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.
The Company takes into consideration several
factors in measuring its liquidity, including the ratios set forth below:
As of June 30,
Current Ratio 4.5 to 1 4.6 to 1
Sales to Receivables 4.4 to 1 4.0 to 1
Total debt to equity 0.1 to 1 0.0 to 1
As of June 30, 2020, the Company had no material
commitments for capital expenditures or inventory purchases other than purchase orders issued in the normal course of business.
On April 26, 1993, the Company's foreign subsidiary entered into a 99-year land lease of approximately 4 acres of land in the
Dominican Republic, on which the Company’s principle manufacturing facility is located, at an annual rent of approximately
$288,000.
Working Capital. Working capital increased
by $19,963,000 to $61,046,000 at June 30, 2020 from $51,083,000 at June 30, 2019. Working capital is calculated by deducting Current
Liabilities from Current Assets.
Accounts Receivable. Accounts Receivable
decreased by $3,038,000 to $22,932,000 at June 30, 2020 as compared to $25,970,000 at June 30, 2019. The decrease in Accounts
Receivable was due primarily to a decrease in hardware sales for the quarter ended June 30, 2020 as compared to the same quarter
a year ago.
Inventories. Inventories, which include
both current and non-current portions, increased by $6,917,000 to $41,755,000 at June 30, 2020 as compared to $34,838,000 at June
30, 2019. The increase was due primarily to the Company building up levels of its recently introduced and soon to be introduced
new products.
Accounts Payable and Accrued Expenses.
Accounts payable and accrued expenses, not including income taxes payable, increased by $648,000 to $14,472,000 as of June
30, 2020 as compared to $13,824,000 at June 30, 2019. This increase is primarily due to the increase in inventory as described
above.
Off-Balance Sheet Arrangements
The Company does not maintain any off-balance
sheet arrangements.
Results of Operations
Fiscal 2020 Compared to Fiscal 2019
Fiscal year ended June 30, (dollars in thousands)
Gross profit as a % of net sales 43.0 % 42.6 % 0.9 %
Selling, general and administrative as a % of net sales 23.4 % 22.6 % 3.5 %
Impairment of intangible asset 1,852 - -
Interest expense, net 9 21 (57.1 )%
Net sales in fiscal 2020 decreased by $1,573,000
to $101,359,000 as compared to $102,932,000 in fiscal 2019. The decrease in net sales was primarily due to decreased sales of
the Company’s Alarm Lock brand door-locking products ($2,565,000), Marks brand door-locking products ($5,258,000), and Continental
brand access control products ($542,000) as partially offset by increased sales of the Company’s recurring alarm communication
services ($6,608,000) and Napco brand intrusion products ($200,000). The Company’s hardware sales were negatively impacted
by the COVID-19 pandemic, which 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.
The Company's gross profit decreased by $298,000
to $43,592,000 or 43.0% of net sales in fiscal 2020 as compared to $43,890,000 or 42.6% of net sales in fiscal 2019. Gross profit
on hardware sales was $23,380,000 or 30.1% of net hardware sales in fiscal 2020 and $30,265,000 or 35.4% of net hardware sales,
in fiscal 2019. Gross profit on service revenues was $19,712,000 or 82.0% of net service revenues in fiscal 2020 and $13,625,000
or 78.2% of net service revenues, in fiscal 2019. Gross profit was primarily affected by the decrease in hardware sales as discussed
above as partially offset by increased service revenues.
Research and Development expenses remained
relatively constant at $7,257,000 in fiscal 2020 as compared to $7,212,000 in fiscal 2019.
Selling, general and administrative expenses
for fiscal 2020 increased by $458,000 to $23,670,000 as compared to $23,212,000 in fiscal 2019. Selling, general and administrative
expenses as a percentage of net sales increased to 23.4% in fiscal 2020 from 22.6% in fiscal 2019. The increase in dollars resulted
primarily from increases in employee compensation. The increase as a percentage of sales was primarily the result of the decrease
in net sales as described above and the increased employee compensation expenses.
At the conclusion 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 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. There was no impairment charge for the year
ended June 30, 2019.
Interest expense for fiscal 2020 remained
relatively constant at $9,000 as compared to $21,000 for the same period a year ago.
The Company’s provision for income
taxes for fiscal 2020 increased by $1,062,000 to $2,284,000 as compared to $1,222,000 for the same period a year ago. The Company’s
effective tax rate increased to 21% for fiscal 2020 as compared to 9% for fiscal 2019. The increase in the Company’s effective
tax rate resulted from the resolution of an IRS audit of the Company’s 2016 fiscal year, resulting in an additional provision
of $1,555,000.
Net income for fiscal 2020 decreased by $3,703,000
to $8,520,000 as compared to $12,223,000 in fiscal 2019. This resulted primarily from the items discussed above.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K and the documents we incorporate
by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or
the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. All statements, other
than statements of historical fact, included or incorporated in this prospectus regarding our strategy, future operations, clinical
trials, collaborations, intellectual property, cash resources, financial position, future revenues, projected costs, prospects,
plans, and objectives of management are forward-looking statements. The words “believes,” “anticipates,”
“estimates,” “plans,” “expects,” “intends,” “may,” “could,”
“should,” “potential,” “likely,” “projects,” “continue,” “will,”
“schedule,” “would,” and similar expressions are intended to identify forward-looking statements, although
not all forward-looking statements contain these identifying words. We cannot guarantee that we actually will achieve the plans,
intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking
statements. These forward-looking statements involve known and unknown risks, uncertainties, and other factors, which may be beyond
our control, and which may cause our actual results, performance, or achievements to be materially different from future results,
performance, or achievements expressed or implied by such forward-looking statements. There are a number of important factors
that could cause our actual results to differ materially from those indicated or implied by forward-looking statements. See “Risk
Factors” in our Annual Report on Form 10-K for the year ended June 30, 2020 for more information. These factors and the
other cautionary statements made in this prospectus and the documents we incorporate by reference should be read as being applicable
to all related forward-looking statements whenever they appear in this prospectus and the documents we incorporate by reference.
In addition, any forward-looking statements represent our estimates only as of the date that this prospectus is filed with the
SEC and should not be relied upon as representing our estimates as of any subsequent date. We do not assume any obligation to
update any forward-looking statements. We disclaim any intention or obligation to update or revise any forward-looking statement,
whether as a result of new information, future events or otherwise, except as may be required by law.
ITEM 7A: QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's principal financial instrument
is long-term debt (consisting of a revolving credit facility) that provides for interest based on the prime rate or LIBOR as described
in the agreement and the PPP loans which provides for interest at 1%. The Company is affected by market risk exposure primarily
through the effect of changes in interest rates on amounts payable by the Company under these credit facilities.
All foreign sales transactions by the Company
are denominated in U.S. dollars. As such, the Company has shifted foreign currency exposure onto its foreign customers. As a result,
if exchange rates move against foreign customers, the Company could experience difficulty collecting unsecured accounts receivable,
the cancellation of existing orders or the loss of future orders. The foregoing could materially adversely affect the Company's
business, financial condition and results of operations. We are also exposed to foreign currency risk relative to expenses incurred
in Dominican Pesos ("RD$"), the local currency of the Company's production facility in the Dominican Republic. The result
of a 10% strengthening or weakening in the U.S. dollar to the RD$ would result in an annual increase or decrease in income from
operations of approximately $700,000.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY
DATA.
a. Financial Statements: Financial statements required pursuant
to this Item are presented on pages FS-1 through FS-25 of this report as follows:
NAPCO SECURITY TECHNOLOGIES, INC. AND
SUBSIDIARIES
Page
Management Report on Internal Control FS-1
Report of Independent Registered Public Accounting Firm FS-2
Consolidated Financial Statements:
Consolidated Balance Sheets as of June 30, 2020 and 2019 FS-4
Notes to Consolidated Financial Statements FS-8
Management Report on Internal Control
Management has prepared and is responsible for our consolidated
financial statements and related notes. Management is also responsible for establishing and maintaining adequate internal control
over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. Napco
Technologies, Inc. (the “Company”) internal control over financial reporting includes those policies and procedures
that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures
of the Company are being made only in accordance with the authorizations of management and directors of the Company; and (iii)
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the
Company’s assets that could have a material effect on the financial statements.
Internal control over financial reporting is designed to provide
reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements prepared for
external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control
over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future
periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
A material weakness is a deficiency, or a combination of deficiencies,
in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the
company’s annual or interim financial statements will not be prevented or detected on a timely basis.
Management conducted an assessment of the effectiveness of
internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013)
as issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management determined
that as of June 30, 2020, the Company did maintain effective internal control over financial reporting.
The effectiveness of our internal control over financial reporting
as of June 30, 2020 has been audited by Baker Tilly US LLP (formerly Baker
Tilly Virchow Krause, LLP), an independent registered public accounting firm, as stated in their report included herein.
FS-1
Report of Independent
Registered Public Accounting Firm
To the stockholders and board of directors of Napco Security
Technologies, Inc. and Subsidiaries:
Opinions on the Financial Statements and Internal Control
over Financial Reporting
We have audited the accompanying consolidated balance sheets
of Napco Security Technologies, Inc. and Subsidiaries (the "Company") as of June 30, 2020 and 2019, the related consolidated
statements of income, stockholders’ equity, and cash flows, for each of the two years in the period ended June 30, 2020,
and the related notes (collectively referred to as the "consolidated financial statements"). We also have audited the
Company’s internal control over financial reporting as of June 30, 2020, based on criteria established in Internal Control
– Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the consolidated financial statements present
fairly, in all material respects, the financial position of the Company as of June 30, 2020 and 2019, and the results of their
operations and their cash flows for each of the two years in the period ended June 30, 2020, in conformity with accounting principles
generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective
internal control over financial reporting as of June 30, 2020, based on criteria established in Internal Control – Integrated
Framework: (2013) issued by COSO.
Basis for Opinions
The Company’s management is responsible for these consolidated
financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness
of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over
Financial Reporting. Our responsibility is to express an opinion on the Company's consolidated financial statements and an opinion
on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered
with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with
respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities
and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of
the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement, whether due to error or fraud and whether effective internal control over
financial reporting was maintained in all material respects.
Our audits of the financial statements included performing
procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or
fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence
regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the
accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of
the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an
understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing
and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also
included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide
a reasonable basis for our opinions.
FS-2
Definition and Limitations of Internal Control Over Financial
Reporting
A company's internal control over financial reporting is a
process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations
of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over
financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods
are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
We have served as the Company's auditor since 2009.
/s/BAKER
TILLY US LLP (FORMERLY BAKER TILLY VIRCHOW KRAUSE, LLP)
Melville, New York
September 15, 2020
FS-3
NAPCO
SECURITY TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
CURRENT ASSETS (in thousands, except share data)
Prepaid expenses and other current assets 2,049 1,881
Property, plant and equipment, net 8,088 7,694
Operating lease asset 7,395 -
CURRENT LIABILITIES
Current portion of long-term debt 1,794 -
Long term debt 2,110 -
Deferred income taxes 112 72
Long term operating lease liabilities 7,113 -
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 105,838 $ 85,908
See accompanying
notes to consolidated financial statements.
FS-4
NAPCO
SECURITY TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Fiscal Year ended June 30,
Net sales: (in thousands, except for share and per share data)
Cost of sales:
Selling, general, and administrative expenses 23,670 23,212
Impairment of intangible asset 1,852 -
Other expense:
Interest expense, net 9 21
Income before Provision for Income Taxes 10,804 13,445
Income per share:
Weighted average number of shares outstanding:
See accompanying
notes to consolidated financial statements.
FS-5
NAPCO
SECURITY TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED
STATEMENT OF STOCKHOLDERS’ EQUITY
(in thousands except for share data)
Common Stock Treasury Stock
Implementation of ASC606 - - - - - (719 ) (719 )
Stock-based compensation expense - - 160 - - - 160
Stock-based compensation expense - - 583 - - - 583
See accompanying
notes to consolidated financial statements.
FS-6
NAPCO
SECURITY TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED
STATEMENTS OF CASH FLOWS
Fiscal Year ended June 30,
(in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Depreciation and amortization 1,495 1,409
Impairment of intangible asset 1,852 -
Provision for doubtful accounts 238 (26 )
Change to inventory obsolescence reserve (124 ) (272 )
Deferred income taxes 40 755
Stock based compensation expense 583 160
Changes in operating assets and liabilities:
Prepaid expenses and other current assets (168 ) 318
Other assets - (11 )
Net Cash Provided by Operating Activities 10,305 8,653
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, plant, and equipment (1,615 ) (1,988 )
Net Cash Used in Investing Activities (1,615 ) (1,988 )
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from long-term debt 3,904 -
Proceeds from stock option exercises 80 53
Cash paid for purchase of treasury stock (2,454 ) (3,998 )
Net Cash Provided by (Used in) Financing Activities 1,530 (3,945 )
Net Change in Cash and Cash Equivalents 10,220 2,720
CASH AND CASH EQUIVALENTS - Beginning 8,028 5,308
CASH AND CASH EQUIVALENTS - Ending $ 18,248 $ 8,028
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid, net $ 29 $ 23
Surrender of Common Shares - 8
See accompanying notes to consolidated
financial statements.
FS-7
NAPCO SECURITY TECHNOLOGIES,
INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - Nature of Business and Summary of Significant Accounting
Policies
Nature of Business:
Napco Security Technologies, Inc (“NAPCO”, “the
Company”, “we”) 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.
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.
Significant Accounting Policies:
Principles of Consolidation
The consolidated financial statements include
the accounts of Napco Security Technologies, Inc. and all of its wholly-owned subsidiaries. All inter-company balances and transactions
have been eliminated in consolidation.
Accounting Estimates
The preparation of financial statements in
conformity with Generally Accepted Accounting Principles (“GAAP”) requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of contingent gains and losses at the date of the financial
statements and the reported amounts of revenues and expenses during the reporting period. Critical estimates include management's
judgments associated with reserves for sales returns and allowances, allowance for doubtful accounts, inventory reserves, valuation
of intangible assets and income taxes. Actual results could differ from those estimates.
Fair Value of Financial Instruments
The
methods and assumptions used to estimate the fair value of the following classes of financial instruments were: Current
Assets and Current Liabilities - The carrying amount of cash and cash equivalents, certificates of deposits, current receivables
and payables and certain other short-term financial instruments approximate their fair value as of June 30, 2020 and 2019 due
to their short-term maturities. Long-term debt and lease liabilities reflect fair value based on prevailing market rates.
FS-8
Cash and Cash Equivalents
Cash and cash equivalents include approximately
$460,000 of short-term time deposits at June 30, 2020 and 2019. The Company considers all highly liquid investments with original
maturities of three months or less to be cash equivalents. The Company has cash balances in banks in excess of the maximum amount
insured by the FDIC and other international agencies as of June 30, 2020 and 2019. The Company has not historically experienced
any credit losses with balances in excess of FDIC limits.
Accounts Receivable
Accounts receivable is stated net of the
reserves for doubtful accounts of $326,000 and $88,000 as of June 30, 2020 and 2019, respectively. Our reserves for doubtful accounts
are subjective critical estimates that have a direct impact on reported net earnings. These reserves are based upon the evaluation
of our accounts receivable aging, specific exposures, sales levels and historical trends.
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 any excess of the cost of the inventory over 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. In addition,
and as necessary, the Company may establish specific reserves for future known or anticipated events. There is inherent professional
judgment and subjectivity made by both production and engineering members of management in determining the estimated obsolescence
percentage.
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.
Property, Plant, and Equipment
Property, plant, and equipment are carried
at cost less accumulated depreciation. Expenditures for maintenance and repairs are charged to expense as incurred; costs of major
renewals and improvements are capitalized. At the time property and equipment are retired or otherwise disposed of, the cost and
accumulated depreciation are eliminated from the asset and accumulated depreciation accounts and the profit or loss on such disposition
is reflected in income.
Depreciation is recorded over the estimated
service lives of the related assets using primarily the straight-line method. Amortization of leasehold improvements is calculated
by using the straight-line method over the estimated useful life of the asset or lease term, whichever is shorter.
Intangible Assets
Intangible assets determined to have indefinite
lives are not amortized but are tested for impairment at least annually. Intangible assets with definite lives are amortized over
their useful lives. Infinite-lived intangible assets are reviewed for impairment at least annually at the Company’s fiscal
year end of June 30 or more often whenever there is an indication that the carrying amount may not be recovered.
The
Company’s acquisition of substantially all of the assets and certain liabilities of G. Marks Hardware, Inc. (“Marks”)
in August 2008 included intangible assets recorded at fair value on the date of acquisition. The customer relationships
are amortized over their estimated useful lives of twenty years. The Marks trade name was deemed to have an indefinite life. At
the conclusion of fiscal 2020, the Company determined that the trade-name was impaired. Accordingly, the Company recorded an impairment
charge of $1,852,000 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.
FS-9
Changes in intangible assets are as follows
(in thousands):