Sparton Corp. (SPA) reported fiscal 2nd quarter results two weeks ago. The stock dropped sharply on the news, but has since rebounded. A great deal has occurred since my original post on the company.

SPA’s management continues to focus on improving margins and eliminating unprofitable contracts, so the fall in top-line results is probably expected – and sets the company up for a much better future.

Financial Results

Sparton reported results for the fiscal 2nd quarter of 2011, with sales falling from $47.2m to $46.3m, or 1.9%. The company showed top-line weakness across most of the major product divisions including foreign sonobuoy sales in the DSS segment and increased program losses within the EMS segment.

However, the Delphi acquisition has proved profitable, contributing $11.4m in sales on a net income rate of $1.2m, a major boost to the quarter’s final tally.

Operating profits were up 3% to $1.58m compared to $1.48m in the prior year quarter. The 2010 second quarter was negatively impacted by a $1m restructuring charge, but helped by a $1.9m income tax benefit, making bottom line comparisons difficult.

Overall, the company reported net income of $1.4m, or $0.14 per share.

Through the first six months of the year, sales are off 3% with significant declines in the EMS business offset by revenue increases in the Medical segment.

Operating income is much improved, even discounting for a $2.4m gain due to the recent acquisition, up to $5.6m.

The balance sheet remains strong, with $30m in cash offset by only $1.8m in debt (and the company has an unused $20m credit line available).

Business Segment Overview

Since taking over, management has been extremely focused on improving margins in the company’s core businesses. Some of the legacy contracts in the EMS division were unprofitable, and the company has made the difficult decision to cut loose or restructure contracts with those customers, causing the sales decrease.

Long-term, this is a sound strategy, as the remaining customer relationships will translate into higher margins, a key portion of the original investment thesis.

In addition, the legacy Medical business segment has shown declines over the past few quarters, due to softening in several core customers. According to Cary Wood, Sparton’s CEO:

“there have been three major customer issues that have primarily impacted the overall softening, with one customer that suspended production to make product enhancement modifications, a second customer who moved their production back into their own manufacturing footprint, and a third customer who right-sized their inventories due to market softening and a primary working capital initiative.”

Despite the reduction in volume in the Strongsville facility – where the legacy Medical business is performed – the company has maintained a 14% gross margin due to strong cost containment measures, well within their targets.

Finally, SPA’s DSS segment continues to perform due to the long-term nature of Navy contracts. Most of the margin impact is due to variability in international orders.

Major Events

Two weeks ago, the company announced an agreement to sell its New Mexico facility for $4.2m. The sale is expected to close by the end of February, and removes the last idle facility on the company’s books from the recent restructuring, in addition to boosting Sparton’s cash balance.

On Feb 22, the company announced a new acquisition within the Medical Segment, picking up certain assets and liabilities of Byers Peak, Inc.

According to the press release, Byers Peak

“primarily manufactures medical devices for OEM and emerging technology companies in the Therapeutic Device market, including products for surgical navigation, RF energy generation, non-invasive pain relief, arterial disease, and kidney dialysis.”

The company expects to pick up $10m in annual revenue, with the acquisition accretive to earnings no later than the second quarter of fiscal 2012. It also serves to diversify the customer base and will leverage Byers existing customer relationships and field presence.

Conference Call Notes

• Expenses up ~$500k due to legal claims and payments in a lost arbitration class. Frustrating experience but one-time non-recurring expense (almost $0.05/shr)
• Medical: Major customer reduced units by 30% but expected to ramp back up to 100 units per year
• EMS: Vietnam business has doubled in each of past two years. Overall, “won’t populate (segment) with low margin business even if it’s high volume”
• Backlog in latest quarter was $120m, up in each of past five quarters. Highest in history was $124m in fiscal 2009 (but unprofitable backlog at that point in time)

Valuation

Sparton has already generated $5.6m in operating income (or $3.2m w/o the acquisition gain).

Assuming Q2 run-rate is sustainable – probably conservative considering the potential for margin improvement, new acquisition boosts, and sales increases – puts the company on track for roughly $8.6m in annual EBIT run-rate.

With an enterprise value of ~$50m, this translates into a 5.8x multiple, with tons of growth potential.

Conclusion

I’m very impressed with Cary Wood, Sparton’s new CEO, and his outlook and thought process on this turnaround.

He remains committed to improving margins and hasn’t let go of the company’s goal to be a $500m company by 2014.

The business continues to generate cash, and is now sitting on a nice cash pile for future acquisitions. While I normally like to see management return this cash to shareholders, so far it has proven to invest in reasonable, accretive, and smart acquisitions.

As long as that trend continues, I’m on board.

Disclosure

Long SPA

As usual, a few of the best value investing links from the past two weeks:

Sears Holding Corp (SHLD)

Long. Sears is a company with a long brand history that has gone through its share of well known struggles over the past few years.

The stock, a holding company for the 2004 merger of Sears and Kmart, is headed by well-known financier Eddie Lampert of ESL Investments.

Other well-known long-term investors such as Bruce Berkowitz and the Tisch Family (of Loew’s fame) have a large stake as well. While the core business is struggling, the company is backed up billions of dollars of real-estate and other favorable assets, protecting the down-side.

While the stock has run-up since the original analysis, it is a great example of a sum-of-parts breakdown for a complicated company.

ITT Corp (ITT)

Work-out. Another conglomerate, ITT announced a split of the company into three operating businesses: Defense, Water, and Industrial Products.

Spin-offs have been proven to a profitable source of investment ideas, and the article does a great job of breaking down the individual business segments.

Rolling up the respective valuations into the core holding company doesn’t leave much margin of safety, but the new entities could be prime candidates for value investors.

I will be keeping a close eye industrial products segment, especially since the ‘new ITT’ is not as fancy as the other two divisions. This dynamic could lead to forced selling and a resulting attractive price.

Citigroup (C)

Long. After suffering through the financial crisis (including a government rescue and massive dilution for existing shareholders), Citigroup is now trying to move forward with a more conservative strategy and better risk management.

While outside of my circle of competence, there is no doubt that Citigroup has enormous global potential with operations in over 140 countries. Most of the toxic assets were spun-off into the Citi Holdings subsidiary, and the new bank is trying to stick to its core vanilla banking.

Using several optimistic assumptions (rise in ROA, positive valuation of Citi Holdings and tax assets) yields $0.80 EPS in 2014, or only 5.5x the current price.

While I normally like to look at historical earning power and not pay-up for growth, it is a compelling argument that is backed up other well-known value investors including John Paulson, Bill Ackman of Pershing Square, Bruce Berkowitz of Fairholme Capital, and David Tepper of Appaloosa Management, among others.

TravelZoo (TZOO)

Long. As a deep value investor, TZOO is normally a stock I would avoid: it trades at 50x TTM earnings. But with all of the media attention around the phenomenal success of Groupon, TZOO seems to be positioned to compete in a very hot space.

The write-up breaks out the business into its core travel deals segment along with its new entry into the local deals business.

Assigning a $300m valuation to the core business and $335m valuation to the local deals business results in a fair valuation of $635m on 2011 numbers. With a market-cap of $700m, the business seems fairly valued.

However, a thought-provoking quote sums up the investment thesis:

“Of course, we want to skate to where the puck will be and not where the puck has been or to put it in another way, this is a case of buying a great company at a reasonable price based on conservative assumptions.”

If those assumptions play out, it might turn out to be a great investment.

Paradise (PARF.PK)

Long. In my recent journey through the Pink Sheets, PARF was a stock that caught my eye due to a large discount to both book value and NCAV. In addition, the company dominates its core niche – believe it or not, the candied fruit business!

However, despite the significant asset base, the business has struggled with low operating margins and ROE over the past several years. The article outlines several avenues for improvement, but it is still unclear whether management has taken those necessary steps.

For those interested in net-nets, it could be a stock to watch.

Suggestions

If you have links or suggestions to detailed analysis from other value investors, please drop me a line using the Contact Form.

I’m always open to ideas from other investors, especially for a thoughtful and well-researched investment articles.

Disclosure

No positions.

Iteris Inc (ITI) reported fiscal third quarter earnings last week.

Although product sales were up 16%, the company was forced to report a large goodwill impairment charge in its Transportation Systems segment.

The stock dropped sharply on the news, but has since rebounded.

Earnings Highlights

Overall, revenue for the quarter was up 3.4% to $14m, compared to $13.6m in the same quarter last year.

The increase was primarily due to a 16% hike in product sales (with both Roadway Sensors and Vehicle Sensors showing double-digit growth rates) offset by a decline in Transportation Systems revenue of 12.2%.

Despite the top-line increase in the Vehicle Sensors division, ITI still reported a small loss in the segment.

The Roadway Sensors segment commands the highest margins so continued sales increases will help overall profitability and cash flow.

In my analysis of 2nd quarter earnings, I mentioned that a major risk was goodwill impairment in the Transportation Systems division. Those fears came true in the third quarter, with the company taking an $8m impairment charge.

According to management, the charge

“does not impact in any way our bullish long-term view for the business segment”

The impairment charge makes earnings comparisons difficult, with the company officially reporting a loss of $7m, or $0.20 per share.

Excluding the impairment charge and other non-cash items, Iteris would have reported earnings of $0.01 per share, compared to $0.02 per share in 2009.

The company still reported positive free cash flow for the quarter, and added to its cash balance – net cash sits at $9m.

Acquisition

In December, Iteris announced the acquisition of Meridian Environmental Technology, Inc (MET), a leader in 511 advanced traveler information systems. MET has been around for 17 years and is a growing business in an important niche.

The purchase price was approx. $4m in cash, plus another $2m based on an 24-month earn-out provision.

The companies have worked together on projects in the past. The new combination is now one of the top 1 or 2 providers in the U.S.

The good news is that management expects the acquisition to be immediately accretive, to the tune of $1m in revenue plus positive operating income in the upcoming quarter.

Conference Call Notes

Transportation Systems

– Just sent out a $10m design and build proposal to a state agency

– Making additional investments in sales & marketing ; new office in Abu Dhabi

– Federal Highway Bill – a key piece of transportation legislation – is expected to be brought before Congress sometime in the next 6-9 months. ITI expects funding for transportation technology to be significantly higher in the new bill

Vehicle Sensors

– EU is mandating safety features (like LDW) for new commercial trucks by 2013

– Joint announcement & go-to-market strategy with Audiovox for Advanced Driver Assistance System. Over 200 media people in attendance. ITI handled design but VOXX is doing all manufacturing and marketing. Lots of growth potential

Roadway Sensors

– 25% of sales in past two years has been from new products

– Continued push into both domestic and international markets

Conclusions

While the impairment charge put a damper on the earnings release, management seemed extremely bullish on the conference call.

In the past 3 years, free cash flow has averaged $6.1m, a number that the company should approach for fiscal 2011 as well. That would translate into an EV/FCF of only 7.8x, leaving plenty of room for improvement.

Lloyd Miller, a noted microcap investor and large holder of ITI, made a huge purchase on the initial drop after earnings, a positive sign.

This quarter is traditionally the slowest of the year, and management expects improvements in both the top and bottom line for the upcoming quarter.

I think the long-term trends in this business remain extremely strong, especially with the recent acquisition, new product lines / partnerships, and the upcoming Transportation Bill.

Disclosure

Long ITI