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Sparton Corporation (NYSE:SPA)

F1Q2011 Earnings Call Transcript

November 17, 2010 11:00 am ET

Executives

Mike Osborne – SVP, Business Development

Cary Wood – President and CEO

Greg Slome – CFO

Analysts

Andrew Shapiro – Lawndale Capital Management

Jonathan Haines [ph]

[Starts Abruptly] The gross profit percentage remains flat from 15.3% a year ago to 15.4% in the fiscal 2011 first quarter. Impacting the quarter-over-quarter gross margin was the favorable impact of increased sales in the company’s DSS segment, the impact of plant closure and consolidation within the EMS segment and the benefits of our continuous cost improvement programs across the Company. Offsetting these positive trends were unfavorable product mix, customer pricing adjustments and decreased capacity utilization within the medical segment.

Selling and Administrative expenses for the three months ended September 30, 2010, increased approximately 400,000 from the prior year’s quarter reflecting additional expense related to SMS Colorado facility, increased internal research and development expenses, increased informational technology expenses and increased expenses related to the company’s long term incentive plan, partially offset by reduced selling and administrative expenses resulting from the consolidation of our EMS facilities during fiscal 2010.

Restructuring and impairment charges were $100,000 and $900,000 for the three months ended September 30, 2010 and 2009 respectively. Interest expense was $200,000 for the fiscal 2011 first quarter compared to the $300,000 for the same quarter in fiscal 2010. The decrease in interest expense primarily reflects the payment of the company’s outstanding bank debt in August 2009.

We are extremely pleased to have closed on the Delphi Medical System acquisition during the first quarter and we substantially completed our integration plan well ahead of our schedule. The purchase price of $8 million is subject to certain adjustments based on the determination of final inventory value.

The cash consideration paid at closing of approximately $7.8 million including a $2 million escrowed holdback was reduced by $200,000 for the assumption of retained employee accruals and was financed entirely through the use of company’s cash.

The company has estimated that the additional cash consideration due to Delphi is subject to final agreement of the acquired inventory will be approximately 600,000 and has accrued for this amount on September 30, 2010.

Sparton has determined that the fair value of the assets acquired and the liabilities assumed related to this acquisition exceed the total purchase consideration and in compliance with recent acquisition accounting rules.

The company has recorded a gain on this acquisition of 2.4 million in the three months ended September 30, 2010. The acquired business which is reported in the company’s medical segment is expected to add $32 million in projected annual revenue from a new and diversified customer base and provides Sparton with a geographic presence in the western United States.

SMS Colorado primarily manufactures OEM medical devices, including blood separation equipment, spinal surgery products and 3D I-mapping devises. It also provides engineering and manufacturing support to market leading environmental sensor company whose markets include meteorology, weather critical operations and controlled environmental applications.

The operations of SMS Colorado are included in the consolidated operating results for fiscal 2011 first quarter from the August 6, 2010 date of acquisition. SMS Colorado reported first quarter net sales of $5.9 million, gross profit of 600,000 or 9% and operating income of $2.4 million. Excluding the $2.4 million gain on acquisition, the operations essentially had a neutral impact on the consolidated net income in our first quarter.

On a pro forma basis, the revenue for the current and prior comparable full quarters remained relatively flat at $9.4 million and $9.6 million for the quarters ended September 30, 2010 and 2009 respectively. The gross margin percent has increased from 1% for the fiscal 2010 first quarter to 7% for the current year first quarter.

To further enhance SMS Colorado's profitability, Sparton Management quickly initiated certain actions designed to reduce cost. The workforce at this location has been reduced by approximately 18% since acquisition and additionally the Company consolidated the Colorado operations from two facilities to one during the first quarter, terminating the lease for the exited buildings as of November 1, 2010.

Again, we are very pleased at the speed in which we have been able to execute on our cost savings initiatives as part of our 100-day plan having surpassed our internal timeline for the facility consolidation. Initial success in implementation of lien enterprise in Colorado is encouraging. For enhancing the profitability of this business further, as we anticipate this strategic addition to our medical business will be accretive to earnings no later than the third quarter of our fiscal 2011.

I'd like now to turn over to next portion of today’s call to Greg, so he can update you on the individual segment results, our liquidity and our capital resources. Greg?

Greg Slome

Thank you, Cary. For the medical device business, sales decreased 500,000 or 3% in the three months ended September 30, 2010, as compared with same quarter last year, excluding the incremental first quarter sales from SMS Colorado, the quarter-over-quarter medical revenue decreased $6.5 million or 33%.

As previously mentioned, overall sales softening in the medical segment has continued with one customer right sizing their inventories, a second customer suspending production to make product enhancement modifications and a third customer elevating sales in the prior year relating to the initial channel fill for new product production.

The gross profit percentage on medical sales decreased to 10% from 15% for the three months ended September 30, 2010 and 2009 respectively. This decline in margin on medical sales reflects decreased capacity utilization at the company’s Strongsville, Ohio facility. Additionally, contributing to the decrease in margin was unfavorable product mix between the two periods and the loss of certain favorable materials pricing benefits in the prior year due to customer pricing adjustments.

These downward pressures on gross margin were partially offset by greater operating efficiencies from the consolidation of manufacturing operations in fiscal 2010 and the company’s continued efforts to align its cost structure with the decline in revenue. It is anticipated that the fiscal 2011 gross margin for the medical segment will continue to be in the 13-16% range.

For the EMS business, sales for the three months ended September 30, 2010, decreased 5.3 million as compared with the same quarter last year. This reduction primarily reflects decreased sales to two customers. Sparton disengaged with one of these customers, Honeywell during the three months ended December 31, 2009. The decrease in sales to a second customer reflects the quarter-over-quarter loss of certain programs with this customer.

Partially offsetting these decreases were sales to another customer that increased by approximately 600,000. EMS sales include intercompany sales resulting primarily from the production of circuit boards that are then utilized in DSS product sales. Intercompany sales increased approximately 800,000 in the comparable three-month period. These intercompany sales are eliminated in consolidation. Several other customers in the aggregate accounted for the remaining sales variance.

The gross profit percentage on EMS sales increased to 7% for the three months ended September 30, 2010, compared to 6% for the same quarter in the prior year. The quarter-over-quarter comparison reflects improved performance and the reduced overhead costs resulting from the plant closures, consolidation of the EMS operations and an aggressive continuous cost improvement program partially offset by the impact of the overall decrease in sales volume and the favorable pricing on Honeywell sales during its disengagement in the prior year. It is anticipated that fiscal 2011 gross margin for the EMS segment will continue to be in the 5-8% range.

DSS sales for the three months ended September 30, 2010, were significantly above the first quarter of prior fiscal year increasing 4.3 million. This increase is reflective of higher U.S. Navy sonobuoy production in the current year quarter partially offset by a decrease in sonobuoy sales, the foreign governments and a slight decrease in engineering sales revenue.

The gross profit percentage on DSS sales for the three months ended September 30, 2010 was 24% compared to 26% in the same quarter in the prior year. The company continues to realize elevated margins on the production of U.S. Navy sonobuoys reflecting success and sustaining previous improvements in production efficiency through the continued implementation of lien enterprise. It is anticipated that the fiscal 2011 gross margin for the DSS segment will continue to be in the 20-25% range.

I would now like to review our current debt and liquidity positions as of the end of the quarter. The only remaining debt outstanding at September 30, 2010 is our industrial revenue bonds with the State of Ohio of approximately $1.9 million. During the quarter ended September 30, 2010, the company made total principal and interest payments of approximately 100,000. Our debt-to-equity ratio on September 30, 2010 remained at .03:1.

As of September 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. Credit facility is subject to certain customary covenants all of which were met at September 30, 2010.

During the fiscal 2011 first quarter various borrowing restrictions including the $2 million borrowing block have been lifted based on our fiscal year 2010 financial results. Summarizing our cash flows in the fiscal 2011 first quarter, operating activities provided $5 million of net cash flows in the three months ended September 30, 2010. Excluding changes in working capital, operating activities provided 2.5 million in the first quarter of fiscal ‘11 reflecting the company’s operating performance during the period.

Working capital provided $2.5 million of net cash flows in the fiscal 2011 first quarter primarily reflecting the collection of advanced billings related to the U.S. Navy contracts during the quarter in excess of the funding of production under those contracts, partially offset by working capital funding related to the SMS Colorado facility as well as funding of a contribution to the company’s pension plan.

Cash flow is used in investing activities in the three months ended September 30, 2010 totaled $8.3 million. The fiscal 2011 first quarter reflects the acquisition of certain assets of Delphi Medical, to consideration paid of $7.8 million is net of 200,000 of assumed employee accrual adjustments and is subject to adjustments related to the final agreed upon inventory values.

The purchase was financed entirely through the use of company cash. Capital expenditures for the three months ended September 30, 2010 were approximately 500,000.

I'd now like to turn the presentation back over to Cary.

Cary Wood

Thanks, Greg. I'd like to briefly update our investors with the activities that the board of directors have initiated during the past year as well as briefly discussing the significant changes in governance that were proposed and subsequently approved by our shareholders that we believe makes us one of the more advanced public companies in the area of corporate governance.

In the last two years the board has been reduced in size from 11 to nine, with eight directors being independent board members and the only non-independent board member. In that process we gained three new members to the board including myself to further enhance our expertise in strategic growth, operational turnaround and continued financial oversight.

In the past year the board committees has worked on various issues such as updating and revising their charters to reflect today’s business environment, implementing a short-term incentive plan based on annual performance objectives and implementing a long term incentive plan based on long term financial metrics that are in alignment with the interest of our shareholders and concerning oversight related to the company’s financial reporting processes, internal controls, risk managements, legal and regulatory requirements.

Further our shareholders approved the company’s proposals to amend the Articles of Incorporation and the code of regulations to declassify the board and require majority voting on directors in uncontested elections. We also included in our proxy, although not required, an advisory stand pay vote on named executive officer compensation. Within the last year, the company has been progressively moving forward its governance policies in an effort to become a more contemporary leading edge entity that aligns itself well with its interest of the shareholders.

Based on a number of votes cast and the results there of at the 2010 annual meeting of shareholders we believe that it’s evident that the shareholders are pleased with the actions the company has taken to improve its governance.

Finally I'd like to close the presentation by providing a brief outlook on what to expect for the rest of fiscal 2011. With the operational phase of this company’s turnaround and the associated costs substantially complete, we are simultaneously focused on the goals of sustained profitability, but shifting to the next phase of our turnaround, focusing on the successful implementation of our strategic growth plan.

The long term sustainability and continued margin improvement in our EMS business is now primarily volume dependent. So, our addition of a business development manager and a soon to be completed marketing strategy should enable us to increase volume at our EMS facility with profitable contrast.

The DSS expanded business development organization also in place. We anticipate it will continue to perform at recent levels of profitability. With cutbacks in medical facility capital spending taking place as well as diminished consumer spending for medical procedures, the addition of SMS Colorado's diverse customer base to our medical segment and an increase of eight Business Development people across the entire Company will assist in offsetting the challenges seeing in our Strongsville location.

During this past quarter, we made progress in a number of our growth initiatives such as significantly increasing our business development resources, continuing to invest in our next generation digital compass product with a planned launch in calendar year 2011 and continue to prepare for the rollout of our new marketing strategy in the second half of Fiscal 2011.

The pursuit of acquisition targets that are consistent with Sparton’s strategic direction will continue to be part of our strategic growth plan and we expect the recent SMS Colorado acquisition to be accretive no later than the third quarter of our fiscal year. With these initiatives and many others in motion we believe that the company is positioned for prolonged growth well into our future.

I continue to be excited about our company’s position and I look forward to reporting on our future successes. Many things continue to be happening. Our new area continues and we thank you for your support. Mike?

Mike Osborne

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Andrew Shapiro, President with Lawndale Capital Management.

Andrew Shapiro – Lawndale Capital Management

Yeah, hi. If you could help here, you said the medical segment gross margin for fiscal 2011 to be 13-16% is that going forward or is it a makeup of the Q1's lower margin will allow you to finish the full fiscal year in your target range?

Cary Wood

We are going to maintain our guidance for the full fiscal year at this point Andrew. Yes. As we mentioned, we’ve seen recently some softening and a shift in mix out of our Sparton Medical Strongsville facility, but we are also anticipating some good things coming out of what we are doing in our Sparton Medical Systems, Colorado facility. And for now we are confident that we'll maintain a full year results of 13-16% gross margin.

So I guess, that can be looked at as makeup, but we certainly aren’t going to shift our guidance for now. We feel pretty good about what we are seeing in Colorado and we are managing through our costs in our Strongsville location.

Andrew Shapiro – Lawndale Capital Management

Okay. And you explained the sales decline and the gross margin compression inside of Strongsville, but if you could give me – give us a little bit of a better handle on the call today and last quarter, you said you've been able to quickly ramp up your selling efforts and you've added some direct selling teams and you have manufacturing reps, etc., can you just help us quantify your business development and marketing resources that are at work today versus six months ago?

And if you have plans for the next six months that you have further increases or if you think you have the right amount of heads on the street right now?

Cary Wood

Six months ago, we had four direct selling individuals. Today, we’ve got 12, so we’ve got threefold where we were as recent as six months ago. That’s not accounting for the various reps that we now have, two of which are national, three of which are regional. We are still working through our relationship with the rep agencies that we inherited with our SMS Colorado acquisition.

The twelve folks that we currently have actively selling for the company, some of which are resources that were redeployed from within, so they aren't incremental adds but the responsibilities have been significantly changed and a good portion of those are incremental adds to the company.

So your question as to whether or not we believe we’ve got the right resources in place today, we have no pending decisions to add additional incremental resources today. We believe therefore that the 12 individuals we do have, are at the right level given what we expect and anticipate to do over the course of the next 12, 18, 24 months. So we feel fairly confident. We brought on some really good, strong skill sets. We brought on what we believe to be the right core competencies of these individuals.

So long story put to a very short answer, yes, I believe we've got the right resources now currently in place and all of that, the final two to three individuals have come to be a part of this company just in the proceeding 30-45 days. So I think we’ve arrived at our selling resource depth.

Andrew Shapiro – Lawndale Capital Management

Great.

Cary Wood

What haven't completed just yet in certain aspects of our marketing piece and that is when you start talking about our logo, tag lines, selling materials, all of those are currently under way, they will be fully completed by January.

Andrew Shapiro – Lawndale Capital Management

Okay. Now, so it takes some time generally for salespeople to get out their call, bring it in. From us as a shareholder, what is an appropriate amount of time we should be looking to you and to the company for results, payback, visibility on whether this marketing investment has brought the expected results?

Cary Wood

Yeah. That's a tricky question. We've applied certain metrics from within to gauge it so that we're appropriately managing it. We've got a handful of metrics. First, we've got our backlog which is certainly a decent indicator, in and of itself, not the best but if you look over the preceding two or three quarters, we've gone from a $94 million backlog to a $99 million backlog to $112 million backlog, to now since slightly higher around 113 and that has some moving parts in and out. But what that does suggest to me is that there is some level of business that is starting to queue up in our backlog which is an indicator in and of itself. Not the best but it's at least one.

The second is that in the preceding quarter compared to the same quarter last year, there is a certain percentage of that which is new business and within our medical business as a percentage of our revenue about 10% of it is new compared to the same quarter last year. And within EMS, it's about 3% and DSS is a little bit different because you get new contracts, but you don't necessarily introduce new products, something we're interested changing.

The last metric which is one that I certainly kept a close eye on, in the proceeding several quarters has been our new business funnel activity and that is now with 12 people, which was previously four, how much business are they currently engaged within conversations, bidding on, providing responses to, working through engineering questions and technical issues through. That number was significantly less than what it is today. It's about threefold what it was just six months ago, so that's another, hopefully, leading indicator.

At the end of the day and certainly we talk about it around here, it's not going to matter much to measure activity as it is to see results. We expect that we'll start to see some level of momentum towards the end of our fiscal year, even saying, it may go into our first quarter of fiscal ’12. And I think a lot of that hinges on the fact that EMS lead time while lower than the other two business units is still a 6 to 12 month lead time.

You aren't going to take on conquest business per se. You aren't going to take on sizeable opportunities and we're certainly out there looking for those types of things, but I think it's reasonable for us to expect that we're going to get more involved in new program launches, which have a certain lead time with them, so 6-12 on the EMS side.

The medical business unit is even more complicated being that you have to be involved in some level of clinical trial, certain level of validation. You've got an FDA consideration there. You're talking 12 to 18 months and then the last of our three business units our DSS, most of our initiatives is vertically extending new products through that channel that didn't exist before or they existed and they are currently going through changes in their engineering releases.

An example of that being our compass and I think those are more reasonably that we looked at as a, 18 and beyond type of threshold for growth. But I also have been very pleased with some of the progress we've seen much sooner than that, but for planning sake, that's essentially the way we've looked at lead time and the types of metrics that we're tracking to better understand whether or not, our newly implemented resources are actually bringing forth what we expect them to bring.

Andrew Shapiro – Lawndale Capital Management

Okay. Last follow-up and I’m back into the queue to let others on this backlog lead time visibility. Of the medical backlog, just to understand what's going on with the legacy medical, the Strongsville, Ohio medical? What amount is Delphi on the medical backlog and I'm trying to basically understand, what was the legacy medical backlog for this quarter, to know if it’s kept up, dropped off or started to pick up?

Cary Wood

Yeah. Good question. Certainly, I’m not sure we've kept an eye on. Total medical backlog is just north of $30 million and that’s combined with our SMS, Strongsville as well as our Colorado facility. If I looked at our Q4 backlog and that's predominantly where it is, exclusively Strongsville, it was a $14 million backlog and the Delphi Medical Systems, Colorado piece, if you will, is 13 million today.

So, to get to right to your question, Strongsville's SMS backlog in Q4 was $14 million and in Q1 is $17.3 million, Delphi, Sparton Medical Systems Colorado is 13.1 for a total current of $30.4 million of medical backlog.

Andrew Shapiro – Lawndale Capital Management

Good. Outstanding. I'll back into the queue. I have more questions. Please come back to us.

Cary Wood

Great. Thank you.

Operator

Our next question comes from the line of Jonathan Haines [ph], a private investor. Please go ahead.

Jonathan Haines

Good morning, gentlemen.

Cary Wood

Good morning.

Jonathan Haines

A couple quick easy questions and then a couple more qualitative ones. I had trouble getting to 170,000 in interest expense given the debt level and the cash paid on interest was less, but can you ballpark that line for us for going forward?

Cary Wood

Sure. Give us just a minute here.

Greg Slome

Yeah. For the most part, even though we don't have any of the actual bank debt outstanding, we still have an unused line fee that we pay on our loan. Of the 170,000 interest expense that was in the first quarter, 40,000 of that related to the unused loan fee. We also have some other smaller items collateral maintenance, letters of credit and then we also have the amortization of the loan fees, which were capitalized when we entered the agreement that are being amortized over a three year period and that's roughly 85,000 a quarter that we're recognizing on that.

Jonathan Haines

Great. And then I see, CapEx for the quarter was up. Are you comfortable telling us what your CapEx total for current fiscal year might be in ballpark range?

Greg Slome

Conceptually, we've said long before today that this company is in need of long overdue investments. The positive note there is that we're obviously capable of doing that where we weren't before. The other positive note is that given the remainder of our facilities, all of which are much newer, the types of CapEx investments are less involved in facilities or even regulatory types of investment. They are now more in the areas of productivity and new technology and that's certainly a good thing.

However, we do feel like there is a significant need for CapEx investment, when you compare it to two years ago where there was essentially none. Now, our first quarter was 500,000 but we'll manage CapEx appropriately and I certainly would be careful not to give guidance as if it's a $2 million annualized CapEx. What kind of guidance we have given in the past is that we would be a half a point, three quarters of a point? And that puts us somewhere over the course of a year, a million to million and a half upwards of a CapEx investment.

We're going to be very careful, very diligence. Every types of capital expenditure request that's made, goes through a very thorough flushing out and vetting to make sure that it’s got an adequate return on investment, so a long answer to your question. But I think generally, we feel like what we've done in our first quarter was appropriate. I wouldn't take it as a quarter-over-quarter guidance, but I have in the past given some level of guidance and I'll maintain that guidance.

Jonathan Haines

Okay. And then the last quick one on the real estate that's for sale, any movement on that? Have they told you there's much traffic or interested parties?

Greg Slome

Well, frustratingly enough, the real estate market hasn't improved much in Albuquerque compared to any other region. And I think generally having gone through, we went through in the proceeding couple of quarters where we impaired its value, we met with and engaged a new broker, we've tried to dial up the marketing efforts. I wouldn't and I don't hold my breath over that taking place anytime soon.

We're not interested in accelerating its sale by significantly discounting it, so we'll maintain where we're at. I think we're fairly priced. I think we're reasonably priced differently than where we were say two years ago where I was scraping together every bit of cash I could find. It's currently listed at $4.2 million and we feel like that's appropriate, so we'll maintain our position. We'll continue to work on interest, but it's not something that I would expect to move from long-term assets to near-term assets any time soon.

Jonathan Haines

Okay. And then on the recent conference presentation that you made, you talked a little bit about, maybe in the Q&A about M&A. And I think we're all, at least at this point pleased with the Delphi deal, but could you talk about your visibility toward M&A and maybe with regard to your 2015, $500 million revenue objective? Sometimes correct objectives are a good thing, but how would you expect that to breakdown between organic versus acquired businesses?

Greg Slome

Yeah. It's a great question and it's certainly conjured up a great deal of interest and it is a rally cry around here internally. And it's certainly intended to give a good solid line of sight on expectations. And as I give that kind of rally cry, I'm not anxious to discount it, but I think it's reasonable to conclude that it is an ambitious goal. And that it is highly dependent upon acquisitions and as we all know, acquisitions are certainly not something that we altogether have control over.

So, we have looked at a great many opportunities and we've walked away from many, many of those either because they weren't the right situation or circumstances to compliment our business. The prices and the terms and circumstances just weren't advantageous. Certainly, in the case of the Delphi deal, we were very pleased with what we ended up with as a business, its opportunities as well as the value that we got and that certainly has proved to be true in the way that we've modified the business in a very short period of time. And we believe it to be accretive very, very quickly and certainly as a result, shown in the game.

So we did all what we believe to be the right things and we'll replicate that if we can, but that's a very difficult thing. So in our five-year growth strategy, we have certain underlying assumptions for what we call Tier 1 growth, which is fundamental in base growth of anywhere between 2% and 4% on a year-over-year basis, slightly conservative from some peoples perspective.

We certainly look at this company having come through what it has, as a bit of a hangover effect. In some people’s minds it still hasn't come through its liquidity crisis, still is wrestling with its turnaround. While, we all know that not to be true, there are those out there that don't have the investment act that some do and so they look at this company, is still having some of its issues to work through and that comes into play when we have sourcing discussions on some of our base business. So we've been very careful about our Tier 1 outlook, 2% to 4% and that goes into our planning document.

Then we have, what we believe to be Tier 2 kinds of planning and expectations and that's where if we weren't dealing with those overhang effects, if we hadn’t had our business development resources on the ground in the preceding year and a half, if we had had all of our selling collateral and marketing materials fully standardized and deployed and institutionalized. And having been a part of, say a dozen different trade shows that we would be expecting the types of growth that we've kind of asked of ourselves and that's the 8% to 12% type of growth range.

And then the last third tier of that is opportunistic M&A and we've got certain kind of assumptions plugged in and say year two, year three, year four. You've got certain fundamental assumptions about what that means to our debt to equity, so while I can't give you a specific answer to how much of that is acquisition, how much – there's two or three moving parts. If we outperform one band then it certainly has us asking for less than another band, but it's a great question.

I certainly understand the curiosity and we are hard at work on the growth side of things, still dealing with a bit of the overhang effect of this company’s transformation, but certainly not a failed effort on our part with the diligence we're putting to it. I think it's just a matter of time to see how all these things play out, but we're heavily involved in M&A targets. We'll just have to see how those things fall in our lap. Hopefully, that answered your question.

Jonathan Haines

Great answer. Thanks. And then just last one and I'll get back online. Say relative to – when we spoke three months ago, could you maybe just give us a qualitative view on how your forward visibility has changed in each of the three segments revenue wise?

Greg Slome

To make sure I understand, are you talking about the – how the backlog and how the business, new business targets and those types of things are looking at each of the three segments?

Jonathan Haines

Yeah. You don't need to address, while, you did address backlog for medical, but just address maybe the trend in each of the segments and…

Greg Slome

Yeah. Some of it's going to be a bit qualitative, because until business is booked, it's hard to count on it. I think we still feel fairly bullish on our DSS segment and that's a combination of our base business, some new contracts that we anticipate, foreign sales that you can't always count on, but we certainly expect, our new product Development efforts and what types of margins that type of business will ultimately bring us.

The type of investment we're putting towards that and still being able to maintain the business at the margin range we expected, so we feel really very bullish on our DSS segment which is certainly, been on a mixed basis, one of the higher contributing margin businesses that we do have. So we feel – continue to feel real good about that segment.

Our EMS segment is certainly, we believe, making progress. It's not making as incrementally or as quickly as we would like. I think that the margin improvement this quarter compared to say, the same quarter last year, not real significant but when you compare it to say some of the down quarters of our fourth or even our third quarter in fiscal ’10, it certainly a little better. That business appears to show some promise with prospects much faster than the other two and when I say that, that kind of ties in with the guidance I gave of the new business lead time.

I think that's more of a six to 12 month lead time. We have a new prototyping line and that prototyping line introduces a great deal of front-end work with far more customers than what we see in any of the other segments. So I think there's a great deal of promise there and I also believe, given that business being so volume dependent that you'll start to see, at least we're hoping and expect a blended effect of new customers with better margins as well as volume that will further dilute our fixed costs which we haven't put a whole lot more into, so I think generally looking ahead, I've got some sense of confidence in that EMS segment.

I'll tell you in advance that our second quarter volume is not nearly what we would like for it to be and I think it could be a frustrating second quarter on EMS. But we're certainly maintaining our guidance of 5%to 8% gross margin and having exceeded that in our first quarter, we feel pretty – or stayed within in our first quarter. We feel pretty comfortable that guidance is good, which is up significantly from last year’s guidance.

And then the last one is the medical segment. We certainly have gotten excited about having added some additional business development resources. That's the one segment that you're seeing, I think external dynamics, while at the same time not having the breadth and depth of business development resources out there in the field and we now do have.

We have West Coast presence with the rep network. We have West Coast presence with the addition of two selling resources, we’ve added one on the East Coast and then we had certain people within our Cleveland facility, Strongsville facility that have now been redeployed full time to growth initiatives.

So I think we've got a good number of resources on the ground there. The downside there is, that you're talking about long lead time issues. You are talking about validation FDA issues and I think that's going to translate into longer lead time compared to EMS in particular, so 12 to 18 months. I'm confident and it is a frustrating thing for me no less than for everybody else that we're doing all of the right things.

The things that you can't necessarily count on and or project is what they are going to translate to, in a quantitative way, so we've got certain expectations. We'll continue to manage our costs. We'll continue to invest appropriately. What we won't do is we won't squeeze cost out of business development, because we just don't think that that's going to translate well over time in growth.

So I think we're managing all of the right components, putting all of the right activities to work. I think we'll continue to use the metrics to gauge our successes and we talk it around here all the time, until it hits, until it's shown on the revenue line it's not going to matter much. So we've got a ways to go there, but I continue to be confident in what we're doing and surprising as it may sound when I fail to be that confident, I probably would find a way to convey that here in that we're going to step back and redeploy and or punt on our efforts prior. So we continue to be confident. Hopefully, that gave you some insights.

Jonathan Haines

Thanks. Very good.

Operator

(Operator Instructions) Our next question is a follow-up question from the line of Andrew Shapiro with Lawndale Capital Management. Please go ahead.

Andrew Shapiro – Lawndale Capital Management

Hi. You brought up some stuff here about the Delphi acquisition and integration, so I want to ask some questions here about that. You’ve had an 18% workforce reduction. Can you clarify here when it started? Is it now complete?

And the amount and timing of non-recurring costs that have been or would be in the income statement in this most recent quarter and the current Q2 ended December quarter that we're in and will those costs flow through in the – just to corporate SG&A or will they also be found in the medical segment in SG&A, when you had last quarter and this current quarters break up?

Cary Wood

A lot of questions there. I'll take a stab at a few of those and then I'll ask Greg to probably jump in at the tail end on things I might miss. I'm going to generally address the acquisition, the 100 day plan and what some of the major actions and milestones were. We took over as you recall in the first week of August. We were on the ground the following Monday after the close on a Friday and put to work and rolled out 100-day plan that we had clearly been working on long in advance.

And as a matter of having done that, it was a lot of pre-work, a lot of planning, a lot of assessing and validating our figures. But by the time we got to the close of October, we had deployed our reduction in workforce. We had closed the second of two facilities and consolidated all of that work, all of which was done seamlessly and transparent to customers. Certainly, in concert with them but was not a disruptive move in the least.

So all the types of actions we were going to take there we've done. We feel that the costs associated with that restructuring while our original estimates were higher came in much lower and are essentially complete. Now there's a lot of moving parts that make it hard for me to answer the specifics of your question and that is, when did the lease terminate and when did we last pay for that and what was the consequences of the risk and what's that benefit going to be looking like moving forward.

I think substantially complete through the first quarter is essentially the guidance on the restructuring. The expense is essentially behind us but the various costs components are going to move around a bit and they aren't going to be real clear until we get through the full second quarter. Greg? Anything you want to add?

Greg Slome

No. I think that pretty much covers it but just clearly the actions that we took we didn't really see the effect of those cost cuts in the first quarter. They will start to phase in the second quarter and then, I'd say by the time we get to the end of the second quarter, we'll start to realize the full benefit of those actions that we've taken.

Andrew Shapiro – Lawndale Capital Management

So the facility though, when was it closed meaning when is that overhead out of our gross margin? Was it in this quarter we're in now Q2 or how many months into it or did it close, I think you said, the lease didn't terminate until November 1 or something on the?

Cary Wood

We executed our – we exited that facility as of the end of October…

Andrew Shapiro – Lawndale Capital Management

Okay.

Cary Wood

… which clouds what you would expect things to look like even in the second quarter compared to the first because you've got some of the cost dragging over but generally put two-thirds of our second quarter will be out of that building.

Andrew Shapiro – Lawndale Capital Management

Right. And on the workforce reduction, is that similar to two months of it or so was in Q1 and a month or so into this current quarter, we have some of the rift expense as well?

Cary Wood

The rift essentially was executed in its entirety in Q1 so you won't see any more rift benefit in Q2 that wasn't already there in Q1. Unfortunately, Q1 is a bit clouded because you've got a partial month one, a partially fully loaded month two and a fully executed rift somewhat offset by inefficiency expense, as well as the restructuring expense. So a bit of a long answer, that's why it makes it really, really hard to give you guidance with all of the various moving parts. But I think to definitively answer the question the rift took place in Q1 and there is no additional rift to take place in Q2. It was behind us and out of our cost in Q1.

Andrew Shapiro – Lawndale Capital Management

Okay. And on – let's move into DSS real quick here?

Cary Wood

Sure.

Andrew Shapiro – Lawndale Capital Management

In November, that's this current quarter, the Department of Defense announced a $26.8 million ERAPSCO contract for just shy of 5,000 SSQ-101 sonobuoys and you guys have, you always have to have a delay when you get your press release authorized by the Navy.

But what I want to do to find out is because it was announced in November by the DOD, is that when the Sparton share of the ERAPSCO contract, which was announced by the DOD of 61%, is that when it goes into your backlog and even though it's a 50-50 joint venture is it your kind of share of the revenue and work product, that is what goes into the backlog and is that thus in the November – not the November, is that in the current quarter backlog and not the quarterly backlog for September you've just announced?

Greg Slome

I know what award you're referring to and you are right that there is always a delay from the time that it gets awarded and so the time that we're able to openly discuss it and it's not yet been approved the DOD to make that release and make that statement, so I'll probably be a bit kiddish around that award.

I will say generally that when awards are announced in May that it enters into the backlog at that time. Not when it shifts, not when it's produced but at the time of award, in the case of the assess, so given that, any type of an award with any kind of an announced split we use that split, we drop that into our backlog and that's certainly the case with any anticipated awards that we might currently be aware of that that have been publicly announced.

Andrew Shapiro – Lawndale Capital Management

And that would be as of the date of the DOD announcement not the date of the Sparton announcement when it would enter your backlog?

Greg Slome

Correct because when that announcement is made by the DOD, we're already well aware of it and as you mentioned earlier, we very, very quickly puts in our releases for Navy review so that we can do that. Unfortunately, the Navy, the DOD rather takes a little bit longer to approve with consume times look like a very simple release and almost exactly what they just released. But whenever that release approval comes to us, we go ahead and we release it the same day.

Cary Wood Andrew Shapiro – Lawndale Capital Management

Okay. I'll back out in case someone else has questions. I have a few more so come back to me.

Cary Wood

Andrew, why don’t you go ahead and finish up your couple more.

Andrew Shapiro – Lawndale Capital Management

Okay. So you have a sales mix here that's kind of tied to new products and new contracts and you have sales that are existing things that have been going on for a while. Can you give a rough estimate within each of medical and EMS related to those divisions products that weren't in production, let's say a year ago that are in production now?

Cary Wood

Yeah. This is, I mean, I talked a little bit about that. I can't remember who asked the question but generally in our medical segment, in our first quarter compared to the same quarter last year about 10% of that business is new business. It may not necessarily be a new customer but its new business. And within EMS about 3% of that business is new compared to the same quarter and again, may not necessarily be a new customer but it is certainly new programs, so 11%, 10% and 3%.

Andrew Shapiro – Lawndale Capital Management

Yeah. You had that in your script. So do you expect that percentage number to be that low, let's say when we regroup six months or a year from now?

Cary Wood

It's hard for me to give that kind of guidance, Andrew, but I certainly hope that that's not the case.

Andrew Shapiro – Lawndale Capital Management

Okay.

Cary Wood

We're working very diligently on putting our efforts towards organic growth and I think that we're behind. This company having gone through what it did didn't have the right resource. It didn't have customer’s attention. It didn't have the ability to afford the working capital to do it. But I think we're at a different place in time. We've certainly got folks attention. We're performing very, very well from the standpoint of our customer’s viewpoint. So our scorecards look fantastic this year compared to the same time last year.

We're talking about things like quality and cost – the things – and delivery. The things that our customers are most concerned about engaging us and not having had that advantage this time last year certainly made it awful hard for the limited selling force we did have.

So having exponentially dialed that up, having had another couple quarters of significant improved performance and being very cost effective and competitive from pricing standpoint. I think we're positioned well. I just think it's going to take some time. But to your core question I certainly hope I'm not sitting two and three quarters from now talking about such a low percentage of business being new.

Andrew Shapiro – Lawndale Capital Management

Okay. Now the timing and status of this environmental trust escrow release to eliminate that restricted title on it that was there in this most recent 10-Q, when does that title come off and that cash get consolidated with the useable cash.

Greg Slome

Yeah. Andrew, the trust as we are sitting here today has been dissolved and the cash has been freed up and once again was based on our financial results for the fiscal year ended June 30, 2010.

Andrew Shapiro – Lawndale Capital Management

And that amount was $3 – like a little over $3 million?

Greg Slome

$3.2 million.

Andrew Shapiro – Lawndale Capital Management

Okay. And the size of your remaining NOL tax carry-forward, you had a $15 million total at the end of the year. Does the gain for example on Delphi and other profits that get counted toward it and so it's down to around $11 million, does that sound in the ballpark?

Greg Slome

Well, what I would say is that at June 30 we're actually at $15.7 million of federal carry-forwards and while we don't on a quarterly basis go through the detailed timing differences between book and tax income, as we let things kind of fade out through the year and even up, I would say that clearly we had $4 million of book income. There will be some differences between book and tax income that will have an impact on that, but the general assumption is that $15.7 at June 30 and then definitely reduced down to some level based on taxable income in the quarter.

Andrew Shapiro – Lawndale Capital Management

So give or take with your margin assumptions and everything else, the company won't have to be paying tax dollars out in any great amount for the next several quarters?

Cary Wood

Next several quarters, certainly is true.

Andrew Shapiro – Lawndale Capital Management

Okay. So, we'll we're being optimistic, with your…

Cary Wood

No. That's fine. I was worried where you were going to go with that, but, yeah, certainly, I think the next couple quarters would be probably demanding a great deal out of. But, yeah, we can certainly safely assume that we won't run out the NOLs next few quarters.

Andrew Shapiro – Lawndale Capital Management

Okay. So you said various borrowing restrictions have recently been removed. Does the credit agreement now allow for a stock buyback or cash dividends and if it doesn't what steps do you need to take to allow for either stock buyback or cash dividends as an alternative for use of company cash?

Greg Slome

Yeah. As far as the loan agreement goes we do have a provision in the agreement that if we meet certain financial covenants and restrictions, it does allow us to do a stock buyback of up to $1.5 million on an annual basis. So all the restrictions there were included in the agreement we have met, so as we are here today the agreement does allow us to buyback up to $1.5 million.

Cary Wood

Now with that said and I think the bigger question you have, Andrew is, is the company looking at a stock buyback and/or dividend program. And I – we've certainly as a company, myself in particular have met with gee a 100 funds over the last 12 months and we changed over probably a third if not more of our shareholder base and I've spoken to them and I understand their interest in those types of things.

So we certainly have considered what it would mean to us to either do a buyback and/or to consider dividends. But you have to consider those in the context of your cash position and certainly, how you might better put it to use if it's not in the form of dividends or a buyback.

So we're looking at all options, we're certainly discussing that and looking for guidance from our Board while at the same time assessing the various users of cash in our business like working capital for new organic growth, M&A, R&D, CapEx, all of those types of things have to go into consideration. And it's not to forget that a good amount of our cash is accounted for in our Navy advanced payments.

So with that said, we do consider all the various components of that question. We certainly listen to our shareholders. We continue to consider it very, very objectively, very fairly, very quantitatively and when the time comes, we'll certainly execute on that.

Now with the stock being as it has been in the last 60 days, I'm not even sure but the stock buyback would be the best thing for us these days and that's kind of one of those good news, bad news things but that window of opportunity say a year ago where there might have been some level of volume anxious to be purchased and repurchased by the company at a price it once was. We didn't have the cash availability at the time.

So but again back to your core question. We are looking at it. We have objectively assessed the pros and cons to both. We'll continue to do that and we'll continue to seek guidance out from our shareholders, as well as our Board of Directors.

Andrew Shapiro – Lawndale Capital Management

Okay. Final two questions. In prior conference calls, you talked about vertical product developments, programs that are in the works regarding homeland security, harbor protection…

Cary Wood

Right.

Andrew Shapiro – Lawndale Capital Management

…digital comfort uses, et cetera. Can you talk a little bit more at all about your progress status on some of the DSS exciting programs, obviously not the blackout stuff you can't talk about, but are there some things now you are able to talk about in progress milestones on programs?

Cary Wood

Yeah. I mean, generally, we've not revised our outlook on the number of projects and the investments associated with those projects that we've accounted for at the beginning of our planning. So, generally, we continue to move forward with that.

I think without boring you with the details of where we're at with each of them I'll grab one and talk a little bit about the progress we've made, talk a little bit about how things looked today and what our expectations might be for that program looking ahead. And specifically, I'll carve out our compass and while that's a familiar product in the past and it has had very small levels of revenue. We are investing significantly to move it from where it has been in terms of technical capabilities to where we would like to take it.

I think generally, we found good interest from a variety of prospects and to kind of liquidate it down a bit and dilute down the details of it. We're finding land based applications for our compass. There's still DOD application, but they are no longer naval applications, but they are ground force applications but they are ground force applications.

And without going too much further into that we are having active discussions with very large defense contractors or interested in – our compass exclusively, have participated in a bit of our internal R&D efforts to direct some of their expectations that are in product, but right now as it stands there's no change in our plan. We continue to move ahead. The digital compass is a highlight of that.

We're certainly seeing far more interest sooner than I expected which is great. It's not translating into revenue, but it shows some promise that it may and certainly if you look at the trailing gross margins on that product, if we were to significantly uptick the revenue on that, that mix on that DSS segment could be tremendous.

And it continues to be on track for a calendar year ‘11 launch and we certainly expect there could be some revenue gains in our fiscal year ‘11 on that product sooner than we expected. But, I'm not anxious to go there just yet and get anybodies hopes, because there's a lot yet that still has to happen.

Andrew Shapiro – Lawndale Capital Management

Lastly, you had made some presentations of late. What's – on the Investor Relations, if you want to call it, your calendar for IR activities?

Mike Osborne

Yeah. I'll take that one, Andrew. It's Mike. Recap from our last call, we definitely got on the road again. We were out at Rodman & Renshaw Conference in New York. I think we talked about that in the last call, also spent an extra day meeting current and future investors in New York, Philadelphia and Pennsylvania, very successful road-show.

In October, we were up in Minnesota for a day’s worth of meetings and then just recently last week we presented at the Three Parts Advisors, Southwest Ideas Conference in Dallas and also spent a full day visiting existing investors in some new perspectives and those meetings and the conference went extremely well.

Looking forward to the next few months, we have an opportunity to get out on the road in December in the Midwest, with a sell-side investment firm to tell our story with our sales guys and probably make a swing out in the East Coast in the Connecticut, Baltimore and New York City as well, in the December timeframe.

We'll follow that up in January with the Sidoti Conference and spend an extra day there as well. And then right after we release the second quarter, we're going to be coming out actually your way into California probably the San Francisco, L.A. area similar to what we did last year, but we aren't going to be presenting at that Microcap show this year.

Cary Wood

I will tell you. In Dallas here, just this last week, it was actually rewarding to sit down in the one-on-one sessions after the presentation, see a lot of the same faces that I saw this time last year and their first words are, could have, should have, would have and it's actually rewarding to hear. And so my response is you'll say the same thing next year because of what we expect and hope this business to do, so let's get engaged and it’s been a good thing for us to far.

Andrew Shapiro – Lawndale Capital Management

Well, love your optimism. Thank you.

Cary Wood

Thanks.

Mike Osborne

All right. I'd like to thank all participants in today’s call. Again, today’s call includes a question and answer period has been recorded and will be posted to our website under Investor Relations later today. Thank you.

Cary Wood

Thank you.

Operator

Ladies and Gentlemen, this does conclude the Conference Call for today. We thank you for your participation and ask you to please disconnect your lines.

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