UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
   
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period endedSeptember 30, 20052006
or
   
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                    to                    
Commission File number 1-1000
SPARTON CORPORATION
(Exact Name of Registrant as Specified in its Charter)
OHIO
(State or Other Jurisdiction of Incorporation or Organization)
38-1054690
(I.R.S. Employer Identification No.)
2400 East Ganson Street, Jackson, Michigan 49202
(Address of Principal Executive Offices, Zip Code)
(517) 787-8600
(Registrant’s Telephone Number, Including Area Code)
Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.þ Yes      o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, (as definedor a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act Rule 12b-2). YesAct. (Check one):
Large accelerated filero      NoAccelerated filero      Non-accelerated filerþ
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yeso Yes      Noþ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicalpracticable date.
   
  Shares Outstanding at
  October 31, 20052006
Class of Common Stock (Unadjusted for October 25, 2005,2006, Stock dividend)
$1.25 Par Value
 8,906,789
9,356,280

 


TABLE OF CONTENTS
     
Part I. Financial Information
     
(Interim, Unaudited)    
     
2006  3 
     
2005  4 
     
2005  5 
     
2005  6 
     
  7 
     
  1217
Item 3. Quantitative and Qualitative Disclosures About Market Risk24
Item 4. Controls and Procedures24 
     
17Part II. Other Information
     
1. Legal Proceedings  1824 
Item 1(a). Risk Factors  26 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds  26 
18
  2027 
Item 6. Exhibits  28 
Signatures  2028 
20
EX-31.1 CERTIFICATION
EX-31.2 CERTIFICATION
EX-32.1 CERTIFICATION

2


PART I
Part I. Financial Information
Item 1. Financial Statements (Interim, Unaudited)
SPARTON CORPORATION AND SUBSIDIARIES

Condensed Consolidated Balance Sheets (Unaudited)
                
 At September 30, 2005 At June 30, 2005 September 30, 2006 June 30, 2006 
ASSETS
 
   
 
Assets
Current assets:  
Cash and cash equivalents $7,363,567 $9,368,120  $6,199,185 $7,503,438 
Investment securities 22,638,980 20,659,621  11,140,191 15,969,136 
Accounts receivable 22,721,767 26,004,945  25,186,904 25,108,442 
Environmental settlement receivable  5,455,000 
Income taxes recoverable 685,706   987,434  
Inventories and costs on contracts in progress 36,018,276 36,847,385 
Deferred taxes 2,683,862 2,640,561 
Inventories and costs of contracts in progress 49,796,273 46,892,183 
Deferred income taxes 2,470,836 2,662,692 
Prepaid expenses and other current assets 490,048 631,132  608,665 1,462,190 
     
Total current assets 92,602,206 101,606,764  96,389,488 99,598,081 
  
Pension asset 4,848,392 4,968,507  4,284,038 4,420,932 
Property, plant and equipment — net 18,216,067 17,598,906 
Goodwill and other intangibles — net 22,348,385 22,469,807 
Other assets 6,507,696 6,454,526  5,966,734 5,970,010 
Property, plant and equipment, net 16,131,081 16,430,989 
     
 
Total assets $120,089,375 $129,460,786  $147,204,712 $150,057,736 
     
  
Liabilities and Shareowners’ Equity
LIABILITIES AND SHAREOWNERS’ EQUITY
 
 
Current liabilities:  
Current portion of long-term debt $3,823,000 $3,815,833 
Accounts payable $8,755,604 $12,694,057  16,599,572 16,748,814 
Salaries and wages 3,496,199 4,435,089  3,945,866 4,388,396 
Accrued health benefits 1,065,084 1,041,850  1,179,432 1,142,693 
Other accrued liabilities 5,450,697 5,518,920  6,042,691 4,996,408 
Income taxes payable  2,414,294   308,814 
     
Total current liabilities 18,767,584 26,104,210  31,590,561 31,400,958 
  
Long-term debt — noncurrent portion 15,485,463 16,010,616 
Environmental remediation — noncurrent portion 6,115,424 6,184,590  5,725,180 5,795,784 
      
Shareowners’ equity: 
Total liabilities
 52,801,204 53,207,358 
 
Shareowners’ Equity:
 
Preferred stock, no par value; 200,000 shares authorized, none outstanding      
Common stock, $1.25 par value; 15,000,000 shares authorized, 9,340,627 and 8,830,428 shares outstanding at September 30 and June 30, 2005 11,675,784 11,038,035 
Common stock, $1.25 par value; 15,000,000 shares authorized, 9,841,091 shares outstanding (9,392,305 at June 30, 2006) 12,301,364 11,740,381 
Capital in excess of par value 14,607,786 10,558,757  18,664,020 15,191,990 
Retained earnings 63,569,276 70,183,104 
Accumulated other comprehensive loss  (144,833)  (44,198)  (131,152)  (265,097)
Retained earnings 69,067,630 75,619,392 
     
Total shareowners’ equity 95,206,367 97,171,986  94,403,508 96,850,378 
     
 
Total liabilities and shareowners’ equity $120,089,375 $129,460,786  $147,204,712 $150,057,736 
     
See accompanying notes.notes to condensed consolidated financial statements.

3


SPARTON CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Operations (Unaudited)
        
 Three Months Ended September 30,        
 2005 2004 Three months ended September 30, 
 2006 2005 
   
Net sales $37,306,118 $45,188,315  $48,316,771 $37,306,118 
Costs of goods sold 35,611,558 38,721,599  47,664,636 35,611,558 
     
Gross profit 1,694,560 6,466,716  652,135 1,694,560 
  
Selling and administrative expenses 4,014,271 3,387,053  4,321,232 4,014,271 
 
Amortization of intangibles 121,424  
EPA related — net environmental remediation  (29,198) 84,000  9,577  (29,198)
 
Loss on sale of property, plant and equipment 11,156  
Net (gain) loss on sale of property, plant and equipment  (203,675) 11,156 
     
  4,248,558 3,996,229 
Operating income (loss)  (2,301,669) 2,995,663 
     
Operating loss
  (3,596,423)  (2,301,669)
  
Other income (expense):  
Interest and investment income 264,448 215,473  150,931 264,448 
Equity income (loss) in investment 17,000  (20,000)
Interest expense  (296,999)  
Equity income in investment 12,000 17,000 
Other — net 109,275 358,462  107,348 109,275 
     
 390,723 553,935   (26,720) 390,723 
     
  
Income (loss) before income taxes  (1,910,946) 3,549,598 
Provision (credit) for income taxes  (612,000) 1,136,000 
Loss before income taxes  (3,623,143)  (1,910,946)
Credit for income taxes  (1,159,000)  (612,000)
     
Net loss
 $(2,464,143) $(1,298,946)
     
  
Net income (loss) $(1,298,946) $2,413,598 
Loss per share — basic and diluted1
 $(0.25) $(0.13)
     
 
Basic and diluted earnings (loss) per share(1)
 $(0.14) $0.26 
(1) All share and per share information have been adjusted to reflect the impact of the 5% stock dividendsdividend declared in November 2004 and October 2005.2006.
See accompanying notes.notes to condensed consolidated financial statements.

4


SPARTON CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (Unaudited)
         
  Three Months Ended September 30,
  2005 2004
 
         
Cash flows provided by Operating Activities:        
Net income (loss) $(1,298,946) $2,413,598 
Add (deduct) noncash items affecting operations:        
Depreciation, amortization and accretion  484,270   388,557 
Deferred income taxes  14,000    
Change in pension asset  120,115   132,017 
Stock-based compensation expense  65,229    
Loss on sale of property, plant & equipment  11,156    
Loss on sale of investment securities  2,151   5,244 
Equity (income) loss on investment  (17,000)  20,000 
Other, primarily changes in customer and vendor claims  (26,694)   
Add (deduct) changes in operating assets and liabilities:        
Accounts receivable  3,283,178   1,775,005 
Environmental settlement receivable  5,455,000    
Income taxes recoverable  (685,706)  559,706 
Inventories and prepaid expenses  970,193   678,450 
Accounts payable, salaries and wages, accrued liabilities and income taxes  (7,405,793)  (674,165)
 
Net cash provided by operating activities  971,153   5,298,412 
         
Cash flows used by Investing Activities:        
Purchases of investment securities  (2,855,879)  (2,260,706)
Proceeds from sale of investment securities  538,167   2,094,884 
Proceeds from maturity of investment securities  178,047   200,000 
Purchases of property, plant and equipment, net  (195,298)  (1,062,991)
Other, principally noncurrent other assets  (9,476)  (81,888)
 
Net cash used by investing activities  (2,344,439)  (1,110,701)
         
Cash flows provided (used) by Financing Activities:        
Proceeds from exercise of stock options  258,142   6,145 
Cash dividends  (889,409)   
 
Net cash provided (used) by financing activities  (631,267)  6,145 
         
Increase (decrease) in cash and cash equivalents  (2,004,553)  4,193,856 
Cash and cash equivalents at beginning of period  9,368,120   10,820,461 
 
Cash and cash equivalents at end of period $7,363,567  $15,014,317 
 
         
Supplemental disclosures of cash paid during the period:        
Income taxes — net $2,509,000  $ 
 
         
  Three months ended September 30, 
  2006  2005 
   
Cash Flows From Operating Activities:
        
Net loss $(2,464,143) $(1,298,946)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:        
Depreciation, amortization and accretion  748,422   484,270 
Deferred income taxes  145,000   14,000 
Loss on sale of investment securities  52,846   2,151 
Equity income in investment  (12,000)  (17,000)
Pension expense  136,894   120,115 
Share-based compensation  66,710   65,229 
(Gain) loss on sale of property, plant and equipment  (5,000)  11,156 
Gain from sale of non-operating land  (198,675)   
Other, primarily changes in customer and vendor claims     (26,694)
Changes in operating assets and liabilities:        
Accounts receivable  (78,462)  3,283,178 
Environmental settlement receivable     5,455,000 
Income taxes recoverable  (987,434)  (685,706)
Inventories, prepaid expenses and other current assets  (2,663,065)  970,193 
Accounts payable and accrued liabilities  112,179   (7,405,793)
       
Net cash (used in) provided by operating activities
  (5,146,728)  971,153 
         
Cash Flows From Investing Activities:
        
Purchases of investment securities     (2,855,879)
Proceeds from sale of investment securities  4,806,900   538,167 
Proceeds from maturity of investment securities  150,000   178,047 
Purchases of property, plant and equipment  (1,244,161)  (195,298)
Proceeds from non-operating land sale  811,175    
Proceeds from sale of property, plant and equipment  5,000    
Other, principally noncurrent other assets  15,276   (9,476)
       
Net cash provided by (used in) investing activities
  4,544,190   (2,344,439)
         
Cash Flows From Financing Activities:
        
Repayment of long-term debt  (518,333)   
Proceeds from the exercise of stock options  24,552   258,142 
Tax effect from stock transactions  3,248    
Repurchases of common stock  (211,182)   
Cash dividend     (889,409)
       
Net cash used in financing activities
  (701,715)  (631,267)
       
         
Decrease in cash and cash equivalents  (1,304,253)  (2,004,553)
Cash and cash equivalents at beginning of period  7,503,438   9,368,120 
       
Cash and cash equivalents at end of period
 $6,199,185  $7,363,567 
       
See accompanying notes.notes to condensed consolidated financial statements.

5


SPARTON CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Shareowners’ Equity (Unaudited)
                         
  Three Months Ended September 30, 2005
              Accumulated other    
          Capital comprehensive    
  Common Stock in excess income (loss) Retained  
  Shares Amount of par value net of tax earnings Total
 
                         
Balance at June 30, 2005  8,830,428  $11,038,035  $10,558,757  $(44,198) $75,619,392  $97,171,986 
                         
Cash dividend ($0.10 per share)                  (889,409)  (889,409)
Stock options exercised  65,407   81,759   176,383           258,142 
Stock-based compensation expense          65,229           65,229 
Stock dividend (5% declared October 25, 2005)  444,792   555,990   3,807,417       (4,363,407)   
                         
Comprehensive income (loss), net of tax:                        
Net loss                  (1,298,946)  (1,298,946)
Net unrealized loss on investment securities owned              (116,055)      (116,055)
Reclassification adjustment for net loss realized and reported in net loss              1,420       1,420 
Net unrealized gain on equity investment              14,000       14,000 
                         
Total comprehensive loss                      (1,399,581)
 
Balance at September 30, 2005  9,340,627  $11,675,784  $14,607,786  $(144,833) $69,067,630  $95,206,367 
 
                         
  Three months ended September 30, 2006 
          Capital      Accumulated other    
  Common Stock  in excess  Retained  comprehensive    
  Shares  Amount  of par value  earnings  income (loss)  Total 
Balance at July 1, 2006  9,392,305  $11,740,381  $15,191,990  $70,183,104  $(265,097) $96,850,378 
                         
Stock dividend (5% declared October 25, 2006)  468,623   585,779   3,420,951   (4,006,730)       
Stock options exercised  4,255   5,319   19,233           24,552 
Repurchases of common stock as part of 2005 share repurchase program  (24,092)  (30,115)  (38,112)  (142,955)      (211,182)
                         
Share-based compensation          66,710           66,710 
Tax effect of stock transactions          3,248           3,248 
                         
Comprehensive income (loss), net of tax:                        
Net loss              (2,464,143)      (2,464,143)
Net unrealized gain on investment securities owned                  88,067   88,067 
Reclassification adjustment for net gain realized and reported in net loss                  34,878   34,878 
Net unrealized gain on equity investment                  11,000   11,000 
                        
Comprehensive loss                      (2,330,198)
                   
Balance at September 30, 2006  9,841,091  $12,301,364  $18,664,020  $63,569,276  $(131,152) $94,403,508 
                   
                         
  Three Months Ended September 30, 2004
              Accumulated other    
          Capital comprehensive    
  Common Stock in excess income (loss) Retained  
  Shares Amount of par value net of tax earnings Total
 
                         
Balance at June 30, 2004  8,351,538  $10,439,423  $7,134,149  $62,368  $71,230,159  $88,866,099 
                         
Stock options exercised  814   1,017   5,128           6,145 
                         
Comprehensive income, net of tax:                        
Net income                  2,413,598   2,413,598 
Net unrealized gain on investment securities owned              42,699       42,699 
Reclassification adjustment for net loss realized and reported in net income              3,461       3,461 
Net unrealized gain on equity investment              20,000       20,000 
                         
Total comprehensive income                      2,479,758 
 
                         
Balance at September 30, 2004  8,352,352  $10,440,440  $7,139,277  $128,528  $73,643,757  $91,352,002 
 
                 ��       
  Three months ended September 30, 2005 
          Capital      Accumulated other    
  Common Stock  in excess  Retained  comprehensive    
  Shares  Amount  of par value  earnings  income (loss)  Total 
Balance at July 1, 2005  8,830,428  $11,038,035  $10,558,757  $75,619,392  $(44,198) $97,171,986 
                         
Stock dividend (5% declared October 25, 2005)  444,792   555,990   3,807,417   (4,363,407)       
Stock options exercised, net of common stock surrendered to facilitate exercise  65,407   81,759   176,383           258,142 
Cash dividend ($0.10 per share)              (889,409)      (889,409)
                         
Share-based compensation          65,229           65,229 
                         
Comprehensive income (loss), net of tax:                        
Net loss              (1,298,946)      (1,298,946)
Net unrealized loss on investment securities owned                  (116,055)  (116,055)
Reclassification adjustment for net loss realized and reported in net loss                  1,420   1,420 
Net unrealized gain on equity investment                  14,000   14,000 
                        
Comprehensive loss                      (1,399,581)
                   
Balance at September 30, 2005  9,340,627  $11,675,784  $14,607,786  $69,067,630  $(144,833) $95,206,367 
                   
See accompanying notes.notes to condensed consolidated financial statements.

6


SPARTON CORPORATION &AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)
NOTE 1. BUSINESS AND 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 Statementscondensed consolidated financial statements of Sparton Corporation and subsidiaries (the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) 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 of America for complete financial statements. All significant intercompany transactions and accounts have been eliminated. The Condensed Consolidated Balance Sheetcondensed consolidated balance sheet at September 30, 2005,2006, and the related Condensed Consolidated Statementscondensed consolidated statements of Operations, Cash Flowsoperations, cash flows and Shareowners’ Equityshareowners’ equity for the three months ended September 30, 20052006 and 2004,2005 are unaudited, but include all adjustments (consisting only of normal recurring accruals) which the Company considers necessary for a fair presentation of such interim financial statements. Certain reclassifications of prior period amounts have been made to conform to the current presentation. Operating results for the three months ended September 30, 2005,2006 are not necessarily indicative of the results that may be expected for the fiscal year endedending June 30, 2006.2007.
The balance sheet at June 30, 2005,2006, 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 of AmericaGAAP for complete financial statements. It is suggested that these condensed consolidated financial statements be read in conjunction with the Consolidated Financial Statementsconsolidated financial statements and footnotes thereto included in the Company’s Annual Reportreport on Form 10-K for the fiscal year ended June 30, 2005.2006.
Business Acquisition —On May 31, 2006, the Company announced that a membership purchase agreement was signed, and the acquisition of Astro Instrumentation, LLC was completed. The newly acquired entity was renamed Astro Instrumentation, Inc. (Astro), incorporated in the state of Michigan, and is operating as a wholly-owned subsidiary of Sparton Corporation. Astro was a privately owned electronic manufacturing services (EMS) provider located in Strongsville, Ohio that had been in business for approximately 5 years. Astro’s sales volume for its year ended December 31, 2005, was approximately $34 million. The acquisition of Astro furthered the Company’s strategy of identifying, evaluating and purchasing potential acquisition candidates in both the defense and medical device markets.
The acquisition was accounted for using the purchase method in accordance with Statement of Financial Accounting Standards No. 141,Business Combinations; accordingly, the operating results of Astro since the acquisition date have been included in the consolidated financial statements of the Company. Additional details covering the Astro acquisition can be found in the Company’s Annual report on Form 10-K for the fiscal year ended June 30, 2006.
Shown below, and also included in the Company’s condensed consolidated financial statements for the three months ended September 30, 2006, are the sales, costs of goods sold and total assets of Astro, which were as follows:
         
  Total  Astro 
Net sales $48,317,000  $11,355,000 
Costs of goods sold  47,665,000   10,458,000 
       
Gross profit $652,000  $897,000 
       
         
Total assets at September 30, 2006 $147,205,000  $42,803,000 
       
Operations -The Company operates in one line of business, electronic manufacturing services (EMS). 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 aftermarket support. All of the facilities are registered to ISO standards, including 9001 or 13485, with most 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” or “Device Manufacturing” products for Original Equipment Manufacturers, microprocessor-based systems, transducers, printed circuit boards and assemblies, sensors and electromechanical and electrochemical devices. Markets served are in the government, medical/scientific instrumentation, aerospace, and other 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 acceptedThe Company’s interim condensed consolidated financial statements are prepared in the United States of Americaaccordance with GAAP. These accounting principles require management to make certain estimates, judgments and assumptions. The Company believes that the estimates, judgments and assumptions upon which it relies are reasonable based upon informa-

7


tion available to it at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the disclosurereported amounts of assets and liabilities andas of the amounts reported indate of the financial statements, as well as the reported amounts of revenues and accompanying notes. Actualexpenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, could differ from those estimates.the financial statements will be affected. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application. There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result.
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. 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 identified and the amount is determinable. Shipping and handling costs are included in costs of goods sold.
Fair value of financial instruments —The fair value of cash and cash equivalents, trade 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 when purchased of three months or less. With respect to the Company’s recently issued or assumed debt instruments, consisting of industrial revenue bonds, notes payable and bank debt, relating to the May 31, 2006 acquisition of Astro, management believes that the fair value of these financial instruments also approximates their carrying value at September 30, 2006.
Investment securities -Investments in debt securities that are not cash equivalents or marketable equity securities have been designated as available for sale. Those securities, all of which are investment grade, are reported at fair value, with net unrealized gains and losses included in accumulated other comprehensive income or loss, net of applicable taxes. Unrealized losses that are other than temporary are recognized in earnings. The investment portfolio has various maturity dates up to 29 years. Realized gains and losses on investments are determined using the specific identification method.
Other investment —The Company’sCompany has an active investment in Cybernet Systems Corporation, which is accounted for under the equity method, as more fully discusseddescribed in Note 5.10.
Market risk exposure - The Company manufactures its products in the United States, and Canada, and most recently in Vietnam. 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 and Vietnamese 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 economic conditions in the domestic and foreign markets in which the Company operates. However, minimal third party receivables and payables are denominated in foreign currency and the related market risk exposure is considered to be immaterial. Historically, foreign currency gains and losses related to intercompany ac-

7


tivityactivity and balances have not been significant. However, due to the recent strengthened Canadian dollar, the impact of transaction and translation gains has increased. If the exchange rate were to materially change, the Company’s financial position could be significantly affected.
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. In addition, as a result of the May 31, 2006, Astro acquisition, the Company is obligated on bank debt with an adjustable rate of interest, as more fully discussed in Note 6, which would adversely impact operations should the interest rate increase.
Long-lived assets —The Company reviews long-lived assets that are not held for sale for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment is determined by comparing the carrying value of the assets to their estimated future undiscounted cash flows. If it is determined that an impairment of a long-lived asset has occurred, a current charge to income is recognized. Additionally, the Company has goodwill and other intangibles which are considered long-lived assets. While a portion of goodwill is associated with the Company’s investment in Cybernet, the majority of the approximately $22 million of goodwill and other intangibles reflected on the Company’s balance sheets as of September 30 and June 30, 2006, is associated with the recent acquisition of Astro. For a more complete discussion of goodwill and other intangibles, see Note 5.

8


Other assets —At June 30, 2006, undeveloped land with a cost in the amount of $613,000, located in New Mexico, was classified as held-for-sale and carried in other current assets in the Company’s balance sheet at that date. The sale of this asset was completed in August 2006 for a gain of approximately $190,000.
Common stock repurchases —The Company records common stock repurchases at cost. The excess of cost over par value is first allocated to capital in excess of par value based on the per share amount of capital in excess of par value for all shares, with the remainder charged to retained earnings. Effective September 14, 2005, the Board of Directors authorized a repurchase program for the repurchase, at the discretion of management, of up to $4 million of shares of the Company’s outstanding common stock in open market transactions. For the quarter ended September 30, 2006, approximately 24,100 shares were repurchased for cash of approximately $211,000. During that period, the monthly weighted average share prices ranged from $8.50 to $8.75 per share. For the fiscal year ended June 30, 2006, the Company had purchased 39,037 shares at a cost of approximately $363,000. As of September 30, 2006, the dollar value of shares that may yet be repurchased under the program approximates $3,426,000. The program expires September 14, 2007. Repurchased shares are retired.
Supplemental cash flows information —Supplemental cash and noncash activities for the three months ended September 30, 2006 and 2005 were as follows:
         
  2006  2005 
   
Net cash paid for:        
Income taxes $3,000  $2,509,000 
       
Interest $184,000  $ 
       
New accounting standards - In May 2005,September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 158,Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R). This Statement is intended to improve financial reporting by requiring an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. This Statement requires an employer to measure the funded status of a plan as of its balance sheet date. Prior accounting standards required an employer to recognize in its statement of financial position an asset or liability arising from a defined benefit postretirement plan, which generally differed from the plan’s overfunded or underfunded status. SFAS No. 158 is effective for Sparton’s fiscal year ending June 30, 2007, except for the change in the measurement date which is effective for Sparton’s fiscal year ending June 30, 2009. The Company is currently analyzing the expected impact of this new Statement on its results of operations, financial position and cash flows. However, despite the plan’s overfunded status, the Company expects a decrease in shareowners’ equity when SFAS No. 158 is implemented. This decrease will reflect an amount equal to the difference between the recorded pension asset and the current funded status as of the implementation date, adjusted for income taxes. These amounts were $4,421,000 and $965,000 as of June 30, 2006.
In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB No. 108) on quantifying financial statement misstatements. In summary, SAB No. 108 was issued to address the diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the statement of financial position. SAB No. 108 states that both a balance sheet approach and an income statement approach should be used when quantifying and evaluating the materiality of a misstatement, and contains guidance on correcting errors under this dual approach. SAB No. 108 is effective for Sparton’s annual financial statements covering our fiscal year ending June 30, 2007. The Company does not expect the adoption of SAB No. 108 will have a significant impact on its results of operations, financial position or cash flows.
In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements(SFAS No. 157), to eliminate the diversity in practice that exists due to the different definitions of fair value and the limited guidance for applying those definitions. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company does not expect the adoption of SFAS No. 157 will have a significant impact on its results of operations, financial position or cash flows.
In July 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes (FIN No. 48), an interpretation of SFAS No. 109,Accounting for Income Taxes.FIN No. 48 seeks to reduce the significant diversity in practice associated with financial statement recognition and measurement in accounting for income taxes and prescribes a recognition threshold and measurement attribute for disclosure of tax positions taken or expected to be taken on an income tax return. This interpretation will be effective for the Company as of July 1, 2007. The Company does not expect the adoption of FIN No. 48 will have a significant impact on its results of operations, financial position or cash flows.

9


In May 2005, the FASB issued SFAS No. 154, “AccountingAccounting Changes and ErrorsError Corrections,a replacement of APB Opinion No. 20 and FASB StatementSFAS No. 3”3 (SFAS No. 154). SFAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. APB Opinion No. 20, “AccountingAccounting Changes,previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This Statement iswas effective for the Company as of July 1, 2006. The Company does not expect the adoption of SFAS No. 154 will have a significant impact on its results of operations or financial position.
In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment”, which replaces SFAS No. 123, “Accounting for Stock-Based Compensation”, and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25). The Statement requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. The Statement also establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees, except for equity instruments held by employee share ownership plans. The Statement was effective for the Company beginning July 1, 2005, and the “modified prospective” method was required upon adoption. Under the modified prospective method, the Statement applies to new awards and to awards modified, repurchased or cancelled after the effective date. Additionally, compensation cost for the unvested portion of awards as of the effective date is required to be recognized as the awards vest after the effective date. As of July 1, 2005, the Company implemented SFAS No.123(R), with stock-based compensation expense now reflected in the Company’s income statement. See the “Stock options” note below for additional information regarding the adoption of SFAS No. 123(R).
In December 2004, the FASB issued SFAS No. 153, “Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29” (SFAS No. 153), which addresses the measurement of exchanges of nonmonetary assets. The Statement eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchange of nonmonetary assets that do not have commercial substance. It also specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The Statement was effective for the Company beginning July 1, 2005,2006, and did not have an impact on the manner of display of its results of operations or financial position.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs” (SFAS No. 151), which amends the guidance in Accounting Research Bulletin No. 43, Chapter 4, “Inventory Pricing”. The Statement requires that the accounting for abnormal amounts of idle facility expense, freight handling costs, and wasted material (spoilage) be recognized as current-period charges. In addition, the Statement requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. The Statement was effectiveposition for the Company for inventory costs incurred beginning July 1, 2005, and did not have an impact on the results of operations or financial position.
Recently, there have been official discussions and clarifications of certain provisions of FASB Statement No. 13, “Accounting for Leases”. The Company does not have capital leases. All leases are operating leases, mainly for the lease of machinery and equipment, with monthly payments over a fixed term in equal, non-escalating amounts. These discussions and clarifications did not have any impact on the Company’s results of operations or financial position.current fiscal quarter.
Periodic benefit cost -The Company follows the disclosure requirements of SFAS No. 132(R). For the three months ended September 30, 2005 and 2004, $120,000 and $132,000 of expense has been recorded, respectively. The components of net periodic pension expense for each of the periods presented were as follows:
         
  Three Months Ended September 30, 
  2005  2004 
 
Service cost $137,000  $151,000 
Interest cost  166,000   182,000 
Expected return on plan assets  (245,000)  (269,000)
Amortization of prior service cost  24,000   27,000 
Amortization of net loss  38,000   41,000 
 
Net periodic benefit cost $120,000  $132,000 
 

8


Stock options - As of July 1, 2005, SFAS No. 123(R) became effective for the Company. The Company had previously followed APB No. 25 and related Interpretations in accounting for its employee stock options. Under APB No. 25, no compensation expense was 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. Under SFAS No. 123(R), compensation expense is now recognized. Stock-based compensation cost is measured at the grant date, based on the fair value of the award and is recognized over the employee’s requisite service period. Compensation expense is calculated using the Black-Scholes option pricing model and is recorded in the Company’s financial statements. The Black-Scholes calculations performed for the first quarter fiscal 2006 stock-based compensation expense utilized the methodology and assumptions consistent with those used in prior periods under APB No. 25, which were disclosed in the Company’s previously filed Annual Report on Form 10-K for the year ended June 30, 2005. Stock-based compensation expense recorded in the first quarter of fiscal 2006 was $65,000, and increased the net loss by $44,000 and basic and diluted loss per share by less than $0.01.
As of September 30, 2005, $887,000 of total unrecognized compensation costs related to non-vested awards is expected to be recognized in declining amounts over the following four years. The following sets forth a reconciliation of net income and earning per share information for the three months ended September 30, 2004, as if the Company had recognized compensation expense based on the fair value at the grant date for awards under the plan.
Three Months Ended September 30, 2004
Net income, as reported$2,414,000
Deduct:
Total stock-based compensation expense determined under the fair value method for all awards, net of tax effects        (41,000)
Pro forma net income$2,373,000
Pro forma basic and diluted earnings per share          $0.25
The Company has an incentive stock option plan under which 914,827 common shares, 760,000 original shares adjusted by 154,827 shares for the declaration of stock dividends, were reserved for option grants to key employees and directors at the fair market value of the stock at the date of the grant. As of September 30, 2005, there were 640,327 shares outstanding under option, with prices ranging from $3.50 to $9.00, a weighted average remaining contractual life of 3.84 years, and a weighted average exercise price of $6.67.
The following table summarizes additional information about stock options outstanding and exercisable at September 30, 2005:
                     
Options Outstanding Options Exercisable
Range of     Wtd. Avg. Remaining Wtd. Avg.     Wtd. Avg.
Exercise Prices Number Outstanding Contractual Life (years) Exercise Price Number Exercisable Exercisable Price
   
$3.50 to $5.96  330,327   1.07  $5.38   330,327  $5.38 
$6.85 to $9.00  310,000   6.79  $8.03   98,389  $6.96 
Under the plan at September 30, 2005, exercisable options and the per share weighted average exercise price were 428,716 and $5.75, respectively, with 133,132 remaining shares available for grant.
NOTE 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 approximate major classifications of inventory:
         
  September 30, 2005  June 30, 2005 
 
Raw materials $24,391,000  $23,463,000 
Work in process and finished goods  11,627,000   13,384,000 
 
  $36,018,000  $36,847,000 
 
Work in process and finished goods inventories include $2.6 and $1.0 million of completed, but not yet accepted sonobuoys at September 30, 2005 and June 30, 2005, respectively. Inventories are reduced by progress billings to the U.S. government of approximately $8,976,000 and $5,649,000 at September 30 and June 30, 2005, respectively.

9


3. EARNINGS (LOSS) PER SHARE - On October 25, 2005, Sparton’s Board of Directors approved a 5% common stock dividend. Eligible shareowners of record as of December 21, 2005, will receive the stock dividend to be distributed January 13, 2006. Cash will be paid in lieu of fractional shares. For purposes of recording the stock dividend the full 5% stock dividend was assumed on total shares outstanding; no assumption was made with respect to fractional shares nor the related cash distribution. An amount equal to the fair market value of the common shares to be issued was transferred from retained earnings to common stock and capital in excess of par value to record the estimated stock dividend. This transfer has been reflected in the condensed consolidated financial statements at September 30, 2005. Shares outstanding and earnings per share for the three months ended September 30, 2005, have therefore been adjusted accordingly.
Due to the Company’s fiscal 2006 reported net loss, 141,338 outstanding stock option share equivalents were excluded from the computation of diluted earnings per share during the three months ended September 30, 2005, because their inclusion would have been anti-dilutive. For the three months ended September 30, 2005 and 2004, respectively, basic and diluted earnings per share were computed based on the following:
         
  Three Months Ended September 30, 
  2005  2004 
 
Basic — weighted average shares outstanding  8,847,761   8,769,588 
Estimated weighted additional shares to be issued for the 5% common stock dividend declared October 25, 2005  442,388   438,479 
 
   9,290,149   9,208,067 
Effect of dilutive stock options     120,750 
 
Weighted average diluted shares outstanding  9,290,149   9,328,817 
 
Basic and diluted earnings (loss) per share — after stock dividend $(0.14) $0.26 
 
All average outstanding share and per share information have been restated to reflect the impact of the 5% stock dividends declared in November 2004 and October 2005.
4. COMPREHENSIVE INCOME (LOSS) -Comprehensive income (loss) includes net income (loss) as well as unrealized gains and losses, net of tax, on investment securities owned and investment securities held by an investee accounted for by the equity method, which are excluded from net income. Unrealized gains and losses, net of tax, are reflected as a direct charge or credit to shareowners’ equity. Comprehensive income (loss) and the related components are disclosed in the accompanying condensed consolidated statements of shareowners’ equity for the three months ended September 30, 2005 and 2004, respectively:
At September 30 and June 30, 2005, shareowners’ equity includes accumulated other comprehensive losses of $145,000 and $44,000, respectively, net of tax. The components of these amounts are as follows:
         
  September 30, 2005  June 30, 2005 
   
Accumulated other comprehensive income (loss), net of tax:        
Investment securities owned $(206,000) $(91,000)
Investment securities held by investee accounted for by the equity method  61,000   47,000 
 
Accumulated other comprehensive loss $(145,000) $(44,000)
 
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 3029 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 its 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. Those securities are reported at fair value, with net unrealized gains and losses included in accumulated other comprehensive income (loss), net of applicable taxes. Unrealized losses that are other than temporary are recognized in earnings. The Company does not believe there are any significant individual unrealized losses as of September 30, 2005,2006, which would represent other than temporaryother-than-temporary losses and unrealized losses which have existed for one year or more. Realized gains and losses on investments are determined using the specific identification method. ItThese highly liquid securities are designated as current assets, as it is the Company’s intention to use these investment securities to provide working capital, fund the expansion of its business and for other business purposes.
The contractual maturities of debt securities as of September 30, 2006, were as follows:
                     
  Years 
  Within 1  1 to 5  5 to 10  Over 10  Total 
   
Debt securities:                    
Corporate — primarily U.S. $1,232,000  $1,661,000  $184,000  $99,000  $3,176,000 
U.S. government and federal agency  1,484,000   1,249,000   1,815,000   625,000   5,173,000 
State and municipal  1,169,000   1,168,000   454,000      2,791,000 
                
Total debt securities $3,885,000  $4,078,000  $2,453,000  $724,000  $11,140,000 
                
At September 30, 2006 and 2005, the Company had net unrealized losses of $303,000. At that date,$237,000 and $303,000, respectively, on its investment securities portfolio. On those dates, the net after-tax effect of these losses was $161,000 and $206,000, respectively, which isamounts were included in accumulated other comprehensive loss within shareowners’ equity. There were no investments purchased during the three months ended September 30, 2006. For the three months ended September 30, 2005, and 2004, the Company had purchases of investment securities totaling $2,856,000 and $2,261,000, and proceeds$2,856,000. Proceeds from investment securities sales totalingfor the three months ended September 30, 2006 and 2005 totaled $4,807,000 and $538,000, respectively.
NOTE 3. INVENTORIES AND COSTS OF CONTRACTS IN PROGRESS
Customer orders are based upon forecasted quantities of product, manufactured for shipment over defined periods. Raw material inventories are purchased to fulfill these customer requirements. Within these arrangements, customer demand for products frequently changes sometimes creating excess and $2,095,000, respectively.obsolete inventories. 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 excess and obsolete inventories.

10


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 Company owns a 14% interestfollowing are the approximate major classifications of inventory at each balance sheet date:
         
  September 30, 2006  June 30, 2006 
   
Raw materials $30,869,000  $29,388,000 
Work in process and finished goods  18,927,000   17,504,000 
       
  $49,796,000  $46,892,000 
       
Work in Cybernet Systems Corporation (Cybernet), 12% on a fully diluted basis. This investment, with a carrying valueprocess and finished goods inventories include $5.1 million and $4.5 million of $1,701,000 and $1,656,000completed, but not yet accepted, sonobuoys at September 30 and June 30, 2005, respectively, represents2006, respectively. Inventories are reduced by progress billings to the Company’s equity interest in Cybernet’s net assets plus $770,000U.S. gov-

10


ernment, related to long-term contracts, of goodwill (no longer being amortized in accordance with SFAS No. 142, “Goodwillapproximately $14.2 million and Other Intangible Assets”). The investment in Cybernet is accounted for under the equity method,$10.7 million at September 30 and is included in other assets on the condensed consolidated balance sheet. The Company believes that the equity method is appropriate given Sparton’s level of involvement in Cybernet. Prior to June 2002, Sparton accounted for its Cybernet investment using the cost method, which reflected a more passive involvement with Cybernet’s operations. Sparton’s current President and CEO is one of three Cybernet Board members, and as part of that position is actively involved in Cybernet’s oversight and operations. In addition, he has a strategic management relationship with the owners, who are also the other two board members, resulting in his additional involvement in pursuing areas of common interest for both Cybernet and Sparton. The Company’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 the Company’s balance sheet. The contractual maturities of debt securities, and total equity securities30, 2006, respectively. Inventory balances as of September 30 2005,and June 30, 2006, include $11.3 million and $10.0 million of inventory, respectively, at the Company’s newest subsidiary, Astro, which is comprised of $10.9 million of raw materials and $0.4 million of work in process and finished goods as of September 30, 2006 and $8.9 million of raw materials and $1.1 million of work in process and finished goods as of June 30, 2006.
NOTE 4. PENSION ASSET
Periodic benefit cost —The Company sponsors a defined benefit pension plan covering certain salaried and hourly U.S. employees. The components of net periodic pension expense are as follows for the three months ended September 30:
         
  2006  2005 
   
Service cost $128,000  $137,000 
Interest cost  163,000   166,000 
Expected return on plan assets  (227,000)  (245,000)
Amortization of prior service cost  24,000   24,000 
Amortization of net loss  49,000   38,000 
       
Net periodic benefit cost $137,000  $120,000 
       
No cash contributions to the plan were required or have been paid by the Company in either period due to its overfunded status. Due to the overfunded status of the plan, and current actuarial calculations and assumptions, no additional funding of the defined benefit pension plan is anticipated prior to 2008.
NOTE 5. GOODWILL AND OTHER INTANGIBLES
The Company follows SFAS No. 141,Business Combinations(SFAS No. 141), and SFAS No. 142,Goodwill and Other Intangible Assets(SFAS No. 142). SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS No. 141 also specifies the criteria applicable to intangible assets acquired in a purchase method business combination to be recognized and reported apart from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment, at least annually. Cybernet Systems Corporation’s (Cybernet) goodwill is reviewed for impairment annually, with the next review expected in April 2007. Goodwill related to the recent Astro purchase is also expected to be reviewed for impairment in April 2007. See “Business Acquisition”, Note 1 of this report, for additional information on the purchase of Astro, which occurred on May 31, 2006. SFAS No. 142 also requires that intangible assets with definite useful lives be amortized over their estimated useful lives to their estimated residual values and be reviewed regularly for impairment. The change in the carrying amounts of goodwill and amortizable intangibles during the quarter ended September 30, 2006 are as follows:
                     
  Years 
  Within 1  1 to 5  5 to 10  Over 10  Total 
 
Debt securities:                    
Corporate — primarily U.S. $806,000  $3,207,000  $  $277,000  $4,290,000 
U.S. government and federal agency  1,598,000   3,822,000   1,758,000   2,361,000   9,539,000 
State and municipal  969,000   2,832,000   710,000      4,511,000 
Bond fund  4,299,000            4,299,000 
 
Total debt securities $7,672,000  $9,861,000  $2,468,000  $2,638,000  $22,639,000 
 
             
      Amortizable  Total 
  Goodwill  Intangibles  Intangibles 
   
Beginning balance at July 1, 2006 $15,744,000  $6,726,000  $22,470,000 
Amortization     (122,000)  (122,000)
          
Ending balance at September 30, 2006 $15,744,000  $6,604,000  $22,348,000 
          
There were no changes in the carrying value of goodwill associated with Cybernet during fiscal 2006.
Goodwill —$770,000 of the balance of goodwill is related to the Company’s investment in Cybernet, as more fully described in Note 10 and additional goodwill in the amount of $14,974,000 was recognized upon the Company’s purchase of Astro in May 2006.
Other intangibles —Other intangibles of $6,765,000 were recognized upon the purchase of Astro. Other intangibles include non-compete agreements of $165,000 and customer relationships of $6,600,000. These costs are being amortized ratably over 4 years and 15 years, respectively. Accumulated amortization as of September 30, 2006, amounted to $161,000; $14,000 and $147,000 were for the amortization of non-compete agreements and customer relationships, respectively. Amortization of intangible assets is estimated to be approximately $481,000 for each of the four years beginning July 1, 2006, and approximately $440,000 for each of the subsequent 11 years.
NOTE 6. BORROWINGS
Current debt maturities —Short-term debt as of September 30, 2006, includes the current portion of $2,000,000 of long-term bank loan, the current portion of $1,724,000 of long-term notes payable, and the current portion of $99,000 of industrial

11


revenue bonds. Both the bank loan and the notes payable were incurred as a result of the Company’s purchase of Astro on May 31, 2006, and are due and payable in equal installments over the next several years as further discussed below. The Industrial Revenue bonds were assumed at the time of Astro’s purchase and were previously incurred by Astro.
The Company also has available an unsecured $20,000,000 revolving line-of-credit facility provided by a local bank to support working capital needs and other general corporate purposes. Interest on borrowings would be charged using a floating rate of 1.25% plus a base rate determined by reference to a specified bank index. There have been no drawings against this credit facility.
Long-term debt —Long-term debt, all of which arose in conjunction with the Astro acquisition, consists of the following obligations at each balance sheet date:
         
  September 30, 2006  June 30, 2006 
   
Industrial Revenue bonds, face value $2,457,000  $2,477,000 
Less unamortized purchase discount  148,000   150,000 
       
Industrial Revenue bonds, carrying value  2,309,000   2,327,000 
Bank loan  9,500,000   10,000,000 
Notes payable  7,500,000   7,500,000 
       
Total long-term debt  19,309,000   19,827,000 
Less current portion  3,823,000   3,816,000 
       
Long-term debt, net of current portion $15,486,000  $16,011,000 
       
There were no short or long-term debt or other borrowings outstanding as of September 30, 2005.
The Company has assumed repayment of principal and interest on bonds originally issued to Astro by the State of Ohio. These bonds are Ohio State Economic Development Revenue Bonds, series 2002-4. Astro originally entered into the loan agreement with the State of Ohio for the issuance of these bonds to finance the construction of Astro’s current operating facility. The principal amount, including premium, was issued in 2002 and totaled $2,845,000. These bonds have interest rates which vary, dependent on the maturity date of the bonds. Due to an increase in interest rates since the original issuance of the bonds, a discount amounting to $151,000 was recorded by Sparton on the date of assumption.
The bonds carry certain sinking fund requirements generally obligating the Company to deposit funds into a sinking fund. The sinking fund requires the Company to make monthly deposits of one twelfth of the annual obligation plus accrued interest. The purchase discount is being amortized ratably over the remaining term of the bonds. Amortization expense for the three months ended September 30, 2006 was approximately $2,000. The Company has issued an irrevocable letter of credit in the amount of $284,000 to secure repayment of a portion of the bonds. A further discussion of borrowings and other information related to the Company’s purchase of Astro may be found in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2006.
The bank loan, with an original balance of $10 million, is being repaid over five years, with quarterly principal payments of $500,000 which commenced September 1, 2006. This loan bears interest at the variable rate of LIBOR plus 100 basis points, with interest calculated and paid quarterly along with the principal payment. As of September 30, 2006, this interest rate equaled 6.324%, with accrued interest of approximately $48,000. As a condition of this bank loan, the Company is subject to certain customary covenants, which become applicable beginning with the Company’s fiscal year ending June 30, 2007. If these covenants were to have been in place as of September 30, 2006, the Company would have met their requirements. This debt is not secured.
Two notes payable of $3,750,000 each, totaling $7.5 million, are payable to the sellers of Astro. These notes are to be repaid over four years, in aggregate semi-annual payments of principal and interest in the combined amount of $1,057,000 on July 1 and December 1 of each year commencing December 1, 2006. These notes each bear interest at 5.5% per annum. The notes are proportionately secured by the stock of Astro. As of September 30, 2006, there was interest accrued on these notes in the amount of approximately $138,000.
NOTE 7. COMMITMENTS AND CONTINGENCIES -
Environmental Remediation
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, 2005,2006, Sparton has accrued $6,733,000$6,250,000 as its estimate of the minimum future undiscounted financial liability, of which $618,000$525,000 is classified as a current liability

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and included 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 continued monitoring costs for onsite and offsite pump and treat containment systems, as well as periodic reporting requirements.
In 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 cash and the DOE agreed to reimburse Sparton for 37.5% of certain future environmental expenses in excess of $8,400,000 incurred from the date of settlement. 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.
Customer Relationships
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 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 NRTC asked for damages in the amount of $20 million for the loss of its investment in and loans to Util-Link. In addition, the defendant Util-Link had asked for damages in the amount of $25 million for lost profits. Sparton had reviewed these claims and believed they were duplicative. Util-Link did not pursue its claim.
The jury trial commenced on September 19, 2005 and concluded on November 9, 2005. The jury awarded Sparton damages in the amount of $3.6 million, of which approximately $1.9 million represented costs related to the acquisition of raw materials. These costs were previously deferred and are included in other long-term assets on the Company’s September 30, 2006 balance sheet. As expected, there were post-trial proceedings, including motions by the defendant NRTC for judgment as matter of law on its counterclaim and a motion for new trial. On March 27, 2006, the trial court denied the defendant NRTC’s motion for judgment on its counter claim as a matter of law and granted the motion for a new trial unless Sparton accepted a reduction of the judgment. Sparton accepted the reduction, which reduced the collective judgment in its favor to $1.9 million, which would enable the Company to recover the deferred costs and, accordingly, there would be no significant impact on operating results. An amended judgment was entered for $1.9 million in Sparton’s favor on April 5, 2006. On May 1, 2006, NRTC filed an appeal of the judgment with the U.S. Court of Appeals for the Sixth Circuit, which could impact the ultimate result.
The Company has pending an action before the U.S. Court of Federal Claims to recover damages arising out of an alleged infringement by the U.S. Navy of certain patents owned by Sparton and used in the production of sonobuoys. The case was dismissed on summary judgment, however, the decision of the U.S. Court of Federal Claims was reversed by the U.S. Court of Appeals for the Federal Circuit. The case is currently scheduled for trial in the first calendar quarter of 2007. The likelihood that the claim will be resolved and the extent of any recovery in favor of the Company is unknown at this time.
Product Issues
Some of the printed circuit boards supplied to the Company for its aerospace sales have been discovered to be defective. The defect occurred during production at the raw board manufacturer’ssupplier’s facility, prior to shipment to Sparton for further processing. All of the lots involved have yet to be identified and Sparton, the board manufacturer, Electropac Co., Inc. (the raw board manufacturer), and our customer, who received the defective assembled boards, are working to containhave contained the defective boards. While investigations are underway, $2.4$2.9 million of related product and associated expenses have been classified in Sparton’s balance sheet within other long-term assets as of September 30 2005. As of this date, Sparton has made a demand on the board manufacturer for reimbursement of all costs and expenses incurred, and the parties are engaged in discussions regarding the resolution of Sparton’s claim.June 30, 2006. In addition, in August 2005, Sparton Electronics Florida, Inc. filed an action in U.S. District Court of Florida against Electropac Co., Inc. to recover these costs. The likelihood that the claim will be resolved and the extent of Sparton’s exposure, if any, is unknown at this time. No loss contingency has been established at September 30, 2005.2006.
NOTE 8. STOCK OPTIONS
As of July 1, 2005, SFAS No. 123(R) became effective for the Company. Under SFAS No. 123(R), compensation expense has been recognized for all periods presented in the Company’s interim financial statements. Share-based compensation

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cost is measured on the grant date, based on the fair value of the award calculated at that date, and is recognized over the employee’s requisite service period, which generally is the options’ vesting period. Fair value is calculated using the Black-Scholes option pricing model.
The Company has an incentive stock option plan under which 946,007 authorized and unissued common shares, which includes 760,000 original shares adjusted by 186,007 shares for the declaration of stock dividends, were reserved for option grants to directors and key employees at the fair market value of the Company’s common stock at the date of the grant. Options granted have either a five or ten-year term and become vested and exercisable cumulatively beginning one year after the grant date, in four equal annual installments. Options may terminate before their expiration dates if the optionee’s status as an employee is terminated, or upon death.
Employee stock options, which are granted by the Company pursuant to a plan last amended and restated on October 24, 2001, are structured to qualify as “incentive stock options” (ISOs). Under current federal income tax regulations, the Company does not receive a tax deduction for the issuance, exercise or disposition of ISOs if the employee meets certain holding period requirements. If the employee does not meet the holding period requirement a disqualifying disposition occurs, at which time the Company can receive a tax deduction. The Company does not record tax benefits related to ISOs unless and until a disqualifying disposition occurs. In the event of a disqualifying disposition, the entire tax benefit is recorded as a reduction of income tax expense. In accordance with SFAS No. 123(R), excess tax benefits (where the tax deduction exceeds the recorded compensation expense) are credited to “capital in excess of par value” in the consolidated statement of shareowners’ equity and tax benefit deficiencies (where the recorded compensation expense exceeds the tax deduction) are charged to “capital in excess of par value” to the extent previous excess tax benefits exist.
Share-based compensation expense and related tax benefit totaled $67,000 and $400, respectively, for the quarter ended September 30, 2006, which relates to all awards granted. Share-based compensation expense totaled $65,000 for the quarter ended September 30, 2005. Basic and diluted loss per share amounts were impacted by less than $0.01 each period. As of September 30, 2006, unrecognized compensation costs related to nonvested awards amounted to $606,000 and will be recognized over a remaining weighted average period of approximately 1.85 years.
The following table summarizes additional information about stock options outstanding and exercisable at September 30, 2006:
                     
  Options Outstanding Options Exercisable
     Wtd. Avg. Remaining Wtd. Avg.     Wtd. Avg.
Range of Exercise Prices Number of shares Contractual Life (years) Exercise Price Number of shares Exercise Price
$5.49 to $6.66  374,807   1.11  $5.90   364,528  $5.88 
$7.70 to $8.57  189,900   8.74  $8.53   41,694  $8.54 
                     
   564,707           406,222     
                     
In general, the Company’s policy is to issue new shares upon the exercise of a stock option. A summary of option activity under the Company’s stock option plan for the three months ended September 30, 2006 is presented below. All options presented have been adjusted to reflect the impact of the 5% common stock dividend declared in October 2006. At September 30, 2006 shares remaining available for future grant totaled 146,457.
                 
          Wtd. Avg. Remaining  
  Total Shares Wtd. Avg. Contractual Aggregate
  Under Option Exercise Price Term (years) Intrinsic Value
Outstanding at July 1, 2006  542,924  $6.69   3.59  $935,000 
Granted  26,250             
Exercised  (4,255)            
Forfeited or expired  (212)            
                     
Outstanding at September 30, 2006  564,707  $6.77   3.67  $846,000 
                     
Exercisable at September 30, 2006  406,222  $6.14   1.74  $884,000 
                     
The aggregate intrinsic value reflects the difference between an option’s fair value and its exercise price.

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Under SFAS No. 123(R), fair value was estimated at the date of grant using the Black-Scholes option pricing model and the weighted average assumptions for the 25,000 options (26,250 after adjusting for the 5% stock dividend) granted during the three months ended September 30, 2006 were as follows:
     
  Three months ended September 30, 2006
Expected option life 10 years
Expected volatility  32.2%
Risk-free interest rate  4.7%
Cash dividend yield  0.0%
Weighted average grant date fair value $4.75 
Black-Scholes assumption information: Expected life used is the time until expiration of the options, which is consistent with the timing of the exercise of options historically experienced by the Company. The expected volatility is based on a 10-year look-back of average stock prices which is consistent with the current exercise life of options awarded. Risk free interest rate is based upon the yield on 10-year treasury notes. Cash dividend yield has been set at zero, as the Company has not historically declared or paid cash dividends on a regularly scheduled basis.
NOTE 9. EARNINGS (LOSS) PER SHARE
On October 25, 2006, Sparton’s Board of Directors approved a 5% stock dividend. Eligible shareowners of record on December 27, 2006, will receive the stock dividend to be distributed on January 19, 2007. Cash will be paid in lieu of fractional shares. For the purposes of recording the stock dividend, the full 5% stock dividend was assumed on total shares outstanding; no assumption was made with respect to fractional shares nor the related cash distribution. An amount equal to the estimated fair market value of the common stock to be issued was transferred from retained earnings to common stock and capital in excess of par value to record the stock dividend. The transfer has been reflected in the interim condensed consolidated financial statements as of September 30, 2006.
All average outstanding shares and per share information have been restated to reflect the impact of the 5% stock dividend declared in October 2006. Due to the Company’s interim reported net losses for the three months ended September 2006 and 2005, all options outstanding were excluded from the computation of diluted earnings per share for those periods, as their inclusion would have been anti-dilutive.
Basic and diluted loss per share for the three months ended September 30, 2006 and 2005 were computed based on the following shares outstanding:
         
  2006  2005 
   
Weighted average shares outstanding  9,385,557   9,290,149 
Estimated weighted additional shares to be issued for the 5% common stock dividend declared October 25, 2006.  469,278   464,507 
       
Weighted average shares outstanding — after stock dividend  9,854,835   9,754,656 
Effect of dilutive stock options      
       
Weighted average diluted shares outstanding  9,854,835   9,754,656 
       
         
Basic and diluted loss per share — after stock dividend $(0.25) $(0.13)
       
NOTE 10. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) includes net income (loss) as well as unrealized gains and losses, net of income tax, on investment securities owned and investment securities held by an investee accounted for by the equity method, which are excluded from net income. Unrealized gains and losses, net of tax, are excluded from net income (loss), but are reflected as a direct charge or credit to shareowners’ equity. Comprehensive income (loss) and the related components are disclosed in the accompanying consolidated statements of shareowners’ equity. Comprehensive loss is summarized as follows for the three months ended September 30, 2006 and 2005, respectively:
         
  2006  2005 
   
Net loss $(2,464,000) $(1,299,000)
Other comprehensive income (loss), net of tax        
Investment securities owned  123,000   (115,000)
Investment securities held by investee accounted for by the equity method  11,000   14,000 
       
   134,000   (101,000)
       
Comprehensive loss $(2,330,000) $(1,400,000)
       

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At September 30 and June 30, 2006, shareowners’ equity includes accumulated other comprehensive losses of $131,000 and $265,000, respectively, net of tax. The components of these amounts at those dates are as follows:
         
  September 30, 2006  June 30, 2006 
   
Accumulated other comprehensive income (loss), net of tax:        
Investment securities owned $(161,000) $(284,000)
Investment securities held by investee accounted for by the equity method  30,000   19,000 
       
Accumulated other comprehensive loss $(131,000) $(265,000)
       
In June 1999, the Company purchased a 14% interest (12% on a fully diluted basis) in Cybernet for $3,000,000. Cybernet is a developer of hardware, software, next-generation network computing, and robotics products. It is located in Ann Arbor, Michigan. The investment is accounted for under the equity method and is included in other assets and goodwill on the balance sheet. At September 30 and June 30, 2006, the Company’s investment in Cybernet amounted to $1,679,000 and $1,645,000, respectively, representing its equity interest in Cybernet’s net assets plus $770,000 of goodwill (no longer being amortized in accordance with SFAS No. 142,Goodwill and Other Intangible Assets). The Company believes that the equity method is appropriate given Sparton’s level of involvement in Cybernet. Prior to June 2002, Sparton accounted for its Cybernet investment using the cost method, which reflected a more passive involvement with Cybernet’s operations. Sparton’s current President and CEO is one of three Cybernet Board members, and as part of that position is actively involved in Cybernet’s oversight and operations. In addition, he has a strategic management relationship with the owners, who are also the other two board members, resulting in his additional involvement in pursuing areas of common interest for both Cybernet and Sparton. The use of the equity method requires Sparton to record its share of Cybernet’s income or loss in earnings (“Equity income in investment”) in Sparton’s income statements with a corresponding increase or decrease in the investment account (“Other assets”) in Sparton’s balance sheets. In addition, 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 sheets. The unrealized gains (losses) on available-for-sale securities reflect Cybernet’s investment in Immersion Corporation, a publicly traded company, as well as other investments.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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, News Releases, and the Code of Business Conduct and Ethics, as well as the various committeecorporate charters. These items are also available, free of charge, by contacting the Company’s Shareowners’ Relations department. 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/scientific instrumentation, aerospace and industrial markets. These includeThis includes the design, development and/or manufacture of electronic parts and assemblies for both government and commercial customers worldwide. Governmental sales are mainly sonobuoys.
The Private Securities Litigation Reform Act of 1995 reflects Congress’ determination that the disclosuresdisclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by corporate management. This report on Form 10-Q contains forward-looking statements within the scope of the Securities Act of 1933 and the Securities Exchange Act of 1934. The words “expects,” “anticipates,” “believes,” “intends,” “plans,” “will,” “shall,” 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 describes customers needing multiple product types with generally low volume manufacturing runs. As a contract manufacturer with customers in a variety of markets, the Company has substantially less visibility toof 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 within given ranges of production, 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 lost sales with new business.
Other risks and uncertainties that may affect operations, performance, growth forecasts and business results include, but are not limited to, timing and fluctuations in U.S. and/or world economies, 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, including the new plant in Vietnam and the Company’s newest subsidiary Astro Instrumentation, Inc., 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, and uncertainties related to defects discovered in certain of the Company’s aerospace circuit boards. A furtherFurther risk factor isfactors are related to the availability and cost of materials,materials. A number of events can impact these risks and uncertainties, including potential escalating utility and other related costs due to natural disasters, as well as political uncertainties such as the recent damage caused by hurricanes Katrina and Rita.
conflict in Iraq. The Company has encountered availability and extended lead time issues on some electronic components in the past when market demand has been strong; this resulted in higher prices and late deliveries. Additionally, the timing of sonobuoy sales to the U.S. Navy is dependent upon access to the test range 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(NYSE) also passed new rules and 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. For a further discussion of the Company’s risk factors refer to Part II, Item 1(a), Risk Factors of the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2006. 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.

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

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RESULTS OF OPERATIONS
                                        
 Three Months Ended September 30  Three months ended September 30:   
 2005 2004  Fiscal 2006 Fiscal 2005   
 
 % % % 
 Sales of Total Sales of Total Change 
 
MARKET Sales % of Total Sales % of Total % Change 
Medical/Scientific Instrumentation $14,848,000  30.7% $3,008,000  8.1%  393.6%
Aerospace 14,631,000 30.3 12,398,000 33.2 18.0 
Industrial/Other 14,084,000 29.2 12,534,000 33.6 12.4 
Government $9,366,000  25.1% $10,922,000  24.2%  (14.2)% 4,754,000 9.8 9,366,000 25.1  (49.2)
Industrial/Other 12,534,000 33.6 11,883,000 26.3 5.5 
Aerospace 12,398,000 33.2 18,677,000 41.3  (33.6)
Medical/Scientific Instrumentation 3,008,000 8.1 3,706,000 8.2  (18.8)
          
Totals $37,306,000  100.0% $45,188,000  100.0%  (17.4)% $48,317,000  100.0% $37,306,000  100.0%  29.5%
          
Sales for the three months ended September 30, 2005,2006, totaled $37,306,000, a decrease$48,317,000, an increase of $7,882,000 (17%$11,011,000 (29.5%) from the same quarter last year. GovernmentMedical/scientific instrumentation sales decreased by $1,556,000increased $11.8 million from the same quarter last year. This increase in sales was primarily due to timing differences related to the testing and shipmentinclusion of sonobuoys. This decrease wasthe Company’s newest subsidiary, Astro Instrumentation, Inc. (Astro), which totaled approximately $11.1 million. Aerospace sales were also above the prior year. Additional aerospace sales were primarily due to $4.7one existing customer, whose sales increased approximately $2.6 million of delayed sonobuoy sales included infrom the results for the first quarter of fiscal 2005.same period last year. Industrial sales were also higher primarily due to one new customer, which include gamingaccounted for about $2.8 million in sales improved. This improvement is reflective of continued strongduring the quarter ended September 30, 2006; these sales to existing customers. Sales in the aerospace market decreased 34% from prior year, due principally to strong sales of collision avoidance systems in fiscal 2005. The level of sales for these products had not beenlevels are expected to continue. MedicalGovernment sales declined slightly fromwere below the prior year primarily due to delayed program start-ups. Growth inseveral failed sonobuoy drop tests. While rework of failed sonobuoys is underway, this arearework will take time. In addition, as of the date of this report, there is not occurringno planned access to the Navy’s test range anticipated during the month of December. Discussions are underway to give us access to another test range, but we are at this point uncertain as quickly as originally anticipated.to the outcome. Therefore, governmental sales are anticipated to remain depressed until during the third quarter of fiscal 2007.
The majority of the Company’s sales come from a small number of key strategic and large OEM customers. Sales to ourthe six largest customers, including government sales, accounted for approximately 77%74% and 80%77% of net sales in fiscal 20062007 and 2005,2006, respectively. Four of the customers, including government, were the same both years. OneBally, an industrial customer, accounted for 12% and 17% of thetotal sales; additionally, an aerospace customers,customer, Honeywell, with six separateseveral facilities to which we supply product, provided 19%17% and 30%19% of total sales through September 30, 2006 and 2005, and 2004, respectively. Bayer, a key medical device customer of Astro, contributed 20% of total sales during the quarter ended September 30, 2006.
The following table presents income statement data as a percentage of net sales for the three months ended September 30, 20052006 and 2004:2005:
         
  2005  2004 
         
Net sales  100.0%  100.0%
Costs of goods sold  95.5   85.7 
 
Gross profit  4.5   14.3 
         
Selling and administrative expenses  10.7   7.5 
Other operating expenses     0.2 
 
Operating income (loss)  (6.2)  6.6 
         
Other income — net  1.1   1.2 
 
         
Income (loss) before income taxes  (5.1)  7.8 
Provision (credit) for income taxes  (1.6)  2.5 
 
         
Net income (loss)  (3.5)%  5.3%
 
         
  2006 2005
Net sales  100.0%  100.0%
Costs of goods sold  98.7   95.5 
         
Gross profit  1.3   4.5 
         
Selling and administrative expenses  8.9   10.7 
Other operating (income) expenses — net  (0.2)   
         
Operating loss  (7.4)  (6.2)
         
Other income (expense) — net  (0.1)  1.1 
         
         
Loss before income taxes  (7.5)  (5.1)
Credit for income taxes  (2.4)  (1.6)
         
         
Net loss  (5.1)%  (3.5)%
         
An operating loss of $2,302,000$3,596,000 was reported for the three months ended September 30, 2005,2006, compared to an operating incomeloss of $2,996,000$2,302,000 for the three months ended September 30, 2004.2005. The gross profit percentage for the three months ended September 30, 2005,2006, was 4.5%1.3%, down from 14.3%4.5% for the same period last year. Gross profit varies from period to period and can be affected by a number of factors, including product mix, production efficiencies, capacity utilization, and new product introduction, all of which impacted first quarter fiscal 20062007 performance. In addition, as many ofThe primary reason for the Company’s costs and operating expenses are fixed, a reduction in customer demand, as evidenced above, depresses gross profit and operating income.from the prior year was the impact of failed sonobuoy drop tests. In reviewing lot failures, additional rework was identified as necessary to complete certain contracts now in progress. These drop test failures not only reduced sales, but also resulted in anticipated additional program costs of approximately $4.0 million, $2.2 million of which will result in reduced margins on affected sonobuoy sales in future periods. Reflected in gross profit in the first quarter of fiscal

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2007 and 2006 were charges of $553,000$1.8 million and $0.6 million, respectively, resulting from changes in estimates, primarily related to design and production issues on certain sonobuoy programs. The programs are now expected to be loss contracts and the Company has recognized the entire estimated losses as of September 30, 2006 and 2005. The programs, whichDue to the additional rework and anticipated design changes, and reduced access to the Navy’s test range during the second quarter of fiscal 2007, government sales and related margins for the remainder of fiscal 2007 are anticipated to be completed and shipped duringnegatively impacted. As of September 30, 2006, the remainder of this fiscal year, have a backlog of $6government contracts with negative or breakeven margins was approximately $7.7 million. Additional changesThese sonobuoys are anticipated to ship in estimates are not anticipated at this time.fiscal 2007. Included in the first quarter of fiscalthree months ended September 30, 2006 are theand 2005 were results from the Company’s new Vietnam facility, the start-up of which has adversely impacted gross profit by $325,000.$322,000 and $325,000, respectively. The results of our Vietnamese operation are expected to improve during the current fiscal year, breaking even forachieving breakeven levels on a monthly basis during fiscal 2006. In addition,2008, or possibly before dependent on the prior year’s profit benefited by the inclusiontiming of the delayed government salesstart-up of $4.7 million previously discussed. These sales carried a higher than usual margin, contributing $1.7 million in the first quarter of fiscal 2005, which sales in the first quarter of fiscal 2006 were unable to match. The current year’s depressed gross profit also includes several medicalpotential new programs which are in a loss position due to their current status in the start-up phase. Two of these programs had negative margins which, as of September 30, 2005, totaled $330,000. The issues related to these losses are being addressed. Finally, discussions and resolution with a current customer regarding the recovery of past costs, which were previously deferred, were not completed and as a result, $354,000 was charged to expense during the first quarter of fiscal 2006. The Company is continuing its efforts to fully recover these costs.there.

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The majority of the increaseddecrease in selling and administrative expenses, as a percentage of sales, was due to the significant decreaseincrease in sales during the first quarter of fiscal 2006,2007 compared to the same period last year, without a related decrease in these expenses.year. Selling and administrative expenses include litigation expense of approximately $20,000 and $226,000 in fiscalthe three months ended September 30, 2006 also include approximately $226,000 ofand 2005, respectively. This litigation expenses relatedexpense relates to the current trialclaim against NRTC, which is further discussed in Part II, Item 1 — “Other Information- Legal Proceedings” of this report. In addition, beginningBeginning in fiscal 2006, the Company iswas required to expense the vested portion of the fair value of stock options. Stock-basedShare-based compensation expense, recordedtotaled $67,000 and $65,000 in the first quarter of fiscal 2007 and 2006, which isrespectively. For the quarter ended September 30, 2006, $57,000 (or 85%) of the total $67,000 of stock-based compensation expense was included in selling and administrative expense, totaled $65,000.expenses, with the balance reflected in costs of goods sold. The remainder of the increase in selling and administrative expenses relates to minor increases in various categories, such as wages, employee benefits, insurance, and other items.items, which amounts also include those related to Astro. $121,000 of amortization expense for the quarter ended September 30, 2006 is related to the purchase of Astro under the purchase accounting rules; for a further discussion see Note 5.
Interest and investment income increased slightlydecreased from the prior year, mainly due to higher interest rates.decreased funds available for investment. Certain investments were liquidated primarily to fund the operating loss, additions to property, plant and equipment, repayment of debt, and repurchases of common stock. Interest expense of $297,000 in the first quarter of fiscal 2007 is a result of the debt incurred and assumed as part of the acquisition of Astro. A further discussion of debt is contained in Note 6. Other income-net in the first quarter of fiscal 20062007 was $109,000,$107,000, versus $358,000$109,000 in fiscal 2005.2006. Translation adjustments, along with gains and losses from foreign currency transactions, are included in other income and, in the aggregate, amounted to a gaingains of $111,000$106,000 and $361,000$111,000 during the three months ended September 30, 20052006 and 2004,2005, respectively.
Due to the factors described above, the Company reported a net loss of $1,299,000 (($0.14)$2,464,000 ($0.25 per share, basic and diluted) for the three months ended September 30, 2005,2006, versus a net incomeloss of $2,414,000$1,299,000 ($0.260.13 per share, basic and diluted) for the corresponding period last year.

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LIQUIDITY AND CAPITAL RESOURCES
The Company’s primary source of liquidity and capital resources has historically been generated from operations. Short-term credit facilities have been used in the past, but not in recent years. Certain government contracts provide for interim progress billings based on costs incurred. These progress billings reduce the amount of cash that would otherwise be required during the performance of these contracts. As the volume of U.S. defense-related contract work declines,has declined over the past several years, so has the relative importance of progress billings as a liquidity resource. At the present time, the Company plans on usingto use its investment securities to provide additional working capital, and to strategically invest in additional property, plant and equipment, and to accommodatestrategically facilitate growth. Growth is expected to be achieved through internal expansion and/or acquisitionacquisition(s) or joint venture.venture(s). In addition, the Company’s previously announced $4,000,000 stock repurchase program is expected to utilize a portion of the Company’s investments. As ofThrough September 30, 2005, no stock had as yet2006, approximately 63,000 shares, at a cost of approximately $574,000, have been repurchased. These repurchased shares have been retired.
For the three months ended September 30, 2005,2006, cash and cash equivalents decreased $2,005,000$1,304,000 to $7,364,000.$6,199,000. Operating activities used $5,147,000 in fiscal 2007 and provided $971,000 in fiscal 2006, in net cash flows. The primary use of cash in fiscal 2007 was for operations combined with an increase in inventory. The increase in inventory is due to build up related to new customer contracts, as well as the delay in some customers’ schedules. The primary source of cash in the first quarter of fiscal 2006 was the collectionreceipt of $5.5 million$5,455,000 in July 2005cash from a legal settlement, with insurance carriers. In addition, cash flowwhich occurred in both fiscal 2006 and 2005 includes significant receipts from2005. Additionally, the collection of a large amount of accounts receivable attributable to sales recognizedat fiscal 2005 year end contributed to cash in the last quarters of the prior years, which is reflected as a decrease in accounts receivable.fiscal 2006. The primary use of cash in the first quarter of fiscal 2006 was a $7,406,000 decreasefor operations.
Cash flows provided by investing activities in accounts payablefiscal 2007 totaled $4,544,000, and accrued liabilities, which previously included $2.4 millionwas primarily provided by the proceeds from sale of income taxes payable.
investment securities. The primary use of cash in fiscal 2007 was the purchase of property, plant and equipment. The majority of the expenditures were for the current plant expansion at Astro. Cash flows used by investing activities during the three months ended September 30, 2005,in fiscal 2006 totaled $2,344,000, the primary use of whichand was primarily used in the purchase of investment securities.
Cash flows used by financing activities were $702,000 and $631,000 as discussed below.in fiscal 2007 and 2006, respectively. The primary uses in fiscal 2007 were the repayment of debt incurred with the purchase of Astro and the repurchase of common stock, while the primary use of cash in fiscal 2006 was for the payment of a $0.10 per share cash dividend.
Historically, the Company’s market risk exposure to foreign currency exchange and interest rates on third party receivables and payables has not been considered to be material, principally due to their short-term nature and the minimal amount of receivables and payables designated in foreign currency. However, due to the recently strengtheningstrengthened Canadian dollar, the impact of transaction and translation gains on intercompany activity and balances has increased. If the exchange rate were to materially change, the Company’s financial position could be significantly affected. The Company has had no short-term bank debt since December 1996, and currently has an unused informalformal line of credit totaling $20 million and a bank loan totaling $10 million. In addition, there are notes payable totaling $7.5 million outstanding to the former owners of Astro, as well as industrial revenue bonds assumed as part of the acquisition of Astro. These borrowings are further discussed in Note 6.
At September 30, and June 30, 2005,2006, the aggregate government funded EMS backlog was approximately $43$38 million and $42$41 million, respectively. A majority of the September 30, 2005,2006, backlog is expected to be realized in the next 12-15 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.
The Company signed a membership purchase agreement and completed the acquisition of Astro on May 31, 2006. Astro’s sales volume for the twelve months ended December 31, 2005, was approximately $34 million. The purchase price was approximately $26.2 million, plus the extinguishment by Sparton at closing of $4.2 million in seller credit facilities and the assumption of $2.3 million in bonded debt. The purchase price was funded using a combination of cash, $10 million in bank debt, and $7.5 million in notes payable to Astro’s previous owners. During each of the next four years additional contingent consideration may be paid to the previous owners of Astro. This contingent consideration is equal to 20% of Astro’s earnings before interest, depreciation, and taxes as defined, and if paid will be added to goodwill. Astro is an EMS provider that designs and manufactures a variety of specialized medical products, generally involving high-quality medical laboratory test equipment. Astro operates from a 40,000 square foot facility in an industrial park. A 20,000 square foot addition to the facility is now under construction. Sparton now operates the business as a wholly-owned subsidiary at its present location and with the current operating management and staff. A further discussion of the Astro purchase is contained in Notes 9 and 13 to the consolidated financial statements included in Item 8 of the Company’s Annual report on Form 10-K for the fiscal year ended June 30, 2006. The Company is continuing a program of identifying and evaluating potential acquisition candidates in both the defense and medical markets.

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Construction of the Company’s newSpartronics’ plant in Vietnam has been completed. Prototype product has beenwas completed and regular production began in May 2005. This new facility is anticipated to provide increased growth opportunities for the Company, in current as well as new markets. As the Company has not previously done business in this emerging market, there are many uncertainties and risks inherent in this venture. To date,As with the Company’s total investment approximates $6 million, which includes land, build-

14


ing, and initial operating expenses, with approximately $3 million having been expended forother facilities, the constructionmajority of the new facility, primarilyequipment utilized in fiscal 2005. The new company operates under the name Spartronics. The Companyproduction operations is also continuing a program of identifying and evaluating potential acquisition candidates in both the defense and medical markets.leased.
No dividends were paid in the first quarter of fiscal 2005. InDuring fiscal 2006, a $0.10 per share cash dividend, totaling approximately $889,000, $0.10 per share, was paid to shareowners on October 5, 2005. The funds forSubsequently in October 2005, the cashCompany declared a 5% stock dividend. This dividend were transferredwas distributed January 13, 2006, to shareowners of record on December 21, 2005. On October 25, 2006 the Company’s stock transfer agent prior to September 30, 2005 and held in a deposit account on Sparton’s behalf. In addition,Company declared a 5% stock dividend was declared in October 2005, to be paid indistributed January 19, 2007, to shareowners of record on December 27, 2006. This dividend was reflected in the condensed consolidated financial statements at September 30, 2005.
At September 30, 2005,2006, the Company had $95,206,000$94,404,000 in shareowners’ equity ($10.199.59 per share), $73,835,000$64,799,000 in working capital, and a 4.93:3.05:1.00 working capital ratio. For the foreseeable future (12-18 months), theThe Company believes it has sufficient liquidity for its anticipated needs over the next 12-18 months, unless aan additional significant business acquisition iswere to be identified and completed for cash.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
Information regarding the Company’s long-term debt obligations, environmental liability payments, operating lease payments, and other commitments is provided in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” of the Company’s Annual Reportreport on Form 10-K for the fiscal year ended June 30, 2005.2006. There have been no material changes in the Company’s contractual obligations since June 30, 2005.2006.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management’s discussion and analysisThe preparation of financial condition and results of operations is based upon the Company’sour condensed consolidated financial statements which have been prepared in accordanceconformity 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 fiscal year ended June 30, 2005. The preparation of these financial statementsAmerica (GAAP) requires management to make estimates, judgments and assumptions that affect the amounts reported foras 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 could differ from thesethose estimates. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in application. There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result. The Company believes that of its significant accounting policies discussed in the Notes to the condensed consolidated financial statements, which are included in Part I, Item 1 of this report, the following involve a higher degree of judgmentjudgement and complexity. Senior management has reviewed these critical accounting policies and related disclosures with Sparton’s audit committee of the Board of Directors.
Environmental 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). As discussed in Note 7 to the condensed consolidated financial statements included in Part I, Item 1, 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.
Government 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 athe 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. In addition, estimated total contract costs can be significantly affected by changing test routines and procedures, resulting design modifications and production rework from these changing test routines and procedures, and limited range access for testing these design modifications and rework solutions. Estimated costs developed in the early stages of contracts can change, sometimes significantly, as the contracts progress, and events and activities take place. Significant changesChanges in estimates can also

21


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 aat least quarterly basis and the resulting 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.

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Commercial Inventory Valuation Allowances
Inventory valuation allowances for commercial customer inventories require a significant degree of judgment and are 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 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 PossibleProbable Losses on Receivables
The accounts receivable balance is recorded net of allowances for amounts not expected to be collected from customers. 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’customer’s 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 possibleprobable losses. The Company reviews the adequacy of its allowance monthly. The allowance for doubtful accounts was $98,000$121,000 and $6,000$67,000 at September 30, and June 30, 2005,2006, respectively. If the financial condition of customers were to deteriorate, resulting in an impairment of their ability to make payment, an additional allowanceallowances may be required. Given the Company’s significant balance of government receivables and letters of credit from foreign customers, collection risk is considered minimal. Historically, uncollectible accounts have generally been generally insignificant and the minimal allowance is deemed adequate.
Pension Obligations
The Company calculates the cost of providing pension benefits under the provisions of SFASStatement of Financial Accounting Standards (SFAS) No. 87.87,Employers’ Accounting for Pensions, as amended. 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 Condensed Consolidated Balance Sheetsobligation and the unrecognized gain or loss accounts disclosed in the Notes to the financial statements, the effect of changes in these assumptions is not expected to have the same relative effect on net periodic pension expense 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 September 30, 2005. As indicated above, to2006. To the extent the assumptions differ from actual results, as indicated above, or if there are changes made to accounting standards for these costs, there would be a future impact on the financial statements. The extent to which thisthese factors will result in future recognition or acceleration of 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. No cash payments are expected to be required for the next several years due to the plan’s funded status.

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Business Combinations
In accordance with accepted business combination accounting, the Company allocated the purchase price of its recent Astro acquisition to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. The Company engaged an independent, third-party appraisal firm to assist management in determining the fair value of certain assets acquired and liabilities assumed. Such valuations require management to make significant estimates, judgments and assumptions, especially with respect to intangible assets.
Management arrived at estimates of fair value based upon assumptions believed to be reasonable. These estimates are based on historical experience and information obtained from the management of the acquired business and are inherently uncertain. Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected discounted cash flows from customer relationships and contracts assuming similar product platforms and completed projects; the acquired company’s market position, as well as assumptions about the period of time the acquired customer relationships will continue to generate revenue streams; and attrition and discount rates. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results, particularly with respect to amortization periods assigned to identifiable intangible assets.
Goodwill and Customer Relationships
The Company currently reviews goodwill associated with its Cybernet investment on an annual basis for possible impairment. Additionally, the Company will review goodwill and customer relationships, associated with the recent Astro acquisition, for impairment annually, with the first review anticipated to occur in April 2007. Possible impairment of these assets will also be reviewed should events or changes in circumstances indicate their carrying value may not be recoverable in accordance with SFAS No. 142,Goodwill and Other Intangible Assets.The provisions of SFAS No. 142 require that a two-step impairment test be performed. In the first step, the Company compares the fair value of each reporting unit to its carrying value. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to the unit, goodwill is considered not impaired and the Company is not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, management will perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, the Company would record an impairment loss equal to the difference.
Determining the fair value of any reporting entity is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates, operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions and, if appropriate, determination of appropriate market comparables. The Company bases its fair value estimates on assumptions believed to be reasonable, but which are unpredictable and inherently uncertain. Actual future results may differ from those estimates. In addition, the Company makes certain judgments and assumptions in allocating shared assets and liabilities to determine the carrying values for each of the Company’s reporting units. The most recent annual goodwill impairment analysis related to the Company’s Cybernet investment, which was performed during the fourth quarter of fiscal 2006, did not result in an impairment charge.
OTHER
LITIGATIONLitigation
One of Sparton’s former manufacturing 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.
At September 30, 2005,2006, Sparton has $6,250,000 accrued $6,733,000 as its estimate of the future undiscounted minimum financial liability with respect to this matter. The Company’s cost estimate is based upon existing technology and excludes legal and related consulting costs, which are expensed as incurred, and is anticipated to cover approximately the next 2524 years. The Company’s estimate includes equipment and operating costs for onsite and 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 significantly by the impact of the ultimate resolution of this contingency.

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Some of the printed circuit boards supplied to the Company for its aerospace sales have been discovered to be defective. The defect occurred during production at the raw printed circuit board manufacturer’ssuppliers facility, prior to shipment to Sparton for further processing. All of the lots involved have yet to be identified and Sparton, the board manufacturer, Electropac Co., Inc. (the raw board manufacturer), and our customer, who received the defective assembled boards, are working to containhave contained the defective boards. While investigations are underway, $2.4$2.9 million of related product and associated expenses have been classified in Sparton’s balance sheet within other long-term assets as of September 30, 2005. As of this date, Sparton has made a demand on the board manufacturer for reimbursement of all costs and expenses incurred, and the parties are engaged in discussions regarding the resolution of Sparton’s claim.2006. In addition, in August 2005, Sparton Electronics Florida, Inc. filed an action in U.S. District Court of Florida against Electropac Co., Inc. to recover these costs. The likelihood that the claim will be resolved and the extent of Sparton’s exposure, if any, is unknown at this time. No loss contingency has been established at September 30, 2005.2006.
In September��2002, Sparton Technology, Inc. (STI) filed an actionis currently involved in the U.S. District Court for the Eastern Districtother legal actions, which are disclosed in Part II Item 1 - “Legal Proceedings”, 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 NRTC asked for damages in the amount $20,000,000 for the loss of its investment in and loans to Util-Link. In addition, the defendant Util-Link had previously asked for damages in the amount of $25,000,000 for lost profits, which it no longer appears to be pursuing. Sparton has reviewed the respective claims and believes that the damages sought by NRTC were included in Util-Link’s claim for damages and, as such, were duplicative. Sparton believes the counterclaim to be without merit and intends to vigorously defend against it. These claims are now in trial in Detroit, Michigan.this report. At this time, the Company is unable to predict the outcome of this claim.these claims.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKQuantitative and Qualitative Disclosures About Market Risk
Market Risk Exposure
The Company manufactures its products in the United States, and Canada, and most recently in Vietnam. Sales are to 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 and Vietnamese 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 economic conditions in the domestic and foreign markets in which the Company operates. However, minimal third party receivables and payables are denominated in foreign currency and the related market risk exposure is considered to be immaterial. Historically, foreign currency gains and losses related to intercompany activity and balances have not been significant. However, due to the recent strengthened Canadian dollar, the impact of transaction and translation gains has increased. If the exchange rate were to materially change, the Company’s financial position could be significantly affected.
The Company has financial instruments that are subject to interest rate risk, principally short-term investments.investments and long-term debt associated with the recent Astro acquisition on May 31, 2006. 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, and the fact that interest rates were at market values for the debt issued in the recent Astro acquisition, interest rate risk is not currently considered to be material.

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significant.
Item 4. CONTROLS AND PROCEDURESControls and Procedures
The Company maintains internal control over financial reporting intended to provide reasonable assurance that all material transactions are executed in accordance with Company authorization, are properly recorded and reported in the financial statements, and that assets are adequately safeguarded. The Company also maintains a 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, 2005,2006, 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, 2005.2006. There have been no changes in the Company’s internal control over financial reporting 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 IIPart II. Other Information
OTHER INFORMATION
Item 1. Legal Proceedings
OneVarious litigation is pending against the Company, in many cases involving ordinary and routine claims incidental to the business of Sparton’s former manufacturing facilities, locatedthe Company and in Albuquerque, New Mexico (Coors Road),others presenting allegations that are non-routine.
Environmental Remediation
The Company and its subsidiaries are involved in certain compliance issues with the United States Environmental Protection Agency (EPA) and various state agencies, including being named as a potentially responsible party at several sites.

24


Potentially responsible parties (PRPs) can be held jointly and severally liable for the clean-up costs at any specific site. The Company’s past experience, however, has indicated that when it has contributed relatively small amounts of materials or waste to a specific site relative to other PRPs, its ultimate share of any clean-up costs has been involvedminor. Based upon available information, the Company believes it has contributed only small amounts to those sites in which it is currently viewed as a PRP.
In February 1997, several lawsuits were filed against Sparton’s wholly-owned subsidiary, Sparton Technology, Inc. (STI), alleging that STI’s Coors Road facility presented an imminent and substantial threat to human health or the environment. On March 3, 2000, a Consent Decree was entered into, settling the lawsuits. The Consent Decree represents a judicially enforceable settlement and contains work plans describing remedial activity STI agreed to undertake. The remediation activities called for by the work plans have been installed and are either completed or are currently in operation. It is anticipated that ongoing remediation activities will operate for a period of time during which STI and the regulatory agencies will analyze their effectiveness. The Company believes that it will take several years before the effectiveness of the groundwater containment wells can be established. Documentation and research for the preparation of the initial multi-year report and review are currently underway. If current remedial operations are deemed ineffective, additional remedies may be imposed at a significantly increased cost. There is no assurance that additional costs greater than the amount accrued will not be incurred or that no adverse changes in environmental laws or their interpretation will occur.
Upon entering into the Consent Decree, the Company reviewed its estimates of the future costs expected to be incurred in connection with ongoingits remediation of the environmental remediation sinceissues associated with its Coors Road facility over the early 1980’s.next 30 years. At September 30, 2005, Sparton has accrued $6,733,000 as its estimate of2006, the undiscounted minimum accrual for future undiscounted financial liability, of which $618,000 is classified as a current liability and included in accrued liabilities.EPA remediation approximates $6,250,000. The Company’s minimum cost estimate is based upon existing technology and excludes legal and related consultingcurrent costs which are expensed as incurred.have not been discounted. The Company’s estimate includes equipment, operating and continued monitoringmaintenance costs for the onsite and offsite pump and treat containment systems, as well as continued onsite and offsite monitoring. It also includes the required periodic reporting requirements. This estimate does not include legal and related consulting costs, which are expensed as incurred.
Factors which cause uncertaintiesIn 1998, STI commenced litigation in two courts against the United States Department of Energy (DOE) and others seeking reimbursement of Sparton’s costs incurred in complying with, and defending against, federal and state environmental requirements with respect to the Company’s estimate, include, but are not limitedits former Coors Road manufacturing facility. Sparton also sought 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 affectedrecover costs being incurred by the impactCompany as part of changes associated withits continuing remediation at 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 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.
Coors Road facility. In fiscal 2003, Sparton reached an agreement with the United States Department of Energy (DOE)DOE and others to recover certain remediation costs. Under the agreement, Sparton was reimbursed a portion of the costs the Company incurred in its investigation and site remediation efforts at the Coors Road facility. Under the settlement terms, Sparton received cash and the DOE agreed to reimburse Sparton for 37.5% of certain future environmental expenses in excess of $8,400,000 incurred from the date of settlement. With the settlement, Sparton received cash and obtained some degree of risk protection, with the DOE sharing in costs incurred above the established level.
In 1995, Sparton Corporation and Sparton Technology, Inc. (STI)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. In June 2005, Sparton reached an agreement with an insurer under which Sparton received $5,455,000 in cash in July 2005. This agreement recovers2005, which reflects a recovery of a portion of past costs the Company incurred.
In October 2006, Sparton reached an agreement with another insurer under which Sparton received $225,000 in cash in October 2006. This agreement reflects a recovery of a portion of past costs incurred in its investigationrelated to the Company’s Coors Road facility, and site remediation efforts, which began in 1983, and was recordedwill be recognized as income in June 2005.the second quarter of fiscal 2007. The Company continues to pursue an additional recovery from an excess carrier. The probability and amount of recovery is uncertain at this time.
Customer Relationships
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 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 NRTC asked for damages in the amount $20,000,000of $20 million for the loss of its investment in and loans to Util-Link. In addition, the defendant Util-Link had previously asked for damages in the amount of $25,000,000$25 million for lost profits, which it no longer appears to be pursuing.profits. Sparton hashad reviewed the respectivethese claims and believes that the damages sought by NRTCbelieved they were duplicative. Util-Link did not pursue its claim.

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The jury trial commenced on September 19, 2005 and concluded on November 9, 2005. The jury awarded Sparton damages in the amount of $3.6 million, of which approximately $1.9 million represented costs related to the acquisition of raw materials. These costs were previously deferred and are included in Util-Link’sother long-term assets on the Company’s June 30, 2006 balance sheet. As expected, there were post-trial proceedings, including motions by the defendant NRTC for judgment as matter of law on its counterclaim and a motion for new trial. On March 27, 2006, the trial court denied the defendant NRTC’s motion for judgment on its counter claim as a matter of law and granted the motion for new trial unless Sparton accepted a reduction of the judgment. Sparton accepted the reduction, which reduced the collective judgment in its favor to $1.9 million, which would enable the Company to recover the deferred costs and, accordingly, there would be no significant impact on operating results. An amended judgment was entered for $1.9 million in Sparton’s favor on April 5, 2006. On May 1, 2006, NRTC filed an appeal of the judgment with the U.S. Court of Appeals for the Sixth Circuit, which could impact the ultimate result.
The Company has pending an action before the U.S. Court of Federal Claims to recover damages arising out of an alleged infringement by the U.S. Navy of certain patents owned by Sparton and as such, were duplicative. Sparton believesused in the counterclaim to be without merit and intends to vigorously defend against it. These claims are now inproduction of sonobuoys. The case was dismissed on summary judgment; however, the decision of the U.S. Court of Federal Claims was reversed by the U.S. Court of Appeals for the Federal Circuit. The case is currently scheduled for trial in Detroit, Michigan. At this time,the first calendar quarter of 2007. The likelihood that the claim will be resolved and the extent of any recovery in favor of the Company is unable to predict the outcome ofunknown at this claim.time.
Product Issues
Some of the printed circuit boards supplied to the Company for its aerospace sales have been discovered to be defective. The defect occurred during production at the raw board manufacturer’ssupplier’s facility, prior to shipment to Sparton for further processing. All of the lots involved have yet to be identified and Sparton, the board manufacturer, Electropac Co., Inc. (the raw board manufacturer), and our customer, who received the defective assembled boards, are working to containhave contained the defective boards. While investigations are underway, $2.4$2.9 million of related product and associated expenses have been deferred and classified in Sparton’s balance sheet within other long-term assets as of September 30, 2005. As of this date, Sparton has made a demand on the board manufacturer for reimbursement of all costs and expenses incurred, and the parties are engaged in discussions regarding the resolution of Sparton’s claim.2006. In addition, in August 2005, Sparton Electronics Florida, Inc. filed an action in U.S. District Court of Florida against Electropac Co., Inc. to recover these costs. The likelihood that the claim will be resolved and the extent of Sparton’s exposure, if any, is unknown at this time. No loss contingency has been established at September 30, 2005.2006.
Item 1(a). Risk Factors
Information regarding the Company’s Risk Factors is provided in Part I, Item 1(a) “Risk Factors,” of the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2006. There have been no significant changes in the Company’s risk factors since June 30, 2006.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(c) Issuer Repurchases of Equity Securities —As of September 30, 2006, the Company had one publicly-announced share repurchase program outstanding. Announced on August 29, 2005, effective September 14, 2005, the program provides for the repurchase of up to $4.0 million of shares of the Company’s outstanding common stock in open market transactions. The program expires September 14, 2007, and the timing and amount of daily purchases are subject to certain limitations. Through June 30, 2006, the Company had purchased 39,037 shares at a cost of approximately $363,000.
Information on shares repurchased in the most recently completed quarter is as follows:
                 
          Total number Approximate dollar value of
  Total number of Average price shares purchased as part of shares that may yet be
Period shares purchased paid per share publicly announced programs purchased under the program
July 1-31  4,200  $8.65   4,200  $3,601,000 
August 1-31  3,100   8.90   3,100   3,573,000 
September 1-30  16,792   8.77   16,792   3,426,000 
                 
Total  24,092       24,092     
                 
Repurchased shares are retired.

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Item 4. Submission of Matters to a Vote of Security Holders
At the October 26, 2005,25, 2006, Annual Meeting of Shareowners of Sparton Corporation, a total of 8,588,1248,802,263 of the Company’s shares were present or represented by proxy at the meeting. This represented more than 96%93% of the Company’s shares outstanding. Total shares outstanding and eligible to vote were 8,894,099,9,384,221, of which 305,975581,958 did not vote.
The individuals named below were re-elected as Directors to serve a three-year term expiring in 2008:2009:
         
Name  Votes FOR  Votes WITHHELD
 
Richard J. Johns, MD  8,266,316   321,808 
Richard L. Langley  8,029,787   558,337 
William I. Noecker  7,451,239   1,136,885 
         
NAME  Votes FOR   Votes ABSTAINED 
James N. DeBoer  7,679,017   1,123,246 
James D. Fast  7,677,285   1,124,978 
David W. Hockenbrocht  7,657,917   1,144,346 
Messrs. James N. DeBoer, David W. Hockenbrocht, James D. Fast,Richard J. Johns M.D., Richard L. Langley, David P. Molfenter, William I. Noecker, W. Peter Slusser and Bradley O. Smith all continue as directors of the Company.
A second proposal for the ratification of the appointment of the Company’s current independent auditors, BDO Seidman, LLP, was presented to the shareowners for vote. BDO Seidman, LLP was ratified as the Company’s independent auditors for fiscal year 2007 with 8,761,065 votes FOR, 22,879 votes NO and 18,319 votes ABSTAINED.

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Item 6. Exhibits
2Membership Purchase Agreement for the acquisition of Astro Instrumentation, LLC was filed with Form 8-K on June 2, 2006, and is incorporated herein by reference.
 3.1 Amended Articles of Incorporation of the Registrant were filed on Form 10-Q for the three-month period ended September 30, 2004, and are incorporated herein by reference.
 
 3.2 Amended Code of Regulation of the Registrant were filed on Form 10-Q for the three-month period ended September 30, 2004, and are incorporated herein by reference.
 
 3.3 The amended By-Laws of the Registrant were filed on Form 10-Q for the nine-month period ended March 31, 2004, and are incorporated herein by reference.
 
 31.1 Chief Executive Officer certification under Section 302 of the Sarbanes-Oxley Act of 2002.
 
 31.2 Chief Financial Officer certification under Section 302 of the Sarbanes-Oxley Act of 2002.
 
 32.1 Chief Executive Officer and Chief Financial Officer certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
   
Date: November 8, 200510, 2006 /s/ DAVID W. HOCKENBROCHT
  
  
David W. Hockenbrocht, Chief Executive Officer
   
Date: November 8, 200510, 2006 /s/ RICHARD L. LANGLEY
  
  
Richard L. Langley, Chief Financial Officer

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