Greetings, and welcome to NAPCO Security Technologies, Inc. Fiscal Second Quarter 2022 Earnings 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. 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 results for our fiscal second quarter 2022. 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, Executive Vice President and CFO. Before we begin, let me take a moment to read the forward-looking statement. This presentation contains forward-looking statements that are based on current expectations, estimates, forecasts and projections of future performance based on management's judgment, beliefs, current trends and anticipated product performance. These forward-looking statements include, without limitation, statements relating to the growth drivers of the company's business, such as school security products and recurring revenue services, potential market opportunities, the benefits of our recurring revenue products to customers and dealers, our ability to control expenses and costs and expected annual run rate for SaaS recurring monthly revenue. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those contained in the forward-looking statements. These factors include, but are not limited to, such risk factors as described in our SEC filings, including our annual report on Form 10-K. Other unknown or unpredictable factors or underlying assumptions subsequently proving to be incorrect, could cause actual results to differ materially from those in the forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. You should not place undue reliance on these forward-looking statements. All information provided in today's press release and this conference call is as of today's date, unless otherwise stated. And we undertake no duty to update such information, except as required under applicable law. I will turn the call over to Dick in a moment, but before I do, I just want to mention a few things on the IR front. We are hosting virtual NDRs this week with Canaccord Genuity and B. Riley on separate days and if you're interested in having a one-on-one meeting with us, please reach out to your sales rep at either firm. 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. In addition, we will be attending the International Security Conference, the industry's largest trade show, which is taking place March 22 through the 25th in Las Vegas at the Venetian Expo Center. Please contact me if you're interested in attending. 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. We're pleased to report our fiscal Q2 2022 record sales of $33.4 million. Our results reflect our fifth consecutive quarter of sales growth. Recurring revenue continued to grow at a very strong rate and the annual run rate is now $46.2 million, based on January 2022 recurring revenues. Our balance sheet remains strong with our cash balances continuing to grow, now in excess of $47 million, and we have no debt. We continue to focus on capitalizing on key industry trends, which include wireless and cellular fire and intrusion alarm systems, school security solutions, plus enterprise access control systems and architectural locking products. The management team here at NAPCO continues to focus on the key metrics of growth, profits, returns on equity and controlling costs. These metrics are important to us as well as our shareholders. We continue to execute our business strategy, and our interests are aligning with our shareholders as senior management at NAPCO owns approximately 21% of the equity. Before I go into greater detail, I'll now turn the call over to our CFO, Kevin Buchel, who will provide an overview of our fiscal second quarter results and then I'll be back with more of our strategies and outlook. Kevin?

Thank you, Dick, and good morning, everybody. For the second quarter, net sales increased 23% to a second quarter record $33.4 million as compared to $27.2 million for the same period last year. Net sales for the 6 months ended December 31, 2021, increased 28% to $64.5 million as compared to $50.4 million for the same period a year ago. The increase in sales for the 3 and the 6 months were primarily related to increases in each of our sales segments. Recurring service revenue, intrusion and access products and Alarm Lock and Marks brand door locking products. Recurring revenue continued its strong growth, increasing 35% for the quarter to $11 million versus $8.2 million for the same period last year. And for the 6 months, recurring service revenue increased 37% to $21.3 million as compared to $15.5 million for the same period a year ago. This strong growth is primarily attributable to the continued strength of our commercial intrusion and fire alarm business, which has not been significantly affected by the COVID pandemic, as buildings must remain secure. Recurring revenue now has an annual run rate of $46.2 million based on January 2022 recurring revenue. In addition, our equipment sales continued to rebound, increasing 18% for the quarter to $22.4 million from $19 million in the prior year period and for the 6 months increasing 24% to $43.2 million from $34.9 million for the same period last year. Gross profit for the 3 months ended December 31, 2021, increased slightly to $11.44 million or 34% of sales, as compared to $11.4 million or 42% of sales for the same period a year ago. Gross profit for the 6 months ended December 31, 2021, increased 13% to $24.9 million or 39% of sales, as compared to $22 million or 44%…

Kevin, thank you. Our fiscal Q2 2022 was a sales record breaker, and I am proud of the NAPCO team for executing through the challenges that have been brought by the COVID pandemic. The quarter also marked our fifth consecutive quarter of year-over-year sales growth, and we look forward to surpassing the previous streak of 23 quarters that was disrupted in 2020 by COVID-19. The primary driver of our success comes from the commercial fire and intrusion alarm business. The commercial fire business is a mandatory nondiscretionary item, as commercial buildings must have and maintain a fire alarm system in order to receive a certificate of occupancy. Given the high probability and essential nature of this business, we focus on this as a key area of our resources. The recurring revenue annual run rate is now at $46.2 million as of January 2022. And as a reminder, a few quarters ago, we surpassed the goal of $40 million in annualized recurring revenue that we had set several years ago. Our StarLink radios have seen an encouraging trend in activations by growing 46% year-over-year and 11% sequentially in the month of December. If this pace of growth for activations continues, and we are working very hard to see that it does, we believe we could reach our previously mentioned goal of $150 million in recurring revenue in a few years earlier than the goal of 2026. As dealers race to complete upgrades before the 3G sunset at the end of the calendar year 2022, plus the millions of buildings that still need to be converted from old-fashioned copper line-based systems, we believe we are in a strong position to benefit from these growth drivers. Our advanced StarLink alarm communicators offer the widest coverage in the U.S. to dealers with both AT&T…

[Operator Instructions] Our first question comes from the line of Mike Walkley with Canaccord Genuity.

Great. Thanks for the commentary on the accelerating activations that should drive strong, even maybe accelerating recurring revenue trends. I guess for both of you, Kevin and Dick, can you talk about the strategy to gain share in the near term and how that's going to pay off for the longer-term recurring revenue growth? And how should we think about the near-term gross margins for the next few quarters given this mix shift to radios and the supply chain issues versus the longer-term goal of given...

Let me handle the first part of that. So there's been many comments over the past year or so from people, investors who said to us, why don't you spend some of your money on increasing your business, growing the top line of your business. And as you know, we have a lot of cash. So we figured the best way to grow our business is to pick up market share. And we have wonderful products, wonderful cellular products that the dealers love. They're the best cellular products for reporting alarm, fire alarm [ or ] burglar alarm situations to the central stations. So the competition is having a lot of problems in building their products. A lot of the competition gets their complete product from the Pacific Rim. We don't. What we do is we build it in our factory in the Dominican Republic and in New York. So we are able to spend some of that cash that we have to fly the components in and build our products to have more availability for the dealers so they never run out. Because the dealer never wants to run out of a product. He wants to keep putting jobs in. So we're spending money on components. And some of these components are higher priced than they were previously to the supply chain. Certain chips are higher priced, transformers are higher priced. And there are certain manufacturers that have capacity, and we have given them volume, even though their prices are higher, but they can give us delivery because the #1 thing to remember is keep building these products, keep supplying the dealers. The competition is not really doing that. The competition is out of components or finished goods that they get from the Pacific Rim. And that's what we're…

Yes. So Mike, so on the gross margin. Going forward, we've strategically taken some price increases. Not everything has been reflected. We took one in December. We haven't felt that yet. We will feel it this quarter. We might do another one in April. We have to see. It's strategic. We don't just do anything across the board. We don't want to disrupt this avalanche of business that we're now getting on the radio side. So anything that protects that, we're going to keep in mind. But price increases strategically thought of will help. We bought a lot of inventory. Our inventory is up $5 million since June 30. A lot of that is buying these hard-to-get components, lots of them, and that could carry us into future quarters. So we've paid the price. We have it. We won't be scrambling around as much going forward. The mix will probably get better. School security gets higher margin. That helps the mix, and the overall mix of margins should go up as there is more school jobs in that mix. We announced the one big job that we just received. That's not reflected in Q2 numbers, but we'll see that in future quarters, probably in Q3, maybe even in some in Q4. And there are other ones. And then the other part is Q4 for us is our biggest quarter. I think that's the April, May, June quarter. And we still expect that to be the biggest quarter. And you get leverage on the margins from that if you absorb overhead more rapidly. And so we expect that to also happen. So we believe for the upcoming quarters, the margins will get better. And as the supply chain eases, we'll get back to the historic gross margins that we're all used to.

Great. And just a follow-up question for me. Just maybe you can help us a little bit, Kevin, just think about the mix. Where are radios today versus maybe 1 year to 2 years ago? And then I know from what you've shared in the past, the locking and school projects can help that margin. Maybe a little more color on this large school contract, the pipeline there. And maybe you could touch on the opportunity with Latch because that seems like the potential for some nice ramp in the locking higher-margin business also.

Right. So radios represent a very large portion -- or I'll say a larger portion of our hardware sales than they used to. So if you go back a couple of years ago, radios was probably 15% of the hardware sales. Today, in this last quarter, about 32.5%. That's a big difference. And as we've said, the margins are not as strong on the hardware side, and we understand that, and we are happy to see this happen because we know ultimately the big prize of the 87% recurring revenue. So right now, radios dominate. Radios might still dominate, but it's going to have some competition from the school side, because we've seen an uptick in activity. We announced this one big order that we got. There's a bunch of other ones in the works. There's been so many shootings, unfortunately. It's -- I can't even keep track, there's so many. That leads to these security experts at the schools having to do something about this. So now we're seeing more and more activity and more and more money coming down to help the K through 12s. That will help our mix. We also believe with the infrastructure bill that was passed, that leads to airport renovations. And typically, when there's airport renovations, that leads to more locking deals for us. Typically, when I'm in an airport that has had it or is going through an airport renovation, we see our locks all over. That's going to bode well for us. So these are all things that are going to help the margins, the mix. But we are selling a lot of radios and that -- while it doesn't have the margins that we all love, it does lead to the 87%. We have to always keep that in mind. That's the big prize. And then with Latch, we're just really starting out with them. Latch, we believe is going to be a big partner with us. And we haven't felt the effects of that and that leads to more locking business. We have a very good relationship with them. They love our products, and we expect to do a lot of big things. We haven't felt that yet. We do expect to feel that in the upcoming quarters.

Last question for me and I'll pass the line. Strategy makes total sense in the short term to keep the dealers happy. And you mentioned some initial feedback on Air Access was positive. Can you give a little more color on the feedback from the channel? And then also just remind us as this new business ramps, is this a little lower gross margin business to drive recurring revenue? Or how does that impact the model as it ramps over time?

Air Access product is a tremendous innovation that the dealers needed in the Access Control business, which is a multibillion-dollar business, protection of buildings and where people are allowed to go within buildings. And the Air Access system changes the game where there's no wiring required through to the IT department, utilizing their network, which they're always very worried about because they're afraid that hackers can come in through the access control system and upset their network and the ransomware type of things. So we eliminated that concept. Because of the fact that we make these great StarLink radios, we modified the StarLink radios to be the communications to the computers which run the Air Access -- which run the access control system. So we don't have to go through the wiring and the IT department, which eliminates a lot of the politics in companies where the IT professionals don't want anything going into the network and the management gets involved and it takes much longer to get jobs done and solved. And it's necessary to have access control today because you read about all of the problems in buildings and people going where they shouldn't be going. It's a big problem. So this should help increase the Access Control business. And we're unique in the fact that we have a wireless access control system using cellular. And we get recurring revenue for each of the jobs that are put in by the dealers. So it's a great renaissance in the business. It's something that will take us a year to train the Access Control dealers on how to install it, because it is a little different, but it has all the functionality that it needs. And with the early feedback that we're getting is that it's a very exciting…

Our next question comes from the line of Jim Ricchiuti with Needham & Company.

I just wanted to pursue again some of the moving parts around gross margins. I mean I think we all appreciate the benefits of pursuing market share just given how attractive the recurring revenue business is. But what I'm wondering, maybe you could help us, Kevin, if we think about how much of the costs that you're incurring might you be able to recover through some of the pricing actions that you're taking in. Are you seeing any letup at all in some of the freight expense? We've heard from some companies that, that may be starting to ease or perhaps it's peaked.

Well, the price increase is definitely going to help. We haven't really felt the effect yet. We're going to feel it more probably in this quarter. I don't really like to disclose how much we've done. We do it selectively, strategically, but it will help the margins. It has to. The airfare has gotten better. And one of the reasons it's also gotten better is because we've bought up a lot of parts, which means we don't have to keep flying. We bought a lot. We paid the price to get them here and we don't have to keep flying over and over and over. We have them, and it should last us a while. I don't see the supply chain issues abating anytime soon. I think we're still in this situation for months to come. One of the advantages we also have, we didn't really talk about it is, Dick mentioned it in his comments earlier, but we have our engineers right here in Amityville with us. And if we have -- if we can't get one of these parts and it's difficult to get, no matter what we're doing, we get our engineers to redesign the product to utilize a part that we can get. And that helps -- and yes, it utilizes engineers' time where they might be doing R&D activities, but it allows us to keep going, to keep manufacturing and without the large material costs or airfare that we might be incurring otherwise. So I think we're doing a lot of good things. We have a lot of experience with this. We've been down this road before, maybe not quite like this, but I think we know how to manage this situation. So I think price increases will help. I think volume will help, and I think less airfare will help. So I think we hit rock bottom with the margins in this quarter, and I think they will get better in Q3 and much better in Q4.

And again, it's going to take some time for some of these increases, presumably, to work their way through. I don't know if you want to comment or if you can comment on just the level of inventory that's out there at your distributors?

Well, I can't comment so much on the level of inventories that's out there. But what I can comment on is our sell-through. We haven't really talked about the sell-through stats. And if we talk about the sell-through stats of our #1 customer, our #1 customer on the intrusion, the alarm side of the business, was up 108% for the December quarter versus a year ago, sell-through, their sales of our product, 108%. And sequentially was up 29%. So their sell-through was 29% greater in the December quarter than it was in the September quarter. And then if I look at our #2 customer, that is strong, very strong. They were up 49.7%, call it 50% year-over-year sell-through increase and sequentially up 14%. And then when I look at that -- so that's the alarm side. And then when I look at the locking side, our #1 customer was up 43% versus a year ago, sell-through, their sales, and sequentially was up 7%. And the #2 customer was up 13% versus a year ago and sequentially up 2%. So these are very encouraging stats. These stats showing sell-through was up. They're utilizing their inventory. That's why our bookings are so strong, why the backlog is at historic levels. I think we're in a good position. And we just have to navigate through supply chain issues and ultimately we'll be in very good shape.

That's very helpful. And one last question for me, and I'll jump back in the queue, is if you can talk at all about how we might think about OpEx going forward. You've got a trade show, presumably that's also going to be -- attract more folks. The investments are coming back in on the sales and marketing side. How should we think about some of the OpEx levels going forward?

So this quarter the OpEx, obviously, was higher than it was in the year ago period or even in the prior quarter period. We did have the stock-based comp of $1.3 million. So obviously, that impacted it. We won't see that again for the rest of this fiscal year. We'll see it again in Q2 of fiscal '23. So that -- won't have that anymore. Commissions were higher this quarter than last year, even than the prior quarter; obviously with higher sales, higher commissions. And T&A trade show expenses were also higher this year versus a year ago. A year ago, we weren't -- our sales guys weren't traveling as much. There weren't as many shows, but there are now, and so that's back. So I would say the level that we saw in this quarter is kind of what I would expect for the next quarter with the only addition being higher commission expenses because of higher sales, and we won't have the stock-based comp.

Our next question comes from the line of Jaeson Schmidt with Lake Street Capital.

Just curious if you could maybe quantify the backlog number, maybe not a specific number, how much that backlog was up ending December?

Well, I don't like to disclose it, but I will tell you it's historic. It's in the millions. We never had that much before, and it's concentrated in radios. The radios are off the charts. We can't produce them fast enough, although we're giving our best effort to produce it fast enough by doing all the things we've said, by getting the parts in any way we can get them, by increasing the labor in the DR. Labor is very easy to come by. We always hear how there are labor shortages here in the States. But in the Dominican Republic, you can get all the labor you want, and we're doing that. We're expanding our night shift so we can produce more. We're adding more machinery so we can produce more. So we're doing everything in our power to get that backlog down. And sometimes, when business is super strong, it's just -- it's a high-class problem. And that's how I would describe this. It's a high-class problem when you have record-breaking backlog, and you also have record-breaking sales. That's kind of the situation we're in.

Okay. That's helpful. And then just a follow-up for me. Obviously, a nice win in the school market, and your comments make it seem like that space is starting to pick up a little bit. Just curious if some of that uptick is more on that K-12 side of the market or if you're also seeing some increasing interest on the college and university side.

Well, the win that we got is a school district, so that's K-12. There are a few universities that we're hoping that we can announce soon. I think it's on both sides. As you've seen the shootings that have occurred, it's in both areas, the universities and the K-12s. No school is immune from the craziness that's out there today. And so the concern is on all areas, and we've seen uptick on both areas.

Our next question comes from the line of Brian Ruttenbur with Imperial Capital.

Yes. And a lot of my questions have been asked and answered. But can you talk a little bit about the guidance? Is there going to be a step function in here? You've had really strong growth, especially on the recurring side, and you're talking about potentially hitting the goal of $150 million a couple of years earlier. Should we expect a step function to happen in the next couple of quarters or in the next 12 months, something like that?

Well, these are our goals. And as we get more clarity, we may change our goal. We're judging it based on sequential growth of activations. We've seen tremendous sequential growth. I just got the January sequential growth numbers. It was 16%. And that's phenomenal. That means the January activations were 16% higher than the December activations, which were 11% higher than the November activations. So we don't want to get ahead of ourselves and assume that every month is going to be 16% better than the prior, but we can't look away from that. That's pretty powerful stuff. We'll watch it. We believe we'll probably get to the $150 million sooner, maybe a couple of years sooner, but we want a little more data before we specifically say that's what we think is going to happen. But right now, that's our belief. With the 16%, if you do the math, and your activations are 16% higher than it was the prior month, and you keep up something like that, even if you had 5% sequential growth every month, that's huge, huge. And that's kind of what we're feeling right now.

Okay. And then just one other follow-up on that. Your goal, I think, 5-year goal was gross margins of 50% or better. Is that still realistic given everything that you're seeing right now?

Well, based on what we're seeing right now, that's not realistic. But the expectation is that when things normalize, that would be the expectation because the margins still expand based upon volume. And if you have a $37.5 million hardware quarter, the margins are going to expand because the only thing we're going to have to add is labor. And so the overhead absorption, all those theories still hold water. And the mix, we'll have to see how that goes. The radios are becoming a dominant part of the mix. But as schools come back, that might shift it the other way. So for right now, we're not feeling -- obviously, we're not feeling a 50% margin on hardware. But we believe that's temporary. And we believe that the recurring, which might be more powerful than the $150 million at 80% margins, would more than cover any decline that we believe was going to occur in the hardware side. But we haven't given up on the hardware side. We're just in a period now, it is what it is right now, we'll come out of this, and we believe be a lot stronger for it. As Dick mentioned earlier, we have the cash, we could use our money to do an acquisition. Why not use this cash to grow that recurring revenue? It's more definite and more powerful.

There are no further questions in the queue. I'd like to hand the call back 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 '22 results. 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.