Greetings, and welcome to the Napco Security Technologies Fiscal Second Quarter 2021 Earnings Release Conference Call. Please note this conference is being recorded. I would now like to turn the conference over to Patrick McKillop, Director of Investor Relations. Thank you. You may begin.

Thank you. Good morning. I'm Patrick McKillop, Director of Investor Relations here at Napco. Thank you for joining us today for today's conference call to discuss our financial results for our fiscal second quarter 2021. 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 is Richard Soloway, President and CEO of Napco Security Technologies and Kevin Buchel, Senior Vice President and CFO.

Thank you, Patrick. Good morning, everyone. Welcome to our conference call. Thank you for joining us today to discuss our results. We are very pleased to report our record Q2 sales result of $27.2 million. Our recurring revenues continue to grow at an even higher rate than recent quarters, 42% in Q2 and now we have an annual run rate of $33.8 million as of December. Our focus on targeting the professional installations and mostly commercial end markets is driving this continuous growth, especially in the fire alarm sector. Our balance sheet remains strong with our cash balances continuing to grow. We remain focused on capitalizing on key industry trends, which include wireless, fire and intrusion alarms, school security solutions, plus enterprise access control systems and architectural locking products. The management team here at Napco continues to focus on key metrics of growth, profits and return on equity and controlling costs, especially during these difficult times. These metrics are important to us as well as our shareholders. We continue to execute our business strategy and our interests are aligned with our shareholders as senior management at Napco owns approximately 22% of the equity.

Thank you, Dick. Good morning, everybody. For the second quarter, net sales were $27.2 million as compared to $23.2 million last quarter, which represents a 17% increase, and $25.8 million for the same period last year, which is a 5% increase. Net sales for the six months ended December 31, 2020 decreased 3% to $50.4 million as compared to $52.1 million for the same period one year ago. The increases in sales for the quarter were primarily related to increases in recurring services revenue, as well as intrusion and access products. Recurring monthly revenue continued its strong growth, increasing 42% for the quarter and 39% for the six months. This strong growth is primarily attributable to the continued strength of fire radios, which are becoming a larger part of the recurring revenue mix. Recurring revenue now has an annual run rate of $33.8 million based on December 2020 recurring revenue. The sales decrease for the six months was due primarily to decreased sales of door locking products, which were impacted by the COVID-19 pandemic, and partially offset by increased sales of intrusion products and the associated recurring revenue. Equipment sales, which should be pointed out, did however increase by 20% in Q2 versus Q1. Gross profit for the three months ended December 31, 2020 decreased 6% to $11.4 million with a gross margin of 42% as compared to $12.1 million with a gross margin of 47% for the same period a year ago. Gross profit for the six months ended December 31, 2020 decreased 7% to $22.1 million with a gross margin of 44% as compared to $23.6 million with a gross margin of 45% for the same period a year ago. Gross margins for recurring revenue in the second quarter continue to improve, coming in at 85%, a 400 basis point improvement versus the year-ago period while also beating the street consensus estimate of 81% by 400 basis points. For the six months, the gross margin from recurring revenue is also 85%, up from 80% last year, a 500 basis point improvement. The increase in gross margins from recurring revenue was primarily due to the increased sales of our StarLink Commercial Fire Radios, which generate higher margins, and as I previously mentioned continue to become a larger part of the overall recurring revenue mix.

Thank you, Kevin. Our second quarter sales were a record, driven by the increased ability of security equipment professionals to gain access to commercial and residential job sites during the quarter. The recurring revenue annual run rate is now $33.8 million as of December 2020. And we believe that we are on track to achieve our previously discussed goal of exiting fiscal 2021 with a run rate of $40 million. Also, we continue to see positive signs from several of our largest distributors that sell-through rates continue to increase by healthy double-digit percentages. We continue to believe that we are well positioned to rebound from the economic recovery. The fire alarm business continues to be strong and is a mandated business; in order for buildings of all types to have a certificate of occupancy, they must comply with fire codes. The fire radio is in particular helping recurring revenue gross margin expansion as evidenced by the 400 basis point improvement for the quarter versus the year-ago period and 500 basis point improvement for the six months.

Our first question is from Rich Valera with Needham & Company.

First, just encouraging commentary with respect to the sell-through trends that your large distributors are providing for you. Can you just clarify if the double digit percent you were talking about was that year-over-year growth that you were referring to in the sell-through comments?

So, yes. Looking right now at it, just to give you some flavor. So year-over-year, I'm looking at our top guy; he was up 15%. I'm looking at our second guy; he was up 31%. This is year-over-year. I'm looking at another one up 50%. Another one up 37%, low year-over-year. So it bodes well. I could predict and say everything is going to be great in the March quarter because of this. What I don't know is inventory levels. I was happy. The distributors, they have no choice. When the sell-through was that strong, they have to buy. So we don't know what kind of inventory levels they're going to want to keep. But when you have those kinds of year-over-year type growth, they have to buy. So we're optimistic. We'll know a lot as the quarter comes to an end, as a lot of them buy a lot at the very end. More and more of them are buying throughout the quarter. But obviously, with a 20% increase in equipment sales versus last quarter, we think we're back on track.

Yes, Rich. Most of the sales, when we talk about sell-through, that's equipment going into jobs, more and more opportunities for the dealers to get into buildings and they're doing the installation. Most dealers don't carry a lot of inventory. So the inventory is being pulled through and installed. So that's a very good sign.

Yes, it seems like a great leading indicator of future service revenue growth. And then just on the product side, Dick, it sounds like you're making -- continue to make progress with iSecure. Is there anything more you can say about that in terms of just kind of the revenue trends or revenue contribution from iSecure? Sounds like you have good momentum there.

Well, iSecure is a very feature-rich product and a dealer, putting it in, we can do it in an hour. And it takes a little bit of time to make it really a powerful mainstream product. But it has all the legs to be a very powerful mainstream product. So as more and more dealers use it, they want to continue with it and make it their prime control panel, alarm system for commercial and residential. So the hopes are such that for what we see and what we hear, it's going to have great legs to it. We have added some functionality to it, to make it even better as we get feedback from the dealers. So that's going to make it even more powerful. Then the dealers talk to each other, they do some installations. They sit on it for a while, making sure it works just the way they expect it to work. And then so it's to pick up a lot of speed. A lot of the competition has products which are in the category but they don't have the features that this does. They don't have the efficiency the way this works with all kinds of control towers all across the country. And it has very good sensitivity. So it works virtually in every job they want to put it into. It's very, very unique. And its price point is fabulous. We designed it so that it's very cost-effective. The dealer can grow its business without spending as much for equipment and get a fabulous product, which is top of the market in functionality. So we have very strong hopes that this is going to be a major hit for our company.

Our next question is from Mike Walkley with Canaccord Genuity.

Just wanted to ask a quick question. It sounds like the radio business has been quite strong, which is great to see the reacceleration of recurring revenue. But just looking at some of the other hardware businesses. Can you guys talk maybe about how the pipeline is coming together for the locking side of the house soon with the economies hopefully reopening into the summer and students back in full school, hopefully by this fall with vaccinations? It seems like there's got to be some pent-up demand in that area. Can you talk at all about the pipeline on that side of the business?

Kevin, do you want to take that?

So Mike, the hardware sales on radios are doing phenomenal. We haven't missed a beat. It's better than ever. That's why you saw the growth it leads to the recurring revenue, which is why you saw 42%. We couldn't be happier with that. The hardware sales as it relates to state school security has slowed down. A lot of the schools are not operational as we all know, if we don't have a lot of school jobs that those stacks are going to suffer. But we are encouraged by a lot of jobs or motion, or a job that we got from Montana. Now Montana, to me as a guy who lives in New York, is in the middle of nowhere. But they are operating like business as usual. And we got this job from this school in Montana. And it's part of a group of 16 other schools and our hope is we're going to get all 16 of them. There are other school jobs throughout the country. Some are moving along because it depends on where they are, and some are on pause, waiting for schools to open. Schools will be opening soon. We know it. Vaccines are here, things are going to get better. And when we see that part of the business pick up then you're going to see the hardware pick up even better. Hardware was up 20% this quarter versus last quarter. That was very encouraging. We're not where we want to be yet. We want to be over that $20 million threshold. When we get over $20 million, that's when you start to see the margins expand but we're getting close. And so we think as these next couple of quarters come about, we're going to start to see tremendous improvement even on the locking side of the business.

Mike, let me just add something to it. So this is traditional hardware for schools and businesses and as more and more of the installers get into these places, more and more of this traditional hardware will be installed. And we can see that the sell-through is picking up. But the long-term vision for all of this is they had recurring revenue versions of these products done in a new way. And to be the leader in the recurring revenue of hardware, which means access control and locking, which generates recurring revenue for both the dealer and for Napco. And that's what Air Access is all about. So the sale of the unit into a building, a school will generate a monthly stream of recurring revenue, just like we do in the alarm business. Since we understand the cellular networks, we build our own radios. We don't farm this stuff out. We do everything in-house from experts in cellular; we're able to bring this new technology concept into the locking and access control area. And that's the vision. So imagine where we're going to be a couple of years from now. It's going to create a recurring revenue stream for dealers. We don't get recurring revenue streams right now. Only alarm dealers get that, but integrators and locking people want that same recurring revenue stream, and we were able to do this concept with our knowledge of the alarm business and how we do it in the alarm business and the fire business, and the Burglar Alarm business, and how the IoT portion of that business generates recurring revenue. That's going to be done with Air Access. So that's the vision of the future, all businesses that we have, all of our sister companies generating recurring revenue.

I understand the vision, and congrats on the Air Access product. That just leads to my follow-up question kind of for both you and Kevin. Just in terms of more recurring revenue hardware projects, are you willing to give up any hardware gross margin to drive a recurring revenue, or should we expect that the business scales, usually that June quarter seasonally strong? I know it's tough with COVID to predict quarterly results. But assuming equipment revenue gets above $20 million, should we see gross margins start to get back above 30% on the hardware side, or are you willing to trade off a little lower gross margins to accelerate that recurring revenue growth that's been at such strong margin? Thank you.

Mike, we don't need to give up any margin in radio business. We're aggressive as it is. And being aggressive, being in a 20% gross margin, let's say, on radio business, that's good enough because, obviously, it leads to the 85% we get on the back end with the recurring revenue. I don't think we have to be more aggressive. I think the hardware sales are going to come. They're going to come because business is coming back. And just by getting over that $20 million hump, margins will go up. We'll go up into the 30s; the higher we go over the $20 million, the higher those margins will get to. Just a matter of how fast it happens. We're encouraged because of the net growth we saw this quarter versus last, that it will happen sooner rather than later. But I don't think we need to adjust our game plan at all as we go forward.

Our next question is from Jaeson Schmidt with Lake Street.

Just want to follow-up on your comments on Air Access. When should we start to think of that product potentially impacting the P&L?

You have to give that product nine to 12 months. It's just coming out now. It's a new concept for integrators and locking people because they're used to doing a job and then they finish the job, and that's it for them. But now the idea of them getting a recurring revenue stream and building equity in their business is new for them. Along dealers have learned that's the magic trick to making a very strong business. So nine to 12, I would say, would be where we should be thinking right now. And we think out a couple of years from what we do, that's our vision, that's our plan. So we know that this is going to be very exciting for dealers because it's a new revenue stream. They don't have to keep banging down and doing jobs and then doing another job. Once they start building their equity with recurring revenue, it keeps coming in and then they can grow their businesses more strongly because they're going to throw off a lot more profitability. And that's the future for us. We're very unique in the fact that we're the only company in the security industry that has sister companies and all three key legs of security. We have an access control company, we have two locking companies, and we have an alarm manufacturing by Burglar Alarm with IoT. So we're able now to be able to bring the same technology through our whole product line and the locking in access which was installed at once and then get another job; that the business will change and figure nine to 12 months.

And then Kevin, looking at the OpEx line, understanding that it's probably a little muted here, just given the lack of trade shows, traveling, etc., related to COVID. But how should we think about OpEx ramping for the remainder of this calendar year?

Well, I think with COVID still being somewhat prevalent and conferences and trade shows being virtual, that's going to keep these expenses lower than they were used to. Now if you're talking about the calendar year, maybe by the summer, things start to change. As soon as we're able to go to these conferences in person, which we like better whether it's an investor conference or trade show, we'll do it. We'll go. And then you'll see those expenses return to more normal levels. If not, we operate like everybody else in Zoom-type calls and the costs are kept down, which is fine. Eventually, we'll get back to more normal times.

Our next question is from David Robinson with William Blair.

I just had a quick one, related to kind of commentary about the 3G sunsetting. I was just curious, do you anticipate any acceleration, I guess, in sales in the radio business as we kind of approach closer to the calendar 2022 and the anticipated sunsetting of 3G, or have you heard kind of any feedback from dealers in anticipation of the sunsetting?

The sunsetting is extra wind at our back. All the old radios have to be upgraded. So there's a lot of fire alarm radios as well as verbal alarm radios that have to be upgraded. So between that, wind at our back and the window the fact that copper is dead as a communication link for alarm systems, it's lights out for copper all around the country in different sectors of the country. That's happening also simultaneously. And that the dealers are very motivated to convert lots of fire alarm and burglar alarm jobs from the copper because they have to, to cellular. And the 3G sunset, that's the wind at our back. So that's helping to drive the business. And the sunset is two years on the 3G and the copper, I would say, it's going to be over the next five years or longer as more and more of the country is phased out of copper, I guess. The phone carriers don't want to support copper anymore. So the dealers are using StarLink and StarLink has such a wide footprint. It goes everywhere throughout the country and it has the best sensitivity of any radio on the marketplace. So a dealer knows when he puts a StarLink in, he gets communication which is similar to copper.

Our next question is from Raj Sharma with B. Riley.

I wanted to follow-up on equipment sales. Again, you mentioned sell-through improving distributors double digits. Can you address again the pricing power and equipment sales? And I know you mentioned that the lower gross margins, Kevin, you mentioned lower gross margins with locking doors versus the intrusion. So with the current sell-through up double digits year-on-year, can you sense how that impacts gross margins going forward in the next few quarters, or how should we kind of look at that?

So when the locking sales improved, and they started to in this past quarter, their margins are much, much better than the margin on the radio. So radio margin will be 20%. The margin on the door locking device would be 40%. It could go as high as 50% if it's in a school on a lockdown system, combining with our Access Control products. So when you get more of those 40% to 50% margin products, obviously, you're going to start seeing hardware margins go up. That's what we always have experienced. It's on a temporary halt sort of schools being slower than we'd like. But as that comes back, margins will go right back up and then some. The thing that we're very happy about is that throughout this, and like, we haven't seen any decline at all on the radio business, and that's great. So while they are not the highest gross margin items from a hardware point of view, revenue side. So that's the good news in all of this. And the rest of the hardware will come back.

So the radio, of course, the radio sales of course generate the recurring revenues, and that's incredible. So in addition to the product mix change with locking doors, you're also going to get the scale as the double-digit sort of sell-through is pushing up the equipment sales, you're going to get an improvement there as well?

So again, as we go over that $20 million per quarter, then you get into the Dominican Republic manufacturing leverage, where the higher it goes over the $20 million mark, the higher the margins go because you don't have to add any real cost structure is in place. We could do $100 million of annual revenue per shift in the Dominican Republic. It's a low-cost facility; a factory worker earns $2,500 a year. And if that's the only thing we're going to add to the equation because we have base, we have the supervisors in place, we have the machinery, then you're going to get overhead absorption, gross margin expansion, which is what we like to happen every quarter. And as we approach the fourth quarter this year, hopefully, we'll be back getting that strong leverage again.

And then on the recurring side, the rise in the fire and the burglars alarms, were they spread across any sort of broad segments, any particular segments that performed better than the others?

When I look at it, I think fire radios as the main thing. I don't have it broken down within fire radios. Fire Radios, just as a segment was very strong. It's come-- as I've mentioned before, it was the last or the late comer for the radio business. It's only a few years old. And it's becoming a more and more larger part of the mix. That's why you're seeing the kind of growth we're seeing in the margin expansion. So I don't really have anything within fire radios. I will say we are talking to some large players in the industry, some well-known names that I can't mention at this point. But as that becomes more and more of a reality, then the fire business can get even better. So that's what our hope is that as strong as it is now, it will get even better.

Our next question is from Abba Horwitz with OSP.

I don't remember that we are seeing so much cash on your balance sheet? Remind me when the last time you guys carried so much cash.

Abba, it was 12 years ago; we had $40 million of debt. Now here we are probably as later, we're approaching $40 million of cash on the balance sheet.

Any plans with that cash? What are you going to do?

We're talking about utilization of the cash. It's a high-class problem, and we'll work through this. But a lot of opportunities when you have cash, but also doing hard times. We like to have cash, keep my cash a little bit dry so that you never know what could happen with the economy, but there are a lot of opportunities that have been shown to us.

Now just one other question is, you said that in the next two quarters essentially that your recurring revenue will get to $40 million, correct?

Run rate. Yes.

Okay, run rate.

We predicted this years ago, and I don't know if people thought we were nuts, but here we are with six months to go, I think we're like we're right there.

So are you going to give us fiscal 2022 projections for recurring revenue?

We probably should. We have 2026, which I know is five years further out, they will get to 150. But yes, we should probably do that.

We're turning company into a recurring revenue service business, where the five year plan, our goal is to be 50-50 would be about $300 million and $150 million of that will be recurring revenue. That's our goal. That's what we're striving to do. So with the new products being recurring revenue generators plus the existing products, keep growing market share. That's our plan.

And now on the $40 million, you're going to support what an 85 gross margin, approximately?

We don't know what it's going to be. When I model, it is 80%. It's been 85%; fire is so strong. We have a lot of radio products. The mix could shift a little. If you model it, I would say 80% and be happy when we come in at 85%.

But essentially, okay, in two quarters, and this is my final point. So in two quarters, essentially, you're going to be generating around $1.75 to $1, let's say, $1.90 a share on the recurring revenue, just on the recurring revenue side of the business. I understand there's all the corporate costs and all that you have to cover. But essentially, that recurring revenue business is approaching almost $2 a share on its own. Is that correct?

Yes, which is why we're getting this business to be more and more recurring coming out with Air Access. It's the beauty of…

And by the way, I was one of those guys there that heard your projections years ago, and you know I was there. So I just want to know, congrats. I want to say congratulations to you guys, really. You took care of the shareholders. Thank you.

Our next question is from Christopher Hillary with Roubaix Capital.

I just wanted to ask, can you remind us, as you have this growing recurring revenue business. Is there a typical price increase that goes in each year for both the company and for your dealer network?

We want to keep our prices competitive and we'll adjust to the market as necessary, but we're really not seeing any pressure right now. The offering is very, very unique and the performance of the equipment is very, very unique. There’s quite nothing quite like it on the marketplace. So it's not a pressure that we're feeling at this point.

Do prices go up each year or do they tend to stay stable in terms of the monthly fees?

Stability…

Yes, we haven't had to change anything at all. It's a service that speaks for itself, and the dealers are thrilled to get it and it just drives itself. We don't do anything…

And one more, maybe. Obviously, school budgets, it's been a pretty disruptive year. It seems like a lot of districts have down budgets going into next year. At the same time, perhaps there's going to be some national spending support. I mean, is there anything that you're aware of that would shape your perspective on the outlook for spending as you head into the next school year in the fall?

We've seen more and more advancement of bills in Congress in certain states. I know it's not top of mind school security because a lot of the kids are out of school or people just worrying about how to get out of the whole remote learning fiasco. But we are seeing a lot of activity, and again, depending upon what part of the country, there's still a lot of school jobs going in. We know also of a few jobs that are going to happen towards the end of the calendar year. I think as the kids get back in, this will become more of a topic that we'll be talking about. The beauty of it is…

Chris, I just want to jump in. And just to add in terms of -- you talk about the school budgets. What's important to remember is that there's a lot of grants that are available. And so we've talked about this in the past. But just as an example, in December of 2020 at the end of last year, the Virginia Department of Ed, allotted $12 million in grants for the 490 schools they have in the State. So in terms of the budgets, the schools can get the money. They just need to fill out the grant application and the money is available. And the federal government has committed $100 million per year. It started in 2018 for the next 10 years. So we've got a little less than 10 years to go. But there's plenty of funding in terms of helping these schools get the money they need.

There don't appear to be any more questions. Do we have any closing remarks?

So I want to thank everyone for participating in today's conference call. As always, if 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 Q3 '21 results. Bye-bye, and have a great day, everybody.

Thank you. This does conclude today's conference. You may disconnect your lines at this time, and thank you for your participation.