SPARTON CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows (Unaudited)
For the Three-MonthNine-Month Periods ended September 30,March 31, 2004 and 2003 and 2002

See accompanying notes.

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1.1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

- The following is a summary of the Company’s accounting policies not discussed elsewhere within this report.

Basis of presentation —- The accompanying unaudited Condensed Consolidated Financial Statements of Sparton Corporation and all active subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete annual financial statements. All significant intercompany transactions and accounts have been eliminated. The Condensed Consolidated Balance Sheet at September 30, 2003,March 31, 2004, and the related Condensed Consolidated Statements of Operations for the three-month and nine-month periods ended September 30,March 31, 2004 and 2003, and 2002, and cash flows for the three-monthnine-month periods ended September 30,March 31, 2004 and 2003, and 2002, are unaudited, but include all adjustments (consisting of normal recurring accruals) which the Company considers necessary for a fair presentation of such financial statements. Certain reclassifications of prior period amounts have been made to conform to the current presentation. Operating results for the three-month periodand nine-month periods ended September 30, 2003,March 31, 2004, are not necessarily indicative of the results that may be expected for the fiscal year ended June 30, 2004.

The balance sheet at June 30, 2003, has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2003.

Operations —- The Company provides design and electronic manufacturing services, which include a complete range of engineering, pre-manufacturing and post-manufacturing services. Capabilities range from product design and development through after market support. All facilities are registered to ISO 9001, with many having additional certifications. The Company’s operations are in one line of business, electronic contract manufacturing services (EMS). Products and services include complete “Box Build” products for Original Equipment Manufacturers, microprocessor-based systems, transducers, printed circuit boards and assemblies, sensors and electromechanical devices fordevices. Markets served are in the telecommunications, medical/scientific instrumentation, electronics, aerospace, and other industries.industries, with a focus on regulated markets. The Company also develops and manufactures sonobuoys, anti-submarine warfare (ASW) devices, used by the U.S. Navy and other free-world countries. Many of the physical and technical attributes in the production of sonobuoys are the same as those required in the production of the Company’s other electrical and electromechanical products and assemblies.

Use of estimates —- Accounting principles generally accepted in the United States require management to make estimates and assumptions that affect the disclosure of assets and liabilities and the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Revenue recognition —- The Company’s net sales are comprised primarily of product sales, with supplementary revenues earned from engineering and design services. Standard contract terms are FOB shipping point. Revenue from product sales is generally recognized upon shipment of the goods; service revenue is recognized as the service is performed or under the percentage of completion method, depending on the nature of the arrangement. Long-term contracts relate principally to government defense contracts. These contracts are accounted for based on completed units accepted and their estimated average contract cost per unit. Development contracts are accounted for based on percentage of completion. Costs and fees billed under cost-reimbursement-type contracts are recorded as sales. A provision for the entire amount of a loss on a contract is charged to operations as soon as the loss is determinable. Shipping and handling costs are included in costs of goods sold.

Market risk exposure —- The Company manufactures its products in the United States and Canada. Sales of the Company’s products are in the U.S. and Canada, as well as other foreign markets. The Company is potentially subject to foreign currency exchange rate risk relating to intercompany activity and balances, receipts from customers, and payments to suppliers in foreign currencies. Also, adjustments related to the translation of the Company’s Canadian financial statements into U.S. dollars are included in current earnings. As a result, the Company’s financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which the Company operates. However, minimal third party receivables and payables are denominated in foreign currency and, historically, foreign currency gains and losses have not been significant. The Company does not consider the market risk exposure relating to currency exchange to be material.

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The Company has financial instruments that are subject to interest rate risk, principally short-term investments. Historically, the Company has not experienced material gains or losses due to such interest rate changes. Based on the current holdings of short-term investments, the interest rate risk is not considered to be material.

New accounting standards- In December 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 132 Revised (SFAS No.132 (R), “Employers’ Disclosures about Pensions and Other Postretirement Benefits”, which amends SFAS Nos. 87, 88, and 106. The revised Statement retains the disclosure requirements contained in SFAS No. 132, which it replaces, and requires additional disclosures to those in the original SFAS No. 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. SFAS No. 132 (R) is effective for financial statements with fiscal years ending after December 15, 2003. The interim-period disclosures required by this Statement are effective for interim periods beginning after December 15, 2003. The adoption of this statement did not have a material effect on the Company’s disclosure requirements.

Periodic benefit cost- The Company follows the disclosure requirements of SFAS No. 132 (R). For the nine months ended March 31, 2004, $545,000 of expense had been recorded. Total net periodic benefit cost for fiscal 2004 is expected to be $727,000. The components of net periodic pension expense for each of the periods presented were as follows:

Stock options —- The Company follows Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and related Interpretations in accounting for its employee stock options. Under APB 25, no compensation expense is recognized as the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant. The Company follows the disclosure requirements of Statement of Financial Accounting Standards (SFAS) No. 123,SFAS No.123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.”

At September 30, 2003,March 31, 2004, the per share weighted-averageweighted average exercise price of options outstanding was $6.35.$6.06. The weighted-averageweighted average remaining contractual life of those options was approximately 3 years. At September 30, 2003,March 31, 2004, there were 240,040321,047 options exercisable at the weighted-averageweighted average per share price of $5.77.$5.60. Remaining shares available for grant under the plan were 211,312183,741 at September 30, 2003.March 31, 2004.

The following sets forth a reconciliation of net income (loss) and earnings (loss) per share information for the three months and nine months ended September 30,March 31, 2004 and 2003, and 2002, as if the Company had recognized compensation expense based on the fair value at the grant date for awards under the plan.

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2) INVENTORIES

- Inventories are valued at the lower of cost (first-in, first-out basis) or market and include costs related to long-term contracts. Inventories, other than contract costs, are principally raw materials and supplies. The following are the major classifications of inventory:

Work in progress and finished goods inventories include $3.0$1.3 and $1.1 million of completed, but not yet accepted, sonobuoys at SeptemberMarch 31, 2004 and June 30, 2003, respectively. Inventories are reduced by progress billings to the U.S. government of approximately $4,538,000 and $8,317,000 at March 31, 2004 and June 30, 2003, respectively.

3.3) EARNINGS (LOSS) PER SHARE

All share and per share information for 2002 have been adjusted to reflect the impact of the 5% stock dividend declared in January 2003. For the three months ended September 30, 2002, the exercise price for all stock options granted was less than the average market price of the Company’s common stock and therefore, they were included in the computation for weighted average diluted shares outstanding. Stock options were not considered in the September 30, 2003, calculation as the effect would be anti-dilutive due to the current period loss. Basic and diluted earnings (loss) per share were computed on the following:

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- On October 21, 2003, Sparton’s Board of Directors approved a 5% stock dividend. Eligible shareowners of record on November 21, 2003, will receivereceived the stock dividend. The dividend distribution or payment date was established ason December 19, 2003. Cash will bewas paid in lieu of fractional shares of stock. This is a continuationAn amount equal to the fair market value of a process the Company began lastcommon stock issued was transferred from retained earnings ($4,589,000) to common stock ($496,000) and capital in excess of par value ($4,089,000) to record the stock dividend. Accordingly, all share and per share information for fiscal year. The effect2004 and 2003 have been adjusted to reflect the impact of thisall stock dividend will be reflecteddividends declared for the periods shown.

Due to the Company’s fiscal 2004 reported net loss, 139,203 share equivalents from stock options outstanding were excluded from the computation of diluted earnings per share during the nine months ended March 31, 2004, because their inclusion would have been anti-dilutive for the period. For the three months and nine months ended March 31, 2003, options to purchase 103,635 and 3,308 shares of common stock were not included in the Company’s shareowners’ equity in the quarter ending December 31, 2003. Per share data will also be restated for all periods presented to give effect to the stock dividend beginning in that quarter.

Pro formacomputation of diluted earnings (loss) per share, after October 2003respectively, as the options’ exercise prices were greater than the average market price of the Company’s common stock dividend:

4.4) COMPREHENSIVE INCOME (LOSS)

- Comprehensive income (loss) includes net income (loss) as well as unrealized gains and losses, net of tax, which are excluded from net income. TheyUnrealized gains and losses (net of tax), are however, reflected as a direct charge or credit to shareowners’ equity. Total comprehensive income (loss) is as follows for the three monthsthree-month and nine-month periods ended September 30:

At SeptemberMarch 31, 2004 and June 30, 2003, shareowners’ equity includes accumulated other comprehensive income of $368,000$484,000 and $106,000, which relate to unrealized gains,$359,000, respectively, net of tax,tax. These balances include $315,000 and $471,000 for unrealized gains on investment securities owned, and unrealized gains and (losses) of $169,000 and $(112,000) for investment securities held by an investee accounted for by the equity method, respectively. Atas of March 31, 2004 and June 30, 2003, these amounts were $471,000 and $(112,000) respectively.

5.5) INVESTMENT SECURITIES

- The fair value of cash and cash equivalents, accounts receivable, and accounts payable approximate their carrying value. Cash and cash equivalents consist of demand deposits and other highly liquid investments with an original term of three months or less. The investment portfolio has various maturity dates up to 14 years. A daily market

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exists for all investment securities. The Company believes that the impact of fluctuations in interest rates on its investment portfolio should not have a material impact on financial position or results of operations. Investments in debt securities that are not cash equivalents and marketable equity securities have been designated as available for sale.available-for-sale. Those securities are reported at fair value, with net unrealized gains and losses included in accumulated other comprehensive income, net of applicable taxes. Unrealized losses that are other than temporary are recognized in earnings. Realized gains and losses on investments are determined using the specific identification method. The Company’s investment in Cybernet Systems Corporation is accounted for under the equity method.

Cash and cash equivalents consist of demand deposits and other highly liquid investments. The investment portfolio has various maturity dates up to 25 years. A daily market exists for all investment securities. The Company believes that the impact of fluctuations in interest rates on its investment portfolio should not have a material impact on financial position or results of operations. It is the Company’s intention to use these investment securities to provide working capital and fund the expansion of its business and for other business purposes.

At September 30, 2003,March 31, 2004, the Company had net unrealized gains of $584,000.$501,000. At that date, the net after-tax effect of these gains was $368,000,$315,000, which amount is included in accumulated other comprehensive income within shareowners’ equity. For the threenine months ended September 30,March 31, 2004 and 2003, and 2002, purchases of investments totaled $909,000$1,509,000 and $3,034,000,$7,746,000, and sales of investment securities totaled $400,000$7,353,000 and $450,000,$1,176,000, respectively.

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Sparton owns a 14% interest in Cybernet which was purchased for $3,000,000 in June 1999.Systems Corporation (Cybernet). This investment, which amounted to $1,778,000with a carrying value of $1,861,000 and $1,490,000$1,400,000 at SeptemberMarch 31, 2004 and June 30, 2003, and 2002, respectively, is accounted for under the equity method and is included in other assets on the condensed consolidated balance sheet. Sparton’s share of unrealized gains (losses) on available-for-sale securities held by Cybernet is carried in accumulated other comprehensive income (loss) within the Shareowners’ Equity section of Sparton’s balance sheet.

The contractual maturities of debt securities, and total equity securities, as of September 30, 2003,March 31, 2004, are as follows:

6.6) COMMITMENTS AND CONTINGENCIES

- One of Sparton’s former manufacturing facilities, located in Albuquerque, New Mexico (Coors Road), has been involved with ongoing environmental remediation since the early 1980’s.

At September 30, 2003,March 31, 2004, Sparton has a remaining accrual of $7,397,000accrued $7,307,000 as its estimate of the minimum future undiscounted financial liability, with respect to this matter, of which $643,000$705,000 is classified as a current liability and included on the balance sheet in accrued liabilities. Amounts charged to operations, principally legal and consulting fees, for the nine months ended March 31, 2004 and 2003 were $240,000 and $277,000, respectively. These costs were generally incurred in pursuit of various claims for reimbursement/recovery. The Company’s minimum cost estimate is based upon existing technology and excludes legal and related consulting costs, which are expensed as incurred. The Company’s estimate includes equipment, operating, and operatingcontinued monitoring costs for onsite and offsite pump and treat containment systems, a soil vapor extraction program and continued onsite and offsite monitoring.systems.

During the first quarter of fiscal 2003, Sparton reached an agreement with the United States Department of Energy (DOE) and others to recover certain remediation costs. Under the settlement terms, Sparton received $4,850,000 from the DOE and others in fiscal 2003, plus an additional $1,000,000, which was received during the first quarter of fiscal 2004. In addition, the DOE has agreed to reimburse Sparton for 37.5% of certain future environmental expenses in excess of $8,400,000 incurred atfrom the site. The settlement concluded a very lengthy negotiation process and two court actions, one in the Federal Courtdate of Claims and one in the Federal District Court in Albuquerque, New Mexico. With the settlement, Sparton received cash and gained some degree of risk protection, with the DOE agreeing to reimburse future costs incurred above the established level.settlement. The financial impact of the settlement was recorded in the first quarter of fiscal 2003 with $5,500,000 recorded as income.

Uncertainties associated with environmental remediation contingencies are pervasive and often result in wide ranges of reasonably possible outcomes. Estimates developed in the early stages of remediation can vary significantly. Normally a finite estimate of cost does not become fixed and determinable at a specific point in time. Rather, the costs associated with environmental remediation become estimable over a continuum of events and activities that help to frame and define a liability.

Factors which cause uncertainties for the Company include, but are not limited to, the effectiveness of the current work plans in achieving targeted results and proposals of regulatory agencies for desired methods and outcomes. It is possible that cash flows and results of operations could be significantly affected by the impact of changes associated with the ultimate resolution of this contingency.

Amounts charged to operations, principally legal and consulting, for the three months ended September 30, 2003 and 2002 were $74,000 and $153,000, respectively. These costs were generally incurred in pursuit of various claims for reimbursement/recovery.

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OVERVIEW

The following is management’s discussion and analysis of certain significant events affecting the Company’s earnings and financial condition during the periods included in the accompanying financial statements. Additional information regarding the Company can be accessed via Sparton’s website at www.sparton.com. Information provided at the website includes, among other items, the Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Quarterly Earnings Releases, and News Releases, as well as various corporate charters. The Company’s operations are in one line of business, electronic contract manufacturing services (EMS). Sparton’s capabilities range from product design and development through aftermarket support, specializing in total business solutions for government, medical, aerospace and industrial markets. This includes the design, development and/or manufacture of electronic parts and assemblies for both government and commercial customers worldwide. Governmental sales are mainly sonobuoys. Commercial customers are in general industrial markets, as well as the regulated aerospace and medical markets.

The Private Securities Litigation Reform Act of 1995 reflects Congress’ determination that the disclosures of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by corporate management. The following discussion about the Company’s results of operations and financial conditionThis report on Form 10-Q contains forward-looking statements that involve riskwithin the scope of the Securities Act of 1933 and uncertainty.the Securities Exchange Act of 1934. The words “expects,” “anticipates,” “believes,” “intends,” “plans,” and similar expressions, and the negatives of such expressions, are intended to identify forward-looking statements. In addition, any statements which refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The Company undertakes no obligation to publicly disclose any revisions to these forward-looking statements to reflect events or circumstances occurring subsequent to filing this Form 10-Q with the Securities and Exchange Commission (SEC). These forward-looking statements are subject to risks and uncertainties, including, without limitation, those discussed below. Accordingly, Sparton’s future results may differ materially from historical results or from those discussed or implied by these forward-looking statements. The Company notes that a variety of factors could cause the actual results and experience to differ materially from anticipated results or other expectations expressed in the Company’s forward-looking statements.

Sparton, as a high-mix, low to medium-volume supplier, provides rapid product turnaround for customers. High-mix pertains to customers needing multiple product types that lend themselves to lower volume manufacturing runs. As a contract manufacturer with customers in a variety of markets, the Company has substantially less visibility of end user demand and, therefore, forecasting sales can be problematic. Customers may cancel their orders, change production quantities and/or reschedule production for a number of reasons. Depressed economic conditions may result in customers delaying delivery of product, or the placement of purchase orders for lower volumes than previously anticipated. Unplanned cancellations, reductions, or delays by customers may negatively impact the Company’s results of operations. As many of the Company’s costs and operating expenses are relatively fixed, a reduction in customer demand can disproportionately affect the Company’s gross margins and operating income. The majority of the Company’s sales have historically come from a limited number of customers. Significant reductions in sales to, or a loss of, one of these customers could materially impact business if the Company were not able to replace those sales with new business.

Other risks and uncertainties that may affect the operations, performance, growth forecasts and business results of the Company’s business include, but are not limited to, timing and fluctuations in U.S. and/or world economies, customer demand for products, competition in the overall EMS business, availability of production labor and management services under terms acceptable to the Company, Congressional budget outlays for sonobuoy development and production, Congressional legislation, foreign currency exchange rate risk, uncertainties associated with the costs and benefits of new facilities and the closing of others, uncertainties associated with the outcome of litigation, changes in the interpretation of environmental laws and the uncertainties of environmental remediation. An additionalA further risk factor is the availability and cost of materials. The Company has encountered availability and extended lead time issues on some electronic components in the past when market demand has been strong, which have resulted in higher prices and late deliveries. Finally,Additionally, the timing of sonobuoy sales to the U.S. Navy is dependent upon access to, and successful passage of, product tests performed by the U.S. Navy. Reduced governmental budgets have made access to the test range less predictable and less frequent than in the past. Finally, the Sarbanes-Oxley Act of 2002 has required changes in, and formalization of, some of the Company’s Corporate governance and compliance practices. The SEC and New York Stock Exchange have also passed new rules or regulations requiring additional compliance activities. Compliance with these rules has increased administrative costs, and it is expected that certain of these costs will continue indefinitely. Management cautions readers not to place undue reliance on forward-looking statements, which are subject to influence by the enumerated risk factors as well as unanticipated future events.

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto.

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RESULTS OF OPERATIONS

Three-Month Periods

Sales for the three-month period ended September 30, 2003,March 31, 2004, totaled $36,425,000, comparable with fiscal 2003. Overall, sales were below the Company’s expectations, but do reflect the continued depressed economic environment. A modest decline in government EMS sales to $10,300,000 was offset by$43,566,000, an increase in other markets. Sales included $9,025,000, $12,087,000 and $5,013,000 of industrial, aerospace and medical/$2,725,000 (7%) from the same quarter last year. Government sales increased $4,223,000 (43%) to $14,061,000. This increase is principally due to the successful passage of several sonobuoy drop tests during March, as well as the resolution of previous technical difficulties related to one sonobuoy contract. Industrial market sales of $11,169,000 showed a significant decline, down $3,967,000 (26%) from the same period last year. Industrial sales have been adversely impacted by the reduced demand for detection equipment for U.S. airports. Medical/scientific instrumentation sales respectively. Sales in these areaswere consistent with third quarter sales in fiscal 2003 ($4,451,000 versus $4,485,000 last year). Sales to the aerospace markets were $10,456,000, $10,449,000,$13,885,000, versus $11,383,000 last year, an increase of $2,502,000 (22%). This increase was mainly attributable to increased orders from existing customers.

An operating profit of $133,000 was reported for the three months ended March 31, 2004, compared to $801,000 for the three months ended March 31, 2003. Gross margin for the three months ended March 31, 2004, was 8%, up from 4% for the previous three months ended December 31, 2003. The improved margin reflects the conclusion of the start-up phase of several programs, as well as the completion of one sonobuoy contract that had experienced technical problems. The 8% gross margin for the three months ended March 31, 2004, was down from 10% in fiscal 2003. The decrease was partially due to a less favorable product mix. In addition, the provision for pension costs was adjusted by $481,000 to reflect the revised annual estimate of such costs, most of which are carried in cost of goods sold. The costs have increased due to depressed market conditions and $5,034,000, respectively.lower than expected rate of return on pension assets. The Company is focused on continuing to improve margins through cost reductions and/or recoupment of unplanned expenses from several customers. There were no significant cost to complete adjustments on long term contracts for the three months ended March 31, 2004. Gross profit varies from period to period and is affected by a number of factors, including product mix, production efficiencies, component costs, capacity utilization, and new product introduction. In addition, as many of the Company’s costs and operating expenses are fixed, a reduction in customer demand depresses gross profit and operating income. Selling and administrative expenses were consistent with the prior year period.

Interest and Investment Income decreased $31,000 to $157,000 in 2004. This reduction was due to the reduced funds available for investment. Other Expense-Net in 2004 was $65,000 versus $61,000 in 2003. Translation adjustments, along with gains and losses from foreign currency transactions, are included in current earnings and, in the aggregate, amounted to a loss of $10,000 during the three months ended March 31, 2004.

Due to factors described above, the Company reported net income of $156,000 ($0.02 per share, basic and diluted) for the three months ended March 31, 2004, versus $671,000 ($0.08 per share, basic and diluted) for the corresponding period last year.

Nine-Month Periods

Sales for the nine-month period ended March 31, 2004, totaled $113,231,000, a decline of $7,658,000 (6%), compared to the same period last year. All markets, with the exception of aerospace, are down from the same period last year. Government sales were $30,746,000 for the nine months ended March 31, 2004, down slightly from prior year’s sales of $32,715,000, a decline of 6%. Medical/scientific instrumentation sales were $13,497,000 for the nine months ended March 31, 2004, compared to $14,274,000 for the prior year period, a decline of 5%. Industrial sales also declined slightlyfrom the prior year, with sales of $29,089,000 for the nine months ended March 31, 2004, compared to $41,157,000 for the prior year period, a decline of 29%. While other markets have declined, aerospace sales increased by $7,155,000 (22%) to $39,899,000 from the prior year period, primarily due to increased orders from existing customers. Government sales declined from last year in part due to very limited accessthe overall decline in sonobuoy sales to the test range. In addition,U.S. Navy and delayed foreign sonobuoy sales. Technical difficulties have also adversely impacted sales and margins on several current sonobuoy contracts. Industrial sales have declined sharply due to reduced sales for homeland security. Prior year’s sales benefited from strong demand for homeland security products, principally driven by the Company has encountered technical difficultiesdemand for detection equipment in U.S. and Canadian airports. These sales totaled approximately $2 million in fiscal 2004 compared to approximately $22 million last year. This decline in the productionindustrial market was partially offset by increased sales to other existing industrial customers.

The majority of oneour sales come from a small number of its current sonobuoy contracts which has resultedcustomers. Sales to our 6 largest customers, including government sales, accounted for approximately 75% of net sales in minimal marginboth periods. Four of the customers, including government, were the same both years. One of these customers, with 24% and further depressed sales. Also, two additional sonobuoy contracts encountered difficulties. Increased cost to complete estimates on these two sonobuoys further reduced operating margin by $518,000. Sonobuoy16% of the sales are subject to the passageas of testing. During the first quarterMarch 31, 2004 and 2003, respectively, is comprised of 2004, the testing facility was unavailable until mid-September. In late September eight lots were tested. Two sonobuoy lots passed and four failed testing, but were later accepted. However, two other lots, with sales totaling $2.3 million, failed and require rework. These lots will be shipped and the associated sales recognized in future periods.several separate facilities.

An operating loss of $3,399,000$5,358,000 was reported for the nine months ended March 31, 2004, versus an operating profit of $5,587,000 was reported$8,826,000 for the three months ended September 30, 2003, and 2002, respectively. The currentsame period results include several start-up contracts which had negative or minimal gross margins. While improvements have been made on these contracts, sales of $5,533,000 resulted in a gross margin of only $115,000. In addition, a redesign effort on an existing product line resulted in a charge to operations of $496,000. This effort is projected to be completed by December 2003. Given the on-going reduced level of sales, the Company continues to experience underutilized capacity. Selling and administrative expenses as a percentage of sales increased slightly from last year, 10.3% in 2003 and 9.6% in 2002. Most of this increase was due to higher bid and proposal and development activities, primarily related to government contracts, which further reduced

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current earnings.year. Included in 2003prior year’s operating income was a $5,500,000 recovery ($3,630,000 net

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of tax) recovery of certain environmental remediation costs. It reflects Sparton’s settlement with the DOE and others regarding the reimbursement of costs incurred at the Company’s Sparton Technology Coors Road facility.property. Also included were charges related to the New Mexico environmental remediation effort, principally litigation, of $74,000$240,000 in 2004 and $277,000 in 2003, respectively. Several programs were in start-up mode during the nine months ended March 31, 2004, and $153,000contributed minimal or negative margins. An engineering redesign on an existing proprietary product line this year resulted in 2002.charges of $519,000. Finally, as discussed above, increased pension costs further depressed gross margin. Pension costs of $545,000 and $96,000 have been incurred as of March 31, 2004 and 2003, respectively. The majority of pension costs are carried in cost of goods sold, with the remainder in selling and administrative expense. While pension expense has increased, no cash payment will be required this year due to the plan’s funded status. Selling and administrative expenses have increased slightly from the prior year. Most of this increase was due to research and development activities, primarily related to government contracts. Research and development, including bid and proposal, expenses totaled $2.5 million as of March 31, 2004, compared to $1.0 million for the same period in 2003. While these expenses have shown a larger increase as a percentage of sales over the prior year, many expenses in this area are somewhat fixed and do not fluctuate directly based on sales volume.

Interest and Investment Income increased $113,000$20,000 to $231,000$510,000 in 2003, due to increased available funds for investment.2004. Other Expense-Net in 20032004 was $59,000$375,000 versus Other Income-Net of $14,000$107,000 in 2002.2003. Other Expense-Net in 2004 and 2003 includes $60,000a charge of $538,000 and $120,000, respectively, for insurance adjustments forrelated to Sparton’s previously owned automotive segment. The change was for a previously disputed claim, which has since been settled. Translation adjustments, along with gains and losses from foreign currency transactions, included in current earnings and, in the aggregate, resulted in a gain of $163,000 for the nine months ended March 31, 2004.

TheDue to the factors described above, the Company reported a loss of $2,180,000$3,541,000 ($0.27(0.42) per share)share, basic and diluted) for the threenine months ended September 30, 2003,March 31, 2004, versus net income of $3,578,000$6,427,000 ($0.470.77 per share)share basic, $0.76 per share diluted) for the corresponding period last year.

LIQUIDITY AND CAPITAL RESOURCES

For the three-monthnine-month period ended September 30, 2003,March 31, 2004, Cash and Cash Equivalents increased $2,807,000$45,000 to $13,369,000. Overall, Cash and Investments increased by $3,082,000 from June 30, 2003.$10,607,000. Operating activities provided $3,494,000used $464,000 in net cash flows. The primary source of cash was a decrease incollections on accounts receivable, reflective of receipt of paymentreceipts for the unusually large volume of sales recognizedbalance in receivables at June 30, 2003. The primary use of cash was an increase in inventories.inventories, along with operating losses. A portion of thisthe increase in inventories is reflective of delayed customer delivery schedules. An additional inventory increase reflectsschedules and material purchased for new customer contracts. Cash provided by operating activities in 2002 was less than net income because the $5.8 million related to the environmental settlement with the DOE and others had not been received as of September 30, 2002. program start-ups.

Cash flows usedprovided by investing activities for the nine-month period ended March 31, 2004, totaled $702,000,$490,000. Purchases of property, plant and equipment were principally for the purchase of a new manufacturing facility in Albuquerque, New Mexico. This new facility will replace the Company’s existing facility in Rio Rancho, New Mexico, which will be sold. The transition between facilities is anticipated to be completed in the next 3-5 months. The new facility, which was purchased for approximately $4.5 million, is included in property, plant, and equipment within the asset section of the balance sheet as of March 31, 2004. The building was funded through the sale of investment securities. The existing facility will continue in use through the transition, at which point the Company plans to sell it at an anticipated gain. With the new facility, the Company anticipates additional contract opportunities that were previously not available.

Cash flow provided by financing activities for the nine months ended March 31, 2004, totaled $15,000$20,000, primarily from stock options exercised.

The Company’s market risk exposure to foreign currency exchange and interest rates are not considered to be material, principally due to their short term nature and minimal receivables and payables designated in foreign currency. The Company has had no short-term bank debt since December 1996, and currently has an unused informal line of credit totaling $20 million.

At September 30, 2003,March 31, 2004 and June 30, 2002,2003, the aggregate government EMS backlog was approximately $45$53 million and $51 million, respectively. A majority of the September 30, 2003,March 31, 2004, backlog is expected to be realized in the next 8-1012-15 months. Commercial EMS orders are not included in the backlog. The Company does not believe the amount of commercial activity covered by firm purchase orders is a meaningful measure of future sales, as such orders may be rescheduled or cancelled without significant penalty.

TheSparton has continued to pursue operations in Vietnam, which should provide increased growth opportunities. As the Company has had no short-term debt since December 1996,not previously done business in this emerging market, there are many uncertainties and currently has an unused informal linerisks inherent in this potential venture. On April 23, 2004, the Board of credit totaling $20 million from one bank.Directors approved a proposal to proceed with this expansion. The venture will not be

Sparton is continuing to pursue12

conducted as a joint venture operation in Vietnam with Texatronics, our Alliance Partner in Richardson, Texas.Inc. as previously described, as they have voluntarily withdrawn from the plan. Meetings have been held with architects and contractors to investigate the type, design and designcost of the building.a new manufacturing facility in Vietnam. It is estimated that Sparton will invest approximately $5-$7 million, which includes land, building, and initial operating expenses. The actual joint venture continues in a discussion phase. If an agreement is finalized, the new joint ventureoperation will carry the name Spartronics.Spartronics, Inc. The Company is also exploring the possible purchasecontinuing a program of a new facility in the Albuquerque, New Mexico area to replace an existing facility, as well as identifying and evaluating potential acquisition candidates in both the defense and medical markets.

No cash dividends were declared in either period presented. At September 30, 2003,March 31, 2004, the Company had $89,117,000$87,772,000 in recorded shareowners’ equity ($11.2110.52 per share), $75,758,000$70,356,000 in working capital, and a 5.25:4.84:1.00 working capital ratio. For the foreseeable future (12-18 months), the Company believes it has sufficient liquidity for its anticipated needs.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s discussion and analysis of financial condition and results of operations is based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. Significant accounting policies are summarized in Note 1 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended June 30, 2003. The preparation of these financial statements requires estimates, assumptions, and judgements that affect the amounts reported of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Estimates are regularly evaluated and are based on historical experience and on various other assumptions believed to be reasonable under the circumstances. Actual results may differ from these estimates. The following critical accounting policies affect the more significant judgements and estimates used in the preparation of the Company’s consolidated financial statements.

OTHEREnvironmental Contingencies

One of Sparton’s former manufacturing facilities, located in Albuquerque, New Mexico (Coors Road), has been the subject of ongoing investigations and remediation efforts conducted with the Environmental Protection Agency (EPA) under the Resource Conservation and Recovery Act (RCRA). Sparton has accrued its estimate of the minimum future non-discounted financial liability. The estimate was developed using existing technology and excludes legal and related consulting costs. The minimum cost estimate includes equipment, operating and monitoring costs for both onsite and offsite remediation. Sparton recognizes legal and consulting services in the periods incurred and reviews its EPA accrual activity quarterly. Uncertainties associated with environmental remediation contingencies are pervasive and often result in wide ranges of reasonably possible outcomes. It is possible that cash flows and results of operations could be materially affected by the impact of changes in these estimates.

LITIGATIONGovernment Contract Cost Estimates

Government production contracts are accounted for based on completed units accepted with respect to revenue recognition and their estimated average cost per unit regarding costs. Losses for the entire amount of a contract are recognized in the period when such losses are determinable. Significant judgment is exercised in determining estimated total contract costs including, but not limited to, cost experience to date, estimated length of time to contract completion, costs for materials, production labor and support services to be expended, and known issues on remaining units to be completed. Estimated costs developed in the early stages of contracts can change significantly as the contracts progress, and events and activities take place. Significant changes in estimates can also occur when new designs are initially placed into production. The Company formally reviews its costs incurred-to-date and estimated costs to complete on all significant contracts on a quarterly basis. Revised estimated total contract costs are reflected in the financial statements. Depending upon the circumstances, it is possible that the Company’s financial position, results of operations and cash flows could be materially affected by changes in estimated costs to complete on one or more significant contracts.

Commercial Inventory Valuation Allowances

Inventory valuation allowances for commercial customer inventories require a significant degree of judgment and is influenced by the Company’s experience to date with both customers and other markets, prevailing market conditions for raw materials, contractual terms and customers’ ability to satisfy these obligations, environmental or technological materials obsolescence, changes in demand for customer products, and other factors resulting in acquiring materials in excess of customer product demand. Contracts with some commercial customers may be based upon estimated quantities of product manufactured for shipment over estimated time periods. Raw material inventories are purchased to fulfill these customer requirements. Within these arrangements, customer demand for products frequently changes, sometimes creating excess and obsolete inventories.

The Company regularly reviews raw material inventories by customer for both excess and obsolete quantities, with adjustments made accordingly. Wherever possible, the Company attempts to recover its full cost of excess and obsolete inventories from

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customers or, in some cases, through other markets. When it is determined that the Company’s carrying cost of such excess and obsolete inventories cannot be recovered in full, a charge is taken against income and a valuation allowance is established for the difference between the carrying cost and the estimated realizable amount. Conversely, should the disposition of adjusted excess and obsolete inventories result in recoveries in excess of these reduced carrying values, the remaining portion of the valuation allowances are reversed and taken into income when such determinations are made. It is possible that the Company’s financial position, results of operations and cash flows could be materially affected by changes to inventory valuation allowances for commercial customer excess and obsolete inventories.

Allowance for Possible Losses on Receivables

The accounts receivable balance is recorded net of allowances for amounts not expected to be collected from customers. The Company maintains an allowance for possible estimated losses on receivables. The allowance is estimated based on historical experience of write-offs, the level of past due amounts, information known about specific customers with respect to their ability to make payments, and future expectations of conditions that might impact the collectibility of accounts. Accounts receivable are generally due under normal trade terms for the industry. Credit is granted, and credit evaluations are periodically performed, based on a customers’ financial condition and other factors. Although the Company does not generally require collateral, cash in advance or letters of credit may be required from customers in certain circumstances, including some foreign customers. When management determines that it is probable that an account will not be collected, it is charged against the allowance for possible losses. The Company reviews the adequacy of its allowance monthly. The allowance for doubtful accounts was $316,000 and $739,000 at March 31, 2004 and June 30, 2003, respectively. If the financial conditions of customers were to deteriorate, resulting in an impairment of their ability to make payment, additional allowances may be required. The significant reduction in allowance for doubtful accounts from June 30 was primarily due to the write off of $440,000 for one account. The account, which was previously reserved, was deemed uncollectable and, therefore, written off.

Pension Obligations

The Company calculates the cost of providing pension benefits under the provisions of Statement of Financial Accounting Standards (SFAS) No. 87. The key assumptions required within the provisions of SFAS No. 87 are used in making these calculations. The most significant of these assumptions are the discount rate used to value the future obligations and the expected return on pension plan assets. The discount rate is consistent with market interest rates on high-quality, fixed income investments. The expected return on assets is based on long-term returns and assets held by the plan, which is influenced by historical averages. If actual interest rates and returns on plan assets materially differ from the assumptions, future adjustments to the financial statements would be required. While changes in these assumptions can have a significant effect on the pension benefit obligations reported in the Consolidated Balance Sheets and the unrecognized gain or loss accounts, the effect of changes in these assumptions is not expected to have a significant effect on net periodic pension costs in the near term. While these assumptions may change in the future based on changes in long-term interest rates and market conditions, there are no known expected changes in these assumptions as of March 31, 2004. As indicated above, to the extent the assumptions differ from actual results, there would be a future impact on the financial statements. The extent to which this will result in future expense is not determinable at this time as it will depend upon a number of variables, including trends in interest rates and the actual return on plan assets. For example, an increase in the return on the plan assets due to improved market conditions would reduce the unrecognized loss account and thus reduce future expense. During the quarter ended March 31, 2004, the annual actuarial valuation of the pension plan was received. Based on the most recent valuation, pension expense for fiscal 2004 is estimated to be $727,000, versus the prior year’s cost of $128,000. The following factors contributed to this increase: market values at July 1, 2003 (the valuation date) were very low causing a significant decrease in the value of pension assets, the actual rate of return in the current market environment was lower than previous estimates, and the use of a lower discount rate in the calculation further unfavorably impacted the valuation results. While pension expense has increased, no cash payments will be required this year due to the plan’s funded status.

OTHER

Litigation

One of Sparton’s facilities, located in Albuquerque, New Mexico, has been the subject of ongoing investigations conducted with the Environmental Protection Agency (EPA) under the Resource Conservation and Recovery Act (RCRA). The investigation began in the early 1980’s and involved a review of onsite and offsite environmental impacts.

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At September 30, 2003,March 31, 2004, Sparton has an accrual of $7,397,000accrued $7,307,000 as its estimate of the future undiscounted minimum financial liability with respectrelated to this matter.site. The Company’s cost estimate is based upon existing technology and excludes legal and related consulting costs, which are expensed as incurred. The Company’s estimate includes equipment and operating costs for onsite and

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offsite operations and is based on existing methodology. Uncertainties associated with environmental remediation contingencies are pervasive and often result in wide ranges of reasonably possible outcomes. Estimates developed in the early stages of remediation can vary significantly. Normally a finite estimate of cost does not become fixed and determinable at a specific point in time. Rather, the costs associated with environmental remediation become estimable over a continuum of events and activities that help to frame and define a liability. It is possible that cash flows and results of operations could be affected by the impact of the ultimate resolution of this contingency.

In 1995, Sparton Corporation and Sparton Technology, Inc. (STI) filed a Complaint in the Circuit Court of Cook County, Illinois, against Lumbermens Mutual Casualty Company and American Manufacturers Mutual Insurance Company demanding reimbursement of expenses incurred in connection with its remediation efforts at the Coors Road facility based on various primary and excess comprehensive general liability policies in effect between 1959 and 1975. In 1999, the Complaint was amended to add various other excess insurers, including certain London market insurers and Fireman’s Fund Insurance Company. The case remains in pretrial activity.

In September 2002, STI filed an action in the U.S. District Court for the Eastern District of Michigan to recover certain unreimbursed costs incurred as a result of a manufacturing relationshipis currently involved with two entities, Util-Link, LLC (Util-Link)legal actions, which are disclosed in Part II — “Other Information, Item 1. Legal Proceedings” of Delaware and National Rural Telecommunications Cooperative (NRTC) of the District of Columbia. On or about October 21, 2002, the defendants filed a counterclaim seeking money damages, alleging that STI breached its duties in the manufacture of products for the defendants. The defendant Util-Link has asked for damages in the amount of $25,000,000 for lost profits. The defendant NRTC has asked for damages in the amount $20,000,000 for the loss of its investment in and loans to Util-Link. Sparton believes that the damages sought by NRTC are included in Util-Link’s claim for damages and as such, are duplicative. Sparton also believes the counterclaim to be without merit and intends to vigorously defend against it. This case is in the initial stages of discovery.

this report. At this time, the Company is unable to predict the amountoutcome of recovery, if any, that may result from the pursuiteither of these two before-mentioned claims.

Item 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

MARKET RISK EXPOSURE

The Company manufactures its products in the United States and Canada. Sales of the Company’s products are made into the U.S. and Canada, as well as other foreign markets. The Company is potentially subject to foreign currency exchange rate risk relating to intercompany activity and balances and to receipts from customers and payments to suppliers in foreign currencies. Also, adjustments related to the translation of the Company’s Canadian financial statements into U.S. dollars are included in current earnings. As a result, the Company’s financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which the Company operates. However, minimal third party receivables and payables are denominated in foreign currency and, historically, foreign currency gains and losses have not been significant. The Company does not consider the market risk exposure relating to currency exchange to be material.

The Company has financial instruments that are subject to interest rate risk, principally short-term investments. Historically, the Company has not experienced material gains or losses due to such interest rate changes. Based on the current holdings of short-term investments, the interest rate risk is not considered to be material.

Item 4. CONTROLS AND PROCEDURES

The Company maintains internal controls over financial reporting intended to provide reasonable assurance at appropriate cost, that all material transactions are executed in accordance with Companyproper authorization and are properly recorded and reported in the financial statements, and that assets are adequately safeguarded. The Company also maintains a

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system of disclosure controls and procedures to ensure that information required to be disclosed in Company reports, filed or submitted under the Securities Exchange Act of 1934, is properly reported in the Company’s periodic and other reports.

As of September 30, 2003,March 31, 2004, an evaluation was updated by the Company’s management, including the CEO and CFO, on the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures continue to be effective as of September 30, 2003.March 31, 2004. There have been no significant changes in the Company’s internal controls over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II
OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

One of Sparton’s former manufacturing facilities, located in Albuquerque, New Mexico (Coors Road), has been involved with ongoing environmental remediation since the early 1980’s.

In December 1999, the Company increased its accrual for the cost of addressing environmental impacts associated with its Coors Road facility by $10,000,000 pre-tax. This increase was in response to a Consent Decree settling lawsuits, as well as a related administrative enforcement action, and covered costs expected to be incurred over the next thirty years.

At September 30, 2003,March 31, 2004, Sparton has a remaining accrual of $7,397,000accrued $7,307,000 as its estimate of the minimum future undiscounted financial liability, with respect to this matter, of which $643,000$705,000 is classified as a current liability and included on the balance sheet in accrued liabilities. The Company’s minimum cost estimate is based upon existing technology and excludes legal and related consulting costs, which are expensed as incurred. The Company’s estimate includes equipment, operating, and operatingcontinued monitoring costs for onsite and offsite pump and treat containment systems, a soil vapor extraction program and continued onsite and offsite monitoring.systems.

Factors which cause uncertainties forwith respect to the CompanyCompany’s estimate include, but are not limited to, the effectiveness of the current work plans in achieving targeted results and proposals of regulatory agencies for desired methods and outcomes. It is possible that cash flows and results of operations could be significantly affected by the impact of changes associated with the ultimate resolution of this contingency. Uncertainties associated with environmental remediation contingencies are pervasive and often result in wide ranges of reasonably possible outcomes. Estimates developed in the early stages of remediation can vary significantly. Normally a finite estimate of cost does not become fixed and determinable at a specific point in time. Rather, the costs associated with environmental remediation become estimable over a continuum of events and

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activities that help to frame and define a liability. It is possible that cash flows and results of operations could be materially affected by the impact of the ultimate resolution of this contingency.

During the first quarter of fiscal 2003, Sparton reached an agreement with the United States Department of Energy (DOE) and others to recover certain remediation costs. Under the settlement terms, Sparton received $4,850,000 from the DOE and others in fiscal 2003, plus an additional $1,000,000, which was received during the first quarter of fiscal 2004. In addition, the DOE has agreed to reimburse Sparton for 37.5% of certain future environmental expenses in excess of $8,400,000 incurred atfrom the site. The settlement concluded a very lengthy negotiation process and two court actions, one in the Federal Courtdate of Claims and one in the Federal District Court in Albuquerque, New Mexico. With the settlement, Sparton received cash and gained some degree of risk protection, with the DOE agreeing to reimburse future costs incurred above the established level.settlement. The financial impact of the settlement was recorded in the first quarter of fiscal 2003 with $5,500,000 recorded as operating income.

In 1995, Sparton Corporation and Sparton Technology, Inc. (STI) filed a Complaint in the Circuit Court of Cook County, Illinois, against Lumbermens Mutual Casualty Company and American Manufacturers Mutual Insurance Company demanding reimbursement of expenses incurred in connection with its remediation efforts at the Coors Road facility

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based on various primary and excess comprehensive general liability policies in effect between 1959 and 1975. In 1999, the Complaint was amended to add various other excess insurers, including certain London market insurers and Fireman’s Fund Insurance Company. The case remains in pretrial activity.

In September 2002, Sparton Technology, Inc. (STI) filed an action in the U.S. District Court for the Eastern District of Michigan to recover certain unreimbursed costs incurred as a result of a manufacturing relationship with two entities, Util-Link, LLC (Util-Link) of Delaware and National Rural Telecommunications Cooperative (NRTC) of the District of Columbia. On or about October 21, 2002, the defendants filed a counterclaim seeking money damages, alleging that STI breached its duties in the manufacture of products for the defendants. The defendant Util-Link has asked for damages in the amount of $25,000,000 for lost profits. The defendant NRTC has asked for damages in the amount $20,000,000 for the loss of its investment in and loans to Util-Link. Sparton believes that the damages sought by NRTC are included in Util-Link’s claim for damages and as such, are duplicative. Sparton also believes the counterclaim to be without merit and intendsis vigorously positioning itself to vigorously defend against it. This case is in the initial stages of discovery.discovery stage.

At this time, the Company is unable to predict the amountoutcome of recovery, if any, that may result from the pursuiteither of these two before-mentioned claims.

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Item 6. EXHIBITS AND REPORTS ON FORM 8-K