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 10% and 18% of our revenues for the fiscal years ended June 30, 2009 and 2008 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 provided for an annual base rent of $288,750 plus maintenance and real estate taxes and expired in August 2009. In March 2009, the Company began to move the Marks operations into its existing facilities. The Company completed the majority of this consolidation by August 31, 2009. 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 2009 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

Since October 2008, the U.S. and international economies have experienced a significant downturn and continue to be very volatile. In the event that the downturn in the U.S. or international financial markets is prolonged, our revenue, profit and cashflow levels could be materially adversely affected in future periods. This could affect our ability to maintain adequate financing. If the current worldwide economic downturn continues, many of our current or potential future customers may experience serious cash flow problems and as a result may, modify, delay or cancel purchases of our products. Additionally, customers may not be able to pay, or may delay payment of, accounts receivable that are owed to us. Furthermore, the current downturn and market instability makes it difficult for us to forecast our revenues.

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 historically 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. The severity of the current economic downturn may also affect this trend.

Restructuring Costs

In March 2009, the Company began a Restructuring Plan consisting of a series of actions to consolidate its Sales, Production and Warehousing operations of Marks and those in Europe and the Middle East into the Corporate Headquarters in Amityville, NY and its production facility in the Dominican Republic. We expect these restructuring initiatives to cost between $1,200,000 and $1,500,000. The majority of these actions have been completed by July 31, 2009, while certain Production-related actions are expected to be completed by December 31, 2009. Accordingly, the Company recognized restructuring costs of $1,274,000 in the fiscal year ended June 30, 2009. Of this amount, $210,000 relates to Workforce Reductions communicated in March 2009 and $1,064,000 to Business Exits and related costs associated with inventory and lease impairments related to the closure of the Marks, European and Middle East facilities. As of June 30, 2009, $1,138,000 of the $1,274,000 in restructuring costs has been incurred and $136,000 remains in accrued expenses.

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 9% and 6% for fiscal years ended June 30, 2009 and 2008, 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 24% and 34% of the Company's accounts receivable at June 30, 2009 and 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 $400,000 and $405,000 as of June 30, 2009 and 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. 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. For the fiscal years 2009 and 2008, net charges and balances in these reserves amounted to $247,000 and $1,447,000; and $0 and $1,200,000, respectively. 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. 141R, 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. Intangible assets are reviewed for impairment at least annually at the Company's fiscal year-end of June 30 or more often whenever there is an indication that the carrying amount may not be recovered. 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. At the conclusion of fiscal 2009, the Company performed its annual impairment evaluation required by this standard and determined that its goodwill relating to its Alarm Lock and Continental subsidiaries is impaired. Accordingly, the Company recorded an impairment charge of $9,686,000 which represents the unamortized balance of this Goodwill.

The Company's acquisition of substantially all of the assets and certain liabilities of Marks included intangible assets with a fair value of $16,440,000 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 $922,000 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 Company adopted the provisions of FIN 48 as of July 1, 2007. The Company has identified its U.S. Federal income tax return and its State return in New York as its major tax jurisdictions. As a result the Company increased its accrued income tax liability by $715,000, from $1,836,000 to $2,551,000, to provide for additional reserves for uncertain income tax positions for U.S. Federal and State income tax purposes. The fiscal 2006 and forward years are still open for examination. The increase in the accrued income tax liability of $715,000 was offset in part by a $230,000 increase to a deferred income tax asset, resulting in a net reduction to retained earnings of $485,000 (representing the cumulative effect of adopting FIN48).

During the year ending June 30, 2009 the Company decreased its reserve for uncertain income tax positions by $73,000. As of June 30, 2009 the Company has a long-term accrued income tax liability of $176,000. The Company's practice is to recognize interest and penalties related to income tax matters in income tax expense and accrued income taxes. As of June 30, 2009, the Company had accrued interest totaling $37,000 and $141,000 of unrecognized net tax benefits (including the related accrued interest and net of the related deferred income tax benefit of $72,000) that, if recognized, would favorably affect the company's effective income tax rate in any future period.

For the year ended June 30, 2009, the company recognized a net benefit to income tax expense of $53,000 ($99,000 liability reversal including interest, less the related $34,000 reversal of deferred tax asset, plus current year interest accrual on other reserves of $12,000).

The difference between the statutory U.S. Federal income tax rate and the Company's effective tax rate as reflected in the consolidated statements of income for fiscal 2009 is as follows (dollars in thousands):

                                                           % of
                                                          Pre-tax
                                              Amount      Income
                                              ------      -------

Tax at Federal statutory rate                $(5,672)       34.0%
Increases (decreases) in
   taxes resulting from:
   Meals and entertainment                        58       (0.4)%
      State income taxes, net of
         Federal income tax benefit               18       (0.1)%
   Foreign source income and taxes             2,224      (13.3)%
   Stock based compensation expense              107       (0.6)%
   Tax reserve reversal                           53         0.3%
   Other, net                                     19       (0.1)%
                                             --------     -------

Provision for income taxes                   $(3,299)     (19.8)%
                                             ========     =======

Liquidity and Capital Resources

The Company's cash on hand combined with proceeds from operating and financing activities during fiscal 2009 were adequate to meet the Company's capital expenditure needs and long-term debt obligations. The Company's primary internal source of liquidity is the cash flow generated from operations. The primary source of financing related to borrowings under an $11,100,000 secured revolving credit facility. As of June 30, 2009 $11,100,000 was outstanding under this revolving line of credit. The Company expects that cash generated from operations will be adequate to meet its short-term liquidity requirements. As of June 30, 2009, the Company's unused sources of funds consisted principally of $4,109,000 in cash.

On August 18, 2008, the Company and its banks amended and restated the existing $25,000,000 revolving credit agreement. The amended facility was $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 5 of the accompanying consolidated financial statements. The amended revolving credit agreement and term loan was amended in June 2009 to $11,100,000 and is secured by the accounts receivable, a portion of inventory, the Company's headquarters building in Amityville, New York, certain other assets of Napco Security Technologies, Inc. and the common stock of three of the Company's subsidiaries. The agreements bear interest based on either the Prime Rate or an alternate rate based on LIBOR as described in the agreement. Any outstanding borrowings are to be repaid or refinanced on or before that time. As of June 30, 2009 there was $11,100,000 outstanding under the revolving credit facility with an interest rate of 7.25% and $22,321,000 outstanding under the term loan with an interest rate of 7.25%. The term loan is being 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 amended agreement. As of June 30, 2009 the Company was not in compliance with the covenants relating to net income and ratios associated with maximum leverage, a modified quick ratio and debt service coverage for which it has received the appropriate waivers from its banks. The Company and its banks also amended the facilities to provide for a borrowing base formula in calculating availability under the revolving credit line.

Management believes that current working capital and cash flows from operations will be sufficient to fund the Company's operations through at least the first quarter of fiscal 2011.

The Company takes into consideration a number of factors in measuring its liquidity, including the ratios set forth below:

                                    2009             2008
                                    ----             ----
    Current Ratio                 2.0 to 1         5.7 to 1
    Sales to Receivables          3.5 to 1         2.7 to 1
    Total debt to equity          .82 to 1         .23 to 1

As of June 30, 2009, the Company had no material commitments for capital expenditures or inventory purchases other than purchase orders issued in the normal course of business. On April 26, 1993, the Company's foreign subsidiary entered into a 99-year land lease of approximately 4 acres of land in the Dominican Republic, at an annual cost of approximately $288,000.

On August 18, 2008, the Company, pursuant to an Asset Purchase Agreement with Marks, acquired substantially all of the assets and business for $25 million, the repayment of $1 million of bank debt and the assumption of current liabilities as described more fully in the Asset Purchase Agreement. The Marks business involves the manufacturing and distribution of door-locking devices. The Company funded the acquisition with a term loan from its lenders as described above.

The acquisition described above has been accounted for as a purchase and was valued based on management's estimate of the fair value of the assets acquired and liabilities assumed. The estimates of fair value were subject to adjustment for a period of up to one year from the date of acquisition, and such adjustments were not material. Costs in excess of identifiable net assets acquired were allocated to goodwill in the first quarter of fiscal 2009.

Working Capital. Working capital decreased by $18,889,000 to $22,404,000 at June 30, 2009 from $41,293,000 at June 30, 2008. The decrease in working capital was primarily the result of the classification of the Company's outstanding debt under its revolving line of credit as a current liability. The term loan was obtained during fiscal 2009 and the outstanding debt under the revolving line of credit was classified as a non-current liability as June 30, 2008. Working capital is calculated by deducting Current Liabilities from Current Assets.

Accounts Receivable. Accounts Receivable decreased by $5,824,000 to $19,999,000 at June 30, 2009 from $25,823,000 at June 30, 2008. This decrease resulted primarily from the lower net sales during the fourth quarter of fiscal 2009 as compared to the fourth quarter of fiscal 2008 as well as the Company granting less generous credit terms to its customers.

Inventories. Inventories increased by $1,562,000 to $28,834,000 at June 30, 2009 as compared to $27,272,000 at June 30, 2008. The increase in inventory levels was primarily the result of the Company acquiring the assets of Marks as partially offset by a reduction in its procurement and production levels of its non-Marks products..

Accounts Payable and Accrued Expenses. Accounts payable and accrued expenses decreased by $1,296,000 to $7,437,000 as of June 30, 2009 as compared to $8,733,000 at June 30, 2008. This decrease is primarily due to decreased purchases of raw materials during the month of June 2009 as compared to June 2008, which was primarily the result of a lower sales forecast for the fourth quarter of fiscal 2009 as compared to the same quarter a year ago as well as the Company's more accurate forecasting and production planning as previously discussed.

Off-Balance Sheet Arrangements

The Company does not maintain any off-balance sheet arrangements.

Contractual Obligations

The following table summarizes the Company's contractual obligations by fiscal
year:


                                                                    Payments due by period
                                      -------------------------------------------------------------------------------------
                                                        Less than 1                                         More than 5
                                                        ------------                                        ------------
   Contractual obligations                Total             year            1-3 years        3-5 years         years
   -----------------------                -----             ----            ---------        ---------         -----

Long-term debt obligations               $33,421,000    $14,672,000         $7,144,000      $11,605,000     $        --


Land lease (83 years remaining) (1)       23,904,000        288,000            576,000          576,000      22,464,000

Operating lease obligations                  190,000        153,000             37,000               --              --

Other long-term obligations
(employment agreements) (1)                2,609,000      1,464,000            770,000          375,000              --
                                      -------------------------------------------------------------------------------------
Total                                    $60,124,000     $5,477,000         $8,527,000      $23,656,000     $22,464,000
                                      =====================================================================================

(1) See footnote 12 to the accompanying consolidated financial statements.

Results of Operations

Fiscal 2009 Compared to Fiscal 2008

                                         Fiscal year ended June 30,
                                         --------------------------
                                                                  % Increase/
                                          2009         2008        (decrease)
                                          ----         ----       -----------

Net sales                              $  69,565     $ 68,367          1.8%
Restructuring costs included in
cost of sales                              1,110            -
Gross profit                              15,096       20,412       (26.0)%
Gross profit as a % of net sales           21.7%        29.9%        (8.2)%
Selling, general and administrative       20,163       17,275         16.7%

Impairment of goodwill                     9,686            -

Other restructuring costs                    164            -
(Loss) income from operations           (14,917)        3,137      (575.5)%
Interest expense, net                      1,637          819         99.9%
Other expense, net                           127           42        202.4%
(Benefit)for income taxes                (3,299)      (1,408)        134.3%

Net (loss) income                       (13,382)        3,718         11.8%

Net sales in fiscal 2009 increased by 1.8% to $69,565,000 from $68,367,000 in fiscal 2008. The increase in sales was primarily the result of the net sales added from the Marks acquisition ($16,936,000) as partially offset by a decrease in intrusion detection products ($10,977,000), door-locking products ($1,054,000), access control products ($594,000) and products specific to the Company's Middle East operation ($3,113,000). The Company's sales were adversely affected by the worldwide economic downturn.

The Company's gross profit decreased $5,316,000 to $15,096,000 or 21.7% of net sales in fiscal 2009 as compared to $20,412,000 or 29.9% of net sales in fiscal 2008. The decrease in gross profit in both absolute dollars and as a percentage of net sales was due primarily to the decrease in net sales of the Company's non-Marks products and the resulting reduction in overhead absorption in the production of these products.

Selling, general and administrative expenses as a percentage of net sales increased to 29.0% in fiscal 2009 from 25.3% in fiscal 2008. Selling, general and administrative expenses for fiscal 2009 increased $2,888,000 to $20,163,000 from $17,275,000 in fiscal 2008. These increases resulted primarily from the addition of Marks expenses in fiscal 2009, including $1,231,000 in amortization expense on Intangible assets, and the net sales for fiscal 2009 increasing by a lower proportion than these additional expenses.

Interest expense for fiscal 2009 increased by $818,000 to $1,637,000 from $819,000 for the same period a year ago. The increase in interest expense is primarily the result of the increase in outstanding debt relating to the Marks acquisition term loan and higher borrowing rates charged by the Company's primary banks as partially offset by the Company's reduction of its outstanding borrowings under its revolving line of credit.

Other expenses increased slightly to $127,000 in fiscal 2009 as compared to $42,000 in fiscal 2008.

The Company's benefit for income taxes for fiscal 2009 increased by $1,891,000 to a benefit of $3,299,000 as compared to a benefit of $1,408,000 for the same period a year ago. The decrease in provision for income taxes resulted primarily from the Company recognizing a net tax benefit to income tax expense of $3,293,000 resulting from the impairment charge to goodwill recognized in fiscal 2009. In addition, in December 2007 the Company completed a corporate restructuring for which new offshore companies were formed. As a result, the Company's effective rate for fiscal 2009, prior to the effect of the $3,293,000 benefit described above, was 0%, which reflected this restructuring.

Net income for fiscal 2009 decreased by $17,100,000 to $(13,382,000) as compared to $3,718,000 in fiscal 2008. This resulted primarily from the impairment charge to goodwill of $9,686,000, the decrease in Gross profit of $5,316,000 and the increase in Selling, general and administrative expenses of $2,888,000 as partially offset by the $3,293,000 tax benefit, all of which are discussed above.

Forward-looking Information

This Annual Report on Form 10-K 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 . . .