NAPCO Security Technologies, Inc. — Q2 FY2020 Form 10-Q
Business and period: Napco manufactures security products and provides recurring wireless communication services. This unaudited filing covers the three and six months ended December 31, 2019; the comparable periods ended December 31, 2018. Fiscal year ends June 30. Amounts below are in millions unless stated otherwise.
Financial performance and liquidity
| Metric | Quarter ended Dec. 31, 2019 | Prior-year quarter | Six months ended Dec. 31, 2019 | Prior-year six months |
|---|---|---|---|---|
| Net sales | $25.829 | $24.829 | $52.114 | $48.205 |
| Gross profit / margin | $12.127 / 47.0% | $10.671 / 43.0% | $23.645 / 45.4% | $20.230 / 42.0% |
| Operating income / margin | $3.994 / 15.5% | $3.294 / 13.3% | $7.603 / 14.6% | $5.053 / 10.5% |
| Net income | $3.572 | $2.869 | $6.805 | $4.373 |
| Diluted EPS | $0.19 | $0.15 | $0.37 | $0.23 |
| Operating cash flow | Not presented for quarter | Not presented for quarter | $4.813 | $6.346 |
Quarterly revenue rose 4.0%, operating income 21.3%, and net income 24.5%. For the six-month period, revenue rose 8.1%, operating income 50.5%, and net income 55.6%. Service revenue increased to $5.784 million for the quarter (+39.6%) and $11.148 million for six months (+40.5%). Door-locking revenue declined; equipment revenue was slightly lower for the quarter but higher for the six-month period. Management attributed gross-margin improvement primarily to the growth in service revenue.
SG&A rose 12.4% for the quarter, faster than revenue, and was 24.4% of sales versus 22.6%. For six months, SG&A rose 6.9% and declined modestly as a share of sales to 23.9% from 24.2%. The company cited higher media advertising, additional sales staff and salaries, and increased stock-option expense. The six-month effective tax rate was 11%, versus 13% a year earlier.
Cash and cash equivalents were $11.778 million at December 31, 2019, up from $8.028 million at June 30, 2019. Current assets were $71.278 million and current liabilities $15.080 million, a current ratio of approximately 4.7. There were no borrowings under the $11 million revolving credit facility, which expires in June 2021. The company reported $4.813 million of operating cash flow and $1.063 million of capital spending for the six months. Operating cash flow was below the prior-year $6.346 million, in part reflecting a $7.068 million inventory build. Management said working capital, operating cash flows and the credit facility should fund operations for at least the next 12 months.
Total assets were $101.360 million and total liabilities $23.058 million. The balance sheet includes $7.406 million of operating lease right-of-use assets and $7.123 million of operating lease liabilities; adoption of lease accounting guidance on July 1, 2019 resulted in approximately $7.7 million of initial lease assets and liabilities. The company had no outstanding debt borrowings, although its credit facility is secured by company assets and includes financial covenants.
Management commentary, outlook and risks
- Revenue gains were driven mainly by recurring communication services and intrusion/access products; door-locking products partially offset growth. Service revenue growth supported higher gross margins.
- Napco notes seasonal demand: sales historically peak in its fiscal fourth quarter (April–June) and are lower in its first quarter. Demand is also affected by housing and construction markets. No specific earnings or revenue guidance is provided.
- Inventory increased from $34.838 million to $41.906 million, including a build of devices associated with recurring communication services and inventory held as production is level-loaded through the year. $7.166 million was classified as non-current.
- The IRS proposed an approximately $1.8 million tax adjustment, excluding interest and penalties, regarding the company’s fiscal 2016 tax return and IRC Section 956. Napco filed a protest, believes its tax position is correct, and recorded no additional reserve; the outcome is uncertain. In January 2020, the IRS also notified the company of an examination of its fiscal 2017 return. Management believes the provision for that period is adequate.
- Other disclosed exposures include customer concentration (one customer represented 21% of receivables at December 31, 2019), foreign-customer collection and order risk, dependence on the CEO, economic and housing-market conditions, and Dominican peso exposure. Management estimates a 10% U.S. dollar move against the Dominican peso would change annual operating income by approximately $0.7 million.
- Sales returns, rebates and allowances were 9% of gross sales for the quarter and 11% for six months, versus 5% and 7%, respectively, in the comparable periods. The filing attributes this measure to variable consideration estimates; changes to those estimates in subsequent periods were described as not material.
- Management reported effective disclosure controls and no material change in internal control over financial reporting. It said there was no material change in previously disclosed risk factors.
Investor verification priorities
- Confirm whether recurring service revenue growth and the associated margin gains continue, and monitor door-locking sales.
- Track inventory growth, conversion to sales, and operating cash flow, which declined year over year despite higher earnings.
- Follow the IRS fiscal 2016 protest and fiscal 2017 examination, including any change in the approximately $1.8 million proposed exposure or related reserves.
- Review customer concentration, returns and allowance levels, and the impact of seasonal demand and housing/construction conditions.
- Verify lease obligations, credit-facility availability and covenant compliance, and the sensitivity of operating results to Dominican peso movements.