SCHAUMBURG, Ill.--(BUSINESS WIRE)--Breach Inlet Capital Management, an investment firm focused on underfollowed and misunderstood North American small cap equities, sent a letter to the Board of Directors of Sparton Corporation (NYSE:SPA) today.
The full text of the letter follows:
August 29, 2018
Board of Directors
Sparton Corporation
425 North Martingale
Road, Suite 1000
Schaumburg, Illinois 60173
Gentlemen,
Breach Inlet Capital Management, LLC owns more than 2% of the outstanding shares in Sparton Corporation (“SPA”). We have been patient shareholders as we have owned shares since the Board of Directors (the “Board”) began the first sales process 2.5 years ago. But, to the extent any incumbent directors are nominated for re-election at the upcoming 2018 Annual Meeting of Shareholders, we plan to vote “Against” all such directors, except Alan Bazaar, for the reasons below.
1. The Board has a long-history of destroying shareholder value.
SPA’s share price declined ~50% over the past three years, while the Russell 2000 appreciated ~50% equating to SPA underperforming by ~100%. More recently, SPA’s price has dropped 20%+ in the past 30 trading days as the Russell 2000 reaches all-time highs.
2. Better candidates may be available to represent the Board and shareholders.
According to a public source1, a gentleman named Rich McGowan has nominated five directors to SPA’s Board (“Nominees”). Four of the Nominees serve on the Board of TechPrecision Corporation (“TPCS”) and they received more votes than other candidates in 20162. Since these four Nominees were nominated less than two years ago, TPCS’s share price is up 45%3. One Nominee, Walter Schenker, has also been nominated to public company boards several times4 by GAMCO Asset Management, SPA’s largest shareholder. As an example, GAMCO nominated Mr. Schenker to the board of Sevcon (SEV) in 20135. SEV was sold in 2017 for $22 per share equating to a ~40% IRR6. The Nominees seem to have a far better track record than SPA’s current Board.
3. SPA’s current share price and valuation indicates a lack of investor confidence in the Board.
SPA’s share price is near a six-year low. SPA’s Engineered Components & Products (“ECP”) segment and Manufacturing & Design Services (“MDS”) segment contributed ~75% and ~25% of TTM Adjusted EBITDA7, respectively. ECP and MDS peers8 trade for an average EV/TTM EBITDA of ~17.5x and ~7.5x, respectively. Meanwhile, SPA is currently valued for only ~8x TTM adjusted EBITDA. As another metric, SPA trades for only 9x FCF9. This seems too cheap based on the quality of its assets.
ECP is certainly a crown jewel with sonobuoys representing ~80% of sales10. These products act as cheap (< $5k each) yet critical insurance for the US Navy’s $2b+ submarines. Demand for sonobuoys is rising as tensions build with China and Russia. Plus, the Navy is replacing P-3 planes with P-8s that hold ~50% more sonobuoys11. Case in point, the Navy’s fiscal year 2019 budget calls for a 33% increase in sonobuoy purchases12. We believe this higher overall demand could offset SPA’s potential inability to bid on the 125A sonobuoy contract. We also estimate the 125 model (125A’s predecessor) only represented ~20% of SPA’s fiscal year 2018 sonobuoys sales13. In addition to sonobuoys, ECP is the sole supplier of ruggedized LCD displays used in P-8s14. In sum, we believe ECP has high margins, low capital intensity, and an attractive outlook so deserves a premium multiple.
Despite being mismanaged from our view, trends for MDS are improving with the backlog rising four straight quarters and 3Q18 EBITDA increasing year-over-year for the first time in five quarters. Relative to most contract manufacturers, MDS has higher gross margins due to its specialized focus of providing low volumes to highly-regulated markets. As evidence, the business operates five facilities approved by the FDA to manufacture specific products. Also, our understanding is that utilization across all of MDS’ plants is low15. From our perspective, MDS’ improving trends, valuable assets, and excess manufacturing capacity should attract potential acquirers in a simpler process.
4. The Board is not aligned with shareholders.
Our ownership is greater than the cumulative shares held by the Board. We actively purchased our shares in the open market, while the Board was awarded most its shares despite its poor track record. Also, the Board has provided Interim CEO & President Joe Harnett with an employment agreement that is not aligned with shareholders. He receives a base salary of $50k per month and has zero compensation components tied to performance, unlike other SPA executives. As evidence, Mr. Hartnett received total compensation of $1.35mm in fiscal 2017 (representing 40%+ of SPA's pre-tax income) despite a 5% drop in revenue and missing SPA’s EBITDA target by more than 15%16.
5. SPA has been mismanaged since the Board appointed Mr. Hartnett as Interim CEO.
Since Mr. Hartnett’s appointment in February 2016, SPA’s TTM EBITDA has fallen ~30%17. Under his leadership, we believe management has not executed well with revenue declining every quarter except for one (when it was basically flat). As previously stated, his team missed their fiscal 2017 EBITDA target by over 15%. These results should not be surprising based on Mr. Hartnett’s career18. Approximately one year after Platinum Equity purchased US Robotics Corporation, he was replaced as CEO. Mr. Hartnett then served as CEO of Ingenient Technologies until its “sale,” but we do not believe this created much value because the buyer only acquired “certain assets”.
6. The Board never recruited a permanent CEO with relevant experience.
Outside of SPA, Mr. Hartnett has not acted in a managerial capacity since 2010 and has zero relevant industry experience. In fact, he spent more than 20 years of his 30-year operating career as an auditor19. He has also held the “Interim” title for 2.5 years, but we think SPA needs a leader with a successful track record in the Defense industry.
7. The Board has been unable to retain executive talent.
Since the former CEO Cary Wood’s resignation, five of ten executives named in the 2015 Annual Report departed.
8. The Board poorly managed the first sales process20.
Before the Board hired any advisors, it received an unsolicited offer from then-CEO Cary Wood in September 2015. After hiring advisors and beginning the process, the Board received 23 initial indications of interest (“IOIs”) in July 2016. Despite the significant and early interest in SPA, the Board did not agree to a transaction until 12 months after receiving IOIs. More concerning than the lengthy process was the low price negotiated and accepted by the Board. ECP and MDS received IOIs ranging from $220-325mm and $90-$150mm, respectively. Combining these IOIs and deducting for net debt at that time implied values of $18-35 per share. Yet, the Board arguably allowed Ultra Electronics Holdings to disrupt the process and then agreed to sell to Ultra for only $23.50 per share. Given Ultra and SPA were production partners holding an effective monopoly in sonobuoys, we think the Board should have realized the US government was unlikely to approve the merger.
9. The Board has poorly managed the current (and second) sales process.
Six months have passed since the Board began the second sales process and stated: “Sparton will seek to re-engage with parties that previously expressed an interest in acquiring all or a part of Sparton and that are in a position to expeditiously proceed21.” Yet, the Board has provided zero relevant updates or even a deadline for ending the process. We believe this has led to a precipitous decline in SPA’s share price. Once the Board was unable to quickly attract a suitor in this second process, we think the Board should have realized that its sale strategy was not effective.
The ECP and MDS segments are very different businesses that will likely attract very different buyers. The current process is complicated by offering all or parts of SPA for sale. The M&A teams at General Dynamics, Lockheed Martin, and Raytheon evaluate hundreds of acquisitions annually. They likely have zero interest in analyzing or owning MDS. Hence, we think SPA should sell MDS first and then focus on ECP. Multiple discussions with industry insiders highlighted that Lincoln International has the best reputation for selling contract manufacturing businesses. As concrete evidence, Lincoln represented Hunter Technology when it was sold for a significant price to MDS. A focused process led by an advisor with industry expertise could result in a far better outcome.
10. The Board has allowed two Directors to have too much control.
The Board formed a special committee consisting of six Members to “review the Company’s strategic alternatives” at the beginning of the initial sales process. But, the Merger Proxy revealed that key decisions were primarily influenced by Chairman James Swartwout and Director Hartnett. More specifically, they recommended legal counsel, selected the four potential financial advisors, and solely negotiated all non-disclosure agreements with potential buyers. We are highly concerned that two directors would have this much control over the entire sales process, especially since their leadership created little value for SPA shareholders in the past.
11. SPA damaged its most critical customer relationship under the Board’s leadership.
The Navy represents 20%+ of SPA’s sales and is the only material customer (10%+ of sales) listed in SPA’s Annual Report. Facts would indicate the Board has damaged SPA’s relationship with the Navy. First, the Board tried to merge with Ultra and solidify itself as the sole supplier of sonobuoys, but the Navy expressed concerns about this setup so the DOJ planned to stop the merger. Then, the Navy blocked ERAPSCO from even bidding on one of the two future five-year sonobuoy contracts. The Navy took this drastic step despite it being unclear whether another supplier can meet the Navy’s fiscal year 2019 delivery requirements.
12. The Board never retained a reputable restructuring consultant to reduce unnecessary overhead.
The latest amendment to SPA’s Credit Agreement required this action by the end of May 2018 if a definitive agreement had not been signed with an acquirer22, but a consultant was never hired. Instead, overhead has continued to grow under Mr. Hartnett’s tenure23. Based on discussions with former executives of SPA, the savings outlined in the Merger Proxy, and historical overhead relative to sales, we believe unallocated adjusted cash overhead could be reduced by at least 50% or $6mm.
If the Board is unable to negotiate a sale near SPA’s intrinsic value (and a substantial premium to its share price more than 30 trading days ago), then we believe it is time for a meaningful change in leadership and strategy. A new and improved Board could recruit an experienced CEO, reduce overhead with the assistance of a consultant, retain Lincoln to sell MDS in a simpler process, and then eliminate a substantial amount of debt. After doing so, SPA should garner a high valuation multiple as a focused producer of specialty defense products. Shortly thereafter, we think SPA could attract a prime contractor willing to pay a hefty premium for access to SPA’s sonobuoy expertise.
Best Regards,
Chris Colvin, CFA
Founder & Portfolio Manager
Breach
Inlet Capital Management
| 1 |
Go to “Conversations” under SPA on Yahoo Finance: here |
| 2 | |
| 3 | Increase in TPCS share price from 12/8/16 (date of nomination) to 8/28/18 |
| 4 |
GAMCO’s nomination of Mr. Schenker to: TDS in 2015 (here), SUP in 2015 (here), and GRIF in 2014 (here). |
| 5 | |
| 6 |
SEV Sold; IRR from SEV share price on 12/30/13 (date of nomination) to 7/17/17 (date of sale announcement) |
| 7 | Before unallocated overhead |
| 8 | Listed in the Merger Proxy filed on 8/29/17. MDS: BHE, CLS, DCO, FLEX, JBL, PLXS, SANM, TTMI. ECP: CMTL, CUB, HRS, KTOS, MRCY, TDY, ULE.LSE, COB.LSE. |
| 9 | Free Cash Flow = TTM Adjusted EBITDA – Interest Expense at current rates – Taxes at current rates – TTM CapEx |
| 10 | Total sales from sonobuoys disclosed in the 2017 Annual Report. |
| 11 | |
| 12 |
Based on the John S. McCain National Defense Authorization Act for Fiscal Year 2019: here |
| 13 |
Our estimated based on 2017 Annual Report and ERAPSCO Protests Navy Exclusion |
| 14 | |
| 15 | Based on past discussions with management |
| 16 | 2017 Annual Proxy; 2017 Annual Report |
| 17 | Comparing 3/31/18 TTM adjusted EBITDA to 3/31/16 TTM adjusted EBITDA |
| 18 |
See: Mr. Hartnett Replaced as CEO at US Robotics; Platinum Buys US Robotics; Ingenient Sale; |
| 19 | 2017 Annual Proxy |
| 20 | See the Merger Proxy filed on 8/29/17 |
| 21 | |
| 22 | 8-K filed on 5/7/18 |
| 23 | Total Adjusted EBITDA – Segment Adjusted EBITDA with allocated overhead = Unallocated Adjusted Cash Overhead. 3/31/16 TTM = $9.04mm. 3/31/18 TTM = $11.26mm |