Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Sparton Corporation (NYSE:SPA)

F4Q 2011 Earnings Call

September 8, 2011 11:00 AM ET

Executives

Michael Osborne - SVP, Business Development and Supply Chain

Cary Wood - President and CEO

Greg Slome - CFO

Analysts

Mark Jordan - Noble Financial

Andrew Shapiro - Lawndale Capital Management

Jimmy Baker - B. Riley & Company

John Curti - Singular Research

Jonathan Haynes - Private Investor

Mike Osborne

Thank you operator. Good morning and thank you for participating in Sparton’s fiscal 2011 fourth quarter and full year 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.

Adjusted operating income, adjusted net income and adjusted income per share – basic and diluted are non-GAAP financial measures that exclude or add the effect of certain gains and charges, including imputing income taxes at a 36% effective rate. Sparton believes that the presentation of non-GAAP financial information provides useful supplemental information to management and investors regarding financial and business trends relating to the Company’s financial results. More detailed information, including period over period segment comparisons, non-GAAP reconciliation tables and the reasons management believes non-GAAP measures provide useful information to investors, is included in the Fiscal 2011 Fourth Quarter and Full Year Results press release and 8-K dated September 7, 2011.

Today, Cary Wood, our President and CEO, and Greg Slome, our CFO, will report our fiscal 2011 fourth quarter and full year financial results, provide an update on the status of our liquidity and capital resources, review the progress made with our growth initiatives in the past year, and provide a brief update on the outlook going into fiscal 2012. At the end of the narrative, we will allow our investors and other interested parties to ask questions related to the Company’s financial performance and operations. In fairness to all participants, we will ask that one question be asked at a time with the call ending at approximately 12:00pm EDT.

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

Cary Wood

Thanks Mike. Good morning and welcome to our fiscal 2011 year-end conference call. Today, we will begin by reviewing our fiscal 2011 fourth quarter and full year consolidated performance. As most of you are aware, Sparton has gone through a financial and operational turnaround the last few years as well as completing two acquisitions in fiscal 2011. As a result of these actions, there have been a number of one-time gains and charges, restructuring costs, and impairments recognized in our financial statements in the past three fiscal years. In addition, the Company reinstated its deferred tax assets in the fourth quarter of fiscal 2011. Considering the magnitude of the impact these actions have had on our reported financial results, we have provided within our Earnings Release certain non-GAAP disclosures related to Operating Income, Net Income and Earnings per Share that exclude or add the effect of certain gains and charges, including imputing income taxes at a 36% effective rate. We believe that the presentation of such non-GAAP financial information produces useful supplemental information to management and our investors regarding financial and business trends relating to the Company’s financial results.

For the fiscal year 2011 fourth quarter, our consolidated net sales were $60.9 million compared to $40.0 million in fiscal 2010, an increase of 52% from the prior year quarter. The increase was primarily driven by the incremental sales from the Delphi and Buyers Peak acquisitions and a significant increase in U.S. Navy sonobuoy sales within the current year quarter.

Our gross profit in the fiscal 2011 fourth quarter was $10.4 million compared to $5.5 million in the prior year quarter. The consolidated gross profit percentage in the fourth quarter was 17% in fiscal 2011 compared to 14% in fiscal 2010. The increased margin reflects improved results from the Company’s Complex Systems segment, partially offset by the unfavorable impact of the decreased volume of foreign sonobuoy sales from the Company’s DSS segment.

Restructuring charges were approximately $0.1 million and $2.0 million for the quarters ended June 30, 2011 and 2010, respectively. Additionally, impairments of goodwill and customer relationship intangible assets of $13.2 million and $3.7 million, respectively, were recognized in fiscal 2011 fourth quarter related to the 2006 acquisition of the Company’s Ohio Medical business. These impairment charges are reflective of recent downward trends in volume within the Company’s Ohio reporting unit, including the impact of a customer disengagement and Siemens’ fiscal 2011 fourth quarter notification of its intent to dual source certain programs with us as part of an overall dual sourcing strategy for certain of its critical programs.

Our consolidated fiscal 2011 fourth quarter reported operating loss was $12.3 million with adjusted operating income of $4.5 million compared to reported operating income of $2.3 million with adjusted operating income of $1.1 million in the prior year quarter. The improvement in adjusted operating income is reflective of the impact of the increased revenue and improved margins, partially offset by the increased selling and administrative expenses from the Colorado acquisitions and the increase in internal research and development expenses in the current year quarter.

On a reported basis, the fiscal 2011 fourth quarter includes an $11.6 million tax benefit compared to tax expense of $0.1 million in the prior year quarter. The fiscal 2011 income tax benefit reflects the June 30, 2011 reinstatement of approximately $11.7 million of deferred tax assets, as the Company now believes that it will be able to utilize these tax benefits in future periods.

Our consolidated fiscal 2011 fourth quarter reported net loss was $0.7 million or $0.07 per share with adjusted net income of $2.9 million or $0.28 per share compared to reported net income of $2.1 million or $0.21 per share with adjusted net income of $0.7 million or $0.07 per share in the prior year.

For the full fiscal year ended June 30, 2011, our consolidated fiscal 2011 revenue was $203.4 million, increasing 17% or $29.4 million from the prior year. The overall increase in revenue reflects additional sales in the current year from the acquisitions of Delphi Medical and Byers Peak, and increased U.S. Navy sonobuoy sales from our DSS segment, partially offset by decreased sales from our Complex Systems segment and decreased Medical sales from our Ohio facility.

Our gross profit in fiscal 2011 was $33.2 million compared to $26.6 million in fiscal 2010. The consolidated gross profit percentage for the year ended June 30, 2011 increased to 16% compared to 15% in the prior year. The increased margin reflects improved results from the Company’s Complex Systems segment, partially offset by the unfavorable impact of the decreased volume of foreign sonobuoy sales from the Company’s DSS segment.

Selling and administrative expenses as a percentage of sales decreased to 10.2% of sales from 10.5% in the prior year. Additionally, fiscal 2011 includes an investment of $1.1 million to internally funded research and development whereas there were no such expenses in fiscal 2010.

Restructuring charges were $0.1 million and $4.1 million for the years ended June 30, 2011 and 2010, respectively and, as previously discussed, impairments of goodwill and customer relationship intangible assets of $13.2 million and $3.7 million, respectively, were recognized in fiscal 2011 related to the 2006 acquisition of the Company’s Ohio Medical business.

The Company recorded a gain on acquisition of $2.6 million during the current fiscal year in relation to its acquisition of Delphi Medical, and recognized gains on the sale of property, plant and equipment of $0.1 million and $3.1 million for the years ended June 30, 2011 and 2010, respectively. The fiscal 2010 gain reflects the long-term lease of the Company’s Coors Road property.

While we finished fiscal 2011 with a reported operating loss of $3.8 million, on an adjusted basis, operating income was $10.4 million as compared to a reported operating income of $5.7 million and adjusted operating income of $6.7 million in fiscal 2010. Included in the fiscal 2011 financials are the results of operations from the Delphi Medical Systems and Byers Peak acquisitions.

An income tax benefit of approximately $11.4 million for the year ended June 30, 2011 was realized as compared to an income tax benefit of approximately $1.9 million for the year ended June 30, 2010. As previously discussed, the fiscal 2011 income tax benefit reflects the June 30, 2011 reinstatement of approximately $11.7 million of deferred tax assets. The fiscal 2010 benefit reflects the release of $2.3 million of deferred tax asset valuation allowances in relation to tax regulation changes of various carry-back provisions.

Our reported consolidated net income was $7.5 million or $0.73 per share and adjusted net income of $6.6 million or $0.64 per share in fiscal 2011, versus a fiscal 2010 reported net income of $7.4 million or $0.75 per share and an adjusted net income of $4.0 million or $0.40 per share resulting in a 60% improvement in adjusted earnings per share on a year-over-year basis.

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 for the fourth quarter and our liquidity and capital resources.

Greg Slome

Thanks Cary.

Medical Device sales in the fiscal 2011 fourth quarter increased to $28.0 million, up $14.7 million or 110% from the same period a year ago. Recurring sales at our Strongsville, Ohio facility increased to $13.7 million, up $0.5 million, or 3%, in the three months ended June 30, 2011 as compared with the same quarter in the prior year. This increase in comparable sales reflects increased demand for certain programs, partially offset by the disengagement of one customer during fiscal 2011. Incremental fourth quarter sales from the Company’s Delphi and Byers Peak acquisitions totaling $14.2 million contributed to the overall increase in year-over-year sales. Fiscal 2011 revenue related to the Delphi acquisition continued to exceed our internal expectations.

The gross profit percentage on Medical sales remained at 13% for both the three months ended June 30, 2011 and 2010.

Complex Systems sales for the three months ended June 30, 2011 increased to $14.7 million, up $2.3 million or 18% as compared to the same quarter last year. This increase primarily reflects increased intercompany sales, as well as increased volume for a number of smaller customer programs.

The gross profit percentage on Complex Systems sales increased to 12% for the quarter ended June 30, 2011 compared to a negative 2% for the quarter ended June 30, 2010. The quarter over quarter comparison reflects favorable product mix, improved operating performance and the impact of the overall increase in sales volume.

DSS sales for the three months ended June 30, 2011 increased to $22.6 million, up $5.4 million or 31% from the fourth quarter of the last fiscal year, reflecting higher U.S. Navy sonobuoy production in the current year quarter and, to a lesser extent, increased digital compass sales. Partially offsetting these increases were decreases in sonobuoy sales to foreign governments and in engineering revenue. It is not anticipated that future quarter U.S. Navy sonobuoy sales will remain at this level.

The gross profit percentage on DSS sales for the quarter ended June 30, 2011 was 21% compared to 23% for the quarter ended June 30, 2010. Gross profit percentage was adversely affected in the current year quarter by decreased sonobuoy sales to foreign governments as compared to the prior year quarter, partially offset by favorable 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 June 30, 2011 continues to be our Industrial Revenue Bond with the State of Ohio of approximately $1.8 million. During the quarter ended June 30, 2011, the Company made total principal and interest payments of $0.1 million and our debt to equity ratio on June 30, 2011 was at .02 to one.

As of June 30, 2011, the Company had $25 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, which expires in August 2012, is subject to certain customary covenants which the Company was in compliance with at June 30, 2011.

Summarizing our cash flows for the fiscal year ended June 30, 2011, operating activities provided $2.5 million of net cash flows. Excluding changes in working capital, operating activities provided $13.2 million in 2011, reflecting the Company’s positive operating performance during the period. Working capital used $10.7 million of net cash flows in fiscal 2011, primarily reflecting the funding of production related to the U.S. Navy contracts during the year 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 fiscal 2011 totaled $8.5 million. Fiscal 2011 reflects 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 $4.1 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 fiscal year were approximately $3.2 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 of the Company’s Bluewater Road property in Albuquerque, New Mexico of approximately $4.0 million.

Finally, as announced in our recent press release, the Company’s Board of Directors has authorized the repurchase by the Company of up to $3.0 million of the Company’s common stock over the next two years. We believe this plan demonstrates our commitment to increase shareholder value, and continues to leave the Company well capitalized to execute on our current and future growth initiatives.

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

Cary Wood

Thanks Greg.

While pleased with our fiscal 2011 accomplishments, I am disappointed to report that Siemens notified the Company that it intends to dual source two of its larger programs with us beginning in fiscal 2012. Annual sales related to these programs aggregated approximately $27.8 million in fiscal 2011. While the Company cannot determine at this time the ultimate impact that this dual sourcing will have on its future annual sales, unless overall sales related to these programs increase, this dual sourcing is expected to have an adverse impact on fiscal 2012 Medical sales at the Company’s Ohio facility. As we’ve discussed in previous calls, Medical sales at Strongsville have decreased throughout the year and ended at $55.7 million, down $8.7 million or 14% from fiscal 2010. This declining revenue trend coupled with the impact of the Siemens dual sourcing decision resulted in a significant drop in the valuation of the Ohio reporting unit when performing our year end impairment review. Accordingly, the Company recorded impairment charges of $13.2 million and $3.7 million against its goodwill and customer relationships intangible assets, respectively, related to its Ohio reporting unit. We believe that, while this non-cash charge had a negative impact on our fourth quarter and full year fiscal 2011 reported results, we are positioned to successfully grow our Medical segment as well as our other business segments well into the future.

I would like to spend some time reviewing the continuing success of our Frederick, Colorado operation which now includes the ongoing consolidation and integration of the majority of the Byers Peak operation.

We are pleased with the operational progress that has been made at the Fredrick, Colorado facility since acquiring that business from Delphi in August 2010. 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 the Colorado acquisitions are included in the consolidated operating results for fiscal 2011 from the respective dates of acquisition. On a full year pro-forma basis, the combined Colorado operations would have reported fiscal 2011 net sales of $52.4 million, gross profit of $7.0 million or 13%, and operating income of $5.5 million which includes the gain on acquisition of $2.6 million versus pro-forma fiscal 2010 net sales of $39 million, gross profit of $1.4 million or 3%, and operating loss of $1.5 million.

On a pro-forma basis, the comparable revenue for the current and prior full quarters increased to $14.2 million from $9.4 million for the quarters ended June 30, 2011 and 2010, respectively. The gross margin percent has increased from 5% for the fiscal 2010 fourth quarter to 14% for the current year fourth quarter.

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.

With the majority of the Company’s financial and operational issues behind us entering into fiscal 2011, the focus was on implementing the strategic growth plan and, to date, the results have indicated that we are succeeding in this effort.

The growth investments we’ve made are threefold – Targeted Business Development, Internal Research & Development, and Strategic Mergers & Acquisitions, all of which are supported by market research and a new marketing initiative.

Prior to fiscal 2011, Sparton only had two business development resources across the entire Company. By the end of fiscal year 2011, we increased our direct selling staff to nine employees and added ancillary support such as a market analyst, sales engineering, sales administration, and outside marketing resources. A new business development process was initiated to track and monitor all the opportunities across the company and the total and near term, higher confidence program funnels have steadily increased throughout the year.

Excluding sonobuoy sales and acquisitions, new business growth increased to 4.5% of total revenues in fiscal 2011 with 26 new customer programs, up from 2.5% in fiscal 2010, and zero in fiscal 2009. Eleven of these new programs were first-time customers to Sparton. Based on the Company’s internal budgeting process, the 26 new business programs awarded in fiscal 2011 make up 9.1% of the fiscal 2012 revenue plan and, in addition, we expect that we will continue to win new business throughout the year.

For the first time in recent history, Sparton made the decision to invest $1.1 million in internal research & development to create our own proprietary commercial products which were launched at the AUVSI Unmanned Vehicle Symposium in Washington D.C. on August 18th.

Sparton is currently the only company to provide both navigation sensors and a hydrophone for harsh environments that include extreme temperature fluctuations and high shock applications. The new gyro-enhanced digital compass, the GEDC-6, provides an industry leading degree of accuracy due to our proprietary calibration techniques and advanced sensor fusion algorithms that deliver consistently reliable headings in a wide variety of applications and environments. The new PHOD-1 hydrophone is an excellent solution for underwater applications requiring a small, rugged, omnidirectional, broadband hydrophone.

In fiscal 2011, we made two significant strategic acquisitions in our medical segment - Delphi Medical Systems located in Frederick, Colorado, and Byers Peak, located near Denver, Colorado which is being consolidated into the Frederick facility. Both acquisitions were strategic in nature as they added annual revenue of approximately $42 million with a new and diversified customer base, immediate entry into the high growth Therapeutic Device market, expansion of Sparton Medical Systems into a western geographic footprint which will enable us to serve existing and future West Coast customers more proficiently, enhanced Sparton’s business development activities with the addition of key business development leadership and personnel, and provided synergistic operational opportunities that can be leveraged across all of Sparton’s business units.

To support the business development efforts and the launch of our proprietary line of products, we initiated a rebranding strategy of the Company using various mediums in the past year. We refreshed the Company’s logo, nameplate, and developed the more meaningful tagline “Empowering your Vision.” The website was rebuilt to better inform our potential customers of who we are and what we do while also bolstering the Investor Relations portion of the website to provide you with better information. New micro-sites, such as thedigitalcompass.com, have been formed to appeal to, target, and better inform the engineering community who could find use with our products. All new selling collaterals were developed including print media and customer presentations coupled with our largest endeavor of developing a brand new 20’ x 20’ trade show booth that all of our business segments use at significantly increased number of trade show venues. All of these marketing improvements have been important as we tell the story of our transformation from who we were, to who we are, to who we are going to be.

All in all, we are very pleased with the transition from the financial and operational phase to the growth phase of the turnaround and expect that the momentum that we have started in the last year will continue well into the future.

Finally, I would like to close the presentation by providing a brief outlook on what to expect for fiscal 2012.

Despite the declines in the Ohio Medical business in fiscal 2011 and anticipated further decreases in fiscal 2012, we believe we have positioned the Company to offset these reductions with incremental revenue from our Colorado acquisitions combined with increases in volume from across the Company as our business development efforts begin to further take hold. I am encouraged by some of the new opportunities awarded in fiscal 2011, the size of our still developing new business funnel, and the $137 million of backlog as of June 30, 2011.

We will continue to selectively invest in internal research & development projects and have challenged our staff of over 100 engineers to bring forward new and innovative ideas that we could pursue commercially.

Additionally, we continue to remain acquisitive in our search for potential acquisitions that tie to our strategic growth plan.

As our Complex Systems segment continues to win new business at higher margins, we have adjusted our targeted gross margin estimate to be increased to 7-10% in fiscal 2012, up from a target of 5-8% last year.

And, while we do not expect to maintain quarterly volume levels consistent with fiscal 2011 fourth quarter, considering the unusually high amount of sonobuoy sales to the U.S. Navy, I remain optimistic that our current momentum will continue in a positive direction.

As in the past, we will be presenting at various investor and trade show conferences, meeting with our existing investors, and calling on potential new investors throughout the year. In the near term, some of the events that will be occurring in the upcoming months are a presentation and investor meetings at the B Riley Defense & Cybersecurity Investor Conference in Santa Monica on September 20th. Also the same week, we will be exhibiting our new digital compass and hydrophone at The Society of Exploration Geophysicists trade show in San Antonio and our Medical device capabilities at the MD&M Medical Device trade show in Chicago. In first week of November, we will be exhibiting at the MD&M Medical Device trade show in Minneapolis, followed by the BioMEDevice trade show in San Jose at the beginning of December. In January, we will be presenting at Sidoti’s Annual Investor Conference in New York and then the Noble Financial Capital Markets’ Eighth Annual Equity Conference in Fort Lauderdale later the same month. A number of regional investor meeting will be scheduled in the Midwest and Mid-Atlantic regions during the next quarter.

We have many initiatives in-process throughout the Company and I continue to be excited about our current position for future growth and look forward to reporting on future successes.

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

Our first question comes from line of Mark Jordan, Financial Analyst, Noble Financial. Please go ahead with your question.

Mark Jordan - Noble Financial

Good morning. Hopefully it works now. Couple of housekeeping questions; one, with the flow through of the tax benefits in the fourth quarter, are all your NOLs now fully reflected on the balance sheet or do you still have valuation reserves against anything?

Greg Slome

All of the federal NOLs are reflected on the balance sheet. We still have some Canadian NOLs and certain state NOLs that we have maintained a reserve for a little bit over $2 million.

Mark Jordan - Noble Financial

Okay. Secondly, when will the Siemens dual sourcing be fully implemented? And is there any remaining goodwill or intangibles against the Ohio operation?

Cary Wood

There are some remaining goodwill intangibles on the book and I’ll circle back on that number here. I’ll answer the rest of that question. The full timing of it is not frankly fully understood. We’re dealing with a number but not all of the programs associated with Siemens. The difference between those that they’ve included in this dual sourcing and those that they have not are in part those that will ultimately sunset over what they believe to be a time that would justify dual sourcing. And then the full impact of which should start to phase in towards the middle of our year and frankly the full impact is yet to be seen.

We have planned and modeled out what we believe to be a conservative scenario, one that has us contracting cost, one that has us reacting very aggressively and timely, but when you stack it up against what the trend has been, Siemens revenue on a year-over-year basis from ‘09 has been down year-over-year.

We’re talking about a number of programs, not all programs. I would suggest that we’re modeling somewhere in the neighborhood of a third and then we’ve had other scenarios where we’ve taken it up to half and then you combine that with what we’re seeing organically come about from our acquisition in Colorado all of which we expect going into next year will generally be neutralizing the effect of what was frankly a dilutive low margin set of revenue that came from our Colorado facility. The remaining intangible assets –

Greg Slome

As of June 30, the remaining goodwill associated with the Strongsville facility is roughly $6 million and the remaining intangible and the customer list is $700,000.

Mark Jordan - Noble Financial

Okay. Thank you. And I believe you stated that you expect the navy sonobuoy revenues to continue at that current high fourth quarter levels. Could you talk about the visibility that you have with regards to navy intentions over the next 12 months?

Cary Wood

It’s tough to give it within the next 12. We have a plan, of course, but there is some fluid movement particularly in the area of foreign sonobuoy sales. And I’ll first take the question from that vantage point.

When you take the look at that what the trending on foreign sonobuoys have been over the course of the preceding three years, it would suggest that the last 12 months have been down dramatically from what it was in fiscal 2009 and fiscal 2010. So as I suggested there is some pent-up demand for foreign sonobuoy sales. We expect that to materialize and has been expressed publicly in the past, it’s at a much better margin than domestic sonobuoys.

Now that said, we expect that within the defense sector there are likely to be some cuts. We don’t think that they’re ultimately going to affect our business segment and the products that we provide and the justification around that is it’s a niche product one of only two. You still got a fairly large number of carrier fleets out there that none of those have been cut. So I just don’t believe that at this point we’ll see cuts affect Sparton on the sonobuoy program, but I think it’s fair to plan and we have accordingly to see that flatten out.

But, what you will see going into the next 12 months is perhaps a flattening out of domestic sonobuoys, you’ll see somewhat of an increase in the foreign side. We’ve been awarded some high altitude engineering revenue. So there are as many opportunities to offset changes in the domestic production.

But, I do think in the context of the fourth quarter, which was relatively high when it comes to sonobuoy production and sales, more that had to do with say our second and third quarter shift on sales to the fourth quarter, as well as range availability in the summer months and some changes that the navy was making to the range late in the summer, early fall, which didn’t make it available to us.

So with that being the case, I think the fourth quarter on sonobuoy production and sales was somewhat of an anomaly. I think you should look at the fourth quarter - the next four quarters in fiscal 12, we’re still bullish on our product, and we’re particularly excited about what pent-up demand might come about from the foreign sonobuoy sales, which only helps with the overall gross margin mix. Hopefully, I hit on the question.

Mark Jordan - Noble Financial

Yes. Thank you very much.

Cary Wood

Sure.

Operator

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

Andrew Shapiro - Lawndale Capital Management

Yeah, hi. I have a few questions all surrounding Siemens and then I have others, but I’ll back out into the queue and please come back to us. Regarding Siemens, can you give us a little bit of insight, Cary as to what you believe as the factors that led Siemens to move to dual sourcing on two product lines and I think you’ve explained why it’s two product lines, not all of them because these other ones I guess are going to sunset. Is this a disengagement of the relationship?

Cary Wood

I’ve been in close contact regularly since the day I joined the company almost three years ago with Siemens, obviously given the very high concentration of our revenue back in fiscal ‘09 and then on lesser revenue even a higher percent of concentration in fiscal ‘10 it made sense for us to have a close and regular dialog with Siemens.

I would say that prior to what I’ll characterize as a liquidity crisis in fiscal year ‘09 and the dialog that I had with them and all of our customers frankly and so many of our suppliers, I don’t know that it was something they were well aware of. And I think that dialog in itself was a wakeup call to the vulnerability that they have given the exclusive arrangement that they had at one point with Sparton.

I’ve said in the past and I continue to maintain that revalidating and shifting product around particularly in the Medical segment is no small undertaking. It is a high risk proposition, it remains high risk proposition even with this dual sourcing initiative that’s underway but yet completed that - and I think what they took was a spot in time risk, I think they started to apply that logic across the totality of their business not just their business with us.

I think they started to look at where they felt they were most vulnerable and frankly most concerned; they dipped their toe in the water with a couple of products. The remainder of the portfolio of products, they do have a fairly extended amount of time still yet commercially, but they’re not the more near term products as the two that they’ve ultimately decided to dual source. That said, I think I am hitting on the broad strokes of what drove the decision process. I think it was at least in part by us making them aware of what kind of risk they were facing. As undertaking...

Andrew Shapiro - Lawndale Capital Management

I am sorry to interrupt, but just - so this was a Siemens, we will call it medical division companywide policy, it wasn’t one targeting Sparton per se?

Cary Wood

I think it’s a combination of both. It is true that they’ve undertaken a broader dual sourcing risk mitigation policy, that is true. I’ve met with their senior most supply chain individual who surprisingly in the last 60 days is no longer with the company. But that said, they did undertake a much broader dual sourcing risk mitigation approach and we got caught in that. But that said, I do believe that we were certainly very near to the top of the list of concerns given our liquidity crisis of ‘09 and when you go back at how much time and consideration it takes to transition, they started undertaking discussions frankly well over two years ago and that has started to materialize at this point.

There is a lot of frustrating aspects of this frankly, but a bit of the silver lining if you will is that this is a dilutive much lower margin set of business that has up to now been a nice annuity, if you will, and a large percentage of our Strongsville’s revenues and overall company revenue. It’s one of those things that had we had this discussion two years ago would have been devastating, but at this point we’re frankly a bit optimistic around what this can mean for us, given, the remainder of the business, the opportunity -- the Fredrick new business opportunities they are going to provide for us will be shifting some volume and back filling into Strongsville and momentum of business development front. And by the time you get ready, you consolidate all of that which is going on in our medical business and then you take a look at the momentum within complex and even within DSS, I think you stand back and you essentially feel a whole lot less concerned around what this might in isolation mean, but in the broader context, this will ultimately be a better end result.

Andrew Shapiro - Lawndale Capital Management

So, a few clarifying questions around this. So they are dual sourcing everything they do with us that isn’t on its own kind of sunset position as the product line, is that right?

Cary Wood

That’s a fair observation, correct.

Andrew Shapiro - Lawndale Capital Management

Okay. And I think you answered or you had in your script you talked about - you answered a question or you said in your script about the timing. So dual sourcing didn’t begin or have any impact on Q4 numbers, right?

Cary Wood

I think at this point it’s fair to say there were no impact on Q4 numbers, correct.

Andrew Shapiro - Lawndale Capital Management

Okay. And so what is the expected timing of the reduced sales and the reduced gross profit dollar levels? Does it ramp down or it is straight line and beginning when?

Cary Wood

We’ve had conversation around that. I think that the dialog has been first to listen to Siemens plan and then to start to put some of our own planning around that. I think we’ve tried to be a little more aggressive in what the impact might ultimately look like for us. I think we’re planning around a ramping down with the beginning or the end of our second quarter and a lot of that has to do with Siemens frankly, but we’ve planned conservatively into our second quarter by the end of our calendar year. We’ve started to move very aggressively already to extract and eradicate cost that might otherwise weigh down the impact of this revenue change. But I can say that we’re confident maintaining the consolidated medical guidance as we have had up to now, and our view is that we’re extracting cost out very, very quickly. We are backfilling with business out of Frederick, we are winning new business that’s backfilling that which we’re shifting out of Frederick. The new business development as well as the backlog is significantly larger from the same time last year up from $14 million to $42 million, so we feel like there is good momentum there.

And I think by the time we get done looking at this, this is going to be a Sparton time, and I think the consolidated performance will frankly be no different. The revenue could essentially end up flat over the course of the year, but I think there is a whole lot of X factors that still yet need to play out before I can give a lot of guidance on what the revenue end state will look like. But to get to the question, I think by the time you get to the end of our second quarter we will start to see some ramp down on this. It is only two of our total program volume, and I think generally when you look at what the annualized impact was, we are trying to plan around a third of the total volume being impacted by this over the course of the year next year.

Andrew Shapiro - Lawndale Capital Management

A third of the total volume on those product lines, or a third of the total Siemens volume, or a third of total Strongsville volume, what do you mean by a third?

Cary Wood

A third of the total Siemens volume last year.

Andrew Shapiro - Lawndale Capital Management

Of total Siemens, and not a third of the $27 million.

Cary Wood

Correct.

Andrew Shapiro - Lawndale Capital Management

Okay. Now within the largest customer I think you’ve already implied and you said the margins that the are lower, so you have broken out the Strongsville gross margins at around 12.2, so is it fair to assume that the Siemens gross margins are lower than that?

Cary Wood

We don’t typically get into the gross margins of specific products and customer lines, that’s certainly something we’ve long established for now. But I can say that it has typically been dilutive and it’s a fact, on the overall consolidated medical as well as within Strongsville. So I - yeah.

Andrew Shapiro - Lawndale Capital Management

Okay. So within Strongsville then it’s less than 12.2 and we don’t need to have any more detail, I just wanted to get a feel for that. So if I am using - if I am modeling 12.2 against some sales decline, I know I’m being conservative. Does your contract with Siemens have any volume discount clauses that provides Sparton any pricing or gross margin percentage relief as the volume on these products are partially shifted away?

Cary Wood

It doesn’t, but it also doesn’t preclude us from having those discussions and we’re certainly anxious to get into that. It’s always a little bit dicey to talk to in depth about subject matters like this in a public forum, but I think generally this management team is well aware of what this could mean to us in the way of opportunity and we’re taking advantage of those. I think we are no different than the balance of the supply base which is frankly now shipping to two different suppliers, having to deal with two different sets of administrative details. I think it’s going to bring about a degree of cost, it’s essentially a purchase insurance policy by Siemens, I guess, I can understand why they would have undertaken this initiative given the circumstances we were in two years ago.

It’s a bit frustrating given the supply chain that we’ve provided today, our turnaround time, our level of quality even the pricing arrangement. But that said I think the remaining portfolio of business we have with Siemens we are anxious to keep, but at the same time we recognize the opportunity that it provides for us and the balance of the supply chain to address it.

Andrew Shapiro - Lawndale Capital Management

All right. Last two on the Siemens and I’ll back out into the queue. Can you help quantify or provide some metrics to help us determine in the Strongsville operating cost figures provided in your financial disclosure already, kind of what is variable and would automatically drop with any Siemens sales drop and what is kind of fixed that requires managerial cost reduction measures to right size this operation?

Cary Wood

We’ve been through that analysis. It’s awful hard for me to sit here and rattle off the numbers to you that quickly, but –

Greg Slome

And Andrew it’s really kind of a work in process at this point. I mean we’re going to go through and trying to dissect what this means from a cost structure standpoint on a go forward basis. I would say overall our overhead split, I would probably put at about 60% fixed, 40% variable related to the Strongsville facility. But, once again, we’re looking at everything and trying to identify what this means going forward.

Andrew Shapiro - Lawndale Capital Management

Okay. And then what would be the timing for you to determine that new business is refilling the fixed overhead cost hole being created by the Siemens reduction at 60% let’s say fixed and can you discussed the - I think you discussed the prospects and visibility of new business going in there, but kind of what’s the timing for you to determine things and then I guess making cuts. It sounds like you got about through the December quarter at least 2, 3, 4 months or whatever to do things.

Cary Wood

Right, I mean simply you’re asking how quickly are we going to be backfill that hole, and I can appreciate from where it’s coming. We generally established a line of sight on our business plan for fiscal 2012 knowing that this was part of our plan. We’ve established a good amount of confidence around new business opportunities not just for Frederick but Strongsville as well. We’ve seen an uptick in a number of opportunities specifically impacting Strongsville. We’ve seen some reference from customers about optics and devices that will cascade down and ultimately affect us in a positive way. It’s hard for me to sit here today and say that in six months, we’ll see a slow gradual downtick of a third of the Siemens’ revenue that will ultimately be back filled on a dollar-for-dollar basis by the time we get to the end of the year.

But I can tell you, having looked at the fiscal 2012 fiscal plan, I’m confident about how it looks from the standpoint of the top line, I’m confident about how it looks from the standpoint of the bottom line, and we continue to feel real good about the progress that we’re going to provide, given the end of fiscal ‘12 compared to the current fiscal year end ‘11.

Andrew Shapiro - Lawndale Capital Management

And lastly on Siemens, I’ll go back in the queue, is, the relationship with them is such that once they migrate product line into this insurance policy, the second sourcing, is the relationship such that as their products - new products come out or their products grow, we’ll get our 50% or whatever percent share of that growth?

Cary Wood

I think it’s fair to suggest that we’re just as engaged today as a partner with this other supply chain, no differently. So we’re not going to be impeded from opportunities on that which has been dual sourced. And I would add to that, I think, we’re more involved today particularly in the engineering resources than what we have been with Siemens. I think that for whatever period of time or whatever reason for a period of time, we weren’t nearly as involved in Siemens forward-looking as what I believe we are today. I spend a good amount of time there.

My senior staff has spent some time there. I spent some time there with them. I think our local people on the ground in Strongsville, our expanded business developments, our new leadership on the medical side, all of which has been very actively engaged with Siemens about new opportunities and frankly even helping with this dual sourcing.

It’s a battle that’s already train [ph] to fill up the stations. So it’s to our advantage to help with this transition as quickly and seamlessly as possible. It leaves open the opportunity to discuss the remaining portfolio of business. It opens up the opportunity for new development and engineering support on new products that we might ultimately produce for them. So I think long answer to your question, we’re very, very involved with Siemens on all fronts on this thing.

Andrew Shapiro - Lawndale Capital Management

Okay. I’ll get back in the queue. I do have other questions on other segments, but thank you for this Siemens detail.

Cary Wood

Very good.

Operator

Our next question comes from the line of Jimmy Baker, analyst with B. Riley & Company. Please go ahead with your question.

Jimmy Baker - B. Riley & Company

Hi. Good morning, guys.

Cary Wood

Hi, Jimmy.

Jimmy Baker - B. Riley & Company

I think you pretty well answered all my questions on the Siemens business, but I did want to touch on a couple of the other segments. Maybe first the Complex Systems business, which I guess thanks to the strength in your other businesses it’s becoming a little bit less relevant, but it did deliver another quarter with double digit gross margins there. As you kind of gauge visibility into your fiscal year ‘12, are you confident you could maintain or even expand those gross margins? And I’m also interested to learn what would the gross margin be for that business excluding intra company sales?

Cary Wood

All good number of questions. A, I continue to be real bullish on where this business can go. I’ve said that long before now. It’s always been a dicey thing to express too much confidence until we produce. I’m not going to declare the battle over the Complex Systems performance over. I think that there are going to be quarters where the volume is somewhat different than other periods and it’s obviously going to have its effects on the sensitivity on margins.

The internal sales is kind of a pass through from our DSS, and I think that the results of the fourth quarter’s growth margin reflect not just the internal sales but a good number of things. They essentially reflect the internal cost attraction and productivity, the purging of some of the undesirable customer lines at prices that we frankly don’t see as acceptable, changes in pricing with some of our current and continuing customers, new business particularly in the prototyping arrangement and all of those things combined have certainly had its effect.

We’re excited about the new opportunities that seem to be coming our way in our new business funnel. The backlog in that segment is essentially neutral compared to the same time last year, but it’s a much shorter selling cycle as well, so new business opportunities can come on much faster and it is a segment that I continue to be fairly bullish around. We’ve said in the past that it will be a double-digit gross margin performing business segment for us or it just simply won’t be a part of our portfolio moving forward in the way we see it now. And there is a lot of options there that we’ve discussed. We’ve looked internally at further consolidations, we’ve looked at forging out significant customers that just didn’t fit as we looked forward.

None of these types of actions we’ve had undertaken, frankly I have been pleased with what we’ve been able to execute and the resulting margins as you talked about. I continue to look forward going into next year having revised upwardly our guidance and I think that we’ll fit well within that. Now that said, there are going to be quarters that are going to ebb and flow, it’s highly volume sensitive. We’re quoting and continue to be get engaged with opportunities that are not inconsequential from the standpoint of revenue size but as we’ve expressed strategically we’re more interested in the lower volume which typically translate into more complex with more - with much stronger margins. That doesn’t mean that we turn our nose up to larger volume opportunities. We just recognized that that’s a double edged sword and we’re certainly walking through those options very carefully. So that said, I continue to be highly optimistic around the future anticipated results of our Complex System segment.

To the specific question about how you break down those sales, we don’t typically express that openly, but I would say that a good amount of our revenue continues to be internal. But the internal implication from a margin perspective frankly haven’t strengthened a whole lot since the second quarter of this year and - but have dramatically improved on the external related gross margin sales. And essentially, the margins from the internal sales are passed through and relatively similar in nature to what we get out of our DSS segment.

Jimmy Baker - B. Riley & Company

Okay. That’s helpful. And I’m just wondering how we should think about kind of your working capital needs playing out here in fiscal 2012 and may be your ability to generate more meaningful cash flow. I think you’ve talked about in the past, potentially turning inventory little quicker. Do you still see that as an achievable opportunity in the near-term or kind of where we at in that process?

Cary Wood

Yeah, that’s exactly where the opportunity lies I mean is in the inventory arena. It came down slightly towards the end of our year, but nowhere near where we believe the opportunity can be over the course of the next 12 months. We have aligned a good number of the business unit managers, their supporting staff and some of the executives reporting on my staff this year around a reduction in working capital in a meaningful way.

We have a stretched target, which is very ambitious and we have a fundamental expectation around introduction, which we believe is reasonably achievable. Without expressing that I don’t think it’s inconsequential in nature. I think when we acquired the Fredrick facility, we expressed the opportunity to reduce working capital.

Now, that’s said, the increased revenue of this company, the ramp up of new opportunities and the funding of our backlog is also, we’re going to have some offsetting effect with working capital. I do think as we look ahead, we’re optimistic that more cash will drop to naught. And I think it’s going to be a precarious balance between pulling a lot of inventory, managing our payables, receivables and adequately ramping up business.

I think in the near-term, we could see our inventory slightly increase, but for all the right reasons. It’s a question of how quickly and the velocity by which we turn it and that’s going to be the precarious nature of the next several quarters and how we might yield cash out of that by the end of the year.

Jimmy Baker - B. Riley & Company

And will the Siemens business have a meaningful impact on that? Is that a relatively inventory intensive program that you are on there or how should we think about that back half?

Cary Wood

I think that’s a fairly anemic impact. It’s not a heavy inventory opportunity for us moving forward. So it’s hard to suggest that there’s a meaningful reduction in inventory and there by cash as a result of that transition [ph].

Jimmy Baker - B. Riley & Company

Okay. Also interested to hear you talk a little bit more about your acquisition pipeline. I know you’ve been very active in your search. And I mean, I suppose it’s encouraging, you haven’t forced the issue and overpaid. But would you say you’re a little surprised that we’re nearing the end of Q1 here and you haven’t announced the deals since Byers Peak back in February and March.

Cary Wood

Jimmy, I’ll take that as a bit of a backhanded compliment. I appreciate that it would have been nice for us to have announced something by the end of the quarter, but I think your former statement is exactly right. We’ve said in the past, we’re going to be very careful and diligent about how we assess opportunities and we’re going to stay true to our strategy. There are no shortage of opportunities out there. We’ve looked at well over 100 opportunities. We have focused on dozens and I have personally met with and taken a deeper dive and continue to build relationship with no small numbers as well.

We continue to push that pipeline of opportunities and we’re going to bring some things to ahead I’d like to think over the course of this year. I’m not surprised that we haven’t announced an acquisition already, but I can tell you that we have shifted away from looking at $5 million and $10 million revenue types of acquisition to what we believe are a little more meaningful from the standpoints of revenue size 25, 50, some are even well above that which obviously makes the scrutiny challenge a bit different.

So with that said, I think we continue to be optimistic about our prospects on the M&A front. We continue to sit with a lot of dry powder on the balance sheet. I think we’ve got a nice clean leverage standpoint where if we needed to take on debt we could.

I think we continually assess our cash circumstances and a blend of opportunities to our shareholders which is what ultimately led us to a stock buyback which is frankly to be pointed was not a waving of the white flag on the M&A which is simply for now we’ve got an opportunity to deploy our cash better than what our internal rate of return is on our average cost of capital and I think we ought to do it. It’s anti-dilutive in terms of anything we might see on the stock outstanding shares and I think the opportunities that bring about new acquisitions still remain fairly good. And I think over the course of this year, I think we’ll see some more activity around that front.

Jimmy Baker - B. Riley & Company

Thanks for the color there. The larger potential targets that you’re looking at these $25 million to $50 plus million targets, revenue targets, are they focused on any specific end markets or kind of vary across the board?

Cary Wood

You know, Jimmy, they vary across all of the segments. The Complex segment is one that obviously we feel we’ve kind of put through its paces and frankly a bit of transformation from being low end EMS circuit card exclusive to now including more value-add, and I think a nice M&A tuck-in would only further advance that kind of strategic transformation of that business segment. So we’ve been looking pretty hard at opportunities in the industrials that fit well within the description of low volume, complex, nice end markets that bring with it the better margins and we certainly have been active in those spaces.

We’ve spent a good amount of time looking at medical segments as well and we’ve made two acquisitions there, it does not discourage us from continuing to look at those opportunities. So we see a good number there. And in the defense segments, we continue to keep our eyes open, but I think we’ve been a bit reluctant given what the broader defense space dynamics could be. I think in the right spaces in the defense and cyber security segment, you’re going to do very, very well. I believe we sit in that niche spot.

I think if we could find tangentially related acquisitions that further extends our space, our presence, our niche, that’s a good thing and - but that’s been a little bit tougher to come by. So a bit of a convoluted answer, but I think generally to simplify we’ve been looking at a lot of Complex segment opportunities very aggressively given our strategy, given our opportunities. We continue to look at medical no different than we had and I think we have been a little more passive on defense side for a variety of reasons.

Jimmy Baker - B. Riley & Company

Okay. That’s it from me. Thanks, Cary.

Cary Wood

Thanks, Jimmy.

Operator

Our next question comes from the line of John Curti, analyst with Singular Research. Please proceed with your question.

John Curti - Singular Research

Good morning.

Cary Wood

Hello, John.

John Curti - Singular Research

You mentioned that you did about $1.1 million in R&D expense for fiscal ‘11. How much do you anticipate for fiscal ‘12?

Cary Wood

We’ve planned similarly for fiscal ‘12 as we did ‘11 at roughly a $1.5 million on the R&D front, but what we end up doing over the course of the year as we did with the ‘11, where we ended up at 1.1 million against a plan of about $1.5 million. We take into consideration how things are unfolding, what the relative end market dynamics might mean and where we need to make changes along the way, we’ve canceled an R&D program from within. We will do those types of things. But as it sits today, we continue to anticipate and plan well in excess of a $1 million up to $1.5 million and we will make adjustments on the fly where we need to.

John Curti - Singular Research

Okay. And capital spending for fiscal ‘12?

Cary Wood

CapEx, as I’ve said and expressed openly before has typically been about a point or point and a half generally our guidance. There are times and I think fiscal year ‘12 is one of those times compared to ‘11 where it was about a point and half and a year before that it was slightly less. Where we have to go back and expend capital on well over due initiatives whether it be productivity or buildings and equipment, but in this case moving forward it’s more around the ERP transformation that we publicly talked about. We are going to break that down and straddle out over the course of the next fiscal year and started with significant expenditure on the ERP front this year. And so I would give guidance around about a point and half going into next year as well.

John Curti - Singular Research

Okay. And then with respect to DSS, the compass and hydrophone business is incorporated within that, that’s a small up and coming business. How much of a negative impact on DSS was reported results in terms of the operating profit line and will that in time become its own separate reporting unit once you reach the thresholds that you [ph] require?

Cary Wood

It could and we’re certainly anxious to see that kind of momentum materialize. At this point when you look back at fiscal year ‘10 where our compass sales hardly eclipsed a million dollars and then in fiscal year ‘11 we are closing out with a very strong year at well over $3 million in compass related sales and as we said before given its our own IP, it’s one of the highest performing gross margin components of our portfolio. We’ve enhanced the compass beyond where it existed today. I think you got to recognize that it’s a highly engineered solution. It takes some time to spec in and ramp up.

We anticipate revenue in the fiscal year ‘12 similarly as we’ve seen in ‘11. But as we see things start to materialize given the shows and given our presence and involvement in prospecting of the engineering disciplines across a variety of companies that could change, our outlook remains about the same for ‘12 as it was for ‘11. But I think what you’ll see in the outer years is a bit of a winding down of the old compass if you will, a trading out for the new digitally enhanced, Gyro enhanced compass. And we would like to think and have frankly justified the spend on increased revenue in the out years beyond the fiscal year ‘12, ‘13, well into ‘14 and ‘15.

So we have a line of sight on what the outlook could be, I mean this is an end use market that’s well in excess of $300 million it’s predominantly associated with an unmanned vehicle space, the unmanned vehicle space is a show that we were strongly present at Washington in late August.

We were well received, a good number of interviews and a press conference and I think the activities and the prospecting around it leads us to believe that we’ve got good opportunity here. In the M space, the unmanned vehicle space, whether it’s under water, land, or air is certainly one that I think you will see but no cuts when it comes to defense discussion. I think that those are arenas that allow for the reduction in troop casualties and I think that we’ve got a nice piece of engineered solutions that ultimately help to provide that M [ph] space.

John Curti - Singular Research

Okay. Thank you very much.

Cary Wood

Sure.

Operator

Our next question comes from the line of Jonathan Haynes, Private Investor. Please go ahead.

Jonathan Haynes - Private Investor

The last two guys got everything I needed. Thanks.

Cary Wood

Sure.

Operator

Our next question comes from the line of Andrew Shapiro, President, Lawndale Capital Management. Please go ahead, sir.

Andrew Shapiro - Lawndale Capital Management

A few follow-up questions; on the EMS, how are the margins on the sales for the segment data determined for the intercompany sales?

Cary Wood

Yeah. As Cary alluded to before, Andrew, our policy really from a pricing standpoint is really to pass on the bid margin that we get within the navy contracts, pass it on down through to the Complex Systems segment. So you could kind of assume that all the intercompany sales bear a similar margin within Complex Systems to what the bid margin is within DSS.

Andrew Shapiro - Lawndale Capital Management

Okay. So I hear you about that. So that would enhance the segment margins a bit.

Cary Wood

Right, sure.

Andrew Shapiro - Lawndale Capital Management

Now previously all the intersegment sales were for DSF. In the last conference call, you guys mentioned about with the Delphi and Byers Peak acquisition that there might be some migration in the mix for some intercompany or intersegment work to be done in Florida or move to Florida from Colorado. Has some of that occurred or are there expectations for that to occur and then how would margins work for those kind of sales?

Cary Wood

And I would further expand that statement to include migration into our Strongsville facility, and I would say that at this point none of that has materialized. That’s all upside opportunity. I would say that there is a good number of dialog going on about what those might look like. As an example, we’ve acquired a customer with Frederick. They certainly appreciated the vast amount of processing capability that we had to bring to bear. They have no manufacturing assets, which is clearly an advantage to us.

They have a proliferated supply base and they are very pleased with not just the service but the engineering support that they’ve come to seek with us. And we’ve entertained them both domestically as well as currently in Asia; if that hasn’t already taken place, it will by the end of this month and that I think ultimately serves up more opportunity for internalizing what’s currently outsourced business with a customer that we’ve come to expand with.

I think, the internal electronics opportunities within Frederick is yet to be materialized, but I think there’s a bit of a caution there. There are some suppliers or some end customers that have just undergone a significant change in management and a change in direction and accelerated aged [ph] backlog, and all those types of things that has their head frankly spinning a bit, and I think for us to take pause and what we might further internalize, we’ve decided to do, and then the transitioning of business out of Frederick into Strongsville by example is another one of those opportunities that we have to internally maximize assets and the in-sourcing of other electronics which is well underway. In some cases, it’s already been decided, will materialize, in other cases it’s yet to be decided and ultimately could materialize and then there are those that we are just now discussing about expanded opportunities with customers that are currently sourced elsewhere that I think we can better supply. So there is a lot going on in that area.

Andrew Shapiro - Lawndale Capital Management

Okay, on the medical side, what’s the status of the acquisition escrow and the Delphi baseline excess inventory, is that measurement I think comes up in about six months?

Greg Slome

Right. And as part of the year end close we went through and there was a real detailed review on that and if you notice that the gain on acquisition that we originally recorded for Delphi increased by 150,000 and it was really related to that evaluation. So we tracked it quarterly, we still have a reserve that is on the books at June 30 related to what we potentially may need to cover that.

If you recall in the agreement, the first 1.2 million of any leftover inventory is only reimbursed at 50% by Delphi, so we’d be on the hook for another [ph] 50. So we believe we are adequately reserved for anything that might be leftover, but the inventory is continually getting worked down and we track it on a quarterly basis. So it will be six months from now, won’t get to the end of 18 months, we’ll go through into a final calculation and then go from there.

Andrew Shapiro - Lawndale Capital Management

Okay, also here on Medical. You have got Byers Peak now I guess consolidated into Frederick, it’s been greater than 100 days, you accomplished your 100 day plan et cetera. What I wanted to get a feel for are, are there still additional consolidation opportunities of Byers Peak into Delphi and into Frederick and on this acquisition that have margin enhancing features here for the current quarter we’re in September and even maybe for December.

Cary Wood

We’ve executed against the 100-day plan as we expected. There were certain assumptions on the acquisition of Byers Peak that have since now provided additional opportunities the best way to put it. There were certain customer assumptions that we didn’t assume on the forward look that have now presented themselves as an opportunity. And in doing that and being able to capitalize on that, we’ve exhausted the 100-day actions, but we’ve had to extend the time by which we might ultimately shift over a customer to which will take us well into the middle of our second quarter.

So a bit of a convoluted answer, but what that says is - what that’s mean to say is that we’ve executed 100-day plan as we expected. We started to see some beginnings of those effects. We had a handful of customers that frankly wouldn’t expect would go for the move, and we didn’t include them our forward look model. They have now since decided that we believe and we’re transitioning forward as if this is also going to happen that we’re not so bad place to be and they’re going to transition with us to Frederick, but that’s going to take a little bit of an additional couple of months and we’re in the midst of doing that. Now we’ve negotiated well essentially an opportunity to stay at Byers without any cost to us, but I think the fully realized consolidation is yet to be done, and I think frankly we won’t see that fully materialize until the middle to the end of our second quarter.

Andrew Shapiro - Lawndale Capital Management

Okay. And then moving on to the DSS fill up questions that I had, the - can you discuss the size of the market for the new navigation and exploration products that these products are addressing and what size do you think this business could become to?

Cary Wood

I don’t - I would be cautious to speculate as to what the end space could look like for us. We’ve taken a fairly conservative step and dipped our toe into water and we believe a good end market. It’s an unmanned space, unmanned vehicle space. It’s one that has been essentially mandated by the DoD and it’s going to be enabled by complex engineered solutions. We’ve got a couple nice opportunities that we’ve ourselves into those end use spaces with some of our solutions and we believe we will stand up in that arena.

Now that said, I think the way we’ve looked at it is that by the end of I believe 2013, 2014, it’s a $300 million end-use space for our types of products and I think we’re comfortable that that’s going to present good opportunity for us. So about 300 or so is associated with our digital enhanced compass and about a 100 or so is associated with our hydrophone. So combined $400 million end space by around the 2013 timeframe and we planned accordingly. We’d like to think that that’s going to translate into increased revenue in a small way but as we look forward I think it’s going to provide for us good opportunities and when it comes time we will segment that out, we’ll report it as standalone when it make sense.

Andrew Shapiro - Lawndale Capital Management

Okay. And then on the sonobuoy side, we heard a webcast of your presentation at an investor conference a week, week and a half ago and someone had questions or had some concerns with the defense budget and you provided an answer that went in and out, was not all that audible. So with respect to that I’m going to ask, can you share your view as to why Sparton’s products and the sonobuoy mission are not likely to be subject to a high risk in the diminished defense budgets and...

Cary Wood

Absolutely.

Andrew Shapiro - Lawndale Capital Management

...and in what way proposed cuts will affect us?

Cary Wood

Yeah. No actually, I think - firstly, I’ve been asked why I expect defense cuts and what type of impact that will have on Sparton. I think I answered very quickly. I expect there to be cuts in defense. I don’t expect that they’re going to come in the very near term, but they could come over the course of the next 12 to 18 months. And when you start to talk about that in its specific involvement with Sparton, I think you got to stand back and look at our products and understand it.

First of all, we’re a very niche product. We support the coverage in the defense for very highly exposed carrier fleets that are making their way in and out of ports and in open water. We’re one of only two providers of this product. We are frankly one of the only solutions that allows the U.S. Navy to listen, communicate, and find and track open water subs and that’s the solution that’s been highly depended upon for a great deal of time. And not only has it been depended upon at the previous iteration, we’re now starting to transition into a higher altitude deployed solutions. So up to now it has been a P-3 prop aircraft, lower altitude deployed solution for anti-submarine warfare, a significant or complex underwater listening, locating, communicating device.

When you talk about the total expenditure, which has hardly been $150 million to $200 million total with engineering revenue as well as production revenue, that has stayed while it’s uptick in the last few years predominately driven by inventory needs, I think as we look forward, you’re going to start to see that maybe slowly diminish on the older iteration of sonobuoy.

You’re going to start to see the layering in of new engineering revenue as you saw on our most - more recent announcement on a $9 million, roughly $9 million engineering award, and you’re going to start to see that dial up to support the transition to a roughly 2015 high altitude solution, and I think you should get into the outer years of 2014, 2015, you’re going to start to see the overlay of the traditional sonobuoys that we produce and provide today, the engineering revenue to support the ramp of the high altitude and in the beginnings and the placement of orders on the high altitude solution. So I think you’re going to see both in this space for a while.

And then what you’re going to ultimately see over the course of a longer period of time, 2016 and beyond, is a much higher average selling price given the complexity, the bells and whistles on the high altitude solution.

So, in general, I think defense budget should be expected - defense budget cut should be expected. I think their implications on Sparton are going to be neutral if anything. I think as we look ahead to 2015 with a high altitude solution coming on, I think that that spells opportunities for us, but we are frankly planning more conservatively, but I think it’s intuitive to expect that there’s going to be the older sonobuoys, there’s going to be engineering related revenue, and then ultimately there’s going to be the layering in of some ramp up of inventory on the high altitude side, and that’s probably getting out in the 2014, 2015 scenario, but we’re 2012 today. So, that generally gives some broad strokes of our outlook on the space and our specific involvement in it.

Andrew Shapiro - Lawndale Capital Management

Right. Now the SSQ-125, that’s the R&D program and then you have this high altitude. When there are engineering contracts, those are cost plus, right?

Cary Wood

Correct.

Andrew Shapiro - Lawndale Capital Management

Cost plus, and then you move into the fixed price deals. And can you also discuss the status and the milestones on the research project or contracts you’ve had in the budget plans of the navy publish for what’s called communications at speed and depth that’s the CSD program.

Cary Wood

At this point I really can’t. I think that it has been stalled. I think it’s on hold. I’m cautious to say that it has been scratched but at this point I would say that it’s essentially not in our near-term guidance.

Andrew Shapiro - Lawndale Capital Management

Okay. And then on the backlog, do you have any feel or can you discuss apples-to-apples if it’s available on like what Delphi and Byers Peak’s backlog is now versus what it was under prior ownership?

Cary Wood

The current total backlog has been disclosed. It’s just short of $140 million. I mean, it’s the sixth straight increase quarter on backlog. A good amount of that’s obviously driven by our medical segment. When I compare the fourth quarter 2011 combined medical segment to the fourth quarter of fiscal year 10, it’s dramatically different. It’s $42 million today compared to $14 million which was exclusively attributable to Strongsville back in June of 2010.

That said, you got to break them down not just into two but to three pieces, which is Strongsville and Colorado and then Byers Peak. And I would say that of the $42 million, it is very, very strong on Colorado, but frankly it’s somewhat stronger as it sits today out of Strongsville but we see strengthening out of either legacy and or new opportunities materializing from Byers Peak.

So I think each one of them are starting to strengthen to contribute to the sum $42 million, and I think as it sits today Strongsville is the leading horse in terms of booked backlog, but it’s in line with what we’ve seen over the last two quarters. I don’t think it suggests a whole lot particularly in the context of last few quarters. But if you compare it to the same fourth quarter of last year, it’s up fairly dramatic, which is - which was at about $14 million and it sits close to $20 million today. So that’s the reason obviously [ph].

Andrew Shapiro - Lawndale Capital Management

Now, well, I expect a number to not be meaningful with respect to DSS with the Navy being constantly the prime customer, but with respect to medical and Complex Systems backlog, there is shifting. Can you generalize what kind of percent of the current backlog of these segments or each segment is from new customers or new business that was not in Sparton a year ago?

Cary Wood

It’s awful hard to quantify. What I will do is - and we’re starting to peel those numbers so that they are meaningful to us. I would say and as I mentioned in the script, I think that given the fact that we’ve taken on some 26 new opportunities, only about 4% of which materialized into new revenue last year. And at that time it was far less than 26 at that time I think it was 16, I believe.14 or 16. That’s now materialized to 26 new engagements, many of which were brand new customers we’ve never done work within the past. The forward look on that is about 10%. So if you wanted a simple extrapolation, I guess you could say that 4% of the total revenue. I mean there’s a way to get there from here, but it’s a pro-rata, but I can’t go much beyond giving you what the forward guidance is on revenue right now, Andrew.

Andrew Shapiro - Lawndale Capital Management

In terms of the forward guidance, you had gross margin guidance for each segment of this last year for fiscal year 2011. You’ve mentioned here of the call that for 2012 you’re increasing for the Complex Systems area by about 10% in the low and in the high end for that segment? Are you holding the gross margin guidance for the other two segments the same including medical, even in light of the Siemens’ dual sourcing?

Cary Wood

I am. I’m highly confident of that. The guidance I’ve given on the DSS segment will be somewhat skewed [ph] by perhaps flat to some negligible softening on the domestic side, layered in with some engineering revenue on a cost plus basis and then some opportunity. We believe with pent up demand on foreign sales at much higher margins and the sum of that effect will have us highly confident that we’ll stay well within the guidance margins we’ve given and performed within in the past. So, that’s DSS.

From the Medical segment, while we’ve talked about the Siemens piece, we probably can’t spend enough time and the expanded information on new business opportunities, the internalizing of some level of electronics, the new business opportunities for supply chain to shift to us. I think, there is so much to talk about there and I’m confident of what that’s going to ultimately materialize and looking like that I continue to be highly confident and we will maintain the guidance on those margin bands.

And as we look at the Complex, I think I’ve talked a little bit about it. I think that we’ll see some quarters ebb and flow. I certainly don’t expect the strength of our fourth quarter to repeat in the same way as our first. But I wouldn’t suggest that that’s going to back pedal so significantly that it’ll look like we’re marking step backwards. I think we’ve seen some anomaly aspects of our fourth quarter, but as we look into our first quarter and we continue to make changes in our Complex as well as the other two, I continue to be highly confident that - and particularly in the Complex segment that dialing it up a bit is the right thing to do.

Andrew Shapiro - Lawndale Capital Management

Okay. And lastly it was nice to see you’ve share buyback authorized recently. Have you and the Board also considered or will you consider a small conservative dividend that might open your greatly improved business prospects to a whole new class of potential investors who are restricted to investing only in income generating securities.

Cary Wood

I’ll answer that more in the context of the options by which we might deploy the cash, we looked at all options. We looked at investing in short term U.S. treasuries, we looked at dividend, we looked at a buyback, we looked at M&A, we looked at doing nothing. And we assessed it quantitatively and thoroughly. As the management team we also made a recommendation to the board, fleshed that out, and vetted the questions and ultimately came to a recommendation as we recently released and that’s in the form of $3 million buyback over the course of next two years.

Mechanically we haven’t fully executed the start of that, we expect it to initiate sooner than later, we’ll ultimately want to initiate that on a more systematic basis. But that said, we did assess all the pros and cons and the various options. While the dividends could open this up to a great many more funds, the number is frankly anemic compared to those that are non dividend investing micro cap organizations.

We assessed it very, very thoroughly, we looked at the class of stocks in our arena and a very small number provide dividends. And frankly as we’ve said and we want to yet affirm today, we think that a buyback provision was kind of an enhancing step towards the utilization of our cash and its deployment. But we still believe that our number one and top priority is M&A. And with that being the case we wanted to continue to conserve our cash for that use.

We don’t expect to do that in any small way without giving too strong a guidance I think that we want to, we think we’ve earned the opportunity given the two acquisitions and how quickly they were accretive and that we’ve proven not just forward to the public, that this company is no longer in turnaround mode from an operational perspective, and that with a clean balance sheet and a good amount of cash and a line credit and some very interested supporting lenders, I think we’ve got the opportunity to do something in no inconsequential way.

So with that said we wanted to defer our discussion around the dividends, having well understood all the pros and cons.

Andrew Shapiro - Lawndale Capital Management

Great, all right. Well thank you for considering it and deliberating that.

Cary Wood

Sure, thanks, Andrew.

Andrew Shapiro - Lawndale Capital Management

I’ll back out.

Cary Wood

All right.

Michael Osborne

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

Operator

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

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Sparton Corporation's CEO Discusses F4Q 2011 Results - Earnings Call Transcript
This Transcript
All Transcripts