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Executives

Cary Wood – President & CEO

Greg Slome – CFO

Mike Osborne – SVP, Business Development

Analysts

John Roth [ph] – Argon Cap [ph]

Andrew Shapiro – Lawndale Capital Management

Jonathan Haynes – Private Investor

Question-and-Answer Session

Sparton Corporation (SPA) F2Q2011 Earnings Call Transcript February 15, 2011 12:00 PM ET

Operator

And our first question comes from the line of John Roth [ph] with Argon Cap [ph]. Please proceed with your question.

John Roth – Argon Cap

Hey, guys, its John with Argon. Good quarter. Just was hoping you could provide maybe a little bit more color in terms of what the opportunities that looks like on the M&A side? Are you guys seeing assets that you think are attractive there, first of all? And secondly, from a pricing perspective, do you think sellers are being reasonable in terms of their expectations? Just I guess any color in regard to either of those issues will be great? Thank you.

Cary Wood

John, thanks for the question. The deal flow volume has substantially increased. I think it's fair to say that there are a great many of sellers out there that saw themselves in a place they didn’t expect to be say a year or year and a half ago that has been now reevaluating whether or not they want to keep a hand on those businesses.

I think that we represent to some folks a just large enough company and opportunities that somebody might be enticed to want to be a part of, but not so large that say an entrepreneurial manager who might want to stay involved, would get lost in the shuffle of a larger company, so I think we represent an enticing partnership for a lot of folks.

We’re looking at a good amount of volume, but I think as you’ve seen us in the most recent deal with the Delphi acquisition in August, we’re very careful, we’re very thorough in a way we assess the opportunity, and we very, very carefully put our cash to work in a way that is both accretive and is quickly a return on the cash that we lay out there.

So, yes, there’s a lot of deals, but we want to prioritize the right things, we want to prioritize the things that are accretive. We’re certainly looking at a funnel on a constant basis. We’re in constant conversation. It is seemingly a part of our everyday life to be looking at opportunities. Beyond that it's awful difficult to give you much more color about what it is you might see out of us in the coming months.

I do feel confident that there are opportunities that will come sooner than later. And my hope is that we can see eye-to-eye on those things with potential source. I don't think that the level of selling multiples are currently at the levels they were several years ago, but you don't know what the traffic is going to be on those things either and how confident they get in those selling multiples with time.

So I think long answer to your question, I think we're deeply involved, I think we're careful, I think we're looking at things that are more immediately accretive and good returns on the cash outlay. The deal flow is up. We’re highly engaged. I do think that we’re trying to be a little less involved in go big quick, and we're probably being more careful to be slow and methodical and incremental albeit very much in line with the $500 million outlook we have by our fiscal 2015 that we've previously communicated, so, hopefully that gives you a little bit of insight, John.

John Roth – Argon Cap

Yes, that’s helpful. Thanks very much.

Cary Wood

Sure.

Operator

(Operator instructions) Our next question comes from the line of Andrew Shapiro with Lawndale Capital Management. Please proceed with your question.

Andrew Shapiro – Lawndale Capital Management

Good morning. Two questions here on the (inaudible) 26:16 then I will back out into the queue (inaudible). Delphi's excess second facility lease you said stopped at November 1st

Cary Wood

Correct.

Andrew Shapiro – Lawndale Capital Management

And that’s why you had cost efficiencies thereafter. Do those efficiencies flow through cost to goods sold or through SG&A and what is or was the timing this quarter or this past quarter, if any other consolidation activities that enhance cash flow?

Cary Wood

When you ask that, are you taking specifically within the context of the Delphi acquisition?

Andrew Shapiro – Lawndale Capital Management

Correct.

Cary Wood

Yes, we spoke to the closure, as of November 1st, that's all an impact on COGS, so it's more a cost of goods issue. We mentioned the reduction in workforce, which was pretty much in line with that November 1st date as well, and so that was not insignificant, 18% reduction in head count. I think we’ve done a nice job of not just executing a closure and consolidation, but the beginnings in the front end of floor realignment and floor space utilization, those are all things that are a continuous improvement opportunity for us. I think for that reasons it's something I can say confidently, I would not rule continued level of performance enhancement out of Delphi.

We've been very, very pleased with the speed of the progress. It's exceeded both our timing and our performer state in terms of the gross margin, but generally I think that the two big issues there were the reduction in workforce, the closure consolidation. All of that had its impacts on COGS. It wasn't a whole lot of expense otherwise involved in those efforts, but I don't believe that that whole business unit has frankly hit full stride either. I think it still has upside to come and I wouldn't rule out enhanced performance over the coming quarters.

Andrew Shapiro – Lawndale Capital Management

Okay. So your target range for the entire medical segment for gross margins was that 13 to 16, seeing 16 was your target range, and Delphi has already achieved it during the December quarter already, and that’s with your dual facilities for part of the quarter, do you think Delphi can go higher or is it the improvements in order to get to the whole segment to your targeted 16 margin level rely it solely on improving kind of a legacy Strongsville, Ohio medical business?

Greg Slome

Well, that’s a good question. First, I would say that the guidance we give accounts for the consolidated space within our line of business and so I want to maintain that guidance and I'm certainly not anxious to upwardly revise that just yet. I think it's fair to say that the performance we saw out of our acquisition in Colorado was clearly at the upper end of that band.

And as I said, I wouldn't rule out that business to continue to perform slightly better, but at the same time we clearly got growth issues to address, underutilized assets to address, and the rightsizing of costs that we feel like we've adequately executed on in our Colorado facility and it's clearly positioned and I’d say bottomed out from the standpoint of top-line contraction, at least we expect in a way that I think the upside is there for the picking, I think it's just the matter of time.

But, as I say that, I'm very cautious not knowing what dynamics could enter into that business segment over the course of the next quarter and half, and with that in mind we are going to go ahead and maintain our guidance within that band.

But, you are right on the money, I mean, Delphi is at the high end and certainly, don't see any reason to expect it to back slide and if that's the case you have got the accelerator in and then manage what's going on in Cleveland in a way that ultimately could lead to better operating margins and by the time you are done, you've got a consolidated performance, which is outside that band. And we hope that that’s the outcome.

But for conservative reasons, we want to maintain that guidance to the outside world. We’re certainly cognitive of the things we say. I think in just about every case when I made a commitment and the company has conveyed it, we have delivered on it and/or overcommit or overdelivered and I want to continue that.

Andrew Shapiro – Lawndale Capital Management

Okay. Further on Medical, the Medical operating expense for the segment went up $531,000 from the last quarter. So how much of this increase is one-time non-recurring and how much of it was from having a Delphi for a full quarter? I think some of this maybe the arbitration charge, so I would like you to give more detail on that arbitration award and its background and it's all done behind us?

Greg Slome

I think it's a great question. We incurred an expense that was not in my mind insignificant. And I do see it as a one-time non-recurring and a great deal of it was clearly absorbed within the Medical business units, specifically, in Cleveland and then there was even a remainder of it that was accounted for in corporate SG&A, associated with legal expense.

To give a quick snapshot and backdrop to what that's about, some 12 months to 18 months ago, I think probably clearly, when this company was still evolving through the worst of its turnaround time, you had certain customers, who were evaluating their engagements with Sparton. Outright concern is that the company would not be able to deliver on contracts or whether or not they had the liquidity to survive at all.

I think that there were those out there that looked for opportunities to dual source and this is one of those companies and in the process of dual sourcing they decided to hedge their bet by ramping up in one place other than Sparton while maintaining a certain level of purchase request and demand with Sparton.

Unfortunately, it’s our speculation that they entered into those orders, we incurred the expense to fulfill them. And in many cases even shipped on them, without them ever expecting to pay for that. It left us some three quarters, four quarters back, looking at a sizable outstanding order, sizable receivable that we just simply weren't comfortable taking as a bad debt. And we managed that very closely, and we started to actively engage, and it really came to the surface very, very quickly that they had not only disengaged, but frankly, in our minds didn't ever expect to pay that bill.

So, given the terms and conditions of the contract at the time, we were mandated to in arbitration in an out of state location, which made it very inconvenient, but certainly, we would prefer to be known not just as a company that delivers on our commitments, but we expect those we engage would deliver on theirs as well, so we certainly pursued the open receivable as I say it was not insignificant.

We're engaged in arbitration. That arbitration brought with a certain level of legal expense, and then surprisingly to this company, they countersuit in that arbitration, and they were awarded an amount that frankly, I'm still confused by. But it is a binding arbitration. I think it’s clear to say that their argument for the countersuit was about the weaknesses of our Medical and the company at large, developmental processes, I think clearly, today that's changed.

We have a product development processes that is formal in nature. It’s milestone oriented, it has the proper authorities to continue, it has customer sign offs, it has gate reviews, all of which were ominously missing as recent as the year ago, and certainly a shade a grade that this company was able to exploit and ultimately, lent itself well to their counter argument.

So the full impact of that arbitration hearing accounted for a countersuits claim of about $300,000, bad debts allowance that cost the company just short of $200,000, and then legal fees in the neighborhood of $100,000. All of which is a frustrating one-time non-recurring impact in Cleveland. That rise is still a level of about $0.05 a share, so I hope I answered that, there's a lot to it, but I think I hit the high points that there is something in this Andrew want to know.

Andrew Shapiro – Lawndale Capital Management

I can sense your frustration, but it sounds as if there was an SG&A charge in the Medical segment numbers and a smaller charge but a charge in the corporate G&A as well?

Greg Slome

Correct.

Andrew Shapiro – Lawndale Capital Management

And the quantification breakdown is about what 450 and 150 or was it…?

Greg Slome

Yes, I think that's roughly the way to put it. About 450 and 150, 450 above the operating line within the Medical unit, specifically, going to their own SG&A and then about 150 within the corporate line.

Andrew Shapiro – Lawndale Capital Management

Okay. I mean that's outside of the gross margin numbers that are coming out of the Cleveland legacy side. Last question on Medical and I will back out. You mentioned and described customer wanted suspended production, pending modifications and all that, and that you've got production orders starting coming back, but customer number two or three, as you went through three of them was the one that reduced inventory. Is this customer now buying units again and the purchases are just reduced year-over-year, or what is the trend been and expected to be now with that customer who adjusted its inventory?

Greg Slome

Yes, this is one of the largest customers within Sparton as a corporation. And we have a sizable account with them, we have six different constructions, of those two represent the majority of the volume and to kind of give you an illustration of the order of magnitude, we were producing one of those particular devices at the tune of about 100 units a year. That has dropped down in the preceding two quarters to three quarters at an equivalent run rate of about 65 units, so down about 30%, which is obviously very much in line with the kind of contraction we’ve seen out of them on a revenue basis.

So with that said, I did, as I’d indicated met with them on a one-off direct basis to kind of get a line of sight and what the next several years demand might look like and what that might translate to us. In a discussion as recent as few weeks ago, they’ve indicated that they’re re-ramping that back up; it should be in line with the 100 units per year, which obviously we welcome.

I think the speed in which that can materialize is somewhat questionable, because it's dependent highly upon a supply chain readiness. I think everybody within the supply chain including Sparton did the things that needed to do to contract its overhead and related cost. How quickly we are going to be able to absorb that demand is certainly a question that this customer was interested in us responding to.

But I think the bigger takeaway I got was that this is not an engagement that is running the risk of going away. I think it's more important to recognize that they had some of their own issues, starting with softness in capital expenditures to their outside customers, whether it’d be hospitals or labs and certainly, had its impact on a couple line items within the portfolio of products we provide them. Of which, two are very significant. And then they went through, as you would expect their own contraction of inventories and working capital that ultimately cascaded out to affect us.

But the larger question and this has certainly been a pointed [ph] conversation we’ve had as a management is this is less about making sure that this one customer stay is heavily vested with Sparton and maintains its demand. And it's more important to recognize that the state of contract manufacturing brings with it a level of ebbing and flowing that we need to at least accommodate with a new business flow that backflows [ph] and that's certainly been where our focus is, so we are not as concentrated on making sure that accommodate and that incentivize, and that we ready our cost structure for this one large customer, two or three specific constructions and account.

We certainly want to maintain that relationship, but more importantly it's about making sure that we continue to diversify, we dilute their impact on is. This is the large customer that say two years ago had this softness occurred, would have been far more dramatic than what we've seen today, given the way we've advanced our medical business. So again, long answer, Andrew, I hope I hit on the question.

Operator

(Operator instructions) And we have a follow-up question from the line of Andrew Shapiro. Please proceed with your question.

Andrew Shapiro – Lawndale Capital Management

Hi. EMS and DSS, I'm going to ask on both segments since there wasn't a line here. Is Vietnam pulling its weight yet in the EMS segment and what are your thoughts going forward for this facility? In general, you had increased business development efforts over the past few quarters, you had the backlog dropped, so what's your thoughts on the timing of pay back on these business development costs paying off?

Greg Slome

First, the Vietnam, that facility and its top-line revenues, I've said in other calls, has continued to grow. It's doubled this year from last year. It doubled last year from the year before that, so it's certainly evolving slowly and methodically. We've entertained a handful of discussions with other outside EMS providers frankly that have low cost country engagements with manufacturing organizations and we've talked about the use of our assets to shift some of that business to us. But I'm not sure that that's the single best solution for this facility other than it absorbs costs in the near-term. At least in several discussions it would have taken us outside of kind of the core business that we've tried to attract in complex electronics predominantly being aerospace space.

But that being said, the bigger more important endeavor is to get a return on the business development efforts. We talked a little bit about the marketing effort that really hasn't hit full stride until as recent as last week as we rolled out a common standardized Sparton look and selling materials and booth, all the resources that we wanted on the ground are now on the ground as of the close of our second-quarter. Our business development funnel is up dramatically from a year and a half ago, which was essentially non-existent.

A good portion of that is EMS related. And I do believe that well, there's an incubation period across all of the new business opportunities, it's probably a shorter cycle in EMS than any others, and we're certainly doing the things we can to accelerate that. We're not desperate. We're certainly not anxious to sell out our capacity, although the gross margin threshold that we've established, this is a business that we continue to say we won’t populate with low margin business even if it is in high volume. We've still got a handful of contracts that reflect just that, and that certainly serves to reduce the gross margin performance of our EMS segment as it exist today.

I continue to have a line of sight in the next four quarters to five quarters that this business will be a double-digit gross margin segment. There are competitors out there that clearly perform in the 12, 13, 14 gross margin range, some as high as 17, 18. And we're clearly segmenting out what it is they do, how they do it, and there's no magic there. We're just still yet straddled with underutilized assets with a handful of very large contracts. We're still yet suboptimum pricing arrangements. Not a bad thing for them, but it's certainly not ideal for us. We're going to continue to populate the business development funnel that lends [ph] itself well for the growth of Brooksville.

And then I think we continue to sell Vietnam as a value proposition, whether it be specifically within EMS, but also within Medical and DSS. And to the extent that we can shift things there that our ITA [ph] restricted where we can send over high labor content opportunities on sub-assemblies within Medical. We are offering that value proposition as we meet with people.

And in many cases, certainly, in most recent conversations with new business opportunities, all of which are predominantly new customers, they are interested in prototyping domestically, ramping up domestically, and then looking at a low cost country solution over time, which is a further selling proposition for us. We have certainly taken advantage of that. So hopefully that gives you some insight as to where we see Vietnam, how we see EMS and the business development effort (inaudible)

Andrew Shapiro – Lawndale Capital Management

How much time kind of have planned to measure the progress or success or the alternatives?

Greg Slome

We have always said on the EMS business segment that we were going to give it eight quarters of consideration at the beginning of this fiscal year. Well, we are 2.5 quarters into that timeline. We’re seeing progress, it's up to 7, 7.5 gross margin from last year’s 5 and 5 last year up from almost nothing the year before, so we are seeing progress.

Are we seeing at the rate we want? Well, no. I would rather have seen it at that double-digit level long before now. But it is in line with the way we budgeted and expected it. We just want to accelerate the return of profitability at those levels sooner than being faced with the discussion in our seventh quarter or eighth quarter of the return to double-digits proposition we’ve made.

But I also think that it’s fair to say that business development effort is still in its infancy. To kind of illustrate the effects we have already seen on this. The digital compass is a product that we have not only earmarked a great amount of product development funds toward and the rollout of a 6-Axis Compass being scheduled in the fall of this calendar year. We have certainly dialed up our biz dev efforts on that, and we have seen slow and steady growth from the tail end of last year's fiscal year.

Fiscal year Q3 '10 was about not even $0.5 million. It went up to just over $450,000 in our fourth [ph] quarter, it went above $500,000 in the first quarter of fiscal '11, and in this most recent quarter, second-quarter fiscal '11, it was up over $1.1 million in sales. And that's on a product that's not even been launched. That's on the old product.

So, I think that there has been good results in the near-term, where we could on the biz dev effort, but I think we got ways to obviously go there. I wanted to illustrate the compass is a good example of what I think we can expect from a product line extension. It's better margin stuff, it's certainly something our biz dev guys are paying attention to. And in the context of EMS and what's our recovery timetable and what's our expectation, double-digits, eight quarters, we’re two quarters into that.

Andrew Shapiro – Lawndale Capital Management

Okay. And you just dropped the segue right into my DSS or the defense segment question, which is, if you can discuss the R&D expenditures and the timing of payback in some of these investments over the last few calls, you kind of talked about initiatives in various areas from harbor defense to the digital compass and all that. Can you give a little bit more insight as to the progress and timing being made on some of the new product development?

Cary Wood

Sure. As we’d mentioned before, there were a handful of projects that we felt within our DSS segment's technology that we could unbundle, repackage, reconfigure, and seek out other options within either pre-existing channel and/or civilian channels. And a good practical example of that has to do with the compass and it's use not as it exist today within the sonobuoy, but within land based troops. That certainly has garnered the interest of a handful of defense contractors and that certainly lent itself well to some of the increased sales that we’ve experienced in Q2 of fiscal '11.

When we entered into our product development efforts, they were predominantly focused on the compass, the hydrophone technology, some of those things were longer-term in their incubation, some of them like the compass to roll out in the fall were more near-term. We had earmarked roughly about a point of our revenue and generally, we're in line with that, we've under spent to that in the first half of this year, but that's very much in line with what we expected to do.

Our back half is a little bit heavier and has probably more to do with bringing it to market, things like test and validation that you're not necessarily seeing in our first quarter and second quarter. We spent about a portion of what we had targeted as an overall amount of investment this year, as I say, being about a point.

With that said, I think it's a fair question to ask, how that's accounted for, managed, what are the returns on that, we have a very specific return on sales and cash flow analysis that we review from within. I think that we're very much in line with that given what we're seeing out of the compass already without having even launched a product replacement.

So, I think, the cash flows and the return thresholds that we put to at a very specific, they're very deliberate, we review them, we go through gates, we don't pass that gate until those assumptions have been visited, validated and bought off on. The gross margins are substantially higher. And in almost every case of our product development scenarios, we've come up with a two, no greater than five year payback scenario and that's really been our rule of thumb, not just in the product development arena, but also from a standpoint of an acquisition perspective.

So with that in mind it think we've undertaken a very deliberate, careful, well thought out product development strategy. The compass is a near-term success. I think that what we expect to see in the fall we'll continue that momentum. It brings with it a whole lot more in the way of gross margins. It's even subsidized a little bit of what we've seen in the way of change in mix and performance out of DSS in our second quarter, so it's certainly been a welcome contribution from a revenue perspective.

I think the final point on the business development, R&D and then I'll go to your next set of your question has to do with the expense authorities. I think we've put in a very rigorous delegation of authority from within the company, from the CEO down to the operating executives, to the site managers, to the engineers that are dealing with it. And we go through gates before we release the next set of funds to support that R&D.

And then as you would expect within a public company, I think we've got a rigorous delegation of authorities that causes me to take pause, review with the Board on a regular basis and make sure that they are comfortable with those thresholds being achieved before we move forward with the investments that we earmark so. Again, a bit of a longer answer to your question, and probably expect to hopefully hit on all the points.

Andrew Shapiro – Lawndale Capital Management

You hit on those points. I’ll back out into the queue. I do have more questions on corporate allocations and other things. I’m coming back to you.

Cary Wood

Okay.

Operator

Our next question comes from the line of Jonathan Haynes, Private Investor. Please proceed with your question.

Jonathan Haynes – Private Investor

Hello, gentlemen. Two questions unrelated, the first one inventories, most of the inventory increase in the first half of the year is associated with Delphi. How much of that do you think will get worked off over the balance of this fiscal year?

Cary Wood

It's certainly added to our inventories post-acquisition. We acquired, as a matter of disclosure, roughly $10 million, $10.5 million. We have worked of a considerable portion of that already. I believe that there are some opportunities to optimize the product flow of work-in process. I think there are still some considerations to be had about raw material on hand does it apply to some of the larger accounts and we are working through a good amount of backlog that I think has helped to serve not only contribute from a revenue standpoint sooner than not, but also reduce down that inventory to an optimum level.

We are concentrating on turns. We are concentrating on optimizing the speed and the turnover within the facilities. We have been reluctant to assign a target. And part of the reason being that the revenue is up, and we certainly don't want to adversely affect how quickly we might be able to respond to that as a result of inventory initiatives.

I think the incremental gains on working capital reductions, specifically, inventory like what you’ve seen as recent as a year and a half to two years ago are not nearly as opportunistic even given this acquisition. Do I think there is some reduction in order? I do. Do I think it's as incremental on a dollar-basis? No. From a percentage standpoint, it's not inconsequential, if we can reduce that inventory level by 10% to 20% that's certainly to our advantage and I think generally that's in line with our expectations and the targets that we’re driving for that business.

Jonathan Haynes – Private Investor

Okay, great. And then the second question. I understand the position you have been in for the last couple of years. I am just curious, is there a point at which you will feel more comfortable giving forward guidance or is that going to be something that you avoid as a matter of policy?

Cary Wood

It's a good question. There is a school of thought on that. It's certainly been hashed out in our Board meetings about giving guidance. I think we have dramatically increased this company’s transparency in the last year and a half…

Jonathan Haynes – Private Investor

Clearly.

Cary Wood

And then I appreciate, it is recognized. I'd like to be able to provide guidance frankly. I think it's more a matter of what we start to see and can correlate back to new business developments and the percentage of that we win, how quickly we ramp it up. I am confident in our operating performance. I know what we need to do to contract. I am confident in the band guidance. I think the wild card right now has to do with the types of ratios and outlook we would give to new business. And I think that's the piece that we still want to experience several quarters on before I get too far ahead of myself on forward-looking guidance. But I certainly would like to see us get there from here. But, right now, we are going to stay focused on the performance bands and ultimately, in the next several quarters, put me on the spot above that again, I would be glad to discuss it.

Jonathan Haynes – Private Investor

Okay. I think from our perspective, it's necessary to have a comprehensive guidance disclosure, but if you have pieces or bits in pieces so to say, that you can talk about, and that would be welcome and could be part of the process going forward?

Cary Wood

Sure, fair enough, John, I can appreciate your question.

Operator

Our next question comes from the line of Andrew Shapiro. Please proceed with your question.

Andrew Shapiro – Lawndale Capital Management

Okay. Follow-up questions; regarding guidance so to speak. I don't think you had in your slide show or in your script, did you discuss backlog and the backlog of the respective segments might provide some indications of at least the path on the revenue side and when you're providing the spans of margin that also obviously is available already, but what are the backlog levels?

Cary Wood

Good question. We track that. That is certainly one of what we believe to be a good solid leading indicator. It is one of a handful of metrics that we measure within our business development oversight initiative, backlog and new business funnel, our win rate, our close rate, the general gross margin on those wins, there is a handful of metrics. But the backlog is certainly one to be looked at.

To give you a kind of a trailing line of sight on this, we were at a high, I want to say the closing stages of fiscal year '09 of about $124 million. Now it’s not a relatable backlog because a good portion of that wasn't profitable backlog. Now as I relate to that, looking ahead, we closed out our second-quarter at roughly around $120 million in shippable backlog. That's up from about $113 million the quarter before that. It was about $112 million or there about in the quarter before that, but less than a $100 million in the preceding quarter and then less than $95 million, so it's been up every single quarter.

After hitting the high points in June of '09 and then dipping down and then it's worked its way back up for five straight quarters. I think it's fair to say that there are some moving parts to that obviously. The Colorado backlog has only served to help it, but I think it's also not the most robust aspect of our backlog. Only $12 million of our backlog currently is SMS Colorado.

If I was to break down the three segments and that's all out there in our most recent disclosures, about $63 million or so is in the DSS segment, $31 million or so is in the Medical and then about $25 million of it is in what we now call the EMS segment. The DSS is up, the Medical is up, and the EMS segment is down. The EMS segment doesn't surprise us in the fact that it's down. We lost an engagement that was expected to disengage and there are a handful of them that are still in the process of validating and engaging, but they've not reached the magnitude of purchase orders. So, right now, the overall is up for the fifth straight quarter. The DSS segment is up, the medical segment is up and the EMS segment is slightly down. Hopefully, that gives you a line of sight on things.

Andrew Shapiro – Lawndale Capital Management

And now on the corporate level, if you look at the segment break down in the 10-Q, there's a large sequential increase in operating expense from last quarter, can you explain and discuss that?

Greg Slome

Andrew, I’ll take a pass at that. I think we're talking about roughly $300,000 increase from Q1 to Q2 when you look at the pieces remained in the corporate unallocated. Once again going through the mechanics of how we allocate the corporate SG&A.

It's really based on the function and the type and the nature of the expense, really, when you kind of look at what's remaining in corporate and the increase from Q1 to Q2, it's a couple of things; one, we got legal expenses that are up really related to the arbitration and we ended up keeping those in corporate, we don't allocate the legal fees to the various segments, we also have director fees related to the restricted (inaudible) stock grants portion of their director fees that was issued in the second quarter unlike what we’ve done in prior years, the entire amount of that was reflected in the Q2 expense.

And then there is also an increase in some of biz dev, some of the marketing activities, the trade show, the logo, branding and all that kind of stuff that we’re doing were some of that remained incorporated. So it's really those are kind of the bigger items, but it's really a combination of nature of the expenses (inaudible).

Andrew Shapiro – Lawndale Capital Management

Okay. Well, I guess that reinforces my desire to see that nine person Board of Directors for a company this small to be dropped down to the seven person goal of reforming that thing may be at the next coming annual meeting you guys do some evaluations and have some of the former directors may be call it a day. On you PP&E, you sold the Bluewater Road, New Mexico property, the press release came out this morning, that's another $4.2 million that comes into the tale and your release said, the proceeds will be used to fund future strategic growth initiatives, specifically, M&A, internal R&D, enhanced biz dev efforts.

We talked about your biz dev efforts, we talked about your R&D, I'm not sure, when you rolled out your growth initiatives a few quarters ago, you did talk about kind of the areas you’re looking to do kind of M&A. It's been I think at least two quarters since that was discussed. But can you talk a little bit more about what areas your growth investments for an M&A would be focused on?

Cary Wood

Well, we’re certainly prioritizing to continue looking at the Medical space and the Medical Device manufacturing space. We think that it's still yet blends itself. It's got a fragmentation element to it. I think that there are probably more of the size opportunities for this company that seem to fit well and make sense. I think they are very synergistic to where we’re going. We’re entertaining a bit of the ideas of vertical integration in that arena, so there is no shortage of approaches to take when it comes to the M&A within Medical, and we’re highly engaged in that.

I think the second priority might probably logically be in the area of our Defense segment. But as we've started to approach our business, you are talking specifically, not just of Defense but also in navigation and security. And we are look at options out there. As most of the sophisticated investment groups know a company that's got IP comes with it a much higher multiple, and we certainly got to be mindful of that. This company’s debt to equity is essentially nothing. And we are sitting on 30 now $4 million generally in cash and you can back out the prepayments, but it's still not insignificant.

So the real question is how do we best us that capacity in cash? We’re certainly focusing on two segments that we believe are stronger, longer-term performing segments. I think we've certainly deemphasized the complex electronics and/or the EMS space.

But I would also say there is kind of a fourth leg to this table and that is that we would not rule out and it's certainly a source of some debate among the board and hasn't really frankly been fully flushed out. This company would not rule out the opportunities to invest through certain acquisition opportunities that would augment the management teams capabilities, our core competencies, but may not be directly related to the two or three businesses that we’re in, which is a bit of a different twist, but I think generally, Medical tends to be where we've focused a lot of our M&A time and then DSS as a segment.

Andrew Shapiro – Lawndale Capital Management

Okay. Now, you've mentioned, we got a bunch of cash, you're looking at particular areas of doing things, but you've also highlighted the caution because multiples and cheap and easy money is available for other buyers that are out there. Is it time to also consider because Delphi is now accretive and running efficiently and the rest of the company has been returned to sustainable positive cash flows, is it time to be considering the possibility of a stock buyback or a small regular dividend or a combination thereof?

Cary Wood

You know we continually discuss that in our various Board meetings. I wouldn't say that it has been outright ruled out as a policy. I think that it has been decided for now that this company is very interested in being acquisitive. And if we weren't and we weren't having those discussion then I think we're certainly obligated to undertake those discussions sooner than later. Right now, I think the position has been that our cash can be better deployed and bring incremental growth to the earnings in the form of acquisition.

But I also know that this management team owes a little bit of discussion still yet with this Board on pros and cons to stock buyback and even some discussion around dividends. But, I think, it all comes down to what's the best way to use the cash, and for right now, we've certainly prioritized the acquisitive route.

Andrew Shapiro – Lawndale Capital Management

And lastly, I know you're just on the West Coast. What are your IR activities plan for the coming quarter?

Michael Osborne

Mike here, Andrew. Actually this afternoon, Cary, Greg and I are on our way to Detroit to do at Detroit and St. Louis sell side road show and then we're going to be (inaudible) up in Boston and New Jersey in the March time frame, followed up with a revisit out to New York City and Connecticut in the April time frame.

Cary Wood

I’d say that we're in the preceding year, we were seasonally focused if you can call it that, where we’re very, very heavily involved with Investor Relations initiatives starting up in the September-October timeframe and they seem to kind of reach a peak, and then kind of trail off in the January-February. We've reached the mindset that there are plenty of folks that are interested in seeing us and that we're going to continue to do that on a continuous basis whether it would be monthly or even weekly. We're availing ourselves to calls, but it's been a great couple of weeks.

I met in L.A. and San Francisco last week as you are aware, about a dozen funds, and in almost all cases, these were new folks or people that we've been in discussions with well over a year. I think some of them have even joined us today, which I take as a very positive sign that they continue to be engaged in and observing how we're progressing, and certainly have I think won their interest.

So we'll continue to be out there, we'll continue to present at a variety of investment forums, we'll continue to be in front of funds, just to kind of revisit that statistic. We've met with about 500 funds in the last 18 months. 100 funds or so are face-to-face. So we have not slowed that down. We have only increased that rate. But, in the near-term starting this afternoon and tomorrow, Detroit, St. Louis, and then you heard the balance of that schedule from Mike in the coming weeks.

Andrew Shapiro – Lawndale Capital Management

Thank you.

Mike Osborne

Very good, thanks, Andrew. I would like to thank all participants in today's call. Again today's call including question-and-answer period has been recorded and will be posted to our Web site under Investor Relations later today. Thank you.

Operator

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

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