Napco Security Technologies, Inc Q3 FY2023 Earnings Call

Greetings. Welcome to Napco Security Technologies, Inc. Fiscal Third Quarter 2023 Earnings Results Conference Call. Please note, this conference is being recorded. I will now turn the conference over to Patrick McKillop, Vice President of Investor Relations. Thank you. You may begin.

Thank you. Good morning. I'm Patrick McKillop, Vice President of Investor Relations for Napco Security. Thank you all for joining us today for today's conference call to discuss our financial results for our fiscal third quarter 2023. 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, Executive Vice President and CFO. Before we begin, let me take a moment to read the forward-looking statement. This presentation contains forward-looking statements that are based on current expectations, estimates, forecasts and projections of future performance based on management's judgment, beliefs, current trends and anticipated product performance. These forward-looking statements include, without limitation, statements relating to growth drivers of the company's business, such as school security products and recurring revenue services, potential market opportunities, the benefits of recurring revenue products to customers and dealers, our ability to control expenses and costs and expected annual run rate for SaaS recurring monthly revenue. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those contained in the forward-looking statements. These factors include, but are not limited to, such risk factors described in our SEC filings, including our annual report on Form 10-K. Other unknown or unpredictable factors or underlying assumptions, subsequently proving to be incorrect, could cause actual results to differ materially from those in the forward-looking statements. Although, we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. You should not place undue reliance on these forward-looking statements. All information provided in today's press release and this conference call is as of today's date, unless otherwise stated, and we undertake no duty to update such information, except as required under applicable law. I will turn the call over to Dick in a moment, but before I do, I just wanted to mention some upcoming IR calendar events that we have which are: first, the Needham Technology Media Conference on Wednesday, May 17 in New York City; followed by the B. Riley Conference, May 24 through the 25th in Los Angeles. Then we will be at the William Blair Growth Conference, June 6 through the 8th in Chicago. And finally, we'll be attending the Wells Fargo Industrials Conference, June 13 through the 15th, also in Chicago. Investor outreach is crucial, especially for a small-cap company such as Napco, and I would like to thank all 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. We are very pleased to report our fiscal Q3 2023 record sales of $43.5 million. This is our 10th consecutive quarter of sales growth. Recurring revenue continued to grow at a very strong rate, and the annual run rate is now approximately $63 million, based on April 2023 recurring revenues. Our balance sheet remains strong, with our cash balances at $56.9 million, and we have no debt. We continue to focus 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 the key metrics of growth, profits, and returns on equity, and controlling our costs. 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 10% of the equity. Before I go into greater detail, I will now turn the call over to our CFO, Kevin Buchel, who will provide an overview of our fiscal third-quarter results, and then I'll be back with more on our strategies and outlook. Kevin?

Thank you, Dick, and good morning, everybody. Net sales for the 3 months ended March 31, 2023, increased by 21% to a quarterly record $43.5 million, compared to $35.9 million for the same period one year ago. Sales for the 9 months ended March 31, 2023, increased by 25% to $125.3 million, compared to $100.4 million for the same period one year ago. Recurring revenue for the quarter increased 26% to $15.1 million, compared to $12 million for the same period last year. Recurring revenue for the 9 months ended March 31, 2023, increased 32% to $43.8 million, compared to $33.3 million for the same period one year ago. Our recurring service revenues now have a prospective annual run rate of approximately $63 million, based on April 2023 recurring service revenues, and that compares to a $59 million run rate, based on January 2023 recurring service revenues, which we reported back in February. The increase in equipment sales for the quarter was primarily due to increases in both our Alarm Lock and Marks door locking products, as well as increased sales in our Continental Access Control products. The strong growth of our recurring revenue for both the 3 and the 9 months ended March 31, 2023, is primarily attributable to the continued strength of our StarLink cellular radio products, driven by increases in the commercial intrusion and fire alarm business. Gross profit for the 3 months ended March 31, 2023, increased 51% to $22.7 million, with a gross margin of 52%, compared to $15 million, with a gross margin of 42% for the same period one year ago. Gross profit for the 9 months ended March 31, 2023, increased by 51% to $60.3 million, with a gross margin of 48%, compared to $39.9 million, with a gross margin of 40% for the same period one year ago. Gross profit for equipment sales for the 3 months ended March 31, 2023, increased 98% to $9 million, with a gross margin of 32%, compared to $4.5 million, with a gross margin of 19% for the same period one year ago. Gross profit on equipment sales for the 9 months ended March 31, 2023, increased 93% to $21.3 million, with a gross margin of 26%, compared to $11 million, with a gross margin of 16% for the same period one year ago. Gross profit for recurring revenue for the 3 months ended March 31, 2023, increased 30% to $13.7 million with a gross margin of 90%, compared to $10.5 million, with a gross margin of 87% for the same period one year ago. Gross profit on recurring revenues for the 9 months ended March 31, 2023, increased 35% to $39 million, with a gross margin of 89%, compared to $28.9 million, with a gross margin of 87% for the same period one year ago. The significant increase in gross profit dollars, as well as gross margin for equipment sales for both the 3 and the 9 months ended March 31, 2023 is primarily due to the resulting increases in equipment revenues, which also improved overhead absorption rates. The increase in gross profit dollars for recurring service revenues for both the 3 and the 9 months ended March 31, 2023, was due to the continued strong sales of the company's StarLink radios. Research and development expenses for the 3 months ended March 31, 2023, increased 15% to $2.3 million, or 5% of net sales, compared to $2 million, or 6% of net sales for the same period one year ago. Research and development expenses for the 9 months ended March 31, 2023, increased 18% to $7 million, or 6% of sales, compared to $5.9 million, or 6% of net sales for the same period one year ago. The increase in dollars was due primarily to salary increases and some additional staff. Selling, general and administrative expenses for the 3 months ended March 31, 2023 remained relatively constant at $8.4 million, compared to $8.4 million for the same period one year ago. SG&A expenses as a percentage of net sales decreased to 19% for the 3 months ended March 31, 2023, compared to 24% for the same period one year ago. The decrease as a percentage of net sales was due primarily to the increase in net sales without the need to increase SG&A expenses. Operating income for the quarter increased 160% to $11.9 million, compared to $4.6 million for the same period last year. The company's provision for income taxes for the 3 months ended March 31, 2023, increased by $397,000 to $1.5 million with an effective tax rate of 12%, compared to $1.1 million with an effective tax rate of 26% for the same period one year ago. Net income for the quarter was a quarterly record of $10.8 million, or $0.29 per diluted share, compared to $3.3 million, or $0.09 per diluted share for the same period last year, a 231% increase. Adjusted EBITDA for the quarter was a quarterly record, $12.7 million, or $0.34 per diluted share, compared to $5.7 million, or $0.15 per diluted share for the same period last year, a 123% increase. The cash provided by operating activities for the 9 months ended March 31, 2023, was $12.4 million, and that compared to $8.4 million for the same period last year, and that's a 48% increase. And CapEx for the quarter was $1.7 million versus $418,000 in the year ago period. And for the 9 months ended March 31, 2023, was $2.5 million, compared to $1.2 million in the prior year period. That concludes my formal remarks, and I would now like to return the call back to Dick.

Kevin, thank you. Our third quarter was a sales and profits record breaker, continuing our sales growth streak, which is now our 10th consecutive quarter of year-over-year sales growth. Prior to COVID, we had 23 consecutive quarters of growth, and we look forward to surpassing that streak in the future. We're particularly pleased to see the strong growth in the gross margin on equipment revenues, which increased 1,300 basis points to 32%, compared to 19% in last year's Q3, and 900 basis points when compared to the gross margin of 23% last year. This was primarily attributable to lower freight costs, increased overhead absorption from our Dominican Republic factory, which occurred as a result of the large equipment sales increase, and more favorable sales mix. One key area of our success continues to come from our commercial fire and intrusion alarm business. A potential recession driven by higher interest rates from the U.S. Federal Reserve continues to dominate stock market headlines. And I'd like to remind you that our company is highly recession-resistant, as 80% of our business is commercial. The commercial fire alarm business is a mandatory, non-discretionary item. Commercial buildings must have and maintain a fire alarm system in order to receive a certificate of occupancy. Given the high profitability and essential nature of this business, we focus on this as a key area of our resources. Our equipment and recurring revenue both generated strong growth this quarter, increasing 19% and 26% respectively. The annual run rate for recurring revenue is now $63 million as of April 2023. The quarterly increase in recurring revenue was affected by the Verizon 3G sunset, which occurred this past January. There are still many thousands of 3G radios that need to be replaced, and we anticipate that many of these will be replaced with Napco's newer generation radios because alarm dealers must have new, functioning, and recurring revenue producing radios to monitor alarm conditions. This would result in both additional hardware revenue and increasing recurring revenue for the company. We believe we are still on track to reach our previously mentioned goals of $150 million run rate in recurring revenue and $150 million of equipment revenue by the end of fiscal 2026. Achievement of those goals, as well as our gross margin goals of 80% for recurring revenue, and it was 90% in Q3, and 50% for equipment revenue could generate EBITDA margins in excess of 45%. We estimate that there are millions of commercial buildings of all types, such as offices, hospitals, schools, coffee shops, fast food restaurants, and others that still require upgrades from old-fashioned copper phone lines. Our StarLink Radio has the widest coverage of both AT&T and Verizon service and rich feature sets, which our dealers love. The constraints of the supply chain have largely abated for us, and we believe that in the next 3 months, the new supplier resources we have developed will begin to invigorate our equipment margins even further and bring them to even higher levels than what we generated prior to the supply chain crisis. The backlog for the company is getting closer to more normalized levels from the extremely high levels we had experienced in the last few quarters. School administrators are focused on the need for security solutions as more school shootings continue to happen. We continue to see more funding initiatives. Our fully integrated solutions for school security generate healthy margins for our business, and now more than ever, we are laser-focused on further penetration of the school security market, which comprises approximately 130,000 K-12s and 5,000 colleges and universities across our country. The recently launched Air Access product will enable us to generate recurring revenue from all divisions of the company. Air Access will generate recurring revenue from locking, access control, which has never been done before. We believe it is important to balance our capital allocation priorities, including investing in growth opportunities, maintaining a strong balance sheet, and returning capital to shareholders. Thank you for your support, and we believe we can continue this growth streak well beyond the 10th consecutive quarterly streak we are now on.

Our first question is from Matt Pfau with William Blair.

First, I wanted to start off with the improvement in the equipment gross margins, which was good to see. How should we think about the rate we saw in the third quarter in terms of a go-forward rate? There's a bunch of moving parts within there. So I just want to understand how durable that is going forward? And then specifically on the mix component, maybe just some comments clarifying what you mean on the mix side? What was strong? What was weak that drove that benefit?

So Matt, the components that helped us get to 32% on the margins, several of them. Let's start with freight. The freight costs have come down, and we benefit from that too. We also did not have to fly components as much as we have been doing in the past during the supply chain problems. Because during the supply chain crisis, if we could get our hands on parts, we would buy a lot of them, and we'd fly them. We don't want to run out. We don't have to do that anymore. So that's very sustainable going forward. We believe the days of having to fly like crazy because of shortages are over. The overhead absorption, which comes from the Dominican Republic facility, that's very sustainable as the volume of hardware continues to grow. This quarter, the volume was $28.4 million of hardware sales. The more goods that we pack into the Dominican facility, the more overhead absorption we're going to see and the more the margins are going to expand. But that's sustainable. The other part is the mix. The mix is unpredictable. Alarm lock sales were very strong, and they dominated the quarter. The other groups did well, but alarm lock did particularly well. And alarm lock has very strong margins. So those margins compared to margins on radios, as an example. Radios don't have the greatest gross margin. Of course, they lead to recurring revenue, which has 90% gross margin. But from a hardware point of view, locking is better. So the mix was better from that point of view. Is that sustainable? We think it is, but mix is hard to predict. We want all pieces of the puzzle to contribute. And in this particular quarter, they pretty much all did. And that's why we were able to get to 32%. We have not seen the benefit yet of a lot of raw material benefit. Remember, we bought a lot of components at very high costs and we had to do that to keep the recurring revenue going. Now we have solutions to get away from that. We don't have to buy parts from brokers, but we have to work through that inventory. That inventory is still high. We cut our inventory level by $3.4 million this quarter, but we have a lot more work to do in further cutting of inventory.

Just 1 more for me on the recurring revenue side. What did you see in the quarter absent the impact of the Verizon 3G shutdown? How did the business perform excluding that impact versus your expectations?

What we saw with recurring revenue this quarter, besides the 3G sunset effect, is we saw the margins continue to go up, which was nice to see. Now it's 90%. Last quarter was 89%. That's primarily attributable to the fact that fire radios continue to be very strong and become a larger part of the mix. The dealers would be crazy not to replace them. It's a slow process, slower at least than I would have thought. On January 3, boom, it happened and they were caught short. There's thousands and thousands of radios, a good 30,000 plus radios that affected us. That's the difference between being at 35% increase year-over-year versus 26%. I modeled out just to see what's the impact on our 2026 goal, if 26% is the new norm of growth rate. And what it showed was, instead of getting to our goal by the end of fiscal 2026, we get there 6 months later. However, my goal also used 80% as the gross margin for that. And we're at 90%. That more than makes up for it. Not to say that we think we're going to stay at 26%. We think a lot of these radios are going to be replaced, and that rate's going to go up.

Our next question is from Jaeson Schmidt with Lake Street Capital Markets.

Dick, I know you mentioned strong sell-through data in March. Just curious if you think March benefited from any sort of pull-in orders and how we should think about the seasonally strong June quarter for you guys?

Sell-through comes from the fact that the dealers are very, very busy. And going to these distributors of ours, we have 200 locations, and taking product from the distributors so they can do the installations. And I would expect, with what we're seeing and reading in the newspapers every single day, that the dealers are going to be super, super busy. Also, the dealers are so busy that they've neglected some of the radios that we've been talking about, not upgrading them. But they're very busy doing new work. The StarLink radios are the best radio for performance on the market, rated #1 across the board for range. You can use it in all kinds of cities and country, and you get tremendous range compared to our competitors. So there's a lot of advantages. And additionally, realize that the dealers are very busy putting in the control panels and other products, and every one of our control panels now has a radio built in. So we're getting recurring revenue from our control panels and our fire systems like never before. So I expect things to keep along at a very high rate, and I expect that this new Prima product that we showed, which is a residential small business product will become a universal success.

Could you provide an update on whether you implemented any price increases in the March quarter? It seems that some supply chain issues have improved. How are you considering potential price increases for the rest of the year?

We always take a price increase, Jaeson. So we didn't do one in March. Typically, we take it in the July period. We have done some earlier during supply chain where we put 2 or 3 price increases in effect within a fiscal year. I think we're kind of beyond that. So I think the next one will be July 1.

Being in the commercial business, we're 80% commercial, we don't really have pricing issues. Commercial dealers are not as price-sensitive as residential dealers. So it's not really an issue with us. If we need a price increase, we can get it, and the dealers will pass it along.

Our next question is from Brian Ruttenbur with Imperial Capital.

I was wondering if you could dig down a little bit about school security, give us an update? And maybe tell us how much of your revenue right now is generated from school security directly or indirectly, and what the pipeline looks like?

School security remains strong. We can't tell you exactly what percent of our revenue comes from school security, because a lot of times it comes through distribution. But we know a couple of things: One, there's been a bunch of wins that we recently got. We haven't announced it. We always have to work to see if we're able to announce it. That locking is 59% of our hardware sales. When kids went back to school, we all know shootings came back with a vengeance and school security jobs have come back also. And when COVID hit and the kids were out of school, that stat dropped. There’s lots of money for the K-12s.

And just as a follow-up real quick on that. In terms of the locking market, have your biggest competitors started getting products out on time?

Many of our competitors produce their locks in Asia, while we manufacture ours in the Dominican Republic, allowing us to deliver within six weeks without many interruptions. This gives us a significant advantage. Our competitors are still facing production challenges, which benefits us by facilitating the introduction of our lock products to locksmiths, integrators, and dealers. Overall, this situation has worked out favorably for us.

Our next question is from Rajiv Sharma with B. Riley Securities. A lot of our competitors make their parts in Asia. We make our locks in the Dominican Republic, which allows us to get delivery in 6 weeks with minimal interruptions. This gives us a significant advantage. Our competitors are still facing challenges in their production, which benefits us by introducing our line of lock products to locksmiths, integrators, and dealers. That has worked out well for us.

Congratulations on the quarter. Can you share any insights on the dealer sell-throughs? Is the mix changing? Are you seeing an increase in business from them?

The big accounts that we've talked about, which are ADT, Johnson Controls, those are direct sales, and we're just getting started with all 3 of them. So they're not major impact customers yet. The distributors are doing really well with us. Unlocking was very strong, which we've talked about. The margins are great on locking, so we love to see that. But the distributors are doing really well with us. They have been for a while. And the ordering pattern is good too now. It used to be in the old days that the orders would come in at the very end of the quarters, and we'd be sitting here waiting. That's changed. They order more regularly, better for us.

One additional thing and that is that the makeup of our customer base is very diversified. The company built itself with security dealers of all different types. These dealers have between 1 and 3 vans on the road. They're community-oriented dealers. The new dealers that we're talking about, the Johnson Controls, ADTs, these are brand new dealers that we're adding to the smaller dealers. That’s our growth. Our growth is diversified dealers as well as the larger dealers, the largest ones in the business.

And then the recurring revenues came in a little lighter than expected, the margins still exceeded. How should we look at sort of the equipment sales and the recurring revenue growth in the next few quarters?

Well, we grew the hardware by 22% last year. So far it's 22% this year. If you go back a number of years before that, it wasn't the case. But that's the case of where we are now. And we don't see any reason for that to change. When it comes to recurring revenue, we were growing in the mid-30s lately. This one dropped to 26%. We think it will come back. As we work through the very high level of inventory we have that we bought, if they were hard to get, that should come down. Internally, we want to reduce inventory by at least another $10 million.

Our next question is from Jim Ricchiuti with Needham & Company.

Kevin, regarding the inventory question, when do you anticipate that we'll cycle through some of this higher cost inventory?

2 quarters, I would say. By the time we get to Q2 of fiscal '24, we would have gone through a lot of those higher costed components.

Most of my other questions were answered, but this is going to be in the queue and maybe you could just help us, Kevin. What was the year-over-year growth rate in intrusion and alarm versus door-locking products, if you can?

Door-locking products was $16.8 million for the quarter compared to $11.2 million for the prior year's quarter. The intrusion is lumped with Access Control products together. It was $11.5 million for the quarter versus $12.6 for the prior year's quarter.

We have reached the end of our question and answer session. I would like to turn the floor 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. Have a wonderful day.

Thank you. This will conclude today's conference. You may disconnect at this time.