Garth Russell - IR, KCSA Strategic Communications Richard Soloway - Chairman and President Kevin Buchel - SVP of Operations and Finance

Kara Anderson - B. Riley & Co. Peter Jacavone - Barrett & Company Rick Fetterman - Fetterman Investments

Greetings, and welcome to the NAPCO Security Technologies Second Quarter Fiscal 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Garth Russell with KCSA Strategic Communications. Thank you. You may now begin.

Thank you. Good morning, and thank you all for joining us on today's conference call to discuss NAPCO's financial results for the three months ended December 31, 2015. By now, all of you should have had the opportunity to review the press release discussing the results issued earlier this morning. If you have not, please contact KCSA Strategic Communications at napco@kcsa.com, and we will send over a copy to you. On the call today is Richard Soloway, Chairman and President of NAPCO Securities; and Kevin Buchel, Senior VP of Operations and Finance. Before we begin, let me take a moment to read the forward-looking statements. This conference call may contain forward-looking statements that involve numerous risks and uncertainties. Actual results, performance or achievements may differ materially from those anticipated in such forward-looking statements as a result of certain factors, including those set forth in the company's filings with the SEC. With that, let me turn the call over to Richard to cover the prepared remarks. Dick, the floor is yours.

Thanks, Garth. Good morning everyone, and thank you for joining NAPCO's quarterly conference call to discuss the financial results for the three months ending December 31, 2015. I've been in the security industry for most of my career, which is more years than I'd like to admit, and the only constant during my time in this line of work has been change. The security landscape is always evolving. One of those things I'm most proud of is the way NAPCO has been able to remain at the forefront of innovation in the industry even in the face of stiff competition. The financial second quarter was no exception. We've continued to profit from the new products and services introduced over the past few years, delivering our third consecutive period of quarterly record revenues, and we have made investments to position the company for future success. When I talk about innovation, our R&D effort is at the heart of it. We're always receiving valuable feedback from customers and our 10,000 plus dealers in integrated network about new products and services they like to see in the marketplace. At NAPCO we take their feedback and market insight seriously. The good news is that based on our conversations we are seeing opportunities across our business lines in areas such as locking, access control, and alarms recurring revenue services. During the quarter, we put money to work, spending 1.5 million in R&D, approximately 200,000 more than last year's Q2, so that we can arm our sales force with a product line-up that allow us to grow faster. We will provide more information on new products as they hit the marketplace. One area of innovation that we continue to experience, increasing market demand is for our school and college safety system. Our school-vertical-specific project LockDown, which incorporates our School Access Control Vulnerability Index or SAVI, an audit system, takes a holistic and active approach in training security dealers and end-user school officials on how to significantly reduce or prevent a mass incident. Our suite of LockDown Access Control Systems are uniquely designed to play a significant role protecting students, facility, faculty, administrators in both K - 12 and college and universities across the U.S. Integrating and networking products from our Alarm Lock, Marks, and Continental division enable us to wirelessly control access to and within schools providing video monitoring and activate lockdown in seconds. We continue to add features to ensure we're staying at the forefront of school safety. Our Continental Access Control products division has just launched an app that enables a teacher or administrator to initiate a lockdown from their smartphone, receive text messages from a lockdown progress, and alert and summons early responders. Educational institutions are placing a greater focus on safety than ever before. Highly publicized incidents over the past few years have prompted lawmakers to become more aggressive in using public policy as a tool to protect students from violent people. As a number of state legislative bodies convene during the first part of 2016, we are closely monitoring the flurry of activity. In South Dakota, a bill requiring every school to have a safety plan and lockdown drills passed committee. In Indiana, the state senate is voting on a proposal to create a handbook of safety precautions schools can follow. We are also seeing action taking place at the municipal and school board level. As we speak, voters in Albuquerque are weighing a bond offering that would include $7 million in school security upgrades, including LockDown systems. We are encouraged by these developments and applaud politicians for moving in the right direction on this issue. Turning to our recurring revenue products, our StarLink 3G/4G, and Verizon CDMA alarm communicators continues to experience strong sales growth, with recurring revenue increasing by 36% this past quarter. As we've talked about on previous calls, demand for the StarLink products is being driven by users of residential and small business alarm systems looking to replace disappearing traditional phone lines with advanced wireless cellular communications technology. In addition, NAPCO continue to gain traction on the heels of the successful launch of our comprehensive line of StarLink commercial fire and intrusion alarm communicators, increasing our production forecast for the line by 35% from our original projection. This suite of products enables alarm installation companies to replace increasingly rare traditional phone lines with more technologically advanced wireless radio communication paths. I want to touch briefly on one operations point. In a business like ours, optimizing inventory levels is crucial to cash flows. We are constantly monitoring inventory and making adjustments as on an as-needed basis to ensure our supply chain runs as effectively and efficiently as possible. This quarter as a result of our efforts, a larger than usual difference between our beginning and ending inventories impacted our gross margin, which flowed through to the rest of the income statement. We believe that these inventory controls were the right decision effectively trading higher COGS for improved cash flows, which we used to enhance value for shareholders by repurchasing stock and paying down debt. As I discussed previously, once we exceed $20 million in revenue in a quarter, we expect to see a hockey stick like movement in our profitability as we achieve scale. This leverage is achieved by the fact that our own manufacturing facility has produced all of our products and services in-house. As such, this quarter was an anomaly of timing around the inventory activities we took in respect to this quarter. Before turning the call over to Kevin, I want to cap my comments by saying how pleased we are with the company's direction. We're seeing strong interest for our recently released products and we're making the investments necessary to succeed in the quarters and years ahead. With all of this positive momentum in our business, we believe that our stock is undervalued, particularly when you look at the intrinsic value we have been creating. As such during the quarter, we opportunistically bought back stock as part of the 1 million share buyback repurchase program we enacted in September 2014. During the three months ending December 31, 2015, the company repurchased 100,132 shares of its common stock for weighted average price of $5.91 per share. With that, I would like to turn the call over to Kevin to review the quarterly results. Kevin?

Thank you, Dick, and good morning everybody. Revenues for the three months ended December 31, 2015, increased 5% to a quarterly record of 20.5 million compared to 19.6 million in the same period a year ago. For the six months, revenue increased 5% to 38.6 million, a record for the first six months of the fiscal year, from 36.9 million for the same period one year ago. The increase in sales for the three and six months was due primarily to increased sales of the company's door locking product and intrusion product, as well as increases in recurring revenue as partially offset by decreased sales of access control products. Gross profit for the three months ended December 31, 2015 increased approximately 2% to 6.2 million or 30.3% of sales compared to 6.1 million or 31.2% of sales for the same period a year ago. Gross profit for the six months increased approximately 4% to 11.8 million or 30.6% of sales compared to 11.4 million or 30.8% of sales in the same period a year ago. The increase in gross profit for the three months and six months was primarily due to increased sales offset by the aforementioned $200,000 increase in R&D expenses and a reduction in inventory level. As Dick discussed in his remarks earlier, we implemented inventory controls that resulted in inventory levels falling by 1.3 million. Because of the larger than usual difference between our beginning and ending inventories, our cost of goods sold increased which impacted our gross margin. Going forward, we expect inventory levels to rise as we prepare for the end of the fiscal year, which is our prime selling season. Selling, general, and administrative expenses for the quarter increased $168,000 or 3% to 5.2 million or 25.2% of sales compared to 5 million or 25.6% of sales for the same period last year. Selling, general, and administrative expenses for the six months increased by $472,000 or approximately 5% to 10.5 million or 27.1% of sales compared to $10 million or 27.1% of sales a year ago. The increase in selling, general, and administrative expenses for the three months and six months was due primarily to the addition of selling personnel and increased media advertising. Operating income for the quarter decreased by approximately $70,000 or 6% to $1 million as compared to 1.1 million for the same period a year ago. Operating income for the six months increased $8000 or less than 1% to approximately 1.4 million from 1.3 million in the same period a year ago. Interest expense for the quarter decreased by $9,000 or 17%, to $45,000 as compared to $54,000 for the same period a year ago. Interest expense for the six months decreased by $15,000 or 14% to $94,000 as compared to $109,000 for the same period a year ago. The decrease in interest expense for the three and six months ended December 31, 2015, resulted from lower average outstanding debt and lower interest rates during the current period, as compared to the same period a year ago. Net income increased by approximately $25,000 or 3%, to $976,000 or $0.05 per diluted share, as compared to $951,000 or $0.05 per diluted share for the same period last year. Net income for the six months, increased by $181,000 or 16%, to $1.3 million or $0.07 per diluted share, compared to net income of 1.1 million or $0.06 per diluted share for the same period last year. Adjusted EBITDA for the quarter as per the schedule included in today's press release decreased approximately $112,000 or 7%, to 1.4 million or $0.08 per diluted share, as compared to 1.5 million or $0.08 per diluted share last year. Adjusted EBITDA for the six months decreased $63,000 or 3%, to 2.1 million or $0.11 per diluted share as compared to 2.2 million or $0.11 per diluted share for the same period a year ago. At December 31, 2015, the company had $1.9 million in cash and cash equivalents, compared to $2.3 million at June 30, 2015. The company also had working capital of 33.5 million at December 31, 2015, compared with working capital of 35.6 million at June 30, 2015. Paying down our debt and optimizing our cost for capital remains a top priority for NAPCO. During the quarter, we repaid 1.4 million of debt, reducing our outstanding balance excluding cash by 15%, to 7.9 million. For the six months, we repaid $2.8 million of debt, reducing our outstanding balance by 26%. Debt net of cash was $6 million at December 31, 2015. That concludes my formal remarks, and I would now like to return the call back to Dick.

Okay. Thanks, Kevin. In conclusion, we are excited about the company's trajectory as we head into the second half of our fiscal year, which is our prime selling season. We are seeing strong interest in our products across our service lines, and continue to see opportunities to build deeper relationships with our network of dealers and integrators. From a financial perspective, our balance sheet remains sound, and cash flow is strong, enabling us to continue to enhance shareholder value through share repurchases. That concludes our formal remarks. Kevin and I would like to open the call for questions. Operator, please proceed.

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Kara Anderson with B. Riley & Co. Please go ahead with your question.

Hey, guys. Good morning. I'm wondering if you can quantify the impact on the gross margin you saw as a reduction of the inventory in the quarter. A – Kevin Buchel: Well, with the inventory reduction of about 1.3 million that was worth probably 2% in our gross margin. So our gross margin would have been about 2% higher. Our sales came in at about 20 million, what's that worth, about $400,000, something like that.

Okay, and then just a housekeeping question. What was CapEx during the quarter?

CapEx, I have to look for that. You have to give me a minute for that. CapEx that I have for the six months was 271,000. So if you look at your first quarter you'll be able to figure out the difference.

Yes. All right, thank you.

Okay, Kara.

Thank you. Our next question comes from the line of Peter Jacavone with Barrett & Company. Please go ahead with your question.

Hi, guys. Kara asked a part of the question that I had regarding inventory. When you say we reduced inventory by 1.3%, is that a write-down, or is it -- I mean, how -- why -- is it an obsolescence of inventory? So how -- what's -- where is this decision made, and why is the decision made to reduce inventory? I'm just trying to quantify is it obsolete inventory, or is it inventory that is more expensive than we can get it currently now?

Right. So Peter, I mean when you reduce inventory it could be for a lot of reasons. It could be write-offs. It could be lower costs, whatever. It wasn't write-offs. If it was write-offs you would see that in our schedule that when we filed the Q. This was strictly making operational decisions. I'll give you two examples. One example is we always try to get our vendors to consign their materials here, raw materials. It's great for us if we could get a consignment program, because then we don't have to pay for it until we're absolutely ready to use those materials, but we got a couple of guys to agree to that. That helped to reduce inventories, much more efficient for us. A second example is a lot of the vendors who supply us with raw materials they want us to take a six months supply all at once. It's easier for them. They're running a big job. They want us to take it all at once. Well, we don't want to take it all at once. We only want to use what we need for the given quarter. In this particular timeframe, we got two different guys to agree to spread it out just the way we want it. When you add that all up, it's great operational decision. It led to the 1.3 million. Inventory will probably go up now in the next quarter as we prepare for the big fourth quarter as many of you who follow us know. So it's a back-and-forth. This was a good thing for us from an operational cash flow point of view.

Okay, thank you.

You're welcome.

Thank you [Operator Instructions] Our next question comes from the line of Rick Fetterman from Fetterman Investments. Please go ahead with your question.

Thank you. Good morning everyone. Dick, you said that -- and you've said this several times over the past conference call that there's strong interest in the products -- new products that you're bringing out, but it doesn't seem to have translated into revenue acceleration. What's it going to take to get revenues growing more than 3%, 4%, 5%, 6%, a year?

As I've said, Rick, 5% is what we did this quarter, and we've had three quarters of record-breaking revenues, and we're in the second or third inning of the introduction of these products. So we see a lot more growth potential for our radios and our School LockDown, and our Access Control Systems, and our Connected Home. So it just takes time, and it ramps as more and more people join on, and that's the way this is. This is a business where you don't have impulse buying at a counter. This is something where it's tried, true, and lots of dealers are adopting and liking these products, and we're investing in the engineering so that we can keep improving them to keep tweaking them up. We want our fire systems to be able to be sold everywhere at higher volume, great margins on that stuff. So it's a constant thing. It's a growth thing. And we're in a very exciting time where we're electrifying all of our different product lines. Schools are adopting LockDown, radio communications on alarms are mainstream, and Connected Home is a very hot topic with lots of room to grow. So it's a good time for us, and we expect things to ramp up at an accelerated space.

I appreciate that. And is it fair to say in view of what you just reflected that assuming there is no big surprises in the economy that we should expect sales increases certainly greater than 5% quarterly over, say, the next 12 months? A – Richard Soloway: We're trying very hard to get adoption rates quicker. We're doing all kinds of training seminars. We're pushing lots of training and sales emphasis to push these product lines, and we're excited that we could possibly be at higher rates like you are talking about.

Okay. Thank you very much.

Thank you. Ladies and gentlemen, we have no further question in queue at this time. I would like to turn the floor back over to management for closing remarks.

Thank you everyone for participating in today's conference call. As always, should you have any further questions please feel free to call KCSA, Kevin, or me. We thank you for your interest and support, and we look forward to speaking to you all again in a few months to discuss NAPCO's fiscal 2016 third quarter results. Bye-bye.

Thank you. Ladies and gentlemen, this does conclude our teleconference for today. You may now disconnect your lines at this time. Thank you for your participation, and have a wonderful day.