of the next eight quarters, that business must get into a double-digit gross margin kind of performance arena before we look at that business as optimistically as we do the others.

That said, I think there are generally two or three things that need to continue to be kept in near-term focus. A, we reexamined our cost structure and our approach to pricing that business. The previous administration had a different approach, undertook very large volume commodity priced types of engagements. That’s not something that we are interested in doing.

We focused on the more complex, however smaller volume engagements which I think bring with it better volume or better returns on margin. That along with continuing to improve the operating performance, we continue to see opportunities in the areas of scrap and cycle time and throughput and the fundamentals of operations that go to costs, which will improve our current programs and their operating margins as well as cost effectively those that might engage with in the future.

And then lastly, I think it’s generally well understood that even the two remaining footprints we have are 50%, maybe 60% consolidated utilized and I think that brings with it obviously opportunities to better distribute the overhead and fixed costs. So, I think our view is that we have approached the costs, we have introduced a prototyping line that has engaged us with customers in the complex low volume arenas. Since having done so in our most recent number included in the neighborhood of 20 plus customer engagements that were brand new to Sparton, that we believe give us opportunities to be involved not just in prototyping but in production-related quantities and volumes.

And so, I think the consolidation of those half a dozen things I think are significantly going to improve the EMS operating performance, but more importantly we have put it on a very time-specific horizon by which we wanted a double digit or start to consider other alternatives, and those alternatives could include the divestiture of that business for sure, but I think that there are other internal things that we can consider short of that, and we will just stop at that for now. So, hopefully, that gave you at least kind of a broad approach that we are taking on EMS and we are fairly confident revising our guidance going into ’11, it will perform differently and better, and we have obviously put it on a very time sensitive horizon to get it to where we deem it acceptable.

Bruce Baughman – Franklin Templeton

Great. Thank you.

Operator

Our next question comes from the line of Jack Gulati from Safety Care. Please proceed with your question.

Jack Gulati – Safety Care

Thank you. Congratulations to the management team, Cary. I think you have done an excellent job since last year. I have been obviously involved with this equity ownership for over two years now, and I am very pleased.

Cary Wood

Thank you Jack.

Greg Slome

Thank you.

Jack Gulati – Safety Care

I think you guys continue – and I have listened to your presentation with great interest. The key thing to me is growth. And of course the internal growth is always there, and you are on the path of doing so. But I think we still need to keep in mind that we are still relatively a small company in this industry. And obviously there are many ways to grow, but the best and the quickest way to grow and leverage the cash and, most importantly, the management talent that you guys have assembled is through acquisition. And I definitely want to compliment the management on the Delphi acquisitions and I hope you guys will stay focused and try to make more of that.

Cary Wood

Jack, we appreciate the comments. I think the Delphi acquisition trying to contain our enthusiasm was a home run for us. I don’t think it’s too often that we are able to consummate a deal that was well below asset value that provides for us a degree of synergy and opportunities to really enhance that business’ performance and be accretive as quickly as we feel like it will. We are obviously going to go about how we discuss it in open environment very conservatively and we have said it loud that it will be accretive no later than the third quarter. We have seen really good things coming about from that business even in the first 30 days of our involvement, and we are very excited about it.

When you think about what we did with that acquisition and you think about the potential of doing things if not just like it similarly to it on a year-over-year basis. I think you are absolutely right that there is probably more to be gained in growth through acquisitions albeit bringing with it a much higher degree of risk. And so, with that in mind, we are going to go about the integration of this particular acquisition very carefully, very prudently. I think it is our management’s obligation to provide the Board, the shareholders, analysts, potential investors an assurance that we can acquire and integrate. And I think as quickly as we can demonstrate that, I think more will share your opinion that acquisition is something that this business can handle and certainly benefit from. But again, thank you for your comments, Jack.

Jack Gulati – Safety Care

Good. Again, my congratulations and let me just add that the strategies put together and represented today and have been known previously are absolutely the way to follow it. So, my best wishes and congratulations and we will stay with you guys.

Cary Wood

Thank you Jack. We appreciate that.

Jack Gulati – Safety Care

Thank you everybody.

Operator

(Operator instructions) And our next question comes from the line of Jonathan Haines [ph], private investor. Please proceed with your question.

Jonathan Haines

Thanks. With the Delphi deal, I guess you kind of alluded to it in the last question, but could you put or give us a timeline for your expectation of when it would be fully integrated into your existing operations?

Cary Wood

Sure, and I appreciate the question. I will answer it I guess in a couple of different perspective. One as we have said in our script today that we believe it to be fully accretive no later than our third quarter, and we will stay firm to that. However, as I say that, we have initiated a 100-day integration plan, and our approach to this integration is not significantly different than the same 100-day plan we put to the turnaround of Sparton at large. And a lot of the same fundamentals are being put to work with the integration effort as were put to work way back when the Sparton turnaround started things such as assessing the footprint and the degree of asset utilization, lean deployment which is an all encompassing approach to the operations – everything from uptime and throughput analysis to quality and warranty.

We have taken a look at the management effectiveness and provided guidance on how we might otherwise see them put tools to work and manage the business, I think there are some good strengths there that we are going to leverage and perhaps even share back within Sparton. But I think the 100-day plan that we put to work will bring an yield of rewards as quickly as we can bring, but again, we feel like by the time we get to the end of our fiscal year third quarter that we can clearly and fully say that this business has been acclimated and fully integrated, I think to our growth opportunities there that we are just now beginning to better understand and we haven’t even accounted for and I look forward of its performance.

The guidance that we have given on medical within Sparton prior to the acquisition of roughly 13% to 15% gross margins are fairly consistent with what our guidance is going to be on that business. So, I think in summary, we will stick to the third quarter, but I also know that we have put to work a very aggressive 100-day plan and the expectations are internally that we will start to see some kind of yielding results sooner than the third quarter, but again, our guidance this third quarter very similar performance to what medical has been in the past, and we are excited about what we are seeing already. Hope that answers your questions.

Jonathan Haines

That's good. And just to follow-up on that, do you think given that timeframe that you would be unlikely to entertain additional M&A activity during that period, or will you start looking at things sooner than that? How much do you want to have on your plate?

Cary Wood

Yes, that’s the crux of the issue, and that is that while we have assembled a very talented and strong management team, there is only so much bandwidth that can be effectively distributed before you start to diminish their effectiveness. And that’s certainly for me to kind of keep one eye on. We constantly look at acquisitions, targets and opportunities. Those are always in front of us and where we believe there is a near term synergistic opportunity, we certainly aren’t going to stop looking at opportunities. However as I say that, I think to remind ourselves, this company has just come through its first year of profitability, we are seeing sustained profitability, there are still opportunities within this company to address and some of that includes the basics of continuing to enhance our business development efforts and within the core company.

So, with that said, we will continue to concentrate on the basics within Sparton. We will integrate this acquisition, we will keep one eye on additional opportunities. There is no way I would say that we won’t be looking at opportunities, but we would be reluctant to do too much, too quickly, so as to stretch the bandwidth, but I do believe that the bandwidth we have as a management team, albeit a smaller management team than what it was previously say 18 months ago, it is one that I believe has the capability to entertain probably more, not less. Now that said, we would be very careful how we integrate. I think the more important thing at least for where I sit, is that we have got something to prove to the Street and to our Board, and that is that this acquisition was a good bet, that everything we said we can do, we will deliver on and more, and that we will do it quicker than what we are telling the Street and our Board, which is currently our third quarter. And if we are able to do that, I think you can deem this as a successful acquisition, and I think that sets the table for us bringing something for us sooner than later. So, long answer, hopefully it answers your question.

Jonathan Haines

Great. I had a couple of others. Just on Delphi, it looks like their inventory turn is about 3.5 times a year, sales to inventory. How does that compare to Sparton Medical?

Cary Wood

You know, without getting too specific into the financials of that business and our projections, I think it’s safe to say that one of the opportunities that we identify was Delphi’s approach to working capital in general. I think we have gotten very comfortable. Obviously if you look back to two years ago, the inventory levels within Sparton were in excess of 60 million and now well below 30 million. I think that demonstrates the approach that this new management team takes the working capital and how it manages its operations and the implications it might have specifically on inventory, and we are currently in the midst of putting our 100-day plan together in Delphi. And I think generally our expectations is that overtime, we will manage inventory slightly better and that was part of one of the synergies that we saw.

So, without going into the specifics of our segmented inventory performance in medical, which is obviously slightly better than what you see at Delphi and our acquisition of the Frederick facility, we think there is an opportunity to address it, and it’s certainly cash that we expect that can pull out of the system overtime.

So, I know it’s not the specific question you wanted an answer, you wanted me to give you how many terms we have and how many terms we project out there, but I think generally we have improved significantly on inventory management.

Jonathan Haines

And I had two more, hopefully they are quick for you.

Cary Wood

Sure.

Jonathan Haines

The goodwill that's on your balance sheet, is that primarily associated with Sparton Medical?

Cary Wood

It is, it is Sparton Medical included, yes. It’s almost – well, it’s exclusively.

Jonathan Haines

Okay. Great. And then last one, you talked about increasing your marketing spend and your R&D in the new fiscal year. Could you kind of size those for us?

Cary Wood

I can generally give you some guidance. First, I will go back to the perspective of 2008 and 2009 where the R&D spend was zero. The marketing spend was predominantly on headcount and pointedly headcount that was ineffective when it came to selling on the Street. So we have now guided the organizational headcount and upgraded that talent significantly. So with that, most of our investment is going to come in the areas of marketing and go-to-market collateral materials, our selling booths and our presence at shows which will be increased exponentially from what it was in the past. It will go to general payroll of this development talent that we didn’t have. And again, that’s increased exponentially.

The R&D spend having been zero will be exponentially increased, and our CapEx spend guidance in the past has been a point, point-and-a-half per year, we understand to that, but we certainly look ahead to the things that still need to be done. I think we have got a similar approach to R&D and business development without getting specific about that spend, but I think generally, it’s safe to say that the range might end up being somewhere between a point to point-and-a-half, and I think that’s the general guidance we would be comfortable providing as it applies to business development, our marketing efforts and even R&D.

Jonathan Haines

Thanks, that's it.

Cary Wood

Sure.

Operator

And we have a follow-up question from the line of Andrew Shapiro from Lawndale Capital Management. Please proceed.

Andrew Shapiro – Lawndale Capital Management

Okay. A few questions here, in the DSS side and related to your R&D, your 10-K said that the government-funded R&D for the year more than doubled over the year from $4 million to $10 million. Is this work that you get out of them cost plus a margin type of work? And is Sparton retaining your commercial use of the end results of such work?

Cary Wood

It is exactly as you described. It is a cost plus engagement to involve our engineering resources in what they would deem product development enhancements to current sonobuoys predominantly. And just as it has been the case for as far back as I know, most if not all intellectual property that comes from that effort is on license to Sparton, and is owned by the U.S. Navy at the end of the day. And so that’s generally been the extent of any R&D. So, that’s why I delineate what has been historical R&D where that might be at Sparton’s hands compared to being the resource that works on behalf of the Navy and there’s a distinct difference between those two. But yes, it is engineering related revenue of cost plus basis. It is R&D work that the intellectual property ends up back in the hands of the Navy and we are licensed to put to work.

Andrew Shapiro – Lawndale Capital Management

So, are you licensed to use it for commercial use at all?

Cary Wood

There are certain applications where we are and that’s where we have retained that intellectual property. For instance, in the case of the compass, where that is intelligence that we have developed from within, that we have made an integral part of the sonobuoy applications. It has provided us an opportunity to unbundle and commercialize that by revising its packaging so that it can be extended to other applications. And then we believe that we can do some of that same work with other internal applications, for instance not just the compass, but also the hydrophone and other similar applications.

So, up to now, almost every bit of the R&D has been basically handed back over, and now we feel like there are opportunities for us to revisit some of that, and the compass is a good example of that.

Andrew Shapiro – Lawndale Capital Management

Now the margin you get on this, is it in the mix – equal to or lower or increase your DSS segment margins?

Cary Wood

When you look back to the compass sales of last year, and that sales level increased incrementally compared to previous fiscal years. We have what we believe to be a good benchmark on margins. It’s not a margin that we would want to openly discuss, but I think generally it is not a commodity level of pricing product.

Andrew Shapiro – Lawndale Capital Management

No, Cary, I meant on your government funded R&D, the stuff that is cost plus.

Cary Wood

I am sorry. That’s usually competitively priced 10% type of approach to things. That typically –

Andrew Shapiro – Lawndale Capital Management

So, that lowers your segment margins in DSS then?

Cary Wood

It does, yes. I think when you consider the operating performance being in the 20 plus in the last year, a lot of that coming off of either foreign sales or production volume, it’s certainly true to say that engineering related revenue has its diluting effect, but the other side of that is that it lends itself to production volume in subsequent years. So, we got to keep an eye on that as well.

Andrew Shapiro – Lawndale Capital Management

I am glad to have a little information there on the digital compass, but (inaudible).

Cary Wood

Does that take care of your next question?

Andrew Shapiro – Lawndale Capital Management

Yes, well, I have more. But I will back out in the queue in case someone else has.

Cary Wood

Feel free, let’s go ahead, Andrew, keep going.

Andrew Shapiro – Lawndale Capital Management

Okay. On DSS, are you able to discuss the nature and the timing of completing these development phases and the nature and timing potential of new production RFPs and contracts that come from them?

Cary Wood

Yes. That’s a tough one, Andrew, and I think we are a partner and a good example of this partnership was as we announced recently with NICTA. And we are now involved with a different project which is domestic, homeland security and it is a U.S.-based harbor. We are not necessarily the controlling individual on how we go about quoting, when we would expect those types of quotes to be awarded. I think we have got generally a time horizon that it will happen over the course of the next three to four quarters, and that is our general expectation when an award might be announced. But that’s a bit of a moving target, again we are in a development phase with a partner. This is brand new application of technology on land-based harbor protection with some of our technology.

And so before I commit to something that I only have to revise my outlook on in subsequent quarters, I think I will leave it at that.

Andrew Shapiro – Lawndale Capital Management

Okay. In terms of this backlog, do you or Greg have handy your backlog numbers for government in the commercial segments versus last quarter rather than last year? I am trying to just find out if the backlog is building for you and to find out if these backlog numbers, it would seem would not include Delphi if there is a Delphi backlog number.

Greg Slome

It is and I think generally the way to look at this and it’s certainly been a leading indicator for us is that if you were to compare the last two quarters and then even the quarter before that, because it works to our advantage to provide that is that it was in the low-to-mid $90 million range at the end of our second quarter. It got into the upper 90s in the end of our third quarter, and as I mentioned in the script, it has surpassed $112 million at the end of our fiscal year.

So, if you want to use that as a bit of a leading indicator, what it does suggest at least in management’s mind is that the impact of this engagement even some level of softening that we see in medical and continue to see is maybe hit the low watermark in terms of backlog and it’s increased every single quarter for the last three quarters ending with June 30th, 2010.

Andrew Shapiro – Lawndale Capital Management

Great. Do you have the segment breakdown and just versus last quarter? What I want to get a feel for is your medical and EMS clock [ph] versus March just to know, for example, like EMS, which is the next question, deteriorated from last quarter. And to get a handle on that, but to find out at least if the backlog in EMS and the backlog in medical have grown in the June quarter from March. And also does that June number – it shouldn't include Delphi, but I want to confirm it doesn't, and if then you have a Delphi backlog number?

Greg Slome

First of all, there is no Delphi inclusion in anything as of June, so you are correct. On a segmented basis, I think generally the way to look at the backlog over the course of the last three quarters would suggest as follows

Electronics has remained fairly flat, and that medical has slightly increased every single quarter, and that DSS has incrementally increased from second to third to the end of our fourth quarter.

So, the mix is obviously in DSS and medical and remained fairly flat in electronics. In terms of the backlog of Colorado, I think at this point I am reluctant to provide any guidance on that until we spend a little bit more time flushing that through.

Andrew Shapiro – Lawndale Capital Management

Okay. So for next quarter when you give out the backlog, it's going to be part of medical. Just to be prepared to – what Delphi was with that just to get that.

Cary Wood

Sure, no, of course.

Andrew Shapiro – Lawndale Capital Management

Now, as I mentioned in the precursor to that question, EMS, you were on a path of – year-over-year we certainly understand certain declines and also certain improvements in EMS. And I know that things aren't necessarily always a straight line and a stable path. But can you discuss in better detail and color what happened at EMS during the quarter ended June, the fourth quarter, when the operating performance in that June quarter deteriorated from your just recently, you know, Q3 March, and what is being done about it?

Cary Wood

Yes, I can appreciate the question. It’s certainly been squarely in our focus. (Technical Difficulty)

Andrew Shapiro – Lawndale Capital Management

(Technical Difficulty) underabsorption, how much in program startup costs that went through here incrementally took this down?

Cary Wood

Yes, I think generally it’s a combination of two things. When you saw the difference in volume between Q2 and Q4, obviously that is underabsorbed fixed costs. And so, obviously we have got, we still have to address some of that. And that’s a portion of how you bridge that difference. You saw some of the one-time non-reoccurring launch or launching efficiency with the one customer that was previously in Jackson that we were working off inventory to satisfy demand and then we have now since entered into regular production within Brooksville, and that had its implications in excess of $100,000, and then lastly you saw some impact of a shift in mix where a larger percentage of the overall revenue particularly out of Brooksville was much smaller in terms of its gross margin standard, and we have got to address that with some commercial solutions that are on our short list of things to do.

Andrew Shapiro – Lawndale Capital Management

Okay. Have contracts that were profitable turned into money losers on the move down to Florida?

Cary Wood

No, not at all. I think what we continue to see is again operating opportunities and where there might be a contract or two that are sub optimum for us. I wouldn’t suggest they are losers at standard. I think we again have to address a few of them, particularly one with a customer that we are going to have to have a discussion around its current pricing and terms, and we are certainly going to –

Andrew Shapiro – Lawndale Capital Management

It's disturbing always to see a negative gross profit.

Cary Wood

Yes, no doubt, no question. It’s certainly was frustrating or frustrating quarter for us where we felt like we were making good inroads there.

Andrew Shapiro – Lawndale Capital Management

And do you feel in the quarter that we are in right now, this is a September quarter, that things have already turned around inside of EMS in the right direction?

Cary Wood

We have adjusted some of our costing, we feel like we have started to address some of the operating shortfalls and we certainly won’t see new product introduction impacts like what we saw in the fourth quarter. I think that it’s fair to say that the revenue topline is probably going to be softer than what we saw in Q4, but I think what we are expecting to see is a better gross margin performance in Q1 than what we saw in our Q4.

Andrew Shapiro – Lawndale Capital Management

In that segment?

Cary Wood

Correct.

Andrew Shapiro – Lawndale Capital Management

Okay. Again, I will back out if you have anyone waiting, otherwise I have more.

Cary Wood

Okay, we will have one more question, Andrew.

Andrew Shapiro – Lawndale Capital Management

How about two?

Cary Wood

Depending on how hard the second one is okay.

Andrew Shapiro – Lawndale Capital Management

No, we won't be as tough on you here on the next two. You have got an EPA trust that you kind of have restricted cash. That's at $3 million. And you put together a profitable year and sustained profitability. What is the estimate of timing of dissolving the trust and releasing your restricted cash?

Cary Wood

We have met all of the requirements to dissolve that trust with our fiscal year. We have an obligation to now provide audited financials and I think between now and the end of our first quarter, we will clearly have liquidated that and go from being restricted to accessible.

Andrew Shapiro – Lawndale Capital Management

Great, and can you discuss the other investor presentations, targeted cities that you are going to tell the Sparton story to in addition to next week's Rodman and Renshaw Conference in New York City?

Cary Wood

Yes, you know, we are going to really dial up our efforts here over the course of the next three to four months very similarly as we did last call when we saw a great deal of interest and its implications on trading volume improved, and we are certainly looking to replicate that here in our fourth quarter. We have got meetings starting next week Monday in New York as you mentioned, and then we have got one-off meetings with probably up to a dozen different funds over the next several days. I will be down in Philadelphia in the middle part of or towards the end of next week meeting with shareholders and potential investors.

And then looking ahead at dates, without having in front of me, Andrew, we will be in Connecticut. We will be, I believe, give me just a minute, I am going to pull them up. We have got investor road shows in Connecticut and Baltimore in December. We have got a series of investor calls in January. We have got a California road show scheduled for February.

Andrew Shapiro – Lawndale Capital Management

Are you going to Dallas, the Southwest conference anymore or no?

Cary Wood

Yes, we are. I am just going back up here. We have got an investor road show in Minneapolis in October, and then we have got the Dallas investor road show in early November. So, New York, Philadelphia, Minneapolis, Dallas, Connecticut and Baltimore.

Andrew Shapiro – Lawndale Capital Management

Yes, because again, $30 million net cash, soon to be $33 million in net cash and sustained profitability, it's either a buyback or a success on the road telling the story, because your $20 million enterprise value is kind of ridiculous to see.

Cary Wood

Sure.

Andrew Shapiro – Lawndale Capital Management

Can I get one or two more in here since –?

Cary Wood

Sure, go ahead.

Andrew Shapiro – Lawndale Capital Management

Now that Albuquerque has been written down, you should be able to move it out quicker. Is that the case? And what is the status of your sales efforts of the Bluewater Road, Albuquerque facility?

Greg Slome

We reengaged with a new broker several months back. We believe that who we have newly engaged with I should say has a different approach to the market and is a little more aggressive than what at least I was feeling. We have repriced that property in line with appraisals and what we believe to be market potential on it to be and obviously we feel like that ought to probably rise to the level of the sales sooner than later and that’s our ambition. So, we put new focus on the marketing, and we put what we believe to be a more reasonable price on it, and it certainly is our hope to get that move sooner than later, at the very least, it’s a distraction at the end of every quarter having to wonder where we are out with that thing. So, we would like to get it moved sooner than later.

Andrew Shapiro – Lawndale Capital Management

Last question. Your press release mentioned the sale of three of your foreclosed properties will save an estimated $400,000 a year. Is this reduction of cost versus prior year coming out of your corporate SG&A or a particular operating segment?

Greg Slome

Andrew, it’s actually coming out of the other expenses within operating income.

Andrew Shapiro – Lawndale Capital Management

Okay. Great. Thanks guys.

Cary Wood

Thank you Andrew. Very good.

Mike Osborne

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

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 line. Have a great day everyone.

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