2023-08-21 14:41:36 ET
Summary
- Napco Security Technologies released its quarterly earnings and restated the prior three quarters, causing a large drop in stock price.
- I am a current owner and buyer of Napco, and I'm assessing whether the sell-off is justified.
- This article explores whether the stock drop presents a potential opportunity for investors.
On Friday evening, Napco Security Technologies (NSSC) released preliminary fourth quarter 2023 results and a restatement of the prior three quarters. This sent the stock down over 28% after hours. I've been an owner and buyer of Napco for a while, so let's see if this sell-off is warranted or if this creates an opportunity for investors.
What happened?
The press release updated investors about three things:
- Preliminary Q4 sales and net income performance.
- Restatement of the prior three quarters.
- Dividend increase.
Preliminary Results
Let's start with the stated numbers, keep in mind that these aren't final numbers: Net Sales grew to $44.7 million, up 3.4% ($43.2 million last year). This consists of $28.6 million in equipment sales (versus $30.5 million last year, down 7%) and $16.1 million in recurring services revenue (versus $12.7 million last year, up 26%). The fact that sales are projected to grow only by 3.4% probably spooked the market, as this is a big deceleration compared to the 20.3% CAGR over the last four years. Nonetheless, it is vital to see recurring revenues showing continued growth. At 26% it still is a fast growth rate. Equipment sales are much more reliant on the macro conditions of the market and can be postponed, while recurring revenues continue to flow in. If you want to dive deeper into Napco's business, look at my previous article detailing the general thesis surrounding my investment in Napco.
Napco also stated that Net Income is expected to be between $10-11 million, up between 33% and 46% (versus 7.5 million last year). Over the last few years the company showed continued operating leverage as the company scales its recurring revenue model. Furthermore, the cash position is expected to be at $67 million with no debt. This is up from $57 million last quarter, showcasing the cash generation of the business.
Restatement of the financials
The main reason why the stock tanked was the restatement of the first three quarters: The Audit Committee concluded that the previously issued unaudited financial statements for the last three quarters have to be restated. Cost of goods sold ((COGS)) was understated, inventories were overstated, which resulted in overstated gross profit, operating income and net income for the periods.
The adjustments for Net Income are expected to be as follows:
Period End | Net Income - Previously Reported | Net Income - Restated Estimate | $ Difference |
First quarter ended September 30, 2022 | $6.4M | $2.9M | $3.5M |
Second quarter ended December 31, 2022 | $8.4M | $3.7M | $4.7M |
Third quarter ended March 31, 2023 | $10.8M | $9.5M | $1.3M |
We can see that these are quite significant changes and that Net Income for the year was approximately $9.5 million higher than it should be. While this will negatively impact the company's valuation on a P/E or EV/EBITDA basis, we need to keep in mind that this is only an accounting issue: The cash flows aren't affected. Let's look at how this could happen.
Remember, we bought a lot of components at very high costs and we had to do that to keep the recurring revenue going. Now we have solutions to get away from that. We don't have to buy parts from brokers, but we have to work through that inventory. That inventory is still high. We cut our inventory level by $3.4 million this quarter, but we have a lot more work to do in further cutting of inventory.
And as we cut that inventory, we're going to work through those higher costed components, and that will lead to more normalized lower costs. Remember, we talked about some of those micros that are normally $5 or $6, being 10x the amount.
Richard Soloway, CEO Q3 2023 Earnings call .
In the quote below we can see that the company had to buy very overpriced chips to continue production amidst the chip shortage the last years. At the end of the day, continuing products was vital to increase the valuable recurring revenues. These high-cost parts are now mixed with cheaper parts in the inventory calculation. To calculate COGS you can draw from the inventory via FIFO (first in, first out) or LIFO (last in, first out). My guess would be that the company used the wrong method to calculate COGS and inventory dollars, leading to the overstatement of profits. This means that they used cheap parts to calculate, instead of the expensive parts. Going forward this should be a tailwind, as the expensive parts are already out of the inventory.
At the end of the day, to me personally, only the cash flows matter and the cash on the balance sheet. I do not see a problem that would challenge my investment thesis in Napco.
Dividend increase
The last topic of the press release was the increase of the dividend by 28% to 8 cents per share. Napco only just started paying a dividend this year and I expect them to aggressively grow their dividend over the next decade from here.
Valuation
To value Napco, I'm using an inverse DCF model. I use a 10% discount rate and a 3% perpetual growth rate; I also calculate Owner Earnings besides normal Free cash flows. I believe that Owner Earnings are a better representation of the cash flows to owners than normal free cash flow, which several factors can easily distort:
- Stock-based compensation is paid out in shares and replaces cash expenses, but it is a cost to shareholders.
- Often not all of the CapEx spend is going towards maintaining the business, but rather to grow it. These investments could be cut, returned to owners and thus added back to Owner Earnings.
- Changes in Net working capital can distort cash flows, so I adjust them out.
Owner Earnings = FCF - SBC + Growth Capex +/- NWC changes
For my model I used the numbers from the last earnings report and did not adjust it for the overstated net income: This shouldn't affect the cash flows. Changes in Inventory should be offset by lower net income. Using this framework we get to required owner earnings growth of 10% for the next five years, followed by 7% for five years.
If we consider Napco's historical growth and the continued margin expansion these growth rates should be easily exceeded. The long-term target sees adjusted EBITDA margins around 50%, while we are currently only around 25%. I'll use the opportunity this crash presented to increase my position in Napco.
For further details see:
Napco: Why Its Financials Restatement Could Be A Blessing For Long-Term Investors