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NAPCO Security Technologies: Safeguarding your portfolio.


NAPCO Security Technologies is a relatively small company with a market capitalization just over one billion dollars. As a result, it doesn't receive much coverage on various investment sites. However, that doesn't mean it cannot be a good investment. NAPCO Security Technologies is increasing its recurring revenue, which will result in higher margins and, in turn, lead to greater profitability. The question is whether this small-cap company should be added to the portfolio, and that is what I'm going to investigate 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.


Since attending the workshop with Phil Town, I have decided to make some changes to the layout of my analyses. I will perform additional calculations and also provide a brief explanation of why the company is significant to me. If you want to learn more about my company evaluation process, please visit the "MY STRATEGY" section on my website.


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 start your investment journey with as little as $50.



NAPCO Security Technologies was founded in 1969 in New York, United States. NAPCO Security Technologies is a leading manufacturer and designer of high-tech electronic security devices, cellular communication services for intrusion and fire alarm systems, and a top provider of school safety solutions. They offer a diverse range of security products, including access control systems, door-locking products, intrusion and fire alarm systems, and video surveillance products. Their products are used for commercial, residential, institutional, industrial, and governmental applications, and are sold worldwide, primarily to independent distributors, dealers, and installers of security equipment. NAPCO Security Technologies is known for brands such as NAPCO Security Systems, Alarm Lock, Continental Access, and Marks USA. NAPCO Security Technologies operates its own manufacturing facility in the Dominican Republic, which is fully vertically integrated and has the capability to produce up to $300 million worth of hardware annually. This allows for faster product delivery times (6 days on the water) compared to the potential risks and shipping delays often associated with Chinese-made products. NAPCO Security Technologies is a distinctive company in the security industry because it manufactures fire alarms, burglar alarms, locking products, and access products. No other single manufacturer offers all of those segments. NAPCO Security Technologies is the only company that provides an integrated solution, giving their sales group a competitive advantage over their competitors. Furthermore, with a history dating back to the 1960s, NAPCO Security Technologies has established itself as a reputable and reliable provider of security solutions, which is what gives the company a brand moat.


Their CEO is Richard L. Soloway. He also serves as the Chairman of the Board of Directors and has over three decades of experience in the security sector. I haven't been able to find much information about Richard Soloway, but I appreciate that the management of NAPCO Security Technologies has emphasized their ongoing focus on key growth, profit, and return on equity metrics, as well as cost control. They stated that these metrics are important to them and to shareholders. Furthermore, the management intends to continue executing their business strategy and ensure that their interests are aligned with shareholders, as senior management of NAPCO Security Technologies owns approximately 10% of the equity. I also believe that Richard L. Soloway has executed well over the years, which is exemplified when there were supply chain issues. When nobody could get their hands on the microchips, NAPCO Security Technologies decided to spend extra money buying these chips from brokers in order to be able to deliver products. As a result, NAPCO Security Technologies was able to acquire new large accounts because they were able to deliver, while others could not. These new large accounts will continue to contribute to recurring revenue in the future. So, even if the profit margins were low when selling the product, this decision should benefit NAPCO Security Technologies in the long term. Hence, despite the limited information about the CEO, I believe that his experience, alignment with shareholders, and successful execution during supply chain issues are sufficient reasons for me to trust Richard L. Soloway to lead NAPCO Security Technologies in the future.


I believe that NAPCO Security Technologies has a brand moat, and I have confidence in the management despite limited information. Now, let's analyze the numbers to determine if NAPCO Security Technologies meets our criteria for possessing a strong competitive advantage. If you need an explanation of what the numbers represent, you can refer to "MY STRATEGY" on the website.


The first metric we will investigate is the return on invested capital (ROIC). I would like a 10-year history demonstrating a minimum annual growth of 10%. NAPCO Security Technologies has delivered a mixed return on invested capital (ROIC), with some of the older figures falling below 10%. However, since 2018, NAPCO Security Technologies has consistently achieved a Return on Invested Capital (ROIC) of over 10% in all years except for fiscal year 2020, which was impacted by the pandemic. It is encouraging to see that NAPCO Security Technologies achieved its highest Return on Invested Capital (ROIC) in fiscal 2023. I don't believe this is an outlier, as NAPCO Security Technologies continues to expand its high-margin recurring revenue business, which I will 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 how you would like to see the numbers. The equity has been growing year over year for the past ten years, and the growth has accelerated in the past three years, which is very encouraging. Not many companies manage to grow their equity like this, so I'm very impressed.



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 is not surprising to note that NAPCO Security Technologies has consistently generated positive free cash flow every year for the past decade. The numbers have been somewhat mixed over the ten-year period, but it is encouraging to see that NAPCO Security Technologies has achieved its highest free cash flow and levered free cash flow margin in two out of the last three years. However, the free cash flow yield has consistently been low over the past seven years and reached its lowest level by the end of the fiscal year 2023. It could indicate that the shares are trading at a premium, but we will revisit this later in the analysis.



Another important aspect to consider is the level of debt. It is crucial to determine whether a business has manageable debt that can be repaid within a three-year period. We calculate this by dividing the total long-term debt by earnings. However, it is not possible to calculate this for NAPCO Security Technologies because they have no debt. Being debt-free is a positive factor and another reason why NAPCO Security Technologies could be an appealing investment.



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 has its fair share of risks. One risk is macroeconomics. In its annual report, NAPCO Security Technologies mentions that its business could be significantly negatively impacted by general economic and market conditions. In the event that any of these conditions worsen, the revenue, profit, and cash-flow levels could be significantly and negatively impacted in future periods. In the event of such deterioration, many of their current or potential future customers may experience serious cash flow problems. As a result, they may modify, delay, or cancel purchases of their products. Furthermore, during economic downturns, the number of independent distributors, dealers, and installers of security equipment may decrease as the opportunities for home construction and renovation projects diminish. This could also affect their potential for growth. Another risk is competition. NAPCO Security Technologies operates in a highly competitive market, competing with around 12 other companies that manufacture and market security equipment to distributors, dealers, control stations, and original equipment manufacturers in the U.S. Most of these companies have significantly more financial and other resources than NAPCO Security Technologies. The security industry is known for its continuously improved products. While NAPCO Security Technologies invests approximately 5% to 8% of annual revenues in research and development (R&D), many of their competitors have the financial resources to allocate more resources and capabilities to R&D. The final risk is the reissuance of previously issued condensed financial statements. In August 2023, NAPCO Security Technologies' stocks plunged 40% due to accounting errors that would necessitate a restatement of their earnings for the last three quarters. NAPCO Security Technologies has taken steps to address the issue, such as engaging Deloitte & Touche as their new accounting firm and hiring a consulting firm to help perfect their procedures, policies, and internal controls. However, there is still a risk of facing litigation under federal and state securities laws and other claims resulting from the restatement. It is uncertain how it will affect NAPCO Security Technologies, but it will impact investor confidence in the future.


There are also many compelling reasons to invest in NAPCO Security Technologies. One reason is that they are generating recurring revenue. NAPCO Security Technologies continues to introduce new products that generate recurring service revenues. These products are installed at the premises of end customers, and NAPCO Security Technologies generates revenue from the installers through both the upfront purchase of their products and the monthly subscription fees for services. In fiscal year 2023, recurring service revenues amounted to $67 million, representing approximately 35% of the total revenue. The management anticipates that recurring service revenues will reach $72,5 million by the end of fiscal 2024 and $150 million by the end of fiscal 2026. If management succeeds, it will make NAPCO Security Technologies more profitable, as recurring service revenues currently deliver a 90% gross profit margin. Many trends will lead to an increase in demand. There are numerous trends that are driving the demand for NAPCO Security Technologies' products. According to the World Bank, urbanization is an ongoing process, with 56% of the world's population currently living in cities, and this trend is expected to continue. The World Bank estimates that the urban population will more than double by 2050, with 7 out of 10 people projected to live in cities. Continued urbanization is expected to lead to an increase in demand for their products. Another trend is the significant need for increased security in schools. In the U.S., there are over 100.000 K-12 schools and over 5.000 colleges and universities. Management estimates that less than 10% of these institutions have adequate protection from an active shooter or intruder. Finally, infrastructure upgrades at airports and hospitals, including buildings that aim to transition to a more adaptable locking system, are also mentioned as growth catalysts by management. New products. NAPCO Security Technologies is developing additional products to expand its recurring revenue business. NAPCO Security Technologies has recently launched a new high-volume burglar fire alarm system called Prima, designed for small businesses and residential use. This product has the potential to significantly boost hardware sales and profits, while also contributing to substantial recurring revenue for NAPCO Security Technologies. Management has expressed their high expectations for Prima moving forward.



Now it is time to calculate the share price of NAPCO Security Technologies. I perform three different calculations that I learned at a Phil Town seminar. 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 0,73, which is from the fiscal year 2023. I have chosen a projected future EPS growth rate of 15%. (Finbox expects EPS to grow by 22,8% 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 $21,90. 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 $10,95 (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 25, and capital expenditures were 3. 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 2 in our calculations. The tax provision was 5. We have 36,77 outstanding shares. Hence, the calculation will be as follows: (25 – 2 + 5) / 36,77 x 10 = $7,61 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 $0,95 and a growth rate of 15%, if you want to recoup your investment in 8 years, the Payback Time price is $15,00.


I find NAPCO Security Technologies to be an intriguing company. We don't have much information about the management, but I still feel confident in their abilities based on their experience, strategy, and performance. Macroeconomics does pose a short-term risk but will eventually improve. Competition will always pose a risk, but NAPCO Security Technologies is a unique company in the sector and has successfully competed for many decades. Thus, I'm not overly concerned with competition, even though their competitors allocate more funds to R&D. The reissuance of previously issued condensed financial statements is slightly concerning, and we are uncertain about its potential impact. However, it is encouraging that management has taken steps to improve. There are numerous reasons to appreciate NAPCO Security Technologies, such as their expansion of high-margin recurring revenue and the global trends that are expected to boost demand for their products. I appreciate NAPCO Security Technologies' commitment to developing new products, which is crucial in this industry. NAPCO Security Technologies is a small-cap company. Therefore, I will only take a small position, and I will do so only if the share price falls below the intrinsic value of the Payback Time price of $30.


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I hope that you enjoyed my analysis. Unfortunately, I cannot do a post of all the companies I analyze. I am available to copy but if you do your own trades, you can follow me on Twitter instead, as I tweet when I buy or sell anything.


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