NAPCO Security Technologies' (NSSC) CEO Richard Soloway on Fiscal Q3 2018 Results - Earnings Call Transcript

NAPCO Security Technologies, Inc. (NASDAQ:NSSC) Q3 2018 Earnings Conference Call May 7, 2018 11:00 AM ET

Executives

Patrick McKillop – Director of Investor Relations

Richard Soloway – President and Chief Executive Officer

Kevin Buchel – Senior Vice President and Chief Financial Officer

Analysts

Mike Walkley – Canaccord Genuity

Gary Mobley – Benchmark Company

Operator

Greetings and welcome to NAPCO Security Technologies Third Quarter 2018 Results Conference Call. At this time, all participants will be in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to, Patrick McKillop, Director of Investor Relations. Please go ahead.

Patrick McKillop

Thank you. Good morning. My name is Patrick McKillop. I'm the Director of Investor Relations for NAPCO Security. Thank you all for joining us for today's conference call to discuss our financial result for our fiscal third quarter 2018.

By now, all of you should have had an opportunity to review the press release discussing the results. If you have not, a copy of the release is available on the Investors Relations section of our website, www.napcosecurity.com. On the call today is Richard Soloway, President and CEO of NAPCO Security Technologies, and Kevin Buchel, Senior Vice President and CFO.

Before we begin, let me take a moment to read the forward-looking statement. This conference call may contain forward-looking statements that involve numerous risks and uncertainties. Actual results, performance or achievements may differ materially from those anticipated in such forward-looking statements as a result of certain factors, including those set forth in the Company's filings with the SEC.

During the call, we may also present certain non-GAAP financial measures such as adjusted EBITDA and certain ratios that are used within 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 matters 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 to Dick in a moment, but before I do, I just want to mention a few things on the IR front. In terms of our upcoming Investor outreach, we are marketing in Milwaukee this week. If you would like to meet, please contact me to arrange a meeting. Also, we will be presenting at the Robert Baird Conference on June 7, in New York City.

Investor outreach is crucial especially for small cap companies 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.

Richard Soloway

Thank you, Patrick. Good morning everyone and welcome to our conference call. Thank you for joining us today to discuss our results. The third quarter of fiscal 2018 marked another record revenue performance in NAPCO. This quarter marks the 15th consecutive quarter of increased sales growth for the Company. Our past recurring revenues continue to grow at a rapid rate.

During the third quarter of 2018, our recurring revenues increased 49%. The driver of the growth for recurring revenue continues to be, all of our StarLink offering which includes Intrusion, Fire and Connect. The annual run rate is now $12.9 million.

During the third quarter, our investments in R&D, selling and marketing expenses did not increase during the quarter versus the year ago period. The levels and investment for R&D and SG&A, items we believe are not at the appropriate levels and we are beginning to see the return on these investments as evidenced by a 92% increase in net income.

Our balance sheet remains strong with net debt of zero and healthy cash balances. We remain focused on capitalizing on key industry trends. These trends include the creation of school security and safety product, the smart connected home and recurring revenue growth in cellular alarm communication. All these trends are having a positive impact on our result.

Driving growth, profit and returns on equity are important to us and our shareholders. Our business strategy is executing well and our interests are aligned with our shareholders as senior management of NAPCO owns 38% of the equity.

Before I go into greater detail, I'll now turn the call over to our CFO, Kevin Buchel to provide an overview of our fiscal third quarter financial results, and I'll be back with more on our strategies and outlook. Kevin?

Kevin Buchel

Thank you Dick and good morning everybody. So, the third quarter net sales increased 7% to $22.2 million, which was a record third quarter performance. For the nine-months ended March 31, 2018, net sales increased 5% to $64.4 million. The increase in sales for the three-months ended March 31, 2018, we assume primarily to increase recurring service revenue, access control products and door locking products.

For the nine months, the increase in sales was due primarily to increased recurring service revenue as well as increased sales from access control product. Gross profit for the third quarter increased 6% to $8.9 million and for the nine-months increased 5% to $25.9 million.

I'd like to point out that research and development expenses are now shown separately as part of our operating expense and are no-longer included in cost of goods sold. We believe this is a clear presentation and we've made this reclassification for all prior periods as well. So, under this new presentation, the gross margin for both the third quarter and the nine-month ended March 31, 2018 was 40.1% as compared to 40.2% and 40% for the three and nine month last year, respectively.

As Dick mentioned, our R&D and SG&A spend levels did not increase significantly versus the year ago period, and we know believe that we're at the appropriate level. R&D expenses for the quarter were relatively constant at $1.78 million, or 7.5% of sales as compared to $1.7 million or 8.2% of sales last year. For the nine months, R&D expenses were also relatively constant at $4.9 million or 7.6% of sales as compared to $4.9 million or 8% of sales last year.

SG&A cost for Q3 decreased 3.9% to $5.3 million or 23.9% of sales as compared to $5.5 million of 26.6% of sales last year. This decrease was due primarily to decreases in various advertising and marketing expenses. So, the nine months SG&A cost remained relatively constant at $16.8 million or 26.1% of sales as compared to $16.8 million or 27.3% of sales last year.

Operating income for the third quarter increased 68% to $1.9 million as compared to $1.1 million last year. And for the nine months, operating income increased 42% to $4.1 million as compared to $2.9 million last year.

Income before income taxes for the quarter increased 69% to $1.9 million compared to $1.1 million for the comparable period last and for the nine month, income before income taxes increased 42% to $4.1 million as compared to $2.9 million last year.

Income tax expense for the quarter decreased by $103,000 to $64,000 compared to $167,000 last year. Income tax expense for the nine months decreased by $362,000 to $118,000 as compared to $480,000 for the same period a year ago. The decrease in income tax expense for the three and nine month was primarily due to recent changes in the federal tax code. As a result, the Company's effective tax rate was 3% and 15% for the three-month ended March 31, 2018 and 2017, respectively, and 3% and 17%, for the nine month ended March 31, 2018 and 2017, respectively.

Net income for the third quarter increased 92% to $1.8 million or $0.10 per diluted share as compared to $952,000 or $0.05 per diluted share last year. And for the nine months net income increased 66% to $4 million or $0.21 cents per diluted share, as compared to $2.4 million or $0.13 per diluted share last year. The increases in net income for the three and nine months were primarily due to the items previously mentioned.

Adjusted EBITDA for the quarter is outlined in the schedule included in today's press released increased 64% to $2.3 million or $0.12 per diluted share compared to $1.5 million or $0.08 per diluted share last year. And for the nine-month adjusted EBITDA increased 32% to $5.3 million or $0.28 per diluted share as compared to $4 million or $0.21 per diluted share last year.

Moving on to the balance sheet, the cash balance at March 31, 2018 was $4.3 million as compared to $3.5 million at June 30, 2017. Working capital as of March 31, 2018 was $40.5 million as compared to $40.8 million at June 30, 2017. Current ratio is 5.8:1 at March 31, 2018 as compared to 4.9:1 at June 30, 2017. And as we previously mentioned, debt net of cash was zero at March 31, 2018.

CapEx was $367,000 during the quarter and for the nine month was $1 million.

Finally, as we have mentioned previously, we opportunistically buyback our stock and we reactivated the Company's stock buyback program at the end of December 2017. And for the quarter ended March 31, 2018, we repurchased 122,795 shares at a weighted average purchase price or $9.29 per share.

That concludes my formal remarks. And I would now like to return the call back to Dick.

Richard Soloway

Thanks Kevin. The two paradigm shifts in our business that we have been continuing to highlight are school security and the growth of our SaaS recurring revenue, remain as positive forces in our business.

Early in the call, while discussing our financial results for the quarter, we highlighted the strong growth of our SaaS recurring revenue. We continue to see demand coming from alarm communications, the connected home category and the overall expansion of the Internet of Things theme.

The school security opportunity continues to remain significant for us. As a reminder, the total addressable market is very large with over 100,000 K-12 schools and over 10,000 houses and universities in the USA. Many of these schools have little or no security in place to protect them from the constant threat of violence incidences. We believe that going forward the amount of new spending on security and safety products from school will continue at a strong rate for the foreseeable future.

Last month, we attended ISC West trade show in Las Vegas, which had another record year for attendance. During this show, we met with many of our channel partners and targeted new channel partners. These relationships are important to us. Our R&D staff is always hard at work developing new products that will help our channel partners grow and succeed.

Dealer training by us continues to be hosted throughout the country and attendance remains high which is significant as we want to have as many dealers selling our product as possible. As a reminder, we mentioned last quarter that we were voted one of the best intrusion brands alongside industry titans such as Honeywell and Bosch, during a survey that was completed by Security Sales & Integration magazine which is the top industry publication. We are very proud of this as it chose we were able to compete amongst the industry giant.

In our current quarter, fiscal Q4, we plan to introduce a complete line of StarLink Verizon LTE wireless communicators which will keep us at the forefront of cellular technology. Last year at this time we introduced the StarLink Connect which is a perfect solution for the residential and small business market. In 2017 it was voted the winner of two prestigious awards during ISC West trade show.

The Connect communicator allows the transmission of alarm signals over the cellular network in lieu of the traditional phone line that have been used for many years. The Connect communicator is feature-packed and gives the end user the ability to receive and upgrade through their alarm system, without them needing to remove existing hardware that's already installed in their home.

Our iBridge smartphone tablet app which works in tandem with the Connect communicator gives the end user customer interactive services, such as control of the alarm system, lighting, door lock, thermostats and seeing live video. The Connect is compatible with many of the major competitors' brands which our dealers love as well.

Users can save time and money using the Connect during the installation process, which enables them to schedule more jobs during the work day. Remote troubleshooting is also a great feature which can help dealers avoid having to send a truck to a resident or small business, all the while still collecting a service call fee.

The market opportunity for the StarLink Connect we believe is very large and it is applicable for new installed and retrofit. Currently, there are approximately 133 million households in the U.S. and only 22 million have alarm systems installed. The Connect Smart Home vertical continues to grow and we often hear about the DIY service monitored solution that you may find at big box stores or on the internet.

However a recent survey report by First Analysis Securities showed that a large percentage of homeowners install DIY products, ultimately end up removing them and later replacing them with professionally installed and monitored system. We believe that we are still in the early innings of the connected home market and the best is yet to come.

Switching gears to some of the other products in our portfolio, we believe that the outlook for these products is very positive as well. These products include StarLink Dual-Path Fire Communicator, CA4K access control software, architect and network wireless lock. The pace of new construction of high-rise buildings in the U.S. remains robust and we believe this bodes well for us, business in the future.

Many of the new buildings are multi-used residential and commercial space, which will require access control, fire communicators and modern wireless lock. The aforementioned product in our portfolio are perfect solutions to many of these new high-rise multi-use building. Many of these products have the opportunity to be used as retrofit applications as well. For example we've discussed on our last call, University of California, Berkeley project in which they are installing the StarLink Dual-Path Fire Communicators around the campus. The StarLink Dual-Path is going to replace the use of old copper phone line, which will save them money as well as improve fire and safety communications.

According to our internal research, there are millions of commercial buildings across the U.S. which needs to be upgraded from existing plain old telephone line which they are currently using as many of the carriers no longer are supporting these lines. StarLink Dual-Path is a contributor to the growth of recurring revenues we received and the dealers loved this great solution for their commercial clients.

We are focused on bringing more SaaS revenue – recurring revenue product and it has been a great contributor to our success in the last few years. Our R&D staff is working on new products which will bring more recurring revenue to our sales. We'll continue to work on the development of access control as a service which will be used in our CA4K software. NAPCO and its integrators will be able to offer cloud based services to end-users. These cloud base services such as the employee or visitor badge creations, attendance report, and adding or deleting employee from a database can be outsourced by the building owner. By outsourcing the above mentioned services, building owners can save money, and we as well as our integrators will be able to share in the recurring revenues as been generated by providing these outsourced services.

Moving on to a very important topic that many of you know, we have been talking about this sometime school security. We all share a deep sorrow with the event that took place back in February at Marjory Stoneman Douglas High School in Florida. As a result of this tragedy, many would have expected more to be done by now, and frankly the majority of schools in the U.S. are still vulnerable target. Our efforts remain focused on providing the products and solutions that the schools need. We have solutions for all schools, where they have a small budget or large.

So what is changed since the incident in February? We are seeing significant activity upon legislators being reported the news on a regular basis now. A few examples includes, the President hosting a meeting with students and parents to discuss school security solution. Florida passing legislation to spend [indiscernible] on school security, Wisconsin passing a bill to spend $100 million, and Maryland adding $125 million close to school security, plus an additional $50 to be included annually going forward. This is just a few examples and we expect that more will happen in the future.

Our SAVI audits for school safety is a great tool for assessing the potential threats to schools and can be used by our integrator, as well as the administrator of the school, we are trying to address the need at their respective schools. The funding to school security is starting to plot a new course and we believe this will be beneficial to our business going forward. We have announced project this quarter from Pepperdine, which is the third time they have used our product on their campus, as well as project in Albany County School in Wyoming. Our pipeline continues to build and we will announce new wins when we can.

Finally, I'd like to discuss a new initiative that we are currently undertaking, which we believe will be beneficial to our business model. Recently, we have been reviewing our component sourcing model and we have discovered additional ways to save cost. Just a month ago, myself and a team of NAPCO employees made the journey to Asian. We attended trade shows and met with many manufacturers of components that we are using in our products. It is our plans to start utilizing these new sources, and thus create savings, which will be beneficial to our financial model.

The amount of savings we could amass by undertaking this initiative could be in the seven figures, thus creating significantly more profitability. We are focused on delivering profits to our shareholders and addition to driving our sales growth. This is another important initiative. We will begin our Q&A session portion of this call in a few minutes, but first, I'd like to give a brief summary. We now are in the final quarter of the fiscal year.

Our physical fourth quarter traditionally our strongest quarter. NAPCO is in a strong position to continue its growth in sales and profits going forward. We believe that our investments in R&D, sales and marketing are beginning to show returns, and we are excited about the balance of fiscal 2018 and beyond. NAPCO senior management maintains a high level of ownership in our equity, approximately 38%, and I'd like to thank everyone for their support and for joining us in this exciting future we have.

Our formal remarks are now concluded. We'd like to open the call for the Q&A session. Operator, please proceed.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Thank you. The first question today is coming from the line of Mike Walkley with Canaccord Genuity. Please state your question.

Mike Walkley

Great. Thanks for taking my question. Thanks for breaking out the R&D. How do you guys think about the current levels of operating expenses in terms of supporting a business growth going forward? And you hinted some new product introduction. So do you think is the R&D levels to support your new product portfolio?

Richard Soloway

Hello, Mike, it's Dick. Yes. We think we have the right levels at this point now and we expect to get a lot of additional output with this level of spending. We are on the cusp of delivering a lot of new and exciting product in the industry and it should be great for our future.

Kevin Buchel

And Mike, you also now are starting to see the leverage. You could see that R&D as a percentage of sale. The percentage is now lower because the sales are rising. We are starting to see leverage there and the same thing on the selling and marketing, the SG&A, again a lower percentage of sales. We keep those levels steady. The sales grow, the model gets stronger.

Mike Walkley

Great. Congratulations on a strong quarter in leveraging the model. Just in terms of, you talked also about sourcing new components and leverage that could create on the gross margin line. Can you talk about how easy or how quickly it would take to switch components and maybe that time horizon where you could see that seven figure savings coming through the cost of goods sold line?

Kevin Buchel

The savings will be contributing over the next 24 months. It will accelerate, I would guess after about nine months because we have to get the components check and make sure there are exactly the quality we need and then filter them into the assembly line, so that you can get the savings. So I would say the seven figures are very reasonable, and I think we can do that. It was a very exciting trip. We found all the components that we use directly with Asian sources and could make a big difference to our gross profit.

Richard Soloway

And these saving are recurring, another form of recurring. You know, you save it, you save it over and over and over again, which is a great thing.

Mike Walkley

Now it makes sense. And then you highlighted on the call just to the school safety, pipeline growing. Can you help us think about the pipeline maybe now versus a year ago? And how you see that business opportunity improving over time?

Richard Soloway

Well, we talked about with some of the school shooting in February and the state legislatures waking up, and the President talking about making it a national issue listing what more business, we are seeing more business. Not all the business can be published because some of the schools don't want this, but the ones that can be, we do publish so that the shareholders can get a feeling for what's going on. But it's a very important vertical for us and we see that we really only scratched the surface of the 100,000 K-12s and 10,000 colleges and university. We've done hundreds and hundreds of them, but the room for growth there and schools definitely need all this protection with all the craziness that's going on.

Mike Walkley

Okay. And last question for me and I'll pass the line. It's great to see the recurring revenue with another quarter of strong year-over-year growth. Can you talk about the drivers there? And also now that you're breaking out the margins just as you continue to add more skill to that platform, how we could see a margin leverage on that piece of business also? Thank you.

Kevin Buchel

The margin leverage is very exciting because as you see, the gross margin on recurring is in the 70s, pushes 80% sometime. As we add more 75% to 80% gross margin item, which is the recurring revenue. The model is going to get even stronger. And so, we've been seeing tremendous growth quarter-after-quarter, this quarter was 49% as we have that much recurring revenue to our picture and its high gross margin business. The model is only going to get stronger. The GP is just going to get climbing. That's what we expect because we think we are in the early stages of the recurring revenue. There is a lot that's happening on that front. A lot of these products are only out a year, year and half. You know the oldest recurring revenue product is only out three years. So, there is a lot to grow and the R&D guys are working on more stuff. Believe me, we love recurring revenue. We want more of it and it's going to come in new ways as go forward.

Mike Walkley

Thank you.

Richard Soloway

Thank you, Mike.

Operator

The next question comes from the line of Gary Mobley with Benchmark Company. Please go ahead with your questions.

Gary Mobley

Good morning gentlemen. Dick, you mentioned Verizon based LTE StarLink product just launched. And can you help us understand significance of this products in terms of addressable market, in other words, did you not have the Verizon based cellular connectivity in these products in the past, does it give you a new avenue to sort of distributors, value at retailers, et cetera?

Richard Soloway

LTE is something that is new with the carriers for the purpose of data. And we found that in the past, the network wasn't built out as robust as previous technology that are out there. So, we waited now to a point where we can give 100% reliable communications for burglary and fire and medical emergency. So, we've come out with a whole line of LTE, because the market is mature enough to accept it. And LTE has long legs, so it will go on for at least 10 years, if you've seen that technology. So, we've developed some pretty amazing equipment using LTE and more to come which makes is ultra-reliable, because our goal is to be competitive substitute for old-fashioned copper, which has been the traditional way signals are going, and now with our LTE, we can now offer LTE in that reliability.

Gary Mobley

Correct me if I'm wrong, but in the past, weren't you suggesting that [indiscernible] can be on an annualized pace at the end of the fiscal year, the month of June is about $15 million annually and with that level you still feel comfortable with? And then Kevin, last on the tax rate, what would expect your non-GAAP tax rate trend to looking over next 12 month or even longer.

Kevin Buchel

The run rate of recurring, we said should approach $15 million by June 30. And we're $12.9 now, so it will be close. We might beat it. We'll be close to it if we don't beat it. And we've also said by the following June that we expect to be over $20 million. So, our expectations haven't changed. The recurring remains a strong part of the business, and as we go forward, it could get even better as we introduced more products to the mix.

As far as the tax rate, going forward, we expect an effective tax rate somewhere between 15% and 17%. That's what I would use for modeling. It was very low this year because we had, as a result of new – of the new legislation, we had certain segments on book, that we didn't need any more and we were able to take back some of the accrual. But going forward, 15% to 17%, it is a fair estimate.

Gary Mobley

Okay. Thank you guys.

Kevin Buchel

You are welcome Gary.

Richard Soloway

Thank you.

Operator

The next question is from the line of [indiscernible] with [indiscernible]. Please proceed with your question.

Unidentified Analyst

Yeah, quick question. Could you quantify the size of the school security market, how big is it from a developed point of view?

Richard Soloway

You know it's – hundreds of millions, so $1 billion dollar of the segment that we're looking to protect. That classroom doors of K-12 as well as colleges and universities. And that's we – and we think that that's going to grow because it's integrated also with the communications for changing key codes around large campuses. So it's a very, very nice market for us, and we have the best offerings in school security for locked out of schools and protection, because our equipment is totally wireless for the big campuses and then we make the mechanical devices for K-12 where they don't have a big budget.

Unidentified Analyst

Thank you.

Richard Soloway

Thank you.

Operator

[Operator Instructions]. Thank you. At this time, we have no additional question. I'd like to turn the call over to management for further remarks.

Thank you 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 all of you again in a few months to discuss NAPCO's fiscal Q4 2018 results. Bye-bye have a great day.

Operator

Thank you. Today's conference has concluded. You may disconnect your lines this time. Thank you for your participation.