Start Time: 11:00
End Time: 11:27
Sparton Corporation (NYSE:SPA)
Q2 2017 Earnings Conference Call
February 08, 2017, 11:00 AM ET
Joe Hartnett - Interim President and CEO
Joe McCormack - CFO
Chris Ratliff - VP, Digital Information and Technology
Lee Jagoda - CJS Securities
Rudy Hokanson - Barrington
Ladies and gentlemen, thank you for standing by. Welcome to the Sparton Corporation Fiscal 2017 Second Quarter Financial Results Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. [Operator Instructions]. As a reminder, this conference is being recorded Wednesday, February 8, 2017.
I would now like to turn the conference over to Mr. Chris Ratliff, VP of Digital Information and Technology. Please go ahead, sir.
Thank you, operator. Good morning and thank you for participating in Sparton’s fiscal 2017 second quarter conference call. On the call with me today are Joe Hartnett, Sparton’s Interim President and Chief Executive Officer; and Joe McCormack, Chief Financial Officer. Our earnings release and the slide presentation for today’s call will also be available in the Investor Relations section of our Web site later today.
Before we start, a word of caution. During this call, we will be making forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Investors are cautioned that forward-looking statements are inherently uncertain and that there are a number of factors that could cause actual results to differ materially from these statements. These factors are outlined in our SEC filings.
I’d like to now turn the call over to Joe Hartnett.
Thanks, Chris. Good morning, everyone. Welcome to our fiscal 2017 second quarter conference call. I’d like to start out by making a few brief statements about our operating performance for the quarter.
First, we’re very pleased to report that our MDS segment has reported net organic revenue growth this quarter as compared to the prior quarter and Q2 of fiscal 2016. As we have stated in the past, organic growth has and will continue to be a priority and it’s encouraging to see that our efforts are beginning to produce tangible results.
Second, we were able to improve our balance sheet through inventory reductions of almost $8 million while at the same time reducing accounts payable by almost 5 million and long-term debt by over 10 million when comparing this quarter and versus the end of Q1. This significant improvement is the result of the collective effort of the organization and continued evidence of the capabilities of the team.
Third, quarterly revenues came in at approximately 97 million which was within the range of guidance provided on our last call. However, reported margins were at $15.9 million or 16.3% of revenues which was below our guidance of 18%. This miss was largely the result of two issues contained within our ECP segment.
The first issue was unabsorbed fixed overhead costs caused by delays in production of our Q53G sonobuoy. As we moved from producing the Q53F to the Q53G, we experienced greater than expected effort in getting the full production. The second issue was the need to record losses on a contract within our rugged display product line. Both of these issues are behind us and not expected to impact future quarters.
The final topic I would like to discuss before turning the call over to Joe McCormack is on the Board’s previously disclosed decision to explore a potential acquisition in the company. That process is ongoing. And while we are not in a position to provide additional information at this time, we do expect to conclude the process by our next earnings call.
As we have previously communicated, we remind you that the process may or may not lead to an acquisition of the company and that the company will disclose further developments when it’s appropriate to do so.
With that, I would like to turn it over to Joe McCormack who will discuss the additional financial highlights of the quarter.
Thanks, Joe, and good morning. For the second quarter of fiscal 2017 on a consolidated basis, net sales were $97.4 million as compared to $100.4 million in the prior quarter and $103.5 million in Q2 of 2016.
The decrease in net sales as compared to Q2 of 2016 was due to lower sales volume in our ECP segment of $8.2 million as offset by net organic revenue growth in our MDS segment of $2.1 million.
The lower sales volume in the ECP segment was principally due to foreign sonobuoys sales. This reduction was anticipated as foreign sonobuoys sales were particularly strong in Q2 of 2016.
Our gross profit margin was 16.3% compared to 17.2% in the prior quarter and 17.9% in Q2 2016. The decrease in gross margin was due to lower margins in our ECP segment as offset by increased margins in our MDS segment.
The margins in our ECP segment were lower due to; first, the segment experienced higher unabsorbed fixed overhead costs as a result of delays in the fully ramped up production of our Q53G sonobuoy.
The Q53G required a complete changeover from its Q53F predecessor and for most of the quarter, we were running at less than 60% of full production. As of December 2016, the Q53G was in full production and this matter is not expected to have negative margin impacts on future quarters.
Second, we accrue for a loss to complete a contract within our rugged electronics platform. This loss was recognized as a result of production issues experienced on the contract in the quarter.
As a result of these issues, the estimated costs to complete the contract exceeded the contract revenue. The estimated loss through contract completion have been fully accrued and the matter is not expected to have negative margin impact on future quarters.
Selling and administrative expenses were $13 million as compared to $13.4 million in the prior quarter and $14.3 million in Q2 2016. On an adjusted basis, selling and administrative expenses were $12.3 million or 12.6% of sales compared to $12.6 million, also 12.6% of sales in the prior quarter and $13.4 million, 13% of sales in Q2 2016.
The decrease in selling and administrative expenses compared to the prior quarter was due to slightly better healthcare cost experience as well as headcount attrition and continued cost containment initiatives.
Adjusted EPS was $0.10 compared to $0.20 per share in the prior quarter and $0.25 per share in Q2 of 2016. EBITDA on an adjusted basis was $5.6 million compared to $6.1 million in the prior quarter and $7 million in Q2 of 2016.
Free cash flow for the quarter was $10 million compared to $2.1 million in the prior quarter and $6.9 million in Q2 2016.
In our MDS segment, net sales were $65 million compared to $62.8 million in the prior quarter and $62.9 million in Q2 2016. The net organic revenue growth in the quarter was a result of increasing new wins in both Medical and Mil/Aero end markets.
Gross profit margin for the segment was 12.4% compared to 11.2% in the prior quarter and 10.3% in Q2 2016. The increase in gross profit margin was primarily due to higher absorption of fixed overhead costs, as a result of higher sales volume.
Selling and administrative expenses, including corporate allocated costs, were $5.6 million compared to $6 million in the prior quarter and $6.6 million in Q2 2016.
In our ECP segment, the net sales were $32.4 million compared to $37.6 million in the prior quarter and $40 million in Q2 2016. Net sales for the quarter were principally comprised of sonobuoys to the U.S. Navy of $20.8 million, sales of sonobuoys to foreign governments of $2.3 million, engineering revenues of $1.3 million and rugged electronic and other revenues of $8 million.
As compared to Q2 2016, the decrease in net sales was a result of lower total sonobuoy sales of $3.6 million, lower engineering revenues of $3.4 million and lower rugged electronic sales of $1.2 million.
As previously discussed, Q2 2016 was particularly the strong quarter for foreign sonobuoy sales, which limited the production of domestic sonobuoys in that quarter. In the current quarter, the reduced volume of foreign sonobuoys was anticipated and domestic sonobuoys were affected by the delay in the full production of the Q53G sonobuoy as previously discussed.
Engineering revenue was lower compared to Q2 of 2016 principally as a result of the completion of our high-altitude ASW sonobuoy deployment which are now in production, as well as the impact of ongoing continuing resolutions by the federal government which is causing delays in the funding of customer projects.
Revenues from the rugged electronics platform were lower compared to Q2 2016 as a result of increased competition in the Marine and Industrial end markets. The gross profit margin for this segment was 23.3% compared to 26.6% in the prior quarter and 28.3% in Q2 2016.
As previously mentioned, the decrease in gross margin as compared to Q2 2016 was due to unabsorbed fixed overhead costs as a result of a delay in reaching full runway production of the Q53G sonobuoy which reduced margins by approximately 3.9%, and the recording of a lost contract in the rugged electronics platform which reduced margins by approximately 2.3%.
The Q53G sonobuoy was in full production as of the end of the quarter and the loss on the rugged electronics platform contract has been fully reserved. As such, these matters are not expected to have a negative impact on margins in future quarters.
Selling and administrative expenses, including corporate allocated costs, were $3.5 million compared to $3.8 million in the prior quarter and $3.7 million in Q2 of 2016.
With respect to liquidity and capital resources, we generated free cash flow for the quarter of $10 million compared to $6.9 million in Q2 2016. As a result, debt outstanding under our revolving credit facility was reduced by $10.1 million during the quarter.
We ended the quarter with borrowings under the facility of $85.7 million and had availability under the facility of $84.2 million. Our debt to EBITDA ratio was 3.1x as calculated under the terms of the facility.
At this point, I would like to turn it back over to Joe Hartnett.
Thanks, Joe. Let me close by addressing a couple of important topics. First, we closed the quarter with 236 million in backlog consisting of 123 million in the MDS segment and 113 million in our ECP segment. MDS also captured new program wins for the quarter with expected annual revenue of $14.5 million when fully ramped in production.
Our MDS segment has a trailing four-quarter program win total of approximately $59 million. Last earnings call, we disclosed that we were starting to experience delays in certain awards and new business opportunities by both existing customers and prospects. Today, we’re pleased to report that a number of those companies have in fact made a decision to award us the business.
Year-to-date, we have had three new medical programs with first commercial shipments that will equate to an annualized run rate of approximately $7 million when fully ramped up. The new medical wins recorded in the quarter include two multiyear Class 3 next generation diagnostic medical devices with long-term manufacturing agreements expected to follow.
In Mil/Aero, there were four new programs with first commercial shipments that will equate to an annualized run rate of over $5 million when fully ramped. Additionally, one customer has agreed to expand their business from printed circuit cards only to full box build. This customer is expected to be a multimillion dollar customer next year and has selected Sparton as the supplier of choice for all future programs. These are just a few of the exciting business development successes we’re beginning to experience in our MDS segment.
Our ECP segment closed the quarter with backlog of 113 million principally consisting of 89 million in domestic sonobuoys, 11 million in foreign sonobuoys and 9 million in rugged displays. Our ECP division had several exciting new engineering development projects that our outside our traditional sonobuoy markets.
The most promising is our expendable 3-inch hammerhead undersea payload delivery solution. Our hammerhead system is a vehicle which deploys payloads that are not normally designed for undersea or maritime environments. Our first hammerhead payload is an unmanned aerial vehicle, UAV, which is being provided by our industry partner AeroVironment. AeroVironment is an industry leader in the UAV market.
The combined payload floats to the surface and then the hammerhead system launches the UAV. These technologies provide the Navy with the capability not previously available. This solution was recently demonstrated for the Secretary of Defense in a large U.S. Navy exercise. Hammerhead is being considered for fleet use in the near future. We’re also working on several other payload options leveraging the hammerhead platform in an effort to build a portfolio of 3-inch products to accompany our 5-inch sonobuoy portfolio.
Finally, we’re working on a project that involves improving maritime mine warfare, which is another emerging market for Sparton. Sea mine remediation is currently a slow tedious process and Sparton is involved in helping a large defense contractor develop technology improvements for the U.S. Navy. All these new products are expendable and they all utilize Sparton intellectual property. In fact, during the course of the development process, our engineers have created new intellectual property and have filed for patent protection where appropriate.
On the subject of guidance, as noted in our press release, we expect revenues for the third quarter of fiscal 2017 between $97 million and $101 million and gross margins are expected to come in at approximately 18.5%.
Now before I open the call for a Q&A, I would like to take this opportunity on behalf of the Board of Directors and the entire management team to recognize and thank all the employees of Sparton Corporation for their continued commitment, dedication and hard work. Their focus on delivering quality performance each and every day is both impressive and inspiring.
We believe that this team together with our processes, manufacturing assets, certifications, customer base and new business development initiatives represent the solid foundation for future growth. The company remains committed to delivering improved operating performance and looks forward to our next fiscal quarter. Thank you.
I will now turn it back over to Chris Ratliff who will open the call up for questions from our sell-side analysts who cover the company. As I have stated in the past, this in no way limits the ability of our shareholders to reach out to the company and express their views and/or seek clarification on certain matters. Chris?
Thank you, Joe. We will now open the call up for questions to our sell-side analysts who cover the company. Operator, first question please?
Thank you. [Operator Instructions]. Our first question comes from the line of Lee Jagoda from CJS. Please go ahead.
Hi. Good morning.
Good morning, Lee.
So starting with the write-off you had in ECP, can you give us a sense for the total revenue of that project and whether that revenue occurred all in the current quarter or if it was spread out over a couple of different quarters?
Yes, this has been spread out over several quarters, Lee. We anticipate that the final production under that contract would be completed in Q3. The total cost of that contract as we talked about has been accrued so that any potential impact going forward has already been factored into the current quarter results.
Okay. So I guess we won’t know how much revenue was actually affected by the write-down?
It was in effect revenue, it’s a cost item and it diminished our margins by approximately 2.3% in the actual revenue quarter – go ahead.
So then said a different way, the total profit to loss swing on that was about $700,000 all taken in the quarter but the revenue was taken over a bunch of different quarters. Is that the way to look at it?
That’s absolutely correct.
Okay. So then just shifting to your guidance, is there any way to size the revenue spilt by segment in Q3 that you might expect?
I think it will follow as we’ve said in the past. It will mirror the relationship of ECP and MDS revenue to total revenue that we just reported in this quarter.
But with a little bit higher --
Since we had lower foreign sonobuoy sales this quarter, I think historically if you looked at the historical trends on the mix between ECP and MDS, it should match up with the historical trends not necessarily this current last quarter.
Okay. And then two more quick ones from me, first on free cash flow. It looks like the percentage of free cash flow converted from EBITDA has been much higher in the last couple of quarters. Obviously, working capital has had a nice impact on that. Can you speak to sort of your cash conversion expectations from EBITDA over the next several quarters as it compares to the last couple?
Of course. Yes, you’re absolutely right. We would love to report that we were going to run in excess of 100% conversion but that’s clearly we were rightsizing our working capital and we believe we have it in a position now where we feel it’s appropriate for the current run rate and the projected run rate. There probably still are some opportunities for inventory reductions in maybe some other areas. But by and large the working capital implications are that free cash flow has been captured. We think we’re going to get back to more of what our anticipated capture rate would be and that’s at a conversion of EBITDA, so about 35% to 40%.
Okay. Last one from me. Stock-based compensation was up more than double on a quarter-over-quarter basis and I think it’s the highest you’ve had certainly in recent history. Is there anything of note in that number?
Yes, a couple of things drive that. Q2 was typically our highest quarter in terms of stock-based compensation. It’s the quarter in which we provide grants to directors. As you probably know, we have two new directors this quarter which helped drive some of that number. There was additional grants to Joe Hartnett when he signed on as CEO that are being picked up during this quarter. And lastly there’s always the fluctuations in terms of previous tranches that get reversed against the expense as they go un-invested, and we reverse our stock-based compensation expense. And I think what we’re seeing as we compare this to Q2 of last year as well as some of the prior quarters, in this current quarter we didn’t reverse any amounts for un-invested.
And that’s going to expand kind of projections of where we are for the year.
Very helpful. Thank you.
Our next question comes from the line of Rudy Hokanson with Barrington. Please go ahead.
Thank you. Good morning. Could you maybe talk a little bit more about the market environment in MDS? As you said, a number of clients have come on. Does that imply that any kind of question about what your clients maybe facing over the next six or nine months? Are they starting to get more confidence or is it just a matter of the ones who were taking their time happen to come in right now and so you do have them that perhaps there’s still some questioning going on in the MDS market?
Rudy, as a result of what we had learned last quarter, that was a concerted effort by the organization, including me, to sit down with these prospects and existing customers and address their concerns. And we feel like the efforts that was put forth helped ease the concern of those customers and prospective customers, and that’s why we’re seeing an uptick in the new business programs that were awarded.
And to your second point, we are seeing a little more traction in our pipeline as we said both in the Mil/Aero and in the Medical space. We are seeing a strengthening pipeline and strengthening new wins and I think that’s – while it’s difficult to gauge what that means from more of a macroeconomic side, it’s clear that we are seeing increased activity.
Okay, good. And can you give us an indication as to the rugged display market right now? Is that an area where you expect there to be some, maybe an acceleration of interest or wins or is that something that may still take some time to develop or become more meaningful on the ECP side?
Yes, I think as we look at this fiscal year I’d suggest because of the lost contract and some of the delays we experienced because of that lost contract, our revenues will probably be slightly down from last year. And I think as we look forward, we’re going to see growth that’s probably going to be flat to slightly up. And it’s just the matter of continuing to address what’s happening in that marketplace. Again within the Marine and the Industrial side, we’re seeing some increased competition and we’re going to have to deal with that as we move forward. But at this point, as we look at that platform going forward, it’s probably flat to moderate revenue growth.
Okay. And on the new sonobuoys, the G model, is production of that expected to basically – from what it sounds like and what you’re expecting in this quarter and the fact that you’re up to production now, is that something that’s probably going to be fairly steady going forward or might there be something where you have to ramp up or take on added overtime or cost or something to pick up? How should we look at the run rate going forward?
Yes, I think we’re fully ramped up on that, Rudy, and we don’t expect any delays or any other issues. I think as you look at kind of the margins from sonobuoys going forward, it’s going to be very consistent with historical gross margins.
Okay. Thank you. Those are my questions.
I’ll turn it over to you, Mr. Ratliff.
I’d like to thank all the participants in today’s call. Again, today’s call including the question-and-answer period has been recorded and will be posted to our Web site under Investor Relations later today. Thank you.
Ladies and gentlemen, that concludes today’s call. We thank you for your participation and ask you to please disconnect your lines.
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