NAPCO Security Technologies, Inc. — Form 10-Q Summary
Reporting period: Three months ended September 30, 2022, the company’s fiscal first quarter. Comparisons are with the three months ended September 30, 2021. Amounts below are in millions of dollars unless noted.
Business context
NAPCO designs and manufactures security products, including intrusion and fire alarms, access-control and door-locking products, video surveillance, and school-safety solutions. It also provides recurring wireless communication services for alarm systems. Sales are primarily through independent distributors, dealers, and installers. Hardware sales are typically seasonal, with the fiscal first quarter historically softer than the fourth quarter.
Financial performance
| Metric | Q1 FY2023 | Q1 FY2022 | Change |
|---|---|---|---|
| Net sales | $39.5 | $31.1 | +27.2% |
| Equipment revenue | $25.7 | $20.8 | +23.3% |
| Service revenue | $13.8 | $10.2 | +35.0% |
| Gross profit / gross margin | $18.2 / 46.0% | $13.5 / 43.3% | Margin +2.7 percentage points |
| Operating income | $7.2 | $4.2 | +73.5% |
| Net income | $6.4 | $7.8 | -17.4% |
| Diluted EPS | $0.17 | $0.21 | Down from prior year |
| Operating cash flow | $(2.0) | $3.5 | Decrease of $5.4 |
Service gross margin was 88.0%, versus 86.1%; equipment gross margin was 23.4%, versus 22.4%. R&D expense increased 25.7% to $2.4 million, while SG&A rose 15.6% to $8.5 million; SG&A declined as a share of sales to 21.5% from 23.7%. The effective tax rate was 10.4%, compared with 4.3%.
Liquidity, debt, and balance sheet
- Cash and cash equivalents were $29.4 million at September 30, down from $41.7 million at June 30, 2022. The company also held $10.0 million of other investments, primarily certificates of deposit, and $4.9 million of marketable securities.
- Operating cash use of $2.0 million reflected a $14.1 million inventory build, partly offset by a $7.9 million reduction in accounts receivable. Investing cash use was $10.4 million, mainly purchases of investments; capital expenditures were $0.4 million.
- Inventory rose to $63.8 million from $49.8 million, including $11.8 million classified as non-current. Management cited higher component and freight costs, supply constraints, and purchases of hard-to-source parts and radio-product inventory.
- No borrowings were outstanding under the $11.0 million revolving credit facility, which expires in June 2024. Total liabilities were $30.9 million and stockholders’ equity was $120.7 million.
- Management stated that working capital, operating cash flows, and the revolving facility should be sufficient to fund operations for the next 12 months.
Changes, outlook, and risks
- Sales increased by $8.4 million, driven by $3.6 million of additional recurring service revenue, higher NAPCO intrusion-product sales, and increased door-locking and access-control sales. Management attributed equipment growth partly to demand recovery following pandemic-related disruption.
- Net income declined despite stronger operating results because the prior-year quarter included a non-taxable $3.9 million gain from forgiveness of Paycheck Protection Program loans. Excluding that gain, prior-year net income and diluted EPS would have been approximately $3.8 million and $0.10, respectively.
- Management provided no specific revenue or earnings guidance. It cautioned that economic deterioration could delay or reduce customer purchases and impair collections; component shortages and supply interruptions remain relevant. Foreign-currency sensitivity is primarily related to Dominican-peso expenses: a 10% change in the U.S. dollar against the Dominican peso was estimated to change annual operating income by about $0.9 million.
- Internal controls over financial reporting were reported as ineffective due to two previously identified material weaknesses: IT general controls and review controls over excess and slow-moving inventory reserves. Management was implementing remediation and expected to complete actions during fiscal 2023; no material misstatement was identified.
- The company reported ordinary-course litigation that management did not expect, in aggregate, to materially affect results. The IRS is examining the fiscal 2020 income tax return; management believes the related provision is adequate, but the outcome is uncertain. The SBA may audit PPP forgiveness applications.
- The Dominican Republic lease was modified in September 2022, reducing the recorded lease asset and liability by $1.3 million. A proposed employee stock-option plan covering up to 950,000 shares remained subject to shareholder approval in December 2022.
Important facts for investors to verify
- Whether recurring service growth and the reported improvement in gross margins continue, and how much growth depends on product mix and pricing.
- Whether inventory levels convert to sales as planned, and whether supply constraints, higher costs, or reserve estimates create future cash-flow or margin pressure.
- Progress in remediating the IT-control and inventory-reserve weaknesses, and whether controls are subsequently deemed effective.
- Cash generation after the quarter’s inventory build and investment purchases; reported operating cash flow was negative despite higher operating income.
- Potential outcomes of the IRS examination, any SBA review of PPP forgiveness, and other disclosed contingencies.