NSSC - How Napco Stock Rallied 70% From The November Lows

2023-12-12 09:00:56 ET

Summary

• Napco Security Technologies experienced a volatile year, with a 45% stock plunge due to accounting irregularities and overstatement of profits.
• The stock has since recovered over 70% from its low point, prompting a review of what happened and what could happen in the future.
• Napco regained the market's trust by implementing several measures to avoid another similar situation.
• Napco continues to present a good long-term Investment opportunity.

Napco Security Technologies (NSSC) has had a very volatile year. The stock plunged 45% in August after reporting accounting irregularities and overstating profits. I covered the fall , doubled down on my rating (upgraded from Buy to Strong Buy), and bought additional shares myself. The stock continued to fall further until a bottom of -52% from the high before recovering over 70%. Let's review what happened and what could happen going forward to Napco.

Why did Napco rally?

Napco did not do anything special like Adyen (ADYEY) did with its Investor Day, another stock I own that fell from grace a few months ago. Both stocks cratered 50% just to recover explosively again. I covered Adyen in this recent article .

Napco reported strong earnings and a new product launch, but the part that I believe restored the market's confidence was the commentary during the earnings call. Regaining the market's confidence was incredibly important, especially after the CEO and CFO sold a significant amount of their shares in February in a private placement (Seeking Alpha reported it as a secondary offering, but Napco did not offer new shares; it was existing shares sold by insiders). This gave the whole accounting situation a much worse look than it already was.

Q1 results

Napco delivered strong results on earnings, with Net income up 239% to $10.5 million, Adjusted EBITDA 174% to $12.9 million and FCF of $10.95 million compared to a cash outflow last year. Total revenues were only up 6%, which was driven by hardware sales weakness. Recurring revenue, the most important part of the business, grew by 25% to $17.3 million. Management also forecasted a weak hardware quarter due to the tough competition: Last year, distributors loaded up on radios due to the 3G Verizon (VZ) sunset, meaning that they needed a lot of 5G radios in their inventories. Meanwhile, Alarm Lock and locking products (62% of hardware sales) saw 24% growth Y/Y. This also contributed to the operating leverage in the quarter, as locking gross margins (mid-30s-40s %) are higher than radios(20%). These results beat analysts' EPS by 34% and revenue by 2%. Napco beat 7/8 of the last quarters for both EPS and revenues.

Prima SMB burglar/fire alarm

Napco launched a new product in the quarter with Prima, an all-in-one alarm solution aimed at small businesses with easy installation and substantial recurring revenue potential for the company.

Earnings call

The most important topic on the earnings call was last quarter's accounting issues, and management handled the situation very well.

Napco kicked the old accountant and hired Deloitte & Touche as the new one. Founder Richard Soloway stated the following regarding the choice:

At this stage, for Napco, it’s essential to choose a big four firm with industry-specific experience that aligns with our organization and who understands the unique challenges and regulations relevant to our sector.

Deloitte will also be the new consultant to improve procedures, internal controls and policies.

The company also improved its procedures regarding raw material prices at the end of the quarter to avoid another mistake like the previous one. A new software module will go live in Q3 to automate the process.

Napco is investing in an internal control audit on its staff and two industrial engineers to focus on the material and labor costs. Total costs for these measures are expected to be up to a million.

The market liked that management took the issue seriously and implemented several measures, adding additional costs to the business. This restored trust in a management team that is upfront with issues and does not try to sugar coat the problems.

Napco is still a buy

To value Napco, I'm doing an inverse DCF. Napco does not issue many shares and has few capital expenditures, so we don't have much adjustment here. NWC changes weren't high after the accounting adjustments, so FCF and Owner Earnings are similar. At its current price, the market expects five years of cash flow of 15% growth, followed by five years of 12% growth. This seems realistic and conservative. Napco has significant operating leverage ahead, as recurring revenue continues to gain share in the sales mix and hardware margins are also increasing due to the normalization of inventory values. Napco aims to achieve 50% product gross margins, almost double the current 28.2%. Adjusted EBITDA margins also have more room for expansion, with a 45% target compared to 28.4% currently. Napco has demonstrated durable sales growth and strong hardware growth in locking, while radios are going through channel destocking due to the 3G Verizon sunset. Napco is sitting on a pristine balance sheet of $75 million without bank debt.

I continue to see Napco as an attractive long-term investment, but I will downgrade the rating from Strong Buy to Buy to account for the 53% in total returns since my last article, as the bearish sentiment went away for the most part.

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