Napco: This Company Has Excellent Dividend Growth Potential (NASDAQ:NSSC)

Introduction

Dividend growth investing is a style that really suits me as a person. I also like to have a mix of different dividend growth stocks. My portfolio consists of companies that are more stable and where the dividend is growing steadily, but I am also interested in companies with high dividend growth potential. Since I am in my early thirties, I can afford to buy quality companies with a relatively low dividend yield but with the potential to grow into dividend monsters.

With this in mind I came across the company named Napco Security Technologies, Inc. (NASDAQ:NSSC). The company has been around for a long time and has achieved a huge outperformance compared to the S&P 500 index.

And if we took a longer time frame the difference in performance is even bigger. Last year, the company has initiated a dividend and has increased it several times, the last time it was actually 25%! Does that mean that less growth can be expected? I don’t think so. The company appears to be becoming more and more mature and initiating dividend payments certainly does not have to have an impact on the long-term stock performance.

There are a lot of things that I like about the company and I would like to determine whether NSSC is worth adding to my (dividend) portfolio.

NSSC is all about security. The company was founded in 1969 and is headquartered in Amityville, New York. NSSC has a long history in the security sector and is still one of the market leaders in manufacturing security products. This includes, access control systems, commercial fire alarm systems, video intrusion alarm systems and architectural locking hardware.

If you are interested in the entire product portfolio, you can visit the NSSC investor relations website.

The company is also developing new products to keep ahead. An example of this in the all-in-one alarm for security, fire, video and connected home called “Prima”.

Prima has the potential to address different target audiences within the security market, such as residential or small businesses. This product also offers subscription options, which leads to a stream of recurring revenue.

So, now that we have a sense of what the company does, what makes NSSC a high-quality business?

Competitive advantage

What the company differentiates from its competitors is that NSSC is involved in different security product segments. Normally these products require different systems. In the case of NSSC they can offer customers one integrated solution, this should be a benefit for the company and the customer in the long run.

This is an example that NSSC itself gives in their 2023 annual report:

Another example is Pepperdine University in Malibu, California, where the Company provided a lockdown system in place for its over 1,700 dorm rooms that required both locking and access control technologies. We were chosen because we were the only security company that has both locking and access control technologies that work on the same platform and met the needs of the university.

Financials

NSSC has shown that it can grow consistently over longer periods of time.

In 10 years, the company has grew its revenue with a CAGR of 8.6%. Looking at net income is even better with a 10Y CAGR or 22.7%. FCF per share has grew with a 10Y CAGR of 19.4%. This calculation was done over FY 2014 to FY 2023. But if I took FY 2014 as the starting point to TTM, these percentages would be much higher, especially from a bottom line point of view.

This is an indication that the company is becoming increasingly profitable. NSSC seems to be a capital-light business with a CapEx to sales ratio of 1.7% ($2.962 million /$170 million), which is ideal for value creation. Talking about value creation, the ROE and ROIC shows that NSSC is excellent at doing this.

The company also has an extremely healthy balance sheet. Based on their last report they have a total cash and equivalents of $79 million and a total debt of just $5 million.

As you can see in the chart above, the net long term debt is improving and at the moment they don’t have interest expense to worry about.

In short, NSSC has a lot of high-quality characteristics. The company is also in excellent financial shape and appears to be accelerating in terms of profitability in recent years.

Opportunities for growth

The results from the past are of course nice, but investing is of course about the future. So what is left in the tank to keep on growing in terms of revenue and profitability?

Increasing demand for public safety and school security

NSSC is operating in a growing market. Based on the total addressable market there is still a lot to win. NSSC itself says the following about this:

In the U.S., there are over 100,000 K-12 schools, over 5,000 colleges and universities and over 350,000 houses of worship. Management estimates that less than 10% of these institutions have adequate protection from an active shooter or intruder.

Particularly in schools, it is important that public safety is virtually guaranteed. However, the number of terrorist actions and shooting incidents has continued to increase. Burglaries, theft and vandalism are also factors that should trigger market growth.

Based on research, the school and campus security market size was $1.82 billion in 2022 and is expected to grow with a CAGR of 11.3% through 2023 to 2029. Also in the commercial and residential security sufficient market growth can be expected.

Recurring revenue potential

What I really like about NSSC is that a significant part of their revenue (39%) has a recurring nature, generated from their communication services. This mainly consists of monthly subscription fees. Based on the numbers of the 2023 annual report, revenues of these services have increased 77% from FY 2021 to FY 2023. At the moment this services have a gross margin close to 90%. Despite the fact that these margins are insanely high, the recurring revenue also offers a safety cushion for volatility in equipment demand.

NSSC is continuing to introduce products that generate recurring revenues, such as StarLink, iBridge, iSecure and Prima. Management will continue to focus on it and they have a long-term recurring revenue target of 50% with a gross margin of around 80%.

Management

Quality companies are often led by outstanding managers. A big plus is that the company is still founder led. Founder led businesses often tend to outperform the rest. The CEO and Founder of NSSC is Richard Soloway. He has a lot of experience in the security space, just like the other members of management.

Also the CFO, Kevin Buchel has been working at NSSC for a long time (1995). Considering the company’s performance over the past decades, management has an excellent track record. It is also very important that the interests of the managers match those of you as a shareholder. Based on the 2023 annual report management own approximately 10% of total common stock, so they have significant skin in the game. Management with skin in the game are generally more focused on the long term , which offers a higher chance of outperformance.

It should be noted that there was some significant insider selling this year. This is doesn’t have to be a red flag, but it is important to keep an eye on. It isn’t the first time management has sold large amounts of shares, which at the time could not be linked to bad performance of the company.

Dividend

NSSC’s dividend history has just begun. On the 8th of May 2023 they initiated a quarterly dividend of $0.06 per share. Since then they increased it in August with a whopping 28% and in 2024 they hiked it again with 25%.

I think this is a logical step for NSSC as it is becoming a more mature company that is generating more and more free cash flow.

At the moment the company has a TTM dividend yield of 0.8%, which is fairly low, but if we take the growth rates into account this could become an attractive dividend growth stock. Combine this with the future growth prospects and a safe payout ratio of 18.7% and I think NSSC has the potential to become an interesting dividend play.

I haven’t read anything specific about a dividend growth policy yet, but it seems to be part of their capital allocation strategy now.

Q2 2024 results

NSSC is delivering outstanding results. In Q2 2024 they managed to report record sales again. Which was their 13^th consecutive quarter of record sales, which is impressive.

An important part of my investment thesis is the recurring monthly revenue growth. This was 25% higher ($18.5 million) compared to the same period last year ($14.9 million).

It does appear that equipment sales have found their way back up. Equipment sales increased 6% ($29 million) compared to last year, due to increased sales in Alarm Lock, door-locking products and intrusion products. Over a half year period the increase in sale was just 1% compared to the year before.

Their gross margin increased from 34% to 53% from a Q2 to Q2 basis. This is mainly due to the increase in recurring revenue, with a gross margin of 90%. Gross margins in the equipment segment are also rising again, with a strong rebound from 7% to 29%. Long story short, NSSC has delivered strong results. The company expects continuing to do so in the future. NSSC has experienced some supply chain issues, which have led to significantly higher costs. This is not completely resolved but things are really getting better.

Valuation

To calculate the intrinsic value of NSSC, I used discounted cash flow analysis. For the analysis I used the current FCF of $39.74 million. I created two scenarios, a more conservative baseline case and a more bullish case.

For my calculations this is a good starting point, because I expect more consistency and growth in FCF in the coming years .

If we take a look at the earnings estimates on the Seeking Alpha website, analysts also have high growth expectations.

I think a 5Y free cash flow growth of 15% is reasonable. The security market is already growing double digits year-over-year and since there are opportunities for significant margin improvement, 15% is on the conservative side. I used 10% for the 5 years thereafter, because it is more difficult to make assumptions further into the future.

At the moment, NSSC has a PE non-GAAP of 33 and GAAP of 34, which is significantly below its 5Y average of 43 non-GAAP and 48 GAAP. Since this company still has considerable growth potential, it is also good to look at the PEG ratio, which is 0.25 and implies undervaluation.

I used a PE of 25 as a terminal multiple, because NSSC is a high-quality business where I think this multiple can be justified. The sector median is 22.34 and I think NSSC is an above-average business. If the company continues to produce these impressive numbers, a PE of around 30 will not be out of place.

Finally, I used a discount rate of 12% as personal hurdle rate I demand for NSSC. This is higher than usual, because of the higher risk associated with the investment. I will explain this further in the next part of the article.

If we do the math, this comes to a fair value of $39.61 per share and a $55.36 per share for the more bullish case.

As most people know, discounted cash flow analysis is highly sensitive to the input given. What can be concluded is that even when using the more conservative numbers, the current share price of $40.82 is close to the fair value of the baseline case.

Investment risks

Despite there is a lot to like about the company, there is also some risk involved. Small businesses in general carry more risk when it comes to investing. NSSC has a market cap of $1.5 billion and the main risk is the potential disruption by the bigger players in the competitive landscape. There are at least 12 other businesses that are also operating in the security equipment sector, which also includes several large companies.

These companies can potentially make much larger investments that can often be financed more easily compared to NSSC. It is therefore important that NSSC allocates sufficient capital to maintain its competitive advantage.

Despite the fact that the company makes quite a lot of R&D investments (historically 5 to 8% of total revenue), it is only a small amount in absolute terms.

A positive point, NSSC does have a solid long-term track record and, due to its size and the huge total addressable market, still has a lot of upside in terms of growth. However, small caps also have more downside risk as well and if the company loses its competitive edge, revenue growth and enhancement in profitability can go the other way around.

It is also not easy to successfully roll out the strategy with recurring revenue. This is a relatively new part within the company and it remains to be seen whether this will succeed. Competition will also know this business model is quite profitable and interference from other companies can possibly cause margin pressure.

Conclusion

NSSC is a high-quality business. The company has an excellent long-term track record and there is certainly potential to do well in the future. NSSC has excellent financials, good growth prospects and a pristine balance sheet. The company is founder led and management still has significant skin in the game.

Their free cash flow is likely to be more stable and is growing rapidly. Due to excess cash, NSSC has started paying a dividend and the company certainly has the potential to be a strong dividend grower.

The shares are trading around my calculated fair value at the moment. NSSC is trading at a high PE ratio, but the growth prospects make up for it. However, the risk associated with this investment is in my opinion higher than average, but the potential reward is appealing as well. Because of this, my advice is not to make NSSC too large of a position in your portfolio.

Personally, I have certainly become more interested in the company and during the process I bought some shares at the $39 dollar range. At current prices I am leaning more towards a BUY and you should really see it as a long-term investment, so don’t be penny wise pound foolish! I am planning to make it a small portion of my portfolio and I will accumulate slowly according to the dollar cost averaging principle.

Happy investing everyone.