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Sparton Corporation (NYSE:SPA)

FY1Q2013 Earnings Call

November 7, 2012 11:00 AM ET

Executives

Cary Wood – President & CEO

Michael Osborne – SVP, Business Development

Gregory Slome – CFO

Steve Korwin – SVP, Quality & Engineering

Analysts

Steve Shaw – Sidoti

Jimmy Baker – B. Riley & Company

Kevin Casey – Casey Capital

Andrew Shapiro – Lawndale Capital Management

Ross Taylor – Somerset Capital

Jimmy Baker – B. Riley & Company

Michael Osborne

Thank you operator. Good morning and thank you for participating in Sparton’s fiscal 2013 first 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 2013 first quarter financial results, provide an update on the status of our liquidity and capital resources, provide an overview on the planned acquisition of Onyx, and provide a brief update on the remainder of fiscal 2013. 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 ET.

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

Cary Wood

Thanks Mike. Good morning and welcome to our fiscal 2013 first quarter call.

Today, we will begin by reviewing our first quarter performance highlights:

We were awarded 14 new business programs during the quarter with estimated future annualized revenue of $13.4 million. Quarter end sales backlog of approximately $156.1 million was a 6% increase over the previous quarter and a 7% increase over a year ago. The Medical business continued sales growth of 2.2% and gross profit percentage improvement to 14.9% as compared to 13.2% in the prior year quarter. The Company’s revolving credit facility was amended and extended in July 2012.

I would now like to review our first quarter consolidated performance.

Fiscal 2013 first quarter operating income was $1.3 million and net income was $953,000 or $0.09 per share, versus operating income of $2.4 million and net income of $1.5 million or $0.15 per share, for the first quarter of fiscal 2012.

Our consolidated first quarter revenue was $49.0 million, decreasing 5% or $2.8 million from the same period in the prior year. This decrease is mainly due to the timing of U.S. Navy lot deliveries from our DSS business as well as a $1.3 million shift of known demand within our CS segment from the first fiscal quarter into the remainder of fiscal 2013. While we anticipated that sonobuoy sales to foreign governments would be minimal this quarter, we expected our U.S. Navy sonobuoy sales to be higher than what was achieved. The Company had two sonobuoy lots fail under suboptimal environmental conditions which were outside of the product’s design specifications at the Navy test range in the final weeks of September 2012. While these lot failures unfavorably impacted current year first quarter revenues by approximately $3.5 million, it is anticipated that these lots will be accepted by the Navy in the Company’s fiscal 2013 second quarter with revenues being recognized at that time.

Our gross profit in the first quarter of fiscal 2013 was $7.2 million or 14.7% compared to $8.3 million or 16.1% in the first quarter of fiscal 2012, reflecting decreases in the Company’s DSS segment due to the anticipated decrease in foreign sonobuoy sales in the current year quarter, offset by a 1.7% margin percentage increase in the Medical segment.

Selling and administrative expenses remained flat at $5.5 million in the fiscal 2013 first quarter as compared to $5.4 million in the prior year first quarter.

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.

Gregory Slome

Thanks Cary.

Medical sales increased approximately $0.6 million in the three months ended September 30, 2012 as compared with the same quarter last year. Reflected within the increase is $3.2 million of increased sales to this business unit’s largest customer, reflecting expanded demand for its programs and additional refurbishment service revenue which began in the second half of fiscal 2012. Additionally reflected in the increase is $1.4 million of incremental sales to another customer to meet increased demand for its product in both the U.S. and Japan. Partially offsetting these increases were decreased sales to three customers totaling $4.0 million dollars with decreased sales to one customer reflecting the dual sourcing of certain of its programs with the Company during fiscal 2012. Decreased sales to the remaining two customers reflect these customers’ disengagements during fiscal 2012.

The gross profit percentage on Medical sales increased to 14.9% from 13.2% for the three months ended September 30, 2012 and 2011, respectively. This improvement in margin on Medical sales reflects certain favorable product mix between the two periods and increased capacity utilization at the Strongsville, Ohio facility.

Excluding an increase in intercompany sales of $1.1 million, Complex Systems sales to external customers for the three months ended September 30, 2012 decreased $1.3 million as compared with the same quarter last year, primarily reflecting decreased sales to one customer, which delayed certain of its orders into future quarters. Five new programs were won from existing customers during the first quarter with estimated future annualized revenue of $1.7 million and Complex Systems finished the quarter with its highest backlog in three years at $37.3 million.

The gross profit percentage on Complex Systems sales increased to 8.9% for the three months ended September 30, 2012 compared to 8.7% for the three months ended September 30, 2011.

The quarter over quarter comparison primarily reflects favorable product mix, partially offset by lower capacity utilization at the Company’s Vietnam facility in the current year quarter.

DSS sales decreased approximately $2.1 million in the three months ended September 30, 2012 as compared with the same quarter last year, reflecting decreased sonobuoy sales to foreign governments which can fluctuate from quarter to quarter, partially offset by increased U.S. Navy sonobuoy production and engineering sales and increased digital compass sales in the current year quarter.

The gross profit percentage on DSS sales decreased to 14.6% for the three months ended September 30, 2012 compared to 23.8% for the three months ended September 30, 2011. Gross profit percentage was unfavorably affected in the current year quarter by a significant decrease in foreign sonobuoy sales and increased overhead expenses, partially offset by the positive impact from increased digital compass sales as compared to the prior year quarter.

I would now like to review our current debt and liquidity positions as of the end of the quarter. The only remaining debt outstanding at September 30, 2012 is our Industrial Revenue Bonds with the State of Ohio of approximately $1.6 million. During the quarter ended September 30, 2012, the Company made total principal and interest payments of less than $0.1 million. Our debt to equity ratio on September 30, 2012 was at .02 to one.

As of September 30, 2012, the Company had approximately $43 million in cash and cash equivalents and no outstanding borrowings against available funds on its $20 million revolving credit facility provided in July 2012 by PNC Bank, National Association.

Summarizing our cash flows for the fiscal year ended September 30, 2012, operating activities used $2.6 million of net cash flows. Excluding changes in working capital, operating activities provided $1.8 million in the first quarter of fiscal 2012, reflecting the Company’s relative operating performance during the period. Working capital used $4.4 million of net cash flows in the first quarter, primarily reflecting increased inventory, reduced accounts payable and accrued expenses and funding of production related to U.S. Navy contracts during the year in excess of advance billings received, partially offset by decreased accounts receivable.

Finally, cash flows used in investing and financing activities in the quarter ending September 30, 2012 totaled $1.1 million and $0.2 million, respectively.

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

Cary Wood

Thanks Greg.

On Friday, November 2, 2012, Sparton signed a definitive agreement to acquire Onyx EMS, LLC in a $43.25 million all-cash transaction, subject to certain post-closing adjustments. Onyx’s trailing twelve month revenue as of our fiscal year ending June 30, 2012 was $50 million with an 18% gross margin.

With sites in both Watertown, South Dakota and Minneapolis, Minnesota, Onyx primarily manufactures medical devices for OEM and emerging technology companies, including products for cardiovascular diagnostics, hearing assistance, patient temperature and warming, point-of-care diagnostics, and surgical equipment used in intraosseous medicine. The Company also has a presence in the industrial market providing products such as precision measurement instruments for monitoring air quality and pollution, commercial fire and smoke alarm systems, sensing tools, test fixtures, and complex LED assemblies.

The addition of Onyx meets the criteria of our growth strategy by providing further expansion regionally into the Minneapolis medical device corridor, diversifying our customer base through both existing programs and a strong business development pipeline, and to continue to increase the number of complex sub-assembly and full device programs within Sparton. Additionally, Onyx brings solid, long-term customer relationships that will utilize Sparton’s expanded list of service offerings such as our low cost country footprint in Viet Nam and full design engineering capabilities.

We expect this acquisition to be accretive to earnings within our current fiscal year and the addition of the Onyx management team and its skilled workforce will further strengthen our business development efforts to support our organic growth initiatives.

The transaction is expected to close within 30 days and be funded through Sparton’s existing cash balances and borrowings under a new $65 million credit facility with an increase option of up to $100 million which is currently being finalized with BMO Harris Bank N.A. The credit facilities will be available for working capital, additional acquisitions and general corporate purposes.

Finally, I would like to close the presentation by providing a brief outlook on what to expect for the remainder of fiscal 2013.

As Sparton continues to implement its strategic growth plan, we plan to meet our growth expectations by focusing on new business development, internal product research and development, and complementary and compatible acquisitions.

We will focus on sustained profitability by continuing the improve margins in Complex Systems, increase capacity utilization, improve the working capital turnover, and continue to deploy the Sparton Production System throughout the company.

Lastly, we will work with the management team at Onyx to integrate and share best practices between each company in the coming months.

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:

Southwest IDEAS Investor Conference in Dallas on November 14th with investor meetings that previous day, Sidoti’s semi-annual Micro-Cap Conference on January 7, 2013 at New York City’s Grand Hyatt Hotel, and CJS Securities annual investor “New Ideas” conference with the nation’s top institutional funds on January 13, 2012.

We continue to be optimistic with the outlook that both the second quarter and the remainder of the fiscal year will outpace fiscal 2012 results.

We are also pleased to have Onyx joining the Sparton family and look forward to the efficient integration of this business as we expect this acquisition to improve profitability and enhance shareholder value.

Thank you for your continued support.

Michael Osborne

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

Question-and-Answer Session

Operator

Thank you ladies and gentlemen. (Operator Instructions). Our first question comes from the line of Steve Shaw with Sidoti. Please go ahead.

Steve Shaw – Sidoti

Can you guys provide some color on the (inaudible) loss sales?

Cary Wood

As conveyed, we had a combination of two lots that failed as well as a deferral on expected in the CS Complex segment of our business. Our total combined was right around $5 million total. Of that 3.2 million were domestic (inaudible) and twolots; they were tested in highest (ph) conditions which are outside of the testing specification that has been ordinarily adhered to. We have submitted to the captain on the program, a waiver request and we are highly confident that that will be acknowledged within the second quarter. In the near term, I think it’s important to say that we've already passed one of those two lots in the previous weeks, so it is already included as part of our Q2’s results and the second will either give to waiver granted and the revenue we recognized or we’ll put it back into for testing in the same quarter Q2, and so again, we’re highly confident that those things will be in our Q2 results which will shift obviously not just a revenue but earnings to a strong second quarter than what was originally planned.

Steve Shaw – Sidoti

The Complex customer that delayed the orders, any color on that and was that the same quarter who delayed last quarter?

Cary Wood

No it wasn’t. Last year, without going into customer names, we had a delay which was more than two quarters that ultimately started to ramp up. This is more of a delay with an ongoing customer and we fully expect it will be caught here sooner than later caught up. But no, they are very separate customers.

Operator

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

Jimmy Baker – B. Riley & Company

So just a follow up there, with regard to the impact on DSS in the quarter from the two lots, if that 3.5 million revenue had been recognized in the first quarter, can you talk about what the benefit would have been to DSS operating income?

Cary Wood

Yes, it’s hard for me to give you that kind of guidance without starting to get into pricing and those types of things but I would generally say that you know full well that our performance on a gross margin basis on that segment has been much more on scale of the 20 to 25%. More times than not being in the lower percentage of the 20s. We saw a significant dip; frankly it’s the lowest gross margin performance of DSS during my period of time here. And it’s more attributable to these two misses than anything. So I think if you were to take this $3.2 million and you were to generally apply similar margins, obviously you would get at least a good understanding of what could and should have dropped.

Jimmy Baker – B. Riley & Company

And I just want to ask a few questions on Onyx, you mentioned 18% gross margin during your fiscal year ’12; can you talk about your EBITDA margin during your fiscal year ’12?

Cary Wood

We’re restricted at this point given the fact that we haven't closed and we’ll obviously be filing all the detailed financials in the coming weeks, so at this point I am fairly restricted Jimmy from what I can talk about EBITDA is among them.

Jimmy Baker – B. Riley & Company

Then maybe you can tell us this, do you intend to book the Onyx revenue in your medical segment or will it be a combination of medical and DSS?

Cary Wood

Right now our expectation is that it will be in the medical segment reporting.

Jimmy Baker – B. Riley & Company

Okay and then can you maybe talk about relative contribution of medical and industrial end markets for that business and then also just where their capacity utilization stands?

Michael Osborne

Well we’re not prepared at this time to give the split on the actual end markets. We’ll follow that up once we close the business. From a capacity utilization standpoint, as of today, they are actually at 100% but they are just finishing off an expansion that will actually double the size of their facility. So very shortly they’ll be in a 50% utilization rate and that expansion was complete well before the process saw in the business based upon their customer interactions as well as their pipeline of opportunities that are coming up fairly quickly. So it’s reflecting what kind of future business they are seeing coming their way.

Jimmy Baker – B. Riley & Company

Is there any integration timeline that we should be kind of be modeling in terms of the realization of cost synergies and can you just….

Cary Wood

As always, we have aggressively gone after synergies within a 100 days. This is a bit of different business, since some of the last two acquisitions we've done it, it’s a well-run business. It’s a well performing business. There are some opportunities to strengthen it. And so from a synergies perspective, we've got some operational ones that are specific to use of our Sparton production system, lean enterprise program. We think we can start to institute some sales and operational planning techniques which will help with working capital. There are quality systems we think that we can provide some help to and the results of the past while not bad by industry standards, are certainly not matching up to what Sparton’s performance has been the last few years which only lends itself to things like we work first time past yield and asset utilization.

All those types of things are helped along by an improved quality system I think we can help with. And then to set aside that, you’ve got the other intangibles of the geographic expansion into the Minneapolis technical quarter something we've been pursuing for a good amount of time.

And with some of our other facilities, Fredrick specifically, reaching capacity, this allows for us to do some selective redirects on business in the case we need to do that and fully utilize our footprint. So those are some of the broad strokes of what we expect some of the synergies to be but I would say that we’ll go after them fairly aggressively but this is a bit of a different animal than say the last two business acquisitions we've done. This is a well-run business that is actually performing better than we are on a gross margin basis and certainly something to be learnt from that and we expect that we won’t see any deterioration. Frankly we think with the new business funnel and the opportunity on a forward look, we expect that to increase and improve.

Operator

Our next question comes from the line of Kevin Casey with Casey Capital. Please go ahead.

Kevin Casey – Casey Capital

Couple of questions on the new acquisition, some of them you kind of touched on. But one, what was the cost of the expansion?

Michael Osborne

We’re not prepared to send out those details as of yet, you’ll see them in the coming weeks.

Cary Wood

Kevin I apologize, we've got certain restrictions we've got to adhere to between now and the time we close.

Kevin Casey – Casey Capital

And then can you talk about if there are pipeline of customers to fill that expansion?

Cary Wood

Yes, first I'll talk about it in general terms. I'll start with the fact that the customers that we are gaining as a result of this acquisition are brand new to Sparton which is great in of itself. What represented the 80 percentile of our revenue was roughly 15 clients in the last 12 months. That's certainly up from what it was a couple of years ago but with the addition of Onyx that number increases now to 25. That also tells you a little bit about how carefully they have chosen their engagements as not to be heavily concentrated by one or two. Of those, they are going to give us nice regional place and again, we’re not at a position not at a position to tell who those customers are.

Those will come out in due time but we’re certainly, we've been in touch with all of them, particularly the first 80 percentile, I think it came across very positive, not just and that this was unapproved acquisition by them, but that fact that we offer some potentials that will only help to expand the business and secure it further and we walked away from much of those conversations being very optimistic. I think the best way for me to frame with the forward-looking business funnel to be, would be to go back and use Delphi as a reference. If you remember Delphi, at the time of acquisition had a trailing revenue of about $32 million. We quickly seized on it and pursued the business funnel and that business funnel led to exponential growth out there setting aside the additional revenue gain from the Buyers Peak acquisition. So 32 plus the 10 from Buyers Peak was roughly 40 and that business is substantially more than that today. So that's the best way to frame for you what we feel very good about in the way of a forward-looking funnel with new customers that we don't have today.

Kevin Casey – Casey Capital

And so it is accretive right now even with the cost, the depreciation from the expansion and then all the new businesses on top of that accretion?

Cary Wood

It is, yes. That's simply put the answer to yes.

Kevin Casey – Casey Capital

And then can you talk about the trend for medical outsourcing. Where are we in that? Can we compare this to the early 90s of when tax started outsourcing in the United Sates and how fast a growth can we get and do the medical customers realize that they should be developing products as opposed to building them?

Cary Wood

It’s a great setup question, Kevin. We feel very confident and bullish in this arena and we continue to expect that the way you described it is exactly how it is going unfold. I think with the looming device tax to come down sooner than later and that's going to lend itself well to conversations at the least about what alternatives we might present. We have one of the lower labor cost base on such Complex and technical devices.

We've got a good geographic location that in testing and internal engineering resources. I think we present a very compelling case for increased outsourcing for those who are faced with some cost issues that are sooner than later. So it’s hard for me to sit here and tell you what I think the outsourcing trend will quantatively be, but I think all the macro elements that will lend itself well to it has certainly been our investment pieces in that arena.

Operator

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

Andrew Shapiro – Lawndale Capital Management

Since we’re on the topic of acquisitions, I'll ask my acquisitions and then back out into the queue, if you have others in your divisions. So regarding Onyx, Kevin actually asked something about the capacity expansion and while waiting, FYI, there is some publicly disclosed articles that mention the expansion improvement project they started last year is $11 million capacity expansion, so you guys didn’t have to disclose that. It’s out there on the web. South Dakota to Minneapolis is this major medical corridor. I am assuming devices that have spun out of mail clinic and all that. To what extent do you already have business in this corridor or is this in a sense an incremental regional sales grab?

Cary Wood

We have a very little presence today in the Minneapolis corridor and that's something we vocalized in the past, one of our ambitions being and I think this a significant grab towards a presence in that corridor that we didn’t have previously.

Andrew Shapiro – Lawndale Capital Management

Okay and presumably Strongsville, being a suburb of Cleveland, you know there is a corridor there that's involved with device spin-offs out of the Cleveland clinic etcetera. I just have a query now in that, in terms of your other strategic acquisition focus, are there particular geographic areas where you don't have presence that are considered medical device corridors that you’re kind of looking at?

Cary Wood

We have said before, we’re looking in the northeast medical corridor. We certainly are continuing to look at opportunities in the west coast region and those are two corridors we've talked about in the past, particularly the northeast that we’re concentrating on looking for opportunities.

Andrew Shapiro – Lawndale Capital Management

Now this is your biggest acquisition to date. It’s not as troubled as the other acquisitions. Do you feel your integration plans since it’s necessarily not going to be a lot of cost synergies and reduced capacity and the other typical turnaround things? That, maybe it’s not necessarily a 100 days but how quickly do you have this integrated whereby you’re moving forward or focusing on even incremental acquisitions in light of the fact you’ve got 43 million in cash and now a new 60, potentially $100 million credit facility, that you could do another acquisition even of this size. Are things on hold for 100 days or 90 days, three months a quarter, etcetera or could you potentially close and do another acquisition in the next 60?

Cary Wood

Yes, as we said earlier, this is a business that is well run and that provides us good options, one of which being we can quickly integrate it on a standalone basis and add and enhance it as we go and not have to do it with the consumption of resources that we've done some of the past acquisitions. So with that said, we continue to be acquisitive and we’re continuing to examine opportunities. And I am still a bit bullish that we could do a deal sooner than later and that's the hope that we can still find the right opportunities to execute on between now and as you said, 60 days, but certainly over the next several quarters.

Andrew Shapiro – Lawndale Capital Management

Now, hypothetically, I appreciate you can’t discuss the EBITDA right now, I just want to corner this and sense it in a bit. Hypothetically, when you’re looking at IRRs, when you are deciding M&A opportunities, you’re going to pull the trigger on, because it has been a year, you guys have been very disciplined whenever it came close on one or two or something and didn't do it. So you have some higher IRR threshold. So, hypothetically, assuming I guess, we might require a higher IRR on a Delphi or a more risky turnaround versus a cleaner business as this, what are the IRR rangers that you’d be looking for and the board’s looking for when you make these acquisitions?

Cary Wood

Okay, first I would say that the IRR thresholds are always examined against our internal cost to capital which as most everyone on the call knows is roughly a 13-14% range as we quoted in the past. That said, we've examined businesses, not just on a trading multiple basis which is at least a decent barometer to first start with but then we expanded to our own cash flow analysis on a base business, so standalone and then we add some synergies so we kind of have a range of what we expect in the way of this performance.

We have tried to look at things being roughly in the four year payback period as being acceptable, so that puts you generally into the mid-20 percentile range on IRRs, but where the businesses are well run and the trailing basis gives us a view but the future look gives us another. We've softened that a bit. But we generally try to stay in the 20 to 30% range on IRRs.

Andrew Shapiro – Lawndale Capital Management

So I am going to just use the most conservative, a 20% range on this, on a $43 million, we’ll call it a $40 million acquisition, is about 8 million pre-tax, after tax, we’re talking about 5 million and that works out to be about $0.50 a share. Am I in the ballpark because you obviously can’t be specific?

Cary Wood

Yes, this is a tough one because we've got some restrictions. I think your math stands to the reason but we've got some restrictions here Andrew.

Andrew Shapiro – Lawndale Capital Management

Understand, okay. And lastly, on the acquisition, I'll back out. With the clients gained during this acquisition, can you provide some further color on how this acquisition is going to increase or decrease and I am assuming it’s a decrease, your client concentration. These guys aren't in to (inaudible) and into Siemens, right?

Cary Wood

Yes, we mentioned earlier that we further diversified our customer base from 15 customers which made up about 80% of our revenue prior to now 25. And so it has added a significant number of, I won’t call it anchor but substantial customers and they are new to us. And in our initial meetings with them, they have been very upbeat and they have been more affirming than not. And I think what they present is great prospecting opportunities to do account expansion. So generally, we’ll only help with the stickiness and the diversification of our customer base and medical.

Andrew Shapiro – Lawndale Capital Management

So what you mean by that is that, so 80% of your business would have been 15 customers and even fewer years ago before when you guys started this turnaround in growth prospects and now post acquisition it would be 80% of the overall business and that's all of Sparton or just medical?

Cary Wood

Correct all of Sparton. All of Sparton. So 80% of all those Sparton’s business will now encompass 25 customers, so substantial reduce concentration, great. I'll back out of the queue. I have questions about your segments, so please come back to me.

Operator

Our next question comes from the line of Ross Taylor with Somerset Capital. Please go ahead.

Ross Taylor – Somerset Capital

Last night at the close, your stock was trading at about $13.80. If you had spent the $43 million to buy back stock at that price, you would add about $0.40 a share to your underlying earnings from the previous fiscal year, more on out year versus our expectations. Trying to get at a number of how additive this deal should be to earnings, you and I have had a lot of conversations about the fact that deal needs to basically measure up against the alternative uses of capital, the most clear alternative use of capital as a buyback. So when I do my math and my logic, it tells me that this deal should be a deal that adds more than that $0.40 a share to earnings over a 12 month fiscal horizon for Sparton.

Cary Wood

Yes, I get your logic entirely. I think first and foremost I would suggest that we wouldn’t roll out the concept of a buyback over the course of time. We still appreciate its impact on earnings and certainly at the very least in the context of share and we’ve managed that and we’ll continue to do so. In terms of what you described as being a substantial buyback, it was a whole lot of discussion around that and given the options that we have from an M&A standpoint and assessing them on a very quantitative basis, we came to get comfortable with the idea that the acquisitions would far exceed the capital deployment on a buyback and it may not necessarily be the specific, first six to 12 months but that on an aggregate two to three year basis, we certainly got very, very comfortable that it enhanced earnings substantially.

Ross Taylor – Somerset Capital

Yes, I think the stock price today is tell me you guys and I understand your constrains, what you can say, but I think that you need to get unconstrained as quickly as possible because if my phone’s been ringing off the hook, the idea that this deal is additive given that you’re earning pretty much nothing on your cash, is a little bit like you and I going out to plan slams on seven foot hoops, it might be fun but it’s really not much of a challenge. And so as a result, I think with the stock price down basically nearly 10%, I think that's largely a result of investors being confused, disappointed, scared about what you did.

The idea that this might add $0.05 or $0.10 versus a buyback and I know people have done work which indicates that we've been pressing for a buyback and others have been pressing for a buyback since the stock was in a single digit and that would obviously have had a huge impact. So I think that you are bored and looking at this decision, I hope they understood and made the decision that it’s a deal which will add substantially near term, not just wait three years, two years down the road, but rather will substantially accretive and here I think the sooner you can start to talk to us about that accretion, I think the better it’s going to be for all of your current investors.

Cary Wood

Yes, I think it’s a fair statement. It’s an assumption that I want to affirm. We feel very bullish around the next 12 months and I appreciate exactly the math that you’re using, comparing a buyback and its yield against cost of capital compared to an acquisitions yield and earnings and we continue to be very optimistic and confident. This was the right deployment of cash in the near term. So I clearly understand where you’re coming from. I'm also on an editorial basis; I am not shocked at the market’s reaction.

I think our first quarter was less than what I would like for it to have been and certainly with the addition of the $5 million in sales, 3.2 of it being much richer than that, it would have certainly enhanced our earnings, I believe well beyond what the guidance was out there for us. But that combined with the uncertainty of an acquisition is always there. So while I am not shocked by it, today is just one day. And I am comfortable moving forward. The results are going to speak for themselves.

Ross Taylor – Somerset Capital

And we would agree and I do think though that obviously one of the problem that Sparton faces as a company is, analysts always try to kind of smooth a business (inaudible) business is exceptionally difficult to smooth because it isn't smooth.

Cary Wood

Absolutely true. You are absolutely correct.

Operator

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

Andrew Shapiro – Lawndale Capital Management

DSS, you’ve explained somewhat what the suboptimal environmental conditions outside of products design means, but what I am trying to get a handle on, it sounds as if you said already one of the lots has been accepted, the second lot is either going to go for a retest or could get it waved. When the first lot got retested and if the second lot has to go through the retest, is that a material incremental cost and a reduction in the margins that you would get on the products?

Cary Wood

No, not materially.

Andrew Shapiro – Lawndale Capital Management

So it’s not a material incremental cost and already you’ve got one of the lots coming in and the second lot, it sounds as if, can you remind me or clarify, it will get retested and you know assuming it clears the test approved before the end of the December quarter?

Cary Wood

That's the expectation.

Andrew Shapiro – Lawndale Capital Management

(Inaudible) of course.

Cary Wood

I was just going to say, with one or two routes. We’ll either be granted the waiver sooner than later and I think we’re in the midst of those conversations as we speak, that could take place in a matter of week or two and it is currently in the queue to be tested once again as if it had never missed and we’ll expect they test it in specified conditions and we’re very confident that that's going to lend itself to a pass.

Andrew Shapiro – Lawndale Capital Management

If it does come to pass in a week or two on that and in terms of what Ross’ concern or issue was about this in existing investors, something for you or accounts consider if its worthy, if you already know soon thereafter that these two things are coming through and are going to be above and beyond your normal quarterly activity. Perhaps that is worthy of an 8-K disclosure for all to know. Something to consider.

Cary Wood

Fair enough. Yes, fair enough.

Andrew Shapiro – Lawndale Capital Management

Regarding inventory, how much of Sparton’s overall Q1 sequential quarter-over-quarter increase in inventory is then attributable to the (inaudible) its most of the inventory increase then?

Cary Wood

Well, between that and the preparedness for the Complex segment business that we expected in Q1 that got pushed, given the long lead item type of duration on some of the materials. Those two things have lent themselves to what is less than perfect inventory quarter.

Andrew Shapiro – Lawndale Capital Management

So arguably that means that the cost of goods on all those (inaudible) already went through this quarter. And when I say this quarter, the September quarter.

Gregory Slome

No Andrew, the cost won’t go through until we actually…

Andrew Shapiro – Lawndale Capital Management

Oh just built up inventory, it will come through in May.

Cary Wood

It’s sitting in inventory.

Andrew Shapiro – Lawndale Capital Management

And then on DSS, are all your contract wins that have been announced by the DOD press office, are all contract wins presently in your Q1 DSS backlog?

Cary Wood

I believe that yes, they are Andrew; definitely they are in our backlog currently.

Andrew Shapiro – Lawndale Capital Management

Okay and your filings describe new form (inaudible) orders of 8.2 million during the September quarter that were not yet delivered. How does that compare to previous quarters and more importantly is this 8.2 million, the entirety of foreign backlog or just a portion of your backlog that is foreign and presumably higher margin.

Cary Wood

It’s currently the majority of our foreign backlog. But if I were to look at our Q4 which was down substantially to ’12 started to erode, we started to pick that back up here with foreign orders as of Q1 ’13. So I wouldn’t say that it’s on par but it is certainly the type of quarter that we’d like to see.

Andrew Shapiro – Lawndale Capital Management

Okay and are there more information or news about the navy’s current P-3 Orion fleet being sold off to our foreign friendly allies as the P-8 Poseidons start coming online next year?

Cary Wood

No there is nothing new that I am in a position to report when it comes to the P-3 Orion.

Operator

Our next question comes from the line of Ross Taylor with Somerset Capital. Please go ahead.

Ross Taylor – Somerset Capital

Real quick with the lots that were not delivered, were there costs that you did incur that impacted earnings in this last quarter?

Cary Wood

No, I mean we added to standard as of this year, some additional destructive testing that is now a normal part of cost of goods and it’s coated as a component of price. So no, there was nothing extra in the quarter that would have gone with the reject.

Ross Taylor – Somerset Capital

And in the medical area, can you talk about where you add capacity, margin opportunities in Vietnam and your US operations? It looks like you made some nice moves in it.

Cary Wood

Yes, first I would say that we've talked about the fact that capacity is reaching a level in Colorado that we’re going to have to address. We are certainly becoming increasingly optimistic about what we’re seeing in the way of opportunities for Cleveland and we've modeled those things out as we look to manage capacity and then go forward and then in Vietnam as we've talked about in the past, we've now since registered it with the FDA and have shifted several devices there and we are now a legitimate medical device manufacturer in South East Asia. I think all of that is going to probably play out well for us as we work with some of these new customers that we’re talking with it.

Ross Taylor – Somerset Capital

And the kind of time horizon you would expect to be able to bring these new customers into particularly the Vietnam operation.

Cary Wood

Yes, that's hard to say because a lot of that's going to come down into the conversations with each of the accounts. They’ve got to get comfortable as was the case is, one of our key customers out of Colorado over a year ago, one of the largest customers. We had to host them in Vietnam; we had to walk through the capabilities. It was a lot of handholding to get comfortable. And I don't expect that it’s going to be much different with these accounts. We’ll move on them aggressively nonetheless.

Ross Taylor – Somerset Capital

Okay and lastly in the area of (inaudible) Soviet Union has aggressively picked up its activity off the US coast. There was an NSA report that they had put a boat in the Gulf of Mexico which the navy still appears not to know about and there was a report that they had one reasonably close to the Jacksonville Florida base. The Russian admiral indicates that they are looking kicking up their activity from what has been about, what 10 (inaudible) in this direction a year to over 100 (inaudible) in this direction a year. We’re down from what about 240 during the cold war. If they are moving back up from 10 to 100 and if we’re seeing obviously the moves in China, Venezuela is looking at doing something, even drug runners are using submarines it seems. What's that going to do to underlying demand from the US navy for what it really has historically or in the last 10 years has been kind of a no-shore business which is protecting our shores.

Cary Wood

Yes, those are all good dynamics for us we feel. I mean first I would say that the business that's been acquired than and its sitting in the backlog today and the forward look on the ramp up of this business is it starts to support the transition from P-3 to P-8 isn't Obama budget. So regardless of how things played out with our new President today, with the continuation of our current President rather, it’s just that the budget is pretty firm for us and we've always conveyed that we had a high degree of optimism around our forward-looking backlog with our ASW program. Some of the things you just talked about notwithstanding what's going on with the Chinese and the fact that (inaudible) indicated that they are going to deploy much larger percentage of the US navy there than has been in the past, you add to it now, the additional dynamics out of Russia.

They have openly conveyed that they are going to be to looking to upgrade their fleet and add some range to it. They seized the purging of the older submarines within their fleet which is what they had been doing, so they seized those types of operations and as you indicated it exponentially increased patrols. They were in the 200 plus range at the cold war and at the height of the cold and having in the past year has been as low as 10. Certainly a big difference there and as you mentioned, there has been an announcement of a soviet admiral that they would be significantly and exponentially increasing those (inaudible). And I think probably one of the single best examples of that was the Russia Sierra-2 class sub that was essentially found to be off the US coast and generally the thesis is that it was conducting submarine warfare efforts adjacent to our Kings Bay Georgia naval station and so I think those are all dynamics. They are going to lend themselves well to our product as we move forward.

Ross Taylor – Somerset Capital

I would agree, I think seems to me that we’re going to see a fairly substantial uptick overall in demand over the next two, three, four years, pretty much without regard to what happens to the defense budget since not so much carriers and nuke missile boats or rather extensive strategic assets and the navy tends to like to protect them.

Cary Wood

That is correct. We agree with your assessment.

Operator

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

Jimmy Baker – B. Riley & Company

I just want to sneak in a quick follow up on what might amount to just basically housekeeping question but I was just hoping you could help us understand why in a quarter where your DSS sales were unusually low, then your intercompany eliminations where I think the highest they’ve been in your tenure actually.

Gregory Slome

Intercompany, a couple of things, one you’ve got a piece of that is related to the customer we’re doing out of Vietnam now for the medical side and out of the 4.6, about 600,000 of that was non incremental related to the medical segment and that really the intercompany production was then Brooksville they have a lead time based on the production results ultimately going through for maybe on the DSO segment. So doesn’t always match up with the quarterly directly to where they may be some of those sales are.

Cary Wood

And important to add to the conversation Jimmy is that we've increased intercompany business with our medical segment that wasn’t there before.

Jimmy Baker – B. Riley & Company

And should we think about that as at least 600,000 a quarter or is that going to trend even higher in terms of the medical contribution to that?

Cary Wood

It’s hard to give that kind of guidance as I sit here right now Jimmy.

Jimmy Baker – B. Riley & Company

Okay, fair enough. But I mean in general would you say it’s going to be a higher number as a percent of your overall sales going forward than it has been historically?

Cary Wood

You’re going to see a ramp up of intercompany attributable to the medical ads that we've now since acquired. So the answer to that would be yes.

Operator

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

Andrew Shapiro – Lawndale Capital Management

You talk about the breakout on the intercompany, and it sounds like for the September quarter now, there was meaningful amount of medical instead of just defense. Can you for the quarter at least provide what the breakout was of that?

Gregory Slome

Yes Andrew for the quarter out of the total intercompany sales for the first quarter was roughly 4.6 million and of that 600,000 was related to medical, was 4 million in DSS.

Andrew Shapiro – Lawndale Capital Management

And you’ve talked in the past about the margins on that being carried through as the segment margins. Does that mean that the margin on that from the defense side is the lower defense margin incurred for the quarter or it’s more based on an average annual margin of the defense segment?

Gregory Slome

Just a clarification Andrew, are you talking in regards to the DSS gross margin for the quarter?

Andrew Shapiro – Lawndale Capital Management

Yes, well in other words will you guys book on the CS division? On the intercompany sales you guys have said in the past that it’s booked through at the kind of the originating segments margins, right?

Gregory Slome

Right, right.

Andrew Shapiro – Lawndale Capital Management

Gross margins and so with what I am just trying to just clarify now is the DSS portion that came through Complex Systems and intercompany that was DSS, on the margins that are being charged through or booked through, this quarter is very low segment from DSS or is it based more on an average weighted or an overall annual kind of margin from the segment.

Gregory Slome

Right, it’s really based on more of an annualized margin. We don't go back and try to prove it all based on where the actual margins of DSS come in or related to the specific program.

Andrew Shapiro – Lawndale Capital Management

Got it. And then when Jimmy talked about well, you know now its 600 where it might be, is it fair to say that the intercompany activity of Complex Systems on behalf of the two divisions, given where it is in the inventory cycle and the assembly of the final product, that the intercompany sales is somewhat of a leading indicator of the direction of those two segments?

Cary Wood

That is how we viewed it and out along with the increasing backlog give us I think a good barometer of what our forward look is with CS.

Andrew Shapiro – Lawndale Capital Management

Can you talk one last one on DSS and then I've some medicals in CS. Can you talk about the digital compass business and what you might be seeing along that product line that's had several new products over the last now year and a half, two years? And whether that's navigation, oil, gas or whatever and what are the uses for the new AHRS-8 that you just announced?

Cary Wood

First I'll talk about a simple number being that we supplied through 56 different orders, 56 different unique discreet orders, different customers for integration in to whether it be a product for testing or design and development, that activity in the last quarter. Now that said, I'll hand some of your questions over to Steve Korwin who handles the internal research and development among other things to get into the specifics of the questions you had.

Steve Korwin

Yes, this particular product that has been lodged, basically it builds upon capabilities to allow the product to be used and unmanned guided air vehicles as well as land use. The part of the DC-4 was basically for a land application. The GEDC-6 will use for a unmanned land and sea and more of a (inaudible) application gyro enhanced. And now we move up to (inaudible) having reference type devices that have temperature compensation. They are more application for air and then also underwater use as well. Now we see some of the applications going forward to be in civilian, unmanned, air use, defenseair, maritime use and then also in agriculture because there is an expansion in the unmanned tool market guided vehicle and agriculture by some of the large agricultural producers and equipment producers and we do have talks underway with at least one of them right now.

Andrew Shapiro – Lawndale Capital Management

Okay, now moving on to medical. Regarding your customer declines that offset your growth on overall and your growth on your major customer, can you say when the two disengagements during fiscal year ended June 2012 will anniversary this fiscal year?

Cary Wood

First I want to talk about it in general terms. Disengagements happen and we’ll disclose those and they are kind of an inherent nature or contract manufacturing, for instance of these disengagements was a transition from an old gen to a new gen and while we are part of the bidding process on the new gen replacements, we were not awarded that. We still feel confident that they got a very competitive price and the offering that we provided was substantial and we’ll continue to circle around the hoop on that on as it starts to ramp up. But those are the types of things you see when it comes to disengagement. The other one is a much smaller one. But in terms of the anniversary.

Michael Osborne

The biggest one is at the end of the Q2; it will pretty much fall out.

Andrew Shapiro – Lawndale Capital Management

Okay and Siemens dual sourcing decline. When does that anniversary? Was it does quarter?

Cary Wood

It started really actually into the middle of the second quarter of last year I believe.

Andrew Shapiro – Lawndale Capital Management

Okay, so the current quarters we’re in will have some of that and then after it will be anniversaried.

Cary Wood

Correct.

Andrew Shapiro – Lawndale Capital Management

Okay, I only mentioned these other two because they were sighted as a contribution of specifically large enough noteworthy that you guys had of them.

Cary Wood

Yes, they weren't inconsequential. They represented a $5 million impact on the quarter that we would have otherwise have seen and wasn’t completely a surprise to us. It was built into our plan and even net of those, we still had expectations that our quarter was going to be a much higher revenue when it was.

Andrew Shapiro – Lawndale Capital Management

Yes, monitoring this because we had such a good long history and size and we still are one of the two sources for Siemens, does there appear to be any changes in the goals for dual sourcing, more importantly, are you seeing any new RFPs or increased orders from them for existing programs or new programs?

Cary Wood

Our relationship with Siemens continues to be a positive one but it is probably an arrangement that I would see probably with time diminishing more than that. There is nothing to announce today. But I think if you look at the product that we've been involved with. It really falls into a number of buckets. I think their end market dynamics are starting to soften and that certainly had its impact, they dual sourced on some of them and then there are certain other products that are reaching a sunset that we've always known was going to materialize. So long answer to your question but I would say that the relationship continues to be positive. We continue to interact to the extent that we can bid on new opportunities but I have nothing to announce as we sit here today.

Andrew Shapiro – Lawndale Capital Management

Right, so they have other RFPs for newer products out there and we’re not blocked from bidding, we’re invited to bid and we either get them or we don't, is that the [Multiple Speakers]?

Cary Wood

That's exactly the [Multiple Speakers].

Andrew Shapiro – Lawndale Capital Management

Whereas we are not really bidding for any Honeywell [Multiple Speakers].

Cary Wood

That's right.

Andrew Shapiro – Lawndale Capital Management

All right. Any greater visibility from the recent acquisition of Fenwal by, its parent whose name I hate to try to try to pronounce. Are there Fenwal RFPs at Sparton with historically been submitting for that we aren't or are we seeing greater bidding opportunity from Fenwal new parent?

Cary Wood

The parent company for (inaudible) is, we've spent some time getting close to the leadership there. And they have their hands full with an integration that is probably going to shelf any kind of additional concerns on our part as well as may be opportunities. It doesn’t mean that we’re not going to continue to be in Fenwal’s house and see if we can continue to enhance the revenue line with them for service and other opportunities like the insourcing of circuit cards and in Vietnam as we've done, but I think as it sits here today, we have complete understanding who the ownership is. We know what the challenges that they have in front of them. We’ve been in sit down conversations at some of the highest levels there and I continue to be optimistic of the relationship moving forward.

Andrew Shapiro – Lawndale Capital Management

Okay, Complex Systems, Q1 from Q4 suffered a sequentially sizeable increase in your operating expense in Complex Systems this quarter versus last quarter. After you had this very nice sequential drop in your fourth quarter June from Q3, what happened this quarter versus last quarter or its last quarter versus Q3, there has been this up and down going on. Is there some kind of meaningful operating expenses shift and what's sustainable and what's not?

Gregory Slome

Right Andrew, it’s a combination of various items but there are a couple of onetime items related to relocations and other HR type issues that hurt in the first quarter. So that was incremental when you go back to Q4. And then there was also a little bit of an uptick in the corporate allocation from Q4 to Q1.

Andrew Shapiro – Lawndale Capital Management

With the backlog, you have the sizable increase in your Complex Systems backlog versus last quarter and prior year, can you define if it’s different between the two segments but what's the definition for your backlog for the Complex Systems and is this increase sustainable new business processes or is it just a function of delayed programs?

Gregory Slome

No I think it’s a combination. Clearly the delayed program is contributing to that. The overall backlog represents from customer orders that we have within and pretty much expect down to be delivered with a 12 to 18 month window.

Andrew Shapiro – Lawndale Capital Management

Seems medical is the definition.

Gregory Slome

Right.

Andrew Shapiro – Lawndale Capital Management

Okay.

Cary Wood

Generally could be, less amount of time. That's why I typically quoted it as being six to 12 months because there is a range. When Greg just quoted for you more on the 12 to 18 month, that’s certainly taking DSS into consideration but when you talk about medical, those types of backlog, lead times are a little less.

Andrew Shapiro – Lawndale Capital Management

And sequentially and year-over-year your other asset lines kind of had a material jump as well and I know prior, I don't think it’s seasonal because prior year Q1 was down from Q4. What's the increase attributable to? What's being loaded in there?

Gregory Slome

I guess I just want to clarify first Andrew; you’re looking at the other long term assets?

Andrew Shapiro – Lawndale Capital Management

Yes.

Gregory Slome

So other long term assets sequentially have pretty much dropped on a quarter-to-quarter basis. The biggest dropped, if you go back to September quarter of last year, was the sale of the (inaudible) stock. And then sequentially quarter-over-quarter it’s been drop in really due to a couple of things, the amortization of the capitalized loan fees that we had with the PNC loan agreement and then also we have the non-receivable on the (inaudible) land lease which is being paid off on an annual basis. So those two items are really accounting for their continual drop.

Andrew Shapiro – Lawndale Capital Management

But then this quarter it went up by 1.5 million in the September quarter. So what's all the sudden a big increase? [Multiple Speakers] assets below the pension asset, above goodwill, I think it’s about to 1.8 million. At least that what seems to me on my sheet here? We can take care of that offline if I am wrong.

Cary Wood

Why don't we do that Andrew?

Andrew Shapiro – Lawndale Capital Management

Okay, then you know, you’ve talked about the overall the overall, it seems you’ve talked about new programs overall. But I am not sure if you provided or if its available as your new programs by segment, and how many of those, I think one segment you mentioned were from existing customers versus first time customers and I don't know if you broke out engineering versus manufacturing mix but if you have some of that information by segment which I talked with you once about at lunch, maybe you’re able to provide, can you break these new business wins down by segment and by types since engineering might also be a leading indicator?

Michael Osborne

For DSS we had six wins in the first quarter, two of those were engineering. Medical, three of those, those three wins, two of those were engineering. And for Complex Systems, the remaining five, none of those obviously were engineering. Out of the total 14, we have 10 new customers on that list.

Andrew Shapiro – Lawndale Capital Management

And does your acquisition impact your 2013 segment margin range guidance upwards for medical since this was a higher margin business that you are doing and does it impact more than just the medical segment focus or when do you expect that you’ll kind of have your arms around this for which you might say, okay, we’re either sticking with the 2012 margin levels as our current guidance or we’re making some adjustments. This is for general gross margin.

Cary Wood

Yes, I think it’s prudent. We’re going to work hard on the integration and get to that and focus on that immediately. I don't want to get over my skis here and be too bullish around how its additive performance will enhance our guidance on the medical margins. Right now I want to maintain, we’re very confident in the guidance margins we've given and more times that that, we've been on the high side of the band. I am certainly excited about the fact that we've got some new opportunities with new customers that we can bring some value to that. Currently we’re at a higher gross margin and so as we look ahead, I think there is probably some optimism around what that band might look like but for today we’re not going to make any changes.

Andrew Shapiro – Lawndale Capital Management

And last question, you’re supposed to close this I guess by November 30th, I am not sure how soon then after Greg might know, when should we expect to see the 8-K that would then provide for material acquisitions, the disclosures on the finances of the assets acquired etcetera so that we could have a better picture on the multiple paid and the run rates.

Cary Wood

Right, it’s up to 71 days. It could be sooner but it’s the FCC requirement.

Michael Osborne

Well, I'd like to thank everybody today, Paul. Today call including the question and answer period has been recorded and will be posted to our website under investor relations later today. Thank you very much.

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.

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