Napco short report review: How bad is it?
NSSC at >10% growth, 18x EV/EBIT with 40% of recurring revenues still feasible?
On Thursday, Napco shares plunged 20% after already falling sharply upon last earnings following a short report by FuzzyPandaResearch. The company swiftly released a statement addressing the issues the following day. Let’s dive into it and see what you think of the short report.
FuzzyPandaResearch
Fuzzy Panda is a short seller active on Seeking Alpha (2016-2019) and Fuzzy Panda Research. Let’s look at the last short reports and how the shares have done since. FuzzyPanda has been active and has had some successes, especially with EVs like Lucid, Fisker and ELMS. Outside of EVs, the shorts have been hit or miss, without any drawdowns of over 38%, and the last short (GL) has been up 108% since the report halved shares. GL issued a statement the same day, similar to what Napco put out the day after, calling the information in the report false and misleading. I am torn on FuzzyPanda’s (from now on called FP) track record. Airsculpt was a recent IPO amidst the SPAC mania, DocGo was also a new company without a track record and XPOF IPOed in 2021. With the EV SPAC craze, I see that FP liked targeting the following market exuberance. Napco and Globe Life have long histories as public businesses and have returned positive shareholder returns (Napco much more so than Globe Life).
The allegation
Let’s summarize the points brought up by FP:
Napco has reported 26 straight quarters of revenue growth (excluding two quarters in Covid) and has reported beating EPS estimates in 14 out of the last 16 quarters. That is a feat that not even Apple, Google, and Nvidia have achieved and which raised our suspicions. - This point does not convince me at all. There are lots of companies that underpromise and overdeliver. Apple and Nvidia are cyclical businesses, so I don’t see the point here at all.
A former disgruntled employee alleges that Napco committed accounting fraud for years, directed by the CFO and well known within the company.
Large insider selling.
Leading indicator [according to FP] for Recurring revenue turning negative 6 quarters ago.
Deloitte is expressing an adverse Opinion on Napco’s internal controls over financial reporting.
Doesn’t believe Napcos recurring gross margins are achievable.
Locking products are just reimports from China.
Napco is trading at a valuation that is too high.
Napco’s statement
Napco responded with the following statement the next day.
Regarding the statements about accounting fraud happening for years, Napco said that The allegations are centered around incorrect statements from a disgruntled former employee who, based on the admissions made by Plaintiffs in the Class Action complaint, has no knowledge of NAPCO’s accounting processes or financial statement preparation.
Furthermore FP sent similar allegations weeks ago, which were immediately investigated by a global law firm, which did not found any supporting evidence.
Napco has implemented measures to prevent accounting issues to happen again, including enhanced IT, hiring an experienced financial services professional with audit and financial controls expertise (Big four accounting firm Deloitte) and are currently working on a process to eliminate a material weakness in their inventory costing process (in cooperation with Deloitte). All of this is audited and if they were looking to “continue deceiving investors” they wouldn’t have hired a prestigious and reputable firm like Deloitte.
Conflict of interest
FP alleges that there is a conflict of interested in Napco hiring their previous engagement partner from their former auditor as VP of finance and CAO, but the company responded that there is no conflict of interest and that the decision to get a big four auditor was due to the growth in size and market cap of Napco. Furthermore, the short seller claimed that he received $1 million in stock, which he just got 20,000 options vested over four years (a minor detail, in my opinion).
Unsustainable gross margins
FP alleges that the 90% gross margins on Napco’s recurring revenues are unfeasible and that they must be hiding costs on the balance sheet. Napco countered that peer Alarm.com reports an 86% gross margin with its SaaS recurring revenue product, with a focus on residential compared to Napco’s commercial focus. I find this to be a compelling argument.
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Locks made in China
One point FP brought up was the claim that Napco imports its locks from China and just redistributes it instead of producing them in their factory in de Dominican republic. Furthermore, they claim that these locking products should have 10% gross margins instead of high gross margins as claimed by the management. To me this looks like a component list which they import, but I’d love to hear some comments on this situation from management.
Unlikely to penetrate the residential market
FP also states that Napco is unlikely to penetrate the residential market with its Prima product. I tend to agree here, that I’m not very confident that Napco will easily penetrate this market, compared to their well established commercial business. This however is not thesis breaking whatsoever. Prima was only announced a few quarters ago and I just see it as an addition to the portfolio.
Large insider selling
It is correct that management has sold significant parts of their stake in the business. However, I find it unlikely that management would be naive enough to make jokes about selling before investors find out in front of employees and that it would be common around the workplace. We also must remember that Richard Soloway is 77 and CFO Buchel is 70. Selling shares to plan for retirement is a sensible plan. I could not find any mentions of a succession in the earnings reports for the last years, so with declining insider ownership we might see a sale of the company or a promotion from within to CEO.
Leading indicator has been negative for 6 quarters
FP says that recurring revenue will slow drastically as radio sales pushed by the 3G sunset have turned negative and will have a lagging effect of 15 months on recurring revenues. Furthermore, the CEO mentioned in the call that he expects another 5-7 years of retrofits for upgrading old copper stations. Napco has been growing its sales for years, so I don’t think their story of excess inventory with dealers is unrealistic. Covid brought along a lot of supply disruptions and as dealers work through it sales will pick up again.
Furthermore, Napco has recurring revenues in all its divisions and adds further recurring revenue opportunities. The bear argument doesn’t convince me and I doubt that management would blatantly lie about this in the latest earnings call:
I would however like the company to lay out some more KPIs regarding its recurring revenue business. Once installed these products will continue to generate recurring renveue, but it would be nice to get an installed base number and ARR/MRR figures for example.
Valuation and conclusion
I did not find the report convincing. A lot of it is public knowledge and statements from a disgruntled employee who couldn’t have had access to this information, according to the company and independent investigation. I agree that the insider selling is a bad omen, but somewhat understandable concidering that CEO and CFO are 77 and 70 years old. This further raises the question about succession and points to a potential sale of the company down the line, especially now with little insider ownership remaining. I also agree that the residential market is a question mark, even though management seems optimistic. I am happy with the swift response of management, and I increased my stake slightly, as I communicated with premium subscribers last week. Let’s take a look at a quick IRR model. I used a range between 7-12% revenue growth rate, EBITDA margin improvements between 29-40% alongside an exit multiple between 13-22x EV/EBITDA. The average 10-year EV/EBITDA multiple was 21.4, so we have a decline in valuation factored in as well as growth below analyst estimates. This leaves us at a 14.5% average IRR. Let’s see how the next quarters play out and I’ll make sure to keep management on a tighter leech, in light of this report. Despite the sharp fall in the recent month, my Napco position is still well in the green. Let’s see how the future turns out.
Confused by the hate I’ve seen in the comments. You broke down the short report and used the information you had to come up with your own thesis. FP’s track record has been solid, but not perfect. None of the other stocks have had a track record like Napco.
Company reminds me of XPEL due to the previous sharp job after earnings and Culpers short report. Company also has one of the best track records and one of the highest gainers on VIC. 4 months out and stock is up 40ish percent.
Keep up the great work. There’s always two sides and can be very profitable doubling down on a currently out of favor stock with lower expectations.
You can clearly see the confirmation bias tendency you have here because you point out that $GL rebounded. Stock charts don't make a company more or less a fraud, and for GL at least it's clear that their third parties werd committing fraud and that the co's leadership was in on it.
So only for this fact i cannot take seriously what you write, try to detach yourself from your emotions in order to see reality for what it is, same for FP's wrong argument about peforming better than apple and so on.