Napco Security Technologies, Inc. (NSSC) Q3 2019 Earnings Report, Transcript and Summary

Greetings, and welcome to NAPCO Security Technologies Fiscal Third Quarter 2019 Results Conference Call. [Operator Instructions] And as a reminder, this conference is being recorded. I'd now like to turn the conference over to Mr. Patrick McKillop, Director of Investor Relations. Thank you, please go ahead.

Thank you. Good morning. My name is Patrick McKillop, I'm the Director of Investor Relations here at NAPCO Security. Thank you all for joining us for today's conference call to discuss our financial results for our fiscal third 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 Investor Relations sections 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 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 want to mention a few things on the IR front. In terms of upcoming investor outreach, we will be attending the Oppenheimer, Needham and Cowen conferences during the month of May, all of which are taking place in New York. Also in early June, we will be at the William Blair conference in Chicago. Investor outreach is crucial especially for a small cap Company such as NAPCO, and I'd 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.

Thank you, Patrick. Good morning, everyone and welcome to our conference call. Thank you for joining us today to discuss our results. The fiscal third quarter 2019 marked another record revenue and strong profitability performance for NAPCO. We now have 19 consecutive quarters of year-over-year record sales. Our recovering revenues continue to grow at a rapid rate. The annual run rate is now $18.9 million as of March 2019. Our strategy of targeting professional installations and mostly commercial end market is driving the continuous growth. Our cash balances remain healthy and our balance sheet remains strong with zero debt as of this report. We remain focused on capitalizing on key industry trends including school security solution, wireless fire and intrusion alarm communicators, enterprise access control system and architectural locking products. The management team here at NAPCO is focused on key metrics of growth, profit and returns on equity which we know are equally important to our shareholders. Our business strategy is executing well and our interests are aligned with our shareholders and senior management of NAPCO owns 38% of the equity. Before I go into further detail, I will now turn the call over to our CFO, Kevin Buchel. He will provide an overview of our fiscal third quarter financial results and then I'll be back with more on the strategies and outlook. Kevin?

Thank you Dick, and good morning, everybody. For the third quarter, net sales increased 13% to $25.1 million which was a record third quarter performance and the 19th consecutive quarter of year-over-year record sales as compared to $22.2 million last year. For the nine months ended March 31, 2019, net sales increased 14% to $73.3 million as compared to $64.4 million last year. The increase in sales for the three and the nine months ended March 31, 2019 were primarily related to increased sales of our alarm communications services, intrusion and access products and door-locking products. Recurring monthly revenue increased 44% for the quarter to $4.5 million versus $3.2 million a year ago, and for the nine months increased 46% to $12.5 million from $8.6 million last year. Recurring revenue now has an annual run rate of $18.9 million based on March 2019 recurring revenue. Gross profit for the third quarter increased 21% to $10.7 million with a gross margin of 43% as compared to $8.9 million with a gross margin of 40% last year. For the nine months gross profit increased 20% to $31 million with a gross margin of 42% as compared to $25.9 million with a gross margin of 40% last year. The increase in gross profit and gross margin for the three and nine months was primarily due to the increase in sales. R&D expenses for the third quarter increased 11% to $1.9 million with 7% of sales compared to $1.7 million or 8% of sales last year. For the nine months, R&D expenses increased 9% to $5.4 million or 7% of sales as compared to $4.9 million or 8% of sales last year. The increase for the three and nine months was primarily due to increased salaries and additional personnel. SG&A expenses for Q3 decreased 2% to $5.2 million or 21% of sales as compared to $5.3 million or 24% of sales last year. For the nine months, SG&A expenses increased 1% to $16.9 million or 23% of sales as compared to $16.8 million or 26% of sales last year. The SG&A decrease as a percentage of sales for the three and nine months was primarily due to the increase in net sales. Operating income for the three months ended March 31, 2019 increased 91% to $3.6 million as compared to $1.9 million last year. Operating income for the nine months increased 110% to $8.7 million as compared to $4.1 million a year ago. Income tax expense for the quarter increased by $456,000 to $520,000 as compared to $64,000 last year. The Company's effective tax rate was 14% for fiscal Q3 '19 as compared to 3% for Q3 of '18. For the nine months period, income tax expense increased $1.1 million to $1.2 million as compared to $118,000 last year. The Company's effective tax rate for the nine months was 14% as compared to 3% for the same period last year. The increased income tax expense for both the three and the nine months was primarily due to changes to the federal tax code last year, which lowered last year's income tax expense as well as the aforementioned increased operating income this year. Net income for the third quarter increased 71% to $3.1 million which equates to 12% of net sales or $0.17 per diluted share as compared to $1.8 million or $0.10 per diluted share last year. Net income for the nine months increased 90% to $7.5 million which equates to 10% of net sales or $0.40 per diluted share as compared to up $4 million or $0.21 per diluted share for the same period last year. The increased net income for the three and nine months was due to the items previously mentioned. Adjusted EBITDA for the quarter is outlined in the schedule included in today's press release, increased 77% to $4 million which equates to 16% of net sales or $0.22 per diluted share as compared to $2.3 million or $0.12 per diluted share last year. Adjusted EBITDA for the nine months increased 86% to $9.9 million which equates to 13% of net sales or $0.53 per diluted share as compared to $5.3 million or $0.28 per diluted share last year. Moving on to the balance sheet, cash balance at March 31, 2019 was $5.5 million as compared to $5.3 million at June 30, 2018. Our working capital as of March 31, 2019 was $45.7 million as compared with $44.3 million at June 30, 2018. The current ratio was 4.6 to 1 at March 31, 2019 as compared with 5.7 to 1 at June 30, 2018. And debt remained at zero at March 31, 2019. Net cash used in operating activities for the three months ended March 31, 2019 was $583,000, which was primarily related to increases in inventory as we gear up for the fourth quarter sale, April, May and June, the quarter that we're in now, historically, the strongest sales quarter of the fiscal year. Net cash provided by operating activities for the nine months ended March 31, 2019 increased 23% to $5.8 million as compared to $4.7 million last year. CapEx was $479,000 during the quarter and for the nine months period was $1.6 million. Our stock buyback program remains open, and we make purchases opportunistically as we have a strong belief that the best years are yet to come for our Company. During the quarter ended March 31, 2019, we repurchased 87,672 shares at an average price of $15.49. For the nine months ended March 31, 2019, we repurchased 274,065 shares at an average price of $14.59. That concludes my formal remarks, and I would now like to return the call back to Dick.

Kevin, thank you. We continue to be excited about the growth in our business. We expect the growth trend to continue in the future. We continue to see demand for recurring revenue products coming from alarm communications including fire, intrusion and the growth of the smart home category. The topic of school security remains an important issue in the United States, and we continue to believe that the market opportunity is significant in this vertical. While we all remember the events that took place in Florida and Texas last year, we continue to see incidences happening. Most recently, just a few days ago, there was an incident with fatalities at a University in North Carolina. In addition, authorities in Tennessee were fortunately able to thwart a planned shooting at an elementary school. We remain dedicated to providing solutions and products that the schools so desperately need. We believe that this is a market that's very large with over 100,000 K through 12, and 10,000 colleges and universities in the US. We have highlighted during past calls and investor meetings that the state legislatures are taking action with approximately $1 billion in funding allocated to school security since February 2018. We expect that more states will do the same in the future and there is the possibility of more funding from the federal government as well. President Trump's 2020 budget proposal includes a $200 million increase from the 2019 levels in funding for school security. The pipeline for school security projects looks robust and we will continue to announce new wins when we can as we need to receive approval from the schools prior to doing so. Recently, we have witnessed more and more houses of worship undergoing active shooter incidences. We have seen the need to expand the use of our SAVI audit system for this application and other public meeting places as well. The need for securing these public places with our products such as wireless locks and access control is clear. Our latest product, the iSecure alarm system was recently introduced at the largest professional security trade show in the USA. The show was a few weeks ago and it's called the ISC West and tens of thousands of dealers attended. Our show classroom was packed by dealers eager to see the unique fully cellular iSecure system. The iSecure is designed for the new breed of professional security installers and savvy consumers. A professional dealer can install it in one hour and its features are far beyond anything on the market. It's a perfect system for traditional security and protection and also has the capabilities required for advanced smart home installations that are in demand today. It's Go-Anywhere smart-hub can be placed anywhere in the home of business for best cellular communications and to avoid the practice of burglars smashing the panel upon entry to disable the system. This breakthrough product will be offered in ultra cost effective option, three different options so as dealers ROI is much faster than anything on the market. The iSecure won the MVP, Most Valuable Product award in a home controls category at the trade show. We believe that the conversion process from traditional alarm systems to connected systems is in the early stages which will continue to drive growth for the professional alarm monitoring market. From the strong response at the ISC trade show, we strongly believe that the iSecure system could be a strong producer of sales, profits, and recurring service revenue for our company for years to come. Other product introductions that were well-received at the show included our Video Doorbell and the commercial FireLink, Fire Alarm Control. This panel has a built in cellular communicator inside. FireLink comes pre-configured and pre-activated enabling easy installation and cost savings for dealers. The Video Doorbell is something that dealers have been asking us for and our offer of this product, we expect to become very popular. Both the Video Doorbell and FireLink products will add to our already rapidly growing recurring revenue. The continued growth of our business with our product is on the right trajectory and we remain focused on executing our strategy. The R&D team here at NAPCO continues work on developing new products to bring more recurring revenue to our business. As we mentioned before the conversion from traditional alarm systems using old fashioned telephone line is in its infancy and we have a strong product offering to address the needs of the commercial and residential market. During the past year, we launched fire and intrusion communicators with Verizon LTE network capability we expect to introduce LTE communicators for the AT&T network at the end of this fiscal year. The StarLink line of universal fire alarm, intrusion alarm, and IoT communicators are market share leader in the wireless cellular alarm communicator category. We will begin our Q&A session portion of this call in a moment. Our third fiscal quarter 2019 was a very successful record breaking quarter for us, and we continue to grow the company and deliver strong products. Our shareholders have been rewarded with very healthy returns and stock performance. NAPCO is in a strong position to continue its growth in sales and profits going forward. We are excited about the rest of the fiscal 2019 and beyond. 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 have now concluded. We would now like to open the call for the Q&A session. Operator, please proceed.

[Operator Instructions] Our first question is from the line of Matt Pfau with William Blair.

Wanted to start out with the iSecure product and maybe you can just tell us what you're seeing in terms of dealer interest. Are you seeing new security dealers show interest in this that you haven't done business with previously or is it primarily existing dealers. And then when should we start to expect a revenue contribution from the iSecure product?

The show was the first time we unveiled the product. We had three different iSecure products at different price point. The price points are much lower by two-thirds than any of the competition and the feature set on the product is greater than anything on the marketplace by far. We believe it will take years for the competition to catch up. As all security products have to embedded by the dealers. They try a few they make sure everything works fine, we have a great reputation for quality and reliability which is what the dealers like, as they like to put a job in and not have to go back and repair it. So they want to make sure that the product everything is fine has lots of software in it, we want to make sure it's fine. So we're going to be shipping this product in this quarter that we're in now in more or less an advanced beta site methodology. And then we're going to be ramping up throughout the year to sell more and more. But typically an alarm product takes nine months to 12 months for it to have that gestation period with dealers really get behind it. At the show, we saw our traditional dealers who want to do the one hour installs and we saw lots of competition dealers coming over to us because why would somebody want to spend so much more money for less of a product than the iSecure. It doesn't make any sense. These are smart business guys, so we expect to get lots of business from this and every one that's installed we get recurring monthly revenue out of. So it's a win-win for us and for the dealers. So I hope that answers your question.

And then was hoping for an update on the fire opportunity as well it seems like based on the gross margin improvement on services line in the quarter that the StarLink fire product was strong. So maybe you could just give us an update in terms of what you're seeing and where are you adding penetrating that replacement cycle opportunity of these old landline fire systems?

There are so many millions of buildings across the country that use the old landlines. And last the false alarm is caused by those lines that are broken and cracked the providers of the service don't want to service it anymore. So we're in the early stages of converting over as more and more fire dealers learn about it, use the product, they learn about the systems coming to shows like the ISC West, counter meet and greets we do, our lunch and learns, others shows regional shows. And I would say we're in the first inning, but the product line is expanded with dual path, single path now integrated fire communicators in every – in our fire control panel so we're going to get additional equipment sales as well as recurring revenue. So we have many, many years of growth and we are considered the leading product in the category of fire communicators which has great, great future legs and just will keep growing.

And last one from me. Just wanted to dig in a little bit to the places of worship opportunity that you mentioned, how should we think about those potential deals and size relative to ones that you'd have with a K-12 schools is it about the same size. And then in terms of targeting places of worship are there new dealers that you need to go out and have relationships with an order to get those types of deals or do the dealers that you currently have within your ecosystem address places of worship?

Well we have dealers across the country. Some of the dealers buy our locking products, access product, alarm products all the products. Some just do locking or remote control access in place like that. We're trying to train the dealers so they're full bumper to bumper dealers where they can get all kinds of jobs. The number of place of worship at gathering places across the country is tremendous. We have a very, very, wide line can see the widest line of radio control locked down devices. And we have the [SAVI] report which explains to these houses of worship and other gathering places on the best way to protect the equipment - protect with our equipment. And then it also recommends building certain partitions and other things, so it's more comprehensive than just selling equipment, it's a full turnkey way to protect all kinds of places where people gather and we have our dealers out there doing installations and doing a lot of the work. Since we sell most of our products through distributors because dealers buy it for different jobs, we have 1000 SKUs use, they put it together like an erector set on what type of security is required for each installation. Everything is custom. Each building is custom so the alarm system, the budget has to be customized to fit. But we have lots of dealers out there 12,000 in total and picking up more and more with all these fire products bringing new dealers on and the iSecure making the dealers excited. So there's a lot of good things going on here and it bodes well for our future.

Our next question is from the line of Mike Walkley with Canaccord Genuity.

Congratulations on the strong results and the award today as U.S. Just kind of a high level question just, have you seen the channel inventory into your seasonally strong June quarter and should we expect kind of that normal strong seasonality for the June quarter?

We get reports from our distributors, the sell through has been very good, it's why you're seeing the numbers that you're seeing. It's the selling season now, April, May, June the weather's gotten nice in all parts of the country. It's the month that precede the summer when people go away. There's no reason to believe that this quarter that we're in now, the seasonally strongest quarter will be that again. All signs point in that direction. So we geared up our inventory -- our inventory grew but we need that because we expect a very nice strong fourth quarter.

And just building on that, how do you think about the gross margin trajectory given the seasonally strong quarter maybe you could talk a little bit about mix, puts and takes on gross margin and any update from your Asia component sourcing strategy that was going to drive gross margin leverage over time also?

I'll talk about the margins and then Dick could talk about the Asia sourcing point. The margins when we hit, when we go over $20 million in a quarter hardware, we start to see gross margin expansion. We saw it again this quarter. In the fourth quarter last year when the hardware sales were over pushing $24 million, the gross margin just for hardware was about 40%. So if we get close to that again or beat it, I would expect gross margin to be in the 40 plus range for hardware only. And then of course, we would add the recurring revenue piece and I will point out that the recurring revenue in this quarter Q3, it went up to 79.3% which is very good. I keep saying we're going to go over 80% in the future. We may get there soon. That's being helped a lot by the fire, radios and to take through higher margin. The margins are all great at recurring, but the fire radios even a stronger margin. And so I think we saw some input on that. We got up to 79.3%, a few points higher than it was a year ago at this time and I expect that trend to continue. As far as the Asia part, I'll turn that to Dick.

As you know about a year ago, I took a team of buyers over to Asia and we located lots of sources where we could buy directly from Asia. Those parts by the way shipped directly to the Dominican Republic, where they're converted into a finished product. All our parts come from usually a lot of the countries in Asia and then they go to the DR and they converted and then shipped back to Amityville where we have those 1000 SKUs and sending out orders to our distributors. So every couple of weeks we meet with our buyers because targets were set for every item that we're using there large quantity items. And as we reach those targets with the pricing then we get the components, have our engineers check them out and make sure the components are exactly the same quality or better than we're using now because we have a great reputation for quality in the industry. The deal is love our stuff, it never burns out, it goes on forever and ever. They get their recurring revenue, we get our recovery revenue out of this. So all of these parts that are getting approved by engineering and it takes a little bit of time because go back and forth with the manufacturers will be melded in and reduced our cost of materials down. And as we said in the past, this is a multi-year project. It won't happen overnight. You got to ease it in, because you don't want to cause any serious problems to our reputation. But it's all going very, very well in the right direction.

Last question from me and I'll pass it off. Just with all these new exciting products ramping going to drive up recurring revenue. Is there any need for investment on OpEx or are you more harvesting old R&D development I guess. Kevin how should we think about kind of absolute levels of operating expenses going forward to support these new product launches. Thank you.

We have been spending about $750,000 to $1 million on CapEx, more lately because we expanded our knock room, as we've talked about, we spent about a $1.5 million on that, which gives us the capability of recurring revenue up to $50 billion. So I think we're good on that for at least a couple of years. And we also expanded our building here in Amityville. We added 10,000 square feet of warehouse space, so readily for us as we grow and as we get to higher and higher levels, we have to add machinery here and there on a auto insertion fact machinery, plastic molding, injection molding type machines not all that expensive. From a CapEx point of view we are good. From an R&D point of view, we're spending a little more, now you saw that the numbers, we're at a good level down from an R&D point of view. You know we might add a person here or there but we're at a good level. From an SG&A point of view, we're keeping that under control, it's very important for us to keep the SG&A, the R&D all this under control so that you see those expenses as a percentage of sales go down, the leverage, that's what we're starting to see now. We don't expect any large changes in that and that's why the leverage will just keep getting stronger and stronger.

[Operator Instructions] Thank you. We reached the end of our question-and-answer session. I would like to turn the floor back to management for any additional 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 Q4 2019 and fiscal year 2019 results. Bye-bye.

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