Good morning and welcome to NAPCO Security Technologies, Inc. second quarter 2018 earnings conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] I would now like to turn the conference over to your host, Patrick McKillop. Thank you. You may begin.

Thank you. Hello. My name is Patrick McKillop. I'm the Director of Investor Relations for NAPCO Security. Good morning and thank you all for joining us for today's conference call to discuss our financial result for our fiscal second quarter 2018. 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 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 upcoming investor outreach, we are marketing in Dallas and New York this week. If you are in either of those cities and would like to meet, please contact me to arrange a meeting. We expect to meet lots of new investors during these trips and share the bright future we see ahead with them. Investor outreach is crucial especially for small-cap companies such as NAPCO and I'd 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.

Thank you, Patrick. Good morning, everyone, and welcome to our conference call. Thank you for joining us today to discuss our results. Second quarter of fiscal 2018 marked another record revenue performance for NAPCO. This quarter marked the 14th consecutive quarter of increased sales growth for the company. Our SaaS reoccurring revenues continued to grow at a rapid rate. The annual run rate is now $11.7 million as of December. StarLink Connect, our latest addition to the communicator series, started its commercial launch in April 2017 and is performing well thus far in the approximate nine months since the launch. Our investments in R&D, selling, and marketing expenses did not increase significantly during the quarter versus a year-ago period. As we have previously mentioned, we believe the current levels of investment are now appropriate and will have a positive impact on future sales growth. Our balance sheet remains strong with net debt of zero and healthy cash balances. We are capitalizing on the key industry trend that are impacting our results favorably such as recurring revenue growth in cellular alarm communication, the smart connected home, and the creation of school security and safety products. Our business strategy is executing well within the aforementioned trend. Driving growth, profits, and returns on equity are important to us and our shareholders. Our interests are aligned with our shareholders and the senior management at NAPCO owns 38% of the 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 our 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 second quarter, net sales increased 2% to $21.1 million, which was a record second quarter performance. For the six months ended December 31, 2017, net sales increased 3% to $42.3 million. The increase in sales for the three and six months ended December 31, 2017 was due primarily to increased intrusion sales, driven by a 52% and 54% increase in SaaS recurring revenues for the quarter and six months respectively as well as an increase in sales of products from the access control division. As Dick stated before, SaaS recurring revenue now has an annual run rate of $11.7 million based on December 2017 recurring revenue. Gross margin for the second quarter was 32.4% of sales, which was a 50-basis point increase versus the second quarter last year. Gross margin for the six months was also 32.4% of sales, which is a 40 basis point increase versus the six months last year. The increase in margin for the quarter and six months versus a year ago was primarily due to the aforementioned increase in sales. As Dick mentioned, our R&D and SG&A spend levels did not increase significantly versus the year-ago period, and we now believe that we are at the appropriate level. SG&A costs for Q2 increased $121,000 or 2% year-over-year to $5.7 million. And, as a percentage of sales, remain relatively constant to 26.9% versus 26.8% last year. For the six months, SG&A costs increased $205,000 or 1.8% to $11.5 million and as a percentage of sales decreased to 27.2% from 27.6% last year. Operating income for the second quarter increased 10% to $1.2 million as compared to $1.1 million last year. For the six months, operating income increased 25% to $2.2 million as compared to $1.8 million last…

Kevin, thank you. NAPCO's business has two paradigm shifts, which are continuing to have a positive impact. The first being SaaS reoccurring revenue growth and the second is school safety and security. As Kevin just highlighted during his commentary, the growth of SaaS reoccurring revenue for the company continues at a very strong rate. The drivers for growth of our SaaS reoccurring revenue are coming from demand for alarm communications, which includes the connected home category, as well as the Internet of Things. We continue to see significant opportunity in school safety and security market. The total addressable market is very large with 100,000 K-12s and 10,000 colleges and universities in the US needing products to combat the constant threat of violent incidences. It is our expectation that the new spending for schools on security and safety products will continue at a strong rate for the foreseeable future. On channel partner relationships are very important to us and we hold them in the highest regard. Thus, we have our R&D staff working very hard to develop new products that will help them grow and succeed. When we design new products, our goal is for overall appeal and being feature packed for a great end user experience. Additionally, we continue to host dealer training throughout the US and participating continues to grow, thus indicating more interest NAPCO product from the dealers. The US alarm market is a multibillion dollar industry and we have a long history and a great reputation in the security industry. Recently, we were voted one of the best intrusion brands alongside industry titans such as Honeywell and Bosch, according to a survey from Security Sales and Integration Magazine, a top industry publication. It is a great honor and testament for NAPCO as it highlights our ability to…

Thank you. [Operator Instructions] Our first question is from Gary Mobley with The Benchmark Company. Please state your question.

Good morning, gentlemen. Thanks for taking my question. So, I have a question about seasonal patterns for the March quarter. If I look back at your past four years, in some instances, the March quarter was down sequentially. In some cases, it was up. And so, just based on your visibility today, how would you call the March quarter product revenue on a seasonal basis?

Gary, the weather typically has an impact. We haven't had a lot of snow this – so far – January/February. That's a good thing. The cold doesn't usually impact our sales. So, we're only one-third of the way in this quarter. It's a nice mild winter, snow-wise, and it will be okay. That's usually what drives the sales down in a Q3 versus Q2. Usually, our sales go up quarter after quarter, the ones being the lowest, the fourth being the best. So, we expect the year to get stronger. We're heading into the better months coming up. That's starting March, April, May, June.

Got you. Okay, understood. I just had a question about – couple of questions about capital allocation. And so, you mentioned the share buyback in the quarter. Curious to know how much is authorized under the current plan. And then, as well, as it relates to the use of cash, could you give us an update on the M&A outlook, whether the M&A pipeline is hot, cold, mild? And related to that, what your borrowing capacity could be under your current lines of credit and whatnot?

Okay. So, on the stock buyback, as we say, we watch it opportunistically. We get in there and we buyback. So, as of December 31, we had 331,585 more shares to go under the million share buyback that we announced a few years back. In the new period, in the January period, we bought some more back. We'll see how it goes. Again, it's opportunistically. We have the cash to do it, the cash build. We could use some for that. And if we're going to do an acquisition, I'll let Dick talk about the market of acquisition, we have a lot of banks that are out there dying for us to do a deal. They're hungry for us to do business with them. We did that last time using bank debt. If the deal is big enough, we might do a combination of bank debt and stock. But right now, the market is not that hot, but I'll let Dick talk about what's out there.

Gary, what see is that we're very specific at what we want to fit into the NAPCO group of companies. It has to be a company that makes products for our industry, something that is high-volume and repetitive and something that we can build in our Dominican factory and save on the cost structure we have there. It could be in any field of security product that our dealers will use in their pipeline of installations. We don't have any particular drive to do this. We do have lot of products that we're launching and developing, which are maturing as far as sales and profitability. So, it's not a top drive for us. But if we find these companies that could fit, and there aren't that many that would fit into that category, but if we find them, we'd like to bring them into our family of companies. We will figure out the financing later on. The company should be in the range of more than $20 million in revenue because you get a mature company, which has some systems at that time, so – during this transition period, if we can take them over – but it's not a main driver of that.

Okay. Last question for me and I'll hop into the queue. Recent, tax reform act, could you talk about the impact that will have on your overall tax rate looking forward, the repatriation of cash that you may have overseas, if any, and other considerations as well?

Okay. So, it's a very complex bill, as some of you know. Overall, the new tax legislation is helpful to us. There are two tax rates. One is based on cash. One is based on profit that you've accumulated over the years. For us, we don't have a lot of cash offshore. So, that really had a minor impact on us. For profits that were offshore, you get taxed at a fairly low rate, 8%. You also get a number of years to pay it. On our financials, we had that all accrued. And as a matter of fact, we had more than enough accrued which is why we have a little bit of a benefit. Going forward, our tax rate – last year, at this time, it was 18% in the three months and six months. As I look through the full fiscal year, I'm going to say it will be somewhere like 12% for this year when it's all said and done. And for next year, I probably go back to the 18%. We're studying it. There's a lot there. Unlike many companies that are out there, this new tax plan is not bad for us. It's actually pretty good.

Okay, all right. that's helpful. Thank you, guys.

Thank you.

[Operator Instructions]. Our next question is from Mike Walkley with Canaccord Genuity. Please state your question.

Great, thank you. Just wanted to go back to some of your comments about potential for an infrastructure bill to be a catalyst for school security spending. Can you elaborate a little more on that opportunity? And also, can you talk about the pipeline there? Are there schools kind of waiting for this bill and delaying near-term spending or is it that your overall pipeline is quite strong with or without the potential infrastructure bill? Thank you.

The bill is being supplemented, we believe, with extra school security equipment, which, hopefully, will be made mandatory on the bill. You can read about that. It's very complicated. But it's a very necessary thing considering what's going on in the country and the president and Congress understands that. The way it works with us is we have integrators all over the country that are trained on all products and a lot of them are supplying security services, be it fire alarms or burglar alarm or locking, to schools already. As the schools get more nervous over what's going on and the frequency is becoming more frequent, they are calling these security dealers and integrators that we have and telling them what can you do for us to prevent these problems. So, we have a very wide of products. And these integrated dealers recommend the system depending on the budget. If it's K-12, it's a lower budget item. And college and universities can go for the whole enchilada, which is a very sophisticated radio controlled system. You'll be able to control the incoming – active shooters from coming into the buildings or people that should not be in these buildings. So, we have four product lines and at every price point. So, the schools that do install them, roughly – we publish some of the school names, but a lot of schools want it to be private. They don't want people to know, the public to know, exactly what they're doing. So, a lot of it is not published. But rest assured that we have constant sales through the integrators and the installations in schools and we publish as many as we can. We see that only a small portion of the schools have had systems put in. So, the infrastructure bill is going to a big boost to protecting students in the school. And lots of college and universities have big endowments. So, it'd be great if they loosen up the money because we can give lots of protection and we have the best line of products for that purpose.

Right. thanks. And then, just on the Dual-Path Fire alarm, very high recurring revenue relative to the StarLink Connect radios. Can you maybe about some of the standards, changes in New York and Los Angeles driving business and do you see other cities adopting these code changes in terms of just driving a faster even uptake rate of your recurring revenue for the Dual-Path Fire radio?

Typically, when we introduce a new product, it takes nine months to a year for the dealers to adopt it. They have to get used to installing it. They have to get comfortable with it. It's being accelerated, the adoption by the phone companies, which really don't want to supply leased line and telephone service for hardwire. And all the systems that are out there that have been installed over the last 50 years, they use for the most part the old systems, and there's millions of them, the leased lines and phone lines. So, because the phone companies don't want to support it, they really want the cellular network to be the main workhorse of communications. The dealers are installing these fire systems that we have, the new the Dual-Path. Two paths meaning that just two different methodologies for the way the signal gets from the premise that's being protected to the central station in a dual-path mode. LA and New York are very strict and have more code compliance than a lot of other counties around the country. So, we made sure that we have all the features that those counties want, so that the adoption rate would be as quick as possible. But what we're doing is a great competitive substitute at a reasonable price for the dealers. The dealers can now get a piece of the action of the monthly that the building owners who were paying to Verizon, they will be paying some to us and some to the installing company and still the building owner will save half of what he's been paying. So, it's a win-win situation for everybody. And it has many, many years to go and there's millions of building to be re-equipped with communications, which is modern.

Great, thanks. And just, building off of that, with StarLink Connect consumer radio, you're not hitting that kind of nine months, your dealer channel, when you start to see greater uptake. Can you give us any color or any evidence that maybe the accelerating uptake is about to happen? Any kind of data points on how the acceptance and how this has been driving recurring revenue growth?

Well, it's a new product. It's a very exciting product because it retrofits to millions and millions of existing alarms in houses and businesses that are there now, and gives the connected home experience of video and controlled thermostat, et cetera, et cetera. Up to this point, if you wanted to get a modern smartphone-operated alarm and you had an alarm in your home or your business, the dealer would have to rip it out, leave all kinds of holes, make a mess and take days to do it. Now, with the StarLink Connect, it goes in less than an hour and now it gives app control to the homeowner or business owner of that alarm system just by installing this radio. The radio is two units in one small package. The package is about 7 inches x 5 inches x 1 inch. And this package gives connected home connectivity to the consumer smartphone and also cellular connectivity to the central station of the dealer, all within an hour of installation. So, now, the consumers can be free of problems with the phone lines being broken and not working and not being able to get service and also get the smartphone connectivity that you'd have to install with the new alarm, all in one box, very reasonably priced. We have a menu of services that we offer the dealers to sell to the end users. And it's going to be very, very – it's has been successful and it's going to more successful going forward and just keep adding to our SaaS reoccurring revenue line.

Okay, thanks a lot. Last question from me, I'll hand it back to the queue. Kevin, how should we think about the product mix impacting gross margin in the March quarter. And you talked about March through June being better months, so absent of the scale, can you just maybe talk about mix and how we should think about your product gross margin trends for the first half of calendar 2018? Thank you.

Okay, Mike. So, as the sales go up, many of you have seen our infamous hockey stick slide, as we get into the 20s, the gross margins are going to go up. So, we have seen growth so far in the first two quarters. Sales in both over $21 million. We expect the sales to go beyond that in Q3. And in Q4 last year, we were $25.8 million and we really saw the growth on the gross margin. It was close to 40%. Our expectation is, once again, in Q4, we'll see a dramatic increase above whatever the three quarters are, and that'll drive the margins up. And on top of that, we expect the recurring revenue by June 30 to have closed, if not better, then a $15 million run rate. And that has close to 90% gross margin. And you add that on top of the leverage we're going to get from the manufacturing side and that we believe puts us at a pretty good position by June 30. Eventually, the quarters will be much more even than they are, but for those of you that follow us, you know the quarters get stronger. Recurring is evening that out somewhat. School security is somewhat evening it out. That becomes a job that was done in the summer, which is our first quarter, it's also a job that's done when the kids are out of school, which is December/January, and tends to even things out. But, for us now, we still have kind of that seasonality and the expectation is margins will grow more in Q3 and dramatically more in Q4.

Great, thank you.

Okay, Mike.

Our next question is from Christopher Hillary with Roubaix Capital. Please state your question.

Hi. Good morning. How are you?

Good morning, Chris.

I just wanted to ask you, on the product sales, you've had a number of good kind of drivers in place and then you talked about some aspects of the tax reform being a benefit. Can you give us some more color on how you might see your sales growth accelerate with that in mind? And while you're at it, could you also address – there tends to be some concern out there related to commercial real estate and how that may or may not come into play for your results going forward?

Well, as far as the real estate part of the question, at least where we are, in this part of – we're in the Northeast, we see a lot of construction. We see the real estate being strong. We're commercial, 80%. So, we don't really get that much affected by residential sales, home sales. It's great when it's working well, but commercial real estate is where we do the best because it may be the 80-20 rule. And we're seeing a lot of growth still. Every city we visit, including the city that we live in, there are cranes going wild here. There's a lot of action here. And we depend on that. So, we think the best is still yet to come on the commercial end of our business. We're not seeing weakness in that and, hopefully, that won't occur. And more that that occurs, you're going to see our locking sales go even higher or access control go higher. So, we have a bunch of things going for us, if we have that part. And then, on the home side, we have the SaaS revenue because a lot of it's driven from the alarm sales, the home alarm sales and small business. So, first, the signs are still moving in the right direction. It's early in the game. And we're not seeing weakness. The only thing we're seeing is with school security. It's slower than we would have like. We would have liked that move as rapidly as the need is. But the schools tend to move slow, spend their money slow, but, eventually, if there is a bill that drives them, they're going to move quicker. And the new tax legislation, that should drive a lot of businesses to spend money quicker. Now, there's a big tax benefit. You don't have to write-off the investment over a lot of years. You could get an immediate deduction. That's going to drive businesses to spend money faster than they've been doing it.

From our point of view, we have a lot of irons in the fire here. So, we're not dependent on just one vertical. We do residential alarms, and lots of the alarms out there don't have the connected home experience. And we have invented this StarLink Connect, which can upgrade them. So, that's a vertical that is going to get stronger as years go forward. We invented a new fire cellular communicator. That's going to continue to pick up and accelerated our business, especially in commercial building because of the fact that they rely on expensive phone lines. The average phone line system in a commercial building costs hundreds of dollars per month. The StarLink is a more reliable product and, of course, half of the amount to the building owner and the other half can be shared between the dealer and NAPCO. And there's lots of buildings that have to be retrofitted that way. And then, school security is going to become more so. We're going to need more and more school security product. And then, we have our line of architectural locking products, which is sold for retrofits of office buildings, where they're redoing the office buildings or for on our office buildings. So, we have that also. So, there's a lot of things going on here and the world always needs more security. And if things get bad typically, more security is being put in. And the things continue to get better, people want to protect what they've got. So, there's a lot of positives to our business and we're very excited about it.

And then, maybe a quick question on the recurring revenue. Are there any highlights you might share with us about what you expect to be driving the growth there going forward? Is it the same kind of products and just building out the number of end points that you have or are there other things you might discuss?

Well, we have – as I said, 9 months to 12 months it takes for a product to kind of reach to a point where the dealers then very comfortable with it. And a lot of these products that we're talking about, the Dual Fire unit, the StarLink Connect, they haven't reached that point yet, but they have great growth potential from what we've seen. In addition to that, we spent the R&D money on new products, which will have some of the functionality that we're talking about now, which generates recurring revenue, more school lockdown and we'll see more and more of those products coming out. We're a certain role right now of developing a lot of those products with the engineers and we're getting lots of calls from people with special application and we're doing that also with our new CA4K software, which has lots of functionality for entry and exit in buildings and also has the ability to add more recurring revenue from a whole new leg of recurring revenue that we don't have with the alarm business. It's access control recurring revenue. And that's going to be very exciting for the future. So, we have all those things going on.

Okay, thanks so much.

[Operator Instructions]. Our next question is from Ava Horowitz [ph] with OSB Capital [ph]. Please state your question.

Hi. Good morning. Good morning, guys. I was wondering, on the recurring revenue side of the business, would it be fair to say that about $1 million per quarter is adding somewhere between $0.02 to $0.03 cents to your EPS per quarter from where we stand today?

A million a quarter –

A million extra above per quarter will add another – somewhere between $0.02 to $0.03 – probably closer to $0.03 per quarter on every incremental million dollars that you capture per quarter.

Yeah. I think that's very fair to say based on the gross margin of recurring revenue. Very, very robust associated with it. The only cost that we have buying bulk minutes. So, yes, that's fair.

So, would it be fair to say that, as you get through the year, you had said that you're expecting that there will be around $15 million of million run rate come June. So, would it not be fair to say that, at that point, you'll actually be – have an incremental $0.12 EPS per year per share from that point on.

All other things being equal, yes.

Okay, great. Thanks guys.

Thank you.

[Operator Instructions]. Ladies and gentlemen, we have reached the end of our question-and-answer session. I would like to turn the conference back over to management for closing remarks.

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 Q3 2018 results. Bye-bye.

Thank you. This concludes today's conference. You may disconnect your lines at this point. Thank you for your participation.