Napco Security Technologies, Inc. (NASDAQ:NSSC) Q2 2023 Earnings Call Transcript

Napco Security Technologies, Inc. (NASDAQ:NSSC) Q2 2023 Earnings Call Transcript February 6, 2023

Operator: Greetings, and welcome to NAPCO Security Technologies, Inc. Fiscal Second Quarter 2023 Earnings Results Conference Call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Patrick McKillop, Vice President of Investor Relations. Thank you. You may begin.

Patrick McKillop: Thank you. Good morning. My name is Patrick McKillop, Vice President of Investor Relations for NAPCO Security. Thank you all for joining us for today’s conference call to discuss our financial results for our fiscal second quarter 2023. 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 growth drivers of the company’s business, such as school security products and recurring revenue services, potential market opportunities, the benefits of 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 that we are actively planning our Investor Relations calendar for more NDRs and conferences in the near future as investor outreach is crucial, especially for a small-cap companies such as NAPCO and I would like to thank all of those folks that assist us in these conferences and marketing trips.

Also, we invite you to come to visit our booth at the upcoming ISC West Trade Show, March 20 through the 31 in Las Vegas, Nevada. ISC West is the industry’s largest trade show, with over 30,000 attendees. 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.

Richard Soloway: 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 fiscal Q2 2023 record sales of $42.3 million. This is our ninth consecutive quarter of sales growth. Recurring revenue continued to grow at a very strong rate and the annual run rate is now approximately $59 million based on January 2023 recurring revenues. Our balance sheet remains strong, with our cash balances at $47.1 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 the 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 16.5% 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 first quarter results and then I’ll be back with more on our strategies and outlook. Kevin?

Kevin Buchel: Thank you, Dick, and good morning, everybody. Net sales for the second quarter increased 27% to a quarterly record of $42.3 million, as compared to $33.4 million for the same period one year ago. Net sales for the six months ended December 31, 2022, increased 27% to $81.8 million, as compared to $65 million for the same period one year ago. Our equipment sales in Q2 increased 23% to $27.4 million, as compared to $22.4million for the same year ago period and equipment sales for the six month period also increased 23% to $53.1 million as compared to $43.2 million for the same period a year ago. Recurring monthly revenue continued its strong growth, increasing 35% in Q2 to $14.9 million, compared to $11 million for the same period last year and for the six months increased 35% to $28.7 million versus $21.3million in the same period a year ago.

Our recurring service revenues now have a prospective annual runrate of approximately $59 million based on January 2023 recurring service revenues. The increase in equipment sales for the quarter were primarily due to increases in both our Alarm Lock and Marks store locking products, as well as increased sales in our Continental Access Control products. The increase in equipment sales for the six months was primarily due to increased sales of NAPCO’s intrusion products, Alarm Lock and Marks door locking products and Continental Access Control products. The strong growth of our recurring revenue for both the three and six months ended December 31, 2022 was primarily attributable to the continued strength of our StarLink cellular radio products driven by increases in the commercial intrusion and fire alarm business.

Gross profit for the three months ended December 31, 2022, increased 70% to $19.4 million with a gross margin of 46%, as compared to $11.4 million with a gross margin of 34% for the same period a year ago. Gross profit for the six months ended December 31, 2022 increased 51% to $37.6 million with a gross margin of 46% and as compared to $24.9 million with a gross margin of 39% for the same period a year ago. Gross profit for equipment sales for the three months ended December 31, 2022 increased 245% to $6.2 million with a gross margin of 23%, as compared to $1.8 million with a gross margin of 8% for the same period a year ago. Gross profit for equipment sales for the six months ended December 31, 2022, increased 88% to $12.3 million with a gross margin of 23%, as compared to $6.5 million with a gross margin of 15% for the same period a year ago.

Gross profit for recurring revenues for the three months ended December 31, 2022, increased 37% to $13.2 million with a gross margin of 89%, as compared to $9.6 million gross margin of 87% for the same period a year ago and gross profit on recurring revenues for the six months ended December 31, 2022, increased 38% to $25.4 million with a gross margin of 88%, as compared to $18.4 million with a gross margin of 87% for the same period a year ago. The significant increase in gross profit dollars, as well as gross margin for equipment sales for both the three and the six months ended December 31, 2022 was primarily the result of the aforementioned increases in equipment revenues, as well as increased availability and lower cost of certain components and transportation cost, as compared to the same period last year.

This was as a result of improvements within the company’s supply chain. The increase in revenues also resulted in improved overhead absorption rates from our Dominican Republic manufacturing facility. The increase in gross profit dollars for recurring service revenues for both the three and six months ended December 31, 2022 was due to the continued strong sales of the company’s StarLink Radios. The continued increase in gross margin of recurring revenue for both the three and the six months was primarily due to increased service revenues relating to the company’s fire radios, which have higher monthly selling prices than the company’s intrusion radios. Research and development expenses for the three months ended December 31, 2022, increased 12% to $2.2 million, 5% of net sales, as compared to $2 million or 6% of net sales for the same period a year ago.

Research and development expenses for the six months ended December 31, 2022, increased 19% to $4.7 million or 6% of net sales, as compared to $3.9 million or 6% of net sales for the same period a year ago. The increase in dollars for the three and six month periods was due primarily to salary increases and some additional staffs. Selling, general and administrative expenses for the three months ended December 31, 2022, decreased by 5% to $7.8 million or 18% of net sales, as compared to $8.2 million or 25% of net sales for the same period a year ago. The decrease in dollars resulted primarily from higher stock option expense and legal expenses incurred in the three months ended December 31, 2021. The decrease as a percentage of net sales was due primarily to the increase in net sales as well as the aforementioned decrease in expense dollars.

Selling, general and administrative expenses for the six months ended December 31, 2022 increased by 5% to $6.3 million or 20% of net sales from $15.5 million or 24% of net sales for the same period a year ago. The increase in dollars resulted primarily from increases in credit card processing fees, insurance expense and commission expenses. The decrease as a percentage of net sales was due primarily to the increase in net sales as partially offset by the aforementioned increase in expense dollars. Operating income for the quarter increased 643% to $9.4 million, as compared to $1.3 million for the same period last year and operating income for the six months ended December 31, 2022, was $16.7 million as compared to $5.4 million for the same period last year, which is a 206% increase.

The company’s provision for income taxes for the three months ended December 31, 2022, increased by $886,000 to $1.2 million, an effective tax rate of 12%, as compared to $291,000 with an effective tax rate of 22% for the same period a year ago. The increase in the provision for income taxes for the three months was primarily due to higher taxable income. The company’s provision for income taxes for the six months ended December 31, 2022, increased by $1.3 million to $1.9 million with an effective rate of 11% and as compared to $639,000 with an effective tax rate of 7% for the same period a year ago. The increase in the provision for income taxes for the six months was also primarily due to higher taxable income. The effective tax rate for the six months ended December 31, 2021 was reduced due to other income of $3 million – $3.9 million being non-taxable.

Net income for the three months ended December 31, 2022 was a quarterly record $8.4 million or $0.23 per diluted share, as compared to $1 million or $0.03 per diluted share for the same period a year ago, 714% increase. Net income for the six months ended December 31, 2022 increased 69% to $14.8 million per diluted share as compared to $8.8 million or $0.24 per diluted share for the same period a year ago. Net income and earnings per share in last year’s Q1 benefited from $3.9 million of other income from the forgiveness of debt. Without such benefit, net income and diluted earnings per share for the six months ended December 31, 2021 would have been $4.9 million and $0.13, respectively. Adjusted EBITDA for the quarter was a quarterly record $10.3 million or $0.28 per diluted share, as compared to $3.1 million or $0.08 per diluted share for the same period last year, a 232% increase.

Photo by Sebastian Scholz (Nuki) on Unsplash

Adjusted EBITDA for the six months was $18.6 million or $0.50 per diluted share, as compared to $7.8 million or $0.21per diluted share for the same period last year, a 138% increase. The EBITDA margin for the three months ended December 31, 2022, was 24% as compared to 9% in the prior year period and for the six months ended December 31, 2022 the EBITDA margin was 23% as compared to 12% in the prior year period. Moving on to the balance sheet, at December 31, 2022, the company had $47.1 million in cash, cash equivalents, investments in marketable securities, as compared to $46.8 million as of June 30, 2022. Working capital, defined as current assets less current liabilities was $101.6 million at December 31, 2022, as compared with working capital of $93.1 million at June 30, 2022.

The current ratio, defined as current assets divided by current liabilities, was 6.6 to 1 at December 31, 2022 and 4.5 to 1 at June 30, 2022. Cash provided by operating activities for the six months was $1 million, as compared to $7.8 million for the same period last year. This decrease was primarily due to inventories increasing by $14.8 million, resulting primarily from the company’s decision to purchase hard-to-get parts used in products that generate recurring service revenues for the company. The challenges from the supply chain crisis are beginning to subside and the company believes its inventory levels will begin to decrease in the latter part of fiscal 2023 and continuing in fiscal 2024. CapEx for the quarter was $444,000 versus $249,000 in the year ago period and for the six months ended December 31, 2022, was $816,000, compared to $771,000 in the prior year period and we have no debt.

That concludes my formal remarks, and I would now like to return the call back to Dick.

Richard Soloway: Kevin, thank you. Our second quarter was a sales record breaker our sales, continuing our sales growth streak, which is now our ninth consecutive quarter of year-over-year sales growth. Prior to the COVID pandemic, we had 23 consecutive quarters of growth and we look forward to surpassing that streak in the future. We are pleased that we were able to beat published Street consensus estimates for revenue, EPS, net income and adjusted EBITDA metrics. This outstanding performance is the result of the continued strong demand for each of our product lines, including NAPCO, fire and intrusion, Alarm Lock and Marks door locking products, as well as our Continental Access Control systems. One key area of our success continues to come from the commercial fire and intrusion alarm business.

The ongoing concerns about a potential recession in the U.S. and rising interest rates remain as top headlines and I’d like to remind you that our company is highly recession-resistant as 80% of our business is commercial and one of our primary growth drivers. The commercial fire alarm business is a mandatory non-discretionary item. Commercial buildings must have and maintain a fire alarm system in order to receive the certificate of occupancy. Given the high profitability and essential nature of this business, we focus on this as a key area of our resources. Our equipment and recurring revenue both generated exceptional growth in this quarter, increasing 23% and 35%, respectively. The annual run rate for recurring revenue is now approximately $59 million as of January 2023.

Our StarLink radios continue to have strong sales and we are optimistic that we can reach our previously mentioned goals of $150 million in recurring revenue and $150 million of equipment revenue by the end of fiscal 2026 or possibly sooner. Achievement of those goals as well as our gross margin goals of 80% for recurring revenue and 50% for equipment revenue could generate EBITDA margins in excess of 45%. We estimate that there are millions of commercial buildings of all types such as offices, hospitals, schools, coffee shops, fast food restaurants and others that still require upgrades from old-fashioned copper phone wires. Our StarLink radios have the widest coverage with both AT&T and Verizon service and rich feature sets, which our dealers love.

The 3G sunset was completed just a few weeks ago and management believes that a portion of the active NAPCO’s StarLink radios that lost communications due to the Verizon 3G sunset have not yet been replaced because a long deal is expected the sunset to be delayed as was the case with the AT&T 3G sunset in 2021. Ultimately, the company anticipates that many or all these NAPCO 3G radios will be replaced with NAPCO’s newer-generation radios, because alarm dealers must have new functioning and revenue-producing radios to monitor alarm conditions, resulting in both additional hardware revenue and increasing recurring revenue for the company. We are pleased that the equipment margins improved by 1,500 basis points to 23% in this quarter versus 8% in the same period a year ago.

Margins for recurring revenues also improved by 200 basis points to 89% for this quarter versus 87% in the same period a year ago. The constraints of the supply chain have largely abated for us, and we believe that in the next three months, the new supplier sources we have developed will begin to invigorate our equipment margins and bring them to even higher levels than what we generated prior to the supply chain crisis. The backlog for the company remains at a higher-than-normal level. Although it continues to come down considerably and we remain confident in sustainable demand for our products going forward, we remain encouraged by the continued strength of the sell-through statistics we are seeing from several of our largest distributors.

We believe that we are taking market share from our competition based on new customers continuing to tell us that they can’t get products from the competition. School administrators are focused on the need for security solutions as more incidences continue to happen. Our fully integrated solutions with school security generate healthy margins for our business and now more than ever, we are laser-focused on further penetration of the school security market, which is comprised of approximately 130,000 K-12s and 5,000 colleges and universities across the country. Our fully integrated technologies for the school security market continues to remain a top priority for NAPCO. The availability of grants to schools to fund these security projects has never been better.

We are excited to report that we recently received another school security project for a large school district in the state of Massachusetts and the school will be using our Continental Access Control products in its 125 schools. Offering seamless security solutions, which allow for our dealers and us to generate recurring revenue streams is central to our strategy. Historically, recurring revenues have been from our NAPCO Intrusion and Alarms division, but the recently launched Air Access product, we are now €“ with the recently lost air access product, we are now able to generate recurring revenue from all divisions of the company. Air Access should generate recurring revenue from locking and access control which has never been done before.

Air Access is the industry’s first cellular-based access control system, which we believe is a billion dollar opportunity. The benefits of Air Access include no need for upfront investment of expensive hardware, no need to interfere with corporate IT networks, which can be a major problem for installers, and no on-site database backups or software updates. Our R&D team remains hard at work, developing even more products to the future, which will help grow our recurring revenue business. We have experienced tremendous success over the last five years growing our recurring revenue business and believe the best is yet to come. Lastly, I am pleased to announce that David Patterson, the Governor of New York for March 2008 until January 2011 has joined our Board of Directors.

David has vast experience in crime and in security issues and is an outspoken advocate of safety by combating crime traditionally and with new messaging systems. He will bring his unique perspectives to NAPCO and we plan for the future growth and success of the company. We will begin our Q&A session portion of this call in a moment. Our fiscal second quarter 2023 was a record-breaking successful one. We have a strong balance sheet, no debt and continue to generate healthy profits. We believe we can continue this renewed growth streak well beyond the ninth consecutive quarter streak we are on now. NAPCO’s senior management owns approximately 16.5% of our equity and I would like to thank everyone for their support and for joining us in the exciting future we have.

Our formal remarks are now concluded. We would now like to open the call for a Q&A session. Operator, please proceed.

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Q&A Session

Operator: Our first question comes from the line of Jim Ricchiuti with Needham & Company. Please proceed with your question.

Jim Ricchiuti: Thank you. Good morning. I just wanted to follow up on the comment that you made regarding the Verizon 3G sunset. Are you hearing from your channel partners yet of the acceleration in demand that they might be anticipating as a result of this?

Richard Soloway: Kevin, do you want to take…

Kevin Buchel: Sure. So Jim, we know that the dealers who failed to take action sunset hit. A lot of these dealers didn’t think it was really going to happen, because when the AT&T sunset came about, they didn’t €“ they kept delaying it and delaying it. The dealers thought it was going to get delayed this time. Remember this with the dealers. If they don’t have an active radio, then they suffer. They are losing recurring revenue. Remember, they charge the end user recurring revenue, just like we charge the dealer. So the last thing they want is to lose their livelihood, that recurring. So, we’re starting to see a lot of scrambling around as these radios that went dark at the end of January 3rd are being replaced. We’re pretty confident that they are all going to be replaced, and we’re pretty confident they’ll be replaced with our radios.

They’ll go from a NAPCO 3G radio to a NAPCO StarLink 5G radio. There is also the possibility that some of the radios that go dark from other could come over to the NAPCO side because we believe we have a better offering than the competition. So, there is a lot of scurrying about. Let’s watch what happens, but we think in the end, it’s going to mean more radio sales and more recurring revenue for us.

Jim Ricchiuti: Follow-up question and this may be for you, Kevin or Dick. If you could talk a little bit to some of the redesign activities when you start €“ when are you anticipating that, that could produce more meaningful improvement in equivalent gross margins?

Kevin Buchel: Yes, I could take that one. So several months ago, probably about seven months ago, we said that we were going to embark on the journey of getting another source to replace the traditional source, which is Texas Instruments, for our radio business because we can’t keep living with having to buy these hard-to-get parts from brokers. So it takes time to do this. It’s not like you just find the other source and you pop it into the board and you’re off to the races. There is redesigning of the board. There is software updates. There is approvals from the ULs of the world, takes time. Well, we’re happy to say that we’re almost done. We’re about seven months into this journey and probably by the end of this quarter, we’re in the March quarter now.

We’re going to start utilizing these other €“ these new sources. These new sources will be the same cost that we were used to before we had to start buying these parts from brokers. Now we are going to still use TI. It’s not like we’re going to give up on them. But they can’t keep up with us. They can’t keep up with anyone actually. They’re having trouble with everybody. But we’ll use them, if they can deliver. We’ll use the new source when they can when we can get from them. We don’t anticipate any trouble from the new source and that should return margins to more normalized levels that we were used to before the COVID and the supply chain hit. Now we do have a lot of inventory at the higher price, higher priced inventory, the inventory that we’ve been buying from these brokers.

We’ve got to work our way through it and then eventually we’ll be exclusive with lower cost parts for our radios. I think we’ll start to feel a difference a little bit in Q3, more in Q4 and certainly in fiscal 2024, I think we’ll really start to feel it and as we work through that inventory, it will also help reduce the inventory overall, which we’re carrying a lot of extra inventory because we don’t want to be short at all with radios. Radios leads to recurring, which leads to going on forever.

Jim Ricchiuti: All right. And then just 1 quick final question, if I may. Just remind us about ISC West and the impact that has on SG&A in this current quarter?

Kevin Buchel: ISC, okay, go ahead, Dick.

Richard Soloway: ISC, I’ll do the first one. ISC West is the biggest Trade Show in the industry and we’ll get to see lots of dealers, which are great buyers and we’ll be able to pick up a lot of market share. We show a lot of new products at that show. We have a very large out, right in the main section. It’s very important to show our products. We’ll have our sales teams out there. We’d like to have any customers and also financial people come out and see it. You’ll get a feeling for the power of NAPCO in the industry and you can hear the dealers talking to us. As far as what the costs are, Kevin, maybe you can explain that.

Kevin Buchel: Yes, so, it will hit €“ the show is March 28 through the 31st. So it’s a Q3 for us fiscal Q3 expense and expense well worth it. But it’s dollars plus hit to SG&A. So, for those of you that are modeling SG&A, remember that SG&A, in Q3 will have that expense in it and should be somewhere in the neighborhood of $500,000 to $600,000 higher than what you saw in this quarter that we just finished.

Jim Ricchiuti: Got it. Thanks, very much.

Kevin Buchel: Thank you, Jim

Richard Soloway: Thank you.

Operator: Our next question comes from the line of Brian Ruttenbur with Imperial Capital. Please proceed with your question.

Brian Ruttenbur: Yes. Thank you very much. First of all, the gross margin question, it looks like gross margins are going to continue on the equipment side expanding what you just talked about, do you expect steady services gross margin is 89% sustainable?

Kevin Buchel: Well, I modeled this back then when we did our 150, 150 goal at 80% and I was thrilled at that time to be utilizing an 80% gross margin and it just keeps growing and growing and growing and growing. I thought the top was 85% or up to 89%. It keeps growing mainly because we are selling more and more fire radios. And that’s €“ we get more money for those. So the margins expand. I think, if I was modeling this, I use mid-80s, maybe we’ll keep it in the high 80s. It’s not going to go below mid-80s, maybe we’ll even hit 90%, it’s possible. But mid-80s is certainly great enough.

Brian Ruttenbur: Okay. And then, in terms of equipment revenue growth, you beat me by a couple of million on the top line in revenue in the period. Is that – $27 million, $28 million, is that a sustainable number for the third quarter what you had in the second quarter?

Kevin Buchel: Well, the comps get a little harder each quarter. Third is a little harder than the second and the fourth. It’s $30million last year. So, when I model this, I modeled 10% hardware growth with the expectation that we could possibly do better than that and continue. We’ve been in the 20s the last several quarters. We hope we can keep it up. There is no guarantees. There is nothing we’re seeing that says we can’t do it. But when I model, I’m more conservative, so I am more in the 10% range, especially when we get to Q4, which is $30 million, and that would mean 10% would be $33 million. But our guys are charged with – I want 20% out of all of them and that’s what we’re pushing for.

Brian Ruttenbur: Okay. Very good. Then just moving on with cash. You talked a little bit about inventories, maybe coming down over the next couple of quarters. So that should produce, unless I am missing something, you can walk me through, cash should increase sequentially from second to third quarter and third to fourth quarter. Is that correct?

Kevin Buchel: That is 100% correct. So two things are happening. So as the recurring revenue grows, the cash grows with that too. We haven’t really felt it because we’ve been using a lot of that growth that the recurring brings us for inventory. So as recurring keep growing, cash grows and if inventory goes the other way, it will €“ you’ll feel the growth in cash two ways, so to speak. And so, yes, we expect cash to grow in the third quarter and the fourth quarter and beyond.

Brian Ruttenbur: Okay. So receipt pools and other things and payables aren’t going to €“ other working capital isn’t going to change dramatically. It’s all about the inventory of the cash, right?

Kevin Buchel: Exactly.

Brian Ruttenbur: Okay. And then, in terms of price increases, I believe you €“ on the product side, you had a price increase in April, 1 in July. Have you had any other price increases in the last 90 days or do you plan any in the next 90?

Kevin Buchel: We haven’t had one since that second one and we’re discussing it. We haven’t made the decision yet. But typically, we take a price increase every year. So, at the very least, we’d probably do 1 in July. We always do it. The question is, would we do 1 beforehand that we’re talking.

Brian Ruttenbur: Okay. And then, last question in terms of backlog. You mentioned backlog coming down. Are they still near record levels? I’m just worried about our €“ I have a question less worried about your visibility with backlogs coming down slightly.

Kevin Buchel: Backlogs was never a big thing here. Backlogs became a big thing when supply chain and COVID hit, and it was up to $10 million and then we got it down to $6 million and now it’s down to $3.5 million. These are still historically high levels. We don’t like backlog. We want to be able to ship dealers right when they order it. So we’re working hard. As fast as we kill the backlog, we get new orders. When the demand is strong, that’s a good thing. But even with strong demand, we are working to reduce that backlog to less than $1 million. We are not there yet, but working hard towards it.

Brian Ruttenbur: Great. Well, thank you very much.

Kevin Buchel: Thank you.

Operator: Our next question comes from the line of Raj Sharma with B. Riley Securities. Please proceed with your question.

Raj Sharma: Hi, thank you. Again, congratulations on really, really good results.

Kevin Buchel: Thank you, Raj.

Raj Sharma: Yeah, absolutely. My question is on the Continental locking axis, due to €“ were those increases in those equipments indicative of the school security projects?

Patrick McKillop: Certainly, helped it.

Richard Soloway: Yes. The product line utilizing our cellular technology that we invented for the fire intrusion is helping out a lot because of school security where you don’t have to wire the school, but you can get the lockdown functionality out of it and it goes through the cloud and people with cell phones can access what’s going on in the building and there has to be a lockdown electronically. It could be done. So it’s a great product and it has great growth potential. And one thing I’d like to point out, in the $150 million in equipment by 2026, $150million in equipment by 2026 and recurring revenue of $150 million by 2026 or before. We don’t have air access with this application included because it’s a new product with us.

It takes typically a year, in this case, 1.5 years for it to become more mainstream with dealers because it is very different. But it gives the dealer the benefit of recurring revenue. We never have recurring revenue on a product. It’s kind of what the fire and fire and burglar alarm dealers get now for locking and access dealers. So, it’s a very, very new and exciting product, and it’s reteaching the industry on how to sell it.

Raj Sharma: I understand that Air Access is still a minimal part of our non-existing part of the service contracts. Of the equipment €“ on the equipment side any estimate of what the school security contributes to the equipment currently?

Kevin Buchel: It’s hard to say, Raj, because we get a lot of orders that go directly through distribution and we don’t see it or a lot that we see. And what I look at, is to really get an indication. I like to see what’s our locking sales as a percentage of our overall hardware and so I see that our locking sales is about 59% of our overall hardware sales. That’s a lot. That’s a very healthy thing and I know it’s because of schools. It’s not only schools, it’s hospitals, it’s airports, it’s a lot of things. But when schools are doing well, the security end is doing well, that number does better. So I know it. And there are lots of wins we don’t talk about. We mentioned one on this call in a Massachusetts school district. For some reason the schools don’t let us really talk about it a lot.

They like to keep things quiet. We have mentioned a couple of really big wins on largest school districts in the country, which we got over the last six months, two top 10, so two of the 10 largest school districts in the country. So we were proud to get that. It’s early stages. I know we sound like a broken record. Despite all the shootings that have gone on, we’re still in the early stages of this as most schools still haven’t done enough. And now there is all kind of money available from both the federal and the state governments to help them and of course, if it’s a university, they have big endowments and can do it. We’re in the early innings, second and third inning, if you ask me, on school security. Big area. I wish we could be more specific, but we can’t.

Raj Sharma: Got it. Got it. And then, on the inventory increase, the higher-priced inventory, I just wanted to understand, on one hand, the margins €“ our gross margins on equipment are going to be helped because of the higher volumes and the cost absorption. On the other hand, you are going to have higher priced inventory flow through the income statement. I know you just talked about that. Could you help me understand if that is happening? What the cadence of that is happening in the next two quarters or largely the impact of higher-priced inventory on gross margins negative impact? Does that happen in fiscal 2024 or…

Kevin Buchel: That’s going to happen probably in the next two quarters. It’s going to keep our margins in the similar range to where they’ve been in this fiscal year. The fourth quarter is probably going to benefit from a much higher sales level and more overhead absorption. So, last year, as an example, when we had a $30 million hardware quarter, the margins for equipment jumped to 27%. 27% may not sound like a lot, because in the old days, it wasn’t a lot compared to what the rest of last year looked like, that was a significant jump. So we’re going to see a jump probably in the fourth quarter because of that volume overhead absorption from the DR facility, but we won’t feel the back to the good old days yet until we work through this inventory.

We’ll start to feel more of it because we are not buying as much from the brokers. So that helps. We got to work through that inventory that we did buy from the brokers and that will affect Q3, and to some degree for by next year, fiscal 2024, I think we get a lot of this behind us.

Raj Sharma: Got it. And then just lastly, could you give us some more color on the sell-through at the dealers? Are you still seeing, in the top five dealers robust year-on-year increases?

Kevin Buchel: Yeah, the sell-through is still very good. It’s changed. The old sell-through, we wanted the distributors to carry three months supply of everything. And once COVID hit, supply chain crisis, then the distributors became just-in-time distributors. They wanted to carry the bare minimum. We don’t love that. There is a good side to it. Our business €“ our orders come in very steady throughout the quarters. They come in weekly one after the other. We don’t have to wait till the end. I was telling somebody earlier today, I used to sit here in December on New Year’s Eve, because everybody is out celebrating, and I’m waiting for orders to come rolling in. They come in last minute as distributors waited to place their big orders to try to get the best deal they could.

Those days, in large part, they’re over. The orders come in very steady throughout the quarters. You don’t have to go crazy with overtime and flying things as much and you can forecast better. The only negative is, you’ve got to watch their inventory levels that they don’t run too low and that they have product across the board. We don’t want them to run out. If a dealer comes into a distributor and they don’t have the product, they go elsewhere and we better hope that the elsewhere is a place that carries our product. So we monitor it closely, make sure they have everything on the shelf. The days of the three months might be over, but there are benefits from it.

Richard Soloway: Raj, I want to mention something to you. And realize that most of our production goes to distributors and the distributors are our customers that, when Kevin is talking about the stats, he is talking about these large distributors that have the products and he is watching over what’s checking and what’s selling to those dealers. The dealers go to distributors and get the product. Our business was founded on small midsized dealers in every town and city, but now what’s happening is, we are getting big, big ones, the ADTs of the world are coming to us. The Siemens, the Johnson Controls, they are coming to us directly. So it’s a very, very good thing that they are. The products that we have outperform everything in the industry functionality, range and a lot of other feature sets that we talked about.

So the big companies, which have lots of installations want to use these type of products. So those come direct those large companies, and everybody else goes through distribution. Kevin is watching the vast number of dealers we have. We have more than 12,000 dealers that go to distributors and get the products. So everything seems to be checking well.

Raj Sharma: Got it. Thank you. I’ll do it on the questions. Thank you for answering them. I’ll check it on. Thank you.

Kevin Buchel: Thank you, Raj.

Richard Soloway: Thank you, Raj.

Operator: Our next question comes from the line of Christopher Hillary with Roubaix Capital. Please proceed with your question.

Christopher Hillary: Hi, good morning.

Richard Soloway: Hey Chris.

Christopher Hillary: I wanted to ask today, if you could share any other metrics on the re-occurring business. For example, could you share roughly how much is coming from the fire radios? Could you discuss at all annual pricing and how that might change? And then, lastly, could you share any color on products that you see aiding your re-occurring revenue growth in the medium term out two or three years?

Kevin Buchel: We don’t break out the radio sales, Chris, not yet anyway. I know, we’ve been asked about it. And we can start doing that. We just haven’t done it yet. What we have said is that fire radios is the largest piece of the various StarLink radios. And in around three or four years, it’s the newcomer of radios, but yet it’s taken over as the number 1 seller within the group. So we’ll look at that. Maybe eventually, we’re going to break it out. There’s no harm doing that. So, but we haven’t done it yet. As far as looking three years out, Dick, maybe you want to talk about the Air Access and the potential for that?

Richard Soloway: All right. So, our concept in our company is integrated solutions and we have an integrated engineering department to develop all these products in-house. We don’t go offshore. It’s all done in-house. We have our own factory. We don’t use subcontractors. We have our own factory in the Dominican Republic and we have been getting recurring revenue in two of our segments, which is the fire alarm and burglar alarm But we want an integrated recurring revenue solution for all of our segments, which means the locking and access and the introduction of Air Access gets us recurring revenue for every segment and it is a great thing for lock smiths and access control dealers, because they now can start getting recurring revenue like a fire and burglar alarm dealer can do.

And there is a very big if they sell any of these accounts, like, for instance, a fire burglar alarm dealer sells an account to an ADT or another company, there is a 35 to 40 time monthly multiple that the dealer can get by selling one account to one of the large alarm providers. So, we think that the locksmiths and the access control dealers who don’t get that recurring revenue stream from their products, because those products don’t really offer it, but Air Access does. And we think that from our focus groups and the initial training that we’ve done that we think that this is a billion dollar industry, Air Access with recurring revenue and locking and we’re excited about it. But it’s going to take another six months to a year before it becomes more mainstream, because it is a big change for locksmiths and access dealers that they really got recurring revenue.

All they got was a service contract to replace the lock or to come in lubricated it or to upgrade the software and access system on site. Now all of this is done by Air Access and they can now give additional services to their clients, which are very valuable to their end-user clients. So, we’re very excited about the future of Air Access.

Christopher Hillary: Great. Thanks for all that. And then anything on your re-occurring revenue pricing per year that you could share with us? How that tends to evolve or how you’re planning on managing that? Thank you.

Richard Soloway: Yeah, we have a price list. We have a price list for each of the different types of radios we manufacture, including our €“ we talk about it as radios, but NAPCO does more than radios. NAPCO also makes the control panels for new work. We make it both fire and burglary control panels and each of those control panels has a radio built into it. In the past, they all use copper, but as we know, copper is dead and the dealers are switching their new jobs over to radio and now we have radios built into our control panels, which is a very, very popular product line with us. We’re very busy building these control panels with radios inside. So, we do the rip and replace radios for all the lines that are going dead fire and burglary, where you keep the control panel and the system that you have, you want to rip it out, you put our radio there, and our radio is what we call the universal radio, different than anything else on the market because the one radio does any type of control panel, whenever it was made, whichever brand it is, it works on everybody.

It doesn’t just work in the NAPCO ecosystem. And then, we have our control panel with the radio built in. So, we have this menu. It’s a published menu, but we make the most on the fire radios, because the fire radios require more handshakes from the central station. In other words, more signals going back and forth. So there is more traffic and we charge more for those. But we are keeping our pricing the same and we think priced right and you can see where the margins are.

Christopher Hillary: Thank you.

Kevin Buchel: Thanks, Chris.

Operator: There are no further questions in the queue. I’d like to hand the call back to management for closing remarks.

Patrick McKillop: Thank you, everyone for participating in today’s conference call. As always, if 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 2023 results. Bye-bye. Have a wonderful day.

Operator: 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.