NAPCO Security Technologies may be a smaller company with a market capitalization just over one billion dollars, meaning it often flies under the radar on many investment sites. However, that doesn’t mean it lacks potential as an investment. NAPCO is increasing its recurring revenue, which is expected to boost margins and drive greater profitability. The question is whether this small-cap company should be added to the portfolio—a question I'll explore in this analysis
This is not a financial advice. I am not a financial advisor and I only do these posts in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
For full disclosure, I should start by mentioning that at the time of writing this analysis, I do not own any shares of NAPCO Security Technologies. If you would like to view the stocks in my portfolio or copy my portfolio, you can do so on eToro. Instructions on how to do so can be found here. I don't own any stocks in NAPCO Security Technologies' competitors either. Thus, I have no personal stake in NAPCO Security Technologies. If you want to purchase shares or fractional shares of NAPCO Security Technologies, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started on investing with as little as $50.
The Business
Founded in 1969 in New York, NAPCO Security Technologies is a prominent manufacturer and designer of advanced electronic security devices, cellular communication services for intrusion and fire alarm systems, and school safety solutions. NAPCO offers a wide array of security products, including access control systems, door-locking products, intrusion and fire alarm systems, and video surveillance solutions. These products serve commercial, residential, institutional, industrial, and governmental applications worldwide, primarily sold through independent distributors, dealers, and security equipment installers. Recognized brands under NAPCO include NAPCO Security Systems, Alarm Lock, Continental Access, and Marks USA. NAPCO operates its own fully integrated manufacturing facility in the Dominican Republic, capable of producing up to $300 million worth of hardware annually, enabling faster delivery times (six days via shipping) and mitigating risks and delays associated with overseas manufacturing. In the security industry, NAPCO is unique for offering an integrated solution that encompasses fire alarms, burglar alarms, locking systems, and access products, giving their sales team a competitive edge. Unlike much of its competition, NAPCO’s products are Underwriters Laboratory-approved, the gold standard in the security sector. With a history dating back to the 1960s, NAPCO has established itself as a reputable and reliable provider of security solutions, and its integrated approach, UL-approved products, and longstanding industry presence provide a robust moat.
Management
Richard L. Soloway serves as CEO and Chairman of NAPCO Security Technologies, bringing over three decades of experience in the security industry. Although detailed information about Richard Soloway is limited, I appreciate that NAPCO’s management emphasizes key growth, profitability, return on equity metrics, and cost control—metrics they consider important for both the company and shareholders. Management also demonstrates alignment with shareholder interests, as NAPCO’s senior management holds approximately 10% equity in the company. I believe Richard Soloway has shown effective leadership, particularly during recent supply chain challenges. When microchips were in short supply, NAPCO strategically paid premiums to brokers to secure necessary components, allowing them to continue delivering products while competitors faced delays. This approach helped NAPCO acquire significant new accounts, which are expected to contribute to future recurring revenue. While this initially impacted profit margins, it positions NAPCO well for long-term gains. Thus, despite limited personal information, Richard Soloway’s industry experience, alignment with shareholders, and proactive leadership during supply chain constraints inspire confidence in his ability to continue leading NAPCO successfully.
The Numbers
The first metric we’ll examine is the return on invested capital (ROIC). I look for a 10-year history demonstrating a minimum annual growth of 10%. NAPCO Security Technologies has shown a mixed ROIC record, with some older figures below 10%. However, since 2018, NAPCO has consistently achieved ROIC above 10% every year except fiscal 2020, which was impacted by the pandemic. It’s encouraging that NAPCO delivered its second-highest ROIC in fiscal 2023, only to surpass it significantly in fiscal 2024, marking its highest ROIC to date. I don’t view this as an outlier, as NAPCO continues expanding its high-margin recurring revenue business, which I’ll discuss further in the analysis.
The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most significant of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. This is a textbook example of desirable financial performance. Equity has grown year over year for the past ten years, with growth accelerating in the past four years, during which NAPCO Security Technologies has increased equity by over 10% annually. Not only did NAPCO reach its highest equity level ever in fiscal 2024, but it also achieved its highest growth rate to date. These numbers are very encouraging.
Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins provide a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. It’s not surprising to note that NAPCO Security Technologies has consistently generated positive free cash flow every year over the past decade. While the figures have been somewhat mixed throughout this period, it's encouraging that NAPCO achieved its highest free cash flow and levered free cash flow margin in three of the last four years, setting a record in fiscal 2024. The lower free cash flow in fiscal 2022 was due to increased component costs and higher capital expenditures, so it’s not a significant concern. The free cash flow yield, although consistently low since 2016, is currently at its highest point in eight years. This suggests NAPCO Security Technologies may be trading at an attractive valuation—an aspect we’ll revisit later in the analysis.
Debt
Another important aspect to consider is the level of debt. It’s crucial to determine whether a business has manageable debt that can be repaid within a three-year period, typically calculated by dividing total long-term debt by earnings. However, it’s not possible to apply this calculation to NAPCO Security Technologies because they carry no debt. Being debt-free is a positive factor and further enhances the appeal of NAPCO Security Technologies as a potential investment.
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Risks
Based on my findings so far, I find NAPCO Security Technologies to be an intriguing company. However, no investment is without risk, and NAPCO Security Technologies also faces its own set of challenges. One significant risk is macroeconomic conditions. Fluctuations in the broader economy can directly impact customer demand and the company’s cash flow. In times of economic weakness, both individuals and businesses are more likely to delay or reduce security investments. Budget constraints, especially among smaller businesses and institutions, often lead potential buyers to defer security upgrades or installations, thereby reducing demand for NAPCO’s products. The company also relies heavily on a network of independent distributors, dealers, and installers to reach its customers. During economic slowdowns, these partners may face their own risks due to declining construction and renovation activity, which can lead some distributors to exit the market. This contraction in distribution channels limits NAPCO’s reach and growth potential, ultimately affecting customer access.
Another risk is competition. NAPCO Security Technologies operates in a crowded market with roughly 12 other U.S.-based security equipment manufacturers, many of which have substantially greater resources. These larger competitors can allocate more to R&D, product innovation, and customer support. While NAPCO invests 5% to 8% of its revenue in R&D, primarily to enhance existing products, larger rivals often bring new, cutting-edge technologies to market faster and with wider reach. This limitation restricts NAPCO's ability to capture or sustain market share in an industry where constant innovation is expected. Additionally, increased price competition could pressure NAPCO's profit margins, as larger competitors might leverage their resources to attract clients with more competitive pricing. Together, these factors could constrain NAPCO's revenue growth and profitability, posing a notable challenge to its long-term competitiveness.
Another significant risk is accounting integrity. NAPCO Security Technologies faced substantial scrutiny in 2023 after notable accounting errors required a restatement of earnings for the prior three quarters. This misstep led to a sharp 40% drop in stock value, raising serious concerns over the company’s financial transparency and its ability to retain investor confidence. In response, NAPCO has engaged Deloitte & Touche as its new auditor and hired a consulting firm to enhance financial procedures. However, uncertainty lingers due to potential litigation and long-term impacts on investor trust. Recent allegations of accounting fraud, reportedly supported by former employees, have intensified these concerns. The complaints point to alleged income inflation, inventory misstatements directed by senior management, and questionable insider selling practices, collectively casting doubt on NAPCO’s internal controls and future financial stability.
Reasons to invest
There are also compelling reasons to consider investing in NAPCO Security Technologies, one of which is its strong recurring revenue model. NAPCO’s focus on generating monthly recurring service revenue (RSR), particularly through its StarLink line of cellular radios, has made its revenue more predictable and less sensitive to economic fluctuations. In fiscal 2024, RSR grew by 26%, reaching an estimated annual run rate of $84 million with an impressive 90% gross margin. Regulatory changes and network upgrades by Verizon and AT&T have driven a shift away from copper landlines, sustaining demand for NAPCO's StarLink radios, which now play a critical role in fire and security alarm systems. By incorporating radios in both retrofitting and new installations, NAPCO captures two revenue streams: hardware sales and ongoing service fees. The commercial sector, which represents about 80% of NAPCO’s revenue, benefits from mandatory fire alarm upgrades that ensure continuous demand. Over the past seven years, RSR has shifted from single digits to nearly 40% of total revenue. This high-margin, recurring income stream, supported by product innovation and regulatory-driven demand, enhances NAPCO’s long-term growth prospects and resilience.
NAPCO’s locking solutions offer strong investment potential, driven by rising demand in educational, urban, and healthcare sectors. The company's Alarm Lock and Marks brands, which feature advanced electrified and adaptable locks, address growing security needs in K-12 schools and universities, where safety concerns, including increasing incidents of school shootings, heighten demand for secure access and lockdown capabilities. Urbanization also supports NAPCO’s growth, with the World Bank projecting urban populations to reach 70% by 2050, increasing the need for adaptable locking systems in high-density commercial and residential spaces. Additionally, infrastructure upgrades in airports and hospitals, which require modern, scalable access management systems, are expanding NAPCO’s market. In fiscal 2024, NAPCO’s locking sales rose by 18%, with gross margins improving from 18% to 29%.
NAPCO’s commitment to new product development, especially in high-growth areas like small business and residential security, presents a compelling investment case. The recent launch of Prima, an all-in-one burglar and fire alarm system tailored for residential and small business use, highlights NAPCO’s focus on expanding its recurring revenue streams. Prima is designed for fast, 15-minute installations and offers WiFi, cellular connectivity, and smart home integration—features that enhance its appeal to a broad customer base. Each Prima installation is expected to generate ongoing service fees, adding to NAPCO’s recurring revenue. With options for alerts, video monitoring, and smart home features, Prima creates multiple revenue streams. Management has expressed optimism, enhancing the system with additional accessories and dedicated sales teams to support continued growth for Prima.
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Valuation
Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators.
The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 1,34, which is from the fiscal year 2024. I have chosen a projected future EPS growth rate of 15%. (Finbox expects EPS to grow by 21,8% annually over the next five years, but I am using 15% as the highest rate.) Additionally, I have selected a projected future P/E ratio of 30, which is twice the growth rate. This decision is based on NAPCO Security Technologies' historically higher price-to-earnings (P/E) ratio. Finally, our minimum acceptable rate of return has already been established at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $40,20. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy NAPCO Security Technologies at a price of $20,10 (or lower, obviously) if we use the Margin of Safety price.
The second calculation is known as the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company essentially represents its return on investment. The minimum annual return should be at least 10%, which I calculate as follows: The operating cash flow last year was 45, and capital expenditures were 2. I attempted to analyze their annual report to calculate the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated to maintenance purposes. This means that we will use 1 in our calculations. The tax provision was 7. We have 36,874 outstanding shares. Hence, the calculation will be as follows: (45 – 1 + 7) / 36,874 x 10 = $13,83 in Ten Cap price.
The final calculation is referred to as the Payback Time price. It is a calculation based on the free cash flow per share. With NAPCO Security Technologies' free cash flow per share at $1,19 and a growth rate of 15%, if you want to recoup your investment in 8 years, the Payback Time price is $18,79.
Conclusion
I find NAPCO Security Technologies to be an intriguing company. While detailed information about management is limited, I am confident in their abilities based on their experience, strategic focus, and performance. Recently, NAPCO delivered its highest ROIC and free cash flow, indicating continued growth and improvement. Macroeconomic downturns pose a risk to NAPCO by reducing demand for security products as businesses and individuals cut back on spending. Additionally, economic slowdowns could shrink NAPCO’s distribution network as dealers and installers face decreased demand, limiting the company’s market reach. Competition is another risk, with larger rivals often able to outpace NAPCO in product innovation and customer support, challenging its ability to retain market share. Price competition could also pressure profit margins. NAPCO also faces an accounting integrity risk, following financial reporting errors in 2023 that led to a 40% drop in stock value, raising concerns about its financial accuracy and investor trust. Despite efforts to strengthen internal controls, allegations of accounting fraud add further uncertainty, potentially impacting investor confidence and exposing the company to litigation risks. On the positive side, NAPCO’s strong recurring revenue model, driven by high-margin StarLink cellular radios, provides a more stable income stream that is less impacted by economic cycles. Recurring service revenue now accounts for 40% of total revenue. Additionally, NAPCO’s locking solutions offer strong growth potential amid rising demand across schools, urban areas, and healthcare facilities, fueled by increased security needs and urbanization. The company’s commitment to new product development, particularly with the launch of Prima—a quick-install, all-in-one security system for small businesses and residential use—positions it for recurring revenue growth. Overall, I believe NAPCO Security Technologies could be an interesting investment, and I would consider opening a small position if the stock reaches the intrinsic value of the Ten Cap price at $28.
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