Napco Security Technologies, Inc. (NSSC) Q4 2017 Earnings Report, Transcript and Summary

Greetings, and welcome to the NAPCO Security Technologies Inc. Fourth Quarter and Full Year 2017 Results 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 for NAPCO Security Technologies Inc. Thank you, Mr. McKillop, you may begin.

Thank you. Hello, 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 fourth quarter and fiscal year 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 at www.napcosecurity.com. On the call today is Richard Soloway, President and CEO of NAPCO Security Technologies; 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. I will turn the call over to Dick in a moment but before I do I just wanted to mention a few things on the IR front. We are working hard to create shareholder value and one of the ways we do this is by attending conferences and making marketing trips to various cities. This week we will be attending the Liolios Conference in San Francisco, and then heading to Chicago for some marketing. On September 14, we will be attending the CL King Best Ideas Conference in New York City. We expect to meet with lots of new investors during these events and share the bright future we see ahead with them. Investor outreach is crucial, especially for a small cap company such as NAPCO and I would like to thank all of those folks that assist us in these conferences and marketing trips. 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 fourth quarter and fiscal year marked another quarter and year of record revenue performance for NAPCO. Our balance sheet is very healthy as our debt net of cash is now zero. Our recurring revenues continue to grow at a rapid rate. The annual run rate of $9.7 million is now effectively as the stated goal of achieving a $10 million rate in recurring revenue. I would like to note that this is one year ahead of the stated timeframe. Important to note as well, is the approximate $10 million of recurring revenue was achieved largely with the stalling intrusion and single path fire which are the first two versions we produced. The Connect version, our latest addition to the communicator series that we believe will be a great product, just started its commercial launch this past April. And the StarLink Dual Path Fire was just launched a few months ago. As we have previously stated, we increased investments in R&D, selling and marketing expenses. Our growing sales momentum as evidenced by the $25.7 million record breaking revenue for the fourth quarter demonstrates that such increased investments are having a positive impact on our sales while we still maintain the fiscal discipline required to reduce our debt to zero. Capitalizing on key industry trends that continue to impact our results favorably are recurring revenue growth in cellular alarm communications, the creation of products for the Internet of Things and the connected home, and development of products for improving school, security and safety. We are executing our business strategy and taking advantage of these trends. Our senior management collectively owns 38% of the outstanding equity in NAPCO and our interest are aligned with the shareholders in driving growth, profits and return on equity. Before I go into greater detail, I'll now turn the call over to our CFO, Kevin Buchel. He will provide an overview of the 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 fourth quarter, net sales increased 7% to $25.7 million, which was a record fourth quarter performance. For the fiscal 2017, net sales increased 6% to a record $87.4 million. The increase in sales above the quarter and full fiscal year was primarily related to increased sales of our intrusion products, access control products and door locking products. Recurring monthly revenue from the alarm division increased 59% for the quarter, 65% for the fiscal year. Recurring revenue as Dick stated before now has an annual run rate of $9.7 million based on June 2017 recurring revenue. Gross margin for the fourth quarter was 38.3% of sales, which was 170 basis points decline versus the fourth quarter last year. While the decrease in margin for the quarter versus a year ago was primarily due to increased spending in R&D, significant margin leverage and overhead absorption from our Dominican Republic manufacturing facility was still achieved as a result of the $25.7 million quarterly revenue. Gross margin for the fiscal year was 33.9% versus 33.4% for the last fiscal year. The margin improvement for the fiscal year was related to the aforementioned operating leverage from our manufacturing facility, increased sales, increased recurring revenue and a more favorable product mix as partially offset by the previously mentioned increased investment in R&D to support the launch of new products and services. As Dick mentioned, 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 cost during the quarter and fiscal year. SG&A costs for Q4 increased 9% year-over-year to $6.4 million and as a percentage of sales increased to 24.8% from 24.4% last year. For fiscal 2017, SG&A increased 9% to $23.2 million and as a percentage of sales increased to 26.6% from 25.8% last year. The increase in dollars and as a percentage of sales for the fourth quarter and fiscal year was due primarily from increases in selling wages and commissions as well as increased advertising and trade show expenditures. As we previously mentioned, we increased these expenditures in order to generate higher sales and we do not expect these expenditures to increase significantly in fiscal 2018. Operating income for the fourth quarter decreased 8% to $3.5 million as compared to $3.8 million last year. For the fiscal year operating income increased 1% to $6.4 million compared to $6.3 million last year. Income before taxes for the quarter decreased 8% to $3.4 million compared to $3.7 million for the comparable period last year. And for the fiscal year, income before taxes increased 2% to $6.3 million compared to $6.1 million last year. Income tax expense for the quarter decreased by $72,000 to $216,000. For the year income tax expense increased $325,000 to $696,000 for an effective tax rate of 11%. The increase in income taxes from fiscal 2016 to fiscal 2017 resulted primarily from the benefit recognized in fiscal 2016 from a one-time reversal of certain reserves. During the fourth quarter, net income decreased by approximately 6% to $3.2 million or $0.17 per diluted share as compared to $3.4 million or $0.18 per diluted share last year. For the year, net income decreased 3% to $5.6 million or $0.30 per diluted share as compared to $5.8 million or $0.31 per diluted share for the same period a year ago. The change in net income for the quarter and the year ended June 30, 2017 was primarily due to the items we previously mentioned. Adjusted EBITDA for the quarter was outlined in the schedule included in today's press release, decreased 7% to $3.8 million or $0.20 per diluted share compared to $4.1 million or $0.22 per diluted share last year. And for the year, adjusted EBITDA was $7,354,000 or $0.42 per diluted share as compared to $7,846,000 or $0.42 per diluted share last year. Moving on to the balance sheet; cash balance at June 30, 2017 was $3.5 million as compared to $3.8 million at June 30, 2016. Our working capital as of June 30 was $40.8 million as compared to $36.9 million at June 30, 2016. The current ratio was 4.9:1 at June 30, 2017 as compared to 5.1:1 at June 30, 2016. At debt, net of cash was zero at June 30, 2017. CapEx was $299,000 during the quarter and was $1,414,000 for the year, 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 is we expanded 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.

Thanks, Kevin. Recurring revenue and school security are two key paradigm shifts for the NAPCO business. As Kevin and I mentioned in our prior statements, recurring revenue continues to grow at a very strong rate for us driven by alarm communications and the Internet of Things which includes the connected home and school security which continues to receive significant amount of attention. And we expect new spending related to making improvements for school safety to continue at a strong rate. A recent report from the Phedonia [ph] Group research firm stated they expect the U.S. alarm market to reach $4.9 billion in 2021. Our strategy is focused on introducing new and innovative products and services that are compelling to the end user, as well as products and services that help our dealers grow and succeed. NAPCO is positioned strongly to take part in the growth of the U.S. alarm market both with our legacy products and new products that our R&D staff of 40 plus engineers are currently developing. Demand for smart connected home products and service is growing more and more every day. According to the recent report by IHS market, the global smart home market is forecasted to exceed $14 billion in 2017. The StarLink Connect is a great product entry into this category as evidenced by the two awards it received at the recent ISC West Trade Show in April of this year. The StarLink Connect communicator replaced 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 customers smartphone control of their alarm system, lighting, climate [ph], door lock and remote video viewing. The StarLink Connect is an attractive product for the end user as well as our dealers. One of the unique features that dealers love is the fact it is compatible with most of our competitors alarm system which is a big economic incentive for dealers as they need to replace existing hardware at the installation site is eliminated to now get connected to home functionality. The market opportunity for Connect is not only existing NAPCO systems but the tens of millions installed systems from other providers. Dealers can now upgrade the end user system quickly, allowing them to schedule more jobs during the work day. Our recurring revenue streams will benefit from the StarLink and iBridge Smart Connected home products thus driving growth and profitability for NAPCO and our channel partners. Other new products that we're excited about include the StarLink Dual Path Fire, the CA4K and ArchiTech Series Networx Locks to mention a few. Our StarLink Dual Path fire communicator recently won certification from Los Angeles and New York fire authorities and this is important as they are two very large markets which we now have access to. In commercial buildings many fire systems are still relying on path lines which are old fashioned copper lines which cost a $100 per line per month. The major carriers have been backing away from supporting these lines over the years and in fact we recently learned that one of the major carriers has been sending notices to customers stating they will no longer support these lines in the near future. According to internal research we have done, there are 5.6 million commercial buildings in the U.S. and approximately 2 million multi-tenant high rise buildings that would need to be upgraded. The StarLink Dual Path is the perfect solution for these customers and Dual Path will also add to our recurring revenue line. The ArchiTech Networx Series Locks have been out for about nine months and is an ideal access control solution elegantly blending advanced wireless access control convenience within any décor and choice of trims and finishes. These can be used to control access at a door at any time across a wireless network or is an integral part of a new or existing enterprise security system. These locks are popular option for many high rise residential buildings going up in many major cities across the USA. The battery life is unsurpassed with multiple years of use, even in high traffic areas. We have experienced cross-selling opportunities as well, for every ArchiTech lock on the front door of a condominium high rise resident it generates a need for matching mechanical interior hardware throughout the residence. The recently launched CA4K product for medium and large businesses enters us into cloud based access control as a service market, which enables our company and its integrators to provide cloud based access control services to the integrators end user customers. As a result of this those customers will not be obliged to have in-house personal due task such as compiling attendance reports, security badge creation, removing X employees from the system, 24-hour access control monitor and alerting; all of this and more can now be outsourced to their integrator security company. NAPCO and the integrator will share the recurring revenue fees from these outsourced services. Moving onto a discussion of other major paradigm shift that is driving our business; it's the growth of security and safety in schools. Here at NAPCO we are focused on providing solutions with schools, colleges and universities to help stop the intruders. Recently a letter was sent to President Trump from 11 organizations, one of them being a partner alliance for safer schools. In this letter the organizations are asked to include K-12 public school, security infrastructure as part of President Trump's National Infrastructure Plan. The letter details how many of the 100,000 K-12 schools in the U.S. lack the basic security features such as access control and locks on classroom doors. The organizations recommend that a new security block grant program be created requiring equal state and local matches [ph]. Clearly this highlights the importance of school security issue. Bringing the issue to the federal government level will help secure funding so that every K-12 in the U.S. will have security hardware in place. Activity for our school security vertical continues to be robust. We recently announced that Pepperdine University will be installing more of our products on their campus, specifically the administration buildings and library and the next projects they are working on. This is great example of the ability for us to win repeat business from schools as they focus on safety for the students and faculty. There will be more announcements forthcoming as our pipeline of opportunity continues to grow. We'll begin our Q&A session portion of this call in a few moments but I would like to give a brief summary. Fiscal year 2017 was a very good year for NAPCO as we accomplished many thing; reaching our recurring revenue one year ahead of our schedule, launching an award winning new products, the StarLink Connect gained new institutional shareholders, new analyst coverage and became a member of the Russell 2000 Index. We're very pleased with the current direction of the Company. We believe the elevated engineering and marketing expenditure levels in fiscal 2017 will not increase significantly in fiscal 2018 which would greatly enhance our profitability as our fiscal 2017 investments generate higher sales in fiscal 2018 and beyond. We believe we have the right strategy in place to take advantage of the 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. NAPCO's senior management maintains a high level of ownership in our equity, approximately 38%, 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 the Q&A session. Operator, please proceed.

Thank you. [Operator Instructions] Our first question comes from the line of Gary Mobley from Benchmark. Please proceed with your question.

Good morning, gentlemen. Congratulations for the nice finish to the year. I wanted to start with a question about the continental access as a service. I wanted to know when the services is launching and into the prospects as we look forward of the next 12 months in terms of revenue ramp? And as well as I wanted to know whether or not this is a personal intensive business for NAPCO or is this more data aggregation using features such as mobile apps to access commercial door locks and what-not?

The product line, Gary -- this product is software product spending development for more than two years and it's made into different layers of code. There is a layer of code which will allow us to get recurring revenue from dealers utilizing that layer, they are going to be able to supply a lot of backlog for services for their customers and they are going to be sharing that with us. It's only been out for a few months and it takes a while, it's kind of a new focal point for the dealers, typically these integrated dealers just make money on the installation and maintenance. So over the next year, this 2018 year, there is going to be additions to it and refining of it and I believe we expect it to be a very nice recurring revenue producer. I can't put any numbers to it, I can just tell you it's the right direction for the company, it's just going to add/pile on more and more recurring revenue for us and it's a whole new area of growth.

Okay. Kevin I had a question about the gross margins. My best estimate is the product gross margin in Q4 was perhaps down as much as 400 basis points year-over-year. And then I'm just curious, what types of investments are flowing to the cost of goods that's driving that down into that? And net of that, how would your gross margins have trended based on the manufacturing utilization rates at the Dominican Republican facility?

I think it was down 170 basis points versus last year Q4, 38.3% [ph]. R&D is a good part of it, probably worth six times of a point, so we basically would have been at 39% most of it versus supported [ph]. We typically believe when our sales are in the 20, now we're going to get to 40 or more and a lot of times because of the mix depends on what sale we have in a given quarter, it could jump around a little bit, less than a point [ph]; but as you could see, we're still much higher in Q4 than the rest of the year, that's the leverage of the factory. Yes, it all helps to have the recurring revenue, that's great; but when we're in the 20, lot of that work is done by manufacturing and that's why we got into the high 30s, almost 40%, it's a key part of our story. We want to do better on the manufacturing side, we've done tremendous on the recurring side, going to get both parts going very nicely and then you're going to see us go way up on the hockey stick; for those of you who have seen our hockey stick bid [ph].

Okay. Your sales and marketing or SG&A grew about 9% in 2017; I think the quote was that 'expect the growth to moderate' or like paraphrasing, that's what put it. And so would you expect the growth rate of your SG&A to be less than revenue in 2018? And related to that, would you say that most of your investments in the sales and marketing channel have been strong in sort of at a steady state right now?

I would say yes, it's at a steady rate. And I would say the growth rate of revenue which should far exceed the growth in SG&A. I think we've reached the plateau that we're at now, we don't have to grow it much more in 2018. That's why we think that the profitability is going to be enhanced because you're going to see topline growth, you're going to see the SG&A remains steady. And the R&D is going to remain steady too, we think that's just a level that we're comfortable with. We've said it throughout the year, like this is the new base point; we knew this year was going to be a higher baseline than prior year but we thought we had to do it to get the sales to really start moving. And we think that's the direction that we're in right now.

Got you. Okay, last question for me; I noticed your inventories were up about 22% year-over-year against backdrop of 7% year-over-year sales comp for Q4. Obviously, inventory returns dropped in; is there any -- is there a way through there or is it just sort of noise and the numbers?

We introduced StarLink Connect radio towards the very end of the year, that's going to be a big seller for us. We put a lot of marketing efforts into it and we're building inventory because we bagged a lot of sales on that product. So we just introduced it at the end, we -- you got to ramp up and build because if you're going to market the heck out of a product, you better have it when people are ready to buy it. So that's a good chunk of inventory growth and obviously we're excited about that product; so that will move. And also on top of that it came out with new continental product we talked about a little bit in my presentation here, that's another one where we're marketing it and we expect it to move. So there is the buildup and now we expect it to move out, expect the inventory to drop throughout the first couple of quarters of 2018.

Okay. All right, that's it for me. I'll let others ask questions and I'll hop in the queue. Thanks guys.

Our next question comes from the line of Michael Walkley from Canaccord Genuity. Please proceed with your question.

Thank you. You're just building off the increased inventory or expectations for strong sales for the StarLink Connect product; can you share just -- any early traction maybe this product is receiving? And maybe walk us through how you're training your dealers and incentivizing to sell the iBridge services also?

The concept is wonderful for the dealer and the end user customer. You have these millions of alarm systems that have been installed by our dealers and the competitive dealers that are -- have been putting alarm systems in. If you want to get connected home today with everything else that's out there, you have to rip out all the old software and make a mess in the home while the business can do that. Connect is a very simple solution, it's a small box, looks onto any brand of alarm system from the majors, and now there are apps that are given to the consumer and they can operate newly installed thermostats, door locks and switches and outlets dealer will put in and control everything remotely. And that's a big boost for them because now they can expand their recovering revenue instead of just monitoring burglar alarms and fire alarm or anywhere from $20 to $30 a month depending on what region of the country they are in; now they can add $10 or $15 more to give their end user customer the app control, and it's a very important thing because we know people are doing more modern things and everything is on the smartphone today. So this is a very unique product and we're showing it around to our distributors, dealers; we're getting very nice orders for it, we expect to ramp up; it's a very big market and it will bode great for us for recurring revenue going forward.

Great, thank you. And then just building on that; just with all your new products that are targeting recurring revenue. You hit the $10 million run rate; how should we think about -- maybe new targets one to two years out? Are you willing to share any? Or how do you feel about just the overall growth in recurring revenue trajectory over the next couple of years?

At the rate we're going, probably this year will be $15 million, roughly. Just a gut feeling –estimate because in addition to the stall in Connect you have the Dual Line fire communicator; and as I said it's a very large market, the phone companies are not wanting to supply service anymore at the copper lines. Most of the fire systems that are out there use copper lines. So the dealers can now hook on our dual line fire communicator and do an exact competitive replacement for the old copper line. It's a big boom for them, it's great and because we've got California Fire Marshall and New York City Fire Marshall; those markets alone are huge markets for this type of product. So we expect a lot of increased recovering revenue from this product. So it's an exciting time for us with the new products. We've made the investments because when the wind is at your back let's get the products out, let's get the marketing done and then we can -- just keep pounding away with our dealers showing them the new technology and the sales will continue to grow. So as we stated, we think we're at the right spend level now for engineering with our 40 plus engineers. I think we've got the right sales group, marketing and advertising setup like we had in '17, that level, no higher is what we've planned and that should reap nice profitability for the 18 year.

Great, thanks. So just to clarify; is that $50 million kind of your gut feel for the full year recurring revenue, you hit that run rate during the calendar -- during the fiscal year.

We're talking about fiscal year, thank you.

Great, thank you. And then just -- as we look at the hardware piece of the business, I know you have a longer term goal of hitting $100 million in revenue annually. Can you maybe walk us through how you see that business growth over the course of the year? And when you might think you hit that $100 million annual revenue on the hardware side?

So what we'd like to -- so we're going to keep the momentum up; high single double-digit growth is what we're aiming for hardware this year and the year next and at that point we'll be at $100 million level; roughly at $100 million level. And then the increase in the RMR which comes along with the hardware sales, it will put us in a very good scenario, very high on that hockey stick into the 40% gross profit. And this scenario is what -- that's what we see right now. So it is -- we're going in the right direction making these investment and getting these products out and I'm going to fill the fact with more hardware business.

Great, thanks. And then last question for me; just -- as you look at that hardware growth -- any of your new products or just overall products you think are going to be stronger than others this year you talked about the letter to President Trump with school funding that could be a big catalyst for you. Is that one of the areas you see stronger growth? And within that growth how should we think about maybe gross margin mix during the course of the year given the different projects you have? Thank you.

With the federal government potentially getting involved with the school security, that's a game changer. We're banging away at the 10,000 plus universities, 100,000 plus [indiscernible] why our sales are growing. And once you get a government mandated move on school security then that's going to explode. We're not sure it's going to happen, so quick, we're not counting on it, what we're doing is going one by one, school by school, try to get that to grow fast, that's the biggest area of the hardware schools with most schools don't have much in play and with a lot of schools out there. And as we mentioned, even when you went at school you get repeat business. We also see a big opportunity in Houston, we are big in the Houston independent school district area with all the problems they are having with the flooding, their schools are going to need new equipment; so that's another opportunity. So school security is probably the biggest area but we have a lot of other products, we don't have time to talk about each one but there is a lot of R&D effort that goes into a lot of hardware because the $100 million hardware is a key goal for us and it's the one that we want to make sure we hit.

Great, thanks. I will ask one more. Just given -- coming off the seasonally strong June quarter offset by all these new products ramp; and should we think about kind of normal seasonal trends kind of down mid-teens revenue sequentially or is the September quarter looking little stronger with some of these new products coming into the channel?

Last year I think we did low 20 in Q1 and we expect to beat that. So not teens, we're in the 20s now, every quarter should be in the 20.

Sure. I was talking mid-teens sequential decline, just off the strong quarter.

I said it percentage-wise.

Correct.

Yes. I would say we're not going to do another $25 million quarter at Q1 but we expect to beat last year's Q1 which I believe was $20.8 million or something like it. So we expect to beat that whenever that translates into $21 million and change, $22 million, whatever that decline is versus the $25 million; maybe we'll go higher up in Q1. There is a lot of action here. We built a lot of inventory, lot of radios, we expect a lot of that to move this quarter.

Great. Thanks for taking my questions and good luck for a strong fiscal year.

Thanks so much.

[Operator Instructions] There are no further questions in the queue. I'd like to hand the call back over to management for closing comments.

Thank you everyone 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 you all again in a few months to discuss NAPCO's fiscal Q1 '18 results. Thank you and bye-bye.

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