SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED: MARCH 31, 2004 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM __________ TO __________. Commission File number: 0-10004 -------------------------------------------- NAPCO SECURITY SYSTEMS, INC -------------------------------------------- (Exact name of Registrant as specified in its charter) Delaware 11-2277818 - -------------------------------------------- ------------- (State or other jurisdiction of (IRS Employer Identification incorporation of organization) Number) 333 Bayview Avenue Amityville, New York 11701 - -------------------- ---------- (Address) (Zip Code) (631) 842-9400 -------------------------------------------------- (Registrant's telephone number including area code) None ------------------------------------------------------ (Former name, former address and former fiscal year if changed from last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act): Yes [ ] No [X] Number of shares outstanding of each of the issuer's classes of common stock, as of: APRIL 27, 2004 COMMON STOCK, $.01 PAR VALUE PER SHARE 6,960,636 1
<TABLE> <CAPTION> Page ---- <S> <C> PART I: FINANCIAL INFORMATION ITEM I. Financial Statements (unaudited) NAPCO SECURITY SYSTEMS, INC AND SUBSIDIARIES INDEX - MARCH 31, 2004 Condensed Consolidated Balance Sheets, March 31, 2004 and June 30, 2003 3 Condensed Consolidated Statements of Operations for the Three Months ended March 31, 2004 and 2003 4 Condensed Consolidated Statements of Operations for the Nine Months ended March 31, 2004 and 2003 5 Condensed Consolidated Statements of Cash Flows for the Nine Months ended March 31, 2004 and 2003 6 Notes to Condensed Consolidated Financial Statements 7 ITEM II. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 ITEM III. Quantitative and Qualitative Disclosures About Market Risk 17 ITEM IV. Controls and Procedures 18 PART II: OTHER INFORMATION 19 SIGNATURE PAGE 21 </TABLE> 2
PART I: FINANCIAL INFORMATION ITEM 1. Financial Statements NAPCO SECURITY SYSTEMS, INC AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) <TABLE> <CAPTION> March 31, June 30, 2004 2003 ----------- --------- (restated, see Note 1) (in thousands, except share data) <S> <C> <C> ASSETS Current Assets: Cash $ 1,488 $ 1,794 Accounts receivable, less reserve for doubtful accounts: March 31, 2004 $ 305 June 30, 2003 $ 215 15,905 17,425 Inventories, net (Note 3) 16,464 16,922 Prepaid expenses and other current assets 623 525 Deferred income taxes 1,253 1,253 ----------- --------- Total current assets 35,733 37,919 Property, Plant and Equipment, net 9,086 9,466 Goodwill 9,686 9,686 Other assets 169 278 ----------- --------- $ 54,674 $ 57,349 =========== ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Current portion of long-term debt $ 1,900 $ 1,900 Accounts payable 3,027 3,374 Accrued expenses 805 1,812 Accrued salaries and wages 1,496 1,501 Accrued income taxes 924 489 ----------- --------- Total current liabilities 8,152 9,076 Long-term debt 10,175 14,100 Deferred income taxes 816 816 ----------- --------- Total liabilities 19,143 23,992 ----------- --------- Shareholders' Equity (Note 1): Common stock, par value $.01 per share; 21,000,000 shares authorized, 6,960,632 and 6,397,392 shares issued, respectively; 6,960,632 and 6,397,392 shares outstanding, respectively 70 64 Retained earnings 35,461 33,293 ----------- --------- Total stockholders' equity 35,531 33,357 ----------- --------- $ 54,674 $ 57,349 =========== ========= </TABLE> See accompanying notes to condensed consolidated financial statement 3
NAPCO SECURITY SYSTEMS, INC AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) <TABLE> <CAPTION> Three Months Ended March 31, ------------------------------- 2004 2003 ----------- ---------- (restated; see Note 1) (in thousands, except share and per share data) <S> <C> <C> Net Sales $ 14,742 $ 13,406 Cost of Sales 10,120 9,910 ----------- ---------- Gross profit 4,622 3,496 Selling, General and Administrative Expenses 3,363 3,487 ----------- ---------- Operating income 1,259 9 ----------- ---------- Interest Expense, net 101 141 Other Expense, net 30 69 ----------- ---------- Other expense 131 210 ----------- ---------- Income (loss) before provision (benefit) for income taxes 1,128 (201) Provision (benefit) for income taxes 394 (65) ----------- ---------- Net income (loss) $ 734 $ (136) =========== ========== Net income (loss) per share (Note 1 and Note 4): Basic $ 0.11 $ (0.02) =========== ========== Diluted $ 0.11 $ (0.02) =========== ========== Weighted average number of shares outstanding (Note 1 and Note 4): Basic 6,706,752 6,607,392 =========== ========== Diluted 6,947,574 6,607,392 =========== ========== </TABLE> See accompanying notes to condensed consolidated financial statements 4
NAPCO SECURITY SYSTEMS, INC AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) <TABLE> <CAPTION> Nine Months Ended March 31, ------------------------------- 2004 2003 ----------- ---------- (restated; see Note 1) (in thousands, except share and per share data) <S> <C> <C> Net Sales $ 39,206 $ 38,990 Cost of Sales 27,049 28,877 ----------- ---------- Gross profit 12,157 10,113 Selling, General and Administrative Expenses 9,945 9,913 ----------- ---------- Operating income 2,212 200 ----------- ---------- Interest Expense, net 331 577 Other (Income) expense, net 66 (118) ----------- ---------- Other expense 397 459 ----------- ---------- Income (loss) before provision (benefit) for income taxes 1,815 (259) Provision (benefit) for income taxes 635 (85) ----------- ---------- Net income (loss) $ 1,180 $ (174) =========== ========== Net income (loss) per share (Note 1 and Note 4): Basic $ 0.18 $ (0.03) =========== ========== Diluted $ 0.17 $ (0.03) =========== ========== Weighted average number of shares outstanding (Note 1 and Note 4): Basic 6,555,282 6,697,492 =========== ========== Diluted 6,772,018 6,697,492 =========== ========== </TABLE> See accompanying notes to condensed consolidated financial statements 5
NAPCO SECURITY SYSTEMS, INC AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) <TABLE> <CAPTION> Nine Months Ended March 31, ------------------------------- 2004 2003 ----------- ---------- (in thousands) <S> <C> <C> Net Cash Provided by Operating Activities $ 3,173 $ 4,180 Cash Flows used in Investing Activities: Net purchases of property, plant and equipment (444) (606) ----------- ---------- Cash Flows from Financing Activities: Proceeds from long-term debt 1,000 4,250 Proceeds from exercise of employee stock options 890 259 Principal payments on long-term debt (4,925) (5,377) Payments for purchase of treasury stock - (2,442) ----------- ---------- Net cash used in financing activities (3,035) (3,310) ----------- ---------- Net Increase (Decrease) in Cash (306) 264 Cash, Beginning of Period 1,794 1,500 ----------- ---------- Cash, End of Period $ 1,488 $ 1,764 =========== ========== Cash Paid During the Period for: Interest $ 336 $ 586 =========== ========== Income taxes $ 96 $ 14 =========== ========== </TABLE> See accompanying notes to condensed consolidated financial statement. 6
NAPCO SECURITY SYSTEMS, INC AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED STATEMENTS 1.) Summary of Significant Accounting Policies and Other Disclosures The accompanying Condensed Consolidated Financial Statements are unaudited. In management's opinion, all adjustments (consisting of only normal recurring accruals) necessary for a fair presentation have been made. The results of operations for the quarterly period ended March 31, 2004 are not necessarily indicative of results that may be expected for any other interim period or for the full year. The unaudited Condensed Consolidated Financial Statements include the accounts of the Company after elimination of all material inter-company balances and transactions. The Company has made a number of estimates and assumptions relating to the assets and liabilities, the disclosure of contingent assets and liabilities and the reporting of revenues and expenses to prepare these financial statements in conformity with accounting principles generally accepted in the United States. Actual results could differ from those estimates. The unaudited Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and related notes contained in the Company's Annual Report on Form 10-K for the year ended June 30, 2003. The accounting policies used in preparing these unaudited Condensed Consolidated Financial Statements are consistent with those described in the June 30, 2003 Consolidated Financial Statements, except as disclosed. Advertising and Promotional Costs Advertising and promotional costs are included in "Selling, General and Administrative" expenses in the Condensed Consolidated Statements of Operations and are expensed as incurred. Advertising expense for the three months ended March 31, 2004 and 2003 was $193,000 and $330,000, respectively. Advertising expense for the nine months ended March 31, 2004 and 2003 was $838,000 and $981,000, respectively. Research and Development Costs Research and development costs incurred by the Company are charged to expense in the period incurred. Research and Development expense for the three months ended March 31, 2004 and 2003 was $1,332,000 and $1,568,000, respectively. Research and Development expense for the nine months ended March 31, 2004 and 2003 was $3,885,000 and $4,145,000, respectively. These expenses are included in "Cost of sales" in the Condensed Consolidated Statements of Operations. Business Concentration and 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 it mitigated its risk through diversification of customers. Such risks of loss are manifest differently, depending on the nature of the concentration, and vary in significance. We have three major customers as follows: <TABLE> <CAPTION> Sales for the three months ended March 31, ------------------------------------------- 2004 2003 ------------------ ----------------------- $ % $ % --------- ----- ---------- ----- <S> <C> <C> <C> <C> Customer A 1,329,212 9.0% 794,757 5.9% Customer B 1,123,274 7.6% (1) - Customer C (1) - 3,556,226 26.5% --------- ---- --------- ---- 2,452,486 16.6% 4,350,983 32.4% </TABLE> <TABLE> <CAPTION> Sales for the nine months ended March 31, ------------------------------------------- 2004 2003 ------------------ ----------------------- $ % $ % --------- ----- ---------- ----- <S> <C> <C> <C> <C> Customer A 2,902,857 7.4% 2,675,917 6.9% Customer B 2,333,896 6.0% (1) - Customer C (1) - 7,384,462 18.9% --------- ---- --------- ---- 5,236,753 13.4% 10,060,379 25.8% </TABLE> 7
<TABLE> <CAPTION> Accounts Receivable as of: ------------------------------------------- March 31, 2004 June 30, 2003 ------------------------------------------- $ % $ % --------- ----- --------- ----- <S> <C> <C> <C> <C> Customer A 4,028,310 25.3% 3,877,694 22.3% Customer B 2,014,406 12.7% (1) - Customer C (1) - 3,787,173 21.7% --------- ---- --------- ---- 6,042,716 38.0% 7,664,867 44.0% </TABLE> (1) The customer did not qualify as a major customer in this period. These customers sell primarily within North America. Although management believes that these customers are sound and creditworthy, a severe adverse impact on their business operations could have a corresponding material adverse effect on our net sales, cash flows, and/or financial condition. In the ordinary course of business, we have established an allowance for doubtful accounts and customer deductions in the amount of $305,000 and $215,000 as of March 31, 2004 and June 30, 2003, respectively. Our allowance 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 aging, specific exposures and historical trends. Stock Options During the three and nine months ended March 31, 2004 the Company granted 52,000 stock options to employees. In addition, 260,300 and 281,620 options were exercised during the three and nine months ended March 31, 2004, respectively. Stock Split In March 2004, the Company's Board of Directors approved a two-for-one stock split in the form of a 100% stock dividend of the Companys common stock payable to stockholders of record on April 13, 2004. The additional shares were distributed on April 27, 2004. The Company utilized all 2,871,056 of its shares held as Treasury stock as of April 27, 2004 plus an additional 609,260 shares in paying this stock dividend. All share and per share amounts (except par value) have been retroactively adjusted to reflect the stock split. There was no net effect on total stockholders' equity as a result of the stock split. The retroactive effect of the two-for-one stock split within Stockholders' Equity at June 30, 2003 is as follows (in thousands): <TABLE> <CAPTION> As reported Effect of Stock Split As adjusted ----------- --------------------- ----------- <S> <C> <C> <C> Common stock $ 61 $ 3 $ 64 Additional paid-in capital 1,342 (1,342) - Retained earnings 39,813 (6,520) 33,293 Less: Treasury stock, at cost (7,859) 7,859 - ----------- ----------- --------- Total Stockholders' equity $ 33,357 $ - $ 33,357 =========== =========== ========= </TABLE> Prior Period Adjustment The Company's financial statements for the three and nine months ended March 31, 2003 have been restated to reflect an adjustment of its income tax provision related to the taxation of one of the Company's foreign subsidiaries, Napco/Alarm Lock Grupo International S.A. As further described in Note 6 of the Company's 10-K for June 30, 2003, in March 2003, the Company made an election with the filing of its income tax return for the fiscal year ended June 30, 2002. As a result, the tax provision and related deferred tax balance sheet accounts have been restated. 8
The effect of this restatement on the Company's operations for the three and nine months ended March 31, 2003 is as follows (in thousands, except per share data) (restated to reflect two-for-one stock split as previously discussed): <TABLE> <CAPTION> As Previously Reported As Restated ---------------------- ----------- (in thousands except per share data) <S> <C> <C> Three months ended March 31, 2003: Provision (Benefit) for income taxes $ 5 $ (65) Net loss (206) (136) Earnings per share: Basic (0.03) (0.02) Earnings per share: Diluted (0.03) (0.02) Nine months ended March 31, 2003: Provision (Benefit) for income taxes $ 15 $ (85) Net loss (274) (174) Earnings per share: Basic (0.04) (0.03) Earnings per share: Diluted (0.04) (0.03) </TABLE> 2.) Employee Stock-based Compensation As of March 31, 2004, the Company had established a number of share incentive programs as discussed in more detail in our annual report on Form 10-K for the year ended June 30, 2003. The Company applies the intrinsic value method as outlined in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations in accounting for stock options and share units granted under these programs. Under the intrinsic value method, no compensation expense is recognized if the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant. Accordingly, no compensation cost has been recognized. The Company adopted the disclosure portion of Statement of Financial Accounting Standard ("SFAS") No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" requiring quarterly SFAS No. 123 pro forma disclosure. The following table illustrates the effect on earnings and earnings per share as if the fair value method had been applied to all outstanding and unvested awards in each period presented. <TABLE> <CAPTION> Three Months Nine Months Ended March 31, Ended March 31, ------------------------ ------------------------ 2004 2003(1) 2004 2003(1) ------- ------- -------- ------- (unaudited) (in thousands, except per share data) <S> <C> <C> <C> <C> Net income (loss), as reported $ 734 $ (136) $ 1,180 $ (174) Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects (63) (263) (118) (370) ------- ------- -------- ------- Pro forma net earnings, attributable to common stock $ 671 $ (399) $ 1,062 $ (544) ======= ======= ======== ======= Earnings per common share (1): Basic - as reported $ 0.11 $ (0.02) $ 0.18 $ (0.03) ======= ======= ======== ======= Basic - pro forma $ 0.10 $ (0.06) $ 0.16 $ (0.08) ======= ======= ======== ======= Diluted - as reported $ 0.11 $ (0.02) $ 0.17 $ (0.03) ======= ======= ======== ======= Diluted - pro forma $ 0.10 $ (0.06) $ 0.16 $ (0.08) ======= ======= ======== ======= </TABLE> (1) Information is presented as restated. See Note 1. 9
3.) Inventories Inventories consist of: <TABLE> <CAPTION> March 31, June 30, 2004 2003 ---------- ----------- (in thousands) <S> <C> <C> Component parts $ 9,366 $ 9,626 Work-in-process 2,377 2,443 Finished products 4,721 4,853 ---------- ----------- $ 16,464 $ 16,922 ========== =========== </TABLE> For interim financial statements, inventories are calculated using a gross profit percentage. 4.) Earnings Per Common Share The Company follows the provisions of SFAS No. 128, "Earnings Per Share". In accordance with SFAS No. 128, earnings per common share amounts ("Basic EPS") were computed by dividing earnings by the weighted average number of common shares outstanding for the period. Earnings per common share amounts, assuming dilution ("Diluted EPS"), were computed by reflecting the potential dilution from the exercise of stock options. SFAS No. 128 requires the presentation of both Basic EPS and Diluted EPS on the face of the consolidated statements of operations. A reconciliation between the numerators and denominators of the Basic and Diluted EPS computations for earnings is as follows (Information restated as described in Note 1): <TABLE> <CAPTION> Three months ended March 31, 2004 (in thousands, except per share data) ----------------------------------------------------------- Net Income Shares Per Share (numerator) (denominator) Amounts ----------- ------------- --------- <S> <C> <C> <C> Net income $ 734 - - -------- ----- ----- BASIC EPS Net income attributable to common stock $ 734 6,707 $0.11 EFFECT OF DILUTIVE SECURITIES Options $ - 241 - -------- ----- ----- DILUTED EPS Net income attributable to common stock and assumed option exercises $ 734 6,948 $0.11 ======== ===== ===== </TABLE> Options to purchase 10,000 shares of common stock in the three months ended March 31, 2004 were not included in the computation of Diluted EPS because the option price was in excess of the average market price for the three months ended March 31, 2004. These options were still outstanding at the end of the period. 10
<TABLE> <CAPTION> Three months ended March 31, 2003 (as restated) (in thousands, except per share data) ------------------------------------------- Net Income Shares Per Share (numerator) (denominator) Amounts ----------- ------------- ---------- <S> <C> <C> <C> Net loss $ (136) - - ---------- ----- ------ BASIC EPS Net income attributable to common stock $ (136) 6,607 $(0.02) EFFECT OF DILUTIVE SECURITIES Options $ - - - ---------- ----- ------ DILUTED EPS Net loss attributable to common stock and assumed option exercises $ (136) 6,607 $(0.02) ========== ===== ====== </TABLE> Options to purchase 843,720 shares of common stock in the three months ended March 31, 2003 were not included in the computation of Diluted EPS because the Company incurred a loss for the nine months, therefore the impact would have been anti-dilutive. These options were still outstanding at the end of the period. <TABLE> <CAPTION> Nine months ended March 31, 2004 (in thousands, except per share data) ------------------------------------------- Net Income Shares Per Share (numerator) (denominator) Amounts ----------- ------------- ---------- <S> <C> <C> <C> Net income $ 1,180 - - ---------- ----- ------ BASIC EPS Net income attributable to common stock $ 1,180 6,555 $ 0.18 EFFECT OF DILUTIVE SECURITIES Options $ - 217 $(0.01) ---------- ----- ------ DILUTED EPS Net income attributable to common stock and assumed option exercises $ 1,180 6,772 $ 0.17 ========== ===== ====== </TABLE> Options to purchase 60,800 shares of common stock in the nine months ended March 31, 2004 were not included in the computation of Diluted EPS because the option price was in excess of the average market price for the nine months ended March 31, 2004. These options were still outstanding at the end of the period. 11
<TABLE> <CAPTION> Nine months ended March 31, 2003 (as restated) (in thousands, except per share data) ------------------------------------------- Net Income Shares Per Share (numerator) (denominator) Amounts ----------- ------------- ---------- <S> <C> <C> <C> Net loss $ (174) - - ---------- ----- ------ BASIC EPS Net loss attributable to common stock $ (174) 6,697 $(0.03) EFFECT OF DILUTIVE SECURITIES Options $ - - - ---------- ----- ------ DILUTED EPS Net loss attributable to common stock and assumed option exercises $ (174) 6,697 $(0.03) ========== ===== ====== </TABLE> Options to purchase 843,720 shares of common stock in the nine months ended March 31, 2003 were not included in the computation of Diluted EPS because the Company incurred a loss for the nine months, therefore the impact would have been anti-dilutive. These options were still outstanding at the end of the period. 5) Long Term Debt In May 2001, the Company amended its secured revolving credit agreement with its primary bank. The Company's borrowing capacity under the amended agreement was increased to $18,000,000. The amended revolving credit agreement is secured by all the accounts receivable, inventory, the Company's headquarters in Amityville, New York, common stock of three of the Company's subsidiaries and certain other assets of Napco Security Systems, Inc The revolving credit agreement bears interest at either the Prime Rate less 1/4% or an alternate rate based on LIBOR as described in the agreement. In April 2004 the Company's bank approved an extension of the expiration date of the secured revolving credit agreement from January 2005 to April 2005 and any outstanding borrowings are to be repaid or refinanced on or before that time. The agreement contains various restrictions and covenants including, among others, restrictions on payment of dividends, restrictions on borrowings, restrictions on capital expenditures, the maintenance of minimum amounts of tangible net worth, and compliance with other certain financial ratios, as defined in the agreement. 6.) Geographical Data The revenues attributable to the Company's domestic and foreign operations for the periods presented are summarized in the following tabulation (in thousands): <TABLE> <CAPTION> Three Months Nine Months Ended March 31, Ended March 31, -------------------------- -------------------------- 2004 2003 2004 2003 --------- --------- --------- ---------- <S> <C> <C> <C> <C> Sales to external customers(1): Domestic $12,467 $11,508 $32,615 $32,368 Foreign 2,275 1,898 6,591 6,622 ------- ------- ------- ------- Total Net Sales $14,742 $13,406 $39,206 $38,990 ======= ======= ======= ======= </TABLE> (1) All of the Company's sales occur in the United States and are shipped primarily from the Company's facilities in the United States and United Kingdom. There were no sales into any one country in excess of 10% of Net Sales. 12
7) Commitments and Contingencies As previously reported, on or about August 27, 2001, a five-count Verified Complaint was filed against NAPCO Security Group and Alarm Lock Systems, Inc. by Jose Ramirez and Glenda Ramirez in the Supreme Court of State of New York, County of the Bronx. The Verified Complaint seemingly seeks fifteen million dollars ($15,000,000) in damages on behalf of Mr. Ramirez based on theories including strict liability in tort, negligence, breach of warranty, failure to warn, etc. The Verified Complaint also seeks damages in the amount of two million dollars ($2,000,000) on behalf of Ms. Ramirez based on an allegation that she has been, and forever will be, "deprived of the society, services, companionship consortium and support of" Mr. Ramirez based on the personal injuries he suffered in a fire which purportedly occurred on November 5, 1999. This case was consolidated with the related case concerning the same incident, captioned Jose Ramirez and Glenda Ramirez v. Mark T. Miller, Chelsea Gardens Owners Corp., Eichner Rudd Management Associates, Ltd., Napco Security Group and Alarm Lock Systems, Inc., asserting the same claims against the Company. The action is being defended by NAPCO's insurance company on behalf of NAPCO. The Alarm Lock product in question has been tested and still functions correctly, and the Company believes that action is without merit. NAPCO plans to have this action vigorously defended. 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. 13
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Napco Security Systems, Inc. Management's Discussion and Analysis of Financial Condition and Results of Operations This Quarterly Report on Form 10-Q and the information incorporated by reference may include "Forward-Looking Statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act of 1934. The Company intends the Forward-Looking Statements to be covered by the Safe Harbor Provisions for Forward-Looking Statements. All statements regarding the Company's expected financial position and operating results, its business strategy, its financing plans and the outcome of any contingencies are Forward-Looking Statements. The Forward-Looking Statements are based on current estimates and projections about our industry and our business. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," or variations of such words and similar expressions are intended to identify such Forward-Looking Statements. The Forward-Looking Statements are subject to risks and uncertainties that could cause actual results to differ materially from those set forth or implied by any Forward-Looking Statements. Factors that could cause actual results to differ materially from the Forward-Looking Statements include, but are not limited to, inability to refinance, adverse tax consequences of offshore of operations, distribution problems, unforeseen environmental liabilities and the uncertain military, political and economic conditions in the world. These and other risks are detailed in Part I, Item 1 and elsewhere in this Form 10-Q. The Company assumes no obligation to update publicly the Forward-Looking Statements contained herein, whether as a result of new information, future events or otherwise, except as may be required by law. Critical Accounting Policies The Company's consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America which require, in some cases, that certain estimates and assumptions be made that affect the amounts and disclosures reported in the those financial statements and the related accompanying notes. Estimates are based on current facts and circumstances, prior experience and other assumptions believed to be reasonable. Management uses its best judgment in valuing these estimates and may, as warranted, solicit external advice. Actual results could differ from these estimates, assumptions and judgments and these differences could be material. The following critical accounting policies, some of which are impacted significantly by estimates, assumptions and judgments, affect the Company's consolidated financial statements. Our most critical accounting policies relate to revenue recognition; concentration of credit risk; inventory; goodwill and other intangible assets; and income taxes. Revenue Recognition Revenues from merchandise sales are recorded at the time the product is shipped or delivered to the customer pursuant to the terms of purchase. We report our sales levels on a net sales basis, which is computed by deducting from gross sales the amount of actual returns received and an amount established for anticipated returns and allowances. Our sales return accrual is a subjective critical estimate that has a direct impact on reported net sales. This accrual is calculated based on a history of gross sales and actual sales returns, as well as management's estimate of anticipated returns and allowances. Business Concentration and 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 it mitigated its risk through diversification of customers. Such risks of loss are manifest differently, depending on the nature of the concentration, and vary in significance. We have three major customers as follows: <TABLE> <CAPTION> Sales for the three months ended March 31, -------------------------------------------- 2004 2003 -------------------------------------------- $ % $ % --------- ----- --------- ----- <S> <C> <C> <C> <C> Customer A 1,329,212 9.0% 794,757 5.9% Customer B 1,123,274 7.6% (1) - Customer C (1) - 3,556,226 26.5% --------- --------- 2,452,486 16.6% 4,350,983 32.4% </TABLE> 14
<TABLE> <CAPTION> Sales for the nine months ended March 31, -------------------------------------------- 2004 2003 -------------------- --------------------- $ % $ % --------- ----- --------- ----- <S> <C> <C> <C> <C> Customer A 2,902,857 7.4% 2,675,917 6.9% Customer B 2,333,896 6.0% (1) - Customer C (1) - 7,384,462 18.9% --------- ---------- 5,236,753 13.4% 10,060,379 25.8% </TABLE> <TABLE> <CAPTION> Accounts Receivable as of: -------------------------------------------- March 31, 2004 June 30, 2003 -------------------- --------------------- $ % $ % --------- ----- --------- ----- <S> <C> <C> <C> <C> Customer A 4,028,310 25.3% 3,877,694 22.3% Customer B 2,014,406 12.7% (1) - Customer C (1) - 3,787,173 21.7% --------- --------- 6,042,716 38.0% 7,664,867 44.0% </TABLE> (2) The customer did not qualify as a major customer in this period. These customers sell primarily within North America. Although management believes that these customers are sound and creditworthy, a severe adverse impact on their business operations could have a corresponding material adverse effect on our net sales, cash flows, and/or financial condition. In the ordinary course of business, we have established an allowance for doubtful accounts and customer deductions in the amount of $305,000 and $215,000 as of March 31, 2004 and June 30, 2003, respectively. Our allowance 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 aging, specific exposures and historical trends. Inventory We state our inventory at the lower of cost or fair market value, with cost being determined on the first-in, first-out (FIFO) method. We believe FIFO most closely matches the flow of our products from manufacture through sale. The reported net value of our inventory includes finished saleable products, work-in-process and raw materials that will be sold or used in future periods. Inventory cost includes raw materials, direct labor and overhead. We also record an inventory obsolescence reserve, which represents the difference between the cost of the inventory and its estimated fair market value, based on various product sales projections. This reserve is calculated using an estimated obsolescence percentage based on age, historical trends and requirements to support forecasted sales. In addition, and as necessary, we may establish specific inventory obsolescence reserves for known or anticipated events. For interim financial statements, inventories are calculated using a gross profit percentage. Goodwill and Other Intangible Assets Goodwill is calculated as the excess of the cost of purchased businesses over the value of their underlying net assets. Goodwill is not amortized. Other intangible assets are not material. On an annual basis, we test goodwill and other intangible assets for impairment. To determine the fair value of these intangible assets, there are many assumptions and estimates we choose. To mitigate undue influence, we use industry accepted valuation models and set criteria that are reviewed and approved by various levels of management. Additionally, we evaluated our recorded goodwill with the assistance of a third-party valuation firm. 15
Income taxes We have accounted for, and currently account for, income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes". This statement establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise's activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting of income taxes. Results of Operations Sales for the three months ended March 31, 2004 increased by 10% to $14,742,000 as compared to $13,406,000 for the same period a year ago. Sales for the nine months ended March 31, 2004 increased by 1% to $39,206,000 as compared to $38,990,000 for the same period a year ago. The increase in net sales for the three months ended March 31, 2004 was primarily due to increased sales of the Company's door locking and access control products. The increase in net sales for the nine months ended March 31, 2004 was primarily due to the aforementioned increased sales in the Company's door locking and access control products, as partially offset by lower burglar alarm sales principally as a result of a major distributor's introduction of its company-wide inventory reduction program, which reduced its purchasing levels. During the quarter ended December 31, 2003, the Company began the process of realigning its burglar alarm products distribution network which culminated in the termination of the aforementioned major burglar alarm distributor. The Company reallocated its burglar alarm products business across its extensive national network of independent distributors. The Company's gross profit for the three months ended March 31, 2004 increased by $1,126,000 to $4,622,000 or 31.4% of sales as compared to $3,496,000 or 26.1% of sales for the same period a year ago. Gross profit for the nine months ended March 31, 2004 increased by $2,044,000 to $12,157,000 or 31.0% of sales as compared to $10,113,000 or 25.9% of sales for the same period a year ago. The changes in dollars for the three and nine months ended March 31, 2004 are due primarily to the increase in sales in second quarter as discussed above as well as the increase in gross margin as a percentage of sales. The increase in gross margin as a percentage of sales was primarily due to lower manufacturing overhead costs due, in part, to a favorable change in the exchange rate relating to the Company's Dominican Republic manufacturing facility. Selling, general and administrative expenses for the three months ended March 31, 2004 declined slightly to $3,363,000, or 22.8 % of sales, as compared to $3,487,000, or 26.0% of sales a year ago. For the nine months ended March 31, 2004 selling, general and administrative expenses remained relatively constant at $9,945,000, or 25.4% of sales, as compared to $9,913,000, or 25.4% of sales a year ago. The decline in Selling, general and administrative expenses as a percentage of sales for the three months ended March 31, 2004 was due primarily to net sales increasing as described above while expenses remained relatively constant. Interest expense for the three months ended March 31, 2004 decreased by $40,000 to $101,000 from $141,000 for the same period a year ago. Interest expense for the nine months ended March 31, 2004 decreased by $246,000 to $331,000 from $577,000 for the same period a year ago. These changes for the three and nine months resulted primarily from two factors; a reduction in the Company's average outstanding debt and a decrease in interest rates available to the Company. Other Income/expense for the three months ended March 31, 2004 decreased by $39,000 to $30,000 from $69,000 for the same period a year ago. Other income/expense for the nine months ended March 31, 2004 increased by $184,000 to an expense of $66,000 from income of $118,000 for the same period a year ago. The change for the nine months resulted primarily from the Company settling litigation during the quarter ended September 30, 2002 which it had initiated as the plaintiff and realized a gain of approximately $210,000. This gain was recorded as Other Income during the quarter ended September 30, 2002. The Company had a provision for income taxes for the three months ended March 31, 2004 of $394,000 as compared to a benefit of ($65,000), as restated, for the same period a year ago. The Company had a provision for income taxes for the nine months ended March 31, 2004 of 635,000 as compared to a benefit of ($85,000), as restated, for the same period a year ago. The tax provisions and benefit are calculated using an estimated effective tax rate of 35%. Net income increased by $870,000 to $734,000 or $0.11 per share for the three months ended March 31, 2004 as compared to a loss of ($136,000) or ($0.02) per share, as restated, for the same period a year ago. Net income increased by $1,354,000 to $1,180,000 or $0.18 per share for the nine months ended March 31, 2004 as compared to a loss of ($174,000) or ($0.03) per share, as restated, for the same period a year ago. These changes were primarily due to the items discussed above. 16
Liquidity and Capital Resources During the nine months ended March 31, 2004 the Company utilized a portion of its cash generated from operations to reduce certain of its outstanding borrowings, purchase property, plant and equipment and invest in additional inventory as discussed below. During the first quarter of fiscal 2001, the Company entered into an $8,250,000 term loan agreement, payable over 60 equal monthly installments, in order to purchase the assets of Continental Instruments, LLC. The Company's management believes that current working capital, cash flows from operations and its revolving credit agreement will be sufficient to fund the Company's operations through at least the third quarter of fiscal 2005. Accounts Receivable at March 31, 2004 decreased $1,520,000 to $15,905,000 as compared to $17,425,000 at June 30, 2003. This decrease is primarily the result of the higher sales volume during the quarter ended June 30, 2003 as compared to the quarter ended March 31, 2004. Inventory at March 31, 2004 decreased by $458,000 to $16,464,000 as compared to $16,922,000 at June 30, 2003. This slight decrease was primarily the result of the increase in net sales during the third quarter as partially offset by the Company's level-loading its production schedule in anticipation of its historical sales cycle where a larger portion of the Company's sales occur in the latter fiscal quarters as compared to the earlier quarters. In January 2003, the Company repurchased 250,000 shares of its common stock from two stockholders, unaffiliated with the Company, at $9.75 per share, a discount from its then current trading price of $10.01. The transaction was approved by the board of directors and the purchase price of $2,437,500 was financed through the Company's revolving line of credit and a new five (5) year term loan from its primary bank for approximately 50% of the purchase price. This term loan is for $1,250,000 and is being repaid in 60 equal monthly installments commencing on April 30, 2003. Other than the $8,250,000 and $1,250,000 loans described above, the Company's credit facilities consisted of an $18,000,000 secured revolving credit agreement and a $3,000,000 line of credit to be used in connection with commercial and standby letters of credit. In April 2004 the Company's bank approved an extension of the expiration date of the secured revolving credit agreement from January 2005 to April 2005. As of March 31, 2004 the Company had no material commitments for capital expenditures or inventory purchases other than purchase orders used in the normal course of business. Business Outlook We believe the business outlook for our industry has shown signs of improvement in recent months. Strengthening consumer confidence, slightly lower unemployment rates, and recently-enacted changes in U.S. tax legislation appear to have benefited the American economy, resulting in continued advances in the gross domestic product. Housing starts remain strong with interest rates at their lowest levels in over 40 years, and recent comments by the Federal Reserve Board suggest a "patient" approach toward future interest rate increases. These factors seem to have had a positive impact on business and consumer spending habits which could have a positive impact on the Company's incoming order trends. If these apparent signs of economic recovery can be sustained, we believe the longer-term outlook is promising as well. As the economy strengthens, however, it is also possible that costs associated with production (including raw materials, freight, salaries, utilities and marketing expenses such as advertising) may increase. We cannot reasonably predict when, or to what extent, events may occur which could impact the availability of such resources and/or their related cost to the Company. We continue to believe that there is considerable interest on the part of businesses and consumers to invest in security. We also believe that this interest has, until recently, been restrained by such factors as high unemployment and sluggish consumer confidence levels. As the economy improves and this interest in business and home security continues to emerge, as we anticipate it will, we believe we will be well positioned to take advantage of the long-awaited increase in demand as a result of our established products and our vertically-integrated business model. ITEM 3: Quantitative and Qualitative Disclosures About Market Risk The Company's principal financial instrument is long-term debt (consisting of a revolving credit and term loan facilities) that provides for interest at a spread above the prime rate. The Company is affected by market risk exposure primarily through the effect of changes in interest rates on amounts payable by the Company under this credit facility. A significant rise in the prime rate could materially 17
adversely affect the Company's business, financial condition and results of operations. At March 31, 2004 an aggregate amount of approximately $10,000,000 was outstanding under these facilities. If these borrowings remained at this quarter-end level for an entire year and the prime rate increased or decreased, respectively, by 1% the Company would pay or save, respectively, an additional $100,000 in interest that year. Where appropriate, the Company requires that letters of credit be provided on foreign sales. In addition, a significant number of transactions by the Company are denominated in U.S. dollars. As such, the Company has shifted foreign currency exposure onto many of 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. In addition, the Company transacts certain sales in Europe in British Pounds Sterling, therefore exposing itself to a certain amount of foreign currency risk. Management believes that the amount of this exposure is immaterial. ITEM 4: Controls and Procedures At the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13 a - 15(e). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective. During the third quarter of fiscal year 2004, there were no changes in the Company's internal control over financial reporting that have materially affected, or are reasonable likely to materially affect, the Company's internal control over financial reporting. 18
PART II: OTHER INFORMATION Item 1. Legal Proceedings. There are no pending or threatened material legal proceedings to which NAPCO or its subsidiaries or any of their property is subject, except: As previously reported, on or about August 27, 2001, a five-count Verified Complaint was filed against NAPCO Security Group and Alarm Lock Systems, Inc. by Jose Ramirez and Glenda Ramirez in the Supreme Court of State of New York, County of the Bronx. The Verified Complaint seemingly seeks fifteen million dollars ($15,000,000) in damages on behalf of Mr. Ramirez based on theories including strict liability in tort, negligence, breach of warranty, failure to warn, etc. The Verified Complaint also seeks damages in the amount of two million dollars ($2,000,000) on behalf of Ms. Ramirez based on an allegation that she has been, and forever will be, "deprived of the society, services, companionship consortium and support of" Mr. Ramirez based on the personal injuries he suffered in a fire which purportedly occurred on November 5, 1999. This case was consolidated with the related case concerning the same incident, captioned Jose Ramirez and Glenda Ramirez v. Mark T. Miller, Chelsea Gardens Owners Corp., Eichner Rudd Management Associates, Ltd., Napco Security Group and Alarm Lock Systems, Inc., asserting the same claims against the Company. The action is being defended by NAPCO's insurance company on behalf of NAPCO. The Alarm Lock product in question has been tested and still functions correctly, and the Company believes that action is without merit. NAPCO plans to have this action vigorously defended. 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 2. Changes in Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 31.1 Certification Pursuant to Rule 13a-14(a)/15d-14(a) of Richard Soloway, Chairman of the Board and President 31.2 Certification Pursuant to Rule 13a-14(a)/15d-14(a) of Kevin S. Buchel, Senior Vice President of Operations and Finance 32.1 Section 1350 Certifications (b) Form 8-K Filings (i) On March 30, 2004 the Company filed an 8-K reporting under item 5, Other Events, and Item 7, Financial Statements and Exhibits. 19
(ii) On February 23, 2004 the Company filed an 8-K reporting under Item 5, Other Events, and Item 7, Financial Statements and Exhibits. (iii) On February 17, 2004 the Company filed an 8-K reporting under Item 5, Other Events, and Item 7, Financial Statements and Exhibits. (iv) On February 917, 2004 the Company filed an 8-K reporting under Item 5, Other Events, and Item 7, Financial Statements and Exhibits. (v) On January 9, 2004 the Company Company filed an 8-K reporting under Item 5, Other Events, Item 7, Financial Statements and Exhibits, and Item 12, Results of Operations and Financial Condition.. 20
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. May 6, 2004 NAPCO SECURITY SYSTEMS, INC (Registrant) By: /s/ Richard Soloway ---------------------------------- Richard Soloway Chairman of the Board of Directors, President and Secretary (Chief Executive Officer) By: /s/ Kevin S. Buchel ---------------------------------- Kevin S. Buchel Senior Vice President of Operations and Finance and Treasurer (Principal Financial and Accounting Officer) 21