ITEM 1A: RISK FACTORS
The risks described below are among those
that could materially and adversely affect the Company’s business, financial condition or results of operations. These risks
could cause actual results to differ materially from historical results and from any results predicted by any forward-looking
statements related to conditions or events that may occur in the future.
Our business operation and financial performance are
adversely affected by the COVID-19 pandemic and related events.
We are subject to risks related to the global pandemic associated
with the COVID-19 disease, which has spread globally to the U.S. and other countries where we have operations, including the Dominican
Republic. Numerous federal and state governmental jurisdictions have imposed “stay-at-home” orders, quarantines, travel
bans and similar governmental orders and restrictions to control the spread of COVID-19. Such orders or restrictions have resulted
in business closures, work stoppages, slowdowns and delays in commercial activities, unprecedented and widespread unemployment,
disruptions to ports and other shipping infrastructure, border closures, and other travel or health-related restrictions, thereby
negatively impacting our customers, suppliers, distributors, employees, offices, and the industry in which we operate.
As a result of the COVID-19 pandemic and the related economic
downturn, we have experienced a decline in the demand for our products, as our distributors and customers reduced orders and adjusted
their inventory channel in response to slowdown in spending and demand for security products. A prolonged stay-at-home order,
or any other continued decrease in economic activity as a result of COVID-19 pandemic, would have a negative adverse impact on
our customers and their financial condition, which could impact their ability to meet their financial obligations and could result
in elevated levels of delinquencies and bad debt losses. In addition, we rely upon our third-party vendors to provide parts and
materials for us to produce our products. If any of these vendors are unable to continue to provide us with these parts and materials,
it could negatively impact our ability to serve our customers. We also could be adversely affected if key personnel or a significant
number of employees were to become unavailable due to the effects and restrictions of COVID-19 pandemic in areas where we operate.
We manufacture substantially all of products in our factory
in Dominican Republic, which are then shipped to us in the United States for further distribution. The government authorities
in Dominican Republic have imposed curfews and restrictions as a result of the pandemic that impacted activities at the factory,
which may reduce our productivity and output. Additional restrictions and limitation on international travel and transportation,
including air travel, may make it more difficult for us to ship and transport products from Dominican Republic to the U.S., which
may cause delays and disruptions in our supply chain.
Moreover, if we determine that intangible assets are not realizable
as a result of the COVID-19 pandemic, we may be required to write down these assets or incur impairment charge under current accounting
standards, which would have a negative effect on our consolidated financial statements. The continuing adverse economic conditions
in the U.S. due to the pandemic have and may continue to reduce revenues associated with our intangible assets, including assets
acquired in our prior acquisitions, and result in a reduction of future expected cash flows. Such a reduction could result in
significant impairment charges to adjust the carrying value of the intangible assets.
The impact of the COVID-19 pandemic remains highly uncertain
and subject to change. We cannot predict when the pandemic will end and when related governmental orders and restrictions will
be eased or lifted, and any extension or prolonged implementation of these restrictions will further adversely affect our business,
customers and financial results. Even after such orders and restrictions are eased or lifted, the severe economic harm and recession
inflicted upon the jurisdictions and areas in which we operate may last for an extended period of time and continue to adversely
affect our business and financial performance, and there is no guarantee that we will be able to act quickly and effectively to
return to our normal operations.
Our business could be materially adversely affected as
a result of general economic and market conditions.
We are subject to the effects of general economic and market
conditions. In the event that the any of these conditions deteriorate, our revenue, profit and cash-flow levels could be materially
adversely affected in future periods. In the event of such deterioration, many of our current or potential future customers may
experience serious cash flow problems and as a result may, modify, delay or cancel purchases of our products. Additionally, customers
may not be able to pay, or may delay payment of, accounts receivable that are owed to us. If such events do occur, they may result
in our expenses being too high in relation to our revenues and cash flows.
During weak economic times, the available pool of independent
distributors, dealers and installers of security equipment may decline as the prospects for home building and home renovation
projects diminish, which may have a corresponding impact on our growth prospects. In addition, there is an increased risk during
these periods that an increased percentage of independent distributors, dealers and installers of security equipment will file
for bankruptcy protection, which may harm our reputation, revenue, profitability and results of operations.
The markets we serve are highly competitive and we may
be unable to compete effectively.
We compete with approximately 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 may have substantially greater financial and other resources than the Company. The Company competes primarily
on the basis of the features, quality, reliability and pricing of, and the incorporation of the latest innovative and technological
advances into its products, as well as technical support services to its customers. The Company competes on the basis of its expertise,
its proven products, its reputation and its ability to provide products to customers on a timely basis. The inability of the Company
to compete with respect to any one or more of the aforementioned factors could have an adverse impact on the Company's business.
Our business may also be materially adversely affected by the
announcement or introduction of new products and services by our competitors, and the implementation of effective marketing or
sales strategies by our competitors. Our industry is characterized by constantly improved products. There can be no assurance
that competitors will not develop products that are superior to the Company's products. We have historically invested approximately
6% to 8% of annual revenues on R&D to mitigate this risk. However, many of our competitors have dedicated more resources and
capabilities to R&D, including committing more engineers and capital expenditures, to develop and design new product that
may enter the markets sooner or with more penetration. Future success will depend, in part, on our ability to continue to develop
and market products and product enhancements cost-effectively. The Company's research and development expenditures are principally
targeted at enhancing existing products, and to a lesser extent at developing new ones. Further, there can be no assurance that
the Company will not experience additional price competition, and that such competition may not adversely affect the Company's
revenues and results of operations
We may not be able to maintain or control our expenses
proportionate to our sales volumes to generate profit for our business.
Certain of our expenses are fixed or semi-variable, including
our costs for operating our manufacturing facilities. While expense levels relative to current sales levels result in positive
net income and cash flows, if sales levels decrease significantly and we are unable to reduce expenses proportionately, our business
may be adversely affected. The amount of our operating expenses are subject to variables and factors that may not be within our
control, including but are not limited to, unexpected expenses relating to the manufacturing of products; increased compensation
requirement for our employees and cost of raw materials. A significant portion of our expense is labor cost, including costs for
workers who are operating our facility in the Dominican Republic. While we have been able to control our expenses due to the lower
labor costs in the Dominican Republic, there is no guarantee that such costs will not increase in the future, or that sufficient
number of workers in Dominican Republic will be available to operate the facility efficiently, and our failure to maintain effective
labor costs may adversely affect our results of operations.
Our business could be adversely affected as a result
of housing and commercial building market conditions.
We are subject to the effects of housing and commercial building
market conditions. The sales of our security products tend to increase during period in which new housing and commercial real
estate constructions are increasing. If these conditions deteriorate, resulting in declines in new housing or commercial building
constructions, existing home or commercial building sales or renovations, our business, results of operations or financial condition
could be materially adversely affected, particularly in our intrusion and door locking product lines. The condition of the residential
and commercial building markets in which we operate is cyclical and depends on the condition of the economy in the United States,
and on the perceptions of investors of the overall economic outlook. Rising interest rates, declining employment levels, declining
demand for real estate, declining real estate values or periods of general economic slowdown or recession or the perception that
any of these events may occur have negatively impacted the real estate market in the past and may in the future negatively impact
our ability to sell products and generate new revenue sources.
We may not be able to grow our recurring revenue business
to generate consistent revenue and profitability.
A significant driver of our growth is our recurring revenue
business in which customers who purchased our products and equipment are required to pay monthly fees for communications services
to maintain the operation of such products. Our recurring revenue products, such as StarLink, iSecure and iBridge, tend to generate
higher gross margin and are less susceptible to volatility of market demand and economic conditions. However, our revenue recurring
business is relatively new and we have limited experience in developing, marketing and selling such products. We also face intense
competition where other companies with greater resources and experience have established a wider and more entrenched customer
base for similar products and services, making it more difficult for us to penetrate into such market. In addition, we are required
to incur costs to maintain a network operations center to provide customer support and services, and to comply with federal and
state regulations governing the operation and communications of these products. Such costs may reduce our profitability if we
are not able to grow and expand the recurring revenue business. As we are increasingly dependent on recurring revenue products
as a driver for growth, our failure to execute our strategy for this business line will materially adversely affect our financial
conditions and prospects.
We may not be able to sustain and continue the growth
of school security products.
We recently experienced significant growth of demand for our
security products from schools, universities and other educational institutions as a result of the national focus on prevention
of school violence. Federal and state governmental authorities have proposed and enacted numerous legislation and laws, including
the School Violence Prevention and Mitigation Act of 2019 that provide increased funding to public schools to implement and enhance
security systems. While our business has benefited from such additional federal and state funding and increased demand, there
is no guarantee that such funding and trend will continue. For example, if school shutdown continues as a result of the COVID-19
pandemic and various stay-at-home orders imposed by state governments, there could be a reduced need for schools to acquire and
implement security systems, and state and federal government may also decide to reduce funding or impose additional criteria for
funding. These factors may result in a decline of demand for our school security products which in turn may adversely affect our
financial performance.
We rely on distributors to sell our products and an adverse
change in our relationship with such distributors may adversely affect our financial performance.
We distribute our products primarily through independent distributors
and wholesalers of security alarm and security hardware equipment. Our distributors and wholesalers also sell our competitors'
products, and if they favor our competitors' products for any reason, they may fail or reduce their effort to market and sell
our products as effectively or to devote resources necessary to provide effective sales, which would adversely affect our financial
performance. In addition, our distributors order our products and maintain their inventory based on forecasts of potential demands
from dealers and end customers, and our distributors may not be able to forecast such demand accurately, which may adversely affect
our ability to generate sales and revenue in a timely manner. In some cases, distributors may delay ordering our products until
they receive confirmation of orders from dealers and end customers, and this delay may cause disruption and make it more difficult
for us to fill their order timely and effectively, which may adversely affect our revenue and sales.
The financial health of our distributors and wholesalers and
our continuing relationships with them are important to our success. Some of these distributors and wholesalers, particularly
smaller firms with limited working capital and resources, may not be able to withstand adverse changes in business conditions
or mitigate the negative impact of a prolonged economic downturn or recession, including the impact of the COVID-19 pandemic.
The failure of our distributors to maintain financial heath and success will impact our ability to generate revenues. Furthermore,
our relationship with distributors may change or terminate due to other factors beyond our control, including but are not limited
to, acquisition of distributors by third parties may not be willing to continue the relationship with us; internal restructuring
or refocus of business strategies; and changes in management, all of which may negatively impact our ability to continue to sell
to such distributors. Finally, we generally do not have long-term agreements with distributors who purchase our products primarily
through purchase orders. Without an agreement, we are not able to guarantee that such distributors will not discontinue or terminate
relationship with us at any time, and any loss of distributor will negatively impact our financial conditions and results of operations.
We may not able to gain widespread or timely market acceptance
of our new products and continue to build and enhance our brand to achieve growth.
We rely on introduction of new products and services to penetrate
new markets and identify additional sources of revenues order to grow our business. However, many of our distributors and customers
may not be willing to change or switch to new products and equipment, or may require an extended period time to assess, test and
evaluate functionalities and performance of our new products. Any delays in establishing widespread acceptance of our new products
may adversely affect our financial performance and growth. In order to ensure market acceptance of new products, we have incurred
and expect to incur significant expenses in sales and marketing campaign, and we may not be able to justify such costs if the
effort does not produce sufficient sales and customer accounts.
We believe that building
and maintaining market awareness, brand recognition and goodwill of our business and products in a cost-effective manner is important
to our overall success in achieving widespread acceptance of our existing and future products and is an important element in attracting
new customers. An important part of our business strategy is to increase awareness of our brand and to provide marketing leadership,
services and support to our distributor and customer network. While we may choose to engage in a broader marketing campaign to
further promote our brand, this effort may not be successful. Our efforts in developing our brand may be hindered by the marketing
efforts of our competitors and our reliance on our third parties to promote our brand. If we are unable to cost-effectively maintain
and increase awareness of our brand, our business, financial condition, cash flows and results of operations could be harmed.
Our financial results could be materially adversely affected
as a result of offering extended payment terms to customers or if we are not able to collect our accounts receivables on a timely
basis from major customers.
We regularly grant credit terms beyond 30 days to certain distributors
and customers primarily in an effort to keep a full line of our products in-stock at our customers’ locations. The longer
the terms that are granted, the more risk is inherent in the collection of those receivables. We cannot guarantee that distributors
and customers will be able to make payments on a timely basis even after a thorough review of their credit and financial history.
The ability of distributors and customers to make such payments may be subject to factors beyond our control, including their
financial conditions and business operation. We may also incur additional costs and effort to collect past due receivables without
assurance that a sufficient or any amount of bad debt can be collected.
We sell security products and systems and if our solutions
fail for any reason, we could be subject to liability and our business could suffer.
We sell security products and services, which are designed
to secure the safety of our customer and their commercial, residential, institutional, industrial or governmental properties.
Our products and services may contain undetected defects in the software, infrastructure, third-party components or processes.
If these solutions fail for any reason, including due to defects in our hardware, software, a carrier outage or user error, we
could be subject to liability for such failures and our business could suffer. In addition, our products and systems are not installed
by us, and if third parties do not install or maintain our products correctly, our products and systems may not function properly.
If the improper installation or maintenance of our products and systems leads to service or equipment failures after introduction
of, or an upgrade to, our products and systems, we could experience harm to our branded reputation, claims by our customers or
installers or lost revenue during the period required to address the cause of the problem. Any defect in, or disruption to, our
products and systems could cause consumers not to purchase additional products or systems from us, prevent potential consumers
from purchasing our products and systems or harm our reputation.
We are subject to risks relating to the operation of
a manufacturing facility in Dominican Republic.
We operate a manufacturing facility in Dominican Republic where
the majority of our products is made and shipped to our U.S. distributors. The facility requires us to incur certain fixed operating
costs that do not fluctuate with changes in production levels or utilization of our manufacturing capacity. If production levels
decline due to lower demand or reduced customer orders, our fixed costs are spread over reduced levels, which may contribute to
decreasing margins and reduced profitability. Operation of a manufacturing facility also subjects us to certain additional risks,
including but not limited to the following:
·
Unavailability of workers or insufficient workforce to operate the factory;
·
Compliance with local regulatory requirements, including labor laws and tax requirements;
·
Difficulties in communication and coordination with U.S. headquarters;
·
Natural disasters such as hurricanes which may damage our factory; and
·
Effect of general political and economic conditions of the Dominican Republic.
The occurrence of any of these factors may adversely affect
the production output and operation of our factory, which will disrupt our supply chain and negatively impact our financial performance.
Furthermore, we have not identified any alternative third-party factory that can manufacture our products; therefore it would
be difficult for us to replace any loss of output of capacity if our factory in Dominican Republic is not functioning properly
or at all.
Our business could be materially adversely affected by
a weakening of the U.S. dollar against the Dominican peso.
We are exposed to foreign currency risks due to our operations
in the Dominican Republic. We have significant operations in the Dominican Republic, which conducts certain transactions in Dominican
pesos. We are subject to the risk that currency exchange rates between the United States and the Dominican Republic will fluctuate
significantly, potentially resulting in an increase in some of our expenses when US dollars are transferred to Dominican pesos
to pay these expenses. For example, if the U.S. dollars weakens and the currency exchange rate is less favorable, it may be more
costly for us to pay expenses for our factory in the Dominican Republic, which may adversely affect our financial conditions and
results of operations.
Our business could be materially adversely affected by
adverse tax consequences of offshore operations.
We operate on a global basis, with a portion of our operating
income generated outside the United States. We intend to reinvest these earnings in our foreign operations indefinitely, except
where we are able to repatriate these earnings to the United States without material incremental tax expense. A significant portion
of our assets that result from these earnings remain outside the United States. If these indefinitely reinvested earnings were
repatriated into the United States as dividends, we would be subject to additional withholding taxes.
Our failure to
maintain the security of our information and technology networks could adversely affect us.
We are dependent on information
technology networks and systems, including the Internet, to process, transmit and store electronic information and, in the normal
course of our business, we collect and retain certain information pertaining to our distributors, customers, partners and employees,
including personal information. If security breaches in connection with the delivery of our solutions allow unauthorized third
parties to access any of this data or obtain control of our systems, our reputation, business, financial condition, cash flows
and results of operations could be harmed.
The legal, regulatory
and contractual environment surrounding information security, privacy and credit card fraud is constantly evolving and
companies that collect and retain such information are under increasing attack by cyber-criminals around the world. Further, as
the regulatory focus on privacy issues continues to increase and worldwide laws and regulations concerning the protection of data
and personal information expand and become more complex, these potential risks to our business will intensify. A significant actual
or potential theft, loss, fraudulent use or misuse of distributors, customers, employee or other personally identifiable data,
whether by third parties or as a result of employee malfeasance or otherwise, non-compliance with our contractual or other legal
obligations regarding such data or a violation of our privacy and security policies with respect to such data could result in
loss of confidential information, damage to our reputation, early termination of our business relationships, litigation, regulatory
investigations or actions and other liabilities or actions against us, including significant fines by U.S. federal and state authorities,
and other countries and private claims by companies and individuals for violation of data privacy and security regulations.
In addition, cyber-attacks from computer hackers and cyber
criminals and other malicious Internet-based activity continue to increase generally, and perpetrators of cyber-attacks may be
able to develop and deploy viruses, worms, ransomware, malware, DNS attacks, wireless network attacks, attacks on our cloud networks,
phishing attempts, social engineering attempts, distributed denial of service attacks and other advanced persistent threats or
malicious software programs that attack our products and services, our networks and network endpoints or otherwise exploit any
security vulnerabilities of our products, services and networks. Techniques used to obtain unauthorized access or to sabotage
systems change frequently and generally are not recognized until launched against a target. As a result, we may be unable to anticipate
these techniques or to implement adequate preventative measures. We cannot be certain that advances in cyber-capabilities or other
developments will not compromise or breach the technology protecting the networks that access our platforms and solutions, and
we can make no assurance that we will be able to detect, prevent, timely and adequately address or mitigate the negative effects
of cyber-attacks or other security breaches. If any one of these risks materializes, our business, financial condition, cash flows
or results of operations could be materially and adversely affected.
We rely on the effort and service of Richard L. Soloway,
our founder, Chief Executive Officer and major stockholder.
The success of the Company is largely dependent on the effort
and service of Richard L. Soloway, who is our founder, President, Chief Executive Officer, Chairman of the Board and a major stockholder.
We depend on Mr. Soloway on various aspects of our business operation, including his experience and knowledge in the industry,
extensive relationships with distributors and customers, and his leadership to develop and implement business strategies. The
loss or reduction of services by Mr. Soloway could have a material adverse effect on the Company's business and prospects.
Our business could be materially adversely affected as
a result of the inability to maintain adequate financing.
While our business is currently solely dependent on cash-flows
from operations to fund operations and capital expenditures we have an unused credit facility in the event that we need to supplement
current cash-flows with outside financing. The credit facility provides for certain financial covenants relating to ratios affected
by profit, asset and debt levels. If the Company’s profits, asset or cash-flow levels decline below the minimums required
to meet these covenants and we require outside financing, the Company may be materially adversely affected. Effects on the Company
could include higher interest costs, reduction in borrowing availability or revocation of these credit facilities.
We are obligated to develop and maintain a system of
effective internal controls over financial reporting. These internal controls may be determined to be not effective, which may
adversely affect investor confidence in our company and, as a result, the value of our common stock.
We have been and are required, pursuant to Section 404 of the
Sarbanes-Oxley Act, to furnish a report by management on, among other things, the effectiveness of our internal control over financial
reporting on an annual basis. This assessment includes disclosure of any material weaknesses identified by our management in our
internal control over financial reporting. During the evaluation and testing process, if we identify one or more material weaknesses
in our internal control over financial reporting, we will be unable to assert that our internal controls are effective and would
be required to disclose any material weaknesses identified in Management’s Report on Internal Control over Financial Reporting.
While we have established certain procedures and control over our financial reporting processes, we cannot assure you that these
efforts will prevent restatements of our financial statements in the future.
Our independent registered public accounting firm is also required,
pursuant to Section 404 of the Sarbanes-Oxley Act, to report on the effectiveness of our internal control over financial reporting.
For future reporting periods, our independent registered public accounting firm may issue a report that is adverse in the event
it is not satisfied with the level at which our controls are documented, designed or operating. We may not be able to remediate
any future material weaknesses, or to complete our evaluation, testing and any required remediation in a timely fashion.
If we are unable to conclude that our internal control over
financial reporting is effective, or if our independent registered public accounting firm is unable to express an opinion that
our internal controls over financial reporting are effective, investors could lose confidence in the accuracy and completeness
of our financial reports, which could cause the price of our common stock to decline, and we could be subject to sanctions or
investigations by regulatory authorities, including the SEC and Nasdaq. Failure to remediate any material weakness in our internal
control over financial reporting, or to maintain other effective control systems required of public companies, could also restrict
our future access to the capital markets.
Risks Related to Ownership of Our Common Stock
Sales of a substantial number of shares of our common
stock in the public market could cause our market price to decline.
Sales of a substantial number of shares of our common stock
in the public market, or the perception that these sales might occur, could depress the market price of our common stock and could
impair our ability to raise capital through the sale of additional equity securities. We are unable to predict the effect that
sales, particularly sales by our directors, executive officers, and significant stockholders, may have on the prevailing market
price of our common stock. Additionally, the shares of common stock subject to outstanding options under our equity incentive
plans and the shares reserved for future issuance under our equity incentive plans, as well as shares issuable upon vesting of
restricted stock awards, will become eligible for sale in the public market in the future, subject to certain legal and contractual
limitations.
If securities or industry analysts do not publish research
or reports about our business, or publish negative reports about our business, our share price and trading volume could decline.
The trading market for our common stock depends, in part, on
the research and reports that securities or industry analysts publish about us or our business. We do not have any control over
these analysts. If our financial performance fails to meet analyst estimates or one or more of the analysts who cover us downgrade
our shares or change their opinion of our shares, our share price would likely decline. If one or more of these analysts cease
coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which could
cause our share price or trading volume to decline.
We do not intend to pay dividends for the foreseeable
future and, as a result, your ability to achieve a return on your investment will depend on appreciation in the price of our common
stock.
We do not intend to pay any cash dividends in the foreseeable
future. We anticipate that we will retain all of our future earnings for use in the development of our business and for general
corporate purposes. Any determination to pay dividends in the future will be at the discretion of our board of directors and subject
to the restrictions on paying dividends in our Revolving Credit Facility which expires in June 2021 and any future indebtedness.
Accordingly, investors must rely on sales of their common stock after price appreciation, which may never occur, as the only way
to realize any future gains on their investments.
Mr. Soloway, members of management and certain directors
own a significant portion of our outstanding voting stock and exert significant influence over our business and affairs.
Richard L. Soloway, our Chief Executive Officer, members of
management and our board of directors (“Board”) beneficially own approximately 36% of our common stock. Their significant
ownership will, for the foreseeable future, enable them to control our management and affairs, and most matters requiring stockholder
approval, including the election of directors, financing activities, a merger or sale of our assets and other significant corporate
transactions. They may, in their discretion, elect to exercise these or similar rights at any time. Furthermore, the Company has
established a staggered Board where the election of only one class of directors can be held at each annual meeting. This concentration
of ownership, as well as a staggered or classified Board, could have the effect of delaying or preventing a change in our control
or otherwise discouraging a potential acquirer from attempting to obtain control of us, which in turn could materially adversely
affect our stock price and may prevent attempts by our stockholders to replace or remove our Board or management. The Company
filed a Registration Statement on Form S-3 pursuant to which Mr. Soloway may sell up to 2,568,032 shares over the next three years.
If all such shares are sold, members of management and our Board will continue to beneficially own approximately 22% of our common
stock and will likely to continue to be able exert the control described above.
ITEM 1B: UNRESOLVED STAFF COMMENTS.
Not applicable.
ITEM 2: PROPERTIES.
The Company owns executive offices and production
and warehousing facilities at 333 Bayview Avenue, Amityville, New York. This facility consists of a fully-utilized building of
approximately 95,000 square foot on a six acre plot. This six-acre plot provides the Company with space for expansion of office,
manufacturing and storage capacities. These facilities are pledged as security in the Company’s credit facilities with its
primary bank.
The Company's foreign subsidiary located
in the Dominican Republic, Napco DR, S.A., owns a building of approximately 180,000 square feet of production and warehousing
space in the Dominican Republic. That subsidiary also leases the land associated with this building under a 99-year lease expiring
in the year 2092 at an annual cost of approximately $288,000. As of June 30, 2020, a majority of the Company's products were manufactured
at this facility, utilizing U.S. quality control standards.
Management believes that these facilities
are more than adequate to meet the needs of the Company in the foreseeable future.
ITEM 3: LEGAL PROCEEDINGS.
There are no pending or threatened material
legal proceedings to which NAPCO or its subsidiaries or any of their property is subject. The Company is party to an IRS proceeding
described under Income Taxes and in Note 6 to the consolidated financial statements.
.
In the normal course of business, the Company
is a party to claims and/or litigation. Management believes that the settlement of such claims and/or litigation, considered in
the aggregate, will not have a material adverse effect on the Company's financial position and results of operations.
ITEM 4: MINE SAFETY DISCLOSURE.
Not Applicable.
PART II
ITEM 5: MARKET FOR THE REGISTRANT'S COMMON
EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Principal Market
NAPCO's Common Stock is traded on the NASDAQ
Stock Market, Global Market System, under the symbol NSSC.
Approximate Number of Security Holders
The number of holders of record of NAPCO's
Common Stock as of September 10, 2020 was 71 (such number does not include beneficial owners of stock held in nominee name).
Dividend Information
NAPCO has declared no cash dividends during
the past two years with respect to its Common Stock.
Equity Compensation Plan Information
as of June 30, 2020
Equity compensation plans not approved by security holders: — — —
ITEM 6: SELECTED FINANCIAL DATA.
The table below summarizes selected financial
information. For further information, refer to the audited consolidated financial statements and the notes thereto beginning on
page FS-1 of this report.
Fiscal Year Ended and at June 30
(In thousands, except share and per share data)
Statement of earnings data:
Cash Flow Data:
Per Share Data:
Net earnings per common share:
Weighted average common shares outstanding:
Cash Dividends declared per common share (1) $ .00 $ .00 $ .00 $ .00 $ .00
Balance sheet data:
(1) The Company has never paid a cash dividend on its common stock.
ITEM 7: MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Overview
NAPCO is one of the leading manufacturers
and designers of high-tech electronic security devices, as well as a leading provider of school safety solutions. We offer a diversified
array of security products, encompassing access control systems, door-locking products, intrusion and fire alarm systems and video
surveillance products. These products are used for commercial, residential, institutional, industrial and governmental applications,
and are sold worldwide principally to independent distributors, dealers and installers of security equipment. We have experienced
significant growth in recent years, primarily driven by fast growing recurring service revenues generated from wireless communication
services for intrusion and fire alarm systems, as well as our school security products that are designed to meet the increasing
needs to enhance school security as a result of on-campus shooting and violence in the U.S.
Since 1969, NAPCO has established a heritage and proven record
in the professional security community for reliably delivering both advanced technology and high quality security solutions, building
many of the industry’s best-known brands, such as NAPCO Security Systems, Alarm Lock, Continental Access, Marks USA, and
other popular product lines: including Gemini and F64-Series hardwire/wireless intrusion systems and iSee Video internet video
solutions. We are also dedicated to developing innovative technology and producing the next generation of reliable security solutions
that utilize remote communications and wireless networks, including our StarLink, iBridge, and more recently the iSecure product
lines. Today, millions of businesses, institutions, homes, and people around the globe are protected by products from the NAPCO
Group of Companies.
Our net sales were $101.4 million and $102.9 million for the
fiscal years ended June 30, 2020 and 2019, respectively. The changes of our net sales during these periods were driven primarily
by increased sales of our products in the recurring revenue business as offset by a 34% decrease in sales of hardware in the fourth
quarter of fiscal 2020 as compared to the same period a year ago. This decrease was due primarily to the economic effects of the
COVID-19 pandemic and the related closures mandated by federal and state governments. Our net income was $8.5 million and
$12.2 million for the fiscal years ended June 30, 2020 and 2019, respectively. The decrease in net income during this period was
due primarily to the COVID-19 impact described above as partially offset by the growth of our recurring revenue business, implementation
of cost-reduction measures.
Economic and Other Factors
We are subject to the effects of general
economic and market conditions. In the event that the U.S. or international economic conditions deteriorate, our revenue, profit
and cash-flow levels could be materially adversely affected in future periods. In the event of such deterioration, many of our
current or potential future customers may experience serious cash flow problems and as a result may, modify, delay or cancel purchases
of our products. Additionally, customers may not be able to pay, or may delay payment of, accounts receivable that are owed to
us. If such events do occur, they may result in our fixed and semi-variable expenses becoming too high in relation to our revenues
and cash flows.
Seasonality
The Company's fiscal year begins on July 1 and ends on June
30. Historically, the end users of the Company’s products want to install its products prior to the summer; therefore sales
of its products historically peak in the period April 1 through June 30, the Company's fiscal fourth quarter, and are reduced
in the period July 1 through September 30, the Company's fiscal first quarter. In addition, demand for our products is affected
by the housing and construction markets. Deterioration of the current economic conditions may also affect this trend.
Our fourth quarter of fiscal 2020 reflects the challenging
business environment resulting from the COVID-19 pandemic. The COVID-19 pandemic has caused difficulties for security equipment
professionals getting access to both commercial and residential installation sites. The Company believes this access issue is
an industry-wide issue related to COVID-19 and not reflective of the loss of any market share unique to the Company or any long-term
negative reflection of the post-pandemic vibrancy of the security industry as a whole.
Critical Accounting Policies and Estimates
The Company's significant accounting policies
are fully described in Note 1 to the Company's consolidated financial statements included in its 2020 Annual Report on Form 10-K. Management
believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in
the preparation of its consolidated financial statements.
Net Sales
The Company is engaged in one major line of business:
the development, manufacture, and distribution of security products, encompassing access control systems, door security products,
intrusion and fire alarm systems, alarm communication services, and video surveillance products for commercial and residential
use. The Company also provides wireless communication service for intrusion and fire alarm systems on a monthly basis. These products
are used for commercial, residential, institutional, industrial and governmental applications, and are sold worldwide principally
to independent distributors, dealers and installers of security equipment. Sales to unaffiliated customers are primarily shipped
from the United States. The Company has customers worldwide with major concentrations in North America.
Revenue is recognized upon transfer of control of
promised products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange
for those products or services.
For product sales the Company typically transfers
control at a point in time upon shipment or delivery of the product. For monthly communication services the Company satisfies
its performance obligation as the services are rendered and therefore recognizes revenue over the monthly period.
Typically timing of revenue recognition coincides
with the timing of invoicing to the customers, at which time the Company has an unconditional right to consideration. As such,
the Company typically records a receivable when revenue is recognized.
The contract with the customer states the final
terms of the sale, including the description, quantity, and price of each product purchased. Payment for product sales is typically
due within 30 and 180 days of the delivery date. Payment for monthly communication services is billed on a monthly basis and is
typically due at the beginning of the month of service.
The Company provides limited standard warranty for
defective products, usually for a period of 24 to 36 months. The Company accepts returns for such defective products as well as
for other limited circumstances. The Company also provides rebates to customers for meeting specified purchasing targets and other
coupons or credits in limited circumstances. The Company establishes reserves for the estimated returns, rebates and credits and
measures such variable consideration based on the expected value method using an analysis of historical data. Changes to the estimated
variable consideration in subsequent periods are not material.
The Company analyzes sales returns
and is able to make reasonable and reliable estimates of product returns based on the Company’s past history. Estimates
for sales returns are based on several factors including actual returns and based on expected return data communicated to it by
its customers. Accordingly, the Company believes that its historical returns analysis is an accurate basis for its allowance for
sales returns. Actual results could differ from those estimates. As a percentage of gross sales, sales returns, rebates and allowances
were 9% and 8% for the fiscal years ended June 30, 2020 and 2019, respectively.
Concentration of Credit Risk
An entity is more vulnerable to
concentrations of credit risk if it is exposed to risk of loss greater than it would have had if it mitigated its risk through
diversification of customers. Such risks of loss manifest themselves differently, depending on the nature of the concentration,
and vary in significance. The Company had one customer with an accounts receivable balance that comprised 24% and 19% of the Company’s
accounts receivable at June 30, 2020 and 2019, respectively. Sales to this customer did not exceed 10% of net sales during fiscal
year ended June 30, 2020. Sales to this customer comprised 10% of net sales during fiscal year ended June 30, 2019. The Company
had another customer with an accounts receivable balance that comprised 10% of the Company’s accounts receivable at June
30, 2020. Sales to this customer did not exceed 10% of net sales in either of the fiscal years ended June 30, 2020 and 2019. The
Company had another customer with an accounts receivable balance that comprised 10% of the Company’s accounts receivable
at June 30, 2019. Sales to this customer did not exceed 10% of net sales in either of the fiscal years ended June 30, 2020 and
2019.
In the ordinary course of business,
we have established a reserve for doubtful accounts and customer deductions in the amount of $326,000 and $88,000 as of June 30,
2020 and 2019, respectively. Our reserve for doubtful accounts is a subjective critical estimate that has a direct impact on reported
net earnings. This reserve is based upon the evaluation of accounts receivable agings, specific exposures and historical or anticipated
events.
Inventories
Inventories are valued at the
lower of cost or net realizable value, with cost being determined on the first-in, first-out (FIFO) method. The reported net value
of inventory includes finished saleable products, work-in-process and raw materials that will be sold or used in future periods.
Inventory costs include raw materials, direct labor and overhead. The Company’s overhead expenses are applied based, in
part, upon estimates of the proportion of those expenses that are related to procuring and storing raw materials as compared to
the manufacture and assembly of finished products. These proportions, the method of their application, and the resulting overhead
included in ending inventory, are based in part on subjective estimates and actual results could differ from those estimates.
In addition, the Company records
an inventory obsolescence reserve, which represents the difference between the cost of the inventory and its estimated realizable
value, based on various product sales projections. This reserve is calculated using an estimated obsolescence percentage applied
to the inventory based on age, historical trends, requirements to support forecasted sales, and the ability to find alternate
applications of its raw materials and to convert finished product into alternate versions of the same product to better match
customer demand. There is inherent professional judgment and subjectivity made by both production and engineering members of management
in determining the estimated obsolescence percentage. In addition, and as necessary, the Company may establish specific reserves
for future known or anticipated events. The Company also regularly reviews the period over which its inventories will be converted
to sales. Any inventories expected to convert to sales beyond 12 months from the balance sheet date are classified as non-current.
Intangible Assets
Impairment
of Long-lived Assets – The Company reviews its long-lived assets and certain identifiable intangibles for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets
to be held and used is measured by a comparison of the carrying amount of an asset group to future net undiscounted cash flows
expected to be generated by the asset group. If such assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed
of are reported at the lower of the carrying amount or fair value less costs to sell. As of June 30, 2020 and 2019, the Company
has determined that no impairment of long-lived assets exists.
The Company evaluates its indefinite-lived
intangible assets for impairment at least on an annual basis and will evaluate them earlier if there are indicators of a potential
impairment. Those intangible assets that are classified as other intangibles with indefinite lives are not amortized. Impairment
testing is performed in two steps: (i) the Company determines if there is impairment by comparing the fair value of a reporting
unit with its carrying value, and (ii) if there is impairment, the Company measures the amount of impairment loss by comparing
the implied fair value of intangible assets with the carrying amount of the intangible assets.The Company has concluded that no impairment of intangible assets occurred during the year
ended June 30, 2019. During the 4th quarter of fiscal 2020, the Company determined that its indefinite-lived
intangible asset relating to its Marks USA I subsidiary trade-name was impaired. Accordingly, the Company recorded an impairment
charge of $1,852,000 and as a result concluded that the asset no longer was considered to have an indefinite-life and reclassified
the remaining balance of the underlying asset from indefinite-lived to a long-lived asset with a remaining useful life of 20 years
as of June 30, 2020.
Income Taxes
The Company has identified the
United States and New York State as its major tax jurisdictions. Fiscal year 2017 is currently under audit by the Internal Revenue
Service (“IRS”). Fiscal year 2018 and forward years are still open for examination. In addition, the Company has a
wholly-owned subsidiary which operates in a Free Zone in the Dominican Republic (“DR”) and is exempt from DR income
tax.
The Company was audited by the
IRS for the fiscal year 2016. In July 2019, the Company received Form 4549-A, Income Tax Examination Changes from the IRS proposing
an adjustment to income for the fiscal 2016 tax year regarding deemed dividends based on its interpretation of Internal Revenue
Code (“IRC”) Section 956 arising from the intercompany balances on the books of the Company. In August 2019, the Company
filed a formal protest with the IRS requesting an opportunity to appeal the examination findings to the Appeals Office. During
fiscal year 2020, the Company settled the issue at Appeals. There is a provision booked for the federal and state impact of $762,000
and $70,000, respectively.
The Company is currently under
audit for the fiscal year 2017. The IRS has raised the IRC Section 956 issue that was settled during the fiscal year 2016 audit.
The Company strongly believes that the position of the IRS with regard to this matter is inconsistent with the provisions of IRC
Section 956 and that the Company is willing to go to court, if necessary to argue its position. During fiscal 2020, a provision
for the incremental tax liability of $657,000 and interest of 66,000 was recorded for the 2017 and 2018 fiscal years.
For the year ended June 30, 2020,
the Company recognized a net income tax expense of $2,284,000. During the year ending June 30, 2020 the Company increased its
reserve for uncertain income tax positions by $824,000. The Company’s practice is to recognize interest and penalties related
to income tax matters in income tax expense and accrued income taxes. As of June 30, 2020, the Company had accrued interest totaling
$83,000 and $866,000 of unrecognized net tax benefits that, if recognized, would favorably affect the Company’s effective
income tax rate in any future period. The Company claims research and development (“R&D”) tax credits on eligible
research and development expenditures. The R&D tax credits are recognized as a reduction to income tax expense.
Deferred tax assets and liabilities
are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying
amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered
or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that
includes the enactment date. Deferred income tax expense represents the change during the period in the deferred tax assets and
deferred tax liabilities. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more
likely than not that some portion or all of the deferred tax assets will not be realized. The Company measures and recognizes
the tax implications of positions taken or expected to be taken in its tax returns on an ongoing basis.
Leases
Effective
July 1, 2019, the Company adopted the new lease accounting standard using the modified retrospective transition option of applying
the new standard at the adoption date. In addition, we elected the package of practical expedients permitted under the transition
guidance within the new standard, which among other things, allowed us to not reassess (1) whether any expired or existing contracts
are or contain leases, (2) lease classification for any expired or existing leases, and (3) initial direct costs for any existing
leases. Adoption of the new standard resulted in the recording of an operating ROU asset and lease liabilities of approximately
$7.7 million. Given the length of the lease term, the right-of-use asset and corresponding liability assume a weighted
discount rate as disclosed below. A change in the rate utilized could have a material effect on the amounts reported. Financial
positions for reporting periods beginning on or after July 1, 2019 are presented under new guidance, while prior period amounts
are not adjusted and continue to be reported in accordance with previous guidance.
Liquidity and Capital Resources
The Company's cash on hand as of June 30,
2020 combined with proceeds from operating activities during fiscal 2020 were adequate to meet the Company's capital expenditure
and financing needs during fiscal 2020. The Company's primary internal source of liquidity is the cash flow generated from operations.
The primary source of external financing is a revolving credit facility of $11,000,000 (the “Revolving Credit Facility”)
which expires in June 2021. As of June 30, 2020, $0 was outstanding under this revolving line of credit. The Company has not drawn
on this line of credit since June of 2018. In the fourth quarter of fiscal 2020 the Company applied for and received a loan of
$3,904,000 under the Federal government’s Payroll Protection Program (“PPP”) administered by the U.S. Small
Business Administration (“SBA”). Pursuant to the CARES Act, the loan may be forgiven by the SBA. The Company anticipates
applying for forgiveness of these loans during fiscal 2021. The amount of loan forgiveness is determined by and is subject to
the sole approval of the SBA. As of June 30, 2020, the Company's unused sources of funds consisted principally of $18,248,000
in cash and cash equivalents and $11,000,000 unused balance available under its revolving line of credit.
The Revolving Credit Facility contains various
restrictions and covenants including, among others, restrictions on payment of dividends, restrictions on borrowings and compliance
with certain financial ratios, as defined in the restated agreement.
During the year ended June 30, 2020, the
Company utilized a portion of its cash on hand at June 30, 2019 ($4,069,000 of $8,028,000) to repurchase outstanding shares of
its stock ($2,454,000) and purchase property, plant and equipment ($1,615,000).
As of June 30, 2020, the Company’s
primary outside source of financing consisted of the Revolving Credit Facility of $11,000,000 which expires in June 2021 and the
PPP loans which expire in April and May of 2022. As of June 30, 2020 and 2019, there were no outstanding balances under the Revolving
Credit Facility and $3,904,000 was outstanding under the PPP loans. These facilities are described more fully in Note 7 to the
consolidated financial statements.
The Company believes its current working
capital, anticipated cash flows from operations and its Revolving Credit Agreement will be sufficient to fund the Company’s
operations through at least the next twelve months.