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Napco Security Technologies
Manufacturing recurring revenue
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Founded in 1969 by Richard Soloway, who is, believe-it-or-not, still the CEO, Napco Security Technologies is a leading manufacturer of security systems. Soloway founded the company at 22 years old and has been at the helm ever since. The company’s products consist of electronic door locks, alarms, and control panels.
Napco has a razor-and-blades business model where its devices require cellular communications services. These recurring services carry 90% gross margins and now make up 35% of revenue, up from just 12% five years ago.
This is like the classic ADT home alarm model where it’s pretty cheap to get the alarms and cameras installed but then you pay a subscription to make sure their command center is always looped in.
But Napco’s long-term goal is to have recurring services make up at least half of the business; understandably so since the hardware gross margins are ~20%’s. Right now, recurring revenue actually accounts for 60% of overall gross profit though just because of the margin differential in the business segments.
Importantly, the company differs from ADT in that it focuses not so much on the residential vertical but schools, churches and fire stations. In fact, Napco was chosen at my alma mater, Pepperdine University in California, to provide the lockdown services for all 1,700 dorms.
One vertical, in particular, that has really contributed to growth is fire stations. Dual-path radios (both cellular and internet) are required by law in fire stations and Napco’s StarLink (not related to SpaceX) is a leading product.
From 2020 to 2022, revenues grew from $101 million to nearly $144 million. The business is basically broken down into three equal parts:
Intrusion and alarm systems
However, door lock sales barely grew over those two years. If we exclude locks, the growth was more like 72%, or 31% compounded. One real driver was those StarLink fire systems along with the required recurring services.
Before getting further, I’d like to touch on the value chain of the company just to make sure we understand it.
Napco is the manufacturer of the product and it shares in the recurring subscription from the dealers that sell the product to end-customers.
The company actually has a huge manufacturing facility in the Dominican Republic so it can be rather flexible and receive shipments in less than 6 weeks. The product is shipped to 200 independent security dealers around the US that sells systems to commercial entities like office building owners, universities, large churches and fire stations. These dealers then go around and sell the hardware at a slight mark-up, do the installation and then take a percentage of the recurring revenue. There isn’t a clear split as it depends on a few factors like deal size and product type but that’s how the product goes from creation to sale.
So the dealers act as distributors/installers/salespeople to the end customers. A bigger company like ADT would actually be considered a security dealer that might use Napco products. The two biggest players are ADT and Johnson Controls and Napco has yet to really penetrate these accounts, though they are certainly eyeing the opportunity.
Johnson Controls does about $2.4 billion in revenue from fire and security alone and ADT does about $5.6 billion. Seeing as Napco does less than $200 million in revenue and has barely scratched the surface of the two biggest dealers, I think it’s safe to say that there is some more room to run. But it’s important to remember that 80% of Napco’s business is commercial so that $5.6 billion from ADT is likely inflated. Half of that number is probably more realistic.
Another growth driver for Napco has been the sunsetting of 3G networks. Both AT&T and, more recently, Verizon have sunset their 3G networks, leading to increased demand from customers. For instance, if a fire station had an old dual-path radio that used 3G, it would fail its safety inspection. So there was no choice – an upgrade must happen. Even if the old device that was getting switched out was also a Napco, the subscription rates are a little higher for 4/5G networks so there is some incremental benefit.
The company doesn’t convert as much of its earnings to free cash flow since it has inventory issues to deal with and somewhat lenient payment terms for its dealers. The company produced lots of products to make sure it had enough supply during all of the supply chain issues so there has been a little inventory build but it is coming down now. Further, dealers routinely have more than 30 days to pay for delivered product so at the trailing 12 months of Q3 2023, the company did $37 million in EBIT but only $10 million in FCF.
Napco has a long history of delivering quality products at a reasonable cost for its distribution network. As the recurring revenue grows, it also heavily incentivizes these distributors as they get a piece of that sweet recurring revenue. I think two takeaways for me from studying this business are 1) it plays to its strengths and 2) it’s done a great job dealing with the dynamics in its market.
For one, the company is a manufacturer. They don’t sell directly to customers and the Dominican Republic plant enables the company to efficiently improve its products. It didn’t outsource the manufacturing to China because it valued turnaround times and innovation.
Two, the company doesn’t focus on the consumer market even though it’s much bigger. By focusing on commercial buildings, it also has the perfectly aligned business model. The commercial market is so fragmented that it would be rather difficult to sell directly to customers. It’s much easier to ship products to installers and let them take the mark-up on the product. It would be far less efficient to have a huge network of salespeople doing all of the installation and marketing to individual landlords. It’s pretty much the same thing as value-added resellers in the software world.
As recurring revenue gets to 50% of the business, margins could continue to increase. Though there are a few medium term tailwinds like this, the longevity of the business and the founder are far more impressive.
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