Greetings, and welcome to Napco Security Technologies, Inc. Fiscal Third Quarter 2022 Results 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 Patrick McKillop, Director of Investor Relations. Thank you. You may begin.

Thank you. Good morning. I'm Patrick McKillop, Director of Investor Relations for Napco Security Technologies. Thank you for joining for – us today for today's conference call to discuss our financial results for our fiscal third 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 statements. 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 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 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 wanted to mention a few things on the IR front. We will be attending the Needham Technology & Media Conference in New York on May 17. Also be attending the 22nd Annual B. Riley Securities Institutional Investor Conference in LA on May 25 and 26. And then followed by Stifel’s Cross Sector Insight Conference in Boston on June 7 through the 9, and finally on August 10 to 11, we will be attending the Canaccord Genuity Growth Conference also in Boston. Investor outreach is crucial, especially for a small-cap company such as Napco, and I would like to thank all of those folks that assist us in these conferences and marketing trips. With that out of the way, let me turn the call over to Richard Soloway, President and CEO of Napco Security Technologies. Dick, the floor is yours.

Thank you, Patrick. Good morning, everyone, and welcome to our conference call. Thank you for joining us today to discuss our results. We are pleased to report our fiscal Q3 2022 record sales of $35.9 million. Our results reflect our 6th consecutive quarter of sales growth. Recurring revenue continued to grow at a very strong rate and the annual run rate is now approximately $50 million based on April 2022 recurring revenues. Our balance sheet remains strong with our cash balances in excess of $47 million and we have no debt. We continue to focus on capitalizing on key industry trends, which include wireless fire and intrusion alarms, school security solutions, plus enterprise access control systems and architectural locking products. The management team here at Napco continues to focus on key metrics of growth, profits and returns on equity and controlling costs. These metrics are important for us as well as our shareholders. We continue to execute our business strategy, and our interests are aligned 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'll provide an overview of our fiscal third quarter results, and then I'll be back with more on our strategies and outlook. Kevin, the floor is yours.

Thank you, Dick, and good morning, everybody. For the third quarter, net sales for the quarter increased 27% to a quarterly record of $35.9 million as compared to $28.2 million for the same period one year-ago. Net sales for the nine months ended March 31, 2022 increased 28% to $100.4 million as compared to $78.6 million for the same period a year-ago. This strong growth for both the three and the nine months is primarily attributable to the continued strength of our commercial intrusion and fire alarm business, as well as access control and door locking products. Recurring revenue for the quarter increased 35% to $12 million as compared to $8.9 million last year and now has an annual run rate of $49.9 million based on April 2022 recurring revenue. Recurring revenue for the nine months ended March 31, 2022 increased 37% to $33.3 million as compared to $24.3 million for the same period last year. In addition, our equipment sales increased 23% for the quarter to $23.9 million from $19.3 million in the prior year period and for the nine months increased 24% to $67 million from $54.2 million for the same period last year. Gross profit for the three months ended March 31, 2022 increased 13% to $14.6 million with a gross margin of 41% as compared to $12.9 million with a gross margin of 46% for the same period a year-ago. Gross profit for the nine months ended March 31, 2022 increased 13% to $39.4 million with a gross margin of 39% as compared to $35 million with a gross margin of 45% of sales for the same period a year-ago. Gross profit on recurring revenue for the three months ended March 31, 2022 increased 37% to $10.5 million with a gross margin of 87% as compared…

Thank you, Kevin. Our fiscal Q3 2022 was a sales record breaker. In fact, it was the highest sales for any quarter in the company's history. We are happy to see that we are able to beat street consensus on revenue, EPS, net income and adjusted EBITDA metrics. The quarter also marked our sixth consecutive quarter of the 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. One key area of our success continues to come from the commercial fire and intrusion alarm business. While the news headlines are dominated by talk of interest rate hikes and the potential for a recession in the U.S., I'd like to remind you that we are highly recession resistant in one of our primary growth drivers, the commercial fire alarm business, which is a mandatory non-discretionary item for building owners. Commercial buildings must have and maintain a fire alarm system in order to receive a certificate of occupancy. Given the high profitability 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 approximately $50 million as of April, 2022. Our StarLink radios have seen an encouraging trend in activations in Q3 by growing 41% sequentially and 91% versus the same quarter a year ago. We are optimistic that we could reach our previously mentioned goal of $150 million in recurring revenue earlier than 2026. Dealers are racing to complete commercial fire alarm system upgrades before the 3G sunset at the end of calendar 2022. And we believe that we are in a strong position to benefit from this as well as the continued need to upgrade legacy systems of old fashioned copper wire phone…

Thank you. Our first question is from Mike Walkley with Canaccord Genuity. Please proceed.

Great. Thanks for taking my question and congratulations on the strong results in the challenging environment.

Thank you.

Kevin, I guess, first question for you. Strong balance sheet seems to be a competitive advantage. If inventory were at more historical levels then you'd probably even have closer to $60 million in net cash. Can you talk about your strong balance sheet and how building inventory is maybe helping you gain market share relative to the competition?

Yes. Good question, Mike. So a lot of our competition doesn't have the balance sheet that we have. So we have $47 million in cash, no debt. Would have been like you said, closer to $60 million, if we didn't grow the inventory. So why are we growing the inventory? Well, we're growing it in part because it's very important to maintain our shipments of our cellular radios. Our radios bring the beautiful recurring revenue that follows, which has up to 87% gross margin as we've seen. So if we have to pay more to get these components so that we could ship out radios and not have any disruptions, we're going to do it. If we could get our hands on the difficult to get components and buy a one-year or two-year supply of them because we don't want to have to keep going back and searching and searching, we're going to do it. It pays off, we have the money to do it, and we also have the money to kind of break into the line of getting an advantage with some of our vendors. These are hard-to-get components. If we could convince our vendors that a) we can pay fast, we have solid cash flow. They don't have to worry about us, move us to the front of the line, so to speak. We tell them we're an essential business, which we are, we're dealing with life safety, fire, get us those components and we're happy to pay, pay fast and buy as many as these components that we can get our hands on. So if the inventory has to grow, so be it, we don't care at this moment. The year before we spent a lot of time reducing the inventory, we reduced it by about $10 million, but we're in a different environment, now. Now the size of the inventory doesn't matter as much. What matters is the continuance of getting those products shipped out as fast as we can because that leads to the profitable growth situation that we're seeing and that we will continue to see.

Okay. Thank you. That's helpful. And for my follow-up question, just given all that backdrop and taking advantage of the balance sheet, I know Q4 is your seasonally strong quarter and you built inventory ahead of that, but how should we think of gross margin just given one, the product mix and two, just the ongoing supply issues. Gross margin, I think you said should improve, hope, six to nine months how about just the short-term on your seemly strong fourth quarter on the equipment side? Thanks.

We believe that the fourth quarter will be helped by our volume of hardware increasing over where it was in this quarter. So as you said, our fourth quarter seasonally strongest, we expect hardware sales to be greater than what it was in Q3. And that helps because then you start to get leverage from our Dominican factory, the more sales that we can push through that factory, the more leverage we're going to get, the more overhead absorption we're going to get. When you get overhead absorption, the margins expand. Now we're being – we're conservative. We're not going to return to the glory days of higher, much higher margins in Q4, but you saw a 900 basis point improvement in Q3 over Q2, and we believe that the margins can continue to improve in Q4. By the time we get to calendar 2023, when our new supply sources are in place, then we could start to see the return through the margins that we used to see. And we believe it's six to nine months away, maybe a little sooner, but in the meantime, we'll do everything we can to improve margins that you've seen now, that was 900 basis points better. We want to do even better than that. And we're constantly working to do things better than that. Working with our engineers who are on site, coming up with new ways to help get lower cost components, better logistics methods, better methods to ship less by air, more by ocean. All these things help margins. Couple of quarters back, we did tremendous amount of sales promotions, which affected margins. We haven't had to do that. We're already gaining share. We're selling our radio products as an example, to some of the biggest players in the industry. And we continue to win market share. We don't have to do big sales promotions. These customers are all coming to us naturally that helps margin and also winning school jobs that helps margins. We announced one today, we had one last quarter. There are other wins, we only announced the big ones, but as you win more and more school jobs that has better gross margins and that helps improve the overall gross margin.

Great. Well, congrats everybody on the execution in the quarter and I'll jump back in the queue.

Thanks, Mike.

Our next question is from Jim Ricchiuti with Needham & Company. Please proceed.

Thank you. Good morning. Just related to that last point that you made about this – the school security order that you highlighted today, this is separate from the one that you mentioned in the last earnings call?

It is. It's very similar in a lot of ways. It's a very large school district, just like the last one. The last one we got, and we announced it with the Q2 earnings release and we shipped that in Q3. This one we just got and it's different and it's big and our expectation is we'll ship a lot of it, maybe all of it in Q4.

Thank you. And I wonder if you could talk a little bit about the inventory reserve issue that you referenced in the quarterly press release today and yes, to what extent that may also result in some high professional expense in the near-term as you work through that?

Great. So in the release, we talked about the possibility that as a result of – our filing maybe – that maybe delayed up to five days and it has to do with a reevaluation of our inventory reserve methodology. And why is this happening? Where is this coming from? Well, we are a large accelerated filer. We're a victim of our success, so to speak. As a result of being a large accelerated filer, our audited results get audited by an organization called the PCAOB. The non-profit organization, the Congress established six years ago. What they do is they audit the auditors. So our audit was selected for being audited by peekaboo. I call them peekaboo, it's PCAOB. And what are they looking at? Everything looks great, but they're looking at our inventory reserve methodology, and we've been doing the same methodology for 30 years. We spend a lot of time getting into the details. We look at every item very detailed, very thorough that's our methodology. The PCAOB determine that they need something that's not as judgmental as that because there's a lot of judgment that goes in this. When you look at every last item, there are judgments in the electronics industry, everything is different. Every item has a story. We go through it in detail. They wanted a more mechanical methodology to coming up with the inventory reserves. So they did make this determination. We have to go along with it. This is the non-cash event. It's going to be very minor, but we have to reevaluate our methodology. And as a result of that, we are potentially, I'm not sure it's going to happen. Delay the filing of the Q by a couple of days, but it'll have no effect on P&L and it'll have very minor effect if any, on the balance sheet.

Got it. And last question. If you alluded to self metrics that were positive, I wonder if you could expand on that a little bit or…

Can you be a little clear on what the question is?

Sure. You've provided it in the past some commentary about sell-through with some of your larger – I wonder if you could, it sounds like you're seeing pretty good sell-through in the core business. So I wonder if you could just comment a little bit more about that specifics.

The large distributors, the largest distributors we have are – we monitor their sell-through. They're all doing really, really well. Kevin, you have the stats on a couple of those guys that you could.

Yes. I do, Dick. So our number one distributor, our largest distributor was up 111% sell-through stats in Q3 versus Q3 a year ago. Our number two guy was up 74.2% sell-through stats Q3 versus Q3 a year ago. There are other ones. I like to look at the top two. I went down to the third guy, he was up 37%. They're all good. The sell-through stats which is a very good barometer because that means the business is going well. And they're going to have to come back and buy more, more inventory, which they are doing has been super, super strong. I mean to have a sell-through stat, that's over a 100% increase. That's pretty powerful.

What you have to understand is that with the amount of production and the amount of shipping we're doing and our backlog is still huge. We have a huge backlog and it keeps growing and it's growing because of the fact that our dealers are very, very busy. They're installing fire panels, fire radios, burglar panels, all over the place because people are concerned about what's going on and they need more protection. So as much as we ship and you can see the results, the orders keep rolling in and we expect this to continue. And then we are dealing with a lot of distributors all over the world to get our parts. And the factory is running six days a week and it's a very unusual time to have that type of backlog because typically our backlog is a couple of $100,000, but we're talking about $10 million backlog, and we're talking about orders pouring in with the stats that Kevin is talking about. We make a very, very unique product line best in the industry. The dealers that install it know it's the best in the industry. It works in all kinds of applications where the competition doesn't work when you have weak signals or when a device is put into a lower basement and a commercial building, our products work and we make sure that they are the best. So people recognize that and I can see this continuing to continue to grow and continue to grow. So we're fighting to get our parts. We are reengineering a lot of the products with additional hardware changes and software changes such that we can use other products which are less costly and more available in today's marketplace, so that's going to make our gross margins start to get back to where we were pre-supply chain, pre-COVID, and that's what we're talking about when we're talking about six, nine months out. It may happen faster, but we're doing all these things. The company's management has been through shortages of parts before never as severe as this and we know how to deal with it. So expect that our results should be continuing in a strong way for the next year and beyond.

Got it. I have few other questions, but I'll jump back into queue and join later again. Thank you.

Okay, Jim.

Our next question is from Raj Sharma with B. Riley. Please proceed.

Hi. Thank you for taking my questions.

Hi, Raj.

Congratulations on solid equipment margins. I had a couple of questions on – you mentioned that because of the shortages in radios and alarms that you've been because of the supply chain issues, you couldn't meet the growing demand. Is there a number you can quantify the amount of sales – alarm sales or that you kind of lost or you would've done and you not had these supply chain…

Yes. I wouldn't say lost, Raj, it's just backlog. It's not lost, it's deferred. So Dick mentioned before backlog is $10 million, so that's a good guesstimate of, if there was zero supply chain issues, our Dominican facility, they can keep up, we can get all the Dominican workers we want, we can run machines longer. That is no issue, but getting the parts was an issue. So imagine if the sales in this past quarter was $10 million higher. I mean, that's what we'd be potentially looking at.

Distributor, Raj, will say, ship me a 1,000 of this and 500 of this and a 1,000 of that. We get it out to them, the order comes piling in the next week for even greater quantities and net quantity. So it's turning, it's just continuing to grow because dealers do appreciate the type of products we have that are very unique in how they perform and the fact that we're a totally integrated system where our radios and our control panels and our access control all integrate together. It's a time where people recognize, dealers recognize that Napco is a one-stop shop, we can get everything from them, we can get all the technical answers for applications from them. Whereas our competition, some of them make locks, some of them make alarms, some of them make radios, but they don't have an integrated solution. So the dealers have recognized, I need less aggravation in my life. Let me use all Napco and have everything answered. And it's like, when you get something built in your home, you have this mechanic blaming that mechanic that the plumbing doesn't work with the sink, and it's problems with us. You don't have that issue because it's all integrated and designed to work together, no mixed brands. So while our products do work in an open architecture way, we have every product, 2000 SKUs that dealers need. So that's why the orders are piling in.

Thank you. So that's pretty substantial, $10 million equipment revenues would've been higher by $10 million and obviously the recurring revenues that follow from that?

Yes. We wanted recurring revenue radios being installed even during the supply chain. So therefore, something that would cost a $1, we'd pay a $1.50 just to have it because a radio once installed, a control panel with a radio inside of it once installed gets you years and years and years of sales. It's the beginning of the sale and years and years of sales at high margins, so we don't want to have any issues with that. That's what we're willing to sacrifice a little bit of our margin so we can buy parts even though if they're more expensive, but that'll come back under control. As we say, with our re-engineering and with our additional sourcing drive that we have going on.

Got it. Thank you. And then on the school projects, could you kind of – is there a way to estimate the amount of revenues that you would get from this new school project, the number of doors, you had a – was the school project done in Q2, was that similar in the size? Just wanted to get a sense of the equipment revenues and the recurring revenues that would go with it if there are any?

Right. So the size of the two orders, they were similar. The one that we just got is larger than the one that we announced last quarter. I can't give you specifics. As a matter of fact, when we first wrote the release, we wanted to put the name of the school district and give you more specifics to the size where they're located all that, but we couldn't get approval in time of the relief. So we had to make it more generic. It's not – sometimes the school districts don't want you to announce it at all. These guys, they just didn't approve it yet. They may approve it and then we'll be able to be more specific going forward. But, it's hard to say, how many more of these we're going to get. We just know there's 131,000 K-12s out there, and there's over 5,000 universities. And we know just from experience and of hearing, the tragic events that happen every now and then with school shootings that most of them don't have equipment in place. As a matter of fact, the one that we got last quarter, they went to a system where they could lock the classrooms from the inside. And the reason they wanted that is there's so many times where the shootings occur, where the teacher has to go into the hallway, looking for somebody to lock the door because the doors are locked from the outside. That's how these classrooms were built and this particular school district is smart enough to make the move. So now all their classrooms can be locked from the inside. Most districts, most K-12s, most universities, I know we've been talking about this for years. Most still don't have anything. They just go into lockdown. They announce we're in lockdown and it's just words, but there's no equipment. So this is the big area. It's hard for us to say, Raj, how many schools we're going to get, how many doors? We know that when the school security was stronger before the school started to close because of COVID that the locking part of our business was the largest segment of hardware. And it's still the largest segment, but it's not as large as it once was. As it comes back, it'll become, we believe more significant portion of overall hardware sales and school security, jobs. They get us anywhere from 35%, 50% gross margins. So that's a big difference than say a radio hardware margin, which is much lower, but of course the radios lead to recurring and there will be a time when the school jobs will have recurring revenue as well. Right now they don't, but with their access, they might going forward. We expect that they will?

Got it. Thank you. Thank you for answering my questions. I'll take it offline.

Thanks, Raj.

Our next question is from Jaeson Schmidt with Lake Street Capital Markets. Please proceed.

Hey guys. Thanks for taking my questions. Just want to follow-up on your commentary on equipment gross margin. So it's fair to say that you expect kind of equipment gross margin to get back above that 20% range maybe in the second half of fiscal 2023?

Well, our equipment gross margins were in the 30s. That's where they were before any of this supply chain stuff COVID started. Our hardware margins on a weak quarter would be high-20s, on a normal quarter would be low-to-mid-30s, and on a strong hardware quarter would be pushing 40%, big difference obviously from where we are now. But our goal is to get back to those levels and beyond because as the hardware sales become larger and larger than the margins will expand more. So pre-COVID days, we were having $20 million hardware quarters and we just had in Q3, a hardware quarter that was over $23 million. We expect going forward, our goal, if you remember our goal, our goal is to get to $150 million of hardware by 2026, that's a $37.5 million on average hardware quarter. At those levels, our margins will be higher than they were pre-COVID because that's a big difference, $37.5 million on average versus a $20 million hardware quarter. So we just did 17%. We think we'll do better in Q4. We'll get some benefit from having higher sales levels because it's a Q4. But the bigger picture is to get back to restore to the days, pre-COVID, pre-supply chain. And that would put us in the 30s and it'll take time, but we see six to nine months out. We should start to see a bigger difference. We're very happy with the 900 basis point improvement, but obviously 17%. It's good compared to last quarter, but it's not good enough. So we want a lot more than that.

Okay. That's really helpful. And then just as a follow-up looking at the school security market, obviously there's wins that you can announce. And the two most recent wins seem to be pretty sizeable. But in aggregate, are you seeing the deal size in that market steadily increase?

What we're seeing is a lot of deals, a lot of jobs that have been on hold now starting to come off of hold. The jobs come in all sizes and shapes. So when you win a school district job like this one was, and the one last quarter that we talked about, those are big jobs. When you win a university, those are big. They have lots of classrooms and lots of dorm rooms, those are big jobs. We're seeing that's starting to come back. We only announced ones we could talk about, the ones that are sizeable. There'll be more that we're going to be announcing, but there's a lot of wins that – they're smaller ones. It could be a small school district. It could be a small university. They come in all sizes and shapes, but the key point I want to make is most don't have anything done, which means the opportunity is still there. It's huge, and I believe we'll start to pick up as long as COVID doesn't get in our way again, and there's no issues like that this market will come back to where it was.

Okay. Perfect. Thanks a lot guys.

All right. Jaeson, take care.

Our next question is from Brian Ruttenbur with Imperial Capital. Please proceed.

Great. Thank you very much. In terms of backlog levels, you talked about great visibility. For how long do you have that visibility? Are your backlogs three months, six months, two years? I'm just trying to get a level and how far out visibility you can see?

Our backlog is any orders that have been placed. So in most cases, these are orders that are current shipments, if you can do it. In a few cases, we talked about $10 million before as a number. Not all $10 million is current backlog, a small portion of it that had to say maybe 10%, maybe 15% is over time, not all at once. Most of it all at once, which means if you could ship it all, if you had the product, you could make that sale now. But in terms of visibility, that backlog is, we see it, it's based on orders that are placed. If we're talking about backlog of potential orders that's different, so if we're talking about what's the potential backlog for school jobs, we know about a lot of them. But we don't know when they're going to hit. So for example, the one that hit that we announced today, we've known about that one and now they finally pulled the trigger. And similar last quarter, but the backlog that we stated that's real, those are orders that have been placed.

And the orders that are turning, so the sell-through that Kevin, was talking about before were over a 100% up. So the backlog is such that it's being eliminated and then it refills again. So you ship 500,000 to particular distributor, next week another order comes in for a $1 million, 400,000 next order comes in through 600,000, the following week. So it's a turning backlog. And that means that there's, as we know, there's millions and millions of buildings and schools that need protection and the dealers are out working very hard, doing that and we have product. So they're getting it from us plus we give them all the technical support and sales support and we do a lot of seminars with them, so they understand the advantages of our product and that whole thing is working. So the redesign of some of the things that we make, which are big sellers, we're doing it with a different type of component than we've been using for years because it's available and because it does exactly the same job and it's less expensive. So we'll be able to get volume of those. So we can get our backlog down to a couple hundred thousand, which should give a big shot in the arm to our sales and our profitability as we amortize the cost of our Dominican operation over more and more volume. So we'll be getting back to the type of numbers that Kevin was relating to a couple of minutes ago.

Great. And just the last question real quick, long-term guidance on change, you don't see any issue at all with your kind of five-year goals?

I would say, we don’t call it guidance, we call it goals, right. What we believe is we might get there sooner. That's how we're feeling. So we said by 2026, it might very well be sooner.

Thank you.

All right, Brian.

We have reached the end of our question-and-answer session. I would like to turn the conference back over to Richard for closing comments.

Thank you, everyone for participating in today's conference call. As always, should you have any further questions, please feel free to call Patrick, Kevin or myself for further information. We thank you for your interest and support, and we look forward to speaking to you all again in a few months to discuss Napco’s fiscal Q4 and full-year 2022 results. Bye-bye, and we wish you the best. Take care.

Thank you. This does conclude today's conference. You may disconnect your lines at this time and thank you for your participation.