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. For example, the Company is highly dependent on its Chief Executive Officer for strategic planning. If he is unable to perform his services for any significant period of time, the Company's ability to continue growing could be adversely affected. In addition, factors that could cause actual results to differ materially from the Forward-Looking Statements include, but are not limited to, adverse tax consequences of offshore operations, significant fluctuations in the exchange rate between the Dominican Peso and the U.S. Dollar, distribution problems, unforeseen environmental liabilities and the uncertain military, political and economic conditions in the world.

Overview

The Company is a diversified manufacturer of security products, encompassing intrusion and fire alarms, building access control systems and electronic locking devices. These products are used for commercial, residential, institutional, industrial and governmental applications, and are sold worldwide principally to independent distributors, dealers and installers of security equipment. International sales accounted for approximately 12% and 17% of our revenues for the three months ended September 30, 2008 and 2007, respectively.

The Company owns and operates manufacturing facilities in Amityville, New York and the Dominican Republic. A significant portion of our operating costs are fixed, and do not fluctuate with changes in production levels or utilization of our manufacturing capacity. As production levels rise and factory utilization increases, the fixed costs are spread over increased output, which should improve profit margins. Conversely, when production levels decline our fixed costs are spread over reduced levels, thereby decreasing margins.

On August 18, 2008, the Company acquired substantially all of the assets and business of G. Marks Hardware, Inc. ("Marks") for $25.2 million, the repayment of $1 million of bank debt and the assumption of certain current liabilities. The Company also entered into a lease for the building where Marks has maintained its operations. The lease provides for an annual base rent of $288,750 plus maintenance and real estate taxes, expires in August 2009 and provides for two annual extensions thereafter. The Company intends to move the Marks operations into its facilities after constructing extensions of approximately 35,000 square feet. To date, the Company does not have estimates for the cost of this move or the related construction. The Marks business involves the manufacturing and distribution of door-locking devices.

The security products market is characterized by constant incremental innovation in product design and manufacturing technologies. Generally, the Company devotes 7-8% of revenues to research and development (R&D) on an annual basis. Products resulting from our R&D investments in fiscal 2008 did not contribute materially to revenue during this fiscal year, but should benefit the Company over future years. In general, the new products introduced by the Company are initially shipped in limited quantities, and increase over time. Prices and manufacturing costs tend to decline over time as products and technologies mature.

Economic and Other Factors

The post-September 11 era has generally been characterized by increased demand for electronic security products and services. The Company believes the security equipment market is likely to continue to exhibit growth, particularly in industrial sectors, due to ongoing concerns over the adequacy of security safeguards. The Company's business is also affected by the housing markets.

Seasonality

The Company's fiscal year begins on July 1 and ends on June 30. Historically, the end users of Napco's products want to install its products prior to the summer; therefore sales of its products peak in the period April 1 through June 30, the Company's fiscal fourth quarter, and are reduced in the period July 1 through September 30, the Company's fiscal first quarter. To a lesser degree, sales in Europe are also adversely impacted in the Company's first fiscal quarter because of European vacation patterns, i.e., many distributors and installers are closed for the month of August. In addition, demand is affected by the housing and construction markets. Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses reported in those financial statements. These judgments can be subjective and complex, and consequently actual results could differ from those estimates. Our most critical accounting policies relate to revenue recognition; concentration of credit risk; inventories; intangible assets; goodwill; 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 sale. 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 other allowances.

Our sales return accrual is a subjective critical estimate that has a direct impact on reported net sales and income. 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. As a percentage of gross sales, sales returns, rebates and allowances were 7% and 4% for the three months ended September 30, 2008 and 2007, respectively.

Concentration of 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 if it mitigated its risk through diversification of customers. Such risks of loss manifest themselves differently, depending on the nature of the concentration, and vary in significance.

The Company had two customers with accounts receivable balances that aggregated 30% and 34% of the Company's accounts receivable at September 30, 2008 and June 30, 2008, respectively. Sales to neither of these customers exceeded 10% of net sales in any of the past three fiscal years.

In the ordinary course of business, we have established a reserve for doubtful accounts and customer deductions in the amount of $408,000 and $405,000 as of September 30, 2008 and June 30, 2008, respectively. Our reserve 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 agings, specific exposures and historical trends.

Inventories

Inventories are valued at the lower of cost or fair market value, with cost being determined on the first-in, first-out (FIFO) method. The reported net value of inventory includes finished saleable products, work-in-process and raw materials that will be sold or used in future periods. Inventory costs include raw materials, direct labor and overhead. The Company's overhead expenses are applied based, in part, upon estimates of the proportion of those expenses that are related to procuring and storing raw materials as compared to the manufacture and assembly of finished products. These proportions, the method of their application, and the resulting overhead included in ending inventory, are based in part on subjective estimates and approximations and actual results could differ from those estimates.

In addition, the Company records an inventory obsolescence reserve, which represents the difference between the cost of the inventory and its estimated market value, based on various product sales projections. The balance in this reserve was $1,432,000 and $1,200,000 as of September 30, 2008 and June 30, 2008, respectively. This reserve is calculated using an estimated obsolescence percentage applied to the inventory based on age, historical trends, requirements to support forecasted sales, and the ability to find alternate applications of its raw materials and to convert finished product into alternate versions of the same product to better match customer demand. There is inherent professional judgment and subjectivity made by both production and engineering members of management in determining the estimated obsolescence percentage. In addition, and as necessary, the Company may establish specific reserves for future known or anticipated events.

The Company also regularly reviews the period over which its inventories will be converted to sales. Any inventories expected to convert to sales beyond 12 months from the balance sheet date are classified as non-current.

Goodwill and Other Intangible Assets

The Company accounts for Goodwill in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets. These statements established accounting and reporting standards for acquired goodwill and other intangible assets. Specifically, the standards address how acquired intangible assets should be accounted for both at the time of acquisition and after they have been recognized in the financial statements. In accordance with SFAS No. 142, intangible assets, including purchased goodwill, must be evaluated for impairment. Those intangible assets that are classified as goodwill or as other intangibles with indefinite lives are not amortized.

Impairment testing is performed in two steps: (i) the Company determines impairment by comparing the fair value of a reporting unit with its carrying value, and (ii) if there is an impairment, the Company measures the amount of impairment loss by comparing the implied fair value of goodwill with the carrying amount of that goodwill. The Company has performed its annual impairment evaluation required by this standard and determined that its goodwill is not impaired.

The Company's acquisition of substantially all of the assets and certain liabilities of Marks included intangible assets with a fair value of $16,100,000 on the date of acquisition. In accordance with the requirements of SFAS No. 141, "Business Combinations", the Company recorded the estimated value of $9,800,000 related to the customer relationships, $340,000 related to a non-compete agreement and $6,300,000 related to the Marks trade name within intangible assets and Goodwill of $897,000 subject to further adjustment. In accordance with the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets", the intangible assets will be amortized over their estimated useful lives of twenty years (customer relationships) and seven years (non-compete agreement). The Marks USA trade name was deemed to have an indefinite life. The goodwill recorded as a result of the acquisition is deductible for Federal and New York State income tax purposes over a period of 15 years.

Income Taxes

The provision for income taxes represents Federal, foreign, and state and local income taxes. The effective rate differs from statutory rates due to the effect of state and local income taxes, tax rates in foreign jurisdictions and certain nondeductible expenses. Our effective tax rate will change from quarter to quarter based on recurring and non-recurring factors including, but not limited to, the geographical mix of earnings, enacted tax legislation, and state and local income taxes. In addition, changes in judgment from the evaluation of new information resulting in the recognition, de-recognition or re-measurement of a tax position taken in a prior annual period are recognized separately in the quarter of the change.

We do not expect that our unrecognized tax benefits will significantly change within the next twelve months. We file a consolidated U.S. income tax return and tax returns in certain state and local and foreign jurisdictions. There are no current tax examinations in progress. Accordingly, as of September 30, 2008, we remain subject to examination in all tax jurisdictions for all relevant jurisdictional statutes.

Results of Operations
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                                     -------------------------------------------
                                          Three months ended September 30,
                                               (dollars in thousands)
                                     -------------------------------------------
                                        2008           2007        % Increase/
                                                                   (decrease)
                                     -------------------------------------------

Net sales                            $   17,483     $   13,876           26.0%
Gross profit                              5,606          5,224            7.3%
Gross profit as a % of net sales           32.1%          37.6%          (5.5)%
Selling, general and administrative       4,776          4,421            8.0%
Selling, general and administrative
as a percentage of net sales               27.3%          31.9%          (4.6)%
Operating income                            830            803            3.4%
Interest expense, net                       315            195           61.5%
Other expense
                                             79              7        1,028.6%
Minority interest in net loss of
subsidiary, net                              42             38           10.5%
Provision for income taxes                  156            265          (41.1)%
Net income                                  322            374          (13.9)%
                                     -------------------------------------------

Sales for the three months ended September 30, 2008 increased by approximately 26% to $17,483,000 as compared to $13,876,000 for the same period a year ago. The increase in sales for the three months ended September 30, 2008 was primarily the result of the six weeks of net sales added from the Marks acquisition as well as a 2% increase in the Company's other product lines. This 2% increase was primarily due to increases in the Company's door locking and access control products as partially offset by decreased sales of intrusion products.

The Company's gross profit for the three months ended September 30, 2008 increased to $5,606,000 or 32.1% of sales as compared to $5,224,000 or 37.6% of sales for the same period a year ago. The increase in Gross profit in dollars for the three months was primarily due to the addition of the Gross profit of Marks ($1,057,000) resulting from the acquisition on August 18, 2008 as partially offset by a decrease in Gross profit in the Company's other products.

Selling, general and administrative expenses for the three months ended September 30, 2008 increased by $355,000 to $4,776,000, or 27.3% of sales, as compared to $4,421,000, or 31.9% of sales a year ago. The increase in dollars for the three months ended September 30, 2008 was due primarily to the additional expenses relating to Marks ($454,000) as partially offset by a decrease in tradeshow expenses due to a major tradeshow occurring in October 2008 ($199,000). This tradeshow occurred in September 2007 and was therefore included in Selling, general and administrative expense for the first quarter of fiscal 2008. The decrease in Selling, general and administrative expenses as a percentage of net sales was due to the timing of this tradeshow as well as Marks having lower Selling, general and administrative expenses as a percentage of sales as compared to rest of the Company.

Interest expense, net for the three months ended September 30, 2008 increased by $120,000 to $315,000 as compared to $195,000 for the same period a year ago. The increase in interest expense for the three months resulted primarily from the increase in the Company's average outstanding debt, which was due to the $25,000,000 of bank financing utilized for the Marks acquisition.

The Company's provision for income taxes for the three months ended September 30, 2008 decreased by $109,000 to $156,000 as compared to $265,000 for the same period a year ago. The decrease in provision for income taxes for the three months resulted primarily from the Company's corporate restructuring during the quarter ended December 31, 2007. As a result, the Company's effective rate for for income tax was 32.6% for the three months ended September 30, 2008, which reflected the effect of this restructuring and 41.5% for the three months ended September 30, 2007, which did not.

Net income decreased by $52,000 to $322,000 or $0.02 per diluted share for the three months ended September 30, 2008 as compared to $374,000 or $0.02 per diluted share for the same period a year ago. The decrease for the three months ended September 30, 2008 was primarily due to the decrease in gross profit as a percentage of sales as discussed above as partially offset by the additional net income generated from the Marks acquisition ($240) as well as the lower effective tax rate relating to the Company's corporate restructuring described above.

Liquidity and Capital Resources

During the three months ended September 30, 2008 the Company utilized all of its cash from operations and additional borrowings to complete the Marks acquisition ($26,173,000, which includes payment of the $1,000,000 of assumed debt), purchase inventory ($1,317,000) and property, plant and equipment ($115,000). 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 next twelve months.

Accounts Receivable at September 30, 2008 increased $656,000 to $26,479,000 as compared to $25,823,000 at June 30, 2008. This increase is primarily the result of Marks acquisition ($2,540,000) as partially offset by the lower sales volume during the quarter ended September 30, 2008 as compared to the quarter ended June 30, 2008, which is typically the Company's highest.

Inventories at September 30, 2008 increased by $8,058,000 to $35,330,000 as compared to $27,272,000 at June 30, 2008. This increase was primarily the result of the Marks acquisition ($5,774,000) as well as the Company 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. The Company initiated several steps in order to reduce inventory levels in fiscal 2008 and expects to continue them in fiscal 2009.

On August 18, 2008, the Company and its banks amended and restated the existing $25,000,000 revolving credit agreement. The amended facility is $50,000,000 and provides for a $25,000,000 revolving credit line as well as a $25,000,000 term portion of which the entire $25,000,000 was utilized to finance the asset purchase agreement as described in Note 12. The amended revolving credit agreement and term loan is secured by all the accounts receivable, inventory, the Company's headquarters in Amityville, New York and certain other assets of Napco Security Systems, Inc. and the common stock of three of the Company's subsidiaries. The agreements bear interest at either the Prime Rate or an alternate rate based on LIBOR as described in the agreement. The August amendment extended the revolving credit agreement to August 2012. Any outstanding borrowings are to be repaid or refinanced on or before that time. As of September 30, 2008 there was $14,100,000 outstanding under the revolving credit facility with an interest rate of 4.6% and $25,000,000 outstanding under the term loan with an interest rate of 5.0%. The term loan is to be repaid in 19 quarterly installments of $893,000 each commencing in December 2008 and a final payment of $8,033,000 due in August 2013. The agreements contain various restrictions and covenants including, among others, restrictions on payment of dividends, restrictions on borrowings and compliance with certain financial ratios, as defined in the agreement. As of September 30, 2008 the Company was in violation of the covenant relating to the ratio of Funded Debt to EBITDA for which it has received the appropriate waiver from its banks. In addition, the Company's revolving credit line was amended to $20,000,000 from $25,000,000 in November 2008.

As of September 30, 2008 the Company had no material commitments for capital expenditures or inventory purchases other than purchase orders issued in the normal course of business.