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Executives

Cary Wood – President and CEO

Greg Slome – SVP and CFO

Mike Osborne – SVP, Business Development and Supply Chain

Analysts

Jimmy Baker – B. Riley & Co.

Andrew Shapiro – Lawndale Capital Management

Jonathan Haynes – Private Investor

John Curti – Singular Research

Sparton Corporation (SPA) Q1 2011 Earnings Call May 12, 2011 12:00 PM ET

Operator

(Operator Comments)

Mike Osborne

Thank you, operator. Good morning and thank you for participating in Sparton’s fiscal 2011 third quarter financial results conference call.

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

Today, Cary Wood, our President and CEO, and Greg Slome, our CFO, will report our fiscal year 2011 third quarter financial results, provide an update on the status of our liquidity and capital resources, review the progress made with our recently acquired Frederick, Colorado operation, review the Byers Peak acquisition, and provide a brief update on the remainder of fiscal 2011. At the end of the narrative, we will allow our investors and other interested parties to ask questions related to the Company’s financial performance and operations. In fairness to all participants, we will ask that one question be asked at a time with the call ending at approximately 1:00pm EDT.

I would now like to turn the call over to Cary.

Cary Wood

Thanks Mike. Good morning and welcome to our fiscal 2011 third quarter call. Today, we will begin by reviewing our third quarter consolidated performance.

We are pleased to report fiscal 2011 third quarter operating income of $2.7 million and net income of $2.5 million or $0.25 per share, versus operating income of $0.4 million and net income of $0.7 million or $0.07 per share, for the third quarter of fiscal 2010. This is the seventh consecutive quarter in which the Company has posted pre-tax income, after reporting pre-tax losses for the previous 12 consecutive quarters. Included in the fiscal 2011 third quarter financials are the results of operations from the Delphi Medical Systems and Byers Peak acquisitions.

Our consolidated third quarter revenue was $50.4 million, increasing 30% or $11.7 million from the same period in the prior year. The overall increase in revenue reflects additional sales in the current year quarter from the acquisitions of Delphi Medical and Byers Peak, increased sonobuoy sales to the U.S. Navy from our DSS segment and improved Medical sales at our Ohio facility. These developments were partially offset by certain program losses from our EMS segment in the current year quarter.

Our gross profit in the third quarter of fiscal 2011 was $8.2 million compared to $5.6 million in the third quarter of fiscal 2010 and is the largest quarterly gross profit in over five years. The gross profit percentage increased from 14% a year ago to 16% in the fiscal 2011 third quarter. Impacting the quarter over quarter gross margin were improved results from the Company’s EMS and Medical segments, including higher margins achieved at the Frederick, Colorado facility, partially offset by the unfavorable impact of the decreased contribution of foreign sonobuoy sales from the Company’s DSS segment.

Selling and administrative expenses for the three months ended March 31, 2011 increased approximately $0.8 million from the prior year quarter, but decreased to 10% of sales from 11% in the prior year quarter. The additional expense reflects increased business development expenses, additional expenses related to the Company’s acquisitions of Delphi Medical and Byers Peak, partially offset by reduced information technology expense.

No restructuring or impairment charges were incurred in the third quarter of fiscal 2011 compared to $0.2 million in the same quarter of fiscal 2010. Income tax expense of approximately $0.1 million was recognized in the third quarter compared to an income tax benefit of approximately $0.1 million for the same period in the prior fiscal year. The fiscal 2010 benefit reflects the release of $0.2 million of deferred tax asset valuation allowances in relation to tax regulation changes related to carry-back provisions.

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

Greg Slome

Thanks Cary.

Medical Device sales in the fiscal 2011 third quarter increased to $25.4 million, up 78% from the same period a year ago. Recurring sales at our Strongsville, Ohio facility increased to $14.6 million, up $0.3 million, or 2%, in the three months ended March 31, 2011 as compared with the same quarter last year. This increase reflects increased demand in one of the programs with our largest medical customer, partially offset by the fiscal 2011 disengagement with another customer. Incremental third quarter sales from the Company’s Frederick, Colorado facility and the partial quarter revenue from the Byers Peak acquisition totaling $10.8 million contributed to the overall increase in year-over-year sales. Fiscal 2011 third quarter revenue related to the Delphi acquisition continued to exceed our internal expectations.

The gross profit percentage on Medical sales increased to 14% from 10% for the three months ended March 31, 2011 and 2010, respectively. This increase in margin on Medical sales reflects the Company’s continued implementation of Lean Enterprise, product mix, its cost management efforts to mitigate decreased capacity utilization at the Company’s Strongsville, Ohio facility and higher margins achieved at the Company’s Frederick, Colorado facility.

EMS sales for the three months ended March 31, 2011 decreased $0.8 million as compared to the same quarter last year. This decrease primarily reflects certain program losses with two customers, partially offset by increased intercompany sales.

The gross profit percentage on EMS sales increased to 11% for the three months ended March 31, 2011 compared to 5% for the same quarter in the prior year. The quarter over quarter comparison reflects favorable product mix, improved performance and an aggressive continuous improvement program, partially offset by the impact of the overall decrease in sales volume.

DSS sales for the three months ended March 31, 2011 increased by $2.1 million or 14% from the third quarter of last fiscal year, reflecting higher U.S. Navy sonobuoy production and, to a lesser extent, increased digital compass sales in the current year quarter. Partially offsetting these increases were reductions in sonobuoy sales to foreign governments and in engineering sales revenue.

The gross profit percentage on DSS sales for the three months ended March 31, 2011 was 20% compared to 24% for the prior year quarter. Gross profit in the current year quarter was adversely affected by decreased sales to foreign governments as compared to the prior year quarter, partially offset by favorable product mix on increased U.S. Navy sonobuoy sales.

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 March 31, 2011 is our Industrial Revenue Bonds with the State of Ohio of approximately $1.8 million. During the quarter ended March 31, 2011, the Company made total principal and interest payments of $0.1 million. Our debt to equity ratio on March 31, 2011 was at .02 to one.

As of March 31, 2011, the Company had $26 million in cash and cash equivalents and no outstanding borrowings against available funds on its $20 million revolving credit facility provided in August 2009 by PNC Bank, National Association. The credit facility is subject to certain customary covenants which were met at March 31, 2011.

Summarizing our cash flows for the nine months ended March 31, 2011, operating activities provided $3.4 million of net cash flows. Excluding changes in working capital, operating activities provided $8.1 million in the first nine months of fiscal 2011, reflecting the Company’s operating performance during the period. Working capital used $4.7 million of net cash flows in the first nine months of fiscal 2011, primarily reflecting the funding of production related to the U.S. Navy contracts during the nine month period in excess of advanced billings received, the initial working capital funding related to the Company’s newly acquired Frederick, Colorado facility, as well as funding of a pension contribution during the period.

Cash flows used in investing activities in the nine months ended March 31, 2011 totaled $7.8 million. The first nine months of fiscal 2011 reflect the acquisition of certain assets of Delphi Medical. The consideration paid of $8.4 million is net of assumed employee accrual adjustments. Fiscal 2011 also reflects the $4.35 million consideration paid for the acquisition of Byers Peak. These two transactions were financed entirely through the use of Company cash. Capital expenditures for the nine months ended March 31, 2010 were approximately $2.3 million. Partially offsetting these outflows was $3.2 million of cash received from the dissolution of the EPA trust in October 2010 and the proceeds from the sale the Company’s Bluewater Road property in Albuquerque, New Mexico of approximately $4.0 million.

I would now like to turn the presentation back over to Cary.

Cary Wood

Thanks Greg.

I would like to spend some time reviewing the continuing success of our Frederick, Colorado operation as well as provide some detail on our most recent acquisition, Byers Peak.

We are pleased with the operational progress that has been made at the Fredrick, Colorado facility since acquiring that business from Delphi in August of this fiscal year. This strategic addition to our Medical business has provided a solid contribution to sales and became accretive to earnings in the second quarter of fiscal 2011, a quarter ahead of our initial expectations.

The operations of SMS Colorado are included in the consolidated operating results for fiscal 2011 from the August 6, 2010 date of acquisition. SMS Colorado reported third quarter net sales of $10.5 million, gross profit of $1.7 million or 17%, and operating income of $1.1 million.

On a pro-forma basis, the comparable revenue for the current and prior full quarters increased to $10.5 million from $7.2 million for the quarters ended March 31, 2011 and 2010, respectively. The gross margin percent has increased from 0% for the fiscal 2010 third quarter to 17% for the current year third quarter. SMS Colorado enhanced its profitability by initiating certain actions designed to reduce costs as part of the 100-day integration plan. The workforce at this location has been reduced by approximately 18% since acquisition and, additionally, the Company consolidated the Frederick operations from two facilities to one during the first quarter, terminating the lease for the exited building as of November 1, 2010.

Again, we are pleased at the speed by 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, as well as the level and timing of its profitability.

On March 4, 2011, Sparton acquired certain assets and assumed certain liabilities of Byers Peak for approximately $4.4 million, subject to certain post-closing adjustments. As with Delphi, we view this transaction to be strategic in nature with the addition of approximately $10 million of expected annual revenue, a new and diverse customer base, and a solid business development opportunity funnel. It also allows us to continue to expand into the high growth Therapeutic Device market and adds device refurbishment and field service to our growing list of capabilities. Coupled with Sparton’s capabilities, in particular, our internal circuit card assembly operation, low cost country manufacturing option, engineering support, and rapid prototyping, we intend to further facilitate profitable growth opportunities in the Western region of the United States in the coming years.

We are also excited to have been able to enhance our Medical segment’s leadership through the appointment of Jake Rost as the new Vice President and General Manager of Sparton Medical Systems. In this role, Jake will lead the Medical segment’s business development efforts and oversee operations at the Company’s Strongsville, Ohio and Frederick, Colorado facilities. Jake has been responsible for developing the solid business development funnel that has contributed to Byers Peak’s recent success. Prior to Byers Peak, Jake had business development and operational leadership positions with Peak Industries, the precursor to Delphi Medical Systems.

As with the Delphi acquisition, we have deployed a similar 100-day integration plan for the Byers Peak acquisition. One of the major reasons for completing this transaction was the potential advantages of the operational synergies between the Byers Peak and the Frederick locations. If Byers Peak was to remain a stand-alone business, meaning no closure or consolidation, this deal would not have been as attractive to Sparton.  We expect the consolidation efforts of transferring the production and workforce to be completed in the coming quarters, with the business being accretive to earnings no later than the second quarter of fiscal 2012.

Finally, I would like to close the presentation by providing a brief outlook on what to expect for the rest of fiscal 2011.

We continue to be focused on the successful implementation of our strategic growth plan. In the past nine months, the Company has expanded its business development resources and introduced a number of new marketing initiatives to leverage our market exposure. In this quarter, we have been able to announce new business awards from Talyst and Tampa Microwave, bringing a total of 14 new business awards so far in this fiscal year. In addition, we have won three new business opportunities at Byers Peak since closing that transaction on March 4th. We have also won multiple smaller engineering and Sparton Express projects that could eventually turn into larger production orders sometime in the future.

We will continue to work on the integration of Byers Peak into the Frederick, Colorado facility, continue to focus margin improvements in our EMS segment, and continue to align the Company’s cost structure to forecasted sales.

Finally, an integral part of our growth plan is the pursuit of acquisition targets that complement Sparton’s strategic direction, and we are continuously evaluating new opportunities.

I continue to be excited about the Company’s current position for future growth and look forward to reporting on future successes.

Many great things are happening . . . the new era continues and we thank you for your support.

Mike Osborne

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question from the line of Jimmy Baker from B. Riley & Co., analyst. You may proceed with your question, sir.

Jimmy Baker – B. Riley & Co.

Good morning, gentlemen.

Cary Wood

Hi, Jim.

Jimmy Baker – B. Riley & Co.

Looking at the backlog by segment here, the medical backlog is up over 3X where it was this time last year, there is something structurally different about the Delphi and Byers Peak backlog or can you maybe just talk about what’s driving that change?

Cary Wood

Jimmy, you certainly addition of the Byers Peak backlog, you got the addition of the fraudulent backlog and then as we talked about a bit earlier, we’ve seen an uptick in our legacy located in Strongsville, so I think you’re seeing the combination and the effect of those three things all come together in the third quarter like you wouldn’t have seen even as recent as our second quarter when you do a year-over-year comparison just predominantly acquisition related uptick and backlog.

Jimmy Baker – B. Riley & Co.

Okay, thanks. I’ll hop back in the queue.

Cary Wood

Sure, no problem.

Operator

Our next question is from the line of Andrew Shapiro, President of Lawndale Capital Management, you may proceed.

Andrew Shapiro – Lawndale Capital Management

Hi, good morning. A few questions and I’ll be back in the queue. I do have a bunch of them. EMS looks like it was one of the main causes of a good quarter here. It appears to be really nice increase in the gross margin percent but also a sizeable decrease in the operating costs at the segment from historical levels. So, what are the main factors for this quarter success in both operating cost reduction as well as gross margin percentage improvement and is that margin sustainable and can your operating ratios be maintained or even better improved upon?

Cary Wood

Yeah, I would certainly question that we visit fairly regularly, internally, it’s a business that squarely been on our front end priority and generally it’s a combination of the issues, we saw volume up slightly on a quarter-over-quarter basis. We saw the mix be slightly more profitable somewhat based on internal sales to the Sonobuoy side of our business, with that said our operating expenses continued to show opportunity, we did have some small degree of pricing activity and it is among the three business units the most favorable when it comes to its own SG&A. We did add some business development investment there in the preceding quarters, but generally much smaller on a percentage basis compared to the others. So, it’s a combination of facts.

I think the question about sustainability is one that I’m going to be cautious about. We’re certainly pleased with the progress we’ve seen on a quarter-over-quarter basis, a 11% gross margin this quarter, 7% in the last two, but again, I want to remind and the balance of our analysts and shareholders that we have talked about this business being on more of a six to eight quarter timeline by which we’re reviewing and I don’t want to call the war over when it comes to our EMS or complex medical or complex systems business unit. We’ve got considerable way to go. It’s probably more so then any of the other segments, it is a volume play at this point, but we’re also cautious about taking on new business that doesn’t fit well within our acceptable pricing thresholds and something that doesn’t play well to where we see our vision and our strategy taking us. So, with that said it’s a bit of a concluded (ph) answer to your question, it’s a spot on question. It's certainly been one of priority for us.

We are pleased with this performance, we are cautious about the outlook and the guidance we might otherwise give, I’m not sure how to clear that we’re over meaning, I’m not sure I want to call it sustainable as of yet and in the last quarter it’s probably more attributable to volume mix some downward results on cost and certainly the SG&A pieces small on comparison.

Andrew Shapiro – Lawndale Capital Management

Okay. Some questions of Byers Peak in the back out, for the March quarter before Sparton’s acquisition okay. Byers Peak at $10 million in revenue run rate and had a 13.5% gross margin. And for the last month inside of Sparton that run rate was far lower and the gross margin was negative and what changed or what changes your allocations were assigned to Byers Peak and for how long should we expect those items to negatively impact Byers Peak’s results?

Cary Wood

Right, good question. Certainly, not an indicative month in the first month of ownership. There were a handful of items that work there. First, significantly age backlog in line with the consummated agreement was shipped out by the previous ownership and that was done prior to us taking over in the early part of the month and then subsequently we want to add in and took the overall operations down for a period of time and went through a fairly thorough inventory and then we started some relocation activities. And so I think generally, the month is not one that would be indicative of our go forward run rate. We’re going to maintain our guidance at $10 million and it certainly has that track record and we’re comfortable that that something that we’ll continue. But, I think if March is no indication of how we see the business. There were a handful of things that affected what it is, the results came about in the way of March on Byers Peak.

Andrew Shapiro – Lawndale Capital Management

Now, where do you expect Byers Peak’s gross margins to be on a go forward basis in light of the fact that historically we saw last year they had a 21% gross margin and then it’s really strange, is that they had operating margins of only 4.7%. So are there really that kind of operating costs of basically 16.2% of revenue in their type of business because your operating costs have been limited to about 5% to 7% of revenue range and should we expect that you’ll get Byers Peak to that range of operating costs in their business?

Cary Wood

Yeah, there is a handful of questions there. The first that which has to do with the inconsistency between our company and Byers Peak in a way that certain class were counter form classified. So, a gross margin and gross margin comparison is not as pure as we would like it to be, but when you start talking – our operating cost is not as clear as we would like it to be.

From the standpoint of a gross margin comparison, the previous year was somewhat higher based on the richness of their shipments to one large customer involved in the refurbishment aspect of their business which was probably more of an anomaly then the rule, but the bigger broader question is going forward what do we expect and what opportunities should we expect to see as a result of the consolidation of this business within the Frederick facility. We have certainly modeled that out, we’ve got high hopes for how that’s going to ultimately come together.

We’ve been reluctant in the last year and a half to do much in the way of upward revisions on guidance. We’ve done it once with the defense piece because it became so consistent, we were so comfortable to provide that revision at this time, the medical guidance rule remain as it has at 13% to 16%. We’ve got a lot of moving parts going there. The legacy piece is obviously highly influenced by legacy customers, legacy customers count some big customers that haven’t flow fairly strong here in the last three to four quarters.

You combine that with all that’s going on in Frederick which is obviously far more positive than any negative and then you bring the variable of the new acquisition and all that goes into the closure to consolidation and doing all of that seamless is fairly optimistic on our part. We’ve been fortunate, I think we are pretty good at doing that type of thing. We’ve seen nothing but positive results since this new management team got here as a whole, but even more recent when we made the acquisition, but I think to your question, we expect good things out of the combined entity in Frederick that include and will ultimately include Byers Peak.

But, I think, for me to give you any kind of guidance other than what has been historical and medical at 13 to 16, I am not comfortable providing at this point.

Andrew Shapiro – Lawndale Capital Management

Well, 13 to 16 is a lot higher than what it just had been generating so that’s not necessarily the bad thing. I’ll back out into the queue, I do have more questions, so come back to me please.

Cary Wood

Sure.

Operator

Our next question is from the line of Jonathan Haynes, you may proceed.

Jonathan Haynes – Private Investor

Good morning. Could we talk about the, I guess I would call it backlog or the opportunity set in M&A and relate that to your thoughts about capital allocation over the next 6 to 12 months?

Cary Wood

John, good question. I think what I heard you ask was, what’s the trend on backlog as a whole and then from there forward when we talk about capital allocation, I’m going to interpret as being working capital and the needs of working capital, is that correct?

Jonathan Haynes – Private Investor

I was thinking more in terms of –

Cary Wood

Invested Capital?

Jonathan Haynes – Private Investor

EBITDA and share repurchase potentially as opposed to M&A opportunities?

Cary Wood

Okay, fair enough. First, I’ll talk about the backlog. We’ve obviously been fortunate that we have seen six straight quarters of uptick in our backlog and that’s certainly been something we work diligently on, a good portion of that has come from our M&A, but some of it down here most recently coming from fundamental organic growth initiatives.

We’re taking on brand new customer accounts, we took on 14 new opportunities in the preceding quarters and obviously some of them are smaller than some of the larger customers that we have, but I think that’s part of the name of the game as to fill the bucket faster then what we might lose other contracts, unfortunate part of having big customers that they can have disproportionate of fact on you when they even slightly down or tick. The good news of having a big customer is obviously the bad news of having a big customer, they are both kind of plus and minus.

Now, all that said, I think, we feel pretty good about the trajectory of backlog, we feel pretty good that they’re continued, there are some continuing new business funnel opportunities and it’s our expectation that the coming quarter will bring some of those to a close that will ultimately reflect in our year-end backlog. So, I continue to be optimistic about that.

In terms of capital deployment, I think, your fundamental question is, whether it be dividend share buyback or further acquisitions. There is a lot of ways to cut that argument and we’re certainly pleased that we are a debt free company that has a considerable amount of cash at this point. We’re fairly aggressive about how we look at opportunities and I think we are very, very diligent about where we believe the best deployment of our cash to be. We don’t do it in a tabular way, we apply a lot of hard metrics to our cost to capital and its best use.

We apply all the fundamental when it comes to M&A, we apply all the fundamentals of payback internal rates and generally I think, here more recently, we’ve been focused on being acquisitive given the success of the last two, particularly Delphi. But, in terms of the share buyback, we’ve had that conversation that’s been reviewed fairly vigorously not just among the management team but also inclusive of our board, I’m not sure that I can convey anything other than at this time, the position is stock buyback, it’s not on your term priority and that goes the same for dividends at this time.

But, I think we’re fairly investment minded management team that certainly the case with the board and I think generally those things will come up pretty regularly in our quarterly discussions and that position of where we are at today could change with time. We certainly recognize the importance of not diluting shareholders and maintaining a fairly rigid outstanding share position and that certainly important to management team and incentivized by the properly and so with that being the case, we’ll revisit that in the quarters to come Jonathan.

Operator

(Operator Instructions) our next question is a follow up question from the line of Mr. Jimmy Baker, you may proceed with your question, sir.

Jimmy Baker – B. Riley & Co.

Thank you. Actually just a follow on to the kind of earlier questions regarding both acquisitions and kind of use of capital, I mean as you look at acquisitions, would you consider using your stock for currency particularly if the target was a standalone entity?

Cary Wood

Well, it’s a good question, Jimmy. We’ve got the authorized share to go there and that something we wanted to do so I think the best way to look at is that it’s a scenario on our leverage, certainly a way to go, I’m not sure that’s the more immediate for us to look at things, I think that, we view that, and we’re going to model each opportunities, because each opportunities have been different and you will evaluate the variety of sources, whether it be through stock or be through debts or it be through a combination of a cash and debt, every situation is different. What I say that we wouldn’t consider it, I can’t say that. What I say that it is probably less of priority then the use of debts, I think that’s probably true. So, in the near term we are probably assess the opportunity to acquire through debt as opposed to issuing additional equity.

Jimmy Baker – B. Riley & Co.

Okay, fair enough. Probably a wise decision in my opinion. So, moving to the DSS segment, operating margins in that segment were about the lowest, we’ve seen it in sometime as opposed due to reduced sales to foreign governments there and we’re also seeing the backlog down in that segment. Can you just provide some additional contacts around the shift in customer mix towards the US Navy and if we should expect some margin headwind in the quarters to come in that business?

Cary Wood

We’ve certainly seen a downturn on foreign sales in our current fiscal year to the previous fiscal year. And, that has its effects obviously and we’ve talked about that in this environment long before now and that is it’s dramatically different from the standpoint of the gross margin perspective and with that being done where the mix has obviously been on the low side. Some of the other cost components that had been added to that business,

I would necessarily call a drag, we’ve certainly invested heavily on the new product development side and we have invested on the business development side. And, I think the question that’s being implied is more about that investments and what’s it all it going yield in way of a cash flow payback or is the mix going to be any different. It’s hard for me to give sort of guidance going into next year. We are very comfortable that the business will have in flow no different than it has in the past meaning that, coach come on over the course of the fall in the winter, it typically get awarded in the March timeframe. You saw us most recently making announcement on award that was granted to company in April that’s not accounted for in this current backlog.

And so, that makes it tough for us to be as transparent as we might otherwise be because that will fall into our fourth quarter and we will have that discussion. But, I don’t believe that the business that DSS segment is going the meet the headwinds for us other than I do believe that baseline Sonobuoy volume could slightly down tick in the next 12 to 18 months. But I think we’re fairly comfortable that it will be offset in parts by a degree of cost control, but more importantly foreign sales mix and the launch of our company since September which to discuss separately has doubled in volume for two straight years and it has reached as of the third quarter about a $2.5 million total revenue contribution of much higher gross margins and we’re planning going in the next year that’s also going to be a continued strong contributor.

So, I think, there are some headwinds on the domestic side we demand, but I think we are comfortable that it’s going to be offset and I think from the standpoint of backlog, I think you’re saying very normal absent flows if you would look over the preceding couple of years.

Jimmy Baker – B. Riley & Co.

Okay, and just last question from me. I’m just hoping that you could maybe discuss what opportunities you see to maybe wind down the inventory level specifically as it pertains to the medical segment, you as a management team it’s kind of done a great job of that over the prior years and I assume these acquisitions brought on maybe a little bit more inventory then you would typically carry, so just kind of want to understand what maybe, what opportunities do you see for cash generation out of working capital?

Cary Wood

Yeah that’s absolutely true. As a result of the two acquisitions and certainly a notable observation on both of them, on the management team when we went into the opportunities is that they were higher than what we were comfortable with. We were able to significantly reduce the company’s inventory level from two years ago to where the legacy business lies say a year ago before we made the acquisitions and then the uptick has been significantly affected by the acquisitions of these two businesses and then here more recently while we ran a quarter of negative operating cash flow it was predominantly as a result of the investment in new business payables as well as some level of inventory on some of our legacy based business.

So, the question being focused on inventory is spot on, I’m not comfortable of giving guidance as to what it’s going to end up looking like, but it has been very pointedly conveyed to this management team by myself that the working capital side of things have to improve and that it’s an opportunity given the two acquisitions and certainly something we said, we were going to take advantage of early on.

The acquisition of Delphi medical or Frederick has a fairly sizeable customer. And it gets awful for us to run it through as fast as we would like and Byers Peak frankly a whole lot different. We do have ambitions to take it down considerably as I say want to give guidance on where we are going to go in terms of churns but it’s in my view it will not be an inconsequential drop in the inventory over the course of the next 12 months and certainly something that we’re going to start to pay much closer attention now as the two acquisitions are under above the operational aspects of it are predominantly behind us, new business opportunities are being geared up. It’s now a matter of focusing and optimizing our inventory levels given the size of our business. So, there is an opportunity, Jim, its good observation.

Jimmy Baker – B. Riley & Co.

Okay, thanks very much.

Operator

Our next question is a follow up question from the line of Andrew Shapiro, you may proceed sir.

Andrew Shapiro – Lawndale Capital Management

Hi, thanks. Directly following upon Jimmy’s query on the inventory, what is the status of the acquired Delphi inventory and the timing in terms of any claw back to the escrowed monies which would further reduce your acquisition cost as well as drop that inventory down?

Cary Wood

Right, let Greg take that question.

Greg Slome

If we go back to the agreement, we had an 18 month period for potential reimbursement of excess amounts lead inventory. So, at the point of closing we had basically determined a baseline excess and absolute inventory which was low in excess of $2 million. The purchase agreement have provision that Delphi would be responsible for up to $2 million for whatever of that baseline inventory was left at the end of the 18 month period.

We continue to monitor it on a quarterly basis, we are accordingly reporting requirements associated to that with Delphi and we have seen a down turn in that inventory level up till now. But, I look at it and realistically when you analyze that the biggest drop, the one we are going to start to see the utilization of any of that excess is really going to be in the last six months of that 18 month period. So, we continue to monitor it from the timing standpoint, it will be February of 2012 before we come to a final determination on that and at this point we continue to work down, but I would expect that the baseline there start dropping pretty rapidly as we get through the next six months.

Andrew Shapiro – Lawndale Capital Management

But is it down to a million five or million two as of –

Greg Slome

Right, yes, it’s still an access of $2 million as of the end of the March quarter.

Andrew Shapiro – Lawndale Capital Management

Oh, okay. And while we are talking about Delphi how much more room do you have to expand there, you got good gross margin now up to 16.5%, EBITDA, 10% according to the breakout in the 10Q, can you describe and somewhat quantify any further consolidation opportunities and synergies remaining for that acquisition in there timeline?

Cary Wood

I should like to appreciate the question it’s an operation where we are continuingly looking for opportunities to do more with. It’s been so successful and it has moved so quickly and we have been so pleased with the results, we have replaced the management team out there, we have made some significant changes in the layout of the footprint of that operation, that we have been able to win some new business one of which was not an inconsequential engagement that’s going to ramp up here sooner than later and so we are pleased with all of that.

Now that said right now in the more near turn we have got focus on getting the Byers Peak piece over there and we have got to concentrate on maintaining the folks that are involved in there and so I think there is a little bit of a concern over the volatility that inherently goes with that. So, I think our views is, we more want to fight to protect the guidance we have given as opposed to get too excited about what the upside opportunities might be.

Now, I will say that there are evaluations going on continually to assess the circuit card operations that are out there and whether or not that should stay, the fact that they’re footprint opportunities to relocate industrial applications within that medical piece that could otherwise accommodate medical related volume that, if you would move the industrial piece down to say Florida maybe it makes more sense. So, there are opportunities there, there are plenty of them, we continue evaluate those things. But, in terms of giving a revised guidance on how that operations will perform, tough for me to provide today given all the things that are going on here.

Andrew Shapiro – Lawndale Capital Management

Okay, staying within medical since it’s such a big segment so, on Byers Peak can you discuss this business in particular, this field service refurbishment and installation capabilities that Sparton didn’t seem to have previously and is this water filtration and disinfection systems work that you have a large market?

Cary Wood

Yes, the filed service is the, is new to us, we are able to go out with some of the product that we are producing on behalf of the customer installed out there, it is primarily water filtration and purification systems that did come along with the deal, the DI reverse osmosis system. We believe, we’re going to leverage that now we have product but that field service capability to other customers that we currently have across both Frederick and Strongsville and we will have that to our overall capabilities on the go forward basis.

Greg Slome

We also do a series of equipment refurbishments on preexisting accounts that we do have. I think there is an opportunity for us to evaluate whether or not equipment upgrades can come our way in the way of our service capability. So, it’s an opportunity for us to explore a segment that we won’t currently have a lot of depth in, we’re certainly please that it gives us an in road into it, but it’s a tough segment for us to evaluate the size, the opportunity, what it brings to us. We just know that it is another venue, another capability that we didn’t currently have that we think we can further explore.

Andrew Shapiro – Lawndale Capital Management

And is that already been communicated to your customer base across the Sparton medical nationwide yet or not?

Cary Wood

Yes, that actually not only to our customer but our database of thousands of contacts, we announced the acquisition of what those capability were and will continue to modify our collaterals and selling material to reflect that change as well on a go forward basis.

Andrew Shapiro – Lawndale Capital Management

But you are not seeing any revenue feedback yet from them?

Cary Wood

Well, I would say that some of the preexisting customers now having learned that we have that capability are enquiring about what that means. They are asking how they might take advantage of our low cost country footprint, say in the case of Frederick where they didn’t know we had it and now they do, they are as curious about what that might mean to them so we are filling those types of things, the fact that then there are customers that didn’t know we acquired service are now learning about it or asking us to tell them what it might mean and with it being less than 30 days old we are on the front end of the having those discussions. So, we are certainly doing that to your fundamental question, we are certainly communicating it. I think it’s going to translate we hope into opportunities, it adds to the breadth of our capability and we have added it within our selling materials, our collaterals that we provide all of our prospects and current customers and the shows that we find presence in and I think generally, overtime I think it will translate into some opportunity.

Andrew Shapiro – Lawndale Capital Management

Okay, then backing up Delphi and Byers Peak revenues, it looks like legacy medical, Strongsville not only at higher revenue again from prior quarter but this time also from last year. So, in your view has this business stabilized and should continue now sequential growth?

Cary Wood

There is a couple of things to talk about giving that question, the legacy medical business as I am sure you recall, is fairly influenced by a good handful but some sizable accounts and as those accounts have been flow even ever so slightly they have dramatic impacts on that business. In the preceding three, four quarters we saw there major accounts, one that has now since come back with significant volumes in the third quarter and we feel pretty comfortable going into our fourth quarter or remain the same. We saw one that essentially departed, we talked about that before, it won’t be probably coming back and we basically in sourced it giving their own fixed overhead needs and then the last was technical related issue that they had to spent some time resolving in the market past and buy and now they are trying to ramp that back up, but it certainly set us back, okay.

Now that’s three accounts we are talking about and they have such significant impact on the business that obviously we want to migrate away from that and we would rather migrate towards by design more customer account that are, well, I will take large, I will take small profitable opportunities and the question fundamentally is and again we are contract business. So, that the business by design and definition absent flows so, when a contract comes to an end the question is that we back filling it at least this large if not larger and so in absence of having have that effort anything that tailed off, whether it was volume related from the economy or it was in sourced in one case or somebody is going to a working capital issue, whatever it was, it was nothing but downside for us.

The real solution and the fundamental question is being a contract manufacturer are we putting as much time and focus on diluting the effects of very large customer accounts with new accounts at a rate higher or equal to those that start to tail off. So, do I think that we have reached the bottom, I think that there are lot of things that didn’t go as I would want them to out of our legacy medical business specifically Strongsville and that volume was down. It’s back this quarter and it’s back as a result of one very significant account up ticking its volume.

If I can count on that for the long hold then I certainly don’t fear that I will ever see a downturn again. I don’t expect that to be the case. I think that the better focus has to be around new business opportunities to backfill the inevitable downturn of very large customer accounts that could go away overtime. I mean that’s just the fundamentals of the contract business that we got to be sensitive to. So, I am pretty comfortable that we are doing that, we are putting our focus to the right things and the bottom line for now the bleeding has stopped it seems, it has come back in the third quarter nicely, but I am not ready to call that over with you, I don’t want to get burned by that again. So, the business development effort has got to refill that bucket.

Andrew Shapiro – Lawndale Capital Management

Okay, I have more questions, I’ll back out to the queue then.

Cary Wood

Okay.

Operator

Our next question is from the line John Curti an analyst at Singular Research, you may proceed, sir.

John Curti – Singular Research

Good morning. I had a question on your complex systems unit, trying to figure out maybe how much business that unit does internally for you and are there further opportunities to increase that business internally given the acquisition that you have made and may be some of the potential acquisitions that you are looking at and being able to maybe not a higher margin on that business then on third party business so that you are kind of using it as an in-house profit enhancer as you kind of maybe scale back some of the outside third party business which is done at lower margins?

Cary Wood

Well it’s a good question, it’s a series of questions, then I will see if I don’t hit on those and where I miss certainly don’t be shy to ask where I seemingly miss the question. It’s our complex business a good portion of it is internal. It provides predominately if not almost solely to our defense segment. The internal vertical opportunities and something we’ve always identified as upside to our more recent acquisition is to internalize some of those electronics and that’s been the play and we will continue to be away in which we evaluate future acquisition opportunities and certainly there are some in-sourcing thing that we can look at given those acquisitions, they’re not going to come right away, we always knew they wouldn’t come right away it’s a very tricky thing to do.

It’s tricky enough to tell somebody that your new owner and don’t worry about the fact that I reduced the overhead by 18%, close one of your buildings down and change that all your people – that’s tough enough and now the next step is to start having some discussions around how we might make some changes to the supply chain, which includes further in-sourcing of some of the product that was otherwise in some cases sourced by them. So, it gets a little bit dicey, but I think overtime that certainly been on our list of opportunities that I think will work to our advantage and the fact that we have that vertically capable expertise has been what we believe to be at least one part of the value proposition making the acquisitions we have.

So, we will certainly continue to leverage that and when you think about the performance of that segment which two years ago was so gismo that hardly breakeven and certainly was a cash consumer and now it made its way back from what last year was 4%, 5% gross margin run rate to the last three quarters being between 7 and 11, it certainly been in line with our guidance, it’s been in line with our expectations and some quarters exceeding it, others been slightly down from where we would have liked for it to have been.

But, I think the complex segment as an opportunity to grow with external business, it is a business that has a landscape out there a lot of fragmented M&A opportunities that don’t come in nearly the same premium as some of our other segments. The other segment that we have acquired have internal opportunities to vertically be shifted over to our complex system, so it’s a great question you broke the code essentially and what it is we’re trying to do with the complex piece. I don’t want to make it entirely internal sales dependent and it doesn’t have to be, it’s got own rapid prototyping line it certainly helps us from within, but it’s a selling proportion for outside opportunities as well. So, I think we’re maximizing right now every opportunity to commercialize that business externally as much as it being a clear play to acquisitions that have those types of need that we can continue to further support.

Frankly, better than some of the other suppliers out there, I think we’ve gone from being a mediocre supplier among a lot of mediocre suppliers, I think that we have become a very fast turnaround organization, our quality is second to none, we are more recently while I keep the customer’s name out of the discussion we will rank number one among a 150 suppliers and that is in stark contrast from where we were just a year ago, we were on the bubble of being thrown out of their supply base.

So, the complex systems piece has come a long way, the gross margin performance hasn’t reflected how far it comes just yet, again I’ve set cautiously I am not declaring the war on that business segment over just yet, but I am fairly optimistic there are lot of things going more in its direction then having headwinds. So, long answer for your question and if I didn’t hit on some of it please going ahead and ask again so I make sure I counter it.

John Curti – Singular Research

The other part of the question would be there seems to be a lots of small EMS companies out there, nobody seems to be making lot of money assuming there’s some economies of scale to the business, are there opportunities to do on the EMS side which you done with medical and make some acquisitions and fold that business into your two existing facilities?

Cary Wood

You are spot on and there are but just as I say that and I have to contain my own enthusiasm around that. There are segments of that business that we frankly would prefer not to be in. I don’t want to sit here and say we’ll never ever. You are getting into the variety of market space which include consumer products or computer or telecommunications, those effort predominately found the way offshore. They undergo a great deal of pricing pressures, there really are a ton of external regulatory boundaries to it that the commodity play albeit it brings good amount of volume and that segment is a volume play.

What we would rather concentrate, it has expressed fairly specifically in our strategy and that is we want to focus on highly regulated segments of the electronic industry which includes predominately defense related stuff which is obviously (inaudible) restricted. Medical which has a restriction given FDA regulations and then a little bit of more on the way of complex industrials. I think that we have become as I say a very good operating organization that has introduced far more in the way of contemporary method then a lot of peers and the fact that is a very fragmented space, and fragmented space where people that are doing all that well. Yes, to be careful but you are not buying a business that’s in spaces you don’t want to be in so that’s a filter for us.

Secondly, is that it’s a type of business that plays well to our strengthens and frankly we are not interested in being a solely circuit card only provider and we want to be very careful about how much of our ultimate complex systems volume might be in circuit card arena, we rather look at things like cables, connectors, subassemblies, full or social box build and all those of things can lend themselves well, if they happen to be also located in say the medical and defense segment because all by the way we got two other segment that can really bring that whole assembly to completion and we got the engineering capabilities on top of it so you are asking exactly the question that help to illustrate exactly our strategy and the approach we want to take. The entire sector is fragment, I mean, a lot of so awfully performing financially for sure, but even operational suboptimum and I think with this company has long way to not just be a mediocre provider among a lot of mediocre, it is standout operationally.

Our turnaround, our delivery, our fill rate, our uptime, our internal quality all of those industries are significantly better, I think we are ultimately provider to a lot of our larger customers and the word is still to get its way out there entirely and the roll up of a couple of other pieces that would augment medical and defense is certainly on our mind when it comes to M&A activity.

John Curti – Singular Research

Thank you very much.

Operator

Our next question is another follow up question from the line of Andrew Shapiro, you may proceed, sir.

Andrew Shapiro – Lawndale Capital Management

Yeah hi, regarding DSS can you discuss, I think its DSS or its coming out of there on your new website. Can you discuss this new product activity and opportunities in the DSS side that you’ve been spending R&D money on and also your newly unveiled exploration and navigation business line?

Cary Wood

Yeah, they are predominately the same thing and if you go back and obviously Andrew you’ve been close to us for a long time, you remember the discussions we had early on, say several years ago when we felt like some of the intelligent firms within weren’t being adequately leveraged and specifically within our Sonobuoy product line there is within it a fairly sophisticated listening device and locating device and communication devices and if we were to spend a little bit of time, effort and money to evaluate the market potential, pull it out of there, bundle and package is different, put some marketing efforts behind it, focus the opportunity to sell into either defense and even civilian but yet actually related opportunities we think there is some lives there that’s obviously been true even in the last year and a half given the increase in compass sales without having really introduced the product that we want in the coming fall.

So to back to what that trajectory has been in ‘09, we did about $700,000 of compass sales in ‘10 $1.2 and on a year-to-date is about 2.5 and that’s in three quarters. So, we’re going to put a little of bit marketing effort around it, we are going to put some R&D monies to which we have thus far this year in no insignificant but I don’t believe it’s been over the top buyers, it’s a fairly rich product for us and we felt with time it’s clearly going to be deserving of its own commercial business unit identity if you will which is where that that segment comes from.

So, it goes back to our strategy, our three legged store what we set organic growth of the business that were in, product line extension with opportunities that we haven’t taken advantage of in M&A and that’s the second of our three and something we put some monies to, I think we’re confident with the timetable, we roll the product out in September. We gave it its own business unit identity so that it doesn’t get lost in the shuffle with our traditional defense products, which is predominately Sonobuoy and all the cash flow announces that we’ve done upfront at least to-date has been exceeded.

The timing has been slightly – or the timing has been on pace with the investment has even been less then what we thought it to be given how we’ve been able to approach it. So, we’ll see some heavier R&D investment in our fourth quarter on our compass release, we see the overall investment for the year slightly down and we expected it to be, but we are contracting that investment based on the right internal decision.

So, we are pretty excited about the compass and rollout in August of the show in Washington DC, we did the show about month or two ago already with the preexisting compass and it got a good amount of visits and enquiries and that’s not something we had ever done before, so I think we are on right track there, but generally I think time will tell.

Andrew Shapiro – Lawndale Capital Management

And this is higher margin then even Sonobuoy kind of product?

Cary Wood

It is and I’m reluctant to say is dramatically better, but it is a very, very different gross margin scenario. I think the way to view it is that is it our own intelligence and as you can imagine when you introduced your own IP and it has certain specific niche to it that maybe other products don’t, it certainly brings with it not just an interest level, but it also brings with it the types of margins that we certainly are excited about.

Andrew Shapiro – Lawndale Capital Management

And then what is this, I guess exploration type of product line is that the compass or something different?

Cary Wood

Well, what we try do is put a segment identity around what are these were interested in applying our current intelligence on products too. So the compass has a versatile degree of applications, and it could be in exploration, it could be in navigation, it could in a lot of different places, as could be the hydrophone and generally what we’re trying to do is present ourselves to a variety of markets that we don’t serve almost at all today with products that are currently within our defense segment, but we wanted to give it its own effectively its own identity, its own platform to build upfront and I think that’s what customers little segments will be looking forward as opposed to being a defense guy trying pull out product item that might or might not be applicable to their venue, so that’s why we called up the identity forward as we have.

Andrew Shapiro – Lawndale Capital Management

Okay, and within around DSS, well I’ll back out in the queue if you got anyone?

Cary Wood

No, go ahead Andrew.

Andrew Shapiro – Lawndale Capital Management

Okay with a new Sonobuoy under your government funded development in other words this is in our own R&D, this is a government’s R&D contracts that you guys have announced that the SSQ-125, I think?

Cary Wood

Correct.

Andrew Shapiro – Lawndale Capital Management

When should we expect to see the first production orders and revenues from those new Sonobuoy?

Cary Wood

We’re still in the midst of prototyping, I think it’s very it’s safe in saying that the government has been pleased with everything we’ve done on a year-to-date basis with our testing and the assessment of prototyping, but we’re going to continue to be going through lot of that in the coming months, even quarters. Essentially how the calendar works is that come summer months, fall months. We’ll start to have some discussions around what a finished products that looks like, what a quote would look like, pricing terms, quantities, all of that will start to come to a bit of ahead in the winter months of calendar year ‘12, and while it’s been hard to identify exactly when the award might be made, typically its somewhere between March all way out into April even then, so I think for now our view is that, we might see something on a more production volume basis of the Q125s in the early part of next year.

Andrew Shapiro – Lawndale Capital Management

And this would be in a new design and all that, add or above current kind of Sonobuoy margin levels?

Cary Wood

I don’t want to give guidance on the margins, I think generally it’s an advanced product compare to the common Buoys that we had in past, so obviously brings with it some enhanced technology, could it in a rich margins, it could but you got to keep in mind too that its bringing on some additional infrastructure costs and engineering relate so. I’m afraid to take that question from the standpoint we could have a dramatic effect on the business, but it certainly something that we’re anxious to get involved with, I think it’s going to present an opportunity for us to enhance a new Sonobuoy over time in. And that’s all is an opportunity for us.

Andrew Shapiro – Lawndale Capital Management

And then in terms of quantities this is the new Sonobuoy plan of the new PA?

Cary Wood

This will be part of the entire PA Platform with time, correct.

Andrew Shapiro – Lawndale Capital Management

Okay. All right, on the NOL, what’s the size of the remaining NOLs and given Sparton is now sustainable profitable and in our final quarter here, before your year end audit, do you’ve an estimate of when these NOLs would to be utilized to tax shield income and thus probably have a formal balance sheet value?

Cary Wood

Yeah sure, I’ll let Greg talk a little bit about that.

Greg Slome

And in you go back to June 30 of 2010, our analog carry forward for Federal, they expect $15.7 million so far this year we got year-to-date book income of $8 million when we get to the end of the year, we’ll obviously convert that to taxable income and we’ll then look and see what are remaining level is at the end of the year. As far as when we expect to have that utilize, I’d have prefer to a put a timeframe on that, but the one thing I’d like to add is that the two years of profitability under our belts obviously looking forward into the future with high expectations going back few years ago, if we recall we sort of valuation allowance you can see entire deferred tax asset that the company had, in the June 30 last year that was $13 million now, we’ve lot of piece of that really and use about $5 million so you’ve got lot of other timing difference that ultimately resulted into deferred tax asset. In conjunction with the year-end level this year we’ll clearly be the evaluating and taking a close look whether it’s the right time to reinstate the deferred tax asset and there is no real black and white rules that dictate the specific timing on when you do that, lot of factors go into play based on the historical income where you see the future going.

So, we will be evaluating that as of the year end audit and make a determination, but there is a chance that we may decide to reinstate the deferred tax asset at the end of this year which then clearly on a go forward basis would mean we’d be recognizing periodic tax expense within each quarter.

Andrew Shapiro – Lawndale Capital Management

Okay and Cary what are your presentation in investor relation plans for the coming quarter or two.

Cary Wood

We got a fairly aggressive couple of quarters, I’ll let Mike Osborne talk about those things here.

Mike Osborne

While coming up again next of couple of weeks through end of the West Coast again. May 27 in San Francisco and then going down the Las Angeles the following day and we’re presenting up the valley conference in Norway on May 26 and then moving into June, we’re going to be at the MDNM east trade show that’s a medical trade show, we are actually receiving a design award as a supplier to one of our customers. So these are my good information coming out on that little later on, and while we’re east we’re going to work on scheduling new some more meetings in New York city, Boston and in mid Atlantic, that’s being followed up with the June 14 speech that Cary has got at the outsourcing council sort of institutional trade show of large OEMs in the Chicago area and then at the end of June, on June 27, we’re going to be in Connecticut and that’s little firm but right now but you know, we’re working with Biomass and working on some other opportunities (inaudible) this as well.

Andrew Shapiro – Lawndale Capital Management

Yeah do we have any prospects for finally getting Sparton for several south side research coverage and initiation at all.

Mike Osborne

Well, actually we’ve got south side coverage from two, two organizations we have added actually our latest one that joined last month, and then Sidotti out of New York has been covering us on a limited basis from almost a year now, and we’ve been entertaining some other analysts from other firms as well, but nothing concrete as of yet, but, we got to sort of pretty close with that.

Cary Wood

So, two as of today and more cases we have involved in their south side force as well.

Andrew Shapiro – Lawndale Capital Management

I heard Jimmy on the call, I just (inaudible) for an initiation with Byers expedition, if he waits too long, it’s going to be the higher price.

Cary Wood

Yeah I know, I think yeah alright if I remember the right that we did initiate the Byers a few weeks ago, and then more recent, I think there is a report out there in Sidotti obviously has issued second reports of a months ago so.

Andrew Shapiro – Lawndale Capital Management

Okay, well thank you guys.

Mike Osborne

All right, I appreciate it, come and see me when you are in San Francisco.

Andrew Shapiro – Lawndale Capital Management

I will be sure to put that on account. Thank you.

Cary Wood

Well, I’d like to thank all the participants into today’s call. It does conclude our call today. The call including the question and answer period has been recorded and will be posted to our website under investor relations later on today. Thank you once again.

Operator

Ladies and gentlemen that does conclude the conference call for today. We thank you for your participant and ask that you please disconnect your lines. Have a good day everyone.

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