NAPCO SECURITY TECH INC NSSC
November 29, 2011 - 11:27pm EST by
Lukai
2011 2012
Price: 2.20 EPS $0.27 $0.51
Shares Out. (in M): 19 P/E 8.0x 4.3x
Market Cap (in $M): 42 P/FCF 6.5x 3.9x
Net Debt (in $M): 20 EBIT 8 13
TEV ($): 62 TEV/EBIT 8.1x 4.9x

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Description

Napco has $1 per share earnings power, a $2 stock price, asset value buried in the footnotes, profitability at depressed revenue levels, three avenues for growth, ferocious operating leverage, and an enterprise value near five-year lows. We believe it's absurdly cheap. Assigning a 15x multiple to our FY+2 EPS projection results in an $11.60 per share equity value. Discounted back to today at 20% per annum results in a $7.36 target representing a reasonable 14.5x our FY+1 EPS estimate. Both of these numbers are well below management's $1 multi-year EPS target. 
 
SUMMARY
Napco is a commercial and residential security products company that's been public for more than 40 years. NSSC's security products are sticky and entry-barriers are high. The Company's new technologies have won high-profile industry awards and we expect associated products to drive significant revenue and margin expansion. We further expect that Napco's emergent recurring business segment will dramatically enhance NSSC's profitability profile. In the last three fiscal years, Management has overseen more than $16m of deleveraging (42% of current market cap), rationalized the business to be breakeven at trough revenue levels, and taken operations back to profitability. Despite these improvements the market assigns NSSC an enterprise value near its lowest level in five years.
 
A 14.5x multiple on our FY+1 (June '13) $0.51 estimate represents a 270% return before adjusting for $8m+ (21% of market cap) of after tax owned real estate value absent from the balance sheet. Over the past 10 years, NSSC's PE multiple has averaged 29.9x (lower than its median) when it was a smaller business with limited growth. Additionally, with a more efficient cost structure, overhead absorption from Marks, and new product categories, management believes they can drive $1 per share in earnings over the next roughly three years before assuming significant contribution from the recurring segment. While small, we expect NSSC will be a memorable homerun.
 
THE COMPANY
Based in Amityville New York, Napco is a pure play manufacturer of security products including locking devices (50%), intrusion/fire alarms (35%), and access control systems (15%). NSSC's products are used for commercial, residential, institutional, industrial and governmental applications. The Company sells principally through a network of more than 15k independent distributors, dealers and installers. Commercial represents roughly 80% of Napco's overall sales (70% pre-recession and pre-Marks). Roughly 20 customers contribute more than $1m of revenue per annum but the largest is around 7%. Napco has just over 1k employees and manufactures principally at its 100% owned 250k square foot facility located in the Dominican Republic.
 
Door locking technologies include Marks USA (2008 acquisition - products in the White House, US Senate, Pentagon, etc.) and Alarm Lock. Marks does primarily new installs while Alarm Lock sells aftermarket products. Intrusion and fire alarms refer to Napco branded alarm products. Access control refers to NSSC's Continental Access subsidiary. With these three pieces of the security puzzle, dealers can get an end-to-end solution for all security needs. Additionally, Napco's systems work together and dealers have only one call to make for support.
 
Napco's primary competitors are typically larger than Napco but are relatively small divisions of large conglomerates. No one competitor has an end-to-end solution similar to Napco. Honeywell, like United Technologies and GE's Interlogix, makes alarms and access control but doesn't have meaningful presence in locks. Stanley makes locks but no alarms or access. Ingersoll makes locks but none of the others.
 
Security products are sticky. Product lifecycles can be 10 years or more. Products that are large sellers continue to be sold and older parts and technologies that are difficult to get are held in inventory. Once a dealer is familiar with a product they don't want it discontinued and will stack new technologies on top of existing platforms. As such, new technologies typically don't cannibalize rather, they create a layering effect. For example, though Tyco owns ADT Home Security (2010 acquisition of Broadview from Brinks) and DSC Alarm Systems (10+ year old acquisition), ADT installs are likely to be done using a Honeywell-owned Ademco system due to dealer preference.
 
NSSC spends significantly on R&D. In the last two years Napco has spent more than $9m developing new security products in an effort to roll out new technologies that are less dependent on the economy and new construction. 
 
INVESTMENT STORY
Near its lowest enterprise value in years, we believe NSSC is dramatically undervalued at a time when its earnings growth potential is higher than it's been in the company's 40+ year history. 
 
Breakeven at the Trough, Profitable at Depressed Revenue Levels
Management has driven efficiencies to bring the operation to breakeven at $17m per quarter or $68m per annum. As sales post Marks acquisition hit an annual low of $67.8m, we view NSSC as breakeven at trough revenue levels. From there, management has taken NSSC to profitability for the first year in three while revenue remains at extremely depressed levels.
 
Ferocious Operating Leverage
Napco's Dominican manufacturing facility can do $100m per shift with three possible shifts. The implication is that they're currently operating at a little over 70% of one shift's capacity (24% of max capacity) and are profitable at that level. In August 2008, NSSC acquired Marks USA, a maker of door-locking devices, for $25m or 1x sales and 8x EBITDA. With Marks in the picture, The Company's pre-recession revenue foundation is $93m ($68m Napco + $25m Marks). Napco subsequently brought Marks' manufacturing in-house, closed and cancelled Marks' leases and drove significant additional acquisition synergies. Therefore, simply building back toward mid-decade numbers can drive EPS expansion well beyond what Napco achieved at the height of the global economy. Upon pressing management we believe NSSC can do mid-30s gross margins above $80m in sales and CFO Kevin Buchel believes they'd do 42-43% gross margin at their ~three-year target of $100m of sales with only $2-3m additional G&A. At that point they'd do nearly $1 of EPS. 
 
  Mgmt Target
Sales 100.0
COGS 57.0
GP 43.0
Margin % 43%
   
SG&A 20.0
EBIT 23.0
Margin % 23%
   
Interest 0.0
EBT 23.0
   
Tax 4.6
Rate % 20%
Net Income 18.4
   
EPS 0.96
Shares 19.1
 
At this point we take a step back to contemplate whether Napco has this much operating leverage inherent in the business. We look back at F4Q06 during which time NSSC did $23.9m in sales. At that level, The Company achieved a 20.3% operating margin. After rationalizing their operation and load-leveling COGS over four quarters of $25m average revenue, we think this is well within reach. Accordingly, investors have yet to see what Napco can do given the timing of the Marks acquisition.
 
How will they get to the $80-$100m revenue mark and close in on $1 EPS? We see multiple layers contributing to Napco's growth and margin expansion.
 
New Product Growth
In April of 2011, Napco introduced its Gemini C-Series Commercial Combination product and won the 2011 Security Industry Association award for Best Fire / Life Safety product. The GEMC-C is a combination burglary/fire alarm system and is technologically innovative, combining two code compliant system installations into a single design. This largely represents NSSC's entry into the commercial fire business yet they're selling to the same dealers that were previously going elsewhere for fire products. GEMC-C alone provides a new market opportunity of over $1bn and management thinks they can achieve $20m per annum with the product. This, by itself, would propel NSSC above $90m in revenue before any core business improvement.
 
GEMC-C took three years to develop and a full year in UL labs due to the strict fire compliance requirements. Honeywell currently owns the market with their Vista panel but it's been viewed as more of an afterthought to burglary than a technologically advanced solution. Our channel checks indicate that despite the heightened requirements of the 9th UL code revision, Honeywell introduced a new version which is a similarly "adequate" product without many of the features and cost savings built into Napco's more flexible system. In the six short months since its introduction, more than 1k GEMC-C installations have taken place in commercial buildings. Checks indicate that it's been difficult to keep inventory on the shelves. We view this product as a meaningful revenue driver over the next 18 months.
 
Recurring Revenue Business Model
The recurring business model is highly profitable and poised for growth. NSSC introduced one of the first live, streaming, remote video services. If for example, an ADT customer wants video capabilities in their home, it's a Napco product and NSSC receives $2-3m per month recurring revenue. We believe Napco is already doing $1-1.5m of iSeeVideo revenue at 100% gross margin and this product continues to grow.
 
The larger recurring opportunity however, is Napco's recent introduction of StarLink GSM. This product is half the price of, twice as powerful as, and significantly more useful than, traditional wireless products and they're already receiving sizable orders. In fact, management has visibility into 2,700 shipments this quarter and 4,000 units next. We see significant value inherent in the StarLink product especially as more than a quarter of homes have dropped their wirelines and 1/3 of new homes are wireless only. 
 
StarLink monitoring provides dealers with $25-30/month and NSSC receives $4.95 of that. NSSC's cost is $0.75-1.00 to AT&T or T-Mobile and so incremental monthly EBITDA is $4.08 and annual is $48.90 per household at the midpoint. NSSC believes it will sell nearly 7k units in the next two quarters. Let's assume that they sell 10k units by the end of FY12 (June) and each of those units subscribe.
 
With just 10k units shipping this fiscal year, we think NSSC can generate a recurring $500k in EBITDA once customers ultimately connect. As monitoring companies command 12x+ EBITDA, this new revenue stream would be worth nearly $6.0m (16% of market cap) to equity with just one year of shipments.
 
StarLink Monthly Per Annum
Revenue 4.95 59.40
Cost 0.88 10.50
EBITDA 4.08 48.90
Units 10,000 10,000
Total EBITDA 40,750 489,000
Value @ 12x 489,000 5,868,000
 
Such a small portion of revenue obviously does not warrant a sum-of-the-parts analysis yet, but management has indicated that they both expect to report recurring revenue once it hits 10%, and that they expect to report this in the near/mid-term.
 
We take a step back to contemplate the StarLink model as it effectively stands in-between a dealer and its customer. If a customer calls an independent dealer and says that they've cut their landline in favor of individual cell phones, the dealer has few other choices than to install a Napco StarLink radio and pay Napco. Once installed however, dealers can add ancillary services such as a text when their child gets home. Additionally, they can upload and manage a Napco security system remotely saving time and cost.
 
Ultimately, while we remain conservative in our expectations, the recurring revenue from this and other products represents a highly profitable growth opportunity. 
 
Core Business Strength
Top-line can close in on $90m with mid-single digits revenue growth over the next few years as the core business begins to trend back toward some semblance of normal (still keeping core revenue below where it was several years ago and conservatively implying a negative multi-year CAGR). Aside from continuing on the current positive growth trajectory we think a catalyst to get the ball rolling faster is NSSC's introduction of "Fusion" six weeks ago. Fusion integrates security, video, access and locking technologies into one scalable, interoperable software platform. The Company's inter-segment cross selling efforts were previously limited to putting in a good word and following up on sales opportunities. Under Fusion, Napco's sales associates are trained and eligible for commissions on all products regardless of their designated channel or division. 
 
CAPITALIZATION
With 19.1m shares outstanding, Napco has a $38.2m market value and hasn't had a dilutive offering in the company's 40+ year history. Current net debt of $19.9m ($3.9m cash, $8.6m drawn on revolver, $14.3m amortizing term loan) results in a $58.1m enterprise value. The term loan is being repaid in 19 quarterly installments of $893k each which commenced in December 2008 and a final payment of $8.0m is due in August 2013. The revolver expires in August 2012. Napco is currently paying LIBOR+450bps and Kevin Buchel (CFO) believes they can refinance this debt at significantly lower interest rates in the near-term.
 
The world fell apart shortly after Napco took on $25m of debt to acquire Marks and The Company fell short of covenants soon thereafter. The outstanding debt therefore is pursuant to an amended credit agreement. Typically this isn't good but two positives came out of the negotiations: 1) Napco went from paying 7.5% interest to 4.75%; 2) in order to amend, the lenders required Napco to have its land and building reappraised. The current appraisal values NSSC's land and buildings north of $8m after tax (21% of market value) though the balance sheet reflects a negligible value for the assets.
 
With a current enterprise value of $58.1m, Napco is trading near 5-year lows. We studied average closing prices on a quarterly basis for the past 20 quarters and found that excluding March 2009 when the S&P hit its low, Napco is within roughly 10% of its lowest average enterprise value despite growing sales, paying down debt, returning to profitability, and introducing award winning products with significant growth potential.
 
VALUATION
Our base-case scenario contemplates 9.7% FY0 growth and 9.9% growth in FY1. At that point, we believe NSSC will do $0.51 EPS (detail below). At a 10x multiple, NSSC would be worth $5.10 vs. today's $2.00 price tag. We believe however, that growth to $0.44 EPS would deserve a multiple closer to 15x or $7.62. Our FY2 $0.77 estimate is well below management's $1 multi-year target and still represents a 137% 3-year CAGR. We believe that growth of this nature would bestow upon NSSC a higher multiple than 10x. At 15x our FY2 EPS estimate, the shares are worth $11.60. Discounted to today at an aggressive 20% annually results in a $7.36 target price ($11.60/1.2^2.5). This also represents what we believe is a fair 14.5x our FY1 estimate. Therefore, we believe shares are worth roughly $7 over the next 12-18 months as continued growth and margin expansion drive exponential earnings growth. 
 
Our model assumes that no single revenue driver knocks the ball out of the park; rather, all three avenues of growth contribute below our estimate of their full potential. The business is seasonal with the first quarter being the weakest and subsequent quarters building on a sequential basis. We use a tax rate of 20% as 3-4 years ago Napco undertook a detailed transfer pricing study which allowed them to lower the tax rate by attributing a portion of earnings to the Dominican Republic. Given the permanently lower tax rate, EPS will be substantially higher at comparable margins than in the past.
 
Year 0 1 2
Fiscal Year 2012 2013 2014
Core revenue 74.2 77.9 81.8
Combo Burg/Fire revenue 1.0 3.0 5.0
Recurring revenue 3.1 5.2 7.5
Total revenue 78.3  86.0 94.3 
Product & Combo contribution % 96.0% 94.0% 92.0%
Recurring contribution % 4.0% 6.0% 8.0%
       
Product growth % 6.0% 5.0% 5.0%
Combo growth % nm 200.0% 66.7%
Recurring growth % 119.3% 64.8% 46.2%
Total growth %
9.7% 9.9% 9.6%
       
Product & Combo GP 22.5 26.5 31.1
Recurring GP 3.0 4.6 6.8
Total GP 25.5 31.1 37.9
       
Product & Combo margin % 30.0% 34.0% 38.0%
Recurring margin % 95.0% 90.0% 90.0%
Total margin % 32.6% 36.2% 40.1%
       
SG&A 17.9 18.5 19.0
EBIT 7.6 12.6 18.9
Margin % 9.7% 14.7% 20.0%
       
Interest 1.1 0.5 0.4
EBT 6.6 12.1 18.5
       
Income tax 1.3 2.4 3.7
Tax rate % 20% 20% 20%
Net income 5.2 9.7 14.8
       
EPS 0.27 0.51 0.77
Shares 19.1 19.1 19.1
       
P/E @ $2 7.3 3.9 2.6
       
Value @ 10x 2.75 5.08 7.74
Value @ 15x 4.12 7.62 11.60
 
CONCERNS
  • Napco's stock has limited liquidity due to high management ownership, smaller capitalization and $2 stock price. Looking back to 2007/8 when the stock was in the $5-6 range NSSC traded well over $500k per day. We think that similar or better liquidity would accompany a price rise to those levels
  • Management brought the business to breakeven at the lowest level of annual sales post-Marks. If another downturn is more severe, NSSC could show a loss.
  • Although management stands by their long-term earnings target, achieving $1 EPS represents nearly twice the operating margin the company has historically achieved. Though operating leverage is significant as sales ramp and Q406 is evidence that NSSC can achieve these levels near $25m in quarterly revenue, we keep this in mind.
  • NSSC has a 99-year operating lease in the DR on which they pay $24k per month. Multiplying $24k by the 80 remaining years results in an off-balance sheet liability of roughly $23m. While in a wind-down NSSC would be able to cancel this lease, we figured to note it.
  • NSSC has one customer, Slomin's, with a significant amount of receivables outstanding. Slomin's is a regional home security and fire protection provider operating in the northeast and along the eastern seaboard. While less than a 5% revenue customer, Slomin's has agreed to use NSSC's products exclusively and hence the better payment terms.
  • Insiders own 40% of the shares outstanding and so have the practical ability to determine the outcome of shareholder votes.
  • Though there is exchange rate risk, the Dominican peso has trended in a straight southwest direction since mid-'07 against the dollar.
  • Tax jurisdictions - if they were to lose favorable tax treatment in the DR, or if the geography of pre-tax income earned shifted toward the US, earnings could be impacted.
 
Note: We wrote the report when the stock was at $2 and it's drifted to $2.20 on light volume. We elected to keep the $2 in the report to save on labor. As our expected upside is in the 200% range, we didn't figure the first 10% would be of significant consequence to the write-up. 
 

Catalyst

  • Continued core business growth
  • Ramp up of GEMC Combo revenue
  • Contribution from StarLink and achievement/announcement of 10% recurring revenue
  • Realization of operating leverage and significant margin expansion
  • Continued de-leveraging and refinancing of debt to lower interest payment
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