Napco Security Technologies, Inc. (NASDAQ:NSSC) Q2 2023 Earnings Call Transcript

Napco Security Technologies, Inc. (NASDAQ:NSSC) Q2 2023 Earnings Call Transcript February 6, 2023

Operator: Greetings, and welcome to NAPCO Security Technologies, Inc. Fiscal Second Quarter 2023 Earnings Results Conference Call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Patrick McKillop, Vice President of Investor Relations. Thank you. You may begin.

Patrick McKillop: Thank you. Good morning. My name is Patrick McKillop, Vice President of Investor Relations for NAPCO Security. Thank you all for joining us for today’s conference call to discuss our financial results for our fiscal second quarter 2023. By now, all of you should have had the opportunity to review the press release discussing the results. If you have not, a copy of the release is available in the Investor Relations section of our website, www.napcosecurity.com. On the call today is Richard Soloway, President and CEO of NAPCO Security Technologies; and Kevin Buchel, Executive Vice President and CFO. Before we begin, let me take a moment to read the forward-looking statement. This presentation contains forward-looking statements that are based on current expectations, estimates, forecasts and projections of future performance based on management’s judgment, beliefs, current trends and anticipated product performance.

These forward-looking statements include, without limitation, statements relating to growth drivers of the company’s business, such as school security products and recurring revenue services, potential market opportunities, the benefits of recurring revenue products to customers and dealers, our ability to control expenses and costs and expected annual run rate for SaaS recurring monthly revenue. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those contained in the forward-looking statements. These factors include, but are not limited to, such risk factors described in our SEC filings, including our annual report on Form 10-K. Other unknown or unpredictable factors or underlying assumptions, subsequently proving to be incorrect, could cause actual results to differ materially from those in the forward-looking statements.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. You should not place undue reliance on these forward-looking statements. All information provided in today’s press release and this conference call is as of today’s date, unless otherwise stated and we undertake no duty to update such information, except as required under applicable law. I will turn the call over to Dick in a moment, but before I do, I just wanted to mention that we are actively planning our Investor Relations calendar for more NDRs and conferences in the near future as investor outreach is crucial, especially for a small-cap companies such as NAPCO and I would like to thank all of those folks that assist us in these conferences and marketing trips.

Also, we invite you to come to visit our booth at the upcoming ISC West Trade Show, March 20 through the 31 in Las Vegas, Nevada. ISC West is the industry’s largest trade show, with over 30,000 attendees. With that out of the way, let me turn the call over to Richard Soloway, President and CEO of NAPCO Security Technologies. Dick, the floor is yours.

Richard Soloway: Thank you, Patrick. Good morning, everyone, and welcome to our conference call. Thank you for joining us today to discuss our results. We are very pleased to report our fiscal Q2 2023 record sales of $42.3 million. This is our ninth consecutive quarter of sales growth. Recurring revenue continued to grow at a very strong rate and the annual run rate is now approximately $59 million based on January 2023 recurring revenues. Our balance sheet remains strong, with our cash balances at $47.1 million, and we have no debt. We continue to focus on capitalizing on key industry trends, which include wireless, fire and intrusion alarms, school security solutions, plus enterprise access control systems and architectural locking products.

The management team here at NAPCO continues to focus on the key metrics of growth, profits and returns on equity and controlling costs. These metrics are important for us as well as our shareholders. We continue to execute our business strategy and our interests are aligned with our shareholders as senior management at NAPCO owns approximately 16.5% of the equity. Before I go into greater detail, I’ll now turn the call over to our CFO, Kevin Buchel, who will provide an overview of our fiscal first quarter results and then I’ll be back with more on our strategies and outlook. Kevin?

Kevin Buchel: Thank you, Dick, and good morning, everybody. Net sales for the second quarter increased 27% to a quarterly record of $42.3 million, as compared to $33.4 million for the same period one year ago. Net sales for the six months ended December 31, 2022, increased 27% to $81.8 million, as compared to $65 million for the same period one year ago. Our equipment sales in Q2 increased 23% to $27.4 million, as compared to $22.4million for the same year ago period and equipment sales for the six month period also increased 23% to $53.1 million as compared to $43.2 million for the same period a year ago. Recurring monthly revenue continued its strong growth, increasing 35% in Q2 to $14.9 million, compared to $11 million for the same period last year and for the six months increased 35% to $28.7 million versus $21.3million in the same period a year ago.

Our recurring service revenues now have a prospective annual runrate of approximately $59 million based on January 2023 recurring service revenues. The increase in equipment sales for the quarter were primarily due to increases in both our Alarm Lock and Marks store locking products, as well as increased sales in our Continental Access Control products. The increase in equipment sales for the six months was primarily due to increased sales of NAPCO’s intrusion products, Alarm Lock and Marks door locking products and Continental Access Control products. The strong growth of our recurring revenue for both the three and six months ended December 31, 2022 was primarily attributable to the continued strength of our StarLink cellular radio products driven by increases in the commercial intrusion and fire alarm business.

Gross profit for the three months ended December 31, 2022, increased 70% to $19.4 million with a gross margin of 46%, as compared to $11.4 million with a gross margin of 34% for the same period a year ago. Gross profit for the six months ended December 31, 2022 increased 51% to $37.6 million with a gross margin of 46% and as compared to $24.9 million with a gross margin of 39% for the same period a year ago. Gross profit for equipment sales for the three months ended December 31, 2022 increased 245% to $6.2 million with a gross margin of 23%, as compared to $1.8 million with a gross margin of 8% for the same period a year ago. Gross profit for equipment sales for the six months ended December 31, 2022, increased 88% to $12.3 million with a gross margin of 23%, as compared to $6.5 million with a gross margin of 15% for the same period a year ago.

Gross profit for recurring revenues for the three months ended December 31, 2022, increased 37% to $13.2 million with a gross margin of 89%, as compared to $9.6 million gross margin of 87% for the same period a year ago and gross profit on recurring revenues for the six months ended December 31, 2022, increased 38% to $25.4 million with a gross margin of 88%, as compared to $18.4 million with a gross margin of 87% for the same period a year ago. The significant increase in gross profit dollars, as well as gross margin for equipment sales for both the three and the six months ended December 31, 2022 was primarily the result of the aforementioned increases in equipment revenues, as well as increased availability and lower cost of certain components and transportation cost, as compared to the same period last year.

This was as a result of improvements within the company’s supply chain. The increase in revenues also resulted in improved overhead absorption rates from our Dominican Republic manufacturing facility. The increase in gross profit dollars for recurring service revenues for both the three and six months ended December 31, 2022 was due to the continued strong sales of the company’s StarLink Radios. The continued increase in gross margin of recurring revenue for both the three and the six months was primarily due to increased service revenues relating to the company’s fire radios, which have higher monthly selling prices than the company’s intrusion radios. Research and development expenses for the three months ended December 31, 2022, increased 12% to $2.2 million, 5% of net sales, as compared to $2 million or 6% of net sales for the same period a year ago.

Research and development expenses for the six months ended December 31, 2022, increased 19% to $4.7 million or 6% of net sales, as compared to $3.9 million or 6% of net sales for the same period a year ago. The increase in dollars for the three and six month periods was due primarily to salary increases and some additional staffs. Selling, general and administrative expenses for the three months ended December 31, 2022, decreased by 5% to $7.8 million or 18% of net sales, as compared to $8.2 million or 25% of net sales for the same period a year ago. The decrease in dollars resulted primarily from higher stock option expense and legal expenses incurred in the three months ended December 31, 2021. The decrease as a percentage of net sales was due primarily to the increase in net sales as well as the aforementioned decrease in expense dollars.

Selling, general and administrative expenses for the six months ended December 31, 2022 increased by 5% to $6.3 million or 20% of net sales from $15.5 million or 24% of net sales for the same period a year ago. The increase in dollars resulted primarily from increases in credit card processing fees, insurance expense and commission expenses. The decrease as a percentage of net sales was due primarily to the increase in net sales as partially offset by the aforementioned increase in expense dollars. Operating income for the quarter increased 643% to $9.4 million, as compared to $1.3 million for the same period last year and operating income for the six months ended December 31, 2022, was $16.7 million as compared to $5.4 million for the same period last year, which is a 206% increase.

The company’s provision for income taxes for the three months ended December 31, 2022, increased by $886,000 to $1.2 million, an effective tax rate of 12%, as compared to $291,000 with an effective tax rate of 22% for the same period a year ago. The increase in the provision for income taxes for the three months was primarily due to higher taxable income. The company’s provision for income taxes for the six months ended December 31, 2022, increased by $1.3 million to $1.9 million with an effective rate of 11% and as compared to $639,000 with an effective tax rate of 7% for the same period a year ago. The increase in the provision for income taxes for the six months was also primarily due to higher taxable income. The effective tax rate for the six months ended December 31, 2021 was reduced due to other income of $3 million – $3.9 million being non-taxable.

Net income for the three months ended December 31, 2022 was a quarterly record $8.4 million or $0.23 per diluted share, as compared to $1 million or $0.03 per diluted share for the same period a year ago, 714% increase. Net income for the six months ended December 31, 2022 increased 69% to $14.8 million per diluted share as compared to $8.8 million or $0.24 per diluted share for the same period a year ago. Net income and earnings per share in last year’s Q1 benefited from $3.9 million of other income from the forgiveness of debt. Without such benefit, net income and diluted earnings per share for the six months ended December 31, 2021 would have been $4.9 million and $0.13, respectively. Adjusted EBITDA for the quarter was a quarterly record $10.3 million or $0.28 per diluted share, as compared to $3.1 million or $0.08 per diluted share for the same period last year, a 232% increase.

Adjusted EBITDA for the six months was $18.6 million or $0.50 per diluted share, as compared to $7.8 million or $0.21per diluted share for the same period last year, a 138% increase. The EBITDA margin for the three months ended December 31, 2022, was 24% as compared to 9% in the prior year period and for the six months ended December 31, 2022 the EBITDA margin was 23% as compared to 12% in the prior year period. Moving on to the balance sheet, at December 31, 2022, the company had $47.1 million in cash, cash equivalents, investments in marketable securities, as compared to $46.8 million as of June 30, 2022. Working capital, defined as current assets less current liabilities was $101.6 million at December 31, 2022, as compared with working capital of $93.1 million at June 30, 2022.

The current ratio, defined as current assets divided by current liabilities, was 6.6 to 1 at December 31, 2022 and 4.5 to 1 at June 30, 2022. Cash provided by operating activities for the six months was $1 million, as compared to $7.8 million for the same period last year. This decrease was primarily due to inventories increasing by $14.8 million, resulting primarily from the company’s decision to purchase hard-to-get parts used in products that generate recurring service revenues for the company. The challenges from the supply chain crisis are beginning to subside and the company believes its inventory levels will begin to decrease in the latter part of fiscal 2023 and continuing in fiscal 2024. CapEx for the quarter was $444,000 versus $249,000 in the year ago period and for the six months ended December 31, 2022, was $816,000, compared to $771,000 in the prior year period and we have no debt.

That concludes my formal remarks, and I would now like to return the call back to Dick.

Richard Soloway: Kevin, thank you. Our second quarter was a sales record breaker our sales, continuing our sales growth streak, which is now our ninth consecutive quarter of year-over-year sales growth. Prior to the COVID pandemic, we had 23 consecutive quarters of growth and we look forward to surpassing that streak in the future. We are pleased that we were able to beat published Street consensus estimates for revenue, EPS, net income and adjusted EBITDA metrics. This outstanding performance is the result of the continued strong demand for each of our product lines, including NAPCO, fire and intrusion, Alarm Lock and Marks door locking products, as well as our Continental Access Control systems. One key area of our success continues to come from the commercial fire and intrusion alarm business.

The ongoing concerns about a potential recession in the U.S. and rising interest rates remain as top headlines and I’d like to remind you that our company is highly recession-resistant as 80% of our business is commercial and one of our primary growth drivers. The commercial fire alarm business is a mandatory non-discretionary item. Commercial buildings must have and maintain a fire alarm system in order to receive the certificate of occupancy. Given the high profitability and essential nature of this business, we focus on this as a key area of our resources. Our equipment and recurring revenue both generated exceptional growth in this quarter, increasing 23% and 35%, respectively. The annual run rate for recurring revenue is now approximately $59 million as of January 2023.

Our StarLink radios continue to have strong sales and we are optimistic that we can reach our previously mentioned goals of $150 million in recurring revenue and $150 million of equipment revenue by the end of fiscal 2026 or possibly sooner. Achievement of those goals as well as our gross margin goals of 80% for recurring revenue and 50% for equipment revenue could generate EBITDA margins in excess of 45%. We estimate that there are millions of commercial buildings of all types such as offices, hospitals, schools, coffee shops, fast food restaurants and others that still require upgrades from old-fashioned copper phone wires. Our StarLink radios have the widest coverage with both AT&T and Verizon service and rich feature sets, which our dealers love.

The 3G sunset was completed just a few weeks ago and management believes that a portion of the active NAPCO’s StarLink radios that lost communications due to the Verizon 3G sunset have not yet been replaced because a long deal is expected the sunset to be delayed as was the case with the AT&T 3G sunset in 2021. Ultimately, the company anticipates that many or all these NAPCO 3G radios will be replaced with NAPCO’s newer-generation radios, because alarm dealers must have new functioning and revenue-producing radios to monitor alarm conditions, resulting in both additional hardware revenue and increasing recurring revenue for the company. We are pleased that the equipment margins improved by 1,500 basis points to 23% in this quarter versus 8% in the same period a year ago.

Margins for recurring revenues also improved by 200 basis points to 89% for this quarter versus 87% in the same period a year ago. The constraints of the supply chain have largely abated for us, and we believe that in the next three months, the new supplier sources we have developed will begin to invigorate our equipment margins and bring them to even higher levels than what we generated prior to the supply chain crisis. The backlog for the company remains at a higher-than-normal level. Although it continues to come down considerably and we remain confident in sustainable demand for our products going forward, we remain encouraged by the continued strength of the sell-through statistics we are seeing from several of our largest distributors.

We believe that we are taking market share from our competition based on new customers continuing to tell us that they can’t get products from the competition. School administrators are focused on the need for security solutions as more incidences continue to happen. Our fully integrated solutions with school security generate healthy margins for our business and now more than ever, we are laser-focused on further penetration of the school security market, which is comprised of approximately 130,000 K-12s and 5,000 colleges and universities across the country. Our fully integrated technologies for the school security market continues to remain a top priority for NAPCO. The availability of grants to schools to fund these security projects has never been better.

We are excited to report that we recently received another school security project for a large school district in the state of Massachusetts and the school will be using our Continental Access Control products in its 125 schools. Offering seamless security solutions, which allow for our dealers and us to generate recurring revenue streams is central to our strategy. Historically, recurring revenues have been from our NAPCO Intrusion and Alarms division, but the recently launched Air Access product, we are now €“ with the recently lost air access product, we are now able to generate recurring revenue from all divisions of the company. Air Access should generate recurring revenue from locking and access control which has never been done before.

Air Access is the industry’s first cellular-based access control system, which we believe is a billion dollar opportunity. The benefits of Air Access include no need for upfront investment of expensive hardware, no need to interfere with corporate IT networks, which can be a major problem for installers, and no on-site database backups or software updates. Our R&D team remains hard at work, developing even more products to the future, which will help grow our recurring revenue business. We have experienced tremendous success over the last five years growing our recurring revenue business and believe the best is yet to come. Lastly, I am pleased to announce that David Patterson, the Governor of New York for March 2008 until January 2011 has joined our Board of Directors.

David has vast experience in crime and in security issues and is an outspoken advocate of safety by combating crime traditionally and with new messaging systems. He will bring his unique perspectives to NAPCO and we plan for the future growth and success of the company. We will begin our Q&A session portion of this call in a moment. Our fiscal second quarter 2023 was a record-breaking successful one. We have a strong balance sheet, no debt and continue to generate healthy profits. We believe we can continue this renewed growth streak well beyond the ninth consecutive quarter streak we are on now. NAPCO’s senior management owns approximately 16.5% of our equity and I would like to thank everyone for their support and for joining us in the exciting future we have.

Our formal remarks are now concluded. We would now like to open the call for a Q&A session. Operator, please proceed.

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Q&A Session

Operator: Our first question comes from the line of Jim Ricchiuti with Needham & Company. Please proceed with your question.

Jim Ricchiuti: Thank you. Good morning. I just wanted to follow up on the comment that you made regarding the Verizon 3G sunset. Are you hearing from your channel partners yet of the acceleration in demand that they might be anticipating as a result of this?

Richard Soloway: Kevin, do you want to take…

Kevin Buchel: Sure. So Jim, we know that the dealers who failed to take action sunset hit. A lot of these dealers didn’t think it was really going to happen, because when the AT&T sunset came about, they didn’t €“ they kept delaying it and delaying it. The dealers thought it was going to get delayed this time. Remember this with the dealers. If they don’t have an active radio, then they suffer. They are losing recurring revenue. Remember, they charge the end user recurring revenue, just like we charge the dealer. So the last thing they want is to lose their livelihood, that recurring. So, we’re starting to see a lot of scrambling around as these radios that went dark at the end of January 3rd are being replaced. We’re pretty confident that they are all going to be replaced, and we’re pretty confident they’ll be replaced with our radios.

They’ll go from a NAPCO 3G radio to a NAPCO StarLink 5G radio. There is also the possibility that some of the radios that go dark from other could come over to the NAPCO side because we believe we have a better offering than the competition. So, there is a lot of scurrying about. Let’s watch what happens, but we think in the end, it’s going to mean more radio sales and more recurring revenue for us.

Jim Ricchiuti: Follow-up question and this may be for you, Kevin or Dick. If you could talk a little bit to some of the redesign activities when you start €“ when are you anticipating that, that could produce more meaningful improvement in equivalent gross margins?

Kevin Buchel: Yes, I could take that one. So several months ago, probably about seven months ago, we said that we were going to embark on the journey of getting another source to replace the traditional source, which is Texas Instruments, for our radio business because we can’t keep living with having to buy these hard-to-get parts from brokers. So it takes time to do this. It’s not like you just find the other source and you pop it into the board and you’re off to the races. There is redesigning of the board. There is software updates. There is approvals from the ULs of the world, takes time. Well, we’re happy to say that we’re almost done. We’re about seven months into this journey and probably by the end of this quarter, we’re in the March quarter now.

We’re going to start utilizing these other €“ these new sources. These new sources will be the same cost that we were used to before we had to start buying these parts from brokers. Now we are going to still use TI. It’s not like we’re going to give up on them. But they can’t keep up with us. They can’t keep up with anyone actually. They’re having trouble with everybody. But we’ll use them, if they can deliver. We’ll use the new source when they can when we can get from them. We don’t anticipate any trouble from the new source and that should return margins to more normalized levels that we were used to before the COVID and the supply chain hit. Now we do have a lot of inventory at the higher price, higher priced inventory, the inventory that we’ve been buying from these brokers.