Napco Security Technologies, Inc. (NSSC) Q3 2017 Earnings Report, Transcript and Summary

Greetings, and welcome to the NAPCO Security Technologies Third 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. I’d now like to turn the conference over to your host Mr. Patrick McKillop, Director of Investor Relations. Thank you, sir. You may begin.

Thank you. Good morning. My name is Patrick McKillop, I’m the Director of Investor Relations here at NAPCO Security. Good morning and thank you all for joining us for today’s conference call to discuss our financial results for our fiscal third 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 website www.napcosecurity.com. On the call today with me 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.

Thanks Patrick. Good morning everyone and welcome to our conference call. It's a pleasure for me to be here with you today to discuss our results. The third quarter marked another quarter of record revenue performance for NAPCO. The third quarter sales were 20.8 million. Sales were once again above the $20 million mark for the quarter. We have stated many meetings before that $20 million mark is where we begin to see significant expansion in our margin performance as incremental sales are leveraged over our fixed cost structure. Our SG&A was higher this quarter as we are in the midst of one of the largest product introductions in the company's history with the StarLink Connect. We are focused on the future and are committed to make this and other products we have developed launch successfully. Recurring revenue continues to grow at a solid pace up 68% year-over-year. The annualized run rate now exceeds 10% of the trailing 12 month sales. We love recurring revenue as it provides greater contribution to our margins as well as its effect on greater consistency and predictability in our financial results. Growth in a alarm communications, the Internet of Things and improving school security and safety are key industry trends that continue to impact our results favorably. We expect our business strategy will continue to take advantage of these trends and drive growth, profitability and shareholder returns going forward. Before I go into greater detail, I will now turn the call over to our CFO, Kevin Buchel. He will provide an overview of our financial results, then I'll be back with more on our strategies and outlook. Kevin?

Thank you Dick, and good morning everybody. For the third quarter, net sales increased 5% to 20.8 million, which was a record third quarter performance. For the nine months, net sales increased 6% to 61.7 million. The increase in sales for the third quarter was primarily related to increased sales of our intrusion products, access control products and door locking products. The increase in sales for the nine months was primarily due to increased sales of our intrusion products and door locking products. Recurring monthly revenue from the alarm division increased 68% for the quarter, 67% for the nine months and sequentially the increase was 14%. Gross margin for the third quarter was 32% of sales, which was 120 basis points improvement versus the second quarter last year. Gross margin for the nine months was 32%, which was 130 basis points improvement versus the nine months last year. The margin improvement for both the three and nine months was related to operating leverage in our business model, increased sales, increased recurring revenue and a more favorable product mix as partially offset by an increased investment in R&D to support the launch of new products and services. As Dick mentioned, we also have 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 cost during the quarter. SG&A costs for Q3 increased 13% year-over-year to 5.5 million and as a percentage of sales, increased to 26.6% from 24.7% last year. For the nine months, SG&A increased 9% to 16.8 million and as a percentage of sales increased to 27.3% from 26.3% last year. The increase in dollars for the three and nine months was due primarily from increased advertising and the addition of selling personnel. The increase as a percentage of sales for the three and nine months is due primarily to the increase in expenses being proportionately greater than the increase in sales. Operating income for the third quarter decreased 6% to 1.1 million as compared to 1.2 million last year. For the nine months operating income increased 14% to 2.9 million compared to 2.6 million last year. Income before taxes for the quarter decreased 4% to $1,119,000 compared to $1,169,000 for the comparable period last year. For the nine months, income before taxes increased 18% to 2.9 million compared to 2.4 million for the nine months last year. Income tax expense for the quarter increased by $42,000 to 167,000 or an effective tax rate of 15%. For the nine months, income tax expense increased 397,000 to 480,000 or an effective tax rate of 16.8%. The increased income tax expense for the nine months this year versus last year was due to the reversal of a tax accrual last year that was no longer required. During the third quarter, net income decreased by approximately 9% to $952,000 or $0.05 per diluted share as compared to $1,044,000 or $0.06 per diluted share last year. For the nine months, net income increased 2% to 2.4 million or $0.13 per diluted share as compared to $2.3 million or $0.12 per diluted share for the same period a year ago. The change in net income for the three and nine months ending March 31, 2017 was primarily due to the items previously mentioned. Adjusted EBITDA for the quarter as outlined in the schedule included in today’s press release decreased 6% to 1.5 million or $0.08 per diluted share compared to 1.6 million or $0.08 per diluted share last year. And for the nine months, adjusted EBITDA increased 9% to $4 million or $0.21 per diluted share as compared to $3.7 million or $0.19 per diluted share last year. Moving on to the balance sheet. Cash balance at March 31, 2017 was 2.4 million as compared to 3.8 million at June 30, 2016. Our working capital as of March 31 was 37.4 million compared to 36.9 million at June 30, 2016. And our current ratio was 5.3:1 at March 31, 2017 as compared to 5.1:1 at June 30, 2016. CapEx was $535,000 during the quarter and is now $1,115,000 for the nine months. These are higher spend levels than our normal spending range of $500,000 to $750,000. One of the primary reasons for the higher spend in this quarter is that we are expanding our network operations center or NOC to handle the rapidly increasing recurring revenue we have generated and which we expect to continue for years to come. That concludes my formal remarks and I would now like to return the call back Dick.

Okay Kevin, thank you. Today’s business has two key paradigm shift happening. One, recurring revenue and two, school security. Recurring revenue continues to grow at a very strong rate for us driven by alarm communications and the Internet of Things. School security continues to receive a significant amount of attention and we expect new spending related to making improvements for school safety to continue at a strong rate. To take advantage of these paradigm shifts, our strategy is focused on introducing new innovative products and services that are compelling to the end user as well as products and services to help our dealers grow and succeed. Our staff of 40 plus R&D engineers are working diligently to get new products developed as quickly as they can. At the recent ISC West Industry Trade Show in Las Vegas which saw record attendance, we unveiled new products that will add to our already existing portfolio. I would like to highlight the StarLink Connect communicator which won not one but two awards at the show. The first award is the 2017 Security Industry Association New Product Showcase best in residential and monitoring solutions award. And the second being the MVP, most valuable product annual 2017 award. The StarLink Connect communicator replaces the need for traditional phone lines in order to send the alarm signals to the central station. In addition, StarLink Connect can be used in tandem with our iBridge smartphone tablet app which gives the customers control of lighting, climate, door locks and remote video viewing. Demand for smart home products, as service is growing more and more every day and StarLink Connect is a great product entry into this category as evidenced by the two awards it received. It is important to understand that in addition to being a compelling value proposition to the end user, the StarLink Connect also expands the addressable market, not just to our own alarm system, but also to the tens of millions of already installed alarm systems from other providers. StarLink Connect is compatible with most of our competitor system. Therefore, dealers can install StarLink Connect without having to replace existing hardware in a home, which saves both time and money. StarLink and iBridge products will have a positive impact on our recurring revenue stream, which is an important driver for the growth and profitability for us as well as our channel partners. Other new products that we showed at ISC West include the CA4K, which is our updated software program for Continental Access customers with new features that add more capabilities for the integrator end user. The CA4K launch enters us into the cloud based access control as a service market, which enables our company and integrators to provide a cloud based access control solution to our customers. This saves them from making investments in the infrastructure and IT expense. Also, CA4K will deliver a recurring monthly revenue income stream for NAPCO. Our Continental Access Division also introduced the uniVerse POE, power over Internet single door controller. The uniVerse POE fills the need for miniature and easily installed network access control system as it fits into a light switch enclosure. Our new iLock app, which works on both alarm lock and Marks locks was also unveiled at the show. The app allows for the control of locks that are already used in many high rise buildings, schools and universities. iLock is a strong addition to the school security product line. Moving on to a discussion of the other major paradigm shift that is driving our business, the growth of security and safety in schools. According to Everytown for Gun Safety, a non-profit organization, there was a gun discharged on the school campus on average about once per week. Most recently, we heard about the incident at San Bernardino, California school, which was another tragic event. At NAPCO, we are focused on providing solutions to schools, colleges and universities to help stop the intruders. Activity for a school security vertical continues to be robust. There will be more announcements forthcoming as our pipeline of opportunity continues to grow. We will begin our Q&A session -- portion of this call in a few minutes, but I would first like to give a brief summary. We are very pleased with the current direction of the company. The level of interest in many of our recently released products remains high and based on anticipated demand, as previously mentioned, we will continue our investment in sales and marketing expenditures as well as R&D. The current spend level is deemed appropriate based on our assumptions for the business and we expect to see a very positive impact on future sales. We believe we will -- we have the right strategy in place to take advantage of our current paradigm shifts that are taking place in our business as well as the positive trends in the security industry. NAPCO is in a strong position to continue its growth in sales and profits going forward. Our formal remarks is now concluded. We would now like to open the call for Q&A session. Operator, please proceed.

[Operator Instructions] Our first question is from Gary Mobley from The Benchmark. Please go ahead.

Kevin, what was the cash flow from operations? I’m assuming it was perhaps negative because you're building for a seasonally strong Q4, is that right?

That's correct. Our inventory was up and continues to be up, because as many of you know, our fourth quarter is our big quarter, last year, we did 24 million. So we're building the inventory up. We know that this one will be no different, will have a big quarter and so that did impact cash from ops. So cash from ops was about $1 million. Inventory change from last year is a significant change, as we drive inventory to new heights and hopefully it'll all be gone or a lot of them will be gone by June 30. That’s our expectation.

Okay. If I look back in time, I see that your fourth quarter is normally up about 20% sequentially. That's focused specifically on the product side. Would you expect a similar type growth rate for the fourth quarter this year?

Well, if it was up 20%, that would mean we'd be 24 million about. So that would be the same as last year. Our expectation is we want to do better than that, but you wouldn't be out of line 20% sequential increase over this quarter.

Okay. I'm assuming you guys have a pretty good handle on what type of RMR or recurring revenue you can generate just based on the installed base of radios out there and as well the revenue generator per radio out there, and so if you just took that installed base, extrapolated out a revenue run rate, where would you be at today and maybe if you’re not wanting to share that with me, could you give me a sense of whether you expect the RMI sales to slow over time and therefore not grow at 14% quarter-over-quarter rate you’ve seen for the past two quarters?

The way it is there's roughly 22 million installed alarms, installed by dealers all across the country. Those alarms predominantly use dial up phone line. But dial up phone lines are expensive, they are hard to get and they break and they're dangerous because a burglar can cut the wires which they do. It’s a low voltage wire and they break in. Also as houses sell, people want to upgrade, especially younger people to app controlled products. So that 22 million is a great place for our dealers to go after those accounts and turn those into StarLink Connect. They can get rid of the phone lines for the consumer. They can add IoT control what consumers want to turn your alarm on or off, see video and all the other good things you can get. So the potential is great and it’s a very new market for our industry, because typically if you want to upgrade an alarm system, you have to rip out all the old hardware and put it in. This invention is revolutionary and will bring us a lot of business. We don't really predict how much, but we're spending a lot of money in trade shows, training, advertising to make the whole industry aware of it and get the dealers all motivated to sell it and they are motivated because they make more money when they sell a StarLink Connect than just monitoring a traditional alarm when they get $20 to $30 a month. With StarLink Connect, the dealers can get up to $50 a month with all of the services and NAPCO gets a piece of that, because we supply the whole back end where they enroll the alarm system on StarLink Connect.

Okay. And with the StarLink Connect launched and I'm sure you’re still advertising the product, trying to sow the seeds in the marketplace, but perhaps the SG&A might slow over the next couple of quarters. Could we actually see an absolute dollar amount decline as we look into Q4 and as well the start of next year?

As we said, we think we're in balance now to keep advertising at the current levels and then we have a bunch of other products like we mentioned CA4K and we would maybe shift some of the advertising expenses, try to hold the line the CA4K, which also gets us recurring revenue, which is a new phenomenon for us and for our dealers. They can do managed systems of all kinds of buildings. They make recurring revenue when we make recurring revenue. So where we see the wind at our back, and we’re driving to make sure the dealers are trained, know about it and you have thousands of dealers. There were 30,000 dealers that showed up in ISC West. So we're trying to process as many of those dealers as we can and train those dealers. So we think that the spending level is appropriate now.

[Operator Instructions] And as there are no further questions, I’d like to turn the floor back over to management for any closing comments.

Okay. Thank you. Thanks everybody for participating in today's conference call. As always, should you have any further questions, please feel free to call Patrick, Kevin or myself for further information. We thank you for your interest and support and we look forward to speaking to all of you again in a few months to discuss NAPCO’s fiscal Q4 ’17 and fiscal 2017 annual results. Bye-bye.

This concludes today’s teleconference. Thank you for your participation. You may disconnect your lines at this time.