Market Overview

Breach Inlet Capital Sends Letter to Board of Sparton Corp.


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)

The full text of the letter follows:

August 29, 2018

Board of Directors
Sparton Corporation
425 North Martingale
Road, Suite 1000
Schaumburg, Illinois 60173


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

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

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

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

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

9. The Board has poorly managed the current (and second) sales

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
Inlet Capital Management

1 Go to "Conversations" under SPA on Yahoo Finance: here
2 TPCS Voting Results
3 Increase in TPCS share price from 12/8/16 (date of nomination) to
4 GAMCO's nomination of Mr. Schenker to: TDS in 2015 (here), SUP in
2015 (here), and GRIF in 2014 (here).
5 SEV Nomination
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,
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 P-8 vs. P-3 Capacity
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
14 Initial Release of P-8; Aydin Displays Presentation
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 Sparton Terminates Merger
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

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