Napco Security Technologies, Inc. (NSSC) Q2 2017 Earnings Report, Transcript and Summary

Greetings, and welcome to the NAPCO Security Technologies Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Patrick McKillop, Director of Investor Relations. Thank you, sir. You may begin.

Hello. Good morning. My name is Patrick McKillop from the Director of Investor Relations here at NAPCO Security. Thank you all for joining us on today’s conference call to discuss our financial results for our fiscal second quarter 2017. 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 Web site, napcosecurity.com. On the call today is Richard Soloway, President and CEO of NAPCO Security Technologies and Kevin Buchel, Senior Vice President and CFO. Before we begin, let me take a moment to read the forward-looking statement. This conference call may contain forward-looking statements that involve numerous risks and uncertainties. Actual results, performance or achievements may 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 SEC. During the call, we may also present certain non-GAAP financial measures such as adjusted EBITDA and certain ratios that are used with these measures. In the press release and on the other financial tables issued earlier today, you’ll find the definition of these non-GAAP financial measures, a reconciliation of these non-GAAP financial measures with the closest GAAP financial measure, as well as a discussion about why we think these non-GAAP financial measures are relevant to our results. These financial measures are included for the benefit of investors and should not be considered instead of GAAP measures. 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.

Thank you, Patrick. Good morning, everyone. Welcome to the call, and thank you for your interest in NAPCO. It's pleasure for me to be here with you today to discuss our results. The second quarter marked another quarter of record revenue performance for NAPCO. The second quarter sales were $20.7 million. While the sales for the quarter was modest it is important to note that sales were once again above the $20 million mark. We have stated many meetings before the $20 million mark is where we begin to see significant expansion and our margin performance as incremental sales are leveraged over our fixed cost structure. As we have discussed previously, our SG&A and R&D spend were higher. We are focused on the future, and had we not incurred the highest spend, our operating income would have been approximately 50% increase over last year. Recurring revenue continues to grow at a solid pace, up 68% year-over-year. We are now rapidly approaching the 10% of total sales mark with this revenue line. We love recurring revenue as it provides greater margin contribution, as well as greater consistency and predictability in our financial result. Growth in alarm communications, the Internet of Things and improving school security and safety, are the key industry trends that continues to impact our results favorably. We expect our business strategies will continue to take advantage of these trends and drive growth, profitability and shareholder returns going forward. Before I go into greater detail, I would like now to turn the call over to our CFO, Kevin Buchel. He will provide an overview of our financial results and then I'll be back with more on our strategies and outlook. Kevin?

Thank you, Dick and good morning everybody. For the second quarter, net sales were $20.7 million, a record second quarter performance as compared to $20.5 million last year. For the six months, net sales increased 6% to $40.9 million. The increase in sales for the second quarter was primarily related to increased sales of our intrusion products, as well as growth of our recurring revenue, as partially offset by increased sales of door locking products. Door locking products were impacted by some locking distributors deploying an inventory reduction year-end strategy. However, we continue to sell-through data with such distributors, and it indicates increased vitality in their businesses. And thus, we expect a return to normal purchasing habits in the upcoming quarters. The increase in sales for the six months was due to increased sales of our intrusion products, increased recurring revenue, as well as increased sales of our door locking products. Recurring monthly revenue from the alarm division increased 68% for the quarter, 66% for the six months and sequentially the increase was 14%. Gross margin for the second quarter was 31.9% of sales, which was a 160 basis-points improvement versus the second quarter last year. Gross margin for the six months was 32%, which was 140 basis-points improvement versus the six months last year. The margin improvement for both the three and six months was directly related to the operating leverage in our business model and was due in part to increased production levels during the quarter, which resulted in increased overhead absorption, as well as increased recurring revenue, as partially offset by an increased investment in R&D to support the launch of new products and services. We’ve also been investing in sales and marketing to support our portfolio of new products. This incremental investment was one of the primary drivers of the increase in SG&A costs during quarter. SG&A costs for Q2 increased 7.2% year-over-year to $5.6 million, and as a percentage of sales, increased to 26.8% from 25.3% last year. For the six months, SG&A increased 7.6% to $11.2 million, and as a percentage of sales, increased to 27.6% from 27.2% last year. The increase in dollars for the three and six months was due primarily from increased advertising and the addition of selling personnel. The increase, as a percentage of sales for the three and six months, is due primarily to the increase in expenses being proportionately greater than the increase in sales. Operating income for the second quarter increased 4% to $1.1 million as compared to $1 million last year. For the six months, operating income increased 33% to $1.8 million compared to $1.3 million last year. Income before taxes for the quarter increased 7% to $1,046,000 compared to $978,000 for the comparable period last year. For the six months, income before taxes increased 39% to $1.7 million compared to $1.2 million for the six months last year. During the second quarter, net income decreased by approximately 12% to $857,000 or $0.05 per diluted share as compared to $986,000 or $0.05 per diluted share last year. For the six months, net income increased 10% to $1.4 million or $0.08 per diluted share as compared to $1.3 million or $0.07 per diluted share for the same period a year ago. The decrease in net income for the quarter was due to an additional $187,000 tax provision this year compared to last year, which was primarily due to higher R&D tax credit last year. The increase in net income for the six months was primarily due to increased sales and higher margins this year versus last year. Adjusted EBITDA for the quarter, as outlined in the schedule included in today's press release, increased approximately 2% to $1.5 million or $0.08 per diluted share compared to $1.4 million or $0.08 per diluted share last year. For the six months, adjusted EBITDA increased 19% to $2.5 million or $0.13 per diluted share as compared to $2.1 million or $0.11 per diluted share last year. Moving on to cash flows and the balance sheet, we generated $1,041,000 in operating cash flow during the second quarter versus $1,207,000 during the same period last year. For the six months, operating cash flow amounted to $3 million as compared to $3.3 million a year ago. Our working capital at December 31, 2016 was $35.3 million with a current ratio of 4.9:1. During the quarter, we repaid $1,575,000 of our debt, which ended the quarter at $2.35 million and our net debt position remains at zero. CapEx was $446,000 during the quarter, which was higher than last year and higher than what we normally incur. As we stated in our Q1 '17 quote, CapEx this year will likely be slightly above the higher-end of our normal spending range, which is $500,000 to $750,000, as we're making a relatively small incremental investment in our Amityville facility to expand our shipping and warehouse capacity. I would again note that our production facility in the DR has plenty of room to expand before we would need to make an additional investment there. The cash balance at December 31, 2016 was $3.8 million. We expect to generate significant cash this year. And by the end of the fiscal year, our cash balance should significantly exceed whatever debt remains. That concludes my formal remarks. And I would now like to return the call back to Dick.

Thank you, Kevin. Our business continues to be driven by the two key paradigm shifts that are positively affecting our industry; first, is the significant growth in alarm communications and the Internet of Things; and second, is the significant amount of attention and new spending related to improving school security and safety. Alarms, locks and access control, are one of the first and fastest growing set of devices and system to show great benefit from connecting to the cellular networks and the Internet. As a result, there are opportunities for NAPCO to take market share while upgrading the installed base of existing technologies, as well as benefit from accelerated end-market growth as customers realize the benefits of connecting these devices and systems to these networks. To take advantage of this paradigm shift, our strategies are focused on introducing new and innovative products and services that are compelling for the end-user, as well as products and services that help our dealers grow and succeed. During the unbecoming International Security Conference called ISC West trade show, the largest in our industry, we will be unveiling new products that will add to our already existing portfolio. These new items will give dealers even more of what they want and need. One example is CA4K, which is our updated software program for Continental Access customers with new features that add more capabilities for the integrator and the end user. One of the unique features of CA4K is the ability for real-time screening against regional and governmental data bases to pre-screen for potential threats. The update also allows for easy integration with older systems made by our competitors that are currently in store. Another exciting product is our new dual path fire radio, which addresses the need in certain markets where it is required for both a cellular and Internet signal to be sent to the central station. This should expand the fire communicator business nationwide and generate more recurring revenue. In the locking side of the business, we will be unveiling our new iLock app, which works with Alarm Lock and Marks Locks that are already used in many schools, universities and high-rise buildings, and allows for control from a smartphone to lock and unlock the door. This is a strong enhancement to the school security product line. These are just a few examples, and there will be many other new products to see during the show. The ISC West show takes place in Las Vegas, and we expect 30,000 plus dealers, integrators and security professionals to be there. Please let us know if you are attending or if you would like to as we would love to have you visit our booth during this exciting show. Last quarter, we unveil our wireless Internet of Things cellular communicator, the StarLink Connect controller. The first beta shipments have already gone out to dealers, and we expect full commercial launch next month. The StarLink Connect replaces the need for traditional phone lines in order to send the alarm signal to the central station. In addition, the StarLink Connect can be used in tandem with our iBridge smartphone, tablet app, which gives customers control of lighting, climate, door lock and remote video viewing. It is important to understand that in addition to being a compelling and value proposition to the end-user, the StarLink Connect also expands the addressable market, not just to our own alarm systems but also to the tens of millions of already installed alarm systems from other providers. StarLink and iBridge products will have a positive impact on our recurring revenues streams, which is important driver for growth and profitability for us, as well as our channel partners. Moving onto a discussion of the other major paradigm shift that is driving our business, the growth of security and safety in school. It is unfortunate that we continue to hear hot firing news about school shootings. Most recently we heard about events at Ohio State University. Report issued earlier this year by the Citizens Crime Commission of New York City analyze the college gun violence epidemic and found out there was 153% increase in shootings from 2002 to 2006 versus 2012 to 2016 period. Also the number of casualties during the same time period increased a whapping 241%. As both K through 12 and universities across the U.S. increasing to look to protect students’ faculty and administrators, we continue to see growing market demand for our diverse suite of products that fit every budget, whether it is K through 12 or a large university. This is important as budgets of schools vary, and we have the ability to cater to all, whereas some competitors do not. Activity is up for our school security vertical. We continue to announce some wins with schools and we mentioned one of this in this morning's press release where our Continental Access division was chosen by the Northeast Independent School District of San Antonio to install its keyless access control system. There will be more announcements forthcoming as our pipeline of opportunity continues to grow. We will open the call for questions in a moment, but first I would like to summarize. I want to state how pleased we are with the direction of the Company. We are seeing strong interest in many of our recently released products, and based on anticipated demand, as previously mentioned, we have increased our investment in sales and marketing expenditures, as well as R&D. We believe that the current spend level is appropriate and we expect to see a nice positive impact on future sales. With the right strategies in place to take advantage of the paradigm shifts that are positively affecting our industry, we are well positioned to grow, and our sales and continues to generate significant increases in our profitability. This concludes our formal remarks. Kevin and I would now like to open the call for questions. Operator, please proceed.

Thank you. We will now be conducting the question-and-answer session [Operator Instructions] Thank you. Our first question comes from the line of Gary Mobley with The Benchmark Company. Please proceed with your question.

I just had one question I think probably some questions as well. Just want to get a sense of the inventory reduction that took place in the channels that relates to the Marks USA door lock. Perhaps you can share with us the percentage of revenue derived from that specific product, and then as well how the sell-through comparison out of the channel make compared to the sale in-channel, just to give us a sense of how the end market continue to grow versus what you experienced, is your sell-out for the quarter?

Gary, the reduction was not necessarily with the market, it was lacking distributors, so it was a bunch of different ones. What we do is when we see something like that, we always compare to our sell-through data. We get sell-through data from the distributors every month, and when we see that the direction is going up, that’s what really makes us happy. And so much for the reduction of inventory, it doesn’t matter in the long-run. We can’t tell what these guys are going to do with their inventory levels, but when sell-through is up, they have to come back. And we’ve seen this before at year-end, especially calendar year end, every now and then some of these guys do this. As long as the sell-through data is increasing, and we saw nice increases, different guys had different percentage increase, double-digit increases. As long as we see that, then, though in the long-term, we’re going in the right direction. So, we’re not that concerned about this. This is, to me, a temporary thing and for those who follow us, they’ve seen this periodically before.

Thank you.

Our customer base goes to the distribution, and they pick up the products they need for the different job. So, we watch to see that they’re pulling it out of the distributor, which shrinks the distributor’s inventory. And we would expect that as long as the distributors satisfy these dealers and integrate it, they’re going to have to raise their inventory level. So they don’t have any stock-out. And we’re working out on that right now with them. So, as Kevin mentioned, we believe it’s a temporary situation because the vitality is still very good.

Our next question comes from the line of [indiscernible] with The Benchmark Company. Please proceed with your question.

First, as it relates to the balance of the fiscal year in your OpEx, how should we look at that taking in consideration your seasonality of the business, but also your U.S. product line in the StarLink family?

We just finished Q2, and as the year progresses, our quarters get stronger, especially off fourth quarter. So, our operating expenses should stay in a similar level to what you’ve seen in the first two quarters. We expect that to be similar in Q3 and Q4. We’re not raising operating expense levels for the rest of the year. The only thing that could change on the SG&A line is as sales growth and we expect much higher sales in the upcoming quarters, especially the fourth, you’ll see higher commissions and higher freight. And so the SG&A might be higher than the run rate you’ve seen in that fourth quarter. But with a much higher sales level, it will be clearly able to support that.

And then going back to the StarLink final product, specifically the white box, that’s your newest product. Can you give us a sense of -- or your assessment of what -- when it should become more meaningful contributor to the recurring revenue stream?

The StarLink connect, which has created a lot of excitement, the datas were put out over the last few months and we expect to mainstream it, meaning that our distributors will have it and the dealers that are clamoring for it will get it. We wanted to make sure that it was a flawless product, it has tremendous lengths to it, because it updates alarm systems that are out there and there is millions of millions of them. And there it could be used for new work on new jobs also. So in March, we’re going to be mainstreaming the production. And it should be a nice contributor all year along, and we expect it to grow. It's very unique. There’s nothing like it. And it modernizes millions of alarm systems, and the dealers are going to love it, because of the fact that make recurring revenue on monitoring the alarms using it, and also up-selling Internet of Things to the consumers and users.

And could you just comment real quick on how does it compares with the other generation with the StarLink products?

Well, we have StarLink. The basic StarLink radio is cellular radio used for small business and residential. Then we have the StarLink connect, which is that, plus Internet of Things using apps and the smartphone that also can be uploaded and downloaded to competitors’ alarm panels when it’s put and sold on competitors’ alarm systems of which I say there’s tens of millions of them that are out there, so that expanded two-in-one capability. Then we have fire radios, which are very, very unique. Fire radios -- traditional fire radios, which replace two phone lines and we’ve come out with our new fire radio, which is Internet, as well as cellular built-in, to certain jurisdictions like New York City and California. The city wants dual functionality, two different technologies and that we just got through UL about two weeks ago. So, that is going to be very important in the major cities where the municipalities want that functionality. So, we have a very, very wide range of recurring revenue generating products, and also there will be the amount of hardware sales along with the recurring revenue of those radios.

[Operator Instructions] Our next question comes from the line of Beth Lilly with GAMCO. Please proceed with your question.

So, I just wanted to drill down a little bit, congratulations on the growth in the quarter in terms of the recurring revenue piece. But I wanted to just drill down and better understand in terms of the core products revenue, what went on in the quarter. And then Kevin alluded, and Dick you’ve alluded to also to growth as the year progress. So, can you just give some better granularity into the flat growth in the quarter on the product side?

Beth, what we saw this quarter is on the intrusion side, tremendous growth. Obviously, from the recurring revenue, but the recurring revenue is driving that whole division. And it's doing really well across the board, not just on the recurring, which is part of that division. So, we have that part. On the locking side, we’ve had, quarter-after-quarter after quarter, tremendous growth. This quarter, it was a little different. We saw certain distributors lower their inventory levels, but as we mentioned, and yet we saw sell-through grew up, going up. Why is that happening? Certain guys told us they like to keep their inventory levels down to their year-end calendar 12/31 year-end, simple strategy like that. For us, as long as the sell-through is up, we expect the locking part to do what it's been doing quarter-after-quarter after quarter. It's really been the intrusion division that hasn’t been doing as well as the locking. But now, that’s doing tremendous. And so, when locking comes back, and we expect it to come back, you’re going to see the type of growth numbers that we’ve been talking about. It's still our expectation that sales on manufacturing, that counting recurring, is going to get to the $100 million in the next couple of years. We still standby that. That’s our guess of what's going to happen. We maybe off by a couple of quarters here or there. But there is no reason to believe that that’s not going to happen. As we get school wins also that also helps the locking division. And we announced one today in the San Antonia win those type of wins that also propels locking. And then on the access side, the access side is going get buoyed by this new product that Dick mentioned in the prepared remarks. Continental software that’s coming out is going to be a big boom to that division, and we expect that to happen. That product being introduced at the show and that’s probably going to happen later on in the fiscal year, but then you’ll that piece strong too. That’s why we feel that all divisions are going to be performing well, while we still believe in the $100 million manufacturing revenue in a couple of years.

And then you’ve talked as you reach that $100 million on the manufacturing side, you’ve talked about $10 million reoccurring revenue piece. Is that still where you forecast that?

Well, what we said in the remarks here today is we’re getting closer and closer to being 10% of our overall revenue, so a trailing 12 revenue is what about $85 million so we’re getting close. So we think that’s going to be couple years too. My hunch is that will be much sooner, the $10 million.

Our next question comes from the line of Chris Hillary with Roubaix Capital. Please proceed with your question.

I just wanted to ask if you can share any comments just on the margins within the core manufacturing business and other certain areas where you see greater contribution margins than others.

Well, obviously the recurring has the best margin, that’s virtually all profit. So that’s got the higher margin. And then within the rest of the division, access control products have the highest margins. Just typically without getting into specific orders that we received, because every order could be different. That’s more likes a 50% GP. Locking tends to be 40% and intrusion, without regards to recurring, is more like 25% to 30% margin. And that’s the blend. And in any given quarter, it could move around. But what really helps the margin more than any of that is the utilization of the Dominican facility. When that factory is coming, we have overhead absorption in gross margin expansion. And anytime we go over the $20 million mark in a given quarter, we’d start to see that. The higher-up over $20 million we go, the higher the GP goes on all of the pieces of the business, because you get that overhead absorption gross margin expansion. Like in the fourth quarter, the June quarter when the sales was $24 million, the overall GP for that quarter was 40%. So, that’s the biggest helper besides recurring revenue for the GP. So, we want to be over $20 million every quarter. This quarter, while the sales increase wasn’t what we like, we were happy that it was over $20 million, $20.7 million, you start to see that leverage moving in, that’s the biggest thing that we look for every quarter.

And then maybe just one more kind of general question, we’ve seen a lot of improvements in the business sentiment and improvement in the manufacturing surveys. What some of feedback or the tone that you’ve been getting from your end-markets as this calendar year that’s gotten underway?

Well, the alarm dealers are -- we have alarm dealers who sell our intrusion products. And they’re retooling lots of jobs with our radios, because radios are the communication standard right now. And our radio is -- it does a lot of functionality to them very similar to the what the phone lines used to do for them when they were phone lines on job. So, the dealers are very positive. They're upgrading jobs with Internet of Things, they’re adding cellular communicators. And people are uneasy about what’s going on in the country, so the dealers are busy. And we keep adding more and more products, which generate recurring revenue for the fire part of our industry, for the Internet of Things part that they get could sell to their end-users. Locking is very important, and we sell locking in two different ways. One way is through distribution, which, as Kevin explained, distributors where cutting their inventories back. But the sell-through, the jobs that are being done, the inventory has being pulled out from the distributors. So that’s the positive sign. It means that it should be going that they’re going to have to take more inventory in in-order to keep up with the demand in the upcoming quarters. Also, school security more and more schools, including the one we announced, have bond issues and we’re getting more and more bids that are being sent to the schools. So we expect with school safety and security and the increase in problems on campus, we expect due to the more school security on our locking. Access Control, which as this new 4K software, which has been in the works for a year now and it’s a very sophisticated level of software to do analysis and to control all aspects of building. That is going to be very well received at the International Security Conference, also. So, there is a lot of positive momentum to our business. And fundamentally, American needs more safety and security, and we’re supplying it, because we’re the only Company in the business that has access control, alarm and locking. There is no competitors that have all those integrated systems, and our systems are well integrated. So, we expect that this year will be typical with other years, and it gets stronger towards the end of the year, and the fourth quarter will be also strong like it's been historically.

[Operator Instructions] Mr. Soloway, it appears we have no further questions, at this time. I would now like to turn the floor back over to you for closing comments.

Okay. Thank you everybody for participating in today’s conference call. As always, if you have any further questions, please feel free to contact Patrick, Kevin or me. We thank you for your interest and support. And we look forward to speaking to you all again in a few months to discuss NAPCO’s fiscal Q3 ’17 results. Have a great day. Bye-bye.

Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.