Greetings, and welcome to the Napco Security Technologies Fiscal Third Quarter 2021 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to our host, Patrick McKillop, Director of Investor Relations. Thank you. You may begin.

Good morning. I'm Patrick McKillop, Director of Investor Relations for Napco Security Technologies. Thank you all for joining us for today's conference call to discuss our financial results for our fiscal third quarter 2021. 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 and Kevin Buchel, Senior Vice President and CFO.

Thank you, Patrick. Good morning, everyone. And welcome to our conference call. Thank you for joining us today to discuss our results. We are very pleased to report our record Q3 sales results of $28.2 million and our record Q3 net income results of $4.4 million, both of which beat street consensus estimates. Our EPS and EBITDA figures also came in above street consensus estimates.

Thank you, Dick. And good morning, everybody. For the third quarter net sales were a third quarter record of $28.2 million as compared to $26.2 million for the same period last year, an 8% increase. Net sales for the nine months ended March 31, 2021 increased 0.3% to $78.6 million, as compared to $78.4 million for the same period a year ago. The increase in sales for the quarter were primarily related to increases in recurring services revenue, as well as intrusion and access products. Recurring monthly revenue continued strong growth, increasing 43% for the quarter, and 40% for the nine months. This strong growth is primarily attributable to the continued strength of our commercial business, which has not been affected by the COVID pandemic, as buildings must remain secure. Recurring revenue now has an annual run rate of $36.7 million based on March 2021 recurring revenue. The sales increase for the nine months was also primarily due to increases in recurring services revenue, as well as intrusion and access products. Gross profit for the three months ended March 31, 2021, increased 8% to $12.9 million, with a gross margin of 46% as compared to $11.9 million, with a gross margin of 46% for the same period a year ago. Gross profit for the nine months ended March 31, 2021 decreased 2% to $35 million, with a gross margin of 45% as compared to $35.6 million with a gross margin of 45% for the same period a year ago.

Kevin, thank you. Our third quarter was a record breaker, and we delivered the highest sales in net income for a Q3 in the company's history. We are witnessing more and more opportunities for our dealers to get access to the residential and commercial buildings, where they install our products and thus driving sales to record levels. As the country continues to vaccinate more people, and we recover from the harshest days of the COVID pandemic, Napco is positioned to capitalize on new business opportunities. Every recurring revenue product that we sell is the beginning of a new relationship, not the end.

Thank you. Ladies and gentlemen, at this time we will be conducting our question-and-answer session. Our first question comes from Mike Walkley with Canaccord Genuity. Please state your question.

Great. Thanks. Kevin and Dick congratulations on the results. And it's great to see the recurring revenue goal, you said quite a while ago $40 million annually by the end of fiscal ‘21. Seems like it's attractive to reach those levels, despite you know, this unexpected year of COVID. The question in that area is, coming off this good growth. One, can we even re-accelerate as more things reopen or given you know, the law of large numbers, should we think about the growth rates kind of maintaining high 30s going forward? Thank you.

I think that the opportunities are great for us, because of the 3G network going down, copper being eliminated. But I would be conservative in and follow the path that we have been following. Kevin, you have the stat on that, right.

Yeah. So obviously, you've seen the growth go up to 43% this quarter on recurring and it was 42 last quarter. We were in the 30s last year. I hope we hit 50% as we go forward. But as Dick mentioned, it's good to be conservative, high 30s, because as the numbers get larger, it's harder and harder to have these big percentage increases. We've managed and we’ll hopefully keep doing that. But you know, healthy high 30s is pretty good even by itself, and if we could be in the 40s even better.

We've just explained the two products that I mentioned in my conversation, which are iSecure and Air Access. Those have long legs, and those should continue to add recurring revenue, especially in the access control and locking area which we don't have recurring monthly revenue. So it's a build out, because we're looking forward to many, many years of increases. But, as we said, be conservative because these products have to be adopted by the dealers. The focus groups that we put together show that the dealers love the concept. It's perfect for them, they can build out their businesses, make it easy for them to get more sales. So we're really paving a lot of roads going forward.

That’s great. That’s helpful. It sounds like lots of good tailwinds. But we'll maintain some cautiousness and modeling. Just a follow up question for me, and I'll pass line to the other people on it. Its great to see you hit your goals of lowering inventory levels and generate really strong cash flow this quarter. Can you provide maybe some additional color on trends, one from your distribution partners. And then two, just the overall supply chain dynamics, there's a lot of shortage of components. So you feel like you have enough components, you know, should your distributors start to ramp demand back quicker than expected, given their sell-through trends. And you think your distributors knowing there's industry shortages, might be willing to take on a little extra inventory, given you know, the size of reopening that you mentioned in your script? Thank you.

So the sell-through stats, which I've been talking about for several quarters in a row are still very good. Some of our key distributors really had significant increased sell-through stat in March, March of 2021. That's compared to March 2020. One distributor was up 79%, another one was up 68%, another one was up 54%, another one was up 35%. These are healthy increases. What I believe is still going on is the cautiousness of carrying inventory levels below where they used to be. And I understand that the cautious, it's COVID times. But now we're coming out of it. And things are going to pick up. And you're right, Mike, they should bump up those inventory levels, because they're going to be quite short, if they don't increase inventories, when demand starts to really pick up, and it looks like it's happening already, they want to be quite short. So - but right now they've been acting conservative. And that's why I think we've seen the sell-through stats exceed what we're seeing on the factory sales. There are components shortages out there, you know, supply chain is a big mess. We all read about it. We've been very lucky. We had extra inventory, preparing before COVID even started. And we've kept the extra inventory on those certain important items, like, chips that you need to build these key products. We watch this like a hawk. We are the squeaky wheel with any supplier who has any issues. We've been doing pretty well. We've been - we've expanded our night shift in the Dominican Republic, because they can't keep up, the radio business is just so strong, which is a great thing. And we expect that we're not going to have any supply chain issues. But we do watch it. We're not taking anything for granted. It's important that we don't run out of any key components.

Okay. That's great to hear. It sounds like you guys are managing it better than a lot in the industry. I'll pass one.

Thank you, Mike.

Our next question comes from Jaeson Schmidt with Lake Street. Please state your question.

Hey, guys. Thanks for taking my questions. Just following up on those comments. If there is a pretty sizable replenishment cycle coupled with the tightness of the supply chain and maybe the school market perking back up. Would you be able to meet any potential upside demand?

I believe that. We put all the building blocks in place where we have the factory both in the Dominican and New York, building whatever we need. We have enough personnel to do that. People have - you know, have come back to work and we can keep the production lines going. And then the components that we use, we have duplicate vendors. And we're important customers of those vendors. So we get our share what we need. We're on a computer based purchasing system, which gives enough lead time to the vendors, so that they can get parts for us. Some of the larger vendors were small compared to the car companies, you know that. So we get what we need, where the large car companies may not get what they need to run their production lines. But we get what we need, because it's small quantities in the big picture, but plenty for us, and plenty for getting the products out to the distributors, which resell them to the dealers. So we're right now, watching it, we're vigilant. But things seem to be working well for us.

Okay, that's helpful. And then just as a follow up, it sounds like the commercial business continue to see some nice momentum. But curious if you could discuss what you're seeing on the residential side?

For the residential side, which is only a portion of our burglar alarm, and fire alarm division. There are concerns on the residential side because of the fact that consumers don't have the amount of cash to spend on systems as they had. There's still - many people still at home and they don't want outsiders coming in. So there's some impact on that. But in the commercial side where we are, the buildings all have to be protected. They have lots of materials and computers, and all kinds of equipment there. And many of the buildings have fire alarms. Most of the older buildings have their fire alarms. So those systems have to be kept working, they have to be upgraded to meet the latest specs by the fire marshals. So our original goal was to be a commercial security supplier. And that's what we do. We do like the residential business. And we do have nice residential business. But little of our business is in the commercial side. And now that we've introduced recurring monthly revenue products to the commercial side for locking and access control, that gives us the vision that we've always wanted to have. And that vision is to have recurring monthly revenue on all of our product line divisions. And over the next years going forward, as I said, we're laying a lot of pipe to make sure that we keep the recurring revenue to a new high level, and we're going to be setting a lot of goals for the industry where you'll be able to get recurring revenue, if you're a locking dealer, you'll be able to get recurring revenue if you're an access control dealer. Just like we've done in the commercial and residential alarm business. We're bringing in the opportunity for these dealers to build equity in a business, which locking people and access people don't really do that the way an alarm company does. So we are using that footprint in that direction to help get recurring revenue for them and for us.

Okay. Thanks a lot guys.

Thank you, Jason.

Our next question comes from Raj Sharma with B. Riley. Please state your question.

Hi. Good morning, guys. Congratulations on another good quarter. I had some - just wanted to follow up on the comments around to sell through your dealers and how large their inventories, are they still low and also any sort of color around any specific products that contributed to really good results. Last quarter, you had very good results on fire alarms. Any sort of breakdown on what worked this time and…

Hey, Raj. We usually don't break it down. That's fine, but always said was that the commercial business is growing nicely. And then all the commercial buildings additionally need fire alarms, and fire alarms have to be maintained. And even if the people aren't in the buildings, they have to maintain the fire. They have to have good intrusion burglar alarms to keep people from coming in and doing destruction or taking property. These people need money there. And there's a lot of – there is criminality where they have to take equipment and resell it. So these buildings have to protect it. It's big investments in all kinds of computers and equipment in these commercial buildings. So look at it as across the board. It's not just one area.

Right. And, and on equipment sales, I know that in the last few quarters, a lot of the establish has had not been open, is that sort of improving, you have more access to sell more equipment? And also around seasonality, would seasonality trends sort of fall, similarly, as last few years, the June being one of the highest quarters?

Kevin, you want to do that?

So seasonality is still a factor, at least on the hardware side, doesn't matter on the recurring side.

Right.

And things are starting to open up. So I wouldn't say at least if I was projecting and trying to be conservative, I wouldn't say it's business as usual, like it was in a traditional Q4. But I would say with the country opening up again, and there is a certain factor in Q4 being better than the rest of the year, is the end of the year, it's the selling season, the weather is better, et cetera, et cetera, that, you know, we're very optimistic about Q4. If I'm projecting, I'm cautious, but cautiously optimistic that things are going to be better. And also because I see those sell-through stats. I don't think that a contributor can carry - you know, he can't continue to carry low levels, it's going to burst, you keep having a 79% year-over-year sell-through month, it's got to lead to something very positive. So that's what we think is going to happen.

The way we look at it is, we have multiple distributors in multiple markets. And the dealers don't necessarily go to the distributors locations and pick up merchandise and products for each job, like they used to do in days - in the olden days. They order online, a lot of them. And if a distributor doesn't have the merchandise that the dealer wants, he goes to the second distributor that's on his list, and he gets it from them. So the distributors have to have enough inventory of all the different models and equipment when they put together a system - commercial system or residential system to supply the dealer with that merchandise, and they don't have it to deal, we'll move on and has multiple accounts, multiple distributors. So the distributors they need to watch what they're doing, and make sure they have enough inventory of all the different products. And keep it to a point where the dealers aren't disappointed. So there's a lot of pressure on them to do that. Occasionally you have a distributor that for some reason can't do it. Maybe the company was being sold, like we had the Anixter thing while ago. But that's abnormal. The normal thing is for them to supply these dealers, integrators, locksmiths, with merchandise, have everything in stock. And if they don't have it, the dealer will move on to another distributor. And that's what we find. So it's good to have multiple distributors, just in case a distributor doesn't watch his P's and Q's for his inventory levels.

Right. Thank you for that. And then on the school, the university side, I know that - I guess part of the seasonality in the past has been - you know June being better a higher quarter was because the schools and universities. Are you seeing anything on the locks, on the access control, any indications that I know you've said in the past that its tough to kind of tell where the business is coming from. But do you see a pickup in schooling and universities?

There is a lot of coding activity, more than ever. You got to realize that these schools were preoccupied with whether or not students should come back or should they not come back or should it be hybrid, the combination. They really weren't focused on school security. And a lot of these school jobs they didn't want the integrators on the campus. If the students aren't there, they don’t want anybody there. And I think that impacted the ability to get more jobs these last six, nine months. But that's starting to change. Kids are coming back. They were in a lot of discussions with a lot of schools. Okay, now that they're coming back, when do you think we could do this job, that kind of thing. So school security hasn't gone away. As we mentioned, in our in our comments, there's been shootings even since the small amount of time that the kids did return. One in Tennessee, there's been several. That issues not going away, where they are to supply the solutions that these schools need. And I think you'll start to see that happen. At least we'll be able to announce it over these next several quarters.

Got it. Thank you. Thank you, you answered my questions. I'll get back in the queue.

Thanks, Raj.

Congratulations, again.

Our next question comes from Jeff Kessler with Imperial Capital. Please state your questions.

Thank you. And it's great talking to you guys, again. In terms of the - let's call the timing of when coding and talking turns into revenue for you, in talking to the large installers and monitoring companies, and also the integrators who are either covered publicly or privately, they are seeing and they haven't seen record amounts of - record amounts of let's say pipeline and backlogs on some which are at record levels, some which is just at increasing - increasingly high levels. They're hoping that these discussions turn into new revenue for them later on this year, later on is a kind of nebulous term. But let's hope for the fourth quarter. Can you talk a little bit about when the people who are installing in whether it's access control or whether it's intrusion, et cetera, when the installers get in, about how long a period of time? Where are you in that cycle in terms of you being able to get paid and book revenues?

Hi, Jeff.

Hi.

Well, we have - we sell to three different types of dealer groups. We sell to alarm dealers, which to fire and burglar alarms. We sell to access control dealers, which put in larger jobs, and we sell to locksmiths. So typically, what happens is the customer of any of those companies wants to get more protected, or he needs to expand his building, or he needs to renew his certificate of occupancy for the building. So the deals will come in, especially in the commercial side. And quote on those jobs. A lot of people - a lot of these companies, and these buildings, get two or three different quotes. And they - and the system really has to go in because of the fact that it's - kind of it's a crazy world today. And those dealers and Napco are in the right industry at the right time. So those jobs go in, larger jobs may take a little bit longer because there's some funds that have to be granted from the company and approvals from the board of the company and the building. So there's no particular one answer, we have a lot of irons in the fire. Remember, we have more than 10,000 of these companies, these are installing type of companies out there canvassing the streets and doing jobs. So there's no one answer. But you can see that we're putting together a continuous growth pattern of recurring revenue, which means that a lot of our alarms with radios and our StarLink with radios, and now our Air Access will generate the recurring revenue. Because remember, with us, a sale of a recurring revenue product is just the beginning of a relationship. A relationship goes on for many, many years, because the building has to be protected for many, many years. So once we make that sale, it's not the end, it's a new beginning with a new relationship. So this whole thing keeps building, it's like a snowball. And we're the leader in recurring radios, with great performance working in all the networks, so that's what's driving growth. In addition to supplying the locking, which will have recurring revenue soon, and the access control, the same thing will have recurring revenue soon. So it's - everything is moving forward, Jeff.

Okay. One other questions related to actually that what you just said, and that is one of the things about recurring revenue product, I mean, one of the great things is that it's recurring, obviously, and that - the margins there need to be high, and you can, plan your - you can plan your budget more easily with this company going, you know, with your clients going out. One of the challenges of recurring revenue is that over a period of time as the beginning, but certainly getting into after two or three years, you have to prove yourself over and over again, to sometimes different regimes that come in to the companies or for that matter, if you work with a state, different secretaries of state, or who's ever set, giving out the contracts, that you are still - you still provide the best service for, in some cases, the best price, it doesn't always have to be the best price. But you know, what I'm getting at is that, you have to prove yourself over time. Because there are tough, it is not easy. But there are incumbents who do get knocked out of recurring revenue projects from time to time. You know, again, it's probably not going to happen with you. But the question is, is what are you folks doing in advance to make sure that you remain the z value proposition for them, so that they don't ever think of having to leave you for some other - somebody who says, we can provide the same thing as Napco for a lower price, which probably will happen in two or three years?

We don't see it that way. Because the fact that we give the best radio coverage that can be gotten with unique circuitry, a unique product, at a very, very good price, very value of price. So if a new regime comes in, a new installation company that wants to knock out the old installation company, our units can be reprogrammed to go into the new installation company's network. And it's been very reliable. And why would somebody want to rip out all kinds of equipment, we haven't had that experience. They keep it, they reprogram it with our blessing to get them what they need to get code wise. And they use our back end network. We have multiple back end networks. Now, the clouds, we keep adding more and more capacity to our systems. And now we're going to be adding the capacity and we've already added a capacity for access control. So we have very little churn. This is not a residential thing, you know, where people are leaving. Residential is more is, you know, more of a flaky type of business, people stop paying. When a commercial, they got to keep the system's going, as long as they work well, they keep upgrading them. So we don't see much of a churn compared to the residential companies.

Okay. If I could sneak in one final, real quick question. As you know, there's been a lot of, just want to call it, crazy valuations, a lot of hype on access control of late, you know, and I'm not going to mention the companies, but valuations on some of these stacks that have been combined at over, you know, several billions of dollars for companies that are generating less than a million or just a couple of million dollars. And it appears that for several reasons, access control is going to become - is being recognized for what it's always been, but probably never value that way, which is absolutely key to not just getting in and out of out of a premises, but also visitor management and things like that. Can you discuss a little bit more of what your plans are in access control when you talk about going beyond locks into recurring revenue?

Well, access control is really two different industries. Napco is the only company that is in both of those industries. Access control is the network in which locks go on to. So the locking companies make locks, but they don't make the actual access company - they access equipment. We make both. So we make an access control system, enterprise class. And now we have a cellular version, which puts all of the equipment up in the cloud for midsize jobs, which is a very important part of the business. The enterprise class, we manufacture a fantastic enterprise class system, where you have world renowned companies using our access control across the world, where it's a network. But our locks hook on to our access control and get functionality that you can't get when you put in a brand of lock that you may know of Jeff, and you attach it to an access control system, it doesn't have the same functionality. We are totally integrated, and we're the only company doing that. So as you say the billions of dollars of valuation today, for the access control business, people are really recognizing that. And we're the only guys that make both sides of it. So the opportunities for us are great. And now that we introduced the recurring revenue for the dealers to build equity in their business, rather than just selling a service contract where they can build equity in their business, that's very exciting future for us. I expect a number of years going forward, as we laid this pipe with the access control, and the radio communications is going to be an exciting business for us and for all of you …

Great. Thank you very much. Appreciate it.

Thank you.

Thank you, Jeff.

Thank you. Our next question comes from Abba Horwitz with OSP. Please state your question.

Hey, guys. Congratulations on another great quarter. No surprises there. Two questions. One is the cash that keeps building every quarter. And I think last time you said it's a good problem to have. And I agree. And certainly we both remember the days when you had $35 million of debt. But still at the same time, are you going – are there any usage in the near term for that cash?

You want to take that one?

Yeah. The best options for us, which is what we're studying, is cash, dividend, investing, acquisitions, all those are on the table. Right now, our focus is so away from any of that, because we're trying to finish the year on a strong note, very strong note. After year end, we'll have meetings, we'll figure out which way to go. There's a lot of bankers who knock on our door, we always say if you bring us the right deal, we're interested, we'll hear what you have to say. So we don't rule out acquisitions, but we're very specific. We want something new creative from day one. It's got to be the right multiple. We want it to be a product we can make in the DR We wanted to be able to give us more recurring revenue, all those things were all yours. You know, we did an acquisition when and created the $35 million of debt years ago, like you mentioned, why wouldn't we be interested now, it'll help us get to where we want to go that much faster. Right now, nobody's brought anything of interest. And again, our focus is on finishing this year on a very strong note. And the same thing really goes with dividends, because that's come up also. We're studying that. And eventually, you know, we might see something in that area.

Okay…

It's not there - have a little bit of dry powder, waiting in the wings.

Certainly, I agree with you.

We don't consider ourselves you know, spending wildly. It's got to be the right type of deal. So we love it when the dry powder keeps building up. And eventually we'll come to a conclusion and utilize it in a conservative way.

Okay. I mean, just to point out that, that with the debt, and now the cash position, that really is a reversal of almost $4 a share in terms of cash, I mean, the generation of cash on your balance sheet is pretty strong over that period of time, reducing the debt and increasing the cash. Very impressive. My second question is actually about, I wanted to understand what's the lag time between installation, and then turning on the recurring revenue?

Products that have recurring revenue get turned on immediately, as part of the installation?

Okay. So there's no lag time?

Right.

Yeah, the only lag is we sell it to a distributor, potentially, right? The distributor then has to sell it to the dealer, once the dealer has it, it gets activated.

Okay. And what would you say that timeframe is?

Well, the way they're carrying such tight inventory levels is that as long as it used to be, might be a month or so, month and a half, something like that.

So when we look at that - those levels, we can actually, meaning if I - the minute you sell to the distributor, it's about a month timeframe till you actually activate the recurring revenue?

And I would say, on average, something like that.

Wow! Okay. And just finally, the Dominican Republic factory, what was your utilization for the quarter?

We've been at about 80% utilization. The misleading part of that is the radio part of the equation, we can't keep up with that. We can't keep up with that demand. We started a night shift for radio business, about six months ago, maybe a little more, and we just hired a lot more people because the demand for the radios is stronger, is stronger than ever. So while it's 80% capacity in total, we're over capacity for one shift anyway, for radios, and now we're in that second shift mode, big time.

So shouldn't that increase the gross margin already or soon as you get closer and closer to 100% utilization?

Yeah, as it will, we have to get back to the levels of hardware that we had before and you'll see that margin expansion.

Okay. So in theory, you could have where these two things come together, the recurring revenue, becoming much more significant part of your business, and also the expansion of the gross margin on the hardware part, as the utilization gets closer to a 100%?

Yeah. One of the things we've talked about, we mentioned that we hit our goal of $40 million run rate on recurring revenue. We talked about it years ago, people looked at us cross-eyed, what are these guys talking about? They only have $10 million of recurring. They're going to be at $40 million by 2021. Yeah, we're on the cusp of doing that. One of the other goals we talked about is five years out, we want to get to $150 million of recurring, but we also want to get to $150 million of hardware, when we get to that $150 million of hardware, the margins will be tremendous. It'll be over 50% gross margin on the hardware pipe. We want both. We know the recurring is fantastic, the margins are in the 80s. We want the other side also to be into the 50s. So that's our long term goal. And we think we'll get there.

All right, beautiful. Thank you guys, again.

Thanks, Abba.

There are no further questions at this time. I'll turn it back to management for closing remarks. Thank you.

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. We look forward to speaking to you all again in a few months to discuss Napco’s fiscal Q4 21 and Fiscal Year 2021 Results. Bye-bye. Have a wonderful day.

Thank you. This concludes today's conference. All parties may disconnect. Have a good day.