Earnings Call Transcript - NSSC Q1 2020

Operator, Operator

Greetings, welcome to the NAPCO Security Technologies, Inc. Fiscal First Quarter 2020 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, that this conference is being recorded. I will now turn the conference over to your host, Patrick McKillop, Director of Investor Relations, you may begin.

Patrick McKillop, Director of Investor Relations

Good morning, my name is Patrick McKillop. I'm the Director of Investor Relations for NAPCO Security. Thank you all for joining us on today's conference call to discuss our financial results for our fiscal first quarter 2020. 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 on the Investor Relations section of our website. 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 statements. 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 upcoming investor outreach, we will be marketing in Montreal on November 7, St. Louis on November 14, San Francisco and Portland on November 20 and 21. Also on November 20 and 21, we will be showcasing our product at the ISC East Trade Show in New York. If you would like to attend, please contact me for an invite. During the month of December, we will be attending the Benchmark Conference and the Raymond James Technology Conference. Investor outreach is crucial, especially for a small-cap company such as NAPCO. Now, I would like to thank all of those folks that assist us in these conferences and marketing trips. With that out of the way, let me turn the call over to Richard Soloway, President and CEO of NAPCO Security Technologies. Dick, the floor is yours.

Richard Soloway, President and CEO

Thank you, Patrick. Good morning everyone, and welcome to our conference call. Thank you for joining us today to discuss our results. The fiscal first quarter 2020 marked another record revenue and profitability performance for NAPCO. Our SaaS recurring revenues continued to grow at a rapid rate. Our recurring revenues' annual run rate is now $21.9 million as of September. Our focus on targeting mostly commercial end markets and professional installation is driving this continuous growth. Our balance sheet remains healthy with no debt as of this report, and our cash balances continued to grow. Capitalizing on key industry trends remains our focus. These trends include school security solutions, wireless fire and intrusion alarm communicators, enterprise access control systems, and architectural locking products. Management, here at NAPCO, continues to focus on the key metrics of growth, profits, and returns on equity. These metrics are important for us as well as 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'll 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?

Kevin Buchel, Senior Vice President and CFO

Thank you, Dick and good morning everybody. For the first quarter, net sales increased 12% to $26.3 million, which was a record quarterly performance and the 21st consecutive quarter of year-over-year record sales, compared to $23.4 million for the same period a year ago. The increase in sales for the quarter was primarily related to increased sales of our alarm communication services, intrusion and access products, and door locking products. Recurring monthly revenue from the alarm's division increased 42% for the quarter. Recurring revenue now has an annual run rate of $21.9 million, based on September 2019 recurring revenue. Gross profit for the first quarter increased 20% to $11.5 million with a gross margin of 44%, compared to $9.5 million with a gross margin of 41% last year. The 300 basis point increase in gross margins year-over-year was primarily driven by the 42% increase in recurring revenue, where the gross margin was 79%, as well as increased equipment sales and the leverage that we get from the Dominican Republic manufacturing facility and those sales exceeding $20 million in a given quarter. R&D expenses for the quarter remained relatively constant at $1.7 million or 6.5% of sales, compared to $1.7 million or 7.5% of sales last year. Selling, general and administrative expenses for Q1 remained relatively constant at $6.1 million compared to $6 million for the same period a year ago. Selling, general and administrative expenses as a percentage of net sales decreased to 23.4% for Q1, compared to 25.9% for the same period a year ago. The decrease as a percentage of sales for the three months ended September 30, 2019, was due primarily to the increase in net sales. Operating income for the first quarter increased 105% to $3.6 million compared to $1.7 million last year. Income tax expense for the quarter increased by $121,000 to $369,000, compared to $248,000 last year. The increase in the provision for income taxes for the three months was caused primarily by an increase in income before the provision for income taxes. As a result, the Company's effective tax rate was 10%, versus 14% for the three months ended last year. Net income for the first quarter increased 115% to a first quarter record of $3.2 million or $0.17 per diluted share, compared to $1.5 million or $0.08 per diluted share last year. The change in net income for the quarter ended September 30, 2019, was primarily due to the items previously mentioned. Adjusted EBITDA for the quarter, as outlined in the schedule included in today's press release, increased 91% to $4 million or $0.22 per diluted share, compared to $2.1 million or $0.11 per diluted share last year. Moving on to the balance sheet. Cash balance at September 30, 2019, was $10.8 million, compared to $8 million at June 30, 2019. Our working capital as of September 30, 2019, was $53.6 million compared to $51.1 million at June 30, 2019. The current ratio was 4.6:1 at September 30, 2019, compared to 4.6:1 at June 30, 2019. And debt remained at zero at September 30, 2019. Net cash provided by operating activities for the quarter was $2.9 million. Inventory levels are higher than normal as we continue to gear up for several new product launches that we have mentioned on previous calls, including iSecure, our new Marks' anti-ligature locks, and our new line of AT&T LTE StarLink radios. CapEx was $181,000 during the quarter versus $424,000 in the year-ago period. That concludes my formal remarks and I would now like to return the call back to Dick.

Richard Soloway, President and CEO

Kevin, thank you. NAPCO continues to have strong growth in its business and we believe that growth trend will remain vibrant. Alarm communications, including fire, intrusion, and growth of the smart home category are driving demand for our recurring revenue products. The school security market remains a significant opportunity that continues to have positive tailwinds with the new funding coming to help the schools pay for the upgrades they need. Tragic events of 2018 will live with us forever and we always worry that it could happen again. In the US, there are 100,000 K-12 schools and 10,000 colleges and universities. NAPCO is dedicated to providing these schools with the solutions and products they need to help protect the students and faculty. Recently, at the end of October, the Department of Justice announced that it had awarded a total of $85 million in grants to schools for security projects. The School Violence Prevention and Mitigation Act of 2019 legislation was proposed by representatives Williams and Deutch in the House of Representatives. In July 2019, this legislation would authorize $2 billion over 10 years to identify and address any shortfall in school security. And as we have mentioned in the past, many states are actively passing funding legislation as well. These are examples of the changes happening in the school security market, which we believe will create a positive tailwind for our business. We continue to see a robust pipeline for school security projects and we will continue to announce new wins as allowed by each school's approval process. Increased violence such as activist students in public places like houses of worship and other meeting areas have been taking place as well. These incidents have seen the need to expand the use of our SAVI audit for locations other than schools. The need for more security with our locking and access control products in these areas is clear. Recently, we began the launch of our new LTE StarLink line of universal fire, intrusion alarm, and IoT communicators. Our StarLink communicators now offer the widest LTE coverage in the US to the dealers in our network with both Verizon and AT&T service. The StarLink Fire LTE, Verizon and AT&T-powered communicators continued to exhibit strong sales growth. During our last earnings call in September, we also highlighted the newest anti-ligature lock for our Marks division, which are currently being rolled out to the dealer community across the US. These anti-ligature locks meet ADA (Americans with Disabilities Act) requirements and the highest BHMA standard. The locks are designed to restrict the attachment of lines, laces, etc. to doorknobs and levers. We offer these locks in multiple styles and models, combined with the ability for easy installation and retrofit for all popular door construction. We continue to be very excited about the upcoming launch of our latest product, the iSecure. The iSecure is designed for the new breed of professional installers and savvy consumers. It has a quick installation time and rich feature sets for the advanced smart homes that are in demand today. The iSecure won the MVP (Most Valuable Product) award in the Home Controls Category at the ISC West Trade Show earlier this year and drew lots of traffic from the dealers into our trade show booth. Our FireLink fire alarm control panel with a cellular communicator inside was launched earlier this year and continues to see good sales growth. FireLink is an all-in-one 8-32 zone fire alarm control with a built-in cellular LTE StarLink-powered alarm communicator. Looking into the future, the R&D team here at NAPCO is working on leveraging our StarLink cellular communication technology experience into other product categories we have, such as electronic locks and enterprise access control, in order to generate more recurring revenue for these product lines. It is our business to have new recurring revenue products and services by fiscal 2021 for these product lines. We will begin our Q&A session portion of this call in a moment. Our fiscal Q1 2020 was a very successful record-breaking quarter for us, and as we continue to grow the company and deliver strong profits, 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 remainder of fiscal year 2020 and beyond. NAPCO senior management maintains a high level of ownership in our equity, approximately 38%, and I would like to thank everyone for their support and for joining us in the exciting future we have. Our formal remarks are now concluded. We would now like to open the call for the Q&A session. Operator, please proceed.

Operator, Operator

Thank you. At this time, we will be conducting the question and answer session. Our first question comes from the line of Matt Pfau of William Blair. Please proceed with your question.

Matt Pfau, Analyst

Hey guys, thanks for taking my questions. Wanted to first ask on the iSecure product. When was that released into the dealer base or when will it be released, and how should we think about when that product will start to contribute to both hardware revenue and recurring revenue?

Richard Soloway, President and CEO

Typically what happens is it takes nine to twelve months for the dealers to trial it, and then it starts to pick up momentum. It has unique feature sets, unique pricing. We have many, many dealers who already signed up to see it at the ISC East Show. We expect to release the first group of it in this calendar year. And then, keep pushing more and more production as the dealers demand.

Matt Pfau, Analyst

Great. On the gross margin, hardware gross margin improved year-over-year in the quarter. Can you talk about where that leverage came from and how we should think about hardware gross margin going forward?

Kevin Buchel, Senior Vice President and CFO

Sure, Matt. The margin was 34.8%, increasing from last year's 33.6%. This improvement is attributed to leverage from the DR factory. Hardware sales reached $20.9 million, compared to just over $20 million during the same period last year, which is over $1 million less. Once sales exceed the important threshold of $20 million, as many of you are aware, margin leverage starts to activate. The further we surpass that $20 million mark, the more we anticipate an increase in margin. When we reach $25 million in quarterly sales for hardware, we expect margins, specifically for hardware, to approach 40%. Our target is to achieve $100 million in hardware sales, averaging $25 million per quarter, and we aim for the gross margin on hardware to be around 40%. We're making significant progress toward that goal.

Matt Pfau, Analyst

Okay. And last one for me. On the school opportunity, you mentioned that the pipeline there continues to build nicely. Maybe you can just give us an idea of how long the lead times are with these projects that are in your pipeline to the ones that you're seeing coming now, are there more projects that are going to be implemented into this upcoming summer, while school is out of session or how should we think about the visibility into that area of the business with those projects that are in the pipeline?

Richard Soloway, President and CEO

Some school jobs are completed relatively quickly. For K-12 jobs, we are aware of them and they can often be done while students are in or out of school. For example, updating classroom locks is a common task since many doors are currently locked from the outside. There has been ongoing discussion about ensuring that classrooms are secured from the inside so that teachers do not have to leave the room to find a custodian to lock up. We are making progress in providing locks that can be secured from the inside, which can be installed while school is in session. We are consistently seeing locking jobs throughout the year. Larger projects usually take place during school breaks. University jobs, for instance, are often completed when students are not on campus, including in December and January or between terms. As the academic year ends in April, we often see more projects in May and June. Activity is ongoing year-round, with no specific downtime for us. There are lead times from initial interest and quoting to job awarding, which can take a few months. However, we are encouraged by the increased quoting activity, indicating growth in this area. Our numbers reflect this trend, and we anticipate continued growth. Many schools still lack the necessary updates, and despite our discussions on this topic over the years, most have not yet achieved the standards needed.

Matt Pfau, Analyst

Got it, that's all I had. Nice job on the quarter and thanks for letting me ask some questions guys.

Richard Soloway, President and CEO

Thank you.

Operator, Operator

Our next question comes from the line of Jaeson Schmidt of Lake Street. Please proceed with your question.

Jaeson Schmidt, Analyst

Hey guys, thanks for taking my questions. Just following up on your commentary on the school security market, I know you don't break out the percentage of revenue. But at least directionally, were school security revenue up sequentially in September?

Kevin Buchel, Senior Vice President and CFO

School security, compared to jobs compared to Q4, remember Q4 is our biggest quarter. So, sequentially I would say it was not versus the Q4 because Q4, we had a lot of big jobs in that quarter. But it was up compared to last year's Q1. And we were encouraged by that and we expect it to be up in Q2 versus last year's Q2. Q4 is the hardest quarter to be up sequentially, a lot happens. For schools also, a lot happens. That’s the biggest time when schools are out. But the encouragement is still there, up versus a year ago, expected to be up next quarter, expected to be up in Q3, this is going to be up every quarter as schools finally get to the point of doing something about the fact that they're not protected. And beyond schools, I will point out that our business also gets aided by a lot of houses of worship now needing the same thing. Churches, synagogues, they need the same thing. We're seeing a lot of activity in that perimeter as well.

Jaeson Schmidt, Analyst

Okay, that's helpful. And then I know in the last call, you mentioned targeting equipment revenue growth in that high-single-digit range for fiscal '20. Is that still the ballpark target for this year?

Richard Soloway, President and CEO

Yes. We came in about a 7% this quarter, and we have been doing 7%-type growth quarters for last few, maybe a little less in Q4, but 7% this quarter. Yes, the goal is to be high-single-digits, eventually double-digits as we head into the back-end of fiscal '20 and as we head into 2021. There are a lot of reasons why we feel good about that. The iSecure, with its release is going to help. The new anti lig is going to help. It’s in the product interest we are doing. The new AT&T LTE radios are going to help. That one is only going to help hardware; that's going to help recurring revenue. So, we have reasons to believe that 7% could be high-single digits and eventually double-digits in the near future.

Jaeson Schmidt, Analyst

Okay. And the last one from me and I'll jump back into queue. How could we think about OpEx, needing to ramp this year?

Kevin Buchel, Senior Vice President and CFO

Historically, we have managed our operating expenses quite effectively. In this quarter, research and development and selling, general and administrative expenses remained relatively flat compared to last year. However, I do not anticipate this trend to continue in the upcoming quarters. I would project approximately a 4% increase year-over-year due to salary increases and similar factors. We haven't significantly expanded our personnel, maybe just one or two engineers here and there. On the sales side, we are transitioning from outside representatives to in-house sales personnel. This process is progressing well, and we believe it will lead to improved sales in the future, as these individuals will be fully dedicated to our company rather than selling different product lines alongside outside representatives. Therefore, if I were to forecast, I would anticipate a 4% growth in both research and development and selling, general and administrative expenses.

Jaeson Schmidt, Analyst

Okay, I appreciate the color. Thanks, guys.

Kevin Buchel, Senior Vice President and CFO

Thank you, Jaeson.

Richard Soloway, President and CEO

Thank you.

Operator, Operator

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

Unidentified Analyst, Analyst

Hi, this is Antony on for Mike. Actually, thanks for taking the questions. I just wanted to confirm the product gross margins, they were not reflecting any discounting like you saw last quarter with the AT&T LTE radios, correct? And also on the AT&T rollout, in terms of the recurring revenue associated with it, how many quarters of lag is typical before you see that begin to hit the number?

Richard Soloway, President and CEO

There was no discounting like last quarter. We thought there might be a 100 basis point effect, it wasn't. We didn't have to do it. We make these decisions as we see that there was tremendous excitement on getting those radios out; people want it, people are willing to pay for it. The recurring revenue eventually will come. So, what happens is you sell these radios, a lot of times you are selling them to distributors. The distributors may have it on their shelf for a month and they'll sell it to the dealer. As soon as the dealer gets it, the radio is activated. That's when the recurring revenue should begin to happen. And sometimes, there are things that weigh in a little more, but generally you got to figure that once the dealer gets it, that’s when the switch is turned on. It’s not a big gap, but there is a month maybe two.

Unidentified Analyst, Analyst

Got it, okay. And then in terms of the recurring revenue now rapidly growing to $22 million on a run rate this month, can you help us think about the timing expectations. Is it still a June '21 target to hit your $40 million and getting there? Maybe if you could provide color on what's growing fastest across the different recurring revenue categories, whether it's fire, intrusion, now you're doing locking; it’s recurring. Any color on the breakdown would be great. Thanks.

Kevin Buchel, Senior Vice President and CFO

Our goal remains to be a $40 million run rate by June of '21. So, essentially by the end of that fiscal year, by the end of the following fiscal year. Why do we feel pretty comfortable about that? Well, we've introduced all these radios that you see out there. Very recently, the Fire radio is doing really well. That’s one that was introduced back and, as we say, the Fire radio business is on fire. And that perhaps drives two things; it helps us get to our $40 million goal. It also helps us drive up the margin on the recurring revenue; that’s the highest-margin radio of the group. And so, you keep seeing recurring go up, the margin go up, this quarter was 79%. I wouldn't be surprised if we see 80% in the near term. A lot of that's because of the Fire radio business. In the early stages, there is a lot more to be done, a lot of buildings are making the switch over to cellular from the hard line; it’s not being supported anymore by Verizon. This is a big area for us.

Richard Soloway, President and CEO

We expect that the conversion from copper to cellular, there are millions and millions of commercial buildings that have to be done with the fire systems. And we think this is going to go on for years to come. So, our radios are being well-received and we wanted to put out the LTE radio at a good price, and we did it last quarter and it's the business for the future. And as I said, it could just keep building 9 months to 12 months, typically when you really start to feel a lot of volume. But, the radios are installed within a few months after they ship to the distributor and distributors push them out to the dealer; so it's a very important aspect of our business. And also the connected home part of our business, using our StarLink Connect, that's doing very nicely. That's for small business residential, where you can get app control of the alarm system and a lot of functionality of the alarm system at a very good price. The iSecure will add more and more volume in the residential and small business side when that comes out this year. And it builds, as I said, nine months to 12 months. So, we see lots of alarms for retrofit to homes and small businesses of existing alarms using the Connect, and we see lots of new business that’s going to be generated from the iSecure product line, which can be installed in an hour, has all kinds of great features, and is priced very attractively. So, the dealers' ROI is very quick. So, we have that, and then we have additional cellular performance that's going to be put into our access control business and our locking business because we wanted to get recurring revenue from each of our product lines, across each of our verticals, and that’s our goal over the next couple of years to do all of that for the other lines of products that we manufacture.

Unidentified Analyst, Analyst

All right, great. And just one last question from me before I pass it on. Can you provide any updates on the progress of sourcing components from Asia and when we might see significant margin benefits from that?

Kevin Buchel, Senior Vice President and CFO

We've begun to see that. Dick took a team of buyers to Asia with the goal of buying more components direct from Asia versus going through distributors, paying a higher price, if you're going through a middleman, so to speak. And it takes time, first you go there, you identify sources. Then, you qualify the sources because you don't want to have poor quality. We have an ISO certified high-quality Dominican Republic manufacturing facility. We don't want to mess with that formula. We get the quality from the new sources; if they pass tests, we introduce it. We have to use our existing inventory and then you could fully get the benefits of the new source. It's having an effect. We have said, originally we want to save over $1 million on an annual basis or more than $1 million on annual basis from that effort. And we're not there yet, but we're saving a lot. And as we use up the inventory on the older vendors, that goal should be realized. It's having an impact, helping the margins somewhat, and it will help more in the future. And the other big part of that whole story is by buying direct and going from Asia to the DR, we are bypassing that whole tariff discussion that we all hear about; we're renewing from that problem.

Unidentified Analyst, Analyst

Great. Thank you again.

Kevin Buchel, Senior Vice President and CFO

Thank you.

Operator, Operator

Our next question comes from the line of Jeff Kessler of Imperial Capital. Please proceed with your question.

Jeffrey Kessler, Analyst

Thank you. I was intrigued by your comments on your transition to iSecure and also about StarLink, particularly how it is starting to integrate into your main installations, focusing on the commercial sector rather than residential. You mentioned electronic locks and access control, and there is certainly a fast-moving trend in that business, especially when considering recent M&A activities. I'm curious about your perspective on this segment of your business, specifically regarding its impact on the growth of your locking and access control divisions, as well as its effect on your margins and recurring revenue growth.

Richard Soloway, President and CEO

Hi, Jeff. Dick. What we are doing is pioneering a new approach in the locking and access control industries by incorporating cellular reporting capabilities. This allows dealers, including locksmiths and system integrators, to understand the benefits of recurring revenue. This recurring revenue is a significant factor driving dealers to sell burglar and fire alarm systems, as they often seek profits from long-term monitoring contracts. Although I am not personally familiar with these different business types, we have identified two primary segments: locking and access control. We are going to demonstrate specific functionalities to dealers, and we have developed our locks to support this innovation. Over the next couple of years, we will launch several new products that will appeal to locksmiths and system integrators, enabling them to build equity and generate more than just annual service revenue, leading to monthly recurring income. This will empower all locksmiths and integrators to market services to end-user customers via our cellular network, which is something we find very exciting. This opportunity is focused on commercial businesses rather than residential, representing a significant untapped market in these industries with higher margins.

Jeffrey Kessler, Analyst

When one of the small companies that started this years ago, Brivo, was trying to adopt a recurring revenue model, they faced significant resistance due to the lack of upfront gross margin. Do you believe that you have a strong relationship in place, and do you have the business model ready to engage particularly those locksmiths and some of the systems integrators? I assume they may have some experience with recurring revenue businesses, but it will require substantial education and relationship-building on your part. Are you confident that you have the ecosystem and the right people to make this happen?

Richard Soloway, President and CEO

We've been doing recurring revenue for four years. Previous to that, we've been doing alarm sales to dealers for 25 years. So, we know the velocity and these are human beings. Human beings want to make a profit. They want to build equity. All these people are entrepreneurial. They don't want to just put a lock on the door and leave, and maybe it'll break, and they'll come back and fix it. They want to be able to get recurring revenue out of that lock. And they want that lock to be able to be something that their end-user customer uses that lock, wants to get data out of that lock. And that we know how to do with the dealers because we deal with alarm systems, and now we're going to carry it over. We're the only company in the entire security industry that owns a locking company and an alarm manufacturing company. So, it's natural for us to kind of move these dealers and integrators into this, and we have the people; we have been doing it for years. We train dealers to utilize our radios. You can see the growth in our radios. You can see how the dealers are going from dial-up, which they've been using to cellular very successfully. And now, we're going to do the same thing with the locking and access. That’s our goal. Now, nothing happens overnight. But over the next two years, we're going to start introducing the products, but it has such long way because it’s such a motivational thing for a locksmith or an integrator to want to get recurring revenue rather than working job-by-job. So, we know it goes along with human nature of these types of people.

Jeffrey Kessler, Analyst

Okay. Great, thank you very much. Appreciate it.

Kevin Buchel, Senior Vice President and CFO

Thanks, Jeff.

Richard Soloway, President and CEO

Thank you, Jeff.

Operator, Operator

We have reached the end of the question-and-answer session. I will now turn the call back over to Richard Soloway for any closing remarks.

Richard Soloway, President and CEO

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 '20 results. Bye-bye.

Operator, Operator

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.