The Bull Case For Napco Security Technologies Inc.

With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in Napco Security Technologies NSSC. Firms such as T. Rowe Price, Fidelity, and Wellington Management Group have all added to their NSSC positions recently. Most notably, T. Rowe Price increased shares held by 14.83% (as filed on 9/30), bringing their total NSSC holdings to 1,912,126 shares worth around $54.5 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on Napco Security Technologies Inc. 

Earlier this month, Napco Security Technologies reported record revenues, net income, and adjusted EBITDA for the first quarter of FY24. During the quarter, the recurring revenue annual run rate increased to $72.5 million dollars based on October 2023 recurring revenues, compared to an annual run rate of $67 million dollars based on July 2023 recurring revenues, showcasing strong demand growth for the business’ product line. Management stated that the business’ Alarm Lock and Marks locking hardware lines continued to see growth in school and classroom security, healthcare, retail-loss prevention, and residential applications. In addition to this growth, Napco Security Technologies announced a new product offering, Prima by NAPCO, a new all-in-one panel for security, fire, video, and connected home. Management anticipates that Prima will address an important mass segment of the security market, including residential and small business systems. This new product offering allows for the addition of more recurring-revenue generating accounts, as each installed system offers subscription offerings for built-in WiFi / cellular radio communications, customer alert notifications, and smart home subscription offerings. With strong financial performance over the quarter, strong demand tailwinds, and a new product offering to generate additional recurring revenue and penetrate a mess segment of the larger security industry, we believe that Napco Security Technologies is a stellar business trading at a fair valuation.

Napco Security Technologies NSSC is one of the leading manufacturers and designers of high-tech electronic security devices and cellular communication services for intrusion and fire alarm systems since 1969. Additionally, the business is a leading provider of school safety solutions. Napco offers a diversified array of security products, encompassing door-locking products, intrusion and fire alarm systems, video surveillance products, and access control systems. The business has experienced significant growth in recent years (net sales of $170 million, $143.6 million, and $114 million in fiscal years 2023, 2022, and 2021, respectively), driven by fast growing recurring service revenues from wireless communication services for intrusion and fire alarm systems, along with growth in demand for their school security products to meet the increasing needs to enhance school security.

As briefly mentioned above, growth drivers for the business include school security and public safety, and especially the growth of their recurring revenue business. In 2012, Napco began to generate recurring revenues by developing their cellular radio technology. In the 11 years since, the business has continued to introduce additional products to generate recurring revenue, primarily in cellular communication devices such as StarLink, iBridge, and most recently, the iSecure product lines. The monthly recurring revenue (MRR) of these products allows Napco to generate a more predictable and consistent stream of income, while mitigating the risks of fluctuation in market demand for their products. These services also generate much higher gross margins, increasing the business’ overall profitability.

The security products industry is highly competitive, and Napco primarily competes with 12 other companies that manufacture and market security equipment to distributors, dealers, original equipment manufacturers, and central stations. However, none of these competitors manufacture all of the key building security products (intrusion alarms and access control, connectivity, and locking devices). As more security installations include multiple security-related systems, there is more demand for these various systems to communicate with each other. By manufacturing everything under one roof, Napco offers customers one integrated platform solution without the risk of incompatible equipment from multiple vendors to communicate with each other. With all products being manufactured and seamlessly integrated under one roof, switching costs are high for consumers. This gives Napco a strong switching costs moat, as consumers are highly unlikely to switch to another provider if Napco is able to seamlessly integrate all of their products together. If a consumer has all of their security products integrated together through Napco, the likelihood of them switching to a competitor is slim, especially considering the high costs of such a switch.

Management is solid, and their capital allocation priorities are shareholder friendly, helping to align shareholder and management interests. In 2014, Napco’s Board of Directors authorized the repurchase of up to 2 million of the 38.8 million shares of outstanding common stock at the time. Since then, however, repurchases have rarely been made, with no repurchases occurring in fiscal years 2021, 2022, and 2023. While this is disappointing, the business currently operates at a healthy ROIC to WACC ratio, meaning that the business can reinvest cash back into the business at favorable rates of return, helping to further scale and grow the business. With the stock price currently trading at a 14.4% implied growth rate in FCF over the next 10 years (which is arguably a little expensive at the moment), it would make more sense for the business to reinvest cash flows back into the business rather than repurchasing stock. While management hasn’t repurchased many shares over the last few years, they do usually offer a quarterly cash dividend, with the most recent cash dividend being $0.08 per share in Q1 of FY23. While capital allocation (at least at the moment) may not seem too shareholder friendly, we argue that management is acting in the business’ best interest by reinvesting cash back into the business.

In terms of management incentives, Napco’s NEOs are incentivized well, with a compensation structure that allows management to build equity in the business, further aligning shareholder and management interests. The compensation structure includes a base salary, annual cash incentives, and long-term incentive rewards paid out in the form of stock options. The annual cash incentive incentivizes management to meet predetermined financial metric goals, allowing the business to meet its financial and growth goals, much to the benefit of shareholders. Additionally, the long-term incentive rewards (paid out via stock options) retain executive talent over the long-term, while also allowing management to build equity in the business. This further incentives management to improve the business’ operating results, further benefiting shareholders and aligning shareholder and management interests.

Napco Security Technologies Inc. is an efficient business. The business currently operates at a LTM ROE of 26% and a LTM ROIC of 24.6%. With a WACC of 10%, Napco Security Technologies operates at a ROIC to WACC ratio of 2.46x, showcasing the business’ ability to generate returns on cash reinvested back into the business at rates of return far higher than the business’ weighted average cost of capital. Businesses that are able to efficiently reinvest cash back into the business at favorable rates of return are considered to be compounders, businesses that are able to rapidly compound intrinsic value over the long-term, handsomely rewarding shareholders. Looking further at efficiency metrics, we can see that ROIC has handsomely expanded within the last few years, possibly showing that Napco Security Technologies has a strengthening competitive advantage or moat within the security technology industry. In 2014, the business operated at a ROIC of 7.8%, compared to today where it operates at a LTM ROIC of 24.6%.

Analyzing Napco Security Technologies’ income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last decade. Since 2014, Napco Security Technologies has grown revenue at a CAGR of 8.6%, with gross profit growing at a CAGR of 11.9% in that same time frame. This growth in gross profit within the last decade can largely be attributed to expanding gross margins. In 2014, the business operated at a gross margin of 31.9% of revenue, compared to today where the business operates at a gross margin of 46.8%. In terms of earnings, Napco Security Technologies has grown EBITDA at a CAGR of 18% and EPS at a CAGR of 23.5% since 2014. This growth in EPS can largely be attributed to share repurchases, with Napco Security Technologies’ management lightly repurchasing shares within the last few years.

Looking at the business’ balance sheet, we can see that Napco Security Technologies operates in stable financial health. The business currently holds around $74.6 million dollars in cash and equivalents and short term investments, paired with no long-term debt and relatively no debt in general. With a net debt of nearly -$69 million dollars, Napco has plenty of cash on hand with relatively no debt, which can be used to repurchase more shares, reinvest back into the business, and / or offer / increase a dividend, all of which increase shareholder value. With no debt on the balance sheet and healthy cash flows, Napco is in a great position to take advantage of its high ROIC and compound its earnings and intrinsic value over the long-term.

Analyzing Napco’s cash flow statement, we can see some stellar sustained growth in net income and free cash flow within the last decade, showcasing the business’ improved operational efficiency and ability to generate cash from revenue. Since 2014, Napco has grown net income at a CAGR of 22.8%, with free cash flow growing at a CAGR of 18.5% in that same time frame. The growth in free cash flow can largely be attributed to expanding free cash flow margins. In 2014, Napco operated with a free cash flow margin of 5.4% of revenue, compared to today where the business operates at a LTM free cash flow margin of 20.3% of revenue. With the business able to efficiently generate more and more cash from revenue (which is also growing at a healthy rate), Napco is a great contender for a long-term compounding business.

After conducting a reverse discounted cash flow analysis, we found that Napco Security Technologies is trading at share prices that imply a 14.4% growth rate (CAGR) in free cash flow over the next ten years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 10%. Napco Security Technologies is a quality business, and we believe that this is a fair valuation for the business, if not just a little overpriced. While past performance is certainly not indicative of future results, Napco has been able to grow free cash flow at a healthy rate (18.5% CAGR) within the last decade, paired with incredible free cash flow margin expansion during that same time frame. If the business is able to continue to grow revenue at a healthy pace and expand free cash flow margins further, it is very possible that this business will be able to grow free cash flow at a 15%+ growth rate over the next decade, making this valuation a little expensive but quite fair in the grand scheme of things. Of course, this valuation and opinion is based solely on our proprietary models, and we encourage all investors to do their own diligence when it comes to valuation.

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