Napco Security Technologies, Inc. (NSSC) Q1 2013 Earnings Report, Transcript and Summary

Greetings, ladies and gentlemen, and welcome to the NAPCO Security Technologies Incorporated First Quarter Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, James Carbonara of Hayden Investor Relations. Thank you. Mr. Carbonara, you may begin.

Good morning, and thank you all for joining us for today's conference call to discuss NAPCO's financial results for the first quarter ended September 30, 2012. By now, all of you should have had the opportunity to review the press release discussing the results. If you have not, please call Hayden IR at (646) 419-4300, and we will immediately send it to you either by fax or email. On the call today is Richard Soloway, Chairman and Chief Executive Officer of NAPCO Security Technologies; and Kevin Buchel, Senior VP of Operations and Finance. Before I ask our host, Dick Soloway, CEO of NAPCO, to discuss the particulars of this morning's news, let me take a moment to read the forward-looking statement. This conference call may contain certain forward-looking statements that involve numerous risks and uncertainties. Actual results, performance or achievements could differ materially from those anticipated in such forward-looking statements as a result of certain factors, including those set forth in the company's filings with the Securities and Exchange Commission. With that out of the way, let me turn the discussion over to Richard Soloway, President and Chief Executive Officer of NAPCO Security Technologies. Dick, please proceed.

Thanks, James. Good morning, everyone. Thank you for joining NAPCO's quarterly conference call to discuss the financial results for the 3 months ending September 30, 2012. For the last several quarters, we have been discussing strategic initiatives key to our long-term growth and profitability. We made solid progress against these goals, driving new product development, increasing our presence in the high-margin commercial security sector, expanding our base of recurring revenues, increasing our gross margin and reducing our debt load. However, this strategic and tactical progress was impacted by some inventory rebalancing by a few customers in one division. As a result of this inventory rebalancing, sales were down 6% to $15,200,000 compared to $16,200,000 in the prior year quarter. However, we get sales reports from many of these customers. These reports indicate that demand and sell-through for our products is up. Just as importantly, our Marks Division is growing again, and our high-margin commercial lock and recurring revenue products contributed to increased gross margins of 27.2%. In the coming quarters, customers that lowered their inventories are expected to increase orders to meet the increased demand and sell-through that the aforementioned reports are indicating. Combined with the growing Marks division and solid sales of commercial locking and recurring revenue products, we expect fiscal 2013 to be better than last year, both in terms of top line revenue and higher profitability. The reason Marks is growing again after bottoming out in Q4 is due to the success of a number of changes we made to the Marks Division. The changes include expansion of the product line and increasing the sales force as well. Specifically, we added more sales reps and modified the way products are being engineered by changing the structure of the engineering in Marks to deliver more products quicker. Rapid new product introductions are important for locking distribution and for the contract hardware business. Additionally, we made a substantial push into anti-ligature ADA commercial locks to create the most advanced line of that product, and we expect the rollout to be by calendar year end. This is a big growth area for Marks and a new area in a market segment that now requires the use of ADA locks in hospitals, prisons, detention rooms and the like. To further support Marks going forward as well as our high-margin commercial products, we made a heavy investment in a trade show during the first quarter. As a result, SG&A increased by $237,000. The sales increases as a result of attending the show were not instantaneously felt in Q1 but created a pipeline of potential new business for the coming quarters. Turning to new products in other divisions, we are seeing substantial market penetration from the point of view of dealer education and trial. Also, many companies that did the trial aspects are slowly but surely installing them on more and more jobs. These new products include our iSeeVideo as well as Starlink 2 radios, the latter of which was launched less than 1 year ago. These exciting and innovative products are already generating a lot of volume and a high-margin recurring revenue. We expect to reach peak sales in approximately 18 to 24 months for these products. However, they are already starting to have a positive impact on margins. The award-winning GEM-C combo product that we sell for commercial fires is also relatively a new product. The margins on this product are excellent. But we have thus far been disappointed in the volume of sales, so we made a strategic move. We recruited a seasoned fire product manager, an executive especially experienced in the fire industry. In the past, we left the sales of this product to our general security sales group. Now we have a dedicated fire product manager to beat the drum commissioned to drive the sales of the GEM-C and to get it back on track to reach its multimillion dollar sales potential. Our network radio control systems for schools and institutions is a leader in a field that is in its infancy stage, locking professionals that are typically not versed in how to use radio-controlled locks. So there's training and education involved. Hence, the investment for the Q1 trade show. With the introduction of Fusion 2.9 software, we have high hopes that this integration will be an important factor in our growth. Fusion blends into network locks and is a good fit because Networx is expansive. Networx includes access control, hardwire and wireless locking, wireless and hardwire intrusion alarms and fire all rolled into one platform. So learning it all in detail is an education process that is going to take some time. NAPCO is the only company that manufactures its own locking, intrusion, fire and access control products across one platform. This gives us a big advantage in the security marketplace. Fusion also incorporates our Continental Access Control products, which are very high end and profitable. Adding the Fusion 2.9 software puts the Continental Access line in a new league with radio-controlled locks and also works well with fire. The Fusion reboot, after listening to the marketplace to learn the additional features it needed, is great for our medium and long-term plans. We expect it to be very profitable. And finally, there is the iBridge platform, and we are particularly excited about this. Based on market reaction, it really seems to be a winner. We showed it to our largest accounts, and they love it. At this point, we just need to finish the software, which will be by the end of this calendar year. iBridge remote services utilizes advanced Z-Wave technology that allows consumers to control their thermostats, lighting and home entry locks from any Internet-enabled device. This product, a Product of the Year winner, provides a recurring revenue and also helps to cross-sell iSeeVideo, boosting sales of our video monitoring recurring revenue product. I'd now like to turn the call over to Kevin to briefly review financial details of the financial results. Kevin?

Thank you, Dick. Good morning, everybody. Thanks for joining the call. As Dick mentioned, sales for the 3 months ended September 30, 2012, decreased by 6% to $15.2 million as compared to $16.2 million for the same period a year ago. The decrease in sales for the 3 months was primarily due to decreased sales in the company's intrusion products, and partially offset by an increase in the company's door-locking products. The decrease in sales of intrusion products was due primarily to a few intrusion customers reducing their inventory levels. For the quarter, gross margins increased to 27.2% as compared to 25.6% a year ago despite $1 million less in revenue year-over-year. The increase in gross margin for the quarter was primarily due to increased sales from higher-margin commercial locking and recurring revenue products. Gross profit for the quarter remained relatively constant at $4,136,000 as compared to $4,156,000 last year. Selling, general and administrative expenses for the quarter increased by $237,000 to $4.5 million or 29.8% of sales as compared to $4.3 million or 26.5% of sales a year ago. The increase in SG&A expenses for the quarter was due primarily to increased trade show expenditures and additional sales staff. Operating income for the quarter decreased by $257,000 to an operating loss of $399,000 as compared to a loss of $142,000 for the same period a year ago. Net interest for the quarter decreased by $127,000, or 42%, to $177,000 as compared to $304,000 for the same period a year ago. The decrease in interest expense for the first quarter resulted from lower interest rates charged by our bank as well as lower outstanding debt in the current period. Net loss increased by $267,000 to a loss of $434,000 or minus $0.02 per diluted share for the quarter as compared to a loss of $167,000 or a loss of $0.01 per diluted share for the same period a year ago. The change for the 3 months ended September 30, 2012, was primarily due to the items previously described as well as a reduction in the benefit for income taxes of $148,000. With a lot of noncash and one-time expenses as well as our interest expense, our adjusted EBITDA as per the schedule included in this morning's release decreased $319,000, or 79%, to $85,000 as compared to $404,000 for the same period a year ago. Cash generated by operating activities increased 100% to $1.6 million compared to $800,000 for the first quarter last year. Debt, net of cash, has been reduced by $20.1 million from $35.9 million to $15.8 million since acquiring Marks in August of 2008. $2.2 million of debt reduction occurred in the 3 months ended September 30, 2012. Debt repayment in Q1 increased 144% compared to repayment for the same period in the prior year, which was $900,000. That concludes my formal remarks. I'd now like to return the call back to Dick.

Thanks, Kevin. We did not plan to see a 6% decrease in revenue this quarter, but inventory tightening happens periodically among a small cross-section of customers in a single division. This happened in NAPCO in the past, and in subsequent quarters it comes back. Importantly, demand and sell-through are up, and we expect sales to normalize and be up for the year. We look to the distributors as our local inventory shows, but the dealers are our vitality, and we can say confidently that they remain strong. The 2 major strategic initiatives of increasing our presence in the high-margin commercial security sector and the aggressive marketing of our increasing number of SaaS-based, recurring revenue-generating product lines are progressing nicely. Gross margins were higher, even with $1 million less in revenue, demonstrating that we are making progress in achieving these goals. It proves that the positive changes implemented to our product mix in the direction of higher-margin offerings are taking shape. From our perspective, while the inventory rebalancing results in a down quarter, we believe this is temporary, and we remain confident we will deliver higher revenues and profits for the full year compared to last year. The vital signs are positive for the business, especially the recurring revenue product category. With Marks' sales increasing, commercial locking solid and increasing demand and sell-through in the intrusion division, we look forward to a robust, profitable fiscal 2013. That concludes our formal remarks. Kevin and I would like to open the call for any questions. Operator, please proceed.

[Operator Instructions] Our first question comes from Mark Jordan with Noble Financial.

Question for Kevin. It's nice to see inventories' trend climb down even despite the fact that the revenue -- although revenues were below your expectations for the quarter. Could you outline what you feel will be the goals for inventory levels as you move through the year?

Well, the inventory usually goes up in the early quarters because we're building throughout the year and then we have that -- the big finish to the fiscal year, the big -- especially the big fourth quarter. So we have been aggressively trying to reduce the inventory at all points of time. And as you saw from the numbers, we did a good job, especially compared to last year. We were almost $3 million to $4 million below last year's level at this time, which helps us generate nice cash flow, pay down the debt rapidly. That's our goal. So we expect to reduce the inventory by several more million throughout this year. We still have not hit the bottom on that. We have room to reduce further, which again will allow us to hit that debt level even lower. Debt net of cash is -- it was $15 million. We're getting close to going below $10 million. That, to me, is a major point, and I hope we can get there by the end of the year. And with a few more million dollars lopped off in the inventory level, we can do that.

Again, as you alluded to, you think that's a good goal for you for year end, is to have that net debt down to $10 million?

I think if we can get below $10 million, that would be a good goal.

Okay. Final question. You alluded to the higher trade show expenses and about $0.25 million you spent. I believe you mentioned that that was a Networx lock show. Could you talk about what show that was? I take it this was a new one for you. And how are you going to track the relative success of that expenditure?

There are 2 shows that are very important to us. And the show with the high commercial products and radio-controlled and access control type of products is called the ASIS show, A-S-I-S, American Society of Industrial Security. At that show, we wanted to show our 2.8 -- 2.9 Fusion, our wireless locks and all the other commercial type of products, including the GEM-C. So it's once a year, and we wanted to have quite a dramatic show. So that was very important for us. The other show that we wanted to use the same equipment for as far as trade show booth and setup is the National Burglar and Fire Alarm show, which will be also once a year, the national show, and that's in Las Vegas. So we're getting all of our displays, our literature, our technology and everything mounted and showing, and bringing in our salespeople also to the trade show so everybody can see everything together as a group and then have questions and answers. So it becomes an expense, but an expense that is very important because all of this is about educating not only our dealers but our sales groups and getting trials from our dealers. And the gestation period, as we said, takes a few years, but it reaps benefits for years and years and years. And now that everything is ready, we've put a lot of money into the software and to the hardware. It was a good time to show everything.

Our next question comes from Michael Epstein with Northeast Securities.

Dislocated but I'm in someone's office. And let me just say, isn't historically the first quarter, like, your low quarter as far as sales and earning's concerned?

Traditionally, it's always been the lowest quarter. And then it fills sequentially through to the fourth, which is our strongest quarter, ending June 30.

Okay. Just I see that you have almost miniscule foreign sales. I assume that's Canada or in Mexico and other places. Have you addressed that or thought about spending some effort there?

We used to spend a lot of development time and sales time with a crew of salespeople in Europe. But what's happened is there's been a lot of blockage of U.S. products in the various countries overseas. They put in regulations for each individual country. Each country has like their own UL good housekeeping standards. So the products are not really volume enough to go through all the testing and flying people in from these countries to visit our factory and all the other rigmarole that we have to go through. So we've been focusing more on domestic and also countries that use U.S. specifications rather than to get into the European specifications, which is a big marketplace. So our sales have dropped over the years to about 5% from where they were, about 10% at one time. So we figured it's better. It's a big market here. We've got lots of new products. We will go where we can go with the least amount of spending millions of dollars on getting certifications in these countries.

Got you. Okay just to be redundant and repetitious, what do you have coming on stream between now and year end? And just review some of the new products, so I'd really understand what you're referring to there.

Okay. So we have new products called Fusion. Fusion is a software that we've developed that ties together each of our 4 divisions' products on 1 technology bus. So a dealer can get all of his intrusion, his fire, his enterprise-class access control, his hardwire and wireless locking all from us without having to mix different brands together to try to get a simulated, full-turnkey security package. And we're unique. We're the only company that has these 4 different brands and different product lines, and now we're able to fuse them together into 2.9. And that's going to be very exciting. Because we'll be a one-stop shop, we'll be able to answer all technical questions in one place. We also have our recurring revenue radio, which is Starlink 2, which replaces dial-up phones for commercial and residential accounts where we charge the alarm company a fee to utilize our network. And the future is more radio, less dial-up. Even people that have dial-up now, they can switch over and start using our radios and save money. And the dealers are installing our radios. Radios came out at the end of '11 and have been a very nice success. We have thousands and thousands of radios out there, and each radio generates between $5 and $8, as an example, of recurring revenue to the company per month. So the more of these radios we can get out there, the better it is. As the households retool themselves and go without dial-up, they're going to need radio because it's the only way to communicate through a central office to call for emergencies. And then the iBridge is Starlink radio, I would say, on steroids because iBridge now brings radio, brings video, brings intrusion, brings locking all together so the consumer now can operate his system remotely wherever it is, controlling the locks, can have light, seams, control everything, its temperature and heating within a household, sees video. And everything could be done with radio. And that's going to be a very important product for the younger generations that want to have more smartphone control of their lock systems. So that's a very exciting product. GEM-C, which is our commercial fire line, which is a fabulous line but it's been a disappointment as far as its sales because it's a multi, multimillion dollar product line because buildings have to have commercial fire to get a certificate of occupancy. That has -- the product technologically works very, very well, but it's lost in the existing sales organization because it takes a lot of time to train the dealers, to get them to do trial and things like that. So we decided strategically, we want to get a fire product manager who lives and breathes fire his entire career and knows everybody, and make him the bandleader in moving commercial GEM-C into the dealers and make it an important contributor to their installations. And that person is coming on board this month. So that's a new area for us with having product management and a bandleader leading it. So he'll make sure that its commissioned right with all the people, that all the specs are set up, everybody is very focused on it and he'll be a leader of this. So that's exciting. So we have a lot of things going on.

And all these, they should be in -- by the end of this year, you think that'll be in the marketplace?

They'll be introduced to the marketplace and then there's trial. And it's education and trial, part of what we did with the trade shows. And we would expect to build upon our existing base of products all these new incremental products, which should drive us to our highest numbers we've seen. And as we said, it's kind of a logarithmic kind of progression. You have to get the education, the trial, they have to adopt it, use it more and more. And it'd be very helpful if the building business comes back and household spending grows because then more and more of this stuff is going to be needed. But with what's going on in the world today, even the way things are going now without great amounts of building, both commercial and residential people are very, very security conscious and need more protection because it's -- times are tougher around there, and security is a way to prevent tragedy.

[Operator Instructions] Our next question comes from Peter Stone [ph] with Broad Street Capital.

In light of a lower-than-expected Q1, how much better do you think this fiscal year can be compared to last at the top and bottom line and why?

Peter, we have certain things that are going in our favor. And the only thing that seems to have been -- gone against us this quarter was an inventory level. An inventory level would bother me more if I didn't see sell-through strong. So if sell-through is strong and inventory levels -- eventually, they're going to have to be replenished because the sell-through is going to demand it. Then that one problem should clear itself out. Combine that with the new products that are doing better, the radio product that's doing better -- and it's fairly new -- the iSeeVideo product that's doing better, the strength of the locking products. That makes us believe that top line should be stronger than last year. If top line is stronger than last year, so we know the bottom is going to be stronger because the higher we can get to the top, I think the margins will expand. We even had margin expansion this quarter even with lower top line revenue. And that's the power of the mix and the power of the recurring revenue. We also have the benefit of interest expense coming down. We renegotiated the deal with our bank, HSBC, at the end of June, this past June, which meant that for a full fiscal year, all of fiscal 2013, we're going to have lower interest cost. The debt level's coming down as well. That's worth a lot to the bottom line. So those are the reasons why we're optimistic. We look at Q1 as a very small part of what we expect this year to be. As the year develops, we think the year will get stronger. We know it always does. Q2 is always better than 1, and 3 is usually as good as or better than 2 and then 4 is the big finish. So for us, there's no reason for us not to still feel optimistic as we head to the conclusion now of Q2.

Our next question comes from Rich Molinsky with Max Communications.

And do you say that you're going to bring the debt down, you believe, below $10 million from the Marks acquisition? That'd be tremendous. Maybe I missed this part of it. From the hurricane, how much of business do you see coming from that because of the homes -- needing to fix up these homes and put back new locks or whatever? What kind of demand are you seeing from that? I might have missed it from the beginning of the call?

Well, we can -- Rich, we can go by history before. Remember that hurricane that was in Louisiana?

Sure, I know. Yes.

Right, right. And that, it took about 9 months or so for the demand by the local security dealers, locking dealers and access control and intrusion fire dealers, before they saw enough work and before we start to feel the pull-through of inventory. So this is a bad one here, and I would say it's probably going to -- by the time everybody gets together, it's probably going to be the same type of period of time. Immediately, now, people have to get some type of security repairs. But the big systems, redoing the systems, all the wiring and everything that got all full of salt water, that's all going to have to be redone all along the coastline. It's pretty rough around here.

Yes, I understand. So you'd expect that within next 9 months or so on the part?

Right.

All right. And with -- last questions. With the hotel business, how do you find that business coming along for you right now at this point in time? With the new ideas you have, with the fingerprints, with the new technologies, what kind of results do you see happening and demand you see from just the hotel side?

Well, we don't make hotel locks per se. Like a lot of the hotels, we make these heavy duty locks, which, for instance, in Las Vegas, they protect the cash rooms and a lot of that. The room locks, we don't manufacture. That's a lower-end type of lock line. But more and more universities want to have radio-controlled, heavy-duty locks on their dormitory doors and other areas, classrooms and laboratories. And we do very nice job with schools and universities on that, such that they don't have to go to the individual doors anymore. Everything is controlled by our Networx locks. And now we're going to -- with Fusion 2.9, it expands out our reach to schools, universities and even hotels because of the fact that now the fire system, the intrusion system can now be hooked, the access control. And it's radio-controlled, so they could wire up these places very quickly and get full service like you used to have to do with hardwire. Now you can get with our wireless locks. And 2.9 software is part of that. And we expect that to have many, many years of life and to be a very important factor and allow each of the sales teams of each of our 4 divisions to cross-sell and recommend to others sales teams to install -- other dealers install the products. So we have one integrated network, one question-and-answer place to come, the NAPCO technologies company. And we can do a lot of business that way. So we think 2.9 is very important.

Our next question comes from William Bremer with Maxim Group.

How was the pricing environment? You haven't alluded to that right now. Do you have any type of pricing power with some of your premiere products at this point? Or are you more in essence a price taker in the marketplace?

Pricing doesn't seem to be an issue with us, a strategic -- a severe issue with us. We have had over the last 2 years increases in metals and things like that, and we've had price increases to cover our costs. But since the technology is such that it's unique, it's -- we don't really see a lot of pricing pressures. We don't want to outprice ourselves and go carte blanche with the prices because we want to make it a very attractive offering as a competitive substitute for other products because we want to get that trial by the dealers and integrators. So that's how we're looking at pricing.

There are no further questions in queue at this time. I would like to turn the call back over to Mr. Soloway for closing comments.

Okay. Thank you, everyone, for participating in today's conference call. As always, should you have any additional questions, please feel free to call Hayden IR, Don Weinberger of Wolfe Axelrod, Kevin or myself. We thank you for your interest and support and look forward to speaking to all of you again in a couple of months to discuss NAPCO's second quarter results of fiscal 2013. Thank you and bye-bye.

This concludes today's teleconference. You may now disconnect your lines at this time, and thank you for your participation.