Complex Systems Segment
Sparton's Complex Systems Business Unit, with locations in Florida and Vietnam, provides multiple industries with complex electronics systems
offering end-to-end development and manufacturing solutions focused on high expectations of quality and delivery performance through a global
footprint. As a vertically integrated business unit, Sparton assists in providing its customers with seamless development of circuit card assemblies
for integration into electro-mechanical solutions. Complex Systems has a diverse and highly skilled group of engineers that focus on maximizing
efficiency and cost containment at the various steps in the design, engineering, and manufacturing process. These electronic specialists act as
an intelligent source and ideal partner for development firms and OEMs. This business unit is a trusted source and supplier for low to medium
volume/high complexity commercial and military aerospace applications, medical devices, telecommunications, energy, and industrial controls.
Current portfolio of product line applications include: flight controls, cockpit displays, fuel system controls, secure communications,
early warning detection, diagnostics systems, security systems, detection systems, lighting, satellite communications, audio, nuclear detection,
inventory control, and defense.
Complex Systems provides to its customers support services that include engineering services, design, material management, obsolescence analysis
and management, documentation development, and process improvement. The company's engineering services, led by a rapid prototype and pilot build process,
offer Sparton's customers a high quality product that can quickly be placed into their channels of distribution. Once a product has been proven viable,
Sparton offers domestic and low cost country manufacturing and distribution solutions.
The segment strives to exceed customers' expectations of low cost with high delivery and quality performance. As these attributes are demanded by
customers that produce the aforementioned products, Complex Systems strives to exceed those expectations through utilization of contemporary
management tools to ascertain the effectiveness of all business operating systems. This has allowed Complex Systems to gain competitive traction
in the market place.
Competitors in Sparton's market segments are much larger in size and typically operate in a medium to higher volume sector. These competitors, however,
typically do not provide low-volume, high-mix legacy services that Sparton can provide, as this remains the company's niche in the market.
Other EMS providers of comparable size to Sparton's Complex Systems Business Unit are forecasted to modestly grow by leading industry experts. OEM's in its market
segments are continually driving costs out of their respective businesses through outsourcing strategies, allowing opportunity for Sparton to
capture additional value adding opportunities.
Complex Systems continues to engage in ongoing strategic initiatives to expand market awareness of Sparton's capabilities.
As Sparton continues to execute its growth strategy, the company anticipated adding additional resources in Marketing Services, Business Development,
and Program Administration services. Sparton further intends to expand its web presence and continue direct participation in trade shows and
networking forums. Sparton is also engaged with local and regional economic development authorities. The Company continues to gain traction in this
area as partnerships have developed with higher educational institutions research and development programs and county and regional
economic leadership teams. Sparton's Vietnam location continues to be engaged with the local government authority assisting North American
companies seeking to conduct business in Vietnam. These additional efforts will allow focused marketing for each of Sparton's identified
markets optimizing the company's ability to selectively target new customers.
Complex Systems' backlog was approximately $29.5 million and $29.1 million at June 30, 2011 and 2010, respectively. A majority of the
June 30, 2011 Complex Systems backlog is currently expected to be realized within the next 12 months.
The majority of Sparton's Complex Systems customers are in regulated industries where strict adherence to regulations is required such as
Federal Drug Administration (FDA), International Tariff and Arms Regulations (ITAR), Federal Aviation Administration (FAA).
These requirements are highly technical in nature and require strict adherence and documentation related to operational processes and documentation.
Sparton's quality system provides the ability to service such markets, differentiating Sparton from some potential competitors that lack such
systems.
DSS Segment
DSS operations, located in Florida, are comprised of design, development and production of products for a number of technologically significant
programs aimed at fulfilling defense and commercial needs. Specializing in the development and production of complex electromechanical equipment,
DSS designs and manufactures sonobuoys, anti-submarine warfare (ASW) devices used by the U.S. Navy and foreign governments. This business unit
also performs an engineering development function for the United States military and prime defense contractors on advanced technologies targeted
as future defense products as well as replacement of current systems. The sonobuoy product line is built to the customer's demanding specifications.
These products are ITAR restricted, which limits opportunities for competition.
DSS is partner to a 50/50 joint venture agreement (JV) with UnderSea Sensor Systems, Inc. (USSI), the only other major producer of sonobuoys in
the West. USSI's parent company is Ultra Electronics Holdings PLC, based in the United Kingdom. The joint venture arrangement operates
under the name ERAPSCO and allows Sparton and USSI to consolidate their own unique and complementary backgrounds to jointly develop and produce
U.S. derivative sonobuoy designs for the U.S. Navy as well as foreign countries. In concept, and in practice, ERAPSCO serves as a pass-through
entity with no funds or assets. While the joint venture agreement provides the opportunity to maximize efficiencies in the design and development
of the related sonobuoys, both venture companies function independently as subcontractors; therefore, there is no separate entity to be accounted
for or consolidated. The Board of Directors of ERAPSCO has the responsibility for the overall management and operation of the JV. The six
member board consists of equal representation (full time employees) from both JV partners for three year terms. Manpower for ERAPSCO,
specifically a general manager role, contract administrator role and financial manager role, is similarly assigned by the JV partners for
rotating three year terms and the costs of these assigned individuals are borne by the party assigning the personnel. In response to a
customer request for proposal (RFP) that ERAPSCO will bid on, the Board of Directors of ERAPSCO determines both the composition of a
response to the RFP and the composite bid to be submitted to the customer. The Board of Directors strives to divide the aggregate contract
awards at a 50/50 share ratio. Each joint venture partner bears the costs it incurs associated with the preparation and submission of proposals.
Each JV partner submits to ERAPSCO a proposal for the estimated cost of performing that portion of the RFP applicable to it.
Upon award of a contract to the JV, separate subcontracts are generated between ERAPSCO and each of the JV partners defining
the responsibilities and compensation for each JV partner. These subcontracts contain terms and conditions consistent with the prime contract.
Each JV partner is responsible for the successful performance of its bid to the JV for its respective scope of work and each JV partner
is responsible for profit or losses sustained in the execution of the subcontract against its respective bid. Under ERAPSCO, individual
contract risk exposures are reduced, while the likelihood of achieving U.S. Navy and other ASW objectives is enhanced. ERAPSCO has been
in existence for approximately twenty years and historically, the agreed upon products included under the joint venture agreement
were generally developmental or sonobuoys with low volume demand. Four years ago, the company's ERAPSCO arrangement was expanded to include
additional products for U.S. customers and substantially all U.S. derivative sonobuoy products for customers outside of the United States.
Beginning with the U.S. Government 2011 fiscal year contracts, all U.S. sonobuoy products are now bid and executed through ERAPSCO,
completing the joint venture expansion which now includes sales of all U.S. derivative sonobuoys worldwide.
While the ERAPSCO agreement provides certain benefits to Sparton as described above, the company does not believe that it is substantially
dependent upon this agreement to conduct its business. If in the future, Sparton determines that this commercial arrangement is no longer
beneficial, the company has the ability to terminate the joint venture in relation to future business awards and return to independent
bidding for U.S. Navy and foreign government ASW awards.
New internally funded products are under development for sale as commercial products to the navigation and underwater acoustic systems market.
Markets for these products include autonomous underwater and ground vehicles, as well as unattended aerial vehicles as its product offerings grow.
The principal example of such products is a family of precision electronic compasses for applications such as navigation and mineral or
petroleum exploration.
Competition among companies that build these products is intense and dynamic. As such, development of its commercial
products requires the identification of sustainable competitive advantages (SCA) prior to investment to ensure there is a viable market
for its products. Each new product must advance the technology available to the market enough to overcome the inherent inertia preventing
potential customers from switching from competitors products. Likewise, existing products are evaluated periodically to ensure their SCA
is still maintained and if not, either redesign or end-of-life occurs. The expansion of Sparton's commercial product lines leverages the intrinsic
engineering talent at DSS and capitalizes on the sonobuoy product volumes to provide technological as well as economies of scale advantages.
Sonobuoy and related engineering services, including sales to the U.S. Navy, accounted for approximately 33%, 36% and 19% of consolidated
revenue for the fiscal years ended June 30, 2011, 2010 and 2009, respectively. Sales to the U.S Navy, including subcontract sales through
ERAPSCO, accounted for 30%, 28% and 14% of consolidated revenue for the fiscal years ended June 30, 2011, 2010 and 2009, respectively.
The U.S. Navy issues multiple contracts annually for its sonobuoy and engineering requirements. The loss of U.S. Navy sonobuoy sales would
have a material adverse financial effect on the company. While the overall relationship with the U.S. Navy is important to Sparton, the
contracts with the U.S. Navy, including subcontracts through ERAPSCO, are such as ordinarily accompany the kind of business conducted by
Sparton and the company does not believe that it is substantially dependent on any individual contract or agreement with this customer
other than the Subcontract effective June 20, 2011 between Sparton Electronics, Florida, Inc. and ERAPSCO. Pursuant to the Subcontract,
DSS will supply sonobuoys to the U.S. Navy through ERAPSCO for a total contract value of approximately $32.2 million to Sparton Electronics.
DSS backlog was approximately $65.5 million and $69.6 million at June 30, 2011 and 2010, respectively. A majority of the June 30, 2011 DSS
backlog is currently expected to be realized within the next 12 to 16 months.
U.S. Government contracts allow Sparton to submit advance billings, which are then applied against inventories purchased and
manufacturing costs incurred by the Company throughout its performance under these contracts. Inventories were reduced by advance billings
to the U.S. government for costs incurred related to long-term contracts, thereby establishing inventory to which the U.S. government then has title,
of approximately $9.0 million and $7.4 million, respectively, at June 30, 2011 and 2010. At June 30, 2011 and 2010, current liabilities include
advance billings of $13.0 million and $21.6 million, respectively, on government contracts. As these billings are in excess of cost,
there is no inventory to which the government would claim title and, therefore, no offset to inventory has been made.
DSS's business is affected by numerous laws and regulations relating to the award, administration and performance of U.S. Government contracts.
The U.S. Government generally has the ability to terminate DSS contracts, in whole or in part, without prior notice, for convenience or for
default based on performance. If any of these U.S. Government contracts were terminated for convenience, Sparton would generally be
protected by provisions covering reimbursement for costs incurred on the contracts and profit on those costs, but not the anticipated
profit that would have been earned had the contract been completed.
Medical Segment
Medical Device operations, with locations in Ohio and Colorado, are comprised of contract development, design, production and distribution of
complex and sophisticated medical related electromechanical devices for customers with specialized needs, specifically in the design and
manufacturing process, to assure product reliability and safety in accordance with Food and Drug Administration (FDA) guidelines and approvals.
This group specializes in systems and procedures targeted to the requirements of medical OEM and ET customers primarily in the In Vitro Diagnostic
and Therapeutic Device segments of the Medical Device market space.
The Medical segment's objective is to be the preferred contract design and manufacturer of medical devices/instruments for market leading OEM's
as well as emerging technologies. The market is driven by providing the total solution concept, at a competitive price to the customer.
Sparton's market advantage is its experience and knowledge of the market, breadth of services that the company offers, and the referral relationships
which have developed over the past 20 years. The major corporations on the customer side want to focus their time and energy supporting their
major profit areas of consumables and new innovation through research and development. In addition, many companies are outsourcing certain
engineering activities finding it costly and inefficient to have full time engineers available for new product development which cycles with
new projects every three to five years. This is the niche that has proven to be successful to Sparton Medical.
The contract manufacturing of highly complex medical instrumentation is a fairly young industry with no dominate player in the market.
In the past, large Printed Circuit Board contract manufacturers have sold their "box build" capabilities and have been very successful.
The industry has continued to grow with more companies developing Printed Circuit Board Assembly (PCBA) capabilities and others entering
the market via mergers and acquisitions of smaller companies. This has led to stronger competition with larger companies that have
the financial resources to offer the services that the customers are requiring. Customers will assume that quality will be 100% and
will drive their decisions based on pricing and services offered that best fit their total solutions needs.
The understanding of the medical market needs is critical for its success. Sparton is well positioned with its engineering development,
reliability engineering, manufacturing/testing, and service support services to meet current organic growth plans. Additional growth
may be gained through an acquisition strategy employed to expand its market reach and footprint into other geographic areas of the U.S.
On August 6, 2010, the company completed the acquisition of certain assets related to the contract manufacturing business of
Delphi Medical Systems, LLC (Delphi Medical) in an approximate $8.4 million all-cash transaction. The acquired business,
which is reported in the company's Medical segment, provides a new and diversified customer base and provides Sparton with a geographic
presence in the western United States. Delphi Medical primarily manufactures OEM medical devices including blood separation equipment,
spinal surgery products and 3-D eye mapping devices. It also provides engineering and manufacturing support to a market-leading
environmental sensor company whose markets include meteorology, weather critical operations and controlled environment applications.
On March 4, 2011, the company completed the acquisition of certain assets and assumption of certain liabilities of Byers Peak,
Incorporated (Byers Peak) in an approximate $4.1 million all-cash transaction. The acquired business, which is reported in
the company's Medical segment, provides further expansion into the therapeutic device market, diversifies Sparton's customer base,
and further expands the company's geographic reach into the western United States. Additionally, the acquisition increases Sparton's
offerings with the inclusion of field service and refurbishment capabilities. Byers Peak primarily manufactures medical devices for
OEM and emerging technology companies in the Therapeutic device market, including devices for surgical navigation, RF energy generation,
arterial disease, and kidney dialysis. It also has a field service and installation group that primarily provides water filtration and
disinfection systems for the medical industry as well as device refurbishment programs. Additionally, Byers Peak provides electromechanical
device manufacturing support for a limited number of customers outside of the medical industry.
Medical sales to Siemens Diagnostics accounted for 18%, 21% and 17% of consolidated revenue for the fiscal years ended
June 30, 2011, 2010 and 2009, respectively. Fenwal Blood Technologies, which became a customer with the Delphi acquisition,
contributed 12% of consolidated revenue during the year ended June 30, 2011. The loss of either Siemens Diagnostics or
Fenwal Blood Technologies as a customer could have a material adverse financial effect on the company. While the overall relationships with
the Siemens Diagnostics and Fenwal Blood Technologies are important to Sparton, the contracts with these companies are such as ordinarily
accompany the kind of business conducted by Sparton and the company does not believe that it is substantially dependent on any individual
contract or agreement with these customers. The contractual arrangements entered into with Siemens Diagnostics and Fenwal Blood Technologies
are represented by master agreements which include certain master terms and conditions of Sparton's relationship with these customers.
These agreements do not commit the customers to any specific volume of purchases. Moreover, these terms can be amended in appropriate circumstances.
Thus, until these customers submit a purchase order to Sparton, there is no guarantee of any revenue to Sparton. Rather than depending
on these contracts for revenue, the company accepts purchase orders from these customers which determine volume and delivery requirements.
Medical backlog was approximately $42.3 million and $14.0 million at June 30, 2011 and 2010, respectively. A majority of the June 30, 2011
Medical backlog is currently expected to be realized within the next 12 months.
As a medical device manufacturer, Sparton Medical Systems operates in a heavily regulated environment. Despite efforts to harmonize
domestic and international regulations, inconsistencies still exist. Quality Management System requirements are generally compatible
but device approval, licensing and environmental requirements vary widely and change frequently. RoHS (Restriction of Hazardous Substances)
and REACH (Registration, Evaluation and Authorization of Chemicals) directives are among the more recent regulatory challenges.
Similar environmental regulations are expected from other countries and the United States. Non-compliance risks range from variance
notifications to production/shipping prevention depending upon the agency and form of non-compliance.
