Napco Security Technologies, Inc: Form 10-Q for the period ended Mar 31, 2023

Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q and the documents we incorporate by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. All statements, other than statements of historical fact, included or incorporated in this prospectus regarding our strategy, future operations, clinical trials, collaborations, intellectual property, cash resources, financial position, future revenues, projected costs, prospects, plans, and objectives of management are forward-looking statements. The words “believes,” “anticipates,” “estimates,” “plans,” “expects,” “intends,” “may,” “could,” “should,” “potential,” “likely,” “projects,” “continue,” “will,” “schedule,” “would,” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guarantee that we will achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties, and other factors, which may be beyond our control, and which may cause our actual results, performance, or achievements to be materially different from future results, performance, or achievements expressed or implied by such forward-looking statements. There are a number of important factors that could cause our actual results to differ materially from those indicated or implied by forward-looking statements. See “Risk Factors” in our Annual Report on Form 10-K for the year ended June 30, 2022 for more information. These factors and the other cautionary statements made in this prospectus and the documents we incorporate by reference should be read as being applicable to all related forward-looking statements whenever they appear in this prospectus and the documents we incorporate by reference. In addition, any forward-looking statements represent our estimates only as of the date that this prospectus is filed with the SEC and should not be relied upon as representing our estimates as of any subsequent date. We do not assume any obligation to update any forward-looking statements. We disclaim any intention or obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise, except as may be required by law.

Overview

Napco Security Technologies, Inc (“NAPCO”, “the Company”, “we”) is one of the leading manufacturers and designers of high-tech electronic security devices, cellular communication services for intrusion and fire alarm systems as well as a leading provider of school safety solutions. We offer a diversified array of security products, encompassing access control systems, door-locking products, intrusion and fire alarm systems and video surveillance products. These products are used for commercial, residential, institutional, industrial and governmental applications, and are sold worldwide principally to independent distributors, dealers and installers of security equipment. We have experienced significant growth in recent years, primarily driven by fast growing recurring service revenues generated from wireless communication services for intrusion and fire alarm systems, as well as our school security products that are designed to meet the increasing needs to enhance school security as a result of on-campus shooting and violence in the U.S. Our wireless communication services have led to the substantial growth in our monthly recurring revenues.

Since 1969, NAPCO has established a heritage and proven record in the professional security community for reliably delivering both advanced technology and high-quality security solutions, building many of the industry’s widely recognized brands, such as NAPCO Security Systems, Alarm Lock, Continental Access, Marks USA, and other popular product lines: including Gemini and F64-Series hardwire/wireless intrusion systems and iSee Video internet video solutions. We are also dedicated to developing innovative technology and producing the next generation of reliable security solutions that utilize remote communications and wireless networks, including our StarLink, iBridge, and more recently the iSecure product lines. Today, millions of businesses, institutions, homes, and people around the globe are protected by products from the NAPCO Group of Companies.

Economic and Other Factors

We are subject to the effects of general economic and market conditions. If the U.S. or international economic conditions deteriorate, our revenue, profit and cash-flow levels could be materially adversely affected in future periods. In the event of such deterioration, many of our current or potential future customers may experience serious cash flow problems and as a result may, modify, delay or cancel purchases of our products. Additionally, customers may not be able to pay, or may delay payment of, accounts receivable that are owed to us. If such events do occur, they may result in our fixed and semi-variable expenses becoming too high in relation to our revenues and cash flows.

Seasonality

The Company's fiscal year begins on July 1 and ends on June 30. Historically, the end users of the Company’s hardware products want to install these products prior to the summer; therefore, sales of these products historically peak in the period April 1 through June 30, the Company's fiscal fourth quarter, and are reduced in the period July 1 through September 30, the Company's fiscal first quarter. Our monthly recurring service revenue, which is less susceptable to these fluctuations, allows us to generate a more consistent and predictable income stream.

Critical Accounting Policies and Estimates

The Company’s significant accounting policies are fully described in Note 1 to the Company’s consolidated financial statements included in its 2022 Annual Report on Form 10-K. Management believes these critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Results of Operations

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Net Sales for the three months ended March 31, 2023 increased by $7,627,000, or 21.2%, to $43,352,000 as compared to $35,905,000 for the same period a year ago. The increase in sales for the three months ended March 31, 2023 was due primarily to revenue increases in recurring communication services ($3,110,000), Alarm Lock brand door-locking products ($4.278,000), Marks brand door-locking products ($927,000), and Continental brand access control products ($113,000) as partialy offset by a decrease in Napco brand intrusion products ($1,250,000). Net Sales for the nine months ended March 31, 2023 increased by $24,975,000, or 24.9%, to $125,339,000 as compared to $100,364,000 for the same period a year ago. The increase in sales for the nine months ended March 31, 2023 was due primarily to revenue increases in recurring communication services ($10,544,000), Napco brand intrusion products, which include the Company’s cellular radio products ($1,993,000), Alarm Lock brand door-locking products ($9,045,000), Marks brand door-locking products ($2,212,000), and Continental brand access control products ($1,182,000). The Company’s increase in equipment sales was primarily due to a general increase in demand for the Company’s hardware products.

The Company's gross profit increased by $7,638,000 to $22,671,000, or 52.1% of net sales, for the three months ended March 31, 2023 as compared to $15,033,000, or 41.9% of net sales, for the same period a year ago. Gross profit on equipment sales was $9,002,000, or 31.7% of net equipment sales, for the three months ended March 31, 2023 and $4,539,000, or 19.0% of net equipment sales, for the same period a year ago. Gross profit on service revenues was $13,669,000, or 90.3% of net service revenues, for the three months ended March 31, 2023 and $10,494,000, or 87.2% of net service revenues, for the same period a year ago. The increase in gross profit in dollars and as a percentage of net sales on equipment sales and service revenues was primarily the result of the increase in revenues of each as described above as well as increased availability and lower costs of components and transportation as compared to the same period last year, which resulted from improvements within the Company’s supply chain. The increases in revenues resulted in improved overhead absorption rates. In addition, the increase in gross margin on service revenues was due, in part, to increased service revenues relating to the Company’s fire radios, which have higher monthly selling prices than the Company’s intrusion radios.

The Company's gross profit increased by $20,368,000 to $60,300,000, or 48.1% of net sales, for the nine months ended March 31, 2023 as compared to $39,932,000, or 39.8% of net sales, for the same period a year ago. Gross profit on equipment sales was $21,271,000, or 26.1% of net equipment sales, for the nine months ended March 31, 2023 and $11,003,000, or 16.4% of net equipment sales, for the same period a year ago. Gross profit on service revenues was $39,029,000, or 89.1% of net service revenues, for the nine months ended March 31, 2023 and $28,929,000, or 86.9% of net service revenues, for the same period a year ago. The increase in gross profit in dollars and as a percentage of net sales on equipment sales was primarily the result of the increase in revenues as described above, which improved overhead absorption rates, increased availability and lower costs of components and transportation as compared to the same period last year as well as a favorable shift in product mix the the Company’s Alarm Lock brand door locking products, which typically have higher margins. The increase in gross margin on service revenues was due primarily to increased service revenues relating to the Company’s fire radios, which have higher monthly selling prices than the Company’s intrusion radios.

Research and development expenses for the three months ended March 31, 2023 increased $305,000 to $2,314,000, or 5.3% of net sales, as compared to $2,009,000, or 5.6% of net sales, for the same period a year ago. Research and development expenses for the nine months ended March 31, 2023 increased $1,046,000 to $6,964,000, or 5.6% of net sales, as compared to $5,918,000, or 5.9% of net sales, for the same period a year ago. The increase in dollars was due primarily to salary increases and additional staff.

Selling, general and administrative (“SG&A”) expenses for the three months ended March 31, 2023 remained relatively consistent at $8,425,000 as compared to $8,442,000 for the same period a year ago. SG&A expenses as a percentage of net sales decreased to 19.4% for the three months ended March 31, 2023 as compared to 23.5% for the same period a year ago. The decrease as a percentage of net sales was due primarily to the increase in net sales without the need to increase to increase SG&A expenses. SG&A expenses for the nine months ended March 31, 2023 increased by $736,000, or 3.1%, to $24,719,000 from $23,983,000 for the same period a year ago. SG&A expenses as a percentage of net sales decreased to 19.7% for the nine months ended March 31, 2023 as compared to 23.9% for the same period a year ago. The increase in dollars resulted primarily from increases in expenses relating to the Company's President and Chairman and the Company’s Executive Vice President and Chief Financial Officer selling shares of our Common stock in an underwritten secondary public offering, which is discussed more fully in Note 11 to the Condensed Consolidated financial statements, and credit card processing fees related to our monthly recurring service revenues. The decrease as a percentage of net sales was due primarily to the increase in net sales as partially offset by the aforementioned increase in expense dollars.

Interest and other income (expense), net for the three months ended March 31, 2023 increased by $614,000 to income of $437,000 as compared to expense of $177,000 for the same period a year ago. Interest and other income (expense), net for the nine months ended March 31, 2023 increased by $623,000 to income of $521,000 as compared to expense of $102,000 for the same period a year ago. The increases in income for the three and nine months was primarily due to interest income on certificates of deposits purchased during the nine months ended March 31, 2023.

Gain on extinguishment of debt resulted from a one-time gain in the nine months ended March 31, 2022 which resulted from the forgiveness of the Company’s PPP loans as described in Note 8 to the condensed consolidated financial statements.

The Company’s provision for income taxes for the three months ended March 31, 2023 increased by $397,000 to $1,529,000 as compared to $1,132,000 for the same period a year ago. The increase in the provision for income taxes for the three months was primarily due to higher taxable income in the U.S. The Company’s effective rate for income tax was 12.4% and 25.7% for the three months ended March 31, 2023 and 2022 respectively. The Company’s provision for income taxes for the nine months ended March 31, 2023 increased by $1,679,000 to $3,450,000 as compared to $1,771,000 for the same period a year ago. The increase in the provision for income taxes for the nine months was primarily due to higher taxable income in the U.S. The Company’s effective rate for income tax was 11.8% and 12.8% for the nine months ended March 31, 2023 and 2022, respectively.

Net income for the three months ended March 31, 2023 increased by $7,567,000 to $10,840,000 or $0.29 per diluted share as compared to $3,273,000 or $0.09 per diluted share for the same period a year ago. Net income for the nine months ended March 31, 2023 increased by $13,626,000 to $25,688,000 or $0.69 per diluted share as compared to $12,062,000 or $0.33 per diluted share for the same period a year ago. The increase in net income for the three and nine months ended March 31, 2023 was primarily due to the items described above. Without the inclusion of $3.9 million of income from the forgiveness of debt net income and diluted earnings per share for the nine months ended March 31, 2022 would have been $8.2 million and $0.22, respectively.

Liquidity and Capital Resources

During the nine months ended March 31, 2023, the Company utilized a portion of its cash balance at June 30, 2022 ($32,732,000 of $41,730,000) to purchase marketable securities and other investments ($30,185,000) and property, plant and equipment ($2,547,000). The securities and investments consist of money market accounts, CD’s and time deposits. During the nine months ended March 31, 2023, the Company generated cash flows from operations of $12,416,000. The Company believes its current working capital, cash flows from operations and its revolving credit agreement will be sufficient to fund the Company’s operations through the next twelve months.

Accounts receivable at March 31, 2023 decreased by $5,048,000 to $24,170,000 as compared to $29,218,000 at June 30, 2022. This decrease is primarily the result of the higher sales volume of equipment during the quarter ended June 30, 2022, which is typically the Company’s highest, as compared to the quarter ended March 31, 2023. In addition, sales of the Company’s radio communication devices were unusually high in the month of June 2022 due to the Company fulfilling backorders of these products which had built up during the world-wide supply chain difficulties. Sales of these products were at more normal levels in the month of March 2023.

Inventories, which include both current and non-current portions, increased by $11,000,000 to $60,786,000 at March 31, 2023 as compared to $49,786,000 at June 30, 2022. The increase was due primarily to a build-up of inventory of the Company’s radio products in order to mitigate potential supply chain interuptions of these products. The increase was also due to the ongoing shortages of certain component parts and the Company purchasing large quantities of these hard to source component parts when they become available. As these challenges begin to subside, the Company believes it’s inventory levels will decrease.

Accounts payable and accrued expenses, not including income taxes payable, decreased by $7,129,000 to $17,496,000 as of March 31, 2023 as compared to $24,625,000 as of June 30, 2022. This decrease is primarily due to a decreases in the Company’s accrued refund liability, which is explained in Note 2 to the Notes to the Company’s Consolidated Financial Statements, accrued employee compensation, and accounts payable, which relates to the Company reducing purchases of component parts in the latter part of the quarter ended March 31, 2023 after building up it’s inventory in fiscal 2022.

As of March 31, 2023 and 2022, long-term debt consisted of a revolving line of credit of $11,000,000 (“Revolver Agreement”), with no amounts outstanding, which expires in June 2024. The revolving credit facility contains various restrictions and covenants including, among others, restrictions on borrowings and compliance with certain financial ratios, as defined in the agreement. The Company’s long-term debt is described more fully in Note 8 to the condensed consolidated financial statements.

As of March 31, 2023, the Company had no material commitments for capital expenditures or inventory purchases other than purchase orders issued in the normal course of business. In addition, the Company’s balance sheet reflects a refund liability of $4,841,000 as of March 31, 2023 for customer returns and promotional credits which is more fully discussed in Note 2 to the Condensed Consolidated Financial Statements.

The Company's principal financial instrument is long-term debt (consisting of a revolving credit facility) that provides for interest based on the prime rate or LIBOR as described in the agreement. The Company is affected by market risk exposure primarily through the effect of changes in interest rates on amounts payable by the Company under these credit facilities.

All foreign sales transactions by the Company are denominated in U.S. dollars. As such, the Company has shifted foreign currency exposure onto its foreign customers. As a result, if exchange rates move against foreign customers, the Company could experience difficulty collecting unsecured accounts receivable, the cancellation of existing orders or the loss of future orders. The foregoing could materially adversely affect the Company's business, financial condition and results of operations. We are also exposed to foreign currency risk relative to expenses incurred in Dominican Pesos ("RD$"), the local currency of the Company's production facility in the Dominican Republic. The result of a 10% strengthening or weakening in the U.S. dollar to the RD$ would result in an annual increase or decrease in income from operations of approximately $885,000.

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management to allow timely decisions regarding required disclosure. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which, by their nature, can provide only reasonable assurance regarding management’s control objectives.

At the conclusion of the period ended March 31, 2023, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. As disclosed in our Annual Report on Form 10-K for the year ended June 30, 2022, management identified two material weaknesses in internal control.

One material weakness in internal control related to ineffective information technology general controls (ITGCs) in the area of user access and lack of effective program change-management over certain information technology (IT) systems that support the Company’s financial reporting processes. Our business process controls (automated and manual) that are dependent on the affected ITGCs were also deemed ineffective because they could have been adversely impacted. We believe that these control deficiencies were a result of: IT control processes lacking sufficient documentation and risk-assessment procedures to assess changes in the IT environment and program change management of personnel that could impact internal controls over financial reporting. The material weakness did not result in any identified misstatements to the financial statements and there were no changes to the previously released financial results. Based on this material weaknesses, the Company’s management concluded that at June 30, 2022 the Company’s internal controls over financial reporting were not effective.

The second material weakness in internal control related to the reserve for excess and slow-moving inventory. This control deficiency was a result of a lack of effective review and reconciliation controls over the forecasted sales and usage data. The material weakness did not result in a material misstatement to the financial statements. There were no changes to the previously released financial results.

Management is currently designing and implementing additional controls and procedures to remediate these items and expects to complete these actions during fiscal 2023. These include, but are not limited to, modifying its program change-management process over certain of its information technology (IT) systems that support the Company’s financial reporting processes as well as implementing changes to its forecasted sales and usage data used in calculating its reserve for excess and slow-moving inventory.

During the three and nine months ended March 31, 2023, there were no changes in the Company’s internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting. As of March 31, 2023, the Company’s controls over financial reporting were not effective because of the two material weaknesses noted above.

Information regarding the Company’s Risk Factors are set forth in the Company’s Annual Report on Form 10-K for the year ended June 30, 2022. There has been no material change in the risk factors previously disclosed in the Company’s Form 10-K for the three and nine months ended March 31, 2023.