NAPCO Security Technologies Inc (NSSC) 2017 Q4 法說會逐字稿

Greetings, and welcome to the Napco Security Technologies, Inc. Fourth Quarter and Full Year 2017 Results Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Patrick McKillop, Director of Investor Relations for Napco Security Technologies, Inc. Thank you, Mr. McKillop. You may begin.

Thank you. Hello, good morning. My name is Patrick McKillop. I'm the Director of Investor Relations here at Napco Security. Good morning, and thank you all for joining us for today's conference call to discuss our financial results for our fiscal fourth quarter and fiscal year 2017.

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; 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. The 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. We are working hard to create shareholder value, and one of the ways we do this is by attending conferences and making marketing trips to various cities. This week, we will be attending the Liolios Conference in San Francisco and then heading to Chicago for some marketing. On September 14, we will be attending the CL KING Best Ideas Conference in New York City. We expect to meet with lots of new investors during these events and share the bright future we see ahead with them. Investor outreach is crucial, especially for a small cap company such as NAPCO, and 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.

Thanks, Patrick. Good morning, everyone. Welcome to our conference call. It's a pleasure for me to be here with you today to discuss our results. The fourth quarter and fiscal year marked another quarter and year of record revenue performance for NAPCO. Our balance sheet is very healthy, as our debt, net of cash, is now 0. Our recurring revenues continue to grow at a rapid rate. The annual run rate of $9.7 million is now effectively as the stated goal of achieving a $10 million rate in recurring revenue. I would like to note that this is one year ahead of the stated time frame.

Important to note as well is the approximate $10 million of recurring revenue was achieved largely with the StarLink Intrusion and Single Path Fire, which are the first 2 versions we produced. The Connect version, our latest addition to the communicator series that we believe will be a great product, just started the commercial launch this past April. And the StarLink Dual Path Fire was just launched a few months ago.

As we have previously stated, we increased investments in R&D, selling and marketing expenses. Our growing sales momentum, as evidenced by the $25.7 million record-breaking revenue for the fourth quarter demonstrates that such increased investments are having a positive impact on our sales, while we still maintain the fiscal discipline required to reduce our debt to 0.

Capitalizing on key industry trends that continue to impact our results favorably are: recurring revenue growth in cellular alarm communications; the creation of products for the Internet of Things and the connected home; and development of products for improving school security and safety. We are executing our business strategy and taking advantage of these trends. Our senior management collectively owns 38% of the outstanding equity in NAPCO, and our interests are aligned with the shareholders in driving growth, profits and return on equity.

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

Thank you, Dick. And good morning, everybody. For the fourth quarter, net sales increased 7% to $25.7 million, which was a record fourth quarter performance. For the fiscal 2017, net sales increased 6% to a record $87.4 million. The increase in sales for both the quarter and full fiscal year was primarily related to increased sales of our intrusion products, access control products and door locking products. Recurring monthly revenue from the Alarm division increased 59% for the quarter and 65% for the fiscal year. Recurring revenue, as Dick stated before, now has an annual run rate of $9.7 million based on June 2017 recurring revenue.

Gross margin for the fourth quarter was 38.3% of sales, which was 170 basis points decline versus the fourth quarter last year. While the decrease in margin for the quarter versus a year ago was primarily due to increased spending in R&D, significant margin leverage and overhead absorption from our Dominican Republic manufacturing facility was still achieved as a result of the $25.7 million quarterly revenue. Gross margin for the fiscal year was 33.9% versus 33.4% for the last fiscal year. The margin improvement for the fiscal year was related to the aforementioned operating leverage from our manufacturing facility, increased sales, increased recurring revenue and a more favorable product mix, as partially offset by the previously mentioned increased investment in R&D to support the launch of new products and services.

As Dick mentioned, we've also been investing in sales and marketing to support our portfolio of new products. This incremental investment was one of the primary drivers of the increase in SG&A costs during the quarter and fiscal year. SG&A costs for Q4 increased 9% year-over-year to $6.4 million and as a percentage of sales, increased to 24.8% from 24.4% last year. For fiscal 2017, SG&A increased 9% to $23.2 million and as a percentage of sales, increased to 26.6% from 25.8% last year. The increase in dollars and as a percentage of sales for the fourth quarter and fiscal year was due primarily from increases in selling, wages and commission as well as increased advertising and trade show expenditures. As we previously mentioned, we increased these expenditures in order to generate higher sales, and we do not expect these expenditures to increase significantly in fiscal 2018.

Operating income for the fourth quarter decreased 8% to $3.5 million as compared to $3.8 million last year. And for the fiscal year, operating income increased 1% to $6.4 million compared to $6.3 million last year.

Income before taxes for the quarter decreased 8% to $3.4 million compared to $3.7 million for the comparable period last year. And for the fiscal year, income before taxes increased 2% to $6.3 million compared to $6.1 million last year.

Income tax expense for the quarter decreased by $72,000 to $216,000. For the year, income tax expense increased $325,000 to $696,000 for an effective tax rate of 11%. The increase in income taxes from fiscal 2016 to fiscal 2017 resulted primarily from the benefit recognized in fiscal 2016 from a onetime reversal of certain reserves.

During the fourth quarter, net income decreased by approximately 6% to $3.2 million or $0.17 per diluted share as compared to $3.4 million or $0.18 per diluted share last year. For the year, net income decreased 3% to $5.6 million or $0.30 per diluted share as compared to $5.8 million or $0.31 per diluted share for the same period a year ago. The change in net income for the quarter and the year ended June 30, 2017, was primarily due to the items we've previously mentioned.

Adjusted EBITDA for the quarter, as outlined in the schedule included in today's press release, decreased 7% to $3.8 million or $0.20 per diluted share compared to $4.1 million or $0.22 per diluted share last year. And for the year, adjusted EBITDA was $7,354,000 or $0.42 per diluted share as compared to $7,846,000 or $0.42 per diluted share last year.

Moving on to the balance sheet. Cash balance at June 30, 2017, was $3.5 million as compared to $3.8 million at June 30, 2016. Our working capital as of June 30 was $40.8 million as compared to $36.9 million at June 30, 2016. The current ratio was 4.9:1 at June 30, 2017, as compared to 5.1:1 at June 30, 2016. And debt, net of cash, was 0 at June 30, 2017.

CapEx was $299,000 during the quarter and was $1,414,000 for the year. These are higher spend levels than our normal spending range of $500,000 to $750,000. One of the primary reasons for the higher spend is we expanded our Network Operations Center, our NOC, to handle the rapidly increasing regarding revenue we have generated and which we expect to continue for years to come.

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

Thanks, Kevin. Recurring revenue and school security are 2 key paradigm shifts for the NAPCO business. As Kevin and I mentioned in our prior statements, recurring revenue continues to grow at a very strong rate for us driven by alarm communications and the Internet of Things, which includes the connected home and school security, which continues to receive significant amount of attention. And we expect new spending related to making improvements for school safety to continue at a strong rate.

A recent report from the Freedonia Group research firm stated they expect the U.S. alarm market to reach $4.9 billion in 2021. Our strategy is focused on introducing new and innovative products and services that are compelling to the end user as well as products and services that help our dealers grow and succeed. NAPCO is positioned strongly to take part in the growth of the U.S. alarm market, both with our legacy products and new products that our R&D staff of 40-plus engineers are currently developing.

Demand for smart connected home products and service is growing more and more every day. According to a recent report by IHS Markit, the global smart home market is forecast to exceed $14 billion in 2017. The StarLink Connect is a great product entry into this category as evidenced by the 2 awards it received at the recent ISC West trade show in April of this year. The StarLink Connect Communicator replaces the need for traditional phone lines in order to send the alarm signals to the central station. In addition, StarLink Connect can be used in tandem with our iBridge smartphone/tablet app, which gives customers smartphone control of their alarm system, lighting, climate, door locks and remote video viewing. The StarLink Connect is an attractive product for the end user as well as our dealers. One of the unique features that dealers love is the fact that it's compatible with most of our competitors' alarm systems, which is a big economic incentive for dealers as the need to replace existing hardware at the installation site is eliminated to now get connected to home functionality.

The market opportunity for Connect is not only existing NAPCO systems but the tens of millions installed systems from other providers. Dealers can now upgrade the end user system quickly, allowing them to schedule more jobs during the work day. Our recurring revenue streams will benefit from the StarLink and iBridge smart connected home products, thus driving growth and profitability for NAPCO and our channel partners.

Other new products that we're excited about include the StarLink Dual Path-Fire, the CA4K and ArchiTech Series Networx Locks, to mention a few. Our StarLink Dual Path Fire Communicator recently won certification from Los Angeles and New York Fire Authorities; and this is important, as they are 2 very large markets which we now have access to. In commercial buildings, many fire systems are still relying on POTS lines, which are old-fashioned copper lines, which cost $100 per line per month. The major carriers have been backing away from supporting these lines over the years. And in fact, we recently learned that one of the major carriers has been sending notices to customers stating they will no longer support these lines in the near future.

According to internal research we have done, there are 5.6 million commercial buildings in the U.S. and approximately 2 million multi-tenant high-rise buildings that would need to be upgraded. The StarLink Dual Path is the perfect solution for these customers, and Dual Path will also add to our recurring revenue line.

The ArchiTech Networx Series Locks have been out for about 9 months and is an ideal access control solution, elegantly blending advanced wireless access control convenience within any decor in choice of trims and finishes. These can be used to control access at a door at any time across a wireless network or as an integral part of a new or existing enterprise security system. These locks are a popular option for many high-rise residential buildings going up in many major cities across the U.S.A. The battery life is unsurpassed with multiple years of use, even in high-traffic areas. We have experienced cross-selling opportunities as well. For every ArchiTech Lock on the front door of a condominium high-rise residence, it generates a need for matching mechanical interior hardware throughout the residence.

The recently launched CA4K product for medium and large businesses enters us into cloud-based access control as a service market, which enables our company and its integrators to provide cloud-based access control services to the integrators' end user customers. As a result of this, those customers will not be obliged to have in-house personnel do tasks such as compiling attendance reports, security badge creation, removing ex-employees from the system, 24-hour access control monitoring and alerting. All of this and more can now be outsourced to their integrator security company. NAPCO and the integrator will share the recurring revenue fees from these outsourced services.

Moving on to a discussion of other major paradigm shift that is driving our business, it's the growth of security and safety in schools. Here at NAPCO, we are focused on providing solutions for schools, colleges and universities to help stop the intruders. Recently, a letter was sent to President Trump from 11 organizations, one of them being the Partner Alliance for Safer Schools. In this letter, the organizations are asked to include K-12 public school security infrastructure as part of President Trump's national infrastructure plan. The letter details how many of the 100,000 K-12 schools in the U.S. lack the basic security features such as access control and locks on classroom doors. The organizations recommend that a new security block grant program be created, requiring equal state and local matches. Clearly, this highlights the importance of school security issue -- of the school security issue. Bringing the issue to the federal government level will help secure funding, so that every K-12 in the U.S. will have security hardware in place.

Activity for our school security vertical continues to be robust. We recently announced that Pepperdine University will be installing more of our products on their campus, specifically the administration buildings, head library and the next projects they are working on. This is great example of the ability for us to win repeat business from schools as they focus on safety for the students and faculty. There will be more announcements forthcoming as our pipeline of opportunity continues to grow.

We will begin our Q&A session portion of this call in a few moments, but I would like to give a brief summary. Fiscal year 2017 was a very good year for NAPCO as we accomplished many things: reaching our recurring revenue 1 year ahead of our schedule; launching an award-winning new product, the StarLink Connect; gained new institutional share -- gaining of new institutional shareholders; new analyst coverage; and became a member of the Russell 2000 index.

We are very pleased with the current direction of the company. We believe the elevated engineering and marketing expenditure levels in fiscal 2017 will not increase significantly in fiscal 2018, which should greatly enhance our profitability as our fiscal 2017 investments generate higher sales in fiscal 2018 and beyond. We believe we have the right strategy in place to take advantage of the current paradigm shifts that are taking place in our business as well as the positive trends in the security industry.

NAPCO is in a strong position to continue its growth in sales and profits going forward. 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 this 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 Instructions) Our first question comes from the line of Gary Mobley from Benchmark.

I wanted to start with a question about the Continental Access as a service. I wanted to know when the services is launching and -- into the prospects, as we look forward over next 12 months in terms of revenue ramp. And as well, I wanted to know whether or not this is a personnel-intensive business for NAPCO or is this more data aggregation and using features such as mobile apps to access commercial door locks and whatnot.

The product line, Gary -- this product -- the software product has been in development for more than 2 years. And it's made into different layers of code. There's a layer of code which will allow us to get recurring revenue from our dealers utilizing that layer. They're going to be able to supply a lot of back-office services for their customers, and they're going to be sharing that with us. It's only been out for a few months, and it takes a while. It's kind of a new focal point for the dealers. Typically, these integrated dealers just make money on the installation and maintenance. So over the next year, this 2018 year, there's going to be additions to it and refining of it, and we expect it to be a very nice recurring revenue producer. I can't put any numbers to it. I can just tell you, it's the right direction for the company. It's just going to add pile-on more and more recurring revenue for us, and it's a whole new area of growth.

Okay. Kevin, I had a question about the gross margin. My best estimate is the product gross margin in Q4 was perhaps down as much as 400 basis points year-over-year. And then, I'm just curious, what types of investments are flowing to the cost of goods that's driving that down? And net of that, how would your gross margins have trended based on the manufacturing utilization rates at the Dominican Republican facility?

Gary, I think it was down 170 basis points versus last year Q4, 38.3% versus 40%. R&D is a good part of it, probably worth 0.6 point. So we basically would have been at 39%, close to it, versus the 40%. We typically believe when our sales are in the 20s that we're going to get to 40% or more. And a lot of times, it's because of the mix, dependent on what sale we have in a given quarter, it could jump around a little bit, within 1 point. But as you can see, we're still much higher in the Q4 than the rest of the year. That's the leverage from the factory. Yes, it all helped to have the recurring revenue. That's great. But when we're in the 20s, a lot of that work is done by manufacturing, and that's why we got it to the high 30s, almost 40%. That's a key part of our story. We want to do better on the manufacturing side. We've done tremendous on the recurring side. We're going to get both parts going very nicely, and then you're going to see us go way up on the hockey stick, for those of you've seen our hockey stick slide.

Okay. Your sales and marketing or SG&A grew about 9% in 2017. I think the quote was that you expect the growth to moderate, or, I guess, paraphrasing is the best way to put it. And so would you expect the growth rate of your SG&A to be less than revenue in 2018? And related to that, would you say that most of your investments in the sales and marketing channel have been sunk and you're sort of a steady state right now?

I would say yes, it's at a steady rate, and I would say the growth rate of revenue should far exceed the growth in SG&A. We think we've reached the plateau that we're at now. We don't have to grow it much more in 2018. That's why we think that the profitability is going to be enhanced because you're going to see top line growth, you're going to see the G&A remains steady, and the R&D is going to remain steady too. We think that's a level that we're comfortable with. We've said it throughout the year that this is the new base point. We knew this year was going to be a higher baseline than prior year, but we felt we had to do it to get the sales to really start moving. And we think that's the direction that we're in right now.

Got you. Okay. Last question for me. I know that inventories were up about 22% year-over-year against the backdrop of a 7% year-over-year sales comp for Q4. Obviously, inventory turn's dropping. Is there any [scare of] rate through there? Or is it just sort of noise in the numbers?

We introduced the StarLink Connect radio towards the very end of the year. That's going to be a big seller for us. We put a lot of marketing efforts into it, and we are building inventory because we expect a lot of sales on that product. So we've just introduced it at the end. We -- you got to ramp up and bill it because if you're going to market the heck out of a product, you better have it when people are ready to buy it. So that's a good chunk of inventory growth. And obviously, we're excited about that product, so that'll move. And also, on top of that, we came out with new Continental product, which we talked about a little bit in our presentation here. That's another one where we're marketing it, and we expect it to move. So there's a buildup. And now we expect it to move out and expect the inventory to drop throughout the first couple of quarters of 2018.

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

You're just building off the increased inventory, your expectations for strong sales for the StarLink Connect product. Can you share just any early traction maybe this product is receiving and maybe walk us through how you're training your dealers and incentivize them to then sell the iBridge services also?

It's -- the concept is wonderful for the dealer and for the end user customer. You have these billions of alarm systems that have been installed by our dealers and the competitive dealers that are -- that have been putting alarm systems in. If you want to get a Connected Home today with everything else that's out there, you have to rip out all of the old hardware and make a mess in the home or the business to do that. The Connect is a very simple solution. It's a, well, it's a small box, hooks on to any brand of alarm system from the majors. And now the -- there are apps that are given to the consumer and they can operate newly installed thermostats and door locks and switches and outlets, which the dealer will put in, and control everything remotely. And that's a big boost for them because now they can expand their recurring revenue instead of just monitoring burglar alarms and fire alarm, or anywhere from $20 to $30 a month, depending on what region of the country they're in. Now they can add $10 or $15 more to give their end user customer the app control. And it's a very important thing because we know, people are doing more modern things, and everything is on the smartphone today. So this is a very unique product, and we're showing it around to our distributors, dealers. We're getting very nice orders for it. We expect it to ramp up. It's a very big market. And it will bode great for us for recurring revenue going forward.

Great. And just building on that, just -- we saw your new products that are targeting recurring revenue. You hit the $10 million run rate. How should we think about maybe new targets 1 to 2 years out? Are you willing to share any? Or how do you feel about just the overall growth in recurring revenue trajectory over the next couple of years?

At the rate we're going, probably this year will be $15 million, roughly, just a gut feeling estimate. Because in addition to the StarLink Connect, you have the dual-line fire communicator. And as I said, it's a very large market. The phone companies are not wanting to supply service anymore to copper lines. Most of the fire systems that are out there use copper line. So the dealers can now hook on our dual line fire communicator and do an exact competitive replacement for the old copper lines. It's a big boom for them. It's great. And because we got California fire marshal and New York City fire marshal, those markets alone are huge markets for this type of product. So we expect a lot of increased recurring revenue from this product. So it's an exciting time for us with the new products. We made the investments because, when the wind is at your back, let's get the products out, let's get the marketing done, and then we can just keep pounding away with our dealers, showing them the new technology and the sales will continue to grow. So as we stated, we think we're at the right spend level now for engineering with our 40-plus engineers. And we think we're right -- got the right sales group, marketing and advertising setup like we had in '17. That level, no higher, is what we have planned, and that should reap nice profitability for the '18 year.

Great. And just to clarify that, is that $15 million kind of your gut feel for the full year recurring revenue, you'll hit that run rate during the calendar -- during the fiscal year?

We're talking about fiscal year.

Great. And I just -- as we look at the hardware piece of the business, I know you have a longer-term goal of hitting $100 million in revenues annually. Can you maybe walk us through how you see that business growth over the course of the year? And when you might think you hit that $100 million annual revenue on the hardware side?

Well, we'd -- what we'd like to -- we are going to keep the momentum up. High single-, double-digit growth is what we're aiming for, for hardware this year and the year next. And at that point, we'll be at $100 million level, roughly the $100 million level. And then, the increase in the RMR, which comes along with the hardware sales, will put us in a very good scenario. Very high on that hockey stick, into the 40% gross profit. And this scenario is what -- that's what we see right now. So it is -- we're going in the right direction, making these investments and getting these products out and are going to fill the factor with more hardware business.

Great. And then last question for me. Just as you look at that hardware growth, can any of your new products or just overall products you think are going to be stronger than others this year? You talked about the letter to President Trump with school funding that could be a big catalyst for you. Is that one of the areas you see stronger growth? And then, within that growth, how should we think about maybe gross margin mix through the course of this year, given different projects you have?

Mike, with the federal government potentially getting involved with school security, that's a game-changer. We're banging away at the 10,000-plus universities, 100,000-plus K-12s, that's part why our sales are growing. And once you get a government-mandated move on school security, then that's going to explode. We're not sure it's going to happen so quick. We're not counting on it. What we're doing is going one by one, school by school, to try to get that to grow fast. That's the biggest area of the hardware, the schools, because most schools don't have much in play, and there's a lot of schools there. And as we mentioned, even when you win a school, you get repeat business. We also see a big opportunity in Houston. We are big in the Houston Independent School District area. With all the problems they're having with the flooding, their schools are going to need new equipment, so that's another new opportunity. So school security is probably the biggest area, but we have a lot of other products. We don't have time to talk about each one. But there's a lot of R&D effort that goes with a lot of hardware because the $100 million of hardware is a key goal for us, and it's one that we want to make sure we hit.

Great. I will ask one more. Just given you're coming off the seasonally strong June quarter, offset by -- you have all these new products ramping, should we think about kind of normal seasonal trends kind of down mid-teens revenue sequentially? Or is the September quarter looking a little stronger with some of these new products coming into the channel?

Last year, I think we did in the low 20s in Q1. And we expect to beat that. So not teens. We're in the 20s now. Every quarter should be in the 20s.

Oh, no, no, I was talking mid-teen sequential decline just off the strong quarter? That's where...

Percentage-wise?

Correct. Yes, correct.

Yes. I would say we're not going to do another $25 million quarter in Q1, but we expect to beat last year's Q1, which I believe was $20.8 million or something like it. So we expect to beat that, whatever that translates into, if we're $21 million and change, $22 million, whatever that decline is versus the $25 million. Maybe we'll go higher up in Q1. There's a lot of action here. We built a lot of inventory, a lot of radios. We expect a lot of that to move this quarter.

(Operator Instructions) There are no further questions in the queue. I'd like to hand the call 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. And we look forward to speaking to you all again in a few months to discuss NAPCO's fiscal Q1 '18 result. Thank you and bye-bye.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.