Sparton Corporation SPA
July 15, 2010 - 8:45am EST by
2010 2011
Price: 5.09 EPS $0.81 $1.00
Shares Out. (in M): 10 P/E 6.0x 5.0x
Market Cap (in $M): 51 P/FCF 4.0x 5.0x
Net Debt (in $M): -13 EBIT 14 16
TEV ($): 38 TEV/EBIT 2.8x 2.3x

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Sparton Corporation ("Sparton" or the "Company", ticker: SPA) announced a transformational acquisition earlier this week, but the stock market's collective reaction has been a yawn.  This surprising reaction provides investors with an outstanding entry point in a rapidly changing business with significant upside potential.  Over the last couple of years an aggressive new management team at Sparton has turned what was a perennially money-losing enterprise into a consistent generator of profits and free cash flow, yet due to the wrenching nature of the changes required for this transformation, and the associated negative impact on the top line, the Company's shares have not yet begun to hit many investors' radar screens.  The recently-announced acquisition will likely change this, as Sparton once again begins to grow its top line and leverage its new, lean manufacturing footprint into rapidly growing operating margins and earnings.  Today, an investor in Sparton can purchase the Company net of roughly $0.80/shr in cash on its balance sheet (pro forma for the acquisition), for just 3-4x its EPS potential and 80% of book value.  On this same basis, the Company trades today for under 10x TTM EPS and 7x last nine months annualized FCF.  Although the Company trades just 1x TTM FCF, this includes a material benefit from 1-time working capital reductions that aren't likely to be repeated.

Sparton is a contract manufacturer that does business through three primary segments: Electronics Manufacturing Services ("EMS"), Medical Device, and Defense & Security Systems.  Contract manufacturing services fall along a continuum, the extremes of which are defined by the extent to which the contract manufacturer provides value-added services to the customer.  At one end of the continuum are low value-added providers whom produce commodity circuit boards and electronic assemblies.  Profit margins at this end are slim and working capital requirements are substantial.  As such, both returns on capital and cash generation are paltry.  At the other end of the spectrum are high value-added providers.  These providers are generally integrally involved with the initial design of the underlying circuit boards and assemblies.  Moreover, production processes are typically exacting and may involve a high degree of specialization.  Profit margins at this end of the spectrum are much more robust, working capital requirements are meaningfully reduced, and both returns on capital and cash generation are greatly improved.  Sparton's EMS division falls at the lower value-added end of this continuum, while both the Medical Device and Defense & Security Systems divisions fall at the higher end of the continuum.  Sparton's Medical Device division holds a unique position as a designer and producer of hardware assemblies for the in vitro diagnostics equipment industry, while its Defense & Security Systems division is one of two primary partners that produce sonobuoys for the U.S. Defense Department and other U.S. allies.

For many years, Sparton's management team pursued a growth-at-any-cost strategy.  This strategy was implemented by focusing on new contract generation at the EMS division.  As the Company signed new EMS contracts it was able to show continued top line growth, however, this growth was achieved at the expense of consistent profitability.  Sparton's reported results were abysmal, with an operating profit generated only once between fiscal 2004 and fiscal 2009.  In mid-2007, as performance at the Company continued to deteriorate, one of its long-time shareholders, Lawndale Capital Management, began to take a more activist stance.  This culminated in a proxy fight, the outcome of which was an ouster of Sparton's CEO and significant reconstitution of the board of directors.  A new CEO, Cary Wood, was brought in late in 2008.

Mr. Wood moved aggressively to address outstanding issues at the Company.  Two of six manufacturing facilities were closed, multiple reductions in force were undertaken, and the entire senior management team was replaced.  The new senior managers, including Mr. Wood, are well-versed in operational turnarounds.  The results of their early efforts have been impressive.  Sparton has now returned to profitability on an operating basis.  Inventory levels have been reduced by 45% and the Company has generated positive operating cash flow in five of the last six quarters.  This has enabled it to pay off all outstanding debt and sign a new credit agreement; an impressive achievement given that the Company was facing a liquidity crisis just one year ago. 

As part of the restructuring, a number of unprofitable contracts in the EMS division have been terminated.  While this was an important driver in helping return the Company to profitability, it has also driven revenue declines on a reported basis for the last several quarters.  Those investors who have not dug beneath the surface to understand the underlying dynamics may see a company in terminal decline, but this is far from the case.  On an organic basis, the contract terminations are now behind the Company and growth should resume from the current base (a view supported on the most recent earnings call).  In addition, the acquisition of Delphi Medical Systems announced this week will add roughly 20% to the MRQ revenue run-rate, and once again return the Company to an obvious growth trajectory.  The Delphi acquisition was smartly structured to limit downside to the Company, and at $8mm represents little more than the net value of the existing inventory.  There is zero overlap in Delphi's customer base with existing Sparton customers, and in addition to increased customer diversity Sparton gains access to several new sales channels.

With the current vastly improved cost structure in place, revenue growth should help drive in excess of $1.00/share in earnings for Sparton over the coming couple of years.  Even after the closure of two of its manufacturing facilities, Sparton still only operates at only about a 60% utilization rate.  Incremental business should therefore continue to enhance the Company's operating margins. 

Equally important, with the de-emphasis of the EMS business, the Company's incremental operating margins, returns on invested capital and cash generation will continue to improve.  Ultimately, in conjunction with a reinvigorated top line, this should lead to multiple expansion for the Company's shares, and significant upside for the stock.



Delphi acquisition begins to flow through P&L, organic growth, improved IR outreach, new military contracts announced
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