Description

Sparton Corporation (SPA) – Long

• SPA is a contract manufacturing and defense manufacturing firm. SPA has sustainable competitive advantages, a scalable business model with excess capacity in its facilities, a strong balance sheet and profitable growth opportunities.
• After nearly going bankrupt, a proxy battle in 2009 led to the appointment of a new board and management team. Cary Wood was brought in as CEO and has completely turned around the Company.
• SPA trades at ~4.5x EBITDA and ~9x after-tax 2011 FCF. Additionally, there are multiple avenues to enhance FCF generation.  The risk/reward is attractive -  we expect SPA’s stock price to double over the next 2-3 years.

   Stock price: $9.57
   S/O: 10.1M
   Market Cap: $96.7M
   Cash & Equiv: $26.7M
   Debt: $1.7M
   EV: $71.7M

SPA overview and competitive positioning

SPA is a low volume/high complexity contract manufacturer (CM), making it more an engineering shop than a traditional CM (many better known CMs operate in the high-volume, more commoditized consumer electronics CM space). Given the customization, contracts tend to be long-term, especially in the medical and defense spaces.

SPA is based in Schaumburg, IL with facilities in CO, FL, OH and Vietnam. SPA’s three core segments are:

1. Defense & Security Systems (DSS): The business is one of two producers of sonobuoys for the US navy and its global allies (the other is USSI, part of UK-listed Ultra Electronics). Sonobuoys are consumable anti-submarine warfare products that are dropped from jets into the ocean to identify enemy submarines. There are high barriers to entry given ITAR restrictions (International Traffic in Arms Regulations) and the strength of the  duopoly. In addition to the US Navy and global allies, customers include Northrop Grumman and BAE Systems and other defense companies. SPA also recently launched the Navigation & Exploration segment, commercializing SPA's defense technology in digital compasses and hydrophones into products for oil & gas exploration, sea floor mapping and port security applications.
2. CM Medical: A CM for specialized medical devices, primarily in the in vitro diagnostic and therapeutic device spaces. Customers include Siemens Diagnostics, NuVasive and Fenwal Blood Technologies. SPA has a competitive advantage in the space due to high switching costs and economies of scale as a result of the customization and niche markets.
3. CM Complex Systems: Though the weakest segment, Complex Systems is profitable. The segment focus is producing components and specialized circuit card assemblies for industrial devices.  Clients include Goodrich, Raytheon, and Parker Hannifin. Wood is improving this division and adjusting/eliminating low-margin sub-segments.

Growth/improvement opportunities

1. DSS: Engineering costs have been elevated as SPA prepares for next-gen sonobuoys. The US navy is transitioning from deploying sonobuoys from the P3-Orion prop jet to the P8A-Poseidon jet, which requires more complex sonobuoys. The P3 planes, as they are retired from service, are expected to be sold to the US Navy’s global allies. In particular, there has been a ramp up in naval capabilities by US allies in Asia (especially in SE Asia) in response to the naval threat from China – SPA management expects to generate meaningful foreign sonobuoy sales to these allies. Foreign sonobuoy sales reached $24 million in the first three quarters of fiscal 2012 as compared to ~$4 million in the prior year.  In the US, the Navy’s transition to sonobuoy deployment via the new P8 jets is an opportunity to increase sales. These sales will commence in 2014, with the bulk of the impact in 2015 and beyond.
2. Medical:  SPA has restructured its sales force and hired additional personnel to grow the business; tuck-in acquisitions also add to the growth potential.  In addition, SPA will benefit from operating leverage as utilization increases in its OH facility, which is currently operating at sub-optimal capacity.
3. CM Complex Systems: There is excess capacity in the Complex Systems facilities. Management has recently indicated the signing of some attractively priced contracts which will increase utilization and also increase margins.

Valuation and financials

• At $9.60 per share, SPA trades at ~4.5x 2011 EBITDA and ~9x after-tax 2011 FCF. This is an attractive price for a quality company with a strong balance sheet, judicious management and multiple avenues to enhance FCF generation including:
  • Higher margins and FCF driven by improved utilization (via new business/program wins)
  • Incremental returns from investments over the past 12-24 months, such as the incremental sales force in medical and defense
  • Re-negotiation and/or purging of the remaining  sub-optimal contracts in Complex Systems
  • Cary Wood noted that further acquisitions could be a component of growing the business; the Company would benefit if Wood can replicate the acquisition success he has had to date (i.e., buying Delphi Medical/Byers Peak at attractive prices)
  • The Navy is transitioning its deployment of sonobuoys to the P8A-Poseidon jet, ultimately leading to increased revenue and lower engineering costs (which have ramped up the past 12 months to prepare for this opportunity).
• As to target price, we believe SPA is a double over the next 2-3 years.  As the catalysts begin to play out and performance improves further, investors will re-rate the stock accordingly.
• Comps: the median trailing EBITDA multiples for standard CM comps in the US are ~6.5x, ~50% higher than where SPA trades. Specialized medical/defense comps (which are more viable comps for SPA) trade at high single-digit EBITDA multiples.
• Moreover, SPA is also an attractive acquisition candidate for a cashed up defense firm or private equity firm.

Other points

• Buyback: SPA recently completed a $3M stock buyback.
• No analyst coverage.
• Restructuring under Wood has taken SPA from the verge of bankruptcy to a well capitalized, strong company. Management closed and sold facilities, froze the pension plan, sold non-core investment Cybernet Systems, implemented best practice manufacturing standards, restructured low-margin contracts and cut bad contracts.
• Siemens issue:  SPA was historically the sole CM/supplier to Siemens for various medical devices.  During the downturn, when SPA was mismanaged and looked headed for bankruptcy, Siemens began shifting to dual-source production for the devices SPA had been solely producing. This negatively impacted revenue from Siemens over the past two years. That Siemens revenue drop has been offset by new business wins and the tuck-in acquisitions in Medical.

Risks

• In 2014, the duopoly for sonobuoys opens up. Although there is a new entrant risk, it is a small market dominated by two players, so an entrant would face a low return on investment by attempting to enter. The production process would require considerable R&D.  We are watching this risk closely although we believe it is more likely that one or both players are acquired as a way for another firm to enter the market.
• SPA's performance is impacted by the overall economy; SPA is not recession-resistant.
• Bad acquisitions: Cary Wood has done smart, tuck-in acquisitions and cares about return on capital. That said, although Wood is patient in finding acquisition opportunities that meet his parameters, any acquisition is fraught with risk.

Catalyst