Shares in Napco Security Technologies (NSSC) have appreciated by almost 600% in a 5-year period. This increase in share price has been merited. Revenues have seen steady growth and operating leverage has contributed to operating profit margin expansion. This has resulted in EPS growth which the market has rewarded by assigning a high P/E multiple.
Current analysts’ estimates expect revenue growth of 11.5% in the short term with margins expanding to 20% from a current 13%. A high share price target of $36 per share indicates further upside.
However, we believe a share price target of $36 per share to be a low probability scenario. The price target implies revenue growth of 16%, 4% above market consensus. A growth rate below the consensus view could see a lower re-rating of Napco’s market multiple currently at a forward P/E of 32x.
We see an unfavorable risk/reward scenario and suggest potential investors to remain on the sidelines waiting for a better entry price.
Napco Security Technologies is a manufacturer of security products. They sell products such as access control systems, door-locking products, fire alarms, intrusion systems and video surveillance.
The company sells its products through a network of dealers and distributors to the commercial markets (80% of revenues) and residential markets (20% of revenues). They own two manufacturing facilities, one in Amityville in NY and the other in the Dominican Republic. The manufacturing facility in the Dominican Republic has a land lease of 99 years that expires in the year 2092. Napco reports results under two sales categories: equipment revenue and services revenue.
Currently the company is focusing efforts in expanding its recurring revenue source by selling its StarLink product (within its services segment), which connects to existing alarm systems and provides users with a platform where they can access their security systems. This product connects via LTE networks provided by AT&T (NYSE:T) or Verizon (NYSE:VZ).
The company has significant operating leverage. Revenue growth by their services segment has accelerated in the last couple of years. This segment enjoys high margins, helping the company with overall operating margins:
Source: company filings
The market has rewarded Napco investors with a 5-year total shareholder return of almost 600%:
We believe high growth expectations are embedded in current share price and expectation revisions can cause share price to decline. We estimate there is a 1 to 1 risk/reward profile as demonstrated in the analysis below.
Shares in Napco currently trade at $27.94 per share. We use the consensus view to estimate the market implied forecast period which will help us in analyzing the embedded expectations about future growth in the stock price.
The following are analysts’ estimates of revenue growth, EBIT, operating margins and price targets for shares in Napco:
Source: interactive brokers, marketscreener.com (bold numbers = estimates)
The consensus view for Napco calls for an increase in revenues from $102.8M to $127.1M in two years for a growth rate of 11.5%. Analysts also expect an increase in operating margins from a current 14.2% to 21.8%, reflecting the significant operating leverage and the assumption that services revenues (which are recurring in nature and have operating margins in the high 70s) increase as a percent of total revenues.
We use the consensus view to analyze the current stock price by doing a reverse DCF model. Doing so, would get us the market implied forecast period which is the number of years the market expects Napco to generate value creating cash flows. This eliminates the need for an analyst to use an arbitrary forecast horizon in a DCF model.
Below is the reverse DCF model:
Source: author estimates (capitalized operating and land leases are included in debt. The company has zero financial debt)
The model shows us a market implied forecast period of 5 years.
Why a target price of $36 seems unlikely
Source: author estimates
Doing an implied market expectation analysis, we concluded that in order to achieve an analyst price target of $36 per share, revenue growth would have to beat the consensus estimate of 11.5% by 4 percentage points to 16%.
Given management comments about their stated goal of growing their recurring revenues to $40M by June, 2021 (they are at a run rate of $20M as of last quarter results), we believe a price target of $36 per share seems unlikely due to the implied revenue growth rate of 16%:
Not only do I feel confident, this is Kevin, not only do I feel confident, Jaeson, I thought you know would be pushing hard to get to 20, we got the $20.4 million run rate, $40 million we could beat it and I’m just keeping on, I’m still saying $40, but if we had recurring revenue into the other areas of the business like we’ve talked about, try to get it into the locking size, the access will blow past the $40 million. For now, let’s just call it $40 million by June of 2021. – Q4 2019 CC
The company recently made the decision to separate total sales into equipment revenues and services revenues. For FY 2017, the company recorded $7.9M in services revenues and $79.4M for their equipment revenues. A target of $40M of recurring revenue by 2021 for their services segment would imply a 5-year CAGR of 50%.
The equipment revenue segment has seen slower growth at a 5-year CARG of 1.9%. However, last year the company grew equipment revenues by 7.3%.
To justify a stock price of $36 per share, Napco would have to achieve revenues of $216M in a 5-year timeframe implied by the market forecasted period. Actual FY 2019 sales were $102.9M.
What growth rates does each business segment have to sustain in a 5-year period?
Equipment revenues would have to grow at a CAGR of 7.3% while services revenues would need to sustain a 33% CAGR:
Source: author estimates (numbers in millions)
Both growth rates seem unsustainable. The probabilities are also not in their favor looking at historical base rates for companies within the same revenue range and sales CAGR from 1950-2015:
Source: Credit Suisse
Only 3.2% of companies have achieved a sales CAGR between 30-35% for five years as shown by historical records. Therefore, the probabilities behind the assumption of a sustainable growth rate of 33% for the service revenue segment within Napco seem highly unlikely if the price target of $36 is to be achieved.
For the equipment revenue segment, the sustainability of a 7% growth rate is doubtful as well if we look at a 10-year financial performance, with average rolling 5-year CAGR of 1.9%.
We can get a valuation range by using base, bear and bull revenue growth estimates and assigning a probability weight to get an expected equity value:
Source: author estimates
With a current share price of $27.94 at the time of this writing, an investment in Napco shares don’t offer a compelling risk/reward opportunity:
At current levels, there is not enough upside opportunity to offset a possible 24% decline in share price if sales growth rates don’t come in-line with market expectations.
For these reasons, I recommend investors to stay on the sidelines and wait for a better entry price.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.