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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to ________
Commission File No. 000-50343
INTEGRATED ALARM SERVICES GROUP, INC.
(Exact name of Registrant as specified in its charter)
Delaware
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
42-1578199
One Capital Center
99 Pine Street,3rd Floor
Albany, New York 12207
(Address of principal executive offices) (zip code)
(518) 426-1515
(Registrant's telephone number, including area code)
(Former name or former address, if changed since 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 Exchange Act of 1934 during the
preceding 12 months (or for such 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
--- ---
As of November 10, 2004 there were 24,681,462 shares of the registrant's
common stock outstanding.
Integrated Alarm Services Group, Inc. and Subsidiaries
Form 10-Q Index
For the Three and Nine Months Ended September 30, 2004
Description
Part I. Financial Information....................................................................................3
Item 1 Financial Statements............................................................................3
Consolidated Balance Sheets as of December 31, 2003 and September 30, 2004......................3
Statements of Operations for the Three and Nine Months Ended September 30, 2003 and 2004........4
Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2004..................5
Notes to Consolidated Financial Statements......................................................6
Item 2 Management's Discussions and Analysis of Financial Condition and Results of Operations.........13
Item 3 Quantitative and Qualitative Disclosures about Market Risks....................................23
Item 4 Controls and Procedures........................................................................23
Part II Other Information.......................................................................................24
Item 1 Legal Proceedings..............................................................................24
Item 6 Exhibits and Reports on Form 8-K...............................................................25
2
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF
----------------------------------
DECEMBER 31, SEPTEMBER 30,
2003 2004
---------------- --------------
Assets (unaudited)
Current assets:
Cash and cash equivalents $ 35,435,817 $ 4,269,912
Current portion of notes receivable 735,149 1,061,788
Accounts receivable, net 4,312,990 5,784,853
Inventories 1,107,899 917,408
Prepaid expenses 1,548,105 1,580,190
Due from related parties 232,300 127,467
--------------- -------------
Total current assets 43,372,260 13,741,618
Property and equipment, net 5,762,586 6,107,488
Notes receivable, net of current portion and allowance 4,525,973 3,276,716
Dealer relationships, net 23,113,617 20,631,598
Customer contracts, net 73,571,131 85,594,928
Goodwill, net 85,515,985 90,508,406
Debt issuance costs, net 1,768,281 1,085,941
Other identifiable intangibles, net 2,187,464 1,898,416
Restricted cash and cash equivalents 1,100,000 1,855,896
Other assets 119,033 4,813,952
--------------- -------------
Total assets $ 241,036,330 $ 229,514,959
=============== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 18,765,000 $ 15,296,000
Current portion of capital lease obligations 431,555 431,997
Accounts payable 2,873,707 943,627
Accrued expenses 8,816,766 5,941,073
Current portion of deferred revenue 7,576,993 7,751,164
Other liabilities 139,066 618,575
--------------- -------------
Total current liabilities 38,603,087 30,982,436
Long-term debt, net of current portion 46,977,612 43,720,112
Capital lease obligations, net of current portion 453,811 190,907
Deferred revenue, net of current portion 312,343 3,040,637
Deferred income taxes 759,425 759,425
Other liabilities 374,119 17,819
Due to related parties 153,203 23,677
--------------- -------------
Total liabilities 87,633,600 78,735,013
--------------- -------------
Commitments and Contingencies
Stockholders' equity
Preferred stock, $0.001 par value; authorized
3,000,000 shares and none issued and outstanding - -
Common stock, $0.001 par value; authorized
100,000,000 shares; issued and outstanding
24,607,731 shares at December 31, 2003 and
24,681,462 at September 30, 2004
24,608 24,682
Common stock subscribed 315,342 -
Paid-in capital 205,086,659 206,365,106
Accumulated deficit (52,023,879) (55,609,842)
--------------- --------------
Total stockholders' equity 153,402,730 150,779,946
--------------- --------------
Total liabilities and stockholders' equity $ 241,036,330 $ 229,514,959
=============== ==============
The accompanying notes are an integral part of the consolidated financial
statements.
3
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2004
(UNAUDITED)
Three months ended September 30, Nine months ended September 30,
2003 2004 2003 2004
------------- ------------- -------------- -------------
Revenue:
Monitoring fees $ 5,930,091 $ 5,529,322 $ 17,872,642 $ 17,366,658
Revenue from customer accounts 3,679,942 13,426,098 9,747,077 37,105,439
Billing fees 45,264 - 87,761 -
Related party monitoring fees - 36,036 282,250 137,847
Related party placement fees - - 90,437 -
Service and subcontractor fees 77,046 2,909,583 168,501 5,017,615
------------ ------------ ------------- ------------
Total revenue 9,732,343 21,901,039 28,248,668 59,627,559
Cost of revenue (excluding depreciation
and amortization) 4,247,531 8,828,605 12,001,091 22,938,107
------------ ------------ ------------- ------------
5,484,812 13,072,434 16,247,577 36,689,452
------------ ------------ ------------- ------------
Operating expenses:
Selling and marketing 229,037 1,001,200 684,531 3,246,126
Depreciation and amortization 2,189,001 5,802,323 8,609,426 16,245,896
General and administrative 2,673,240 5,365,823 7,270,519 14,930,890
General and administrative - related party - - 3,525,000 -
------------ ------------ ------------- ------------
Total operating expenses 5,091,278 12,169,346 20,089,476 34,422,912
------------ ------------ ------------- ------------
Income (loss) from operations 393,534 903,088 (3,841,899) 2,266,540
Other income (expense):
Other income (expense), net 468,245 - 205,495 (3,080)
Amortization of debt issuance costs (1,985,380) (234,273) (2,892,793) (741,307)
Related party interest expense (462,381) - (914,229) -
Interest expense (3,151,893) (1,851,475) (10,820,616) (5,501,517)
Interest income 336,358 180,880 1,113,585 711,428
------------ ------------ ------------- ------------
Income (loss) before income taxes (4,401,517) (1,001,780) (17,150,457) (3,267,936)
Income tax expense (benefit) (35,828) 1,145,431 3,331,345 318,027
------------ ------------ ------------- ------------
Net income (loss) $ (4,365,689) $ (2,147,211) $ (20,481,802) $ (3,585,963)
============ ============ ============= ============
Basic and diluted income (loss) per share $ (0.25) $ (0.09) $ (3.02) $ (0.15)
============ ============ ============= ============
Weighted average number of common
shares outstanding 17,269,123 24,681,462 6,774,349 24,663,426
============ ============ ============= ============
Unaudited:
Pro Forma income tax to give effect to the conversion
from S to C Corporation status:
Income (loss) before benefit from income taxes $ (4,401,517) $ (1,001,780) $ (17,150,457) $ (3,267,936)
Income tax expense (benefit) (35,828) 1,145,431 (285,143) 318,027
------------ ------------ ------------- ------------
Net income (loss) $ (4,365,689) $ (2,147,211) $ (16,865,314) $ (3,585,963)
============ ============ ============= ============
Basic and diluted income (loss) per share $ (0.25) $ (0.09) $ (2.49) $ (0.15)
============ ============ ============= ============
The accompanying notes are an integral part of the consolidated financial
statements.
4
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2004
(UNAUDITED)
2003 2004
-------------- -------------
Cash flows from operating activities:
Net income (loss) $ (20,481,802) $(3,585,963)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization 8,609,426 16,245,896
Amortization of deferred installation cost, net - 95,216
Amortization of debt issuance costs 2,892,793 741,307
Interest expense - non-cash, notes 176,283 675,161
Stock options issued to consultant - 13,018
Provision for bad debts 1,023,569 457,951
Deferred income taxes 3,303,105 -
Non-cash service fees 1,825,000 -
Loss on disposal of property and equipment - 3,242
Loss (gain) on settlement of notes receivable - (48,578)
Changes in assets and liabilities, net of
effects of acquisitions and
non-cash transactions:
Accounts receivable (1,439,648) (1,114,950)
Inventories - 190,491
Prepaid expenses (1,107,155) (32,085)
Other assets (6,960) (117,169)
Due (from)to related parties (8,331) (24,692)
Accounts payable and accrued expenses (3,306,068) (3,108,548)
Deferred revenue 1,137,444 (1,412,741)
Other liabilities (14,555) 123,209
-------------- ------------
Net cash provided by (used in) operating activities (7,396,899) 9,100,765
-------------- ------------
Cash flows from investing activities:
Purchase of property and equipment (376,206) (2,355,529)
Proceeds from sale of property and equipment - 1,800
Purchase of customer contracts and dealer relationships (2,466,319) (14,213,895)
Deferred installation costs - (4,688,733)
Deferred installation revenue - 3,435,311
Financing of customer loans (698,873) (3,095,921)
Purchase of short-term investments (63,906,572) -
Repayment of customer loans 670,864 1,590,683
Decrease (increase) in restricted cash and cash equivalents 2,880,065 (755,896)
Business acquisitions, net of cash acquired 8,082,332 (13,411,560)
-------------- ------------
Net cash provided by (used in) investing activities (55,814,709) (33,493,740)
-------------- ------------
Cash flows from financing activities:
Proceeds of initial public offering 195,856,512 -
Proceeds of long-term debt, related party 2,000,000 -
Proceeds of long-term debt 6,839,404 -
Payments of obligations under capital leases (110,380) (262,462)
Repayment of long-term debt (102,100,626) (6,451,500)
Repayment of long-term debt, related party (3,409,765) -
Debt issuance costs (145,894) (58,968)
-------------- ------------
Net cash provided by (used in) financing activities 98,929,251 (6,772,930)
-------------- ------------
Net increase (decrease) in cash and cash equivalents for the period 35,717,643 (31,165,905)
Cash and cash equivalents at beginning of year 442,082 35,435,817
-------------- ------------
Cash and cash equivalents at end of period $ 36,159,725 $ 4,269,912
============== ============
The accompanying notes are an integral part of the consolidated financial
statements.
5
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. MANAGEMENT OPINION
The financial information as of September 30, 2004 and for the three months and
nine months ended September 30, 2004 and 2003, in the opinion of management,
includes all adjustments, consisting only of normal recurring adjustments, that
are considered necessary for fair presentation of the financial position,
results of operations and cash flows of Integrated Alarm Services Group, Inc.
and Subsidiaries (IASG or the "Company") for the three months and nine months
ended September 30, 2004 and 2003 in accordance with accounting principles
generally accepted in the United States of America. The results for any interim
period are not necessarily indicative of results for the full year. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America have not been presented herein, in accordance with SEC
regulations. These financial statements should be read in conjunction with
financial statements and notes thereto for the year ended December 31, 2003
included in the Company's Annual Form 10-K. Certain prior period data have been
reclassified to conform to the current period presentation.
2. NOTES RECEIVABLE
The Company's notes receivable consisted of the following:
December 31, 2003 September 30, 2004
----------------- ------------------
Performing loans $ 5,040,103 $ 3,204,332
Non-perfoming loans 351,873 1,300,026
Less: reserve (130,854) (165,854)
----------------- -----------------
Net loans 5,261,122 4,338,504
Less: current portion (735,149) (1,061,788)
----------------- -----------------
Long-term portion $ 4,525,973 $ 3,276,716
================= =================
At September 30, 2004, we have non-performing loans aggregating $1.3 million.
During the second quarter of 2004, a non-performing loan in the amount of $2.5
million was foreclosed and reclassified to the existing portfolio group of
customer contracts. The collateral supported the carrying value and therefore no
impairment charge was recorded. Currently the cash flows from the underlying
collateral support the carrying value of the loans. However, if the cash flows
from the underlying collateral continues to deteriorate, it may result in a
future charge to earnings.
3. GOODWILL AND INTANGIBLES
In April 2004, we received a Working Capital Adjustment (per agreement) cash
payment from Lane Industries, Inc. in the aggregate amount of $1,378,000 which
reduced the goodwill recorded by the same amount.
During May 2004, the Company acquired the alarm portfolio and certain other
assets of Alliant Protection Services, Inc. for a total purchase price of $14.5
million. The purchase price allocation which is preliminary is subject to an
independent valuation that will be completed in the fourth quarter of 2004. The
purchase price has been preliminarily allocated, based upon management's best
estimates, to:
Accounts receivable $ 780,000
Customer contracts 8,712,000
Goodwill 6,081,000
Current liabilities (1,073,000)
---------------
$ 14,500,000
===============
The final purchase price allocation may result in additional amortization
expense if the allocation to goodwill decreases. Most, if not all, of this
goodwill will be tax deductible and will reside in the retail services segment.
The operating results of Alliant have been included in the Company's
consolidated results since the date of acquisition (May 21, 2004). The pro forma
revenue and results of operations for this acquisition, had the acquisition
occurred at the beginning of 2003 and 2004, are not significant, and
accordingly, have not been provided.
6
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
During the nine months ended September 30, 2004, goodwill also increased (net)
by approximately $290,000 due primarily to legal and other direct acquisition
costs.
The Company accounts for its goodwill under Statement of Financial Accounting
Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets." Under SFAS No.
142, goodwill is not amortized, but it is tested for impairment at least
annually. Each year the Company tests for impairment of goodwill according to a
two-step approach. In the first step, the Company tests for impairment of
goodwill by estimating the fair values of its reporting units using the present
value of future cash flows approach, subject to a comparison for reasonableness
to its market capitalization at the date of valuation. If the carrying amount
exceeds the fair value, the second step of the goodwill impairment test is
performed to measure the amount of the impairment loss, if any. In the second
step the implied fair value of the goodwill is estimated as the fair value of
the reporting unit used in the first step less the fair values of all other net
tangible and intangible assets of the reporting unit. If the carrying amount of
the goodwill exceeds its implied fair market value, an impairment loss is
recognized in an amount equal to that excess, not to exceed the carrying amount
of the goodwill. In addition, goodwill of a reporting unit is tested for
impairment between annual tests if an event occurs or circumstances change that
would more likely than not reduce the fair value of a reporting unit below its
carrying value. During the second quarter of 2004 and continuing through the
third quarter of 2004, the common stock of the Company has been trading below
its book value. However, the Company completed its annual impairment test in the
third quarter of 2004 and did not record an impairment charge upon completion of
this review as the fair value of the reporting units exceeded their respective
carrying values in the third quarter of 2004. A non-cash goodwill impairment
charge may result in a future period if there is a decline in estimated future
earnings and cash flows.
CUSTOMER CONTRACTS AND DEALER RELATIONSHIPS
SFAS No. 144 "Accounting for the Impairment of Disposal of Long Lived Assets"
requires that long-lived assets be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of the assets to be held and used is measured by
a comparison of the carrying amount of the assets with the future net cash flows
expected to be generated. Cash flows of dealer relationships and retail customer
contracts are analyzed at the same group level (acquisition by acquisition and
portfolio grouping, respectively) that they are identified for amortization, the
lowest level for which independent cash flows are identifiable. All other
long-lived assets are evaluated for impairment at the Company level, using one
asset grouping. If such assets are considered to be impaired, the impairment to
be recognized is measured by the amount by which the carrying amount of the
assets exceeds the fair value of the assets. No impairment losses were required
during the nine months ended September 30, 2004.
Customer contracts at September 30, 2004 consist of the following:
CONTRACTS
EXISTING DEALER ASSUMED FROM
PORTFOLIO ACQUIRED DEALERS TOTAL
---------------- --------------- --------------- ---------------
Customer contracts December 31, 2003 $49,341,567 $23,062,462 $ 8,058,738 $80,462,767
Purchases nine months 21,954,438 2,931,794 - 24,886,232
Sales and reclassifications nine months (117,227) (151,569) - (268,796)
--------------- -------------- -------------- --------------
Customer contracts September 30, 2004 71,178,778 25,842,687 8,058,738 105,080,203
--------------- -------------- -------------- --------------
Accumulated amortization December 31, 2003 1,525,020 3,516,755 1,849,861 6,891,636
Amortization first quarter 2,027,145 1,002,232 597,930 3,627,307
Amortization second quarter 2,753,661 1,025,966 570,513 4,350,140
Amortization third quarter 3,039,566 1,034,329 542,297 4,616,192
--------------- -------------- -------------- --------------
Accumulated amortization September 30, 2004 9,345,392 6,579,282 3,560,601 19,485,275
--------------- -------------- -------------- --------------
Customer contracts, net $61,833,386 $19,263,405 $ 4,498,137 $85,594,928
=============== ============== ============== ==============
7
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Customer contract amortization expense for the nine months ended September 30,
2004 and 2003 was approximately $12,593,639 and $4,644,000, respectively. The
2004 amortization expense was reduced by approximately $1,722,000 of attrition
reserves from contract purchase transactions. The Company is currently
negotiating the potential sale of approximately $130,000 of recurring monthly
revenue.
Dealer relationships consist of the following:
DECEMBER 31, 2003 PURCHASES AMORTIZATION SEPTEMBER 30, 2004
----------------- ------------ ------------- ------------------
Dealer relationships $ 39,958,089 $ 422,316 $ - $ 40,380,405
Accumulated amortization (16,844,472) - (2,904,335) (19,748,807)
----------------- ----------- ------------ ------------------
$ 23,113,617 $ 422,316 $ (2,904,335) $ 20,631,598
================= =========== ============ ==================
Amortization expense for dealer relationships was $3,335,471 and $2,904,335, for
the nine months ended September 30, 2003 and 2004, respectively.
Estimated amortization expense of customer contracts, dealer relationships and
other identifiable intangible assets for the years ending December 31, 2004
through 2008 is as follows:
OTHER
IDENTIFIABLE
CUSTOMER DEALER INTANGIBLE
YEAR CONTRACTS RELATIONSHIPS ASSETS TOTAL
- --------- ------------- --------------- -------------- --------------
2004 (three months) $ 2,646,318 $ 987,539 $ 96,349 $3,730,206
2005 9,970,627 3,096,328 385,398 13,452,353
2006 8,849,394 2,680,398 385,398 11,915,190
2007 7,657,540 2,350,813 363,874 10,372,227
2008 6,993,789 2,170,310 348,500 9,512,599
Customer contract amortization for existing portfolios acquired subsequent to
January 31, 2003 is calculated using an 18 year straight-line rate. No attrition
has been recognized in the customer contract amortization projected for future
years. The actual amortization expense in future periods will be higher due to
the impact of attrition.
4. STOCKHOLDERS' EQUITY
Stock-Based Compensation
The Company's 2003 Stock Option Plan and 2004 Stock Option Plan (approved June
15, 2004) ("SOP") permits the grant of options which may either be "incentive
stock options" ("ISOs") or "non-qualified stock options: ("NSOs"). The total
number of shares of our common stock that may be issued under the SOP may not
exceed 1,350,000, subject to possible adjustment in the future as described
below. All employees, officers, directors, consultants and independent
contractors of the Company, or of any parent, subsidiary or affiliate are
eligible to be granted options.
The exercise price of an option granted under the SOP may not be less than 100%
of the fair market value of the Company's common stock on the date of grant
(110% of such fair market value in the case of an ISO granted to an optionee who
owns or is deemed to own stock possessing more than 10% of the combined voting
power of all classes of our stock).
The number of shares of common stock authorized for issuance under the SOP may
be adjusted in the event our shares of common stock are changed into, or
exchanged for cash, or securities of another entity through a reorganization,
merger, recapitalization, reclassification, stock split, stock dividend, stock
consolidation or combination or other similar transaction. In the event of the
occurrence of any of the following, the compensation committee may adjust the
number of authorized shares under the SOP, and the options issued under the SOP,
as appropriate under the circumstances.
8
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The following table illustrates the effect on net loss and net loss per share if
the Company had elected to recognize stock-based compensation expense based on
the fair value of the options granted at the date of grant as prescribed by SFAS
No. 123.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------ ------------------------------
2003 2004 2003 2004
---- ---- ---- ----
Net loss as reported $(4,365,689) $ (2,147,211) $(20,481,802) $(3,585,963)
ADD: Stock-based compensation included in reported
net loss, net of elated tax effects - - - 7,811
LESS: Stock-based compensation expense determined
under fair method for all awards, net of related
tax effects (129,600) (8,733) (129,600) (109,133)
----------- ------------ ------------ -----------
Pro forma net loss $(4,495,289) $ (2,155,944) $(20,611,402) $(3,687,285)
=========== ============ ============ ===========
Net loss per share, as reported-basic and diluted $ (0.25) $ (0.09) $ (3.02) $ (0.15)
=========== ============ ============ ===========
Pro forma net loss per share-basic and diluted $ (0.26) $ (0.09) $ (3.04) $ (0.15)
=========== ============ ============ ===========
SFAS No. 123 requires the use of option valuation models that were not developed
for use in valuing employee stock options. The Black-Scholes option valuation
model was developed for use in estimating the fair value of traded options that
have no vesting restrictions and are fully transferable. In addition, option
valuation models require the input of highly subjective assumptions, including
the expected stock price volatility. Because options held by Company employees
and directors have characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions can materially
affect the fair value estimate, in the opinion of management, the existing
models do not necessarily provide a reliable single measure of the fair value of
these options.
Company stock options outstanding as of September 30, 2004 include options
granted during the third quarter of 2003 to purchase 48,000 shares of common
stock at a weighted average exercise price of $9.25 per share, with a weighted
average contractual life remaining of 8.83 years. On June 15, 2004, stock
options were issued to purchase 150,000 shares of common stock at an exercise
price of $5.75 per share, with a contractual life of ten years.
Company stock options outstanding become exerciseable as follows:
Weighted Weighted
Average Average
Option Plan Exercise Shareholder Exercise
Period Ending Option Shares Price Option Shares Price
------------- ------------- ----- ------------- -----
Currently exerciseable 90,500 $7.61 570,000 $9.25
September 30, 2005 35,833 $5.75 570,000 $9.25
September 30, 2006 35,833 $5.75 760,000 $9.25
September 30, 2007 35,834 $5.75 - -
-------------- ------------
198,000 $6.60 1,900,000 $9.25
-------------- ------------
SFAS NO. 123 ASSUMPTIONS AND FAIR VALUE
The fair value of each option granted during the nine months ended September 30,
2004 was estimated at the date of grant using the Black-Scholes option valuation
model with the following weighted average assumption:
Risk-free interest rate............4.58%
Volatility.........................29%
Option Term (in years).............10
Dividend yield.....................0%
The weighted average estimated fair value of stock options granted during the
nine months ended September 30, 2004 was $2.89 per share.
9
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Company accounts for activity under the employee stock plans using the
intrinsic value method prescibed by Accounting Principles Board Opinion ("APB")
No. 25, Accounting for Stock Issued to Employees, and has adopted the
disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based
Compensation. Under APB No. 25, the Company generally recognizes no compensation
expense with respect to options granted to employees and directors as the option
exercise price is generally equal to or greater than the fair value of the
Company's common stock on the date of the grant. The value of stock options
granted to non-employees are expensed.
The following table summarized the activity related to stockholders' equity for
the nine months ended September 30, 2004:
Common Stock Common Total
------------------------ Stock Paid-in Accumulated Stockholders'
Shares Amount Subscribed Capital Deficit Equity
----------- ----------- ------------ ------------ -------------- --------------
Balance, December 31, 2003 24,607,731 $ 24,608 $ 315,342 $205,086,659 $ (52,023,879) $ 153,402,730
Net income (loss) - - - - (3,585,963) (3,585,963)
Issuance of contingent shares
for Criticom purchase 34,091 34 (315,342) 315,308 - -
Conversion of debt to stock 39,640 40 - 274,960 - 275,000
Issuance of stock options to consultant - - - 13,018 - 13,018
Imputed interest expense associated
with conversion feature of debt - - - 675,161 - 675,161
---------- ----------- ----------- ------------ ------------- --------------
Balance, September 30, 2004 24,681,462 $ 24,682 $ - $206,365,106 $ (55,609,842) $ 150,779,946
========== =========== =========== ============ ============= ==============
5. INCOME TAXES
As a result of the merger of KC Acquisition with IASG during January 2003, KC
Acquisition, KC Funding Corp., Morlyn Financial Group and Criticom will no
longer be considered flow through entities to their shareholders and members
and, therefore, must record current and deferred income taxes from its earnings
and losses, and recognize the tax consequences of "temporary differences"
between financial statement and the tax basis of existing assets and
liabilities. At the time of the change in tax status (S to C Corporation) of the
enterprise, the Company recorded an additional deferred tax liability of
approximately $3,505,000, which is being included in income tax expense in 2003.
A tax provision is necessary in the third quarter of 2004 to reverse expected
tax benefits recorded in the first half of 2004 and to record the current
quarter's portion of current state taxes payable. Tax expense recorded is based
on the effective tax rate the Company expects to use for the full year. During
the first six months of 2004, the Company recorded tax benefits related to
losses recognized in during that six month period. The Company was expecting
income in the last two quarters of 2004 that would have created current taxes
payable for the year and offset the benefits recognized in the first half of
2004. During the three months ended September 30, 2004, management determined
that the Company is projecting losses for 2004. A benefit related to the
projected losses may not be recognized due to the Company's continued belief
that a full valuation allowance is required as an offset to its deferred tax
assets.
On October 22, 2004 President Bush signed the American Jobs Creation Act of 2004
(the Act) into law. The Act includes many provisions that may materially affect
the Company's accounting for income taxes including a possible increase in its
effective tax rate and changes in its deferred assets and liabilities. The
Company is assessing the impact of the Act.
6. INCOME (LOSS) PER COMMON SHARE
The income (loss) per common share is as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------------------------------------------------------
2003 2004 2003 2004
---- ---- ---- ----
Numerator
Net income(loss) $ (4,365,689) $(2,147,211) $ (20,481,802) $ (3,585,963)
Denominator
Weighted average shares outstanding 17,269,123 24,681,462 6,774,349 24,663,426
Net income (loss) per share $ (0.25) $ (0.09) $ (3.02) $ (0.15)
10
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
For the three and nine months ended September 30, 2004, there are outstanding
promissory notes which are convertible into 753,153 shares of common stock at a
price of $6.94 per share, options outstanding to acquire 1,948,000 shares of the
Company's common stock at a per share price of $9.25 and options outstanding to
acquire 150,000 shares of the Company's common stock at a per share price of
$5.75. For the three and nine months ended September 30, 2003, all of the above
common stock equivalents were outstanding except the options to acquire 150,000
shares of the Company's common stock at a per share price of $5.75. The shares
issuable upon exercise of such options have not been included as common stock
equivalents for any periods presented, as their issuance would be anti-dilutive.
7. LITIGATION
In March 2003, Protection One Alarm Monitoring, Inc., ("Protection One") a
company engaged in the business of providing security and other alarm monitoring
services to residential and commercial customers, brought an action against the
Company in the Superior Court of New Jersey, Camden County for unspecified
damages in connection with the Company's purchase of certain alarm monitoring
contracts from B&D Advertising Corporation ("B&D"). B&D had previously sold
alarm monitoring contracts to Protection One. As part of such sales, B&D agreed
not to solicit any customers whose contracts had been purchased and to keep
certain information confidential. Protection One claims that the Company's
subsequent purchase of contracts from B&D constitutes tortious interference,
that the Company utilized confidential information belonging to Protection One
and that Protection One had an interest in some of the contracts that the
Company purchased from B&D. The Company plans to vigorously defend this claim.
The Company believes the resolution of this matter will not have a material
adverse effect on its financial condition, results of operations or cash flows.
In May 2003, a former employee of McGinn, Smith & Co., Inc. brought an action
against the Company, as well as McGinn, Smith & Co., Inc. and M&S Partners for
wrongful termination. The suit brought in the Supreme Court of the State of New
York seeks damages of $10,000,000. McGinn, Smith & Co., Inc. and M&S Partners
have fully indemnified the Company from any damages or legal expenses that the
Company may incur as a result of the suit. This employee of McGinn, Smith & Co.,
Inc. was never the Company's employee and the Company plans to vigorously defend
this claim. The Company moved to dismiss the plaintiff's complaint against it
and that motion was granted in its entirety, dismissing the Company from the
lawsuit. Plaintiff has filed a notice of appeal. The Company believes the
resolution of this matter will not have a material adverse effect on its
financial condition, results of operations or cash flows.
The Company is involved in litigation and various legal matters that have arisen
in the ordinary course of business. The Company does not believe that the
outcome of these matters will have a material adverse effect on the Company's
financial position, results of operations or cash flows.
8. RELATED PARTY TRANSACTIONS
The Company incurred approximately $462,000 and $0 respectively, in related
party interest for the three months ended September 30, 2003 and 2004. For the
nine months ended September 30, 2003 and 2004, the related party interest
incurred was $914,000 and $0, respectively.
The Company earned monitoring and placement fees from related parties of
approximately $0 and $36,000 for the three months ended September 30, 2003 and
2004, respectively. The fees earned by the Company for the nine months ended
September 30, 2003 and 2004 amounted to $287,000 and $138,000, respectively.
Included in long-term debt (junior debt) are contract certificates held by
related parties that totaled approximately $172,000 at September 30, 2004.
During the nine months ended September 30, 2003, the Company paid $1,700,000 to
and assumed $1,825,000 of debt from Capital Center Credit Corporation resulting
in a charge to general and administrative expense of $3,525,000.
9. SEGMENT AND RELATED INFORMATION
Management has determined that an appropriate measure of the performance of its
operating segments would be made through an evaluation of each segment's income
(loss) before income taxes. Accordingly, the Company's summarized financial
information regarding the Company's reportable segments is presented through
income (loss) before income taxes for the three and nine months ended September
30, 2003 and 2004. Prior to January 31, 2003, the Company operated in only one
segment, alarm-monitoring wholesale services. The acquisition of IASI and
affiliates established the new segment, alarm-monitoring retail services for
independent alarm-monitoring dealers. Intersegment revenues have been
eliminated.
11
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Summarized financial information for the three and nine months ended ended
September 30, 2003 and 2004 concerning the Company's reportable segments is
shown in the following table:
ALARM- ALARM- ALARM- ALARM-
MONITORING MONITORING MONITORING MONITORING
WHOLESALE RETAIL CONSOLIDATED WHOLESALE RETAIL CONSOLIDATED
SERVICES SERVICES SERVICES SERVICES SERVICES SERVICES
-------------- ------------ ------------ ---------- -------------- --------------
THREE MONTHS ENDED SEPTEMBER 30, 2003 NINE MONTHS ENDED SEPTEMBER 30, 2003
Total revenue $ 6,052,401 $ 3,679,942 $ 9,732,343 $ 18,501,591 $ 9,747,077 $ 28,248,668
Intersegment revenue 478,845 - 478,845 1,652,456 - 1,652,456
Cost of revenue (including
depreciation and amortization) 5,462,841 973,691 6,436,532 15,809,922 4,800,595 20,610,517
Income (loss) from operations (410,161) 803,695 393,534 (587,453) (3,254,446) (3,841,899)
Interest income 99,443 236,915 336,358 99,443 1,014,142 1,113,585
Interest expense 646,000 2,968,274 3,614,274 3,253,086 8,481,759 11,734,845
Income (loss) before income taxes (1,047,015) (3,354,502) (4,401,517) (4,348,096) (12,802,361) (17,150,457)
THREE MONTHS ENDED SEPTEMBER 30, 2004 NINE MONTHS ENDED SEPTEMBER 30, 2004
Total revenue $ 5,565,359 $ 16,335,680 $ 21,901,039 $ 17,504,505 $42,123,054 $ 59,627,559
Intersegment revenue 973,802 - 973,802 2,384,233 - 2,384,233
Cost of revenue (including
depreciation and amortization) 5,490,361 9,140,567 14,630,928 15,388,003 23,796,000 39,184,003
Income (loss) from operations (1,030,331) 1,933,419 903,088 (1,257,121) 3,523,661 2,266,540
Interest income 642 180,238 180,880 26,453 684,975 711,428
Interest expense 67,000 1,784,475 1,851,475 207,186 5,294,331 5,501,517
Income (loss) before income taxes (1,117,063) 115,283 (1,001,780) (1,499,479) (1,768,457) (3,267,936)
There has been no material change in the total assets of the reportable segments
since December 31, 2003. The acquisitions in the retail services segment have
been funded with cash balances residing in that segment.
Certain services provided to customers and administrative support services were
performed by the wholesale monitoring services segment in fiscal 2003 and the
responsibility transferred to the retail monitoring services segment in fiscal
2004. The revenue generated by these services in fiscal 2003 was approximately
$77,00 and $347,000 for the three months and nine months ended September 30,
2003, respectively. The revenue generated by these services in fiscal 2004 was
approximately $72,000 and $229,000 for the three months and nine months ended
September 30, 2004, respectively. Cost of sales for fiscal 2003 was
approximately $468,000 and $1,029,000 for the three months and nine months ended
September 30, 2003, respectively. Cost of sales for fiscal 2004 was
approximately $645,000 and $1,677,000 for the three months and nine months ended
September 30, 2004, respectively. General and administrative expenses for fiscal
2003 were approximately $98,000 and $355,000 for the three months and nine
months ended September 30, 2003, respectively. General and administrative
expenses for fiscal 2004 were approximately $43,000 and $142,000 for the three
months and nine months ended September 30, 2004, respectively.
10. SUBSEQUENT EVENTS
On October 1, 2004, the Company entered into a definitive Asset Purchase
Agreement with National Alarm Computer Center, Inc., a unit of Tyco
International Ltd.'s Fire and Security segment. The purchase price is
$49,189,727 and is subject to adjustment based upon account balances as of the
closing date. The closing is expected to take place during November 2004.
On October 19, 2004, the Company received a commitiment from LaSalle Bank, N.A.
for a $30.0 million secured credit faciltiy. The maximum amount available under
the facility will be limited to 10.0X RMR of eligible customer contracts. The
interest rate initially will be LIBOR plus 3.50%. The minimum fixed charge
coverage ratio will be 2.0:1. In the event that the Company does not raise the
planned $125.0 million (see below) from issuing senior unsecured notes, the
maximum available will be $15.0 million. The closing of the facility must be
completed by November 17, 2004.
On October 25, 2004, the Company announced plans to offer approximately $125.0
million of senior secured notes due 2011 in a private placement to be conducted
pursuant to Rule 144A under the Securities Act of 1933, as amended. The senior
notes have not been registered under the Securities Act of 1933, as amended, or
applicable state laws. The interest rate was set at 12% on November 9, 2004 and
the closing is scheduled for November 16, 2004.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2004.
The following discussion should be read in conjunction with the accompanying
Financial Statements and Notes thereto.
CRITICAL ACCOUNTING POLICIES.
Our discussion and analysis of results of operations, financial condition and
cash flows are based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America (GAAP). The preparation of these financial statements requires us to
make estimates and judgments that effect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. These estimates are evaluated on an on-going basis, including
those related to revenue recognition and allowance for doubtful accounts,
valuation to allocate the purchase price for a business combination, notes
receivable reserve and fair value of customer contracts on foreclosed loans,
intangible assets and goodwill, income taxes, and contingencies and litigation.
We base our estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ from these estimates under different assumptions or conditions.
REVENUE RECOGNITION AND ALLOWANCE FOR DOUBTFUL ACCOUNTS.
All revenue is recognized on an accrual basis. Accounts receivable consists
primarily of amounts due from dealers and end-users located in the United
States. Credit is extended based upon an evaluation of the dealers and end-users
financial condition and credit history. Receivables that are deemed not
collectible have been provided for in the allowance for doubtful accounts. If
the dealers financial condition were to deteriorate, resulting in their
inability to make payments, additional allowances may be required.
VALUATION TO ALLOCATE PURCHASE PRICE FOR A BUSINESS COMBINATION. The allocation
of purchase price related to the acquisition of assets of Alliant Protection
Services, Inc. is preliminary at September 30, 2004. The purchase price
allocation is based on management's best estimate. The purchase price allocation
which is preliminary is subject to an independent valuation that will be
completed in the fourth quarter of 2004.
NOTES RECEIVABLE RESERVE AND FAIR VALUE OF CUSTOMER CONTRACTS ON FORECLOSED
LOANS.
We make loans to dealers, which are collateralized by the dealers' portfolio of
end-user alarm monitoring contracts. Loans to dealers are carried at the lower
of the principal amount outstanding or if non-performing, the net realizable
value of the portfolio underlying the loan. Loans are generally considered
non-performing if they are 120 days in arrears of contractual terms. When a
dealer becomes delinquent, we generally foreclose on and take ownership of the
portfolio of end-user monitoring contracts.
Management periodically evaluates the loan portfolio to assess the
collectibility of dealer notes and adequacy of allowance for loan losses.
Management reviews certain criteria in assessing the adequacy of the allowance
for loan losses including our past loan loss experience, known and inherent
risks in the portfolio, adverse situations that may affect the borrower's
ability to repay, the estimated value of any underlying collateral and current
economic conditions. Loan impairment is identified when a portfolio's cash flow
is materially below the minimum necessary to service the loan. In most cases,
loans will be foreclosed and valued at the lower of cost (loan carrying value)
or fair value of end-user contracts using recent transaction prices and industry
benchmarks.
At September 30, 2004, we have non-performing loans aggregating $1.3 million.
Currently the cash flows from the underlying collateral support the carrying net
value of the loans. However, if the cash flows from the underlying collateral
continues to deteriorate, it may result in a future charge to earnings.
INTANGIBLE ASSETS AND GOODWILL.
Alarm monitoring services for dealers' end-users are outsourced to us. We
acquire such dealer relationships from our internally generated sales efforts
and from other monitoring companies. Acquired dealer relationships are recorded
at cost which management believes approximates fair value. End-user alarm
monitoring contracts are acquired from the dealers' pre-existing portfolios of
contracts or assumed upon the foreclosure on dealers' loans.
13
Acquired end-user alarm monitoring contracts are recorded at cost which
management believes approximates fair value. End-user alarm monitoring contracts
assumed as a result of foreclosure on dealer loans are recorded at the lower of
cost (loan carrying value) or the fair value of such contracts using recent
transaction prices and industry benchmarks at the time of foreclosure.
End-user alarm monitoring contracts are amortized over the term that such
end-users are expected to remain a customer of the Company. The Company, on an
ongoing basis, conducts comprehensive reviews of its amortization policy for
end-user contracts and, when deemed appropriate, uses an independent external
appraisal firm to assist in performing an attrition study.
Dealer relationships and customer (end-user) contracts are amortized using
methods and lives which are management's estimates, based upon all information
available (including industry data, attrition studies, current portfolio
trends), of the life (attrition pattern) of the underlying contracts and
relationships. If actual results vary negatively (primarily attrition) from
management assumptions, amortization will be accelerated which will negatively
impact results from operations. If amortization is not accelerated or conditions
deteriorate dramatically, the asset could become impaired. For existing
portfolio accounts purchased subsequent to January 31, 2003, the Company
amortizes such accounts using the straight-line method over an 18 year period
plus actual attrition. This methodology may cause significant variations in
amortization expense in future periods.
Dealer relationships and end-user alarm monitoring contracts are tested for
impairment on a periodic basis or as circumstances warrant. Recoverability of
dealer relationship costs and end-user alarm monitoring contracts are highly
dependent on our ability to maintain our dealers. Factors we consider important
that could trigger an impairment review include higher levels of attrition of
dealers and/or end-user alarm monitoring contracts and continuing recurring
losses.
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
requires that the assets be reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of the assets to be held and used is measured by a
comparison of the carrying amount of the assets with the future net cash flows
expected to be generated. Cash flows of dealer relationships and retail customer
contracts are analyzed at the same group level (acquisition by acquisition and
portfolio grouping, respectively) that they are identified for amortization, the
lowest level for which independent cash flows are identifiable. All other
long-lived assets are evaluated for impairment at the company level, using one
asset grouping. If such assets are considered to be impaired, the impairment to
be recognized is measured by the amount by which the carrying amount of the
assets exceeds the fair value of the assets.
SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS 142 requires us to
account for goodwill using an impairment-only approach. We perform our
impairment test annually in the third quarter of each year or at such time a
triggering event occurs in an interim period.
The Company accounts for its goodwill under Statement of Financial Accounting
Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets." Under SFAS No.
142, goodwill is not amortized, but it is tested for impairment at least
annually. Each year the Company tests for impairment of goodwill according to a
two-step approach. In the first step, the Company tests for impairment of
goodwill by estimating the fair values of its reporting units using the present
value of future cash flows approach, subject to a comparison for reasonableness
to its market capitalization at the date of valuation. If the carrying amount
exceeds the fair value, the second step of the goodwill impairment test is
performed to measure the amount of the impairment loss, if any. In the second
step the implied fair value of the goodwill is estimated as the fair value of
the reporting unit used in the first step less the fair values of all other net
tangible and intangible assets of the reporting unit. If the carrying amount of
the goodwill exceeds its implied fair market value, an impairment loss is
recognized in an amount equal to that excess, not to exceed the carrying amount
of the goodwill. In addition, goodwill of a reporting unit is tested for
impairment between annual tests if an event occurs or circumstances change that
would more likely than not reduce the fair value of a reporting unit below its
carrying value. During the second quarter of 2004 and continuing through the
third quarter of 2004, the common stock of the Company has been trading below
its book value. However, we completed our annual impairment test in the third
quarter of 2004 and did not record an impairment charge upon completion of this
review as the fair value of the reportings units exceeded their respective
carrying values in the third quarter of 2004. A non-cash goodwill impairment
charge may result in a future period if there is a decline in estimated future
earnings and cash flows.
14
INCOME TAXES.
As part of the process of preparing our financial statements, we will be
required to estimate our income taxes in each of the jurisdictions in which we
operate. This process will involve estimates of our actual current tax exposure
together with assessing temporary differences resulting from differing treatment
of items, such as depreciation and amortization, for tax and accounting
purposes.
CONTINGENCIES AND LITIGATION.
In March of 2003, Protection One Alarm Monitoring, Inc., a company engaged in
the business of providing security and other alarm monitoring services to
residential and commercial customers, brought an action against us in the
Superior Court of New Jersey, Camden County for unspecified damages in
connection with our purchase of certain alarm monitoring contracts from B&D
Advertising Corporation ("B&D"). B&D had previously sold alarm monitoring
contracts to Protection One. As part of such sales, B&D agreed not to solicit
any customers whose contracts had been purchased and to keep certain information
confidential. Protection One claims that our subsequent purchase of contracts
from B&D constitutes tortuous interference, that we utilized confidential
information belonging to Protection One and that Protection One had an interest
in some of the contracts that we purchased from B&D. We plan to vigorously
defend this claim. We believe the resolution of this matter will not have a
material adverse effect on our financial condition, results of operations or
cash flows.
In May 2003, a former employee of McGinn, Smith & Co., Inc., brought an action
against us, as well as McGinn, Smith & Co., Inc. and M&S Partners for wrongful
termination. The suit brought in the Supreme Court of the State of New York
seeks damages of $10,000,000. McGinn, Smith & Co., Inc. and M&S Partners have
fully indemnified us from any damages or legal expenses that we may incur as a
result of the suit. This employee of McGinn, Smith & Co., Inc., was never our
employee and we plan to vigorously defend this claim. We moved to dismiss the
plaintiff's complaint against us and that motion was granted in its entirety,
dismissing us from the lawsuit. Plaintiff has filed a notice of appeal. We
believe the resolution of this matter will not have a material adverse effect on
our financial condition, results of operations or cash flows.
We from time to time experience routine litigation in the normal course of our
business. We do not believe that any pending litigation will have a material
adverse effect on our financial condition, results of operations or cash flows.
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 2003.
REVENUE.
Total revenue for the three months ended September 30, 2004 was approximately
$21,901,000 compared to approximately $9,732,000 for the same period during the
prior year, an increase of approximately $12,169,000, or 125.0%.
Wholesale monitoring revenues were approximately $5,565,000 for the three months
ended September 30, 2004 compared to approximately $6,052,000 for the same
period in 2003, a decrease of approximately $487,000. The decrease is due
primarily to a decrease in the aggregate number of accounts (not owned by the
Company, or "external") monitored during the third quarter of 2004. This
decrease in external accounts monitored, of approximately 30,000, primarily from
one customer, resulted in a decrease in revenue of approximately $468,000. In
addition, a decrease in the average revenue per account per month of
approximately $.02 resulted in a decrease to revenue of approximately $19,000.
Revenue from retail segment operations increased approximately $12,656,000 to
approximately $16,336,000 for the third quarter of 2004 from $3,680,000 for the
same period in 2003. Revenue from businesses acquired in the final quarter of
2003 and the second quarter of 2004 (the "Q4-2003 / Q2-2004 acquisitions")
accounted for approximately $10,313,000 of the increase. Additional revenue, of
approximately $2,343,000, was generated due to an increase of approximately
16,000 in the average number of retail contracts owned per month and an increase
in the average revenue per contract which accounted for approximately $1,303,000
and $1,040,000 of the increase, respectively.
15
COST OF REVENUE (EXCLUDING DEPRECIATION AND AMORTIZATION).
Our cost of revenue for the three months ended September 30, 2004 was
approximately $8,829,000 compared with approximately $4,248,000 for the same
period last year, an increase of approximately $4,581,000. This increase in the
cost of revenue was primarily due to approximately $2,746,000 of costs
associated with the Q4-2003 / Q2-2004 acquisitons. In addition, the cost of
revenue for the retail segment, excluding the Q4-2003 / Q2-2004 acquisitions,
increased approximately $1,698,000 as a result of the increase in the number of
accounts. The cost of revenue for the wholesale monitoring operations increased
by approximately $137,000.
Direct margin, as a percentage of total revenue, was 59.7% during the three
months ended September 30, 2004 compared to 56.4% for the same period during
2003. The increase was due primarily to a greater proportion of retail segment
volume which is a higher margin business.
OPERATING EXPENSES.
Operating expenses increased from approximately $5,091,000 for the three months
ended September 30, 2003 to approximately $12,169,000 for the comparable period
in 2004, an increase of approximately $7,078,000, or 139.0%. The increase was
due to approximately $4,973,000 of expenses associated with the Q4-2003 /
Q2-2004 acquisitions and an increase in expenses related to the retail segment
(excluding the Q4-2003 / Q2-2004 acquisitions) of approximately $2,109,000 which
were offset, in part, by a decrease in expenses related to the wholesale segment
of approximately $4,000.
Selling and marketing expenses increased approximately $772,000 from
approximately $229,000 in the third quarter of 2003 to approximately $1,001,000
for the same period in 2004. The increase is attributable to the expenses
associated with the Q4-2003 / Q2-2004 acquisitions which amounted to
approximately $794,000. The expenses related to the Q4-2003 / Q2-2004
acquisitions were comprised primarily of payroll, benefits and other
compensation of approximately $671,000, advertising of approximately $43,000 and
travel and entertainment of approximately $39,000. The increase from the Q4-2003
/ Q2-2004 acquistions was offset, in part, by a decrease in wholesale segment
expenses of approximately $25,000.
Depreciation and amortization expenses increased from approximately $2,189,000
in the third quarter of 2003 to approximately $5,802,000 for the comparable
period in 2004, an increase of approximately $3,613,000, or 165.1%. This
increase was due, in part, to the expenses related to the Q4-2003 / Q2-2004
acqusitions of $1,597,000. The remaining increase consisted of approximately
$2,126,000 in retail operations, exclusive of the Q4-2003 / Q2-2004 acquisitons,
offset, in part, by a decrease in expenses associated with the wholesale segment
of approximately $110,000. The retail segment increase in depreciation and
amortization was due to an increase in the amortization of customer contract
costs as a result of the purchases of contracts in the later half of 2003 and
the first nine months of 2004. The decrease in wholesale operations expense is
attributable to a decrease in amortization of dealer relationship costs due to
the Company's use of declining balance accelerated methods of amortization.
General and administrative expenses increased approximately $2,693,000, or
100.7%, from approximately $2,673,000 in the third quarter of 2003 to
approximately $5,366,000 for the same period of 2004. Approximately $2,582,000
of the increase was associated with the Q4-2003 / Q2-2004 acquisitions and
comprised primarily of payroll, bonus and other compensation, facilities and
utilities, collection and billing, bad debt and travel and entertainment
expenses. Excluding the expenses associated with the Q4-2003 / Q2-2004
acquisitions, general and administrative expenses decreased by approximately
$111,000.
OTHER INCOME/EXPENSE.
Other income for the three months ended September 30, 2003 was approximately
$468,000 as compared to $0 for the three months ended September 30, 2004. The
2003 income was almost entirely related to a litigation settlement resulting
from the acquisition of RTC Alarm Monitoring Services.
AMORTIZATION OF DEBT ISSUANCE COSTS.
The amortization of debt issuance costs decreased approximately $1,751,000 from
approximately $1,985,000 for the three months ended September 30, 2003 to
approximately $234,000 for the same period in 2004. The decrease is due
primarily to a decrease in debt issuance costs to be amortized as a result of
the retirement of debt during the later half of 2003.
16
INTEREST EXPENSE.
Interest expense decreased by approximately $1,763,000 from approximately
$3,614,000 to approximately $1,851,000, or 48.8%, for the third quarter of 2003
to the same period in 2004, respectively. The reduction is due to the reduction
of debt during the later half of 2003 primarily from the use of the proceeds
from the initial public offering of the Company's common stock.
INTEREST INCOME.
Interest income decreased from approximately $336,000 during the third quarter
of 2003 to approximately $181,000 for the same period in 2004.
TAXES.
The expense recored in the third quarter of 2004 comprised primarily of the
reversal of the tax benefits recorded in the first six months of 2004. The tax
benefits reversal was due to management's re-assessment that the Company's
forecasted taxable position at the end of the full year of 2004 would not
support recognizing the tax benefits to be derived from reversal of the
valuation allowances on the deferred tax expense assets.
The third quarter of 2004 expense was comprised of state tax expense
attributable to subsidiaries of the Company which conduct business in separate
taxing jurisdictions.
RESULTS OF OPERATIONS BY SEGMENT
The comparable financial results for the Company's two operating segments;
Alarm-Monitoring, Wholesale Services and Alarm-Monitoring, Retail Services for
the three months ended September 30, 2004 compared with the three months ended
September 30, 2003 are discussed below.
ALARM MONITORING, WHOLESALE SEGMENT. THREE MONTHS ENDED SEPTEMBER 30, 2004.
Alarm Monitoring, Wholesale segment total revenue decreased by approximately
$487,000 to approximately $5,565,000 for the three months ended September 30,
2004 from approximately $6,052,000 for the same period in 2003. The decrease is
due primarily to a decrease in the aggregate number of external accounts
monitored during the third quarter of 2004. This decrease in external accounts
monitored, of approximately 30,000, resulted in a decrease in revenue of
approximately $468,000. In addition, a decrease in the average revenue per
account per month of approximately $.02 resulted in a decrease to revenue of
approximately $19,000.
Direct margin decreased approximately $624,000 from approximately $1,877,000 for
the three months ended September 30, 2003 to approximately $1,253,000 for the
comparable period of 2004. As a percent of total revenue, the direct margin was
31.0% for the three months ended September 30, 2003 compared with 22.5% for the
three months ended September 30, 2004. The decrease in wholesale sector direct
margin was due, in part, to the aforementioned decrease in revenue of
approximately $487,000. The balance of the direct margin reduction resulted from
an increase in the cost of revenue of approximately $137,000 which was primarily
due to increases in labor costs.
The wholesale segment had loss from operations of approximately $1,030,000 for
the three months ended September 30, 2004 compared to loss from operations of
approximately $410,000 for the same period last year, a change of approximately
$620,000. The change is primarily due to the decrease in direct margin.
The segment had a loss before income taxes of approximately $1,117,000 for the
three months ended September 30, 2004 compared to a loss of approximately
$1,047,000 for the three month period ended September 30, 2003. The change of
approximately $70,000 is due to the aforementioned decrease in direct margin and
a decrease in other income of approximately $468,000 with a partially offsetting
decreases in amortization of debt issuance costs and net interest expense of
approximately $538,000 and $480,000, respectively.
ALARM MONITORING, RETAIL SEGMENT. THREE MONTHS ENDED SEPTEMBER 30, 2004.
Alarm Monitoring, Retail segment total revenue increased by approximately
$12,656,000 to approximately $16,336,000 for the three months ended
September 30, 2004 from approximately $3,680,000 for the same period in 2003.
Revenue from the Q4-2003 / Q2-2004 acquisitions accounted for approximately
$10,313,000 of the increase. Additional revenue, of approximately $2,343,000,
was generated due to an increase of approximately 16,000 in the average number
of retail contracts owned per month and an increase in the average revenue per
contract which accounted for approximately $1,303,000 and $1,040,000 of the
increase, respectively.
17
Direct margin increased approximately $8,212,000 to approximately $11,820,000
for the third quarter of 2004. The increase is due primarily to the incremental
margin associated with the Q4-2003 / Q2-2004 acqusitions in the amount of
approximately $7,567,000. The balance of the increase, or approximately
$645,000, was due to the margin realized on the incremental revenues generated
other than by the Q4-2003 / Q2-2004 acquisitions.
For the three months ended September 30, 2004 the segment had income from
operations of approximately $1,933,000 compared to income of approximately
$804,000 for the three months ended September 30, 2003, an improvement of
approximately $1,130,000. The improvement was a result of approximately
$2,594,000 of income from the Q4-2003 / Q2-2004 acquisitions which was offset,
in part, by a decrease of approximately $1,464,000 in the income generated by
the balance of the retail segment.
The segment's income before income taxes was approximately $115,000 for the
three months ended September 30, 2004 compared to a loss for the three month
period ended September 30, 2003 of approximately $3,355,000, an improvement of
approximately $3,470,000. The improvement was a result of income generated from
the Q4-2003 / Q2-2004 acquisitions of approximately $2,577,000 and income of
approximately $893,000 from the remainder of the retail segment.
NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER
30, 2003.
REVENUE.
Total revenue for the nine months ended September 30, 2004 was approximately
$59,628,000 compared to approximately $28,249,000 for the same period during the
prior year, an increase of approximately $31,379,000, or 111.1%.
Wholesale monitoring revenues were approximately $18,502,000 for the nine months
ended September 30, 2003 compared to approximately $17,505,000 for the same
period in 2004, a decrease of approximately $997,000, or 5.4%. The decrease is
due primarily to a decrease in the aggregate number of accounts (not owned by
the Company, or "external") monitored during the first nine months of 2004. This
decrease in external accounts monitored, of approximately 42,000 resulted in a
decrease in revenue of approximately $1,882,000. This decrease was offset, in
part, by an increase of approximately $885,000 generated by an increase in the
average revenue per account per month of approximately $0.27 from the first nine
months of 2003 as compared to the same period of 2004.
Revenue from retail segment operations increased approximately $32,376,000 to
approximately $42,123,000 for the nine month period ended September 30, 2004
from $9,747,000 for the same period in 2003. Revenue from the Q4-2003 / Q2-2004
acquisitions accounted for approximately $26,455,000 of the increase. In
addition, the first nine months of 2004 reflects incremental revenue of
approximately $1,483,000 as a result of the merger of IASI which occurred in
January 31, 2003. Additional revenue, of approximately $4,438,000, was generated
due to an increase of approximately 10,000 in the average number of retail
contracts owned per month and an increase in the average revenue per contract
which accounted for $2,054,000 and $2,384,000 of the increase, respectively.
COST OF REVENUE (EXCLUDING DEPRECIATION AND AMORTIZATION).
Our cost of revenue for the nine months ended September 30, 2004 was
approximately $22,938,000 compared with approximately $12,001,000 for the same
period last year, an increase of approximately $10,937,000, or 91.1%. This
increase in the cost of revenue was primarily due to approximately $8,400,000 of
costs associated with the Q4-2003 / Q2-2004 acquisitons. In addition, the cost
of revenue for the retail segment, excluding the Q4-2003 / Q2-2004 acquisitions,
increased approximately $2,450,000 while the cost of revenue for the wholesale
monitoring operations increased approximately $87,000.
Direct margin, as a percentage of total revenue, was 61.5% during the nine
months ended September 30, 2004 compared to 57.5% for the same period during
2003. The increase was due primarily to a greater proportion of retail segment
volume which is a higher margin business.
18
OPERATING EXPENSES.
Operating expenses increased from approximately $20,089,000 for the nine months
ended September 30, 2003 to approximately $34,423,000 for the comparable period
in 2004, an increase of approximately $14,333,000, or 71.3%. The increase was
primarily due to approximately $14,804,000 of expenses associated with the
Q4-2003 / Q2-2004 acqusitions.
Selling and marketing expenses increased approximately $2,561,000 from
approximately $685,000 for the nine months ended September 30, 2003 to
approximately $3,246,000 for same period in 2004. The increase is primarily
attributable to expenses associated with the Q4-2003 / Q2-2004 acqusitions which
amounted to approximately $2,604,000. The expenses related to the Q4-2003 /
Q2-2004 acquisitions were comprised primarily of payroll, benefits and other
compensation of approximately $2,258,000, travel and entertainment of
approximately $117,000 and advertising of approximately $111,000.
Depreciation and amortization expenses increased from approximately $8,609,000
in the nine months ended September 30, 2003 to approximately $16,246,000 for the
comparable period in 2004, an increase of approximately $7,636,000, or 88.7%.
This increase was partially due to the expenses related to the Q4-2003/ Q2-2004
acqusitions of $5,032,000. The remaining increase consisted of approximately
$3,113,000 in retail operations, exclusive of the Q4-2003 / Q2-2004 acquisitons,
offset, in part, by a decrease in expenses associated with the wholesale segment
of approximately $509,000. The retail segment increase was due to an increase in
the amortization of customer contract costs as a result of the purchase of a
significant amount of contracts in the later half of 2003 and the first nine
months of 2004. The decrease in wholesale operations expense is attributable to
a decrease in amortization of dealer relationship costs due to the Company's use
of declining balance accelerated methods of amortization.
General and administrative expenses increased approximately $4,135,000, or
38.3%, from approximately $10,796,000 in the nine months ended September 30,
2003 to approximately $14,931,000 for the same period of 2004. Approximately
$3,525,000 of the expenses in the first nine months of 2003 related to a charge
associated with transactions with the Capital Center Credit Corporation
("CCCC"). Absent this 2003 charge, the expenses for the 2004 period would have
represented an increase of approximately $7,660,000 from the expenses for the
same period of 2003. Approximately $7,168,000 of the increase was associated
with the Q4-2003 / Q2-2004 acquisitions and comprised primarily of payroll,
bonus and other compensation, facilities and utilities, bad debt, collection and
billing, insurance and travel and entertainment expenses. The additional
increase in expenses, of approximately $492,000, is due primarily to increases
in payroll, employee benefits and temporary services of approximately $830,000,
directors and officers insurance of approximately $580,000, board and transfer
agent fees of approximately $284,000, rent, utilities and telephone of
approximately $273,000 and postage and printing of approximately $110,000, and,
partially offset by decreases in legal, accounting and other professional fees
of approximately $988,000 and bad debt expense of approximately $597,000.
OTHER INCOME/EXPENSE.
Other expense for the nine months ended September 30, 2004 amounted to
approximately $3,000 compared to other income for the same period in year 2003
of approximately $205,000. For the most part, the other income in 2003 was due
to a settlement related to the acquisition of RTC Alarm Monitoring Services.
AMORTIZATION OF DEBT ISSUANCE COSTS.
The amortization of debt issuance costs decreased approximately $2,151,000 from
approximately $2,893,000 for the nine months ended September 30, 2003 to
approximately $741,000 for the same period in 2004. The decrease is due
primarily to a decrease in debt issuance costs to be amortized as a result of
the retirement of debt during the later half of 2003.
INTEREST EXPENSE.
Interest expense decreased by approximately $6,233,000 from approximately
$11,735,000 to approximately $5,502,000, or 53.1%, for the first nine months of
2003 to the same period in 2004, respectively. Approximately $5,985,000 of the
decrease was due to the reduction of debt during 2003 primarily to the use of
the proceeds from the initial public offering of the Company's common stock. The
balance of the decrease, or approximately $248,000, was due to an adjustment of
the accrual for debt related costs.
INTEREST INCOME.
Interest income decreased from approximately $1,114,000 for the first nine
months of 2003 to approximately $711,000 for the same period of 2004.
19
TAXES.
Income tax expense totaled approximately $3,331,000 for the nine months ended
September 30, 2003 compared with an expense of approximately $318,000 for the
nine months ended September 30, 2004. The income tax expense recorded during the
nine months ended September 30, 2003 was due primarily to the merger of
Integrated Alarm Services, Inc. and the Company in January 2003 and the change
in tax status (S to C Corporation) for federal income tax purposes.
The expense recorded in the first nine months of 2004 represents state taxes
attributable to subsidiaries of the Company which conduct business in separate
taxing jurisdictions. The expense recorded in the first nine months is based on
the effective tax rate the Company expects to use for the full year of 2004.
RESULTS OF OPERATIONS BY SEGMENT
The comparable financial results for the Company's two operating segments;
Alarm-Monitoring, Wholesale Services and Alarm-Monitoring, Retail Services for
the nine months ended September 30, 2004 compared with the nine months ended
September 30, 2003 are discussed below.
ALARM MONITORING, WHOLESALE SEGMENT. NINE MONTHS ENDED SEPTEMBER 30, 2004.
Alarm Monitoring, Wholesale segment total revenue decreased by approximately
$997,000, or 5.4%, to approximately $17,505,000 for the nine months ended
September 30, 2004 from approximately $18,502,000 for the same period in 2003.
The decrease is due primarily to a decrease in the aggregate number of accounts
(not owned by the Company, or "external") monitored during the first nine months
of 2004. This decrease in external accounts monitored, of approximately 42,000
resulted in a decrease in revenue of approximately $1,882,000. This decrease was
offset, in part, by an increase of approximately $885,000 generated by an
increase in the average revenue per account per month of approximately $0.27
from the first nine months of 2003 as compared to the same period of 2004.
Direct margin decreased approximately $1,084,000 from approximately $6,657,000
for the nine months ended September 30, 2003 to approximately $5,573,000 for the
comparable period of 2004. The decrease in the direct margin is primarily
attributable the decrease in revenue.
The wholesale segment had a loss from operations of approximately $1,257,000 for
the nine months ended September 30, 2004 compared with a loss from operations of
approximately $587,000 for the same period last year, a change of approximately
$670,000. The change is due to primarily to a decrease in direct margin offset,
in part, by a reduction in depreciation and amortization of approximately
$509,000.
The segment had a loss before income taxes of approximately $1,499,000 for the
nine months ended September 30, 2004 compared to a loss of approximately
$4,348,000 for the nine month period ended September 30, 2003. The improvement,
of approximately $2,849,000, is primarily attributable to a decrease in net
interest expense, of approximately $2,973,000, a decrease in amortization of
debt issuance costs of approximately $751,000 offset, in part, by an increase in
the loss from operations of approximately $670,000 and a decrease in other
income/expense of approximately $205,000.
ALARM MONITORING, RETAIL SEGMENT. NINE MONTHS ENDED SEPTEMBER 30, 2004. Alarm
Monitoring, Retail segment total revenue increased by approximately $32,376,000
to approximately $42,123,000 for the nine months ended September 30, 2004 from
approximately $9,747,000 for the same period in 2003. Revenue from the Q4-2003 /
Q2-2004 acquisitions accounted for approximately $26,456,000 of the increase.
In addition, the first nine months of 2004 reflects incremental revenue of
approximately $1,483,000 as a result of the merger of IASI which occurred in
January 31, 2003. Additional revenue, of approximately $4,438,000, was generated
due to an increase of approximately 10,000 in the average number of retail
contracts owned per month an increase in the average revenue per contract which
accounted for $2,054,000 and $2,384,000 of the increase, respectively.
Direct margin increased approximately $21,526,000 to approximately $31,116,000
for the first nine months of 2004. The increase is due primarily to the
incremental margin associated with the Q4-2003 / Q2-2004 acqusitions in the
amount of approximately $18,055,000. The balance of the increase, or
approximately $3,471,000, was due to the margin realized on the incremental
revenues of the balance of the retail segment.
For the nine months ended September 30, 2004 the segment had income from
operations of approximately $3,524,000 compared to a loss of approximately
$3,254,000 for the nine months ended September 30, 2003, an improvement of
approximately $6,778,000. The improvement was partially due to approximately
$3,251,000 income from operations of the Q4-2003 / Q2-2004 acqusitions. The
balance of the improvement was due to expense associated with the transactions
with CCCC in the amount of approximately $3,525,000 during the first nine months
of 2003.
20
The segment's loss before income taxes was approximately $1,768,000 for the nine
months ended September 30, 2004 compared to a loss for the nine months period
ended September 30, 2003 of approximately $12,802,000, an improvement of
approximately $11,034,000. In addition to the aforementioned improvement in
income from operations, the reduction of the loss before taxes was due to a
decrease of approximately $2,858,000 in net interest expense and a decrease of
approximately $1,401,000 in amortization of debt issuance costs.
LIQUIDITY AND CAPITAL RESOURCES.
Net cash provided by operating activities was approximately $9,100,000 for the
nine months ended September 30, 2004, compared to approximately $7,400,000 used
by operating activities for the nine months ended September 30, 2003. The
increase in cash provided by operations was primarily the result of a decrease
of approximately $16,900,000 in the net loss for the period and an increase in
depreciation and amortization of approximately $7,600,000. The 2003 period had
offsetting benefits of cash provided of approximately $5,000,000 from non-cash
expenses including deferred income taxes.
Net cash used in investing activities was approximately $33,500,000 for the nine
months ended September 30, 2004 compared to approximately $55,800,000 used by
investing activities for the nine months ended September 30, 2003. The
significant decrease in net cash used in investing activities is primarily due
to the acquisition of customer contracts and businesses of approximately
$27,600,000 in 2004 compared to the purchasing of short-term investments with
approximately $64,000,000 of IPO proceeds in 2003.
Net cash used in financing activities was approximately $6,800,000 for the nine
months ended September 30, 2004 compared to approximately $98,900,000 in net
cash provided by financing activities for the nine months ended September 30,
2003. The change is primarily due to IPO proceeds of approximately $196,000,000
offset by net debt repayments of approximately $96,700,000 in 2003 and there
being no borrowings but debt repayments of $6,700,000 during the same nine
months in 2004.
The balance sheet at September 30, 2004 reflects a net working capital deficit
of approximately $17,241,000. Most of this deficiency is the result of
$11,648,000 of notes payable that mature on December 15, 2004. As of September
30, 2004, we had recurring monthly revenue ("RMR") of approximately $4,300,000
in our retail monitoring segment and approximately $2,100,000 in our wholesale
monitoring segment. Total debt decreased by approximately $6,700,000 from
December 31, 2003 to September 30, 2004.
Our capital expenditures anticipated over the next twelve months include
equipment and software of approximately $1.6 million and our strategy to
purchase monitoring contracts, which we anticipate to be approximately $90.0
million. This strategy is dependent on obtaining additional financing. We are
currently negotiating terms with investment bankers and commercial bankers
regarding a combination of privately placed debt securities and commercial bank
credit facilities. We have a commitment from both groups at this time and a
closing is scheduled for November 16, 2004.
On October 19, 2004, the Company received a commitiment from LaSalle Bank, N.A.
for a $30.0 million secured credit faciltiy. The maximum amount available under
the facility will be limited to 10.0X RMR of eligible customer contracts. The
interest rate initially will be LIBOR plus 3.50%. The minimum fixed charge
coverage ratio will be 2.0:1. In the event that the Company does not raise the
planned $125.0 million from issuing senior notes, the maximum available will be
$15.0 million. The closing of the facility must be completed by November 17,
2004.
We believe that our existing cash, cash equivalents, credit facility and RMR are
adequate to fund our operations, including debt payments of $14 million payable
over the next nine months, exclusive of planned contract acquisitions, for at
least the next twelve months.
NEW ACCOUNTING PRONOUNCEMENTS.
On October 22, 2004 President Bush signed the American Jobs Creation Act of 2004
(the Act) into law. The Act includes many provisions that may materially affect
our accounting for income taxes including a possible increase in our effective
tax rate and changes in our deferred assets and liabilities. We are assessing
the impact of the Act.
21
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS.
The Company's significant contractual obligations as of September 30, 2004 are
for approximately $62.9 million. Debt by year of maturity and future rental
payments under operating lease agreements are presented below. The Company has
not engaged in off-balance sheet financing or commodity contract trading.
CONTRACTUAL OBLIGATIONS PAYMENTS DUE BY PERIOD
09/05 09/07 09/09
- -----------------------------------------------------------------------------------------------------------------
Total Less than 1 year 1-3 years 4-5 years After 5 years
Long-term debt $ 59,016,112 $ 15,296,000 $ 38,650,112 $ 5,070,000 $ -
Capital leases 622,904 431,997 190,907 - -
Operating leases 3,214,179 961,884 1,521,583 684,537 46,175
------------ -------------- ------------ ----------- ------------
Total $ 62,853,195 $ 16,689,881 $ 40,362,602 $ 5,754,537 $ 46,175
============ ============== ============ =========== ============
ATTRITION.
Alarm-Monitoring Wholesale Services
End-user attrition has a direct impact on our results of operations since it
affects our revenues, amortization expense and cash flow. We define attrition in
the wholesale alarm monitoring business as the number of end-user accounts lost,
expressed as a percentage, for a given period. In some instances, we use
estimates to derive attrition data. We monitor end-user attrition each month,
each quarter and each year. In periods of end-user account growth, end-user
attrition may be understated and in periods of end-user account decline,
end-user attrition may be overstated. Our actual attrition experience shows that
the relationship period with any individual Dealer or end-user can vary
significantly. Dealers discontinue service with us for a variety of reasons,
including but not limited to, the sale of their alarm monitoring contracts,
performance issues and receipt of lower pricing from competitors. End-users may
discontinue service with the Dealer and therefore with us for a variety of
reasons, including, but not limited to, relocation, service issues and cost. A
portion of Dealer and end-user relationships, whether acquired or originated via
our sales force, can be expected to discontinue service every year. Any
significant change in the pattern of our historical attrition experience would
have a material effect on our results of operations, financial position or cash
flows.
For the quarters ended September 30, 2003 and 2004, our annualized end-user
account growth rates in the wholesale monitoring segment, excluding acquisitions
were (1.8)% and (9.1)%, respectively. For the quarters September 30, 2003 and
2004, our annualized end-user attrition rates in the wholesale monitoring
segment, calculated as end-user losses divided by the sum of beginning
end-users, end-users added and end-users acquired, was 14.4% and 31.2%,
respectively.
2003 2004
------------ -----------
Beginning balance, June 30, 477,064 524,279
End-users added, excluding acquisitions 15,635 31,515
End-users acquired - 813
End-user losses (17,777) (43,424)
----------- ----------
Ending Balance, September 30, 474,922 513,183
=========== ==========
Alarm-Monitoring Retail Services
The annualized attrition rates, based upon customer accounts cancelled or
becoming significantly delinquent, during the third quarter of 2004 are as
follows:
Active RMR at
Portfolio Attrition Rate September 30, 2004
- ------------------------- ---------------- ---------------------
Legacy and flow 15.2% $ 1,020,374
Residential since IPO 12.5% 2,179,669
Commercial since IPO 10.4% 1,117,342
---------------------
Total 12.6% $ 4,317,385
=====================
The decrease in Commercial attrition from the 13.4% last quarter is due
primarily from the loss of one account in the second quarter, a California
school district, and we believe it to be a discrete event. Attrition for
acquired Dealer customer relationships and alarm monitoring contracts may be
greater in the future than the attrition rate assumed or historically incurred
by us. In addition, because some Dealer customer relationships and acquired
alarm monitoring contracts are prepaid on an annual, semi-annual or quarterly
basis, attrition may not become evident for some time after an acquisition is
consummated. We are currently negotiating the potential sale of approximately
$130,000 of recurring monthly revenue.
22
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk is limited to interest income and expense
sensitivity, which is effected by changes in the general level of interest
rates. The primary objective of our investment activities is to preserve
principal while at the same time maximizing the income we receive without
significantly increasing risk. To minimize risk, we maintain our portfolio of
cash, cash equivalents and short-term and restricted investments in a variety of
interest-bearing instruments including United States government and agency
securities, high-grade United States corporate bonds, municipal bonds,
mortgage-backed securities, commercial paper and money market accounts at
established financial institutions. Due to the nature of our short-term and
restricted investments, we believe that we are not subject to any material
market risk exposure. We do not have any foreign currency. At September 30,
2004, we had $6.3 million of variable rate debt outstanding.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
Our management, with the participation of our principal executive officer and
principal financial officer, has evaluated the effectiveness of our disclosure
controls and procedures (as such term is defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange
Act")) pursuant to Rule 13a-15(c) under the Exchange Act as of the end of the
period covered by this Quarterly Report on Form 10-Q. While our Chief Executive
Officer and Chief Financial Officer have concluded that, our disclosure controls
and procedures were effective as of the end of the period covered by this report
our significant growth through acquisitions of companies with complex accounting
and revenue systems not readily adaptable to our own has required us to undergo
major system changes as disclosed in previous filings. Several of our
information technology projects, although making progress, are running behind
schedule. As a result, we can provide no assurance that we will not identify
significant deficiencies or material weaknesses in internal controls over
financial reporting under definitions established by the SEC and PCAOB. We
continue to commit significant resources to the project and have hired a
consulting firm specializing in this area, but our numerous system and control
changes have hindered their progress.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that management document
and test the internal controls over financial reporting and to assert in our
Annual Report on Form 10-K for the year-ended December 31, 2004, whether the
internal controls over financial reporting as of December 31, 2004 are
effective. Any material weakness in internal controls over financial reporting
existing at that date will preclude management's making a positive assertion.
While management intends to complete its assessment of internal controls over
financial reporting and to implement, document and test any required changes to
correct any material weaknesses identified in order to make a positive assertion
as to the effectiveness of internal controls over financial reporting, there can
be no assurance that sufficient progress will be made in time to do so.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
The changes in our internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the
period covered by this Quarterly Report on Form 10-Q that have materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting are as follows.
The Company is undergoing major system changes and software conversions in
revenue, billing, receivables and other accounting systems. Although the Company
believes the process is properly controlled, it is too early to predict the
successful completion of these major information technology projects.
The Company completed the acquisition of two operating companies in the second
half of the fourth quarter of 2003. The Company has not completed its
documentation and testing of the accounting systems of these acquired companies
at this time.
23
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In March of 2003, Protection One Alarm Monitoring, Inc., a company engaged in
the business of providing security and other alarm monitoring services to
residential and commercial customers, brought an action against us in the
Superior Court of New Jersey, Camden County for unspecified damages in
connection with our purchase of certain alarm monitoring contracts from B&D
Advertising Corporation ("B&D"). B&D had previously sold alarm monitoring
contracts to Protection One. As part of such sales, B&D agreed not to solicit
any customers whose contracts had been purchased and to keep certain information
confidential. Protection One claims that our subsequent purchase of contracts
from B&D constitutes tortuous interference, that we utilized confidential
information belonging to Protection One and that Protection One had an interest
in some of the contracts that we purchased from B&D. We plan to vigorously
defend this claim. We believe the resolution of this matter will not have a
material adverse effect on our financial condition, results of operations or
cash flows.
In May 2003, a former employee of McGinn, Smith & Co., Inc., brought an action
against us, as well as McGinn, Smith & Co., Inc. and M&S Partners for wrongful
termination. The suit brought in the Supreme Court of the State of New York
seeks damages of $10,000,000. McGinn, Smith & Co., Inc. and M&S Partners have
fully indemnified us from any damages or legal expenses that we may incur as a
result of the suit. This employee of McGinn, Smith & Co., Inc., was never our
employee and we plan to vigorously defend this claim. We moved to dismiss the
plaintiff's complaint against us and that motion was granted in its entirety,
dismissing us from the lawsuit. Plaintiff has filed a notice of appeal. We
believe the resolution of this matter will not have a material adverse effect on
our financial condition, results of operations or cash flows.
We from time to time experience routine litigation in the normal course of our
business. We do not believe that any pending litigation will have a material
adverse effect on our financial condition, results of operations or cash flows.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not Applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
ITEM 5. OTHER INFORMATION
Not Applicable.
24
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit 11.1: Statement of computation of earnings per share.
Exhibit 31. Rule 13a-14(a)/15d-14(a) Certifications.
Exhibit 32(a). Certification by the Chief Executive Officer Relating to a
Periodic Report Containing Financial Statements.*
Exhibit 32(b). Certification by the Chief Financial Officer Relating to a
Periodic Report Containing Financial Statements.*
* The Exhibit attached to this Form 10-Q shall not be deemed "filed" for
purposes of Section 18 of the Securities Exchange Act of 1934 (the "Exchange
Act") or otherwise subject to liability under that section, nor shall it be
deemed incorporated by reference in any filing under the Securities Act of 1933,
as amended, or the Exchange Act, except as expressly set forth by specific
reference in such filing.
(b) Reports on Form 8-K
October 5, 2004: Announced and filed a copy of Definitive Agreement to purchase
the assets of National Alarm Computer Center, Inc. ("NACC"), a unit of Tyco
International Ltd.'s Fire and Security Segment.
October 25, 2004: Announced plan to offer approximately $125.0 million of senior
unsecured notes due 2011. Filed unaudited condensed consolidated pro forma data
including results of NACC.
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.
November 16, 2004 INTEGRATED ALARM SERVICES GROUP, INC.
By: /s/ Timothy M. McGinn
---------------------------
Name: Timothy M. McGinn
Title: Chief Executive Officer
By: /s/ Michael T. Moscinski
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Name: Michael T. Moscinski
Title: Chief Financial Officer
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