Sparton: Delphi Medical Acquisition Should Be Highly Accretive

| About: Sparton Corporation (SPA)

Sparton Corporation (NYSE: SPA) is a $179MM revenue contract manufacturer serving three business segments: Defense & Security Systems, Medical Devices, and Electronics Manufacturing Services ((NYSE:EMS)). Sparton is moving from a successful turnaround into a growth story by transitioning from a traditionally defined ‘contract manufacturer’ to a higher margin full service developer, designer, and manufacturer of complex & sophisticated electromechanical devices. This growth is being spurred by a proven management team seeking to repeat (in assets Sparton recently purchased from Delphi Medical Systems) the successful restructuring they implemented at Sparton over the past year and a half.

While Sparton reports its Q4 FYE June 2010 results this week, the low cost and terms of the Delphi purchase set the stage for a highly accretive impact on Sparton’s cash flow and bottom line in the coming fiscal year ended June 2011.

Some Background: A Successful Turnaround at Sparton

3 years of consecutive quarterly operating losses and a liquidity crisis were brought to a denouement in late 2008 by a favorable settlement of my firm’s (Lawndale Capital Management, LLC) proxy fight with Sparton, resulting in changes to its Board and the hiring of a new CEO. By early 2009, Sparton’s new CEO Cary Wood had replaced almost all of Sparton’s senior management team. This new team then took substantial restructuring actions (and charges) during FYE June 2009 and early in the current FYE June 2010 to remove huge costs from Sparton’s operations, while jettisoning unprofitable contracts and shuttering grossly under-utilized and inefficient manufacturing capacity.

A Seeking Alpha article entitled “Sparton: An Undiscovered Turnaround”, which discusses the company’s rapid turnaround in late 2009 and steps taken to return this 110-year old company to a level of sustained profitability, is worthy of reading. Among other things, it illustrates that this management team has proven experience to create additional growth by restructuring and improving returns on the cheaply acquired Delphi Medical assets.

Sparton’s Growth Plan Via the Higher Margin Medical and Defense Segment

Sparton’s recent investor presentation (pdf) on its website, highlights new management’s vision for Sparton: “become a $500 million enterprise by fiscal 2015 by attaining key market positions in our primary lines of business and through complementary and compatible acquisitions; and will consistently rank in the top half of our peer group in return on shareholder equity and return on net assets.”

Slide 12 of the presentation shows Sparton’s projected segment breakouts, illustrating management’s plan to grow Sparton’s two higher margin segments, Defense and Medical, while shrinking Sparton’s low margin EMS segment to either earn an adequate return or eventually divest it.

A previous Seeking Alpha article I penned, entitled “Sparton: Ready to Cash In on the Naval Arms Race, discussed Sonobuoy growth opportunities within Sparton’s highest margin Defense segment. The rest of this article will focus on the opportunities and plans for Sparton’s Medical segment, in particular discussing the recent Delphi Medical acquisition, which I believe will be highly accretive.

Sparton Medical’s Growth Plan

Sparton’s Medical Device segment provides a full range of services from design to manufacturing of medical devices and instruments primarily for the In Vitro Diagnostics and now, via Delphi Medical, the Therapeutics Device markets. Essentially, Sparton works with OEMs and emerging biomedical companies to interface their core technology into a complex medical laboratory instrument or point of care device. Key customers have included Siemens Medical (NYSE: SI), the Ethicon Endo-Surgery division of Johnson & Johnson (NYSE: JNJ) and Smith & Nephew (NYSE: SNN). Of Sparton’s $134MM in revenues for the first 9 months of this fiscal year, Sparton’s Medical Device segment accounted for $51.1MM or 38% of the total.

Medical segment revenue growth is planned via: 1) Improvement in market share within the In Vitro Diagnostics market through geographic expansion and new & increased vertical offerings; and 2) Sparton’s move into the Therapeutic Device market, specifically targeting Cardiology, Orthopedic, and Surgical segments. Per slide 12 in the investor presentation referred to above (pdf), and conference calls statements (see SA transcripts here), Sparton management is targeting revenue and operational improvements that will increase the medical device segment’s gross margins to 13-16%. (It should be noted that medical segment gross margins of 10% on $14.2MM of most recently reported Q3 March 2010 revenues still fall short of management’s goals. Achieving the segment’s margin goals on current revenues would mean a $1.7MM to $3.4MM or (approximately $0.17-$0.34/share) annualized incremental gross profits opportunity, above and beyond the Delphi acquisition.)

Delphi Medical: Sparton’s Giant Accretive Step Into the Therapeutic Device Market

On August 6, 2010, Sparton announced that it closed on the purchase of assets from Delphi Medical Systems that are expected to provide an incremental $32MM of annualized revenues, comprising roughly 1/3 of Sparton’s post-acquisition Medical business segment. The findings of our research into Delphi Medical Systems convince us that this acquisition was made to order for Sparton and its management’s proven turnaround expertise.

In 2009, while Sparton management was implementing its own turnaround, a private equity affiliate of Platinum Equity and General Motors (OTC:MTLQQ, GM) split up the pieces of Delphi Corp (OTC:DPHIQ) in a bankruptcy restructuring that sent Delphi Medical with the business units that went to Platinum. Platinum pegged the under-managed low return Medical Systems business as non-core and placed the business up for sale. Sparton CEO Cary Wood was quite familiar with Delphi Corp. as his LinkedIn profile shows he spent the first nine years of his career as a Manufacturing Engineer there. While he didn’t work in the medical products division, the business’ potential fit with Sparton’s was quite obvious.

Delphi Medical primarily manufactures OEM medical devices including blood separation equipment, spinal surgery products and 3-D eye mapping devices. The company also provides engineering and manufacturing support to a market-leading environmental sensor company whose markets include meteorology, weather critical operations and controlled environment applications.

Based on our Internet research and matches, we believe customers include Fenwall, NuVasive (NASDAQ:NUVA), Opthonix and Vaisala Group, (OTC:VAIAF). The acquisition meaningfully catapults Sparton into the Therapeutic Device Market, providing not only a new and diversified customer base but also expanding Sparton’s geographic reach into the western US.

The low cost and terms of this purchase set the stage for an immediately accretive impact on Sparton’s cash flow and bottom line as well. A close review of the Asset Purchase Agreement filed as exhibit 10.1 in Sparton’s July 12, 2010 8-K filing details some items of note:

  1. The $8MM all-cash price purchased $10MM of inventory of which up to $2MM is refundable for any of this inventory remaining unsold after 18 months. This contingency provides sizable protection from the inherent risk that purchased inventory is excessive, obsolete or the related customer is lost.
  2. Sparton obtained Delphi’s two underutilized facilities with favorably structured new leases, providing for lengthened occupancy of the retained Road 18 facility, while shortening the term of the Miller Rd. lease to no more than one-year and the ability to terminate early.

Page 6 listing of facilities in Sparton’s investor presentation makes it clear that Delphi’s second facility has or will be consolidated into the first.

Basically on a smaller but still meaningful scale, Sparton management, which has proven its restructuring and turnaround prowess in prior more difficult circumstances, will be removing costs from operations, while shuttering grossly under-utilized and inefficient manufacturing capacity and repositioning contracts into improved profitability. Not counting other revenue growth synergies, achieving management’s targeted 13-16% gross margin goals for the Medical segment on Delphi’s projected $32MM of annual revenues would mean another $4.2MM to $5.1MM or (approx $0.41-$0.50/share) of incremental annual gross profits opportunity. This is on top of the gross profits improvement opportunity on Sparton’s pre-acquisition Medical segment business.

The Delphi acquisition just closed in the middle of the current Q1 FYE June 2011. Watch for steady improvement in Sparton’s Medical segment throughout the coming fiscal year.

Disclosure: At time of writing, author and/or funds author manages hold a long position in this issuer and is a 13D filer. The funds may buy or sell securities of this issuer at any time.

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