SPARTON CORP SPA
September 16, 2015 - 3:45pm EST by
zzz007
2015 2016
Price: 21.44 EPS 1.75 2.40
Shares Out. (in M): 10 P/E 12 9
Market Cap (in $M): 212 P/FCF NM 9
Net Debt (in $M): 140 EBIT 27 40
TEV ($): 352 TEV/EBIT 13 9

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Description

Sparton Corporation (“Sparton”, “SPA”, or the “Company”) has been written up twice on VIC previously, once by me (Jul 2010) and once by zbeex (Jul 2012).  Absolute returns in both instances were solid (+150-400%), with good annualized returns as well.  Although absolute returns on this go-round may not have as much absolute upside, they should still be decent, with very attractive potential annualized returns as the current cloud of uncertainty and confusion lifts in the near-to-medium term.

Today, Sparton trades at roughly 7.5x EBITDA and 9x cash EPS (fiscal 2016, which ends Jun 2016).  This is roughly in-line with much lower margin commodity-oriented EMS companies (JBL, SANM, FLEX) – modestly pricier on an EBITDA basis, modestly cheaper on an EPS basis.  This, despite the fact that Sparton should be currently, and has frequently been in the past, valued at a significant premium to the EMS “comps” given a superior mix of business with more favorably underlying financial characteristics.

Sparton reports its business through two segments:

Manufacturing & Design Services (“MDS”, 2/3 of revenue, 1/3 of EBITDA) – MDS is the Company’s electronic manufacturing services (“EMS”) business.  In a nutshell, Sparton helps design and assemble printed circuit boards, product sub-assemblies, and full assemblies for its end customers.  For an excellent overview of EMS businesses in general, I refer you to oldyeller’s May 2015 write-up of Flextronics.  The most salient point to keep in mind with respect to Sparton’s MDS segment is that it falls squarely on the “high value added” end of the EMS spectrum (what oldyeller/FLEX refer to as “non-traditional emerging businesses”).  These products require significantly more input (from the EMS provider) with respect to industrial design and assembly planning, and they tend towards lower-volume, higher margin contracts.  Sparton targets a 13-16% gross margin range in this segment, versus the single digit gross margins that a high volume EMS provider typically targets.  Sparton’s target verticals (healthcare, defense, aerospace, other specialty industrial) are also significantly less penetrated from an EMS perspective than the higher volume EMS segments (consumer, computer, communications), with (unsourced) estimates of just 10% EMS penetration for Sparton’s target verticals versus 80%+ penetration for the high volume segments.  This obviously has very positive implications for the segment’s growth trajectory.

Engineered Components & Products (“ECP”, 1/3 of revenue, 2/3 of EBITDA) – This is Sparton’s specialty defense business.  The primary value in this segment lies in the Company’s 50/50 JV with UnderSea Sensor Systems (a subsidiary of publicly-traded Ultra Electronics Holdings plc) to make sonobuoys.  Sonobuoys are consumable electronic devices used in anti-submarine warfare, and the JV has an effective lock on the product for sale to the U.S. military and its allies.  Demand for sonobuoys has been growing consistently, and the outlook continues to be good as both China and Russia continue to flex their naval muscles.  Sparton targets a 25-30% gross margin range in this segment.

What is Sparton worth?  The answer is that I don’t know precisely, but I think it’s considerably more than today’s trading levels.  Here are a few thoughts to help triangulate a value.  Scuttlebutt is that there have been soft expressions of interest in the past for the Company’s ECP division at a range of 10-12x EBITDA.  This doesn’t seem out of line to me, as this business is a true crown jewel with strong margins, strong implicit returns on capital, and good visibility.  At 12x EBITDA (which includes a full allocation for corporate overhead, hence use of the high end of the range), this business would represent the entirety of the Company’s current enterprise value, with upside provided by the MDS segment.  Putting a 6x multiple on the MDS segment would imply about $9-10/shr of upside to today’s price.  On an earnings basis, I am confident that 9x cash EPS is too low.  This implies little-to-no growth, which given the Company’s history and prospects is unrealistic.  With 2/3 of EBITDA provided by the attractive ECP segment, I think a 13-15x multiple is fair, which applied to $2.40/shr in fiscal 2016 cash EPS implies something in the range of $31-$36/shr fair value.

To understand why Sparton stock trades where it does today, it helps to understand the Company’s recent history.  Current CEO Cary Wood has been on board for roughly seven years.  He was initially brought in to right a sinking ship, as previous management had aggressively pursued top line growth at the expense of profitability.  This strategy had led, in turn, to serious liquidity issues.  Mr. Wood quickly implemented significant changes, terminating unprofitable contracts, right-sizing manufacturing capacity, and shoring up the balance sheet.  For the first five years of his tenure, Mr. Wood led something of a charmed existence (from the Street’s perspective), as he routinely underpromised and overdelivered, with the stock moving from under $2/shr when he was first appointed to over $30/shr in early 2014.  At that point, management believed that it had put the foundation in place to support more aggressive growth targets and, as a result, it began a period of relatively heavy tuck-in M&A activity.  This M&A effort necessitated a meaningful ramp-up in what had historically been a relatively lean corporate SG&A line, providing a headwind to reported margins.  Concurrently, during fiscal 2015, the Company lost a major customer account (described further below).  The combination of these factors led to several earnings misses during fiscal 2015 (“misses” vs. consensus, although the Company does not provide point guidance), putting the Company into the investor penalty-box and leading to the current opportunity.

 The lost contract during 2015 was from customer Fenwal (a provider of transfusion products).  The contract in question represented almost $20mm in revenue, or roughly 8% of the MDS segment top line.  This was obviously a heavy headwind to try and overcome.  The contract was not lost as a result of any performance issues and, in fact, Sparton continues to service Fenwal through multiple other programs.  The loss of the contract was due to Fenwal’s purchase by Fresenius, and Fresenius’ subsequent decision to soak up some of their slack internal manufacturing capacity by bringing the product line in-house.  Despite these details being well disclosed by Sparton management, the market has continued to fret over the possible loss of additional Fenwal/Fresenius business.  In fact, B. Riley relaunched coverage on Sparton in July of this year, and listed Fenwal “risk” as their primary reason to stay “on the sidelines” with respect to Sparton stock.  This risk is virtually non-existent.  The remaining Fenwal product lines serviced by Sparton are overwhelmingly end-of-life, small batch programs, with associated logistical challenges of moving in-house far outweighing potential financial benefits.  More broadly, Sparton management has consistently tried to guide investors to expect lumpiness in the MDS business, while guiding to an organic growth rate over time in the low-mid single digits.

A second area of perceived risk in the business has been the flurry of M&A activity over the past 36 months.  Historically, management has been very, very good on the operational side of running the business (Mr. Wood is a Six Sigma guy with a background heavily versed in plant management and manufacturing engineering).  They are less tested, though, on the M&A front.  Prior to fiscal 2013, Mr. Wood’s team had executed two small tuck-ins at Sparton.  Subsequent to that (in the past 36 months), they have completed an additional eight acquisitions with that activity weighted towards the latter part of the 36-month timeframe.  This has had a number of practical implications.  First, the balance sheet has moved from a material net cash position to a net debt position.  While this has rattled some shareholders, leverage today stands at a reasonable 3x net debt:EBITDA, with interest coverage of about 10x.  Although, as a result of the leverage, the margin of safety isn’t what it once was, from a corporate finance perspective the capital structure today is arguably more appropriate for an industrial business than it was several years back.  The recent rapid pace of acquisition has also driven inefficiencies into the Company’s working capital cycle.  The associated proliferation of manufacturing facilities has driven inventory growth ahead of the management team’s ability to optimize it (since most of the acquired facilities come with their own inventory), driving up overall invested capital requirements and compressing returns.  This has had negative implications for the Company’s trading multiple.  Lastly, there are always increased integration risks associated with aggressive M&A activity, as well as the soft concern that acquisitions are being done to hide weakness in the core business.  With respect to the latter issue, I have no concerns.  Management’s financial disclosure is excellent.  Contributions from acquisitions are explicitly broken out in Company’s quarterly press releases, and apples-to-apples comparisons of the core (i.e. non-acquired) business are given.  On the plus side of the ledger, the acquisitions have had significant positive implications for Company backlog (+36% sequentially in the most recent quarter), have substantially decreased customer concentration risk (lowering the likelihood of another Fenwal-type headwind), and should ultimately provide greater opportunity to optimize utilization rates.

Going forward, I see a number of potential catalysts to drive Sparton’s share price back towards something approaching fair value:

Sparton announced its 2015 4th fiscal quarter last week.  As part of the announcement, it disclosed that it would be taking a hiatus from M&A activity.  This is great news.  Not only will it give the market an opportunity to catch up on what should become a cleaner organic growth story, it will give the management team an opportunity to do what they have proved time and again they’re very good at, i.e. optimizing existing operations.  There is undoubtedly a fair amount of facility rationalization that can be undertaken given the acquired businesses, as well as work that can be done on the working capital front to lower overall capital intensity.  Furthermore, with no cash going out the door in the near-medium term for acquisitions, the Company true free cash generation capabilities will become more obvious (more on this below).  Lastly, the M&A hiatus will give Sparton the opportunity to right-size the corporate part of the G&A line, thereby boosting margins.

As mentioned earlier, I think that Sparton’s financial disclosure is excellent.  In addition to their clear approach to identifying organic vs. acquisition-related growth, they’re in the minority of companies who (properly, in my view) do not add back share-based comp in their adjusted earnings presentation.  This said, they’ve also historically done themselves no favors in one very material respect: explicit add-back of acquisition-related intangibles to provide investors a fair assessment of cash earnings.  With the relatively aggressive M&A activity of late, this has become a meaningful number.  Currently, there is something between $0.60 (fully-taxed) and $1.00 (untaxed) of acquisition-related intangible amortization running through the income statement.  Thus, the consensus $1.65/shr in EPS for fiscal 2016 (for which the sell-side conforms to management presentation, i.e. no add-back of acquisition-related intangibles) is actually closer to $2.25/shr on a true cash EPS basis.  This is the difference between an arguably fairly-priced P/E of 14x and an undervalued P/E of 10x.  I expect this to change going forward.  I believe the Company will begin reported an adjusted earnings number going forward that includes this add-back, bringing them into line with the vast majority of other publicly-trade acquisitive companies, and further underlining the Company's strong free cash flow, which I expect to exceed $25mm (>$2.50/shr) in the current fiscal year.

Sparton completed its outstanding share repurchase programs in both 2013 and 2014.  There is currently no plan authorized.  I believe that there is a strong likelihood that if the stock stays at current levels, the BOD will authorize a repurchase program in the near-term and begin executing on it in short order.

Sparton just announced a strong 4th fiscal quarter, and has good visibility into the next two quarters.  Management knows they are in the penalty box, and with a solid backlog and good visibility on the first half of the coming fiscal year, the Company should (hopefully) return to its historical pattern of underpromising and overdelivering.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

*  M&A hiatus leads to consistent earnings performance over next few quarter, significant free cash generation, and re-rating of trading multiple

*  Share repurchase authorization + execution

*  Improved financial disclosure of cash earnings makes undervaluation more apparent

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