Greetings and welcome to the NAPCO Security Technologies Fiscal First Quarter 2019 Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Patrick McKillop. Thank you. You may begin.

Good morning. My name is Patrick McKillop. I’m 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 first quarter 2019. 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 Investors Relations section of our website, www.napcosecurity.com. On the call today is Richard Soloway, President and CEO of NAPCO Security Technologies, and Kevin Buchel, 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 financial tables issued earlier today, you’ll find a 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. In terms of our upcoming investor outreach, we will be marketing in New York City this Wednesday, November 7. Also this later month, we will be attending the benchmark conference in Chicago. And in the first week of December, we will be attending the LD MICRO Conference in Los Angeles, California. Investor outreach is crucial especially for small cap companies such as NAPCO. And I would like to thank 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.

Thank you, Patrick. Good morning, everyone, and welcome to our conference call. Thank you for joining us today to discuss our results. The first quarter of fiscal 2019 marked another record revenue and profitability performance for NAPCO. Our SaaS recurring revenues continued to grow at a rapid rate. Our recurring revenues annual rate is now $15.6 million as of September. The driver of the growth for recurring revenues continues to be all of our StarLink offerings, which include intrusion, fire and connect. In the first quarter, our R&D and selling and marketing expenses increased slightly versus the year-ago period. It is our belief that we have the appropriate levels of investment for R&D and SG&A currently. Our net income increased by 69% this year, thus showing returns on the investments we have made. Our balance sheet remains strong with zero debt as of this report and our cash balances continue to grow. We remain focused on capitalizing on key industry trends. These trends include smart connected home, recurring revenue growth in cellular alarm communications, and the creation of school security and safety products. All these trends are having a positive impact on our results. The key metrics of growth, profits and returns on equity are equally important to both as the shareholders and the management team here at NAPCO. Our business strategies are executing well and our interests are aligned with our shareholders and senior management at NAPCO owns 38% of the equity. 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 fiscal first quarter financial results. And then I'll be back with more on our strategies and outlook. Kevin, the floor is your?

Thank you, Dick, and good morning, everybody. For the first quarter, net sales increased 10% to $23.4 million, which was a record first quarter performance and the 17th consecutive quarter of year-over-year record sales. The increase in sales for the quarter, were primarily related to increased sales of our alarm communication products and services, intrusion products and door locking products. Recurring monthly revenue from the alarm division increased 46% for the quarter and recurring revenue now has an annual run rate of $15.6 million based on September 2018 recurring revenue. Gross profit for the first quarter increased 13% to $9.6 million with a gross margin of 41% as compared to $8.5 million with a gross margin of 40% last year. The increase in gross profit was primarily due to the increase in sales. I would like to remind you that the research and development expenses are now shown separately as part of our operating expenses and are no longer included in cost to goods sold. We believe this is a clear presentation and we have made this reclassification for all prior periods as well. As Dick mentioned, our R&D and SG&A expenses for the year grew slightly versus the year ago period. R&D expenses for the first quarter increased 9% to $1.7 million or 7.5% of sales compared to $1.6 million or 7.6% of sales last year. SG&A expenses for Q1 increased 4% year-over-year to $6.1 million or 26% of sales as compared to $5.8 million or 27% of sales last year. The increase in R&D was due to additional personnel and salary increases and SG&A increased primarily due to higher commissions and freight driven by higher sales. Operating income for the first quarter increased 66% to $1.8 million is compared to $1.1 million last year. Income tax expense for…

Kevin, thank you. We continue to be excited about the two paradigm shifts in our business, which show the addition of SaaS recurring revenue and school security. These two areas are contributing to the growth of our business, and we expect that trend to continue in the future. Earlier during the financial results portion of this call, we highlighted the strong growth of our recurring revenue line. We continue to see demand for recurring revenue premise coming from alarm communication, including fire, the growth of the smart home category and the expansion of the Internet of Things theme. School security remains top of mind with many people and we continue to believe that there is a significant opportunity in this vertical. Many schools do not have physical security in place. Despite all the continued violence we hear about on a regular basis. It is our estimation that this market is very large with over 100,000 K-12 and 10,000 colleges and universities in the U.S. We believe that spending on school security will increase as the legislative environment remains favorable with lots of action and funding being directed to this important topic. Our outlook remains strong for this business line as evidenced by the number of recent press releases, we have issued. I will talk more about school security in a couple of minutes. We continue to expect the professional alarm monitoring market to grow over the next few years as the demand for connected systems over traditional systems continued. Developing new innovative products that are attractive to end-users and will help our dealers grow and succeed as part of our strategy. NAPCO has a top position in the market as evidenced by a survey in Security Sales & Integration magazine that was published a few months ago, which places as…

Thank you. At this time we will be conducting a question-and-answer session. [Operator Instructions] Our first question is from Gary Mobley from The Benchmark Company. Please go ahead.

Want to start up by asking about the building access products, I guess, specifically, continental access and related the door locks that would so with those systems. Just given the increased funding for school security that you just spoke about, Dick, have you guys seen any tangible evidence in increased RFP activity or more specifically backlog, can you share any metrics on that front?

We are bidding more and more jobs. This is gestation period of the jobs. It takes a while because you have to have administration and architecture and the integrator and us. But there are a lot of jobs that if you could take a look at the press releases we put out recently, they're more frequently - more frequent than in the past -- because of the fact that we are winning more jobs. But there are a lot of jobs out there, yet to be brought in-house, some of them we can talk about, some we can’t. Because lots of schools don't want to mention that they put in this type of equipment. But it’s a very important and vibrant part of our business. It’s going to grow for years and years and years since Florida, everything is starting to really jump forward. And we’re excited about the prospects protecting the kids and the faculty.

I guess what it stands out to me in the quarter that you just reported was the acceleration of product revenue, and nice to see that growing year-over-year and showing a bit more seasonal strength in the first quarter. And related seasonality, if I'm not mistaken, the second quarter -- your second fiscal quarter on product revenue front generally trends similar to the absolute dollar amount of Q1. So should we think about that Q1 product revenue you generated $19.6 million as being the base of which the second quarter revenue could maybe trend flat from?

Gary, the second quarter usually is more than the first quarter. Usually, our quarters, Q1 is the weakest and $1.5 million net income not so weak, but that’s how it used to be. Q1 the weakest, Q2 and Q3 are better, Q4 the best. So the hardware sales this quarter were up 5.4%. We believe we can get to high-single whether we get there in Q2, whether it's Q3, we remains to be same. But we are optimistic we see more school jobs coming through, that helps the hardware sales. There are some other things we are doing in many other divisions. So we're basically do better in Q2 and Q3, and as the year goes by eventually get to high singles, low doubles at some point. That’s the goal to utilize the dominican factoring to get more leverage out of it, and overall have higher margins.

Just to focus on one negative thought that is the inventory. It looks like it was sequentially despite while the inventory metrics deteriorated terms and days of inventory, what not. And so, could you speak to that what the sources were?

So Q1 historically, traditionally is going to be more than Q4. Q4 is the big quarter. Q1, we thought the new fiscal year and we level loads of factoring. That means we build evenly throughout the year. And that means the inventory levels are going to grow, and then by the time the fiscal year is over, it comes way down. And so it's similar level to last year's Q1, and that’s important. It will always be more than the Q4 level. So you keep that in mind.

So we like to level load the factory because of the fact that it's consistent production and it bodes well for good quality. And then as Kevin just said, they have to rebuild up this level by the fourth quarter. It all moves out -- it moves up aggressively in the fourth quarter, it then have to go back to rebuild again for the next first quarter. So that’s how we run the business. And the deal is like the quality. They put the NAPCO branded products, Alarm Lock, Continental or Marks in. And it stays and works on and on and on better than most everything on the market.

Last question from me and I'll hop in the queue. There is RSR gross margin was improved. It looks like it improved about 400 basis points from where you concluded last fiscal year. Is that just noise in the number or you really seeing some pricing power as it relates to buying bulk data minutes?

The margins are helped a lot when you're selling more commercial radios - fire radios. I always joke the fire radios are on fire. And they’re doing really well, and that helps the margins. And so if that trend continues and we think it well, margins may pick up more as we go forward. So that’s what I would attribute it to.

Our next question is from Mike Walkley from Canaccord Genuity. Please go ahead.

Thanks and congrats on the 17th consecutive quarter of growth.

Thank you, Mike.

Thank you.

Just building on from Gary’s questions. With the revenue growth in mid-single-digits to maybe higher on hardware combined with your sourcing and cost reduction programs. How are you guys thinking about product gross margin trend over the near-term and longer-term where you think that can get to it the business scales and take some costs out of the model?

The margins will get stronger as our hardware sales grow. We see evidence of it in the fourth quarter, the strongest quarter. Now we’re seeing some evidence even in the first quarter. It’s a very important part of the equation as we’ve talked about it. So when we get to the point, where we’re having $25 million hardware quarters every quarter then you will really see tremendous gross margin leverage. We’re not quite there yet. This quarter was close to $20 million. But that’s our goal to get there in a couple of years to have $25 million hardware quarters. That gives us Dominican Republic factory leverage. On top of that, more school jobs we sell, a lot of them have very high margins. If they’re putting in a sophisticated system at a university, those -- the margins on those jobs could be north of 40%, 45%, 50%, depends on how deep they go to schools. But those are high margin jobs for us. So for us, the outlook is very good. It’ll get stronger as our revenue goes up.

Thank you. And just building on up that was sort of mix of stronger year-over-year hardware growth and then goal to get to high-single-digits and double-digits overtime. Can you kind of rank order some of the growth drivers? Is it ongoing school? Is it one of the bigger opportunities? Is it some new products layering into the model like the doorbell products? Just could you help us think about key things are going to take the hardware revenue to a new level of growth than what it’s been in the last couple of years?

Yes. The locking business is the greatest part of our business. And we expect between school work, retrofit construction and new construction and the innovations in locking business, both standalone and radio control locking, and all the additional functionality into those product lines, but that’s going to be strongest, now it’s going to get stronger. We’re also adding a lot of capabilities to our CA4K continental access. We’re going to make in RMR generating product line in addition to selling hardware, and that should bring the dealers into buying more of the hardware. The alarm business, we've come out with all kinds of the StarLinks and the fire StarLinks, and now we've introduced integrated fire radios in fire control panels -- very profitable area and should be -- it bodes really well for growth both on the hardware as well as the recurring. We like to have a lot of irons in the fire. We don't want to be a one trick pony. There are companies out there that maybe just specialized in residential we would like to be commercial and almost be fastest of the commercial business by unlocking access. And also we have our residential portion which with our StarLink connect it's very good for getting recurring revenue and allowing to dealer to expand his recurring revenue base by offering the consumer more services than just monitoring the alarm. So there is a lot of good things going on over here.

Last question for me and I'll pass it on. Just building of that last answer what's the feedback just from your distribution channel in terms of the competitiveness of your portfolio and what's the case of maybe some new products we should expect in the back half of the year?

Well, between our locking distributors, alarms distributors the access distribution we have more than 300 outlets, and we have the only integrated platform where all these products work together, locks and alarms and access all are in the same network without mixing of the brands. And that bodes well for the distribution because they can sell more products and it's all Napco integrated products rather than mixing brands that don't work well together like if you say a situation like that would be an Apple product and a Windows product, they don't work that well together but with the Napco brand distributors can make more money and also the dealer's ability to go into larger jobs they can do hospitals and high-rise buildings and cities, military, they could a lot of different things. We do have a 1000 SKUs it's a gigantic erector set of components that all plays well together. And they could do any job using that go. So that’s our strategy.

Our next question from Joseph Osha from JMP Securities. Please go ahead.

Following a little on the previous question if I look at your home automation IoT slide and listen to your comments about video door bell there, I mean there is some increasing opportunities here as your residential market flips to smart home. What outside of the video doorbell on the existing portfolio services? What other types of products or services do you think you can plug into this franchise for the residential business? And then I have a follow-up.

So right now we offer the dealer the following services they can sell to those end user. Live video on the smartphone, alarm turning it on turning it off, door locks turn them on and turn them off on a smartphone, lighting the same, any type of product that has Z-Wave capability works on our iBridge and more and more manufacturers like Leviton and Honeywell are offering more and more products, which are the accessories that operate on our iBridge. And we have apps and the dealer will set the consumer up depending on what consumer want as functionality of the smartphone and the deal will be able to bill higher rates than normal type of monitoring, which is $25 to $30 a month, then the dealers can get much higher amounts of money from the consumer and we get our piece of the action, because we have a menu of what these different functions will cost the dealer and he marks it up, so that’s how it works. And it’s also helped a lot by our StarLink Connect which is the only device where you can put it on to an existing alarm system of any brand and control the functionality of that alarm system. That’s what the dealer will do. He can service other brands, because you can uploads, downloads through the StarLink Connect and that StarLink Connect takes and modernizes existing alarms and makes it app functional of the smartphone. So it’s 1-hour install to do that type of work. So the millions and millions, we think 25 million alarms can be upgraded to the people that want to be upgraded and that’s an exciting prospect for the company.

So it sounds to me like you’re saying that is given where Z-Wave is positioned then you mentioned Leviton and Honeywell I guess now to be seem to be Residio. That you don’t feel like between yourself and the other hardware vendors there any big product gaps at this point. Your install partners can put their hands on what they need to?

Right. I think they can use any brand of service that’s Z-Wave or lighting accessory that’s Z-Wave. Because our StarLink, iBridge works those products.

And then shifting gears for a bit you all are in the enviable position of having manufacturing. And in this hemisphere, there are a lot of other people are trying to get that done. I’m curious as to whether your procurement people are telling you that there have been any challenges or any shifts and how your operations given how many people are trying to move production back to this hemisphere from China?

Well we’re experienced with Dominican operation. We do some of the manufacturing here in Amityville and our startup manufacturing. And then we do have mass manufacturing at Dominican factory been down there for more than 20 years. So we understand the ropes and we have a nice group of workers down there and are excited to work on technology products. There are hundreds of American companies down there. And it’s a good place to be, because we can go back and forth, we can get finished goods by water in a week. So that was our choice and it’s working out well.

So you’re not seeing any additional component tightness or any of that is everybody else comes stampeding back this direction?

But what we’re seeing is that it’s a little bit more maintenance for us than in the past years, because the manufacturers that make microchips and other parts discontinue those parts more frequently. You don’t get a 10 year cycle. So it means that we have to go back to the drawing board and design our products and when we redesign the product using the new microchip we add more functionality what the dealers are telling us they would like to ask and that makes it exciting to sell more hardware and more recurring revenue.

Our next question is from Josh Goldberg from G2. Please go ahead.

So just a couple of questions for people that I guess are a little bit newer to this story. Can you just describe the SaaS service revenue in terms of what exactly does it mean by being SaaS, I know it's a service business do you have some sort of technologies on your own infrastructure? And I think that you have made it clear that although it's growing nicely at 46% a year and over 40% now for I think six quarters your confidence is that this will be a $40 million run rate by 2021. I just wanted to help people understand what you have there that gives you such confidence that you can see north of 40% growth for the foreseeable future?

Well, what we did is we built a very large server room which can handle $50 million worth of recurring revenue functionality and we are coming out with a whole bunch of products that we have already released plus new products, which the dealers enroll onto this network operating centers like a giant server cloud. And dealers pay us every month to utilize this network operating center. And with all the new products and the fact that the phone company is not servicing copper anymore and all this great home automation functionality you get out of our iBridge product. We see the future very bright and that’s why we have made the investments into building out this NOC to handle this type of volume. So the new products will give us confidence…

Just help people understand how much the people get that you whether you charge per month for this service from the dealers and what they like I mean customers you think they got signed up what's the opportunity in front of you?

Well, we charge depending on the type of device that’s enrolled anywhere from $5 to $25 a month on these devices. We don't break it down..

This is just StarLink Connect right?

No this is -- we have connect, we have iBridge and we have the fire Control Panel and we have video service. All these different things that the dealers select to sell to their end user customer we have this menu of fees and depending how deep the customer wants to get in on the app if he wants everything controlled, locks, alarms and see live video, and turn his lights on or off at the tap of light into the house when you come home or you could turn it in the car. We supply all those services with this menu and those that’s how we get $5 to $25 on the cellular communication that the alarm dealer will use for his Central Station. We also charge money for each app that the dealer engages to the consumer. So it’s a combination of all those things. And that’s how we get all of this. So the future is all about the cell phone, we know that. More and more about the cell phone and we have engineers and developers all kinds of products using the cell phone and that’s what we’ve made the investment into this.

So if you’re doing around 15 million, 16 million now and let’s say your average is around $10, $12 a month, which is about $120 a year, you only have about 10,000 or 15,000 customers so far at the surface, right?

Well, if you do the math that way, yes. And remember, as we’ve said, we’re in the early innings to this. So very…

I just want to make sure, I mean the right point is around 10,000 and you’re talking about an addressable market of 25 million?

Yes. We don’t break it out, but your math is reasonable.

And the confidence you have about getting to this 40% run rate is because your dealers have embraced this product and instead of having a competitive product with other dealers, they really going to use you to that drive this product going forward?

We have more than one product and the dealers are clamoring to get more recurring revenue for themselves. And the way they’re doing it is by offering all of the functionality that consumer want today and we have that functionality. So as they up-sell their customers or they sell a new customer, they offer this. And we give seamless functionality of high quality to the dealers. And they now can monitor and allow the consumers use the app to control function of their inside their home.

So who else competes with you on this like who you think are the biggest disruptors in this space? Obviously, you kind of believe that ADT and others have products building or might have them going forward?

So ADT is a dealer. They’re a large dealer. We sell ADT. So we have many dealers. We have about 10,000 dealers that use our product either exclusively or they cherry pick the line. And universe of dealers is 30,000. So you want to pick up more and more dealers which we are doing with new products and we don’t have one SaaS product. We have more than a dozen SaaS products.

Sure. And my question is like a company like ADT at the dealer. Do they offer these types of products with competing, recurring, separate service revenue products as well? Do you compete at ADT with other products?

ADT has some of the products that we have. And we have products that ADT doesn’t have.

So who else does ADT sell in what I’m saying. If you’re not selling you for the service, who else would they be selling as a dealer?

ADT is a dealer and they sell consumer. That’s the job. They like the other 30,000 dealer. They’re just a larger version.

All right. So ADT is a dealer, they have a choice of five or six different products to sell to their consumer and one of them is NAPCO. Do they sell other services to consumers besides NAPCO of this type?

Yes, they do. They…

Right. So who are those products?

Those are private labeled, I think you’d have to ask them.

So you’re not seeing one specific company become a big competitor to you in the space?

We have a lot of irons in the fire, we are 80% commercial ADP is mostly residential, it's a different thing. We sell commercial dealers. We sell residential dealers. We sell dealers that do both. We sell fire dealers now with our new fire panels which just came out which -- they have integrated communicators built into them as well as the fire panel. So there is a lot of activity. There is a lot of beef in product.

Just two or three other questions. Continental access, how big of a business is that for you and is there any service revenue in that space in that product line?

We don’t break it out for competitive purposes. But we are adding more -- we are adding armor to it and to that line. Because we built this NOC we got to be adding armor to all our lines, that’s our future, that’s what we plan to do.

Just the continental side, is it 5% or 10% of your business or so?

I don’t break it out.

Two other questions for me would be helpful. Obviously with all the news in last few weeks it would seem that there is a big opportunity in houses of worship to a lock [indiscernible] and that will be something that I think government and states, federal and local governments would spend a tremendous amount of money on security for houses of worship. What products you have had? Has there been any interest from some of these big groups to go after your product after what happened in Pittsburg?

It is how it goes. The dealers are out in the field. We have thousand SKUs that we make for the dealers. These dealers go and canvas where there areas -- where there are burglaries, people moved newly into their homes, people are -- any situations where there are tragedies the dealers are there to bolster up the physical security using Napco products. So we don't sell directly to the churches and to the synagogues and to the schools. We go and jointly with these people when we are requested and they do the installation. We do all kinds of lockdown products and safety products for any public space. So the dealers are still in these products in these public spaces. But we don't call on the end users. We are B2B company.

I just thought with what you are doing on the University side there might be an opportunity to do that as well in these bigger religious offices.

There is opportunities in every area where you need more security which is every place. So the dealers are our marketing arm - banging the streets, they are street smart guys experienced business guys out there and getting jobs. And the more of those dealers that push Napco, the better it is because we're the only company with an integrated solution and it's becoming more apparent to the dealers that's the way they want to go. They want to do large jobs they just don't want to do a residential job or a small business job. So with Napco you can do it all.

Okay, great. Just my last question is as you know as you pencil out the math if you can get the 40 million of recurring service revenue exiting fiscal 2021 and assuming you can maintain single digit incremental revenue growth through that time not even double-digit which just sounds you can do but just single digits, you are looking at a company that's close to 130 million of revenue in 2021, with a margin profile that's very exciting because as much as you’re equipment margin has helped you the last few years, obviously the service margin being much higher can relate lead to a huge EBITDA margin. And again, I’m just calculating just through incremental revenue profit on the revenue, on the server side. If you’re going to do 40 million of service revenue, it would seem to be with your 80% gross margins that you would be able to contribute around $18 million in fiscal ’21 or said differently around the dollar more of earnings per share from where you are currently per year, because of the service opportunity. Regardless of what’s going on with universities or regardless what’s going on with some of your other new products. Is that an accurate way to look at your company right now?

I would say it's our goal, so it’s a very accurate way to look at it. The only thing that we question how fast are we going to be there by ’21, maybe it’ll be ’22. We can’t tell exactly what we do know is we’re growing in the 40s. Let’s do more of a 46% for this quarter. And we’re introducing more products that you guys don’t even know about that are going to give us recurring. And the world is changing to wanting to control devices remotely. So the millions and millions of systems out there, they haven’t changed yet. So that’s why we have this tremendous confidence and more people we’re going to change and go to cellular radios, more fire radio opportunities and more products that haven’t even come out yet. That will give us recurring. So yes, that is very exciting. It’s those kind of numbers. Just a question of how fast we get there ’21, ’22 we'll see. It’s a great journey to be on.

[Operator Instructions]. As there are no further questions. I’d like to turn the floor back to management for any 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 Q2 ’19 results. Bye-bye.

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