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United States Securities and Exchange Commission
Washington, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED December 31, 2003
|_| 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 42-1578199
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
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)
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |X|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X|
The aggregate market value of common stock held by non-affiliates of the
registrant as of June 30, 2003 was $0.
The number of shares outstanding of the registrant's common stock as of
February 28, 2004 was 24,641,822 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrants proxy statement on Schedule 14A to be furnished to
stockholders in connection with its Annual Meeting of Stockholders are
incorporated by reference in Part III of the Form 10-K. Such proxy statement is
expected to be filed with the Commission by April 29, 2004.
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Integrated Alarm Services Group, Inc.
FORM 10-K
For The Fiscal Year Ended December 31, 2003
INDEX
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Page
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Part I
Item 1 Business 2
Item 2 Properties 13
Item 3 Legal Proceedings 13
Item 4 Submission of Matters to a Vote of Security Holders 14
Part II
Item 5 Market for Registrant's Common Stock and Related
Stockholder Matters 14
Item 6 Selected Financial Data 15
Item 7 Management's Discussion and Analysis of Financial
Condition and Results of Operations 16
Item 7A Quantitative and Qualitative Disclosures about
Market Risk 28
Item 8 Financial Statements and Supplementary Data 28
Item 9 Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 28
Item 9A Controls and Procedures 28
Part III
Item 10 Directors and Executive Officers of the Registrant 29
Item 11 Executive Compensation 30
Item 12 Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters 30
Item 13 Certain Relationships and Related Transactions 30
Item 14 Principal Accountant Fees and Services 30
Part IV
Item 15 Exhibits, Financial Statement Schedules, and Reports on
Form 8-K 31
Signatures
PART I
Item 1. Business
We provide an integrated solution to independent security alarm dealers, which
we refer to as "Dealers", to assist them in competing in the residential and
commercial security alarm market. Our services include wholesale alarm
monitoring and financing solutions, including purchasing Dealers' alarm
monitoring contracts for our own portfolio and providing loans to Dealers
collateralized by alarm monitoring contracts. We also provide support for our
Dealers including billing, collection, marketing and access to equipment
discount programs. We believe our package of services allows Dealers to compete
against self-monitoring national providers in the security alarm market by
giving them access to technical sophistication, financing, back office and other
services that they would not otherwise have, while allowing them to remain the
local and visible contact with their customer, the end-user of the alarm.
We believe we are the largest wholesale alarm monitoring company in the United
States, monitoring approximately 410,000 alarm systems on behalf of
approximately 5,000 Dealers. Our alarm monitoring service is provided through
three state-of-the-art, redundant alarm monitoring centers located in New
Jersey, Minnesota and California. We are also a significant provider of capital
to Dealers. Since 1993, we have provided financing to Dealers in the form of
loans or alarm monitoring contract purchases of approximately $424 million in
the aggregate. We currently hold and monitor approximately 119,000 alarm
monitoring contract equivalents in our own portfolio. In addition, we hold
approximately 4,000 contracts as collateral against loans we have made to
Dealers.
Our Industry
Overview
The security alarm industry is characterized by a large number of privately
owned companies involved in security alarm sales, leasing, installation, repair
and monitoring. In 2001, approximately 10,000 such Dealers were active in the
United States. Based on information from Security Distributing and Marketing
magazine ("SDM"), approximately 75% of this market is served by smaller
companies not included in the 100 largest companies. The top 100 companies
include large self-monitoring national providers such as ADT, a subsidiary of
Tyco International, Inc., and Brinks Home Security, Inc., a subsidiary of The
Brink's Company.
Our target market is the portion of the market served by the roughly 10,000
Dealers outside of the top 100, or approximately 75% of the overall alarm
monitoring market.
The growth in the security alarm industry has been fueled by several factors. We
believe the aging of the population and the increase in two-career families have
both contributed to an increased focus on the security of the home. Many
insurance companies offer discounts to home and business owners who install
electronic security alarm systems. In fact, many commercial enterprises are
required by insurance underwriters to have monitored alarm systems. According to
a study conducted by two professors of economics at Temple University, homes
without security systems are between 2.2 and 3.1 times (depending on home value)
as likely to be broken into than homes with security systems. In addition, they
reported losses due to burglary average $400 less in residences with security
systems than in those without security systems. These factors and others,
including a heightened awareness of overall security needs, have resulted in an
increasing number of homes in North America with monitored security systems.
According to The Freedonia Group, Inc., the current penetration of alarm systems
in existing homes in North America is 18% and is expected to exceed 20% by 2006.
Additionally, we believe that many new homes have pre-installed security alarm
systems. We also anticipate that historic growth rates in this industry will be
surpassed as technology continues to lower the cost of remote monitoring and
increases the potential applications of monitoring call centers. Such new
applications include personal monitoring for the elderly or health impaired and
using global positioning systems ("GPS") to monitor the location of equipment
and other assets. In connection with this asset tracking initiative, many
commercial users of GPS are adding a safety and security element for their human
resources.
The performance of the security alarm industry has been impacted by the
significant amount of consolidation that occurred in the mid-to-late nineties.
Self-monitoring national providers such as ADT (acquired by Tyco in 1997) and
Protection One, private regional providers, as well as new entrants into the
market such as Ameritech (a telephone company that has since exited the
business) acquired a large number of independent Dealers (with and without
monitoring call centers) and wholesale monitoring stations. During this period
of consolidation, purchase multiples of recurring monthly revenue ranged from
approximately 35 to 68 times. This growth was largely financed with debt. Most
of these acquirers experienced service disruptions in connection with the
integration of these newly-acquired customer accounts, which increased customer
attrition. Further, many acquirers were facing and continue to face financial
pressures to service the debt used to effect these acquisitions. Consequently,
although the industry is still fragmented, acquisition activity and purchase
multiples of recurring monthly revenue have declined. We believe that the
combination of these higher service-related attrition levels and debt service
requirements, as well as the credit environment generally, presents us with a
unique opportunity to grow our business. We believe that we will be able to
complete acquisitions at purchase multiples of recurring monthly revenue
substantially lower than those which existed industry-wide in the mid- to-late
nineties. Further, we expect that such acquisitions will be completed without
compromising our account underwriting and due diligence criteria.
2
Dealer Operations
The primary sources of revenue for Dealers are the sale and installation of
security alarm systems and the monthly subscription of the monitoring service.
Typically, upon installation, the end-user enters into an annual alarm
monitoring contract. Under an alarm monitoring contract, the Dealer agrees to
monitor, or contract with another company to monitor, the security alarm from a
remote location and to take certain pre-determined actions, such as calling the
police, an ambulance service, or fire department, when a security system is
triggered and an alarm signal is received. After its initial term, most alarm
monitoring contracts are subject to automatic renewal on an annual basis unless
the Dealer or end-user notifies the other party within a defined time period
that the alarm monitoring contract will not be renewed. The average life of
alarm monitoring contracts typically ranges from 8 to 12 years.
Most Dealers do not have the capability to monitor alarms internally, and
outsource the monitoring and/or administrative aspects of the business to an
outside wholesale alarm monitoring company. We believe that Dealers look for a
partner, such as us, who offers a wide array of services, including state-of-
the-art monitoring service, billing and collection capabilities, and marketing
support, all at a reasonable cost.
Financing support is often just as important as monitoring support since many
Dealers are constrained by the working capital requirements required to build
their business. In many cases, the cost of the installed equipment to the
end-user is at or below the Dealer's cost. In these cases, much of the Dealer's
capital and financial return comes from future monthly payments under the alarm
monitoring contracts. As a result, Dealers often need or desire to monetize
these alarm monitoring contracts and will, consequently, sell or borrow against
their alarm monitoring contracts.
Although there is a well-developed market for the purchase and sale of alarm
monitoring contracts and several specialty finance companies have been willing
to lend against alarm monitoring contracts held by Dealers, many Dealers have
not had access to traditional credit lending markets. Several characteristics of
the industry, including the lack of standardization among individual alarm
monitoring contracts and the under-capitalization of most Dealers, make it
difficult for traditional lenders to comfortably lend against the value of
individual alarm monitoring contracts. Further, the ability to provide or
control monitoring service is critical to maximizing the value of the alarm
monitoring contract since service issues are the primary reasons why end-users
do not renew alarm monitoring contracts. Traditional lenders and many specialty
lenders do not have this capability.
When acquiring alarm monitoring contracts from Dealers, purchasers typically pay
a multiple of the "recurring monthly revenue". According to Barnes and
Associates, a financial services provider to the security alarm industry, the
average recurring monthly revenue purchase multiple for portfolios with less
than $50,000 in recurring monthly revenue was 32.7 times in 2001, 31.1 times in
2002 and 30.9 times in 2003. For example, assuming a monthly security alarm
monitoring cost to the end-user of $30.00, the acquisition price of the alarm
monitoring contract would be approximately $950.00.
Our Services
Our two primary business activities are acquiring and managing portfolios of
alarm monitoring contracts and monitoring security alarms. We also offer
administrative services, such as billing and collection, to our Dealers as well
as new and emerging products and services. Our acquisition and financing
solutions provide capital to Dealers, allowing them to compete with larger
competitors on the initial price of equipment and installation to the end- user.
We also provide Dealers with access to technical sophistication and back office
services that they may not otherwise have (or be able to profitably operate),
while allowing them to maintain visible contact with their local customers, the
end-users of the alarm. Our alarm monitoring contract acquisition and financing
solutions and monitoring services complement one another and drive growth in
other areas of our business.
We generally require Dealers to whom we provide alarm monitoring contract
financing to use our monitoring services for all of the alarm monitoring
contracts they continue to own. We typically also require these Dealers to use
our billing and collection services, enabling us to gain an additional level of
control over the reliability of the alarm monitoring contracts' cash flows. This
places us in a unique position to minimize alarm monitoring contract attrition
because we can control the quality of the monitoring, billing and collection
and, to a significant extent, Dealer interaction with the end-user.
Alarm Monitoring Contract Acquisition and Financing Services
Generally, Dealers have had limited access to traditional credit providers.
Several characteristics of the industry, including the lack of standardization
among many individual alarm monitoring contracts, the under capitalization of
Dealers, and their inability to provide monitoring services directly, has
historically made lenders hesitant to provide financing to Dealers. When
providing financing to Dealers, we obtain a security interest in the underlying
alarm monitoring contracts. The payment terms are generally between 36 and 72
months, at interest rates based on prevailing overall interest rates and market
conditions.
3
We believe that we are uniquely positioned to maximize the value of alarm
monitoring contracts through the depth of our knowledge of the security alarm
industry and the integrated nature of the services we provide. We have the
ability to exercise greater control over alarm monitoring contract attrition
than most capital providers because we have direct influence over the quality of
the monitoring, interaction with the end-user and billing and collection.
Consequently, we are able to deploy more capital and achieve higher returns.
With respect to purchased alarm monitoring contracts, we typically acquire them
from the Dealers that originally sold and installed the security alarm systems
giving rise to the alarm monitoring contracts. We structure the payment terms
and pricing of both our alarm monitoring contract purchases and loans to provide
us with a competitive internal rate of return. In a typical transaction, the
Dealer will sell its alarm monitoring contracts for a purchase price that is a
multiple of the recurring monthly revenue. The multiple paid in any actual
transaction is impacted by several factors including average recurring monthly
revenue, the amount of the homeowner's investment in the alarm system,
geographic diversity of the accounts and our own due diligence of the Dealer.
Generally, Dealers that sell or borrow against their alarm monitoring contracts
do so on either a flow basis (as such alarm monitoring contracts are generated)
or a bulk basis (where the Dealer has accumulated a portfolio of alarm
monitoring contracts, and desires to sell or finance, all, or a portion, of
those alarm monitoring contracts at the same time). We purchase alarm monitoring
contracts on both a flow and a bulk basis. Typically, the price paid for a flow
alarm monitoring contract is less than that paid in a bulk purchase because very
often the bulk purchases are comprised of seasoned, performing alarm monitoring
contracts. In either instance, we typically require Dealers to replace any
cancelled alarm monitoring contracts and lost revenues for the first year after
we purchase an alarm monitoring contract. Such replacement must be in cash or
acceptable alarm monitoring contracts. We also hold back a portion of the
purchase proceeds to secure this Dealer obligation.
Since alarm monitoring contract quality is a key driver of our profitability,
underwriting discipline is critical. We maintain a very strict underwriting
discipline. For example, we do not typically purchase alarm monitoring contracts
that were generated by Dealers offering "zero-down" on equipment purchases and
installation, unless the contracts have been outstanding for a minimum of 12
months and exhibit acceptable payment patterns as well as acceptable responses
to quality control calls, since the lack of such costs does not create an
investment stake in the service by the end-user. Further, end-users attracted to
"zero-down" promotions are often of lower credit standing and therefore, may be
more likely to default.
Credit quality of the end-user is also a key consideration when purchasing alarm
monitoring contracts on a flow basis. We require credit rating scores on all
alarm monitoring contracts that we acquire on a flow basis. We typically reject
those alarm monitoring contracts with Beacon Scores (a credit rating employing a
methodology developed by Fair, Isaac and Co., primarily used by Equifax in the
US and Canada) of less than 625 and typically accept alarm monitoring contracts
with a Beacon Score of 640 or more (provided they satisfy all of our other due
diligence criteria). Alarm monitoring contracts with a Beacon Score between 625
and 640 are further scrutinized through an additional review of the end-user's
credit status. We do not conduct a credit review of the end-user for bulk
purchases because of the seasoned performance characteristics of such alarm
monitoring contracts.
Our due diligence process begins with an examination of the Dealer in much the
same way as a bank reviews a mortgage applicant. We perform judgment and lien
searches, review tax filings (corporate and personal), and obtain credit scores,
certificates of good standing and proof of licensure from the state(s) in which
the Dealer does business. In addition, we pre-approve each Dealer's standard
end-user alarm monitoring contract and with respect to flow purchases obtain a
credit rating for each end-user. We also require that the selling Dealers carry
errors and omissions insurance with at least $1 million of coverage and provide
us with a personal guarantee of the dealer recourse obligation. When we purchase
on a flow basis, we also generally contact the end-user to ensure that they
understand the alarm monitoring contract and know how to use the alarm system.
When purchasing alarm monitoring contracts on a bulk basis, we contact a
significant random sample. In all cases, we verify that the alarm system
generates a live signal to our monitoring call centers.
We include certain additional safeguards in our purchase and loan agreements. We
generally bill end-users directly and require that the receipts be deposited
into a segregated lock-box account for our benefit. A lock-box account is
established through a remittance processing agreement between a third party
service provider and us pursuant to which payments made under the end-user alarm
monitoring contracts are forwarded to the third party and placed in a segregated
account. The contents of the lock-box are remitted daily to an accumulation
account from which disbursements are made first to our lenders, as required, and
to us. The Dealers have no right in, or any right to withdraw any amounts held
in the accumulation account. For loans, we also take physical possession of the
original alarm monitoring contracts and file financing statements to perfect our
security interest.
While some of our monitoring competitors also claim to offer alarm monitoring
contract acquisition and financing alternatives to Dealers, many act merely as
an intermediary. In contrast, we operate as a principal and either lend directly
to the Dealers or acquire alarm monitoring contracts for our own portfolio. We
are not aware of any other monitoring competitor in the industry that acts as a
principal for loans to Dealers.
A key element of our alarm monitoring contract acquisition and financing
business is that we are uniquely able to mitigate attrition of the alarm
monitoring contracts we acquire. In addition to the alarm monitoring contract
acquisition and finance process described above, we generally require that
Dealers use us to monitor all of their alarm monitoring contracts, not just
those that have been acquired or financed. This monitoring requirement enables
us to ensure the quality of the monitoring services. Monitoring problems are a
primary cause of alarm monitoring contract cancellation and we believe that we
are the only participant in the industry that has the ability to control every
aspect of its acquired alarm monitoring contracts.
4
Monitoring Services
We provide monitoring to Dealers on alarm monitoring contracts that they have
entered into with an end-user. Dealers typically pay us a fixed monthly
monitoring fee for each account that we monitor on their behalf. The cost of the
monthly monitoring fee is either based on a published list price or is
negotiated between us and the Dealer. The charges are billed to the Dealer on a
monthly, quarterly, semi-annual or annual basis in accordance with the contract
agreement. The collection of payments by the Dealer from their end users have no
effect on the prices charged or collected by us from the Dealer. We currently
monitor approximately 547,000 end-user accounts. Generally, when an alarm is
activated, a signal is sent from the alarm system through a phone line, radio
transmitter, or wireless service to a receiver located at one of our three
monitoring facilities. This signal is immediately routed through our automated
system and an operator personally handles each call. When the operator receives
the alarm condition, his or her computer will simultaneously display a series of
instructions on how to handle the alarm. These instructions are prepared by the
Dealer and the end-user in advance and are customized to the particular
logistics of the geographic area as well as the individual needs of the
end-user.
In many instances, the operator will call a phone number specified by the
end-user and ask for a code word. If the operator is unable to contact the
end-user or an incorrect code word is given, the operator will dispatch the
appropriate authority to the scene of the alarm. In the instance of a fire
alarm, the operator is typically instructed to dispatch emergency vehicles
without making an attempt to contact the end-user. In any event, after
dispatching the appropriate authority, the operator will then call any other
individuals specified in the end-user's instructions and will provide notice to
the Dealer servicing the end-user of the event. The Dealer can then provide
follow-up support with the local end-user.
In a typical week, our operators respond to approximately 84,000 alarm
activations. We have consistently met a response time, measured by us as the
time between when an alarm signal arrives in our monitoring call centers and our
first response to that alarm, of 30 seconds, which we believe is among the best
response times in the industry.
We own and operate three redundant monitoring call centers, which operate with
state-of-the-art equipment and a highly trained staff. Our monitoring call
centers are located in Manasquan, New Jersey, Minneapolis, Minnesota and Santa
Fe Springs, California, and are linked via advanced software that creates a
real-time queuing process. Having three facilities located strategically
throughout the United States allows us to efficiently allocate alarm responses
based on time-of-day or specific event drivers that may cause one area of the
country to have a higher volume of alarms than others. As a result, alarm
signals, which would otherwise wait for available operators during peak periods,
are routed to our other monitoring call centers where they are more quickly
processed. For instance, a large number of alarms at our New Jersey facility
resulting from bad weather in the Northeast would result in the transfer of a
portion of these calls to our California facility.
All of our monitoring call centers are Underwriters Laboratories ("UL") listed.
To obtain and maintain a UL listing, a monitoring call center must be located in
a building meeting UL's structural requirements, have back-up and
uninterruptible power supply, have secure and redundant telephone lines and
redundant computer systems that meet UL criteria. Access to the facility must
also be strictly controlled.
Alarm monitoring offerings vary widely with the specific needs of the end-user
and encompass many types of monitored alarms including burglary, hold-up, panic,
fire, two-way voice communication, industrial process control, medical emergency
and environmental alert. We monitor all of these types of alarms from our
existing monitoring call centers. Our monitoring call centers are also capable
of supporting a full range of add-on services such as remote video monitoring,
network intrusion detection, cellular transmission, private radio access,
personal emergency response systems and GPS monitoring and emergency dispatch
services using GPS technology.
Historically, our monitoring services business has grown by adding new Dealer
relationships generated by both direct marketing and sales activities and by
cross-selling to those Dealers to whom we have provided financing. Additionally,
over the last three years we have acquired four wholesale alarm monitoring
companies and we expect to acquire additional monitoring call centers in the
future, subject to the availability of suitable acquisition opportunities.
We continually monitor the efficiency of each of our monitoring call centers. We
recently consolidated seven monitoring call centers into the three call centers
that we operate today, taking advantage of new technologies that enable us to
monitor large geographic areas very effectively from a single location. This
consolidation has allowed us to increase efficiency and productivity, and
decrease duplicative expenses. However, we intend to always maintain at least
one fully redundant facility.
5
Other Services
Billing and Collection
We create paper invoices and mail them to end-users serviced by our Dealers.
Additionally we may provide collection services for accounts receivable. We
generally charge on a per account basis. In instances where we provide the
billing and collection function in addition to alarm monitoring contract
acquisition and financing, we gain an additional level of assurance that timely
payments will be made on the alarm monitoring contracts that we have purchased
or lent against. It also enables us to minimize billing errors, which are also a
cause of alarm monitoring contract attrition. By offering billing and collection
services to our Dealers, we enable Dealers to focus their efforts on sales and
installation, rather than administration of alarm monitoring contracts.
Guardian Name Brand Program
We offer a name brand program under the Guardian name that is designed to assist
our Dealers in the selling of more security systems by utilizing the brand
awareness of the Guardian name and the many marketing and sales tools that we
provide. The Guardian program is operated and administered by us on an exclusive
basis and each system that is sold and installed under the Guardian brand is
required to be monitored by us. Under the program, a Dealer is provided with all
the marketing material, monitoring agreements and equipment necessary for the
installation of the systems as well as other sales and administrative materials
under the Guardian name. In addition, we act as the exclusive financing company
for the program should the Dealer wish to borrow against or sell alarm
monitoring contracts that are generated from sales under the Guardian brand.
Equipment Discount Program
We provide our Dealers with access to discounts on equipment. For example, we
have entered into a relationship with Alarm Device Manufacturing Company
(ADEMCO), which is the largest security alarm equipment manufacturer and
provider in the world. Our understanding with ADEMCO is that any Dealer who uses
our monitoring services will automatically receive preferential pricing for all
equipment purchased from ADEMCO. This program can represent significant savings
to our Dealers. To be eligible for this program, we require that the Dealer (i)
be an existing customer of ours, (ii) connect all of their new end-users to our
monitoring call center, and (iii) maintain a current standing with regard to
their monitoring charges.
We are currently in discussions with other major manufacturers of alarm
equipment to institute a similar type of discount program for their equipment.
This will give our Dealers a choice of using different types and brands of
equipment while enjoying similar reduced pricing plans.
Sales and Marketing
Our sales and marketing activities are conducted through a network of 75
in-house professionals.
Sales activities are structured by product area (monitoring services, financial
products and new product applications) and geography. Although sales personnel
are focused on one product area, each professional is trained to sell all
products and services. There are six professionals in our wholesale sales force.
Our retail segment has 69 employees involved in sales activities related to
servicing commercial and residential customers. We also maintain two
telemarketing departments (one for monitoring and financial services and related
products and one for new product offerings) that support the sales force.
Our marketing department is comprised of four professionals. This team is
responsible for the production and distribution of print advertising materials
and direct mail marketing pieces. The team also issues corporate communications
to employees, customers, strategic partners and other interested parties through
regular press releases and announcements of new products and services. The group
is also responsible for business development activities including the
identification and procurement of new products and services that Dealers can
sell to their customers.
We believe that this multi-faceted approach to sales and marketing activities is
an important ingredient to the successful ongoing growth in all our business
areas.
Growth Initiatives
Our growth initiatives are focused on four elements: prudently increasing the
number of alarm monitoring contracts that we either purchase from Dealers or
finance; increasing the number of Dealers (and therefore the number of
end-users) to whom we provide wholesale alarm monitoring services; cross-selling
our various services to Dealers and their end-users and leveraging our alarm
monitoring infrastructure across new safety and security applications.
6
Acquisition of Additional Alarm Monitoring Contracts
We intend to expand our acquisition and financing of alarm monitoring contracts
through purchasing alarm monitoring contracts on both a flow business and bulk
purchase basis. We have in 2003, acquired two businesses that not only had a
significant number of contracts but also installed and serviced commercial and
residential monitoring systems.
Our alarm monitoring flow business includes the purchase of newly created alarm
monitoring contracts on a recurring, or as originated, basis from our Dealers.
We have engaged in flow business with over 75 Dealers, and are actively seeking
to increase the number of Dealers with whom we conduct flow business.
Bulk purchases occur when we buy existing portfolios of alarm monitoring
contracts with demonstrated payment histories of at least six months. Bulk
purchases typically range in size from 10,000 to 20,000 alarm monitoring
contracts. These alarm monitoring contracts are typically purchased from Dealers
on a non-recurring basis. The bulk purchases are less predictable in terms of
the timing of account acquisitions, but are generally more predictable in terms
of performance than flow business because the actual historical performance of
individual alarm monitoring contracts is known. Many of the bulk purchases made
by us are made from Dealers who are existing monitoring customers. We expect
that as we increase our penetration of Dealers who use our wholesale alarm
monitoring services, acquire other wholesale alarm monitoring companies and call
centers (see below, "Building Additional Wholesale Monitoring Relationships with
Dealers.") and continue to build Dealer relationships, we will experience
increased opportunities to purchase alarm monitoring contracts on both a flow
and a bulk basis.
In a typical alarm monitoring contract acquisition, we retain the selling Dealer
to service the underlying alarm system, which helps us maintain strong
relationships with the Dealers and encourages the Dealer to sell additional
alarm monitoring contracts to us as new installations are completed.
The impact of the acquired contracts on revenue and profitability will be
affected by the attrition rates of acquired portfolios, as well as the variable
expenses relating to such acquisitions including billing, collection and
servicing.
Building Additional Wholesale Monitoring Relationships with Dealers
In the past, we have grown both internally and by acquiring monitoring call
centers, including the acquisitions of Criticom and Monital.
Our internal growth is driven by the value that we provide to our Dealers. We
provide quality, reliable alarm monitoring services to our Dealers' end-users.
Our Dealer branding program, warranty program, equipment discount programs,
billing and collection services and financing programs are also important
factors that enable us to attract additional Dealers.
Historically, we have also added Dealer relationships through the acquisition of
monitoring companies and the integration of their call centers into our
operations. We plan to grow our business through opportunistic acquisitions of
monitoring call centers in order to capture the associated Dealer relationships.
The impact to profitability of any such acquisition will be dependent upon our
ability to efficiently integrate the acquired business and cost structure into
our existing platforms.
Cross-Selling Opportunities
We have initiated a comprehensive cross-selling program of our primary services
to Dealers. For those Dealers to whom we provide wholesale monitoring services,
we will encourage them to use us as the purchaser when they wish to sell alarm
monitoring contracts, or as a financing source should they wish to borrow funds
against the value of their alarm monitoring contracts. The ability to be a
consistent, readily available provider of financing solutions positions us to be
the preferred provider of our products and services to Dealers.
Dealers have access to a network of local end-users, which allows us to offer
additional services to the Dealers' end-users such as two-way voice
communication, extended warranty coverage and personal emergency response
service. Through an existing strategic marketing partnership, we also give our
Dealers the ability to offer GPS tracking services for any kind of movable
asset.
Since we generally do not participate in the sales and installation market and
provide monitoring services on a transparent basis, Dealers are comfortable that
we will not interfere with their customer relationships, and value our
relationships which provide them with new revenue opportunities that they can
market to their end-users.
7
The cost of effectively marketing new products and services to end-users through
Dealers may be greater than anticipated, which could negatively affect
profitability.
New Business Opportunities
We believe there are substantial opportunities for us to expand our traditional
security alarm monitoring services into new monitoring applications, including
commercial and personal vehicular security monitoring and dispatch, telemedicine
(monitoring medical behaviors and events of individuals) and personal emergency
response services ("PERS"). The Freedonia Group estimates that the market for
vehicular security monitoring services alone was valued at $630 million in 2001
and is projected to be $5.8 billion by 2006. Criticom focuses on these
opportunities and has already begun and/or completed the following projects that
utilize GPS technology to monitor vehicles and their contents.
We are the exclusive provider of GPS monitoring and emergency dispatch service
on systems installed by Minorplanet Systems USA, Inc., of Richardson, Texas,
including over 26,000 vehicles for Minorplanet fleet customers such as SBC
Communications, Ameritech, Southern New England Telephone Co. and Nevada Bell.
The exclusive agreement that we have with Minorplanet will expire in May 2005.
In June 2000, we partnered with Security Trac, LLC, of New York City, which
supplies GPS services linked to our monitoring and emergency dispatch service to
New York City taxis and livery vehicles. Security Trac has installed over 621
units in taxis to date. There are over 80,000 taxis, liveries and vehicles for
hire in New York City.
In September 2002, we co-developed an end-user interface for a leading overnight
shipping company that will allow it to track vehicles that transport high value
assets and, should the driver be involved in an emergency situation, have an
emergency signal transmitted to us using GPS technology for emergency dispatch
service. We are currently in the test phase of this initiative.
We are the first choice provider of Public Safety Answering Point (PSAP)
monitoring services to all customers of Signature Agency, a GE Financial
Assurance Company.
We are the exclusive provider of remote convenience features for vehicles and
monitoring for stolen cars utilizing GPS technology provided by Directed
Electronics, Inc. of Vista, CA. Directed Electronics distributes its vehicle
security systems to customers such as Best Buy, Circuit City and local
automotive aftermarket retailers. This exclusive agreement we have with Directed
Electronics will expire in April of 2006.
The development and implementation of the infrastructure for these new services
is complete, primarily because we are equipped to receive most types of
electronic signals regardless of the source of the signal (i.e., residential
alarm equipment, satellite transmissions and other emergency communication
devices). Consequently, the remaining costs associated with these new
initiatives relate primarily to marketing, administration and operations. In
connection with our acquisition of Criticom, we acquired a 5.03% interest in
Royal Thoughts LLC, for which we received a right of first refusal to provide
monitoring services for any new technology developed by Royal Thoughts.
The timing and economic impact of introducing new services to undeveloped market
segments is difficult to forecast. These activities accounted for approximately
2% of our revenues in 2003.
Risks Related to Our Business
Significant attrition of Dealers or non-renewal of end-user alarm monitoring
contracts could materially adversely effect our results of operations. We
experience attrition of Dealer customer relationships and alarm monitoring
contracts as a result of several factors including relocation of end-users,
adverse financial and economic conditions and competition from other alarm
service companies. In addition, we may lose or experience non-renewal of certain
alarm monitoring contracts of Dealers, particularly acquired Dealer customer
relationships and alarm monitoring contracts, if we do not service those alarm
monitoring contracts adequately or do not successfully integrate new alarm
monitoring contracts into our operations. A significant increase in attrition or
the non-renewal of alarm monitoring contracts could have a material adverse
effect on our revenues and earnings. To the extent that actual attrition exceeds
our expectations, our revenues, profitability, cash flow and earnings would be
adversely effected. 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.
8
We face significant competition in the security alarm industry, which could make
it more difficult for us to succeed in securing relationships with Dealers and
reduce the number of alarm monitoring contracts we are able to acquire. We are
dependent on entering into and maintaining relationships with Dealers who will
either sell their alarm monitoring contracts directly to us, borrow from us, or
enter into alarm monitoring contracts for us to provide monitoring services for
the alarm monitoring contracts retained by them. While we do not typically
compete directly with many of the larger companies in the industry because we do
not primarily sell and install security systems, we are nonetheless impacted by
the competitive challenge these entrants present to Dealers.
There is the potential that larger companies in the industry may generate alarm
monitoring contracts offering "zero down" on equipment purchases and
installation. The independent Dealer may have to offer the same "zero down" deal
in order to effectively compete. Since the end-users attracted to "zero- down"
promotions are often of lower credit standing and thereby are more likely to
default, we will only purchase these contracts if they have been outstanding for
periods longer than 12 months and exhibit acceptable payment patterns as well as
acceptable responses to quality control calls, thus potentially limiting the
available alarm monitoring contracts which meet our due diligence standards.
We also compete with several companies that have alarm monitoring contract
acquisition and loan programs for Dealers and some of those competitors may be
larger and better capitalized than we are. Some of these companies may be able
to pay higher multiples of recurring monthly revenue for the portfolios they
acquire than we can. We may be required to offer higher prices for such
acquisitions than we have in the past, thus making these acquisitions less
financially advantageous. There is also the potential for other entities such as
banks or finance companies to become more active as a source of competition for
the Dealer finance portions of our business.
We may not be able to obtain all of the benefits of the security alarm
monitoring contracts we purchase. A principal element of our business strategy
is to acquire portfolios of alarm monitoring contracts. Acquisitions of end-
user alarm monitoring contracts involve a number of risks, including the
possibility that we will not be able to realize the recurring monthly revenue
stream we contemplated at the time of acquisition because of higher than
expected attrition rates or fraud. Although we complete an extensive due
diligence process prior to acquiring alarm monitoring contracts and obtain
representations and warranties from the seller, we may not be able to detect
fraud on the part of the seller, including the possibility that the seller has
misrepresented the historical attrition rates of the sold contracts or has sold
or pledged the contracts to a third party. If the sale of alarm monitoring
contracts involves fraud or the representations and warranties are otherwise
inaccurate, we may not be able to recover from the seller damages in the amount
sufficient to fully compensate us for any resulting losses. In such event, we
may incur significant costs in litigating ownership or breach of acquisition
contract terms.
We may pursue acquisitions of alarm monitoring call centers that by their nature
present risks and may not be successful. An element of our business strategy is
to acquire additional alarm monitoring call centers. The following are some of
the risks associated with these acquisitions:
o We may be unable to achieve anticipated revenues, earnings or cash flow
because of higher than expected attrition rates or other reasons.
o We may be unable to integrate acquired call centers successfully and
realize anticipated economic, operational and other benefits in a timely
manner. If we are unable to integrate acquired call centers successfully,
we could incur substantial costs and delays or other operational,
technical or financial problems.
o If we are not successful in integrating acquired call centers, we could
have increased attrition of end-users because of service-related problems.
o Acquisitions could disrupt our ongoing business, distract management,
divert resources and make it difficult to maintain our current business
standards, controls and procedures.
We also face competition in identifying and purchasing suitable alarm monitoring
call centers. We would be competing with other firms, many of which have greater
financial and other resources than we do. Should this competition increase, it
will be more difficult to acquire additional alarm monitoring call centers.
Our ability to continue to grow our business is dependent upon our ability to
obtain additional financing. We intend to continue to pursue growth through the
acquisition of end-user alarm monitoring contracts and wholesale monitoring
businesses. We will be required to seek additional funding from third party
lenders and/or from the possible sale of additional securities, which may lead
to higher leverage or the dilution of then existing stockholders. Any inability
to obtain funding through third party financing is likely to adversely effect
our ability to continue or increase our acquisition activities. Third party
funding may not be available to us on attractive terms or at all.
Rising interest rates could negatively effect our profitability. The interest
rate of our financing is generally tied to prevailing market rates. In the event
that interest rates rise, the spread between our cost of capital and the amount
that we can charge Dealers who borrow from us may decrease, which will
negatively effect our profitability.
9
We could face liability for our failure to respond adequately to alarm
activations. The nature of the services we provide potentially exposes us to
risks of liability for employee acts or omissions or system failures. In an
attempt to reduce this risk, our alarm monitoring agreements and other
agreements pursuant to which we sell our products and services contain
provisions limiting liability to end-users and Dealers. However, in the event of
litigation with respect to such matters, there can be no assurance that these
limitations will continue to be enforced. In addition, the costs of such
litigation could have an adverse effect on us.
We may face additional costs and potential liability as a result of "false
alarm" ordinances. Significant concern has arisen in certain municipalities
about the high incidence of false alarms. This concern could cause a decrease in
the likelihood or timeliness of police response to alarm activations and thereby
decrease the propensity of consumers to purchase or maintain alarm monitoring
services.
A number of local governmental authorities have considered or adopted various
measures aimed at reducing the number of false alarms. Such measures include
subjecting alarm monitoring companies to fines or penalties for transmitting
false alarms, licensing individual alarm systems and the revocation of such
licenses following a specified number of false alarms, imposing fines on alarm
end-users for false alarms, imposing limitations on the number of times the
police will respond to alarms at a particular location after a specified number
of false alarms and requiring sufficient further verification of an alarm signal
before the police will respond. Enactment of such measures could increase our
costs and thus adversely effect our future results of operations.
Future government or other organization regulations and standards could have an
adverse effect on our operations. Our operations are subject to a variety of
laws, regulations and licensing requirements of federal, state and local
authorities. In certain jurisdictions, we are required to obtain licenses or
permits, to comply with standards governing employee selection and training and
to meet certain standards in the conduct of our business. The loss of such
licenses, or the imposition of conditions to the granting or retention of such
licenses, could have an adverse effect on us. We believe that we are in material
compliance with applicable laws and licensing requirements. In the event that
these laws, regulations and/or licensing requirements change, it could require
us to modify our operations or to utilize resources to maintain compliance with
such rules and regulations. There can be no assurance as to what new regulations
will be enacted and what effect they may have on us.
The loss of our Underwriters Laboratories listing could negatively impact our
competitive position. All of our monitoring call centers are Underwriters
Laboratories(R) ("UL") listed. To obtain and maintain a UL listing, an alarm
monitoring call center must be located in a building meeting UL's structural
requirements, have back-up and uninterruptible power supply, have secure
telephone lines and maintain redundant computer systems. UL conducts periodic
reviews of monitoring call centers to ensure compliance with their regulations.
Non-compliance could result in a suspension of our UL listing. The loss of our
UL listing could negatively impact our competitive position.
We rely on technology which may become obsolete. Our monitoring services depend
upon the technology (hardware and software) of security alarm systems. We may be
required to upgrade or implement new technology which could require significant
capital expenditures. There can be no assurance that we will be able to
successfully implement new technologies or adapt existing technologies to
changing market demands. If we are unable to adapt in a timely manner in
response to changing market conditions or customer requirements, such inability
could adversely effect our business.
In the event that adequate insurance is not available or our insurance is not
deemed to cover a claim we could face liability. We carry insurance of various
types, including general liability and errors and omissions insurance. Our loss
experience and that of other security service companies may effect the
availability and cost of such insurance. Certain of our insurance policies and
the laws of some states may limit or prohibit insurance coverage for punitive or
certain other types of damages, or liability arising from gross negligence. To
the extent that insurance was not available, or a particular claim was not
covered or exceeded our coverage, we could be exposed to material costs.
Any conflict of interest between us and various affiliates of our senior
management could hurt our business or prospects. There is a possibility that
conflicts of interest will arise between some affiliates of our senior
management and us in various areas relating to our past and ongoing
relationships. Potential factors that may create a conflict of interest include:
Timothy M. McGinn, our CEO, is a Director of McGinn, Smith & Co., Inc., and
David L. Smith, one of our Directors, is President and a Director of McGinn,
Smith & Co., Inc. For the period January 1, 2000 to January 31, 2003, McGinn,
Smith & Co., Inc. has acted as either a placement agent or investment banker in
connection with various financings, as well as an investment banker in
connection with certain acquisitions. McGinn, Smith & Co., Inc., an NASD
registered broker dealer, received commissions and/or investment banking fees of
$4.5 million for acting in such capacity. Subject to our policy on interested
party transactions, McGinn, Smith & Co., Inc. may in the future act as an
underwriter to us. Our policy provides that any future transactions with
affiliates, including without limitation, our officers, directors or principal
stockholders will be on terms no less favorable than we could have obtained from
unaffiliated third parties. Any such transactions will be approved by a majority
of the independent and disinterested members of our board of directors.
10
We are dependent upon our senior management. The success of our business is
largely dependent upon the active participation of our executive officers, who
have extensive experience in the industry. As a result, we have entered into
employment agreements with each of our executive officers. The loss of the
services of one or more of such officers for any reason may have an adverse
effect on our business.
Stockholders should not expect dividends. We do not intend to pay any cash
dividends in the foreseeable future.
Employees
As of December 31, 2003, we had a workforce of 573 employees. Of our total
workforce, 80 are engaged in finance, administration and management, 6 are
engaged in new product applications and services, 300 are engaged in the
monitoring business, 75 are engaged in sales and marketing, and 112 are engaged
in service and installation of monitoring systems. None of our employees are
represented by a collective bargaining agreement, nor have we experienced work
stoppages. We believe that our relations with our employees are good.
Competition
The security alarm industry is highly competitive and fragmented. While we
generally do not compete directly with many of the large companies in the
industry such as ADT, a subsidiary of Tyco International, Inc., Brinks Home
Security, Inc., a subsidiary of the Brink's Company, Protection One, Inc. and
Honeywell International Inc. because we do not primarily sell and install
security systems, we are nonetheless impacted by the competitive challenge these
companies present to Dealers. While all of these companies provide monitoring
services, some of these companies, may from time to time, purchase portfolios of
monitoring contracts.
We compete with several companies that have alarm monitoring contract
acquisition and loan programs for Dealers and some of these competitors may be
better capitalized than us. There is also the potential for other entities such
as banks or finance companies to gain a better understanding of the industry and
become more active as a source of competition for alarm monitoring contract
acquisition and financing portions of our business. Further, we compete with
participants that primarily provide alarm monitoring contract acquisition and
financing services such as Security Alarm Financing Enterprises, Inc., Financial
Security Services, Inc., and Monitronics International, Inc.
History
We were formed as King Central in 1985 in the State of New Jersey. In 1986,
Thomas Few, Sr. our Vice Chairman, President and Chief Operating Officer joined
King Central as Executive Vice President and Chief Operating Officer and
acquired 20% of King Central's capital stock. In January 1998, as part of a
reorganization of King Central, Mr. Few, Sr.'s ownership was increased to 80%
and the remaining 20% was acquired by Timothy M. McGinn, our Chief Executive
Officer, and David L. Smith, a Director. At that time, we changed our name to KC
Acquisition.
In September 2002, KC Acquisition acquired all of the capital stock of Criticom
in exchange for $1.0 million and 155,911 shares of our common stock. An
additional 68,182 shares of our common stock has or will be issued to the
sellers based upon Criticom's financial performance in 2003. Criticom provides
wholesale alarm monitoring services to Dealers. In addition, it provides Global
Positioning System monitoring and asset tracking services to various customers.
Curtis Quady, an Executive Vice President, was the President, Chief Executive
Officer and principal stockholder of Criticom.
In connection with the acquisition of Criticom, we acquired a 5.03% interest in
Royal Thoughts, LLC. The purchase price was approximately $3.5 million net of
cash acquired of $0.6 million as well as a note for $0.7 million. In connection
with our purchase, we received a right of first refusal to provide any
monitoring services for new technology developed by Royal Thoughts.
M&S Partners, a New York general partnership equally owned by Mr. McGinn and Mr.
Smith began to acquire portfolios of alarm monitoring contracts from Dealers in
1992. Each contract was ultimately placed by M&S Partners with one of 41
leveraged trusts of which Mr. McGinn, Mr. Few, Sr. and Mr. Smith were the
beneficiaries. M&S Partners also acquired alarm monitoring contracts through
three limited liability companies (Guardian Group, LLC, Palisades Group, LLC and
Payne Security Group, LLC) which were owned by TJF Enterprises, LLC, which is
owned by Mr. Few, Sr., and First Integrated Capital Corporation, which is
majority owned by Mr. McGinn and Mr. Smith. They bundled those alarm monitoring
contracts and sold them as Trust Certificates collateralized by the underlying
alarm monitoring contracts and their recurring monthly revenue. We do not expect
to engage in securitizing alarm monitoring contracts in the future.
11
Between March and November 2002, IASI, a company that was controlled by Mr.
McGinn, Mr. Smith and Mr. Few, Sr., offered the holders of the trust
certificates the right to exchange such certificates for promissory notes of
IASI. Upon completion of the exchanges, all but eleven of the trusts were
liquidated and their assets were transferred to IASI. The trust certificates of
the remaining trusts were repaid with the proceeds of the offering and the
assets of the trusts were transferred to us. In January 2003, IASI entered into
a merger with a wholly owned subsidiary of ours and became our wholly owned
subsidiary. In connection with the acquisition of IASI, we issued an aggregate
of 772,192 shares of our common stock.
Palisades Group, LLC was the owner of approximately 38% of the alarm monitoring
contracts underlying the trusts. In January 2003, Palisades exchanged all of its
ownership interests for our stock and distributed such stock to its members, TJF
Enterprises, LLC and First Integrated Capital Corporation. In connection with
the acquisition of Palisades, we issued an aggregate of 25,000 shares of our
common stock. This acquisition was accounted for under the purchase method of
accounting. It is anticipated that Palisades will be liquidated concurrent with
this offering. In January 2003, Payne Security Group, LLC and Guardian Group,
LLC were acquired by us and became our wholly owned subsidiaries. In connection
with the acquisition of Payne Security Group, LLC, we issued an aggregate of
50,250 shares to TJF Enterprises, LLC, and First Integrated Capital Corporation.
In connection with the acquisition of Guardian Group, LLC, we issued an
aggregate of 16,750 shares to TJF Enterprises, LLC, and First Integrated Capital
Corporation.
Morlyn Financial Group, LLC was founded in May 2000 to assist Dealers who were
interested in selling their alarm monitoring contracts to IASI. Morlyn
originates alarm monitoring contracts for acquisition and provides due
diligence, billing and other related services. In connection with the
acquisition of Morlyn, in January 2003, we issued an aggregate of 17,000 shares
of our common stock to Messrs. McGinn, Few Sr., and Smith.
In June 1999, KC Acquisition acquired all of the assets and assumed certain
liabilities of Criticom CA, Inc., a monitoring call center in Santa Fe Springs,
California, in exchange for approximately $3.2 million. In May 2000, KC
Acquisition acquired 99.2% of the capital stock of Monital Signal Corporation in
exchange for approximately $10.7 million. Monital, located in Manasquan, New
Jersey, was KC Acquisition's largest competitor in the Northeast, United States.
In October 2001, KC Acquisition acquired Custom Design Security, an independent
wholesale alarm monitoring company which services the Western and Central
Regions of Florida, in exchange for approximately $1.2 million. In January 2002,
KC Acquisition acquired certain assets of RTC Alarm Monitoring Services, a large
alarm monitoring call center in California, in exchange for $5.1 million.
In January 2003, we effected a migratory merger into KC Alarm Services Group,
Inc., a Delaware corporation. The sole purpose of the migratory merger was to
change our jurisdiction of incorporation from New Jersey to Delaware. Subsequent
to the migratory merger, we assumed all of the assets and liabilities of
Integrated Alarm Services Group, Inc., a pre-existing, Delaware company whose
only activity was the sale of $5.5 million of convertible debentures. The
pre-existing Integrated Alarm Services Group, Inc. was then dissolved and we
changed our name to Integrated Alarm Services Group, Inc.
Risk Management
We carry insurance of various types, including general liability and errors and
omissions insurance. Our errors and omissions coverage is $5 million per
occurrence. Our loss experience and the loss experience of other companies in
the security industry may effect the cost and availability of such insurance.
Since 1998 we have had no uninsured losses. Certain of our insurance policies
and the laws of some states may limit or prohibit insurance coverage for
punitive or other types of damages, or liability arising from gross negligence
or wanton behavior. See "Risk Factors--Risk of Liability from Operations."
The nature of the services we provide potentially exposes us to greater risks of
liability for employee acts or omissions or systems failure than may be inherent
in other businesses. Our agreements with Dealers and end-users contain
provisions limiting our liability to end-users and Dealers in an attempt to
reduce this risk. However, in the event of litigation with respect to such
matters, there can be no assurance that these limitations will continue to be
enforced. In addition, the costs of such litigation could have an adverse effect
on us.
Regulatory Matters
A number of local governmental authorities have adopted or are considering
various measures aimed at reducing the number of false alarms. Such measures
include: (i) subjecting alarm monitoring companies to fines or penalties for
transmitting false alarms, (ii) licensing individual alarm systems and the
revocation of such licenses following a specified number of false alarms, (iii)
imposing fines on end-users for false alarms, (iv) imposing limitations on the
number of times the police will respond to alarms at a particular location after
a specified number of false alarms, and (v) requiring further verification of an
alarm signal before the police will respond.
Our operations are subject to a variety of other laws, regulations and licensing
requirements of federal, state and local authorities. In certain jurisdictions,
we are required to obtain licenses or permits to comply with standards governing
employee selection and training and to meet certain standards in the conduct of
our business. Many jurisdictions also require certain of our employees to obtain
licenses or permits.
12
The alarm industry is also subject to requirements imposed by various insurance,
approval, listing and standards organizations. Depending upon the type of
end-user served, the type of service provided and the requirements of the
relevant local governmental jurisdiction, adherence to the requirements and
standards of such organizations is mandatory in some instances and voluntary in
others.
Our alarm monitoring business utilizes radio frequencies to transmit alarm
signals. The Federal Communications Commission and state public utilities
commissions regulate the operation and utilization of radio frequencies.
Item 2. Properties
In September 2003, the Company entered into a five year lease for office space
for its headquarters in Albany, NY. The lease is for approximately 21,000 square
feet. The lease period is November 15, 2003 through November 14, 2008. The lease
has a five year renewal option. Annual rents will be $190,000 for year one and
two and $225,000 for years three through five.
We also have offices and our East Coast call monitoring center in Manasquan, New
Jersey. The facility is 7,200 square feet. We own the premises, free of any
encumbrances.
Morlyn's executive offices are located in Oakland, New Jersey. The offices are
4,705 square feet. The lease expires in March 2006 and provides for a monthly
rental of $6,665.
Our call monitoring center in California is located in Santa Fe Springs. The
facility is 6,551 square feet. The premises are leased pursuant to a two-year
lease expiring in March 2005, at a monthly rental rate of approximately $5,600
per month.
We also have a call monitoring center in Minneapolis, Minnesota. The facility is
13,478 square feet. The lease expires in 2010, and provides for a net monthly
rental rate of $6,360.
As a result of the acquisition of PSI and AHS, we acquired two sales, service
and administration offices as well as seven sales and service branch offices
located in California, New Mexico, Arizona and Nevada. The leases expire at
various dates through 2007 and currently have a monthly rental rate of $58,807.
Item 3. 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 believe the resolution
of this matter will not have a material adverse effect on our financial
condition, results of operations or cash flows.
On December 9, 2003, a complaint was filed against the Company in the United
States District Court in the southern District of New York entitled Ian Meyers
v. Integrated Alarm Services Group, Inc., et al. The Plaintiff alleges, among
other things, that the Company and its professionals engaged in transactions
with the Company that were designed to defraud plaintiff out of funds he was
entitled to pursuant to Plaintiff's agreement with First Integrated Capital
Corp. ("FICC"), his employer, and a company in which he had an equity interest.
FICC was also an affiliate of the Company that sold a portfolio of alarm
contracts to the Company. In particular, plaintiff alleges that the Company and
certain of its principals removed valuable revenue-generating assets from FICC
and transferred the FICC contracts to the Company for less than fair value.
Plaintiff is seeking damages in the amount of $3,000,000. A mediation conference
before the court has been scheduled for April 22, 2004. The Company believes
that the suit is without merit and intends to vigorously defend itself. We
believe the resolution of this matter will not have a material adverse effect on
our financial condition, results of operations or cash flows.
13
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 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of stockholders during the fourth quarter of
the fiscal year ended December 31, 2003, through the solicitation of proxies or
otherwise.
Part II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters
The Company's common stock is traded in the NASDAQ National Market System under
the symbol IASG. The Company's common stock was first traded on the NASDAQ
during the third quarter of 2003. Quarterly high and low bid information for the
third and fourth quarter of 2003 as reported by NASDAQ for normal trading hours
(4 pm EST closing) are set forth below:
2003
----
High Low
---- ---
Quarter
-------
3rd $9.99 $7.75
4th 9.50 6.95
These over the counter market quotations reflect inter-dealer prices, without
retail mark-up, mark-down or commission and may not necessarily represent actual
transactions.
No dividends have been paid on the common shares to date and none are
anticipated for the foreseeable future.
As of December 31, 2003 there were 24,607,731 common shares issued and
outstanding held by 17 shareholders of record, not including persons or entities
where stock is held in nominee or "street" name through various brokerage firms
or banks.
The Company filed a Registration Statement (333-101159) with the Securities and
Exchange Commission on June 27, 2003 to register 25,300,000 shares of common
stock for sale at an aggregate offering price of approximately $278,300,000. The
offering commenced on July 23, 2003 and terminated on August 22, 2003. Upon
completion, the managing underwriter, Friedman, Billings, Ramsey & Co., Inc.,
successfully sold 22,982,729 shares at $9.25 per share for an aggregate offering
price of approximately $212,590,243. Concurrently with the offering, 792,793
shares of common stock were registered on behalf of certain holders of
convertible promissory notes. All of the shares of common stock were sold by us
and none of the selling security holders' shares were underwritten in the
offering.
Initial Public Offering Proceeds
Common stock issued $ 212,590,243
--------------
Underwriter commissions (7%) 14,881,317
Expenses paid to underwriter 573,230
Other expenses 1,279,186
--------------
Total expenses 16,733,733
--------------
Net Offering Proceeds $ 195,856,510
==============
Use of Proceeds (through December 31, 2003)
Repayment of debt $ 91,910,820
Acquisition of contracts and businesses 68,137,570
New dealer loans 3,073,316
Working capital 2,243,553
--------------
Total uses $ 165,365,259
==============
Temporary Investments as of December 31, 2003
Cash and cash equivalents $ 30,491,251
--------------
Total temporary investments $ 30,491,251
==============
14
Item 6. Selected Financial Data
The following selected financial data have been derived from the Consolidated
Financial Statements of the Company.
Year ended December 31
1999 2000 2001 2002 2003
------------- ------------- ------------- ------------- -------------
Statement of operations data (1):
Revenue $ 12,721,583 $ 18,774,517 $ 20,569,037 $ 23,495,607 $ 40,867,598
Total operating expenses, inclusive of
cost of revenue 13,337,323 19,455,562 19,691,838 24,267,532 44,517,078
------------- ------------- ------------- ------------- -------------
Income (loss) from operations (615,740) (681,045) 877,199 (771,925) (3,649,480)
Other (expense), net (2,475,054) (3,824,867) (3,914,509) (5,556,730) (14,828,508)
------------- ------------- ------------- ------------- -------------
Income (loss) before income taxes (3,090,794) (4,505,912) (3,037,310) (6,328,655) (18,477,988)
Income tax expense (benefit) -- (4,793,725) (703,784) (681,443) 3,526,572
------------- ------------- ------------- ------------- -------------
Net income (loss) $ (3,090,794) $ 287,813 $ (2,333,526) $ (5,647,212) $ (22,004,560)
============= ============= ============= ============= =============
Basic and diluted income (loss) per share $ (5.58) $ 0.52 $ (4.21) $ (9.53) $ (1.95)
============= ============= ============= ============= =============
Shares used computing basic and diluted
income (loss) per common share (2) (4) (5) 553,808 553,808 553,808 592,785 11,263,455
Pro forma income tax to give effect as
if a C corporation (3):
Loss before income tax expense (benefit) (4,505,912) (3,037,310) (6,328,655) (18,477,988)
Income tax expense (benefit) (1,519,990) (955,569) (2,871,573) (89,916)
------------- ------------- ------------- -------------
Net income (loss) $ (2,985,922) $ (2,081,741) $ (3,457,082) $ (18,388,072)
============= ============= ============= =============
Net income (loss) per share $ (5.39) $ (3.76) $ (5.83) $ (1.63)
============= ============= ============= =============
Balance sheet data:
Cash, cash equivalents and short-term
investments $ 717,586 $ 1,151,337 $ 1,224,035 $ 3,442,082 $ 35,435,817
Total assets 24,350,032 38,113,543 36,830,768 45,627,797 241,036,330
Long-term debt 22,319,837 35,599,770 37,122,449 45,061,363 65,742,612
Capital lease obligations 258,021 145,355 32,549 507,858 885,366
Total stockholders' equity (deficit) (7,025,866) (7,067,197) (9,345,667) (11,562,881) 153,402,730
Working capital (deficit) (3,975,589) (5,240,872) (7,798,161) (8,076,758) 4,769,173
Other financial data:
Cash provided by (used in) operating activities (32,010) (1,331,125) 1,012,251 2,691,844 (4,238,641)
Cash provided by (used in) investing activities (3,878,468) (11,086,367) (1,705,428) (8,863,018) (57,984,339)
Cash provided (used in) financing activities 3,520,347 12,851,242 765,875 5,389,221 97,216,715
(1) Results of operations for acquired companies are included from the
date of acquisition. As a result comparability of periods presented has been
effected by our acquisitions. For more information about our acquisition
history, see "Business", Management's Discussion and Analysis of Financial
Condition and Results of Operations" and Note 11 to our consolidated financial
statements.
(2) On January 8, 2003, our Board of Directors approved a 6,033-for-one
stock split, as a result, share data has been retroactively restated for all
periods presented.
(3) To give effect to the conversion of KC Acquisition from an S
corporation to a C corporation for federal income tax purposes. The tax
provision was prepared as if we had a combined federal and state effective tax
rate of 40% and giving effect for permanent differences.
(4) On April 17, 2003, the Company's Board of Directors approved a one
for two reverse common stock split, as a result, share data has been
retroactively restated for all periods presented.
(5) During July 2003, the Company successfully completed its IPO and
issued a total of 22,982,729 shares of common stock and received net proceeds of
$195,856,512.
15
Equity Compensation Plan Information
- --------------------------- -------------------------- -------------------------------------- -----------------------------------
Plan category Number of Securities to Weighted-average exercise price of Number of securities remaining
be issued upon exercise outstanding options, warrants and available for future issuance
of outstanding options, rights under equity compensation plans
warrants and rights (excluding securities reflected
in column (a))
- --------------------------- -------------------------- -------------------------------------- -----------------------------------
Equity compensation plans 48,000 $9.25 102,000
approved by security
holders
- --------------------------- -------------------------- -------------------------------------- -----------------------------------
Equity compensation plans -0- -0- -0-
not approved by security
holders
- --------------------------- -------------------------- -------------------------------------- -----------------------------------
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The following discussion and analysis of our financial condition and results of
operations should be read together with the financial statements and the related
notes included in another part of this prospectus. This discussion contains
forward-looking statements that involve risks and uncertainties.
Overview
We provide an integrated solution to independent security alarm Dealers, to
assist them in competing in the residential and commercial security alarm
market. Our services include wholesale alarm monitoring and financing solutions,
including purchasing Dealers' alarm monitoring contracts for our own portfolio
and providing loans to Dealers collateralized by those alarm monitoring
contracts. We also provide support for our Dealers including billing,
collection, marketing and access to equipment discount programs. We believe our
package of services allows Dealers to compete against self- monitoring national
providers in the security alarm market by giving them access to technical
sophistication, financing, back office and other services that they would not
otherwise have, while allowing them to remain the local and visible contact with
their customer, the end-user of the alarm.
We believe we are the largest wholesale alarm monitoring company in the United
States, monitoring approximately 410,000 alarm systems on behalf of
approximately 5,000 Dealers. Our alarm monitoring service is provided through
three state-of-the-art alarm monitoring centers located in New Jersey, Minnesota
and California. Our operators respond to approximately 365,000 alarm activations
per month. We are also one of the largest providers of capital to Dealers. Since
1993, we have provided financing to the alarm industry in the form of loans or
the purchase of alarm monitoring contracts of approximately $424 million in the
aggregate. We currently hold and monitor approximately 119,000 alarm monitoring
contract equivalents in our own portfolio.
Our revenues are derived primarily from our portfolio of customer accounts and
providing alarm monitoring services to Dealers for the benefit of the end-user
of the alarm system. We typically enter into contracts with our Dealers to
provide alarm monitoring services for periods ranging from one to five years.
The majority of monitoring contracts entered into by end-users with our Dealers
generally permit cancellation with notice of 30-60 days before the end of the
original, or any renewal, contract term. Some alarm monitoring contracts with
Dealers have longer, more definitive terms. However, essentially all alarm
monitoring contracts may be broken for non-performance. Our alarm monitoring
contracts with Dealers may require the Dealer to place its entire portfolio of
end-user alarm monitoring contracts in our monitoring facilities. Our revenues
will fluctuate based upon changes in the net number of end-user alarm monitoring
contracts and the timing of connections and disconnections that any one Dealer
has with us. Our revenues will also fluctuate based upon the number of Dealers
that are added or lost during any particular period. We may gain or lose Dealers
based upon the quality, range or price of the services we provide relative to
what is provided by our competitors and the effectiveness of our sales and
marketing efforts. Our revenues may also be affected by the application of
various pricing strategies we may choose to use with our Dealers.
In addition to our organic revenue growth, our revenues will increase because of
acquisitions of customer accounts and wholesale alarm monitoring businesses
(i.e. call centers or central stations) we may make during any particular
period. Our recurring monthly revenues derived from acquired businesses are also
subject to the standard risks associated with any acquisition and subsequent
integration. We may suffer attrition because of differences in, among other
things, the application of policies and procedures, or disruption caused by any
conversion or consolidation activity.
The cost of services is primarily a function of labor, telecommunication, data
processing and technical support costs. Labor costs are driven in part by the
number and productivity of operators, supervisors and management within our call
centers that provide alarm monitoring services on behalf of our Dealer
customers. Labor costs are also a function of the quality of our data
processing, customer service and quality management functions. Labor costs also
reflect the number of technical staff required to maintain and develop our
state-of-the-art monitoring systems. Telecommunication costs reflect, among
other things, the number of signals processed, the time required to process any
particular signal, the number and type of lines, the design and functionality of
our telecommunications network and the negotiated rate with our chosen
telecommunication providers. We are constantly evaluating how to improve the
quality of our services while lowering the cost of providing those services. We
estimate that we presently have sufficient capacity to provide alarm monitoring
services to approximately 750,000 end-users.
16
Our operating expenses are primarily comprised of general and administrative,
selling and marketing and depreciation and amortization expenses. General and
administrative expenses are comprised primarily of office staff and officer
salaries, rent and professional fees. Fluctuations in general and administrative
expenses generally reflect net increases in staff associated with acquisitions,
changes in professional fees primarily associated with acquisition activity and
audits of our books and records and merit compensation increases. Selling and
marketing expenses are primarily driven by the size of our sales force,
commissions based upon successful selling activities, travel and advertising.
Depreciation and amortization expenses are primarily a function of the
acquisition of Dealer relationships and alarm monitoring contracts.
Streamlining of Operations
We have completed the consolidation of two alarm monitoring facilities to
improve operating efficiencies. During 2001, we commenced the process of
consolidating our Van Nuys, California alarm monitoring facility into our alarm
monitoring facility in Santa Fe Springs, California and consolidating our
Hackensack, New Jersey alarm monitoring facility into our alarm monitoring
facility in Manasquan, New Jersey. The consolidations were completed in August
2002. The Manasquan facility now monitors approximately 270,000 accounts. The
Santa Fe Springs facility now monitors approximately 155,000 accounts. We have
identified approximately $2.0 million in annualized expense reductions that we
have realized from the consolidations. The major expense categories where we
have realized savings include telecommunications, operator salaries and rent
expenses. The savings are related to the acquisitions of Monital, Custom Design
Security and RTC Alarm Monitoring Services.
Acquisitions
In December 2003, we acquired all of the capital stock of Lane Security Inc.
("Lane Security") for approximately $43,035,000 in cash, net of holdbacks for
severance payments and attrition of customer contracts. The principal operating
unit of Lane Security is Protection Service Industries, L.P. ("PSI") whose
assets include customer accounts with recurring monthly revenue ("RMR") of
approximately $1,760,000 at December 31, 2003. PSI installs and services
commercial and residential alarm systems in the western United States. The
acquisition was accounted for under the purchase method of accounting.
On November 21, 2003, we acquired all of the outstanding stock of American Home
Security, Inc. (AHS) and certain assets of Emergency Response Network, Inc.
(ERN), (collectively referred to as the acquirees) for approximately $15.0
million inclusive of direct acquisition costs. The acquirees install and service
residential alarm monitoring systems in the Nevada area. The acquisition has
been accounted for as a purchase and the results of the acquirees are included
in the Company's results of operations from the date of acquisition (November
21, 2003). In addition, the former owner of AHS will receive additional
consideration of up to 130,000 shares of Company common stock and up to 140,000
Company stock options, if AHS achieves certain earnings levels in 2004.
Furthermore, the Company entered into a three year employment agreement with the
former owner of AHS. The agreement provides for annual compensation of $420,000
and an annual bonus commencing in 2004 equal to 19% of the amount by which AHS's
pre-tax income (as defined in the agreement) for such year exceeds $1,250,000.
The Company has the option to make a one-time payment up to 125% of AHS' pre-tax
income to the employee under a bonus buy-out provision as defined in the
agreement, at which time the Company would have no further annual bonus
obligation to the employee. The employee for calendar years 2006-2009 has the
right to elect a bonus buy-out. Furthermore, the bonus buy-out shall
automatically trigger upon the expiration of the employment term, and under
other circumstances as defined in the agreement. The agreement also provides
that during the employment term, the employee on an annual basis, will be
granted options to acquire Company common stock if AHS achieves certain earnings
levels. The contingent consideration which includes Company common stock and
stock options issuable upon the achievement of certain earnings levels, may
result in future charges to earnings.
In January 2003, we acquired all of the capital stock of Integrated Alarm
Services, Inc. and affiliates in exchange for an aggregate of 864,192 shares of
our common stock of which 525,452 shares were issued to minority interests for
an estimated total fair value of $11,559,944. The acquisition was accounted for
under the purchase method of accounting.
Prior to the acquisition of Integrated Alarm Services, Inc., Messrs. McGinn and
Smith controlled 41 trusts and three limited liability companies which were
principally created to acquire alarm monitoring contracts. Approximately 62% of
the trust certificates of the 41 trusts were exchanged for promissory notes of
Integrated Alarm Services, Inc. and some of these notes were repaid with
proceeds from the offering. Approximately 38% of the trust certificates were not
exchanged and were subsequently repaid out of the proceeds of the offering. An
additional $9.5 million of bank debt relating to these contract acquisitions was
also repaid with proceeds from the offering. Messrs. McGinn and Smith were
residual beneficiaries of these trusts but have contributed their residual
benefits in the trusts to us. The three limited liability companies, Palisades
Group, LLC, Payne Security Group, LLC and Guardian Group, LLC were acquired by
us in January 2003 and are now our wholly owned subsidiaries.
17
On September 26, 2002, we acquired 100% of Criticom, a Minnesota based alarm
monitoring call center that supports digital alarm monitoring as well as GPS
technology, for approximately $4.3 million, net of cash acquired of $0.6
million. The total consideration consisted of $1.0 million in cash and 155,911
shares of our common stock as well as a note totaling $0.7 million. The former
shareholders of Criticom may receive up to 68,182 additional shares of the
Company's common stock based upon the future performance of Criticom. In 2003,
Criticom achieved its performance targets, as a result, the former shareholders
of Criticom will receive 68,182 shares of Company common stock with an aggregate
value of $630,684. The purchase of Criticom added approximately 400 Dealer
relationships that service 80,000 end-user alarm monitoring contracts with
approximately $0.4 million in recurring monthly revenue.
In connection with the Criticom transaction, IASG also acquired a 5.03% interest
in Royal Thoughts, LLC, a Minnesota limited liability company engaged in the
development of new monitoring applications and monitoring technologies for
emerging markets. In connection with our investment in Royal Thoughts, we
obtained a right of first refusal to monitor signals that stem from Royal
Thoughts' intellectual property and designs.
In January 2002, we acquired certain assets of RTC Alarm, a wholesale security
system alarm monitoring business located in Roseville, California. The total
purchase price was $5.1 million, which included Dealer relationships ($4.4
million), accounts receivable ($0.2 million) and property & equipment ($0.5
million). The purchase was financed with debt totaling $5.8 million, which
funded the purchase price, along with providing a $0.425 million working capital
infusion for us, $0.1 million in restricted cash and financing fees totaling
$0.175 million. The acquisition initially added 270 Dealers to our Dealer count.
As of January 2003, 225 Dealers remain. We pursued a cause of action against the
seller for certain contractual misrepresentations regarding the attrition rates
related to certain Dealer alarm monitoring contracts and received a settlement
in 2003 for $375,000.
In October 2001, we acquired certain assets of Custom Design, a wholesale
security alarm monitoring business located in Sarasota, Florida for $1.2
million, which included Dealer relationships ($1.0 million), accounts receivable
($0.1 million) and property & equipment ($0.1 million). This acquisition was
financed with debt totaling $1.425 million. The sellers received $1.2 million,
while we retained the balance for working capital ($0.1 million), financing fees
($0.075 million) and an attrition reserve fund ($0.05 million). The Custom
Design acquisition initially added 94 Dealers to our Dealer count. As of January
2003, 76 Dealers remain.
A related party placed the debt incurred for the RTC Alarm and the Custom Design
acquisitions and assumed in the acquisition of Criticom. The results of
operations are included in our financial statements from the date of
acquisition.
As a result of this activity, as of December 31, 2003, we have customer
contracts of $73,571,131, dealer relationships of $23,113,617 and goodwill of
$85,515,985.
Operations
In December 2001, we commenced a consolidation process of our monitoring
facilities and a systems conversion for a material percentage of our Dealer and
end-user base. The disruption caused by these activities negatively impacted our
revenues and profitability. We have completed the consolidation of our central
stations. Key expenses such as payroll and telephone line costs have been
reduced. We believe our costs per subscriber will decline as additional
subscriber accounts are added.
Our recurring monthly revenue may include amounts billable to customers or
Dealers with past due balances which we believe are collectible. We seek to
preserve the revenue stream associated with each end-user alarm monitoring
contract, primarily to maximize our return on the investment we made to generate
each alarm monitoring contract or Dealer relationship. As a result, we actively
work to collect amounts owed to us and to retain the end-user at the same time.
In some instances, we may allow more than six months to collect past due
amounts, while evaluating the ongoing customer or Dealer relationship. After we
have made every reasonable effort to collect past due balances, we will
disconnect the customer and include the loss in attrition calculations.
Customer creation and marketing
Our current customer acquisition strategy relies on both internally generated
sales and acquiring Dealer relationships and alarm monitoring contract rights to
monitor security systems. We currently have a salaried and commissioned sales
force that operates in four regions covering the 48 contiguous states. The
internal sales program generated in the wholesale segment 99,106, 84,616, and
64,472 new monitoring contracts in 2001, 2002 and 2003, respectively.
Attrition
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.
18
For the years ended December 31, 2001, 2002 and 2003, our trailing annual
end-user account growth rates in the wholesale monitoring segment, including
acquisitions were 14.0%, 24.7% and 12.3%, respectively. For the years ended
December 31, 2001, 2002 and 2003, our trailing annual end-user account growth
rates in the wholesale monitoring segment, excluding acquisitions, were 10.6%,
(6.1%) and (3.2%), respectively. For the years ended December 31, 2001, 2002 and
2003, our trailing annual 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 13.9%, 18.2%,and 12.7%
respectively. Included in these totals for 2003 are approximately 137,000
contracts that are owned by our retail monitoring segment.
2001 2002 2003
------- ------- -------
Beginning balance, January 1,................... 342,345 390,216 486,650
End-users added, excluding acquisitions......... 99,106 84,616 64,472
End-users acquired.............................. 11,557 120,192 75,375
End-user losses................................. 62,792 108,374 79,848
------- ------- -------
Ending Balance, December 31,.................... 390,216 486,650 546,649
======= ======= =======
We engaged Standard & Poor's Corporate Value Consulting to perform attrition
analyses of certain identified customer relationship groups. As a result of the
study, we identified our end-user attrition rates in the retail customer
contract segment to be 17.2% and 15.4% for the years ending December 31, 2000
and 2001, respectively. In 2000, the majority of the alarm monitoring contracts
we acquired were by foreclosure from Dealers to whom we had made loans. As a
result, our attrition rate was adversely affected in 2000, with carryover into
2001. The Standard & Poor's study presents data for accounts acquired by bulk
purchase, which represents the majority of our end-user alarm monitoring
contracts, which suggests that the maximum expected amortizable life of alarm
monitoring contracts purchased in bulk is approximately 18 years.
We intend to employ, for prospective contracts purchased in bulk subsequent to
January 31, 2003, an amortization methodology which is the total of the charges
calculated by a straight line, 18 year life; together with charges incurred as a
result of actual account attrition.
For contracts previously purchased in bulk by IASI and acquired upon purchase of
IASI on January 31, 2003, we employ an amortization methodology which uses 150%
declining balance over a life of 8 years.
As a result of recent acquisitions, our portfolio of customer accounts has had
substantial growth during the fourth quarter of fiscal 2003. The RMR (recurring
monthly revenue) of active customer accounts of the Company at December 31, 2003
($3,579,513) is more than three times what it was at September 30, 2003
($1,169,039). As a result of this growth, it is more meaningful to present
attrition rates as if the portfolio's purchased had been owned by us as of
September 30, 2003.
The annualized attrition rates, based upon customer accounts cancelled or
becoming significantly delinquent, during the fourth quarter are as follows:
Portfolio Attrition Rate Active RMR at December 31, 2003
- ---------------------- -------------- -------------------------------
Legacy and flow 18.4% $ 1,085,712
Residential since IPO 12.0% 1,485,768
Commercial since IPO 6.8% 1,008,033
-----------
Total 12.5% $ 3,579,513
-----------
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.
19
Critical Accounting Policies
Our discussion and analysis of results of operations, financial condition and
cash flows are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America (GAAP). The preparation of these consolidated 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. We evaluate our estimates on an on-going
basis, including those related to accounts receivable and notes receivable
reserves, Dealer relationships, customer contracts, 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.
Note 2 of the "Notes to Financial Statements" includes a summary of the
significant accounting policies and methods used in the preparation of our
financial statements. The following is a brief description of the more
significant accounting policies and methods we use.
Revenue recognition
All of our 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 Dealer's and
end-users' financial condition and credit history. Receivables that are deemed
not collectible have been provided for in our allowance for doubtful accounts.
If the Dealers financial condition were to deteriorate, resulting in their
inability to make payments, additional allowances may be required.
Notes receivable
IASI makes 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 the net realizable value of the
portfolio underlying the loan. Loans are generally considered nonperforming if
they are 120 days in arrears of contractual terms.
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 IASI's 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.
Notes receivable consists of loans to Dealers which are collateralized by a
portfolio of individual end-user monitoring contracts. If a Dealer becomes
delinquent, the Company generally forecloses on and takes ownership of the
portfolio of end-user monitoring contracts.
Deferred installation costs and revenues
The direct incremental costs associated with installing monitoring systems and
the related revenue from those sales are deferred and recognized over the
expected life of the customer relationship.
Deferred issuance costs
Debt issuance costs represents direct costs incurred in connection with
obtaining financing with related parties and banks. Debt issuance costs are
being amortized over the life of the related obligations using the effective
interest method.
Intangible assets
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.
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 appraisal
firm to assist in performing an attrition study.
The Company's amortization methods for end-user contracts below consider the
average estimated life and historical and projected attrition rates determined
from actual experience and a recent attrition study and consists of the
following portfolios:
20
Acquired as a result of the IASI merger:
Existing at January 31, 2003 Accelerated method Period
- ----------------------------------- ----------------------------- --------
Existing portfolio accounts (bulk) 150% Declining balance 8 years
Dealer acquired new accounts (flow) 160% Declining balance 8 years
Contracts assumed from dealers 160% Declining balance 4 years
Acquired subsequent to the IASI merger:
Acquired after January 31, 2003
- -----------------------------------
Existing portfolio accounts (bulk) Straight-line plus attrition 18 years
Dealer acquired new accounts (flow) 200% Declining balance 12 years
Contracts assumed from dealers 200% Declining balance 8 years
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 will
amortize such accounts using a 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.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, which supersedes SFAS No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
of," and the accounting and reporting provisions of APB No. 30. SFAS No. 144
addresses financial accounting and reporting for the impairment or disposal of
long-lived assets and is effective for fiscal years beginning after December 15,
2001, and interim periods within those fiscal years. SFAS No. 144 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 their fair values. We have not identified any such impairment
losses.
Goodwill was being amortized on a straight-line basis over its estimated useful
life of 15 years through December 31, 2001. Effective January 1, 2002, we
adopted SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS 142 changed
the accounting for goodwill from an amortization method to an impairment-only
approach. An initial transition impairment test of goodwill was required as of
January 1, 2002. We completed this initial transition impairment test during the
second quarter of 2002, which did not result in any impairment charges. An
impairment test is performed annually in the third quarter. To date, no
impairment charges were required. A significant triggering event may occur in
future periods that will require an interim assessment of goodwill and could
result in a future impairment charge to earnings.
Income taxes
As part of the process of preparing our combined 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.
21
Litigation
In March 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 tortious 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 believe the resolution
of this matter will not have a material adverse effect on our financial
condition, results of operations or cash flows.
On December 9, 2003, a complaint was filed against the Company in the United
States District Court in the southern District of New York entitled Ian Meyers
v. Integrated Alarm Services Group, Inc., et al. The Plaintiff alleges, among
other things, that the Company and its professionals engaged in transactions
with the Company that were designed to defraud plaintiff out of funds he was
entitled to pursuant to Plaintiff's agreement with First Integrated Capital
Corp. ("FICC"), his employer, and a company in which he had an equity interest.
FICC was also an affiliate of the Company that sold a portfolio of alarm
contracts to the Company. In particular plaintiff alleges that the Company and
certain of its principals removed valuable revenue-generating assets from FICC
and transferred the FICC contracts to the Company for less than fair value.
Plaintiff is seeking damages in the amount of $3,000,000. A mediation conference
before the court has been scheduled for April 22, 2004. The Company believes
that the suit is without merit and intends to vigorously defend itself. 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--IASG
The following table sets forth, for the periods indicated, selected statements
of operations data for IASG:
Years Ended December 31,
------------------------------------------
2001 2002 2003
---- ---- ----
Total revenue $ 20,569,037 $ 23,495,607 $ 40,867,598
Cost of revenue (excluding depreciation
and amortization) 13,128,010 15,424,912 16,393,439
------------ ------------ ------------
Direct margin 7,441,027 8,070,695 24,474,159
------------ ------------ ------------
Operating expenses:
Selling and marketing 1,117,228 736,866 1,108,621
Depreciation and amortization 3,581,071 5,580,985 12,322,558
General and administrative 1,834,292 2,530,374 14,692,460
Loss (gain) on disposal of equipment 31,237 (5,605) --
------------ ------------ ------------
Total operating expenses 6,563,828 8,842,620 28,123,639
Income (loss) from operations 877,199 (771,925) (3,649,480)
Other income, net 500,000 656,299 295,984
Amortization of debt issuance costs 794,357 1,619,086 3,168,315
Interest expense 3,620,152 4,593,943 13,569,846
Interest income -- -- 1,613,669
------------ ------------ ------------
Income (loss) before income taxes (3,037,310) (6,328,655) (18,477,988)
Income tax expense (benefit) (703,784) (681,443) 3,526,572
------------ ------------ ------------
Net income (loss) $ (2,333,526) $ (5,647,212) $(22,004,560)
============ ============ ============
Basic and diluted income (loss) per share $ (4.21) $ (9.53) $ (1.95)
============ ============ ============
22
The following table sets forth, for the periods indicated, selected statements
of operations data as a percentage of revenues:
Years Ended December 31,
-------------------------------
2001 2002 2003
---- ---- ----
Total revenue 100.0 % 100.0 % 100.0 %
Cost of revenue (excluding depreciation
and amortization) 63.8 % 65.7 % 40.1 %
Direct margin 36.2 % 34.3 % 59.9 %
Operating expenses:
Selling and marketing 5.4 % 3.1 % 2.6 %
Depreciation and amortization 17.4 % 23.8 % 30.2 %
General and administrative 8.9 % 10.8 % 36.0 %
Loss (gain) on disposal of equipment 0.2 % -- % -- %
Total operating expenses 31.9 % 37.7 % 68.9 %
Income (loss) from operations 4.3 % (3.3)% (8.9)%
Other income, net 2.4 % 2.8 % 0.8 %
Amortization of debt issuance costs 3.9 % 6.9 % 7.8 %
Interest expense 17.6 % 19.6 % 33.2 %
Interest income -- % -- % 3.9 %
Income (loss) before benefit from income taxes (14.8)% (27.0)% (45.2)%
Income tax expense (benefit) (3.4)% (3.0)% 8.6 %
Net income (loss) (11.3)% (24.0)% (53.8)%
2003 COMPARED TO 2002
Revenue
Total revenue for the year ended December 31, 2003 was approximately $40,868,000
compared to approximately $23,496,000 for the same period during the prior year,
an increase of approximately $17,372,000 or 73.9%.
Wholesale monitoring revenues increased from approximately $21,701,000 in the
year ended December 31, 2002 to approximately $24,393,000 for the same period in
2003, an increase of approximately $2,692,000, or 12.4%. The increase is due
primarily to an increase in average revenue per account per month from $4.25 for
the year ended December 31, 2002 to $4.68 for the comparable period of 2003
which accounts for approximately $2,241,000 of the total increase. The balance
of the increase in revenue, or approximately $451,000, is due to an increase in
the aggregate number of accounts (not owned by the Company, or "external")
monitored during the year ended December 31, 2003 as compared to the same period
in the year 2002. The net increase in external accounts can be attributed to the
acquisition of approximately 80,000 accounts as a result of the purchase of
Criticom; offset, in part, by approximately 62,000 accounts owned by IASI at the
time of its acquisition by IASG, the revenue from which is eliminated in
consolidation. The increase in the average revenue per account can be attributed
to the fact that the average revenue on external accounts exceeds that of those
owned by IASI.
Revenue from customer accounts totaled approximately $15,855,000 for the year
ended December 31, 2003. Our initial purchase of customer accounts occurred with
the acquisition of IASI and affiliates in January 2003.
Other revenue, which includes billing and placement fees and service and
subcontractor revenue, totaled approximately $620,000, a decrease of
approximately $1,174,000 compared with the prior year. The decrease is due
primarily to the cessation of the recognition of related party placement fees as
a result of the merger of IASI and affiliates.
Cost of Revenue Our cost of revenue totaled approximately $16,393,000, an
increase of approximately $968,000 from the same period of the prior year. For
the most part, this increase is comprised of an increase of approximately
$2,157,000 and $828,000 associated with the acquisition of Criticom and costs
associated the retail segment operation, offset, in part, by expense reductions
of approximately $2,017,000 resulting from increased synergy achieved through
the consolidation of alarm monitoring facilities and monitoring system
conversion program. As a result of the acquisition of customer accounts during
the year 2003, incremental revenues from these accounts exceeded the cost of the
associated revenue by approximately $12,587,000 and, accordingly, resulted in an
improvement to the year 2003 direct margin of 12.4%.
23
Operating Expenses
Operating expenses increased from approximately $8,843,000 to approximately
$28,124,000, or approximately $19,281,000. The increase was due primarily to the
incremental expenses associated with the acquisitions of IASI and PSI ("the
retail segment acquisitions") and Criticom, in the amounts of approximately
$16,848,000 and $1,112,000, respectively.
Selling and marketing expenses increased approximately $372,000, from
approximately $737,000 to approximately $1,109,000, or 50.5%. For the year ended
December 31, 2003, the acqusition of Criticom and the retail segment acquistions
resulted in incremental expenses of approximately $217,000 and $183,000,
respectively. These incremental amounts were offset, in part, by the reductions
to various other expenses of approximately $28,000.
Depreciation and amortization expenses increased from approximately $5,581,000
to approximately $12,323,000, an increase of approximately $6,742,000, or
120.8%. The increase was primarily a result of the incremental expense
associated with the retail segment and Criticom acquistions in the amounts of
approximately $7,070,000 and $577,000, respectively, offset, in part, by a
reductions to amortization of dealer relationship costs and depreciation expense
of approximately $706,000 and $199,000, respectively.
General and administrative expenses increased from approximately $2,530,000 for
the year ended December 31, 2002 to approximately $14,692,000 for the year ended
December 31, 2003, or approximately $12,162,000. The largest components of this
increase relates to the incremental expense associated with the retail segment
acquisitions and the acquisition of Criticom in the amounts of approximately
$9,595,000 and $313,000, respectively. The general and administrative expenses
from the retail segment acquisitions included, in part: assumption of debt from
CCCC in the amount of $1,825,000; a cash payment to CCCC of $1,700,000; payroll
and employee benefits related expenses totaling approximately $2,203,000; bad
debt expense totaling approximately $1,506,000; professional, billing and
collection service fees totaling approximately $492,000; bank, lock box and line
of credit commitment fees of approximately $423,000; postage expense of
approximately $242,000; and, service expenses of approximately $241,000. For the
most part, the balance of the increase in the Company's general and
administrative expenses for the year ended December 31, 2003 can be attributed
to: an increase in accounting fees of approximately $1,155,000 related to
initial public offering activity; an increase in directors and officers
liability insurance expense of approximately $450,000; an increase in salaries,
payroll taxes and employee benefits of approximately $248,000; an increase in
franchise taxes of approximately $180,000; and, an increase in board fees of
approxiately $70,000.
Other Income/Loss
Other income for the year ended December 31, 2003 was approximately $296,000,
due primarily to a settlement related to the acquisition of RTC. For the
comparable period of 2002 other income was approximately $656,000, which, for
the most part, arose from the forgiveness of debt in connection with a
litigation settlement for an uncompleted merger.
Amortization of Debt Issuance Costs
The amortization of debt issuance costs increased approximately $1,549,000 from
approximately $1,619,000 to approximately $3,168,000. Incremental expense
resulting primarily from the prepayment of certain debt from the IPO proceeds
resulted in an increase of approximately $1,437,000 during the current year. In
addition to the expense related to the retirement of debt from the IPO proceeds,
approximately $1,203,000 of incremental expense was recognized in the current
year as the result of the acquisition of IASI offset, in part, by a reduction of
approximately $1,091,000 associated with the Company's wholesale monitoring
segment.
Interest Expense
Interest expense increased by approximately $8,976,000 from approximately
$4,594,000 to approximately $13,570,000. In the wholesale monitoring businesses,
interest expense decreased from approximately $4,594,000 to approximately
$3,033,000, or approximately $1,561,000. The incremental interest expense
recorded in year 2003 associated with the acquisition of IASI totaled
approximately $10,537,000.
Interest income
Interest income increased to approximately $1,614,000 for the year ended
December 31, 2003 from $0 in the comparable of year 2002. This increase is
almost entirely related to interest earned on notes receivable by IASI.
Taxes
Income tax expense of approximately $3,527,000 was recorded in the current
period as compared to an income tax benefit of approximately $681,000 during the
same period last year. As a result of the merger of KC Acquisition with IASG
during January 2003, KC Acquisition, KCF, Morlyn 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 it's 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 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. In the wholesale monitoring businesses,
the prior period tax benefit reflected the change in the deferred tax liability
net of S corporate taxes.
24
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 year ended December 31, 2003 as compared to the same period during 2002 are
discussed below. The Company purchased its Retail Services segment during the
year 2003 and, as a result, data is not available for the comparable periods
during 2002.
Alarm Monitoring, Wholesale Segment. The year ended December 31, 2003
Alarm Monitoring, Wholesale segment revenue for the year ended December 31, 2003
totaled approximately $24,393,000 compared to $23,496,000 for the comparable
period during 2002, an increase of $897,000, or 3.8%.
Direct margin increased from 34.4% for the year ended December 31, 2002 to 40.5%
for same period of year 2003. The loss from operations decreased from
approximately $772,000 for the 2002 period to income from operations of
approximately $71,000 for the same period in 2003. The improvements in the
wholesale segment direct margin and income from operations are attributable to
the expense reductions arising from the consolidation of alarm and monitoring
facilities and monitoring system conversion program.
Alarm Monitoring, Retail Segment. The year ended December 31, 2003
Alarm Monitoring Retail segment revenue totaled approximately $16,475,000 for
the year ended December 31, 2003. The segment's loss from operations for the
period totaled approximately $3,721,000, while the loss before income taxes
totaled approximately $15,174,000.
2002 COMPARED TO 2001
Revenue
Revenue for 2002 was $23,495,607 compared to $20,569,037 for the same period in
the prior year, an increase of $2,926,570, or 14.2%. Monitoring fees increased
$1,352,525 to $20,136,016 from $18,783,491, or 7.2%, reflecting in part the
acquisitions of Custom Design, RTC Alarm and Criticom. Related party monitoring
fees increased $1,058,035 to $1,565,017 from $506,982, or 208.7%, reflecting
additional related party account acquisitions and a reduction in concessions of
approximately $958,000. Related party placement fees increased $261,779 to
$1,236,227 from $974,448, or 26.9%, and represent higher origination fees
associated with additional related party account acquisitions. Billing fees
increased $254,231 to $558,347 from $304,116, or 83.5% as additional Dealers
either subscribed to or were required to use our billing services. The average
price realized for alarm monitoring services per end-user alarm monitoring
contract was $4.09 per month in 2002, a decrease of $.30 per month from
approximately $4.39 per month per end-user alarm monitoring contract in 2001,
reflecting a change in the mix of IASI versus non IASI end-user alarm monitoring
contracts. IASI end-user accounts monitored increased 30,842 to 77,890 at
December 31, in 2002 from 47,048 at December 31, 2001. Non IASI end-user
accounts monitored excluding Criticom decreased 28,727 to 314,241 at December
31, 2002 from 342,968 at December 31, 2001, respectively. The average price
realized for alarm monitoring services, excluding IASI, was $4.86 and $4.79 in
2002 and 2001, respectively. Average recurring monthly revenue and the average
number of end-user alarm monitoring contracts increased in 2002 primarily as a
result of the acquisitions of Custom Design, RTC Alarm and Criticom. The total
number of end-user monitoring contracts monitored at December 31, 2002 was
approximately 486,650, a net increase of approximately 96,400 end-user alarm
monitoring contracts for the year.
Average recurring monthly revenue and the average number of end-user alarm
monitoring contracts increased in 2002 primarily as a result of the acquisitions
of Custom Design, RTC Alarm and Criticom. The total number of end-user
monitoring contracts monitored at December 31, 2002 was approximately 486,700, a
net increase of approximately 96,400 end-user alarm monitoring contracts for the
year.
The acquisitions of Custom Design, RTC Alarm and Criticom added approximately
131,700 monitored accounts. Accounts acquired from Custom Design and RTC Alarm
were consolidated into our existing monitoring facilities. The Criticom accounts
acquired were not consolidated into existing monitoring facilities. Revenue
related to those acquisitions totaled $3,343,715 during 2002 or 14.2% of our
total revenue.
Concessions for monitoring services granted to IASI were $35,000 in 2002 versus
$993,000 in 2001.
Cost of Revenue
The cost of revenue increased $2,296,902 to $15,424,912 in 2002 from $13,128,010
in 2001, or 17.5%, reflecting in part the acquisitions of RTC Alarm and
Criticom. The cost increase includes an 11.3% decrease in operator salaries that
was offset by increases of 38% in telecommunication expenses, 173.8% in Dealer
care salaries, 22.0% in benefit and employer paid taxes and 37.8% in other
operating expenses. As a result, the margin attributable to the central station
operations decreased to 34.3% in 2002 from 36.2% in 2001.
25
Operating Expenses
General and administrative expenses increased by $696,082 to $2,530,374 in 2002
from $1,834,292 in 2001, or 37.9%, resulting primarily from the acquisitions of
RTC Alarm and Criticom and increases in professional fees for audit services.
Selling and marketing expenses decreased by $380,362 to $736,866 from
$1,117,228, or 34.0%. The sales force was reconfigured in the third quarter of
2001 in an effort to increase the productivity of each sales person. The benefit
of this reconfiguration plus lower travel and other sales related expenses
contributed to the decline in selling and marketing expenses.
Depreciation and amortization expenses increased $1,999,914 to $5,580,985 from
$3,581,071, or 56%, reflecting the acquisitions of Custom Design, RTC Alarm and
Criticom. Amortization of dealer relationships increased $2,183,033 from
$2,490,358 in 2001 to $4,673,391 in 2002. Depreciation expense increased
$358,318 to $833,481 from $475,163, or 75.4%, reflecting the acquisitions of RTC
Alarm and Criticom. Effective January 1, 2002 the Company adopted SFAS No. 142
"Goodwill and Other Intangible Assets" and ceased amortizing goodwill. As a
result, goodwill amortization expense decreased from $601,343 in 2001 to $0 in
2002.
Other Income
Net other income increased $156,299 to $656,299 in 2002 from $500,000 in 2001,
or 31.3%, and was primarily attributable to the forgiveness of debt in
connection with a litigation settlement in 2002 for a failed merger with an
unrelated entity. Other income in the prior period of $500,000 reflected a
break-up fee related to the failed merger.
Amortization of Debt Issuance Costs
The amortization of debt issuance costs increased $824,729 to $1,619,086 in 2002
from $794,357 in 2001, or 103.8%, reflecting additional indebtedness associated
with the acquisition of RTC Alarm, plus the write off of $831,717 in debt
issuance costs associated with the refinancing of certain indebtedness in
September and October 2002.
Interest Expense
Net interest expense increased $973,791 to $4,593,943 in 2002 from $3,620,152 in
2001, or 26.9%, reflecting higher levels of average debt outstanding because of
the acquisitions of Custom Design, RTC Alarm and Criticom.
In September 2002, IASG, a pre-existing Delaware company which has been
subsequently dissolved, issued an aggregate of $5.5 million principal amount of
convertible notes, which we assumed in January, 2003. These notes contain a
beneficial conversion feature whereby they can be converted to common stock at a
25 percent discount from the initial public offering price. The common stock
purchased at a discounted price ($11.00 x .75 = $8.25) would have a market value
of $7,333,333. The beneficial conversion feature will be recorded at the
$1,833,333 spread and amortized straight-line over the remaining twenty six
month life of the notes. The resulting interest expense will be approximately
$846,000 per year.
Taxes
A tax benefit of $681,443 was recorded in the current period, reflecting the
change in the deferred tax liability net of S corporate state taxes and the
reversal of a tax liability for a tax year no longer subject to examination in
the amount of ($345,600). A tax benefit of $703,784 was recorded in the prior
period, reflecting the change in the deferred tax liability net of S corporate
state taxes.
As the result of the merger of KC Acquisition with IASG during January 2003, KC
Acquisition, KC Funding Corporation, Morlyn 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 their earnings and
losses, and recognize the tax consequences of "temporary differences" between
financial statement and tax basis of existing assets and liabilities. At the
time of change in tax status of an enterprise, we will have an additional
deferred tax liability of approximately $3,600,000, which will be included in
income tax expense.
Assuming profitable operations, we will begin to pay income taxes that
previously were the responsibility of shareholders and members. This change will
have no impact on our debt covenants since the covenants measure performance
based on EBITDA which will not be impacted by recorded tax expense.
Net Loss
As a result of the above, the net loss increased $3,313,686, or 142.0%, to a net
loss of $5,647,212 in 2002 from a net loss of $2,333,526 in 2001.
Liquidity and Capital Resources
The following tables present the combining cash flows of IASG and subsidiaries
(which includes Criticom from the date of acquisition on September 26, 2002) and
IASI and affiliates based on the historical financial statements. Such table
excludes the purchase accounting adjustments related to the acquisition of IASI
by a wholly-owned subsidiary of IASG in January 2003.
Year Ended December 31, 2002
--------------------------------------------------------------
IASG IASI Elimination Total
---- ---- ----------- -----
(in Thousands)
Cash flows provided by operating activities:
Net Loss $ (5,646) $ (12,224) $ - $ (17,870)
Depreciation and amortization 7,200 11,518 - 18,718
Deferred income taxes (681) - - (681)
Working capital 2,806 (340) - 2,466
Other (987) 1,271 - 284
-------- --------- ------ ---------
2,692 225 - 2,917
Cash flows used in investing activities:
Business acquisitions, net of cash acquired (4,812) - - (4,812)
Purchase of customer contracts - (1,733) - (1,733)
Financing of customer loans - (3,241) (3,241)
Repayment of customer loans - 3,979 (1,494) 2,485
Other (4,051) 328 - (3,723)
-------- --------- ------ ---------
(8,863) (667) (1,494) (11,024)
Cash flows provided by financing activities:
Proceeds of long-term debt 14,300 34,860 - 49,160
Payments of long-term debt (8,161) (23,552) 1,494 (30,219)
Debt issuance costs (670) (2,008) - (2,678)
Capital withdrawals - (7,766) - (7,766)
Other (80) - - (80)
-------- --------- ------ ---------
5,389 1,534 1,494 8,417
Net increase (decrease) in cash and cash equivalents $ (782) $ 1,092 $ - $ 310
======== ========= ====== =========
The following table presents the combining cash flows of IASG and subsidiaries
and IASI and affiliates based on the historical financial statements:
Year Ended December 31, 2001
---------------------------------------------------------------
IASG IASI Elimination Total
---- ---- ----------- -----
(in Thousands)
Cash flows provided by operating activities:
Net Loss $ (2,334) $ (5,764) $ - $ (8,098)
Depreciation and amortization 4,376 6,440 - 10,816
Deferred income taxes (704) - - (704)
Working capital (527) 1,905 - 1,378
Other 201 1,293 - 1,494
-------- -------- ------ --------
1,012 3,874 - 4,886
Cash flows used in investing activities:
Business acquisitions, net of cash acquired (1,192) - - (1,192)
Purchase of customer contracts - (32,186) - (32,186)
Financing of customer loans - (7,144) 2,325 (4,819)
Repayment of customer loans - 1,231 (309) 922
Other (513) (1,069) - (1,582)
-------- --------- ------ --------
(1,705) (39,168) 2,016 (38,857)
Cash flows provided by financing activities:
Proceeds of long-term debt 4,925 41,696 (2,325) 44,296
Payments of long-term debt (3,402) (13,088) 309 (16,181)
Debt issuance costs (644) (2,800) - (3,444)
Capital contributions - 9,779 - 9,779
Other (113) - - (113)
-------- --------- ------ --------
766 35,587 (2,016) 34,337
Net increase in cash and cash equivalents $ 73 $ 293 $ - $ 366
======== ========== ====== ========
Net cash used by operating activities was $(4.2 million) for the year ended
December 31, 2003 compared to $2.9 million provided by operating activities for
the year ended December 31, 2002. The decrease in cash provided by operations
was primarily the result of an increase in the net loss for the period of $(4.1
million) and a decrease in depreciation and amortization of $(6.4 million). Net
cash provided by operating activities was $2.9 million for the year ended
December 31, 2002 compared to $4.9 million for the year ended December 31, 2001.
The decrease in cash provided by operations was primarily the result of an
increase in the net loss for the period of $(9.8 million) offset by an increase
in depreciation and amortization of $7.9 million.
Net cash used in investing activities was $(58.0 million) for the year ended
December 31, 2003 compared to $(11.0 million) for the year ended December 31,
2002. The significant increase is primarily due to the acquisition of two
operating businesses for $(49.8 million) and increased purchases of retail
customer contracts of approximately $(9.1 million). Net cash used in investing
activities was $(11.0 million) for the year ended December 31, 2002 compared to
$(38.9 million) for the year ended December 31, 2001. The decrease is primarily
due to reduced purchases of retail customer contracts of approximately $30.5
million.
Net cash provided by financing activities was $97.2 million for the year ended
December 31, 2003 compared to $8.4 million for the year ending December 31,
2002. The increase is primarily due to the $195.9 million in proceeds from our
IPO, offset by $(100.2 million) used to repay long-term debt. Net cash provided
by financing activities was $8.4 million for the year ended December 31, 2002
compared to $34.3 million for the year ending December 31, 2001. The decrease is
primarily due to an increase of capital withdrawals of $17.5 million, repayment
of long-term debt of $14.0 million, combined with an increase in proceeds of
long-term debt of $4.9 million.
The balance sheet at December 31, 2003 reflects net working capital of
approximately $4.8 million. As of December 31, 2003, we had recurring monthly
revenue ("RMR") of approximately $3,600,000 in our retail monitoring segment and
approximately $1,900,000 in our wholesale monitoring segment. Total debt had
increased to approximately $65.7 million as of December 31, 2003. Approximately
$60.2 million of that debt was acquired as a result of the IASI acquisition.
These debt balances are after initial public offering proceeds of $91.9 million
were used to pay-off existing debt in the third quarter of 2003.
26
On July 29, 2003, the Company successfully completed its initial public
offering. A total of 22,000,000 shares of common stock were issued at a per
share price of $9.25. The net proceeds to the Company after underwriting
commissions (7%) and other direct offering costs were approximately
$187,403,000.
On August 27, 2003, the underwriters exercised a portion of their overallotment
option and an additional 982,729 shares of common stock were issued at a per
share price of $9.25. The proceeds to the Company after underwriting commissions
(7%) were approximately $8,454,000
During 2003, we were in default of our monthly and quarterly financial and
non-financial debt covenants under our various debt agreements with LaSalle Bank
N.A., Key Bank National Association (Key Bank) and SLP Capital. The Key Bank and
SLP Capital debts were paid-off with proceeds from the initial public offering
during August 2003.
On May 9, 2003 we received a permanent bank waiver from LaSalle through April 1,
2003 for certain past covenant violations. With respect to an attrition
covenant, the Company in 2003 and January 2004 has provided LaSalle with a
security interest in approximately $171,000 of additional alarm contract
recurring monthly revenue. After giving effect to the waivers described above,
we are not currently in default of our covenants.
In June 2003, the Company secured a $20 million account acquisition facility
with LaSalle Bank N.A., which was contingent upon the completion of an initial
public offering with minimum net proceeds of $115 million. The facility would
have been available to IASG for acquisitions of security alarm companies and
pools of security alarm contracts. The commitment has expired, but we continue
to negotiate financing alternatives with LaSalle Bank N.A.
Our capital expenditures anticipated over the next twelve months include
equipment and software of approximately $2.5 million and our strategy to
purchase monitoring contracts, which we anticipate to be approximately $120
million. This strategy is dependent on obtaining additional financing.
We believe that our existing cash, cash equivalents and RMR are adequate to fund
our operations, exclusive of planned contract acquisitions, for at least the
next twelve months.
Recent Accounting Pronouncements Not Yet Adopted
In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46).
"Consolidation of Variable Interest Entities". In December 2003, the FASB issued
a revision to FIN 46, and to exempt certain entities from its requirements. FIN
46 gives guidance that determines whether consolidation of a Variable Interest
Entity is required. FIN 46 is effective now for certain Special Purpose Entity
relationships after March 15, 2004. The Company does not expect the adoption of
FIN 46 to have a material effect on its financial statements.
In May 2003, the Financial Accounting Standards Board (FASB) issued Financial
Accounting Standard No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity, (FAS No. 150). The Standard
establishes how an issuer classifies and measures certain financial instruments
with characteristics of both liabilities and equity. This Standard becomes
effective for any financial instruments entered into or modified after May 31,
2003. The Company does not expect the adoption of FAS No. 150 to have a
material effect on its financial statements.
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 included 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 December 31, 2003,
we had approximately $9.0 million of variable rate debt of which $1.0 million of
debt has been fixed with an interest rate swap arrangement.
27
Management's Discussion and Analysis (MD&A) contains statements that are
forward-looking. These statements are based on current expectations and
assumptions that are subject to risks and uncertainties. Actual results could
differ materially because of factors discussed elsewhere in this report.
Off Balance Sheet Arrangements
The Company is not a party to any off-balance sheet arrangements.
Contractual Obligations and Commercial Commitments
The Company's significant contractual obligations as of December 31, 2003 are
for $70,625,866. 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
- --------------------------------- -----------------------------------------------------------------------------------
Total Less than 1 1-3 years 4-5 years After 5 years
year
- --------------------------------- ------------------ --------------- ---------------- -------------- ----------------
Long-term debt $65,742,612 $18,765,000 $12,966,983 $34,010,629 $ 0
- --------------------------------- ------------------ --------------- ---------------- -------------- ----------------
Capital Leases 1,013,429 520,086 447,556 45,787 0
- --------------------------------- ------------------ --------------- ---------------- -------------- ----------------
Operating leases 3,869,825 1,291,804 1,445,661 947,660 184,700
- --------------------------------- ------------------ --------------- ---------------- -------------- ----------------
Total $70,625,866 $20,576,890 $14,860,200 $35,004,076 $184,700
- --------------------------------- ------------------ --------------- ---------------- -------------- ----------------
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
See item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operation, Market Risk.
Item 8. Financial Statements and Supplementary Data
Our consolidated financial statements and supplementary data, together with the
report of PricewaterhouseCoopers LLP, independent public accountants, are
included elsewhere herein. See "Index to Financial Statements" on page F-1.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosures
None.
ITEM 9A. 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 Annual Report on Form 10-K. Based on this evaluation, our Chief Executive
Officer and Chief Financial Officer have concluded that, as of such date, our
disclosure controls and procedures are effective to provide reasonable assurance
that information required to be disclosed by us in reports that we file or
submit under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in applicable SEC rules and forms.
Changes in Internal Control Over Financial Reporting. There was no change 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 Annual Report on Form 10-K that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting
except 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. The Company has not completed its documentation and
testing of the accounting systems of these acquired companies at this time.
28
PART III
ITEM 10. Directors and Executive Officers of the Registrant
The information contained under the caption "Election of Directors" to appear in
the Company's definitive proxy statement relating to the Company's 2004 Annual
Meeting of Stockholders, which definitive proxy statement will be filed with the
Securities and Exchange Commission not later than 120 days after the end of the
Company's fiscal year covered by this report on Form 10-K (hereinafter referred
to as the "Annual Meeting Proxy Statement"), is incorporated herein by
reference.
The names of our executive officers, together with a brief description of their
employment histories, are provided below:
Name Age Position
- --------------------------------------------------------------------------------------------------
Timothy M. McGinn 55 Chairman of the Board and Chief Executive Officer
Thomas J. Few, Sr. 57 Vice Chairman, President and Chief Operating Officer
Curtis Quady 61 Executive Vice President and Director
Brian E. Shea 45 Executive Vice President
Michael T. Moscinski 52 Chief Financial Officer
Robert B. Heintz 48 Vice President, Finance and Administration--Monitoring Services
Mr. McGinn has served as our Chairman of the Board and Chief Executive Officer
since January 2003. Mr. McGinn was the President of Integrated Alarm Services,
Inc. Mr. McGinn is the non-executive Chairman of the Board of McGinn, Smith &
Co., Inc. He has served as Chairman of the Board and as an executive officer of
McGinn, Smith since 1980. He also serves as non-executive Vice Chairman of
Pointe Financial Corp., a publicly traded commercial bank and non-executive
Chairman of its affiliates, Pointe Capital LLC and Pointe Bank. Mr. McGinn also
serves as a Director of Same Day Surgery, Inc. Mr. McGinn was also the Chairman
of Capital Center Credit Corporation, a private company which provides financing
to the Residential Security and Alarm Industry, from 1995 to 2002. Mr. McGinn
served as a Managing Director of On-Line Capital Securities, an internet
investment bank, a position he held from March 2000 until December 2002. From
November 2000 to June 2002, Mr. McGinn also served as Chairman of First
Integrated Capital Corporation, a financial services firm majority owned by Mr.
McGinn and Mr. Smith.
Mr. Few, Sr. is our Vice Chairman, President and Chief Operating Officer and has
over 35 years of experience in the security alarm industry. Mr. Few, Sr. has
been with KC Acquisition and its predecessors since 1985, where he started as
Executive Vice President. Prior thereto, Mr. Few, Sr. held senior positions with
Holmes Protection, Inc., ADEMCO, Guardian and ADT. Prior to his work with these
firms, Mr. Few, Sr. owned and operated an independent alarm company and central
station in New Jersey.
Mr. Quady founded Criticom, which we acquired in September of 2002. Mr. Quady
has served as an Executive Vice President and a Director since October 2002. He
has more than twenty years of experience in the security industry. Prior to
founding Criticom, Mr. Quady served as a pilot in the United States Army and was
an airline captain for a major international airline for eighteen years. Mr.
Quady is the Chief Manager of Royal Thoughts, LLC, in which we have a minority
ownership position.
Mr. Shea has served as an Executive Vice President since March 2003. In this
role, he heads our retail account acquisition division, including portfolio
management, due diligence, performance monitoring and billing and collection.
Prior to serving in his current role, he was our Chief Financial Officer and had
served as the Chief Financial Officer of IASI and its predecessor companies
since 1992. Prior thereto, he was Vice President of Finance/ Controller of
Hiland Park, a real estate development company. Prior to joining Hiland Park, he
was an Analyst at Galesi Group and a Financial Manager for General Electric
Corporation, where he graduated from GE's Financial Management Training Program.
Mr. Moscinski has served as our Chief Financial Officer since March 2003. Prior
to joining IASG, he served as Vice President, Corporate Controller and Interim
Chief Financial Officer for United Road Services, Inc., a public company based
in Albany, NY, where he worked from 1998 to 2001. From 1987 to 1998, Mr.
Moscinski was the Director of Corporate Accounting for National Micronetics,
Inc. From 1976 to 1987, Mr. Moscinski was with KPMG International and its
predecessor firms, where he was a Senior Manager in audit. Mr. Moscinski is a
Certified Public Accountant and a member of the American Institute of Certified
Public Accountants and the New York State Society of Certified Public
Accountants.
Mr. Heintz has served as Vice President, Finance and Administration --
Monitoring Services since January 2003. He was previously our Chief Financial
Officer, a position he held since April 2000. Prior to joining KC Acquisition,
he was Vice President and Chief Financial Officer of Monital Signal Corporation,
which we acquired in April 2000. Before working for Monital, he was Vice
President Finance & Information Services for Brownstone Studio, Inc., a garment
cataloger and manufacturer, where he worked from 1994 to 1996. Before
Brownstone, he spent 14 years with the Dun & Bradstreet Corporation where he
held several finance and accounting positions.
29
We have adopted a Code of Ethics for our officers, including our principal
executive officer, principal financial officer and controller, principal
accounting officer and persons performing similar functions, and our employees
and directors.
Shareholders may request a free copy of the Code of Ethics from:
Integrated Alarm Services Group, Inc.
Attn: Investor Relations
99 Pine Street, 3rd floor
Albany, NY 12207
(518) 426-1515
Any amendment of our Code of Ethics or waiver thereof applicable to any of our
principal executive officer, principal financial officer and controller,
principal accounting officer or persons performing similar functions will be
disclosed on our website within 5 days of the date of such amendment or waiver.
In the case of a waiver, the nature of the waiver, the name of the person to
whom the waiver was granted and the date of the waiver will also be disclosed. A
copy of our Code of Ethics is attached hereto as Exhibit 14.
Item 11. Executive Compensation
The information contained under the caption "Executive Compensation" of the
Annual Meeting Proxy Statement is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information contained under the caption "Security Ownership of Certain
Beneficial Owners and Management" of the Annual Meeting Proxy Statement is
incorporated herein by reference.
The Company has adopted, and the shareholders of the Company have approved, one
equity compensation plan: The Integrated Alarm Services Group, Inc. 2003 Stock
Option Plan (the "Plan"). The purpose of the Plan, (the number of shares of
common stock available for grant and issuance under the plan is 150,000 shares)
is to attract, motivate retain and reward high quality executives and other
employees, officers, director and affiliates by enabling such persons to acquire
or increase a proprietary interest in the Company in order to strengthen the
mutuality of interest between such persons and the Company's shareholders and
providing such persons with annual and long-term performance incentives to
expend their maximum efforts in the creation of shareholder value.
The following table sets forth information regarding our existing compensation
plan and individual compensation arrangements pursuant to which our equity
securities are authorized for issuance to employees or non-employees (such as
directors, consultants, advisors, vendors, customers, suppliers or lenders) in
exchange for consideration in the form of goods or services.
(a) (b) (c)
Number of securities to be Weighted-average Number of securities remaining available
issued upon exercise of exercise price of for future issuance under equity
outstanding options, outstanding options, compensation plans (excluding securities
Plan warrants and rights warrants and rights reflected in column (a))
- ---------------- ----------------------------- ------------------------ -----------------------------------------
2003 Stock 48,000 $9.25 102,000
OptionPlan
Item 13. Certain Relationships and Related Transactions
The information contained under the caption "Certain Relationships and Related
Transactions" of the Annual Meeting Proxy Statement is incorporated herein
reference.
Item 14. Principal Accountant Fees and Services
The information contained under the caption "Principal Accountant Fees and
Services" of the Annual Meeting and Proxy Statement is incorporated herein by
reference.
30
PART IV
ITEM 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) The following documents are filed as a part of this report:
1. The financial statements listed on the accompanying Index to
Financial Statements on page F-1.
2. Financial statement schedules
Schedules have been omitted since they are either not required, are
not applicable or the required information is shown in the
consolidated financial statements or related notes.
3. The following Exhibits:
Exhibit Description
-------------------
Exhibit No.
- -----------
1.1 Form of Underwriting Agreement *
2.1 Merger Agreement by and between KC Alarm Services Group (Delaware Corporation) and the registrant*
2.2 Merger Agreement by and between registrant and Criticom International Corporation*
2.2(a) Amendments to Merger Agreement by and registrant and Criticom International Corporation*
2.3 Contribution Agreement between Morlyn Financial Group LLC and the registrant*
2.4 Contribution Agreement by and between Payne Security Group LLC and the registrant*
2.5 Contribution Agreement by and between Guardian Group, LLC and the registrant*
2.6 Contribution Agreement by and between Palisades Group, LLC and the registrant*
2.7 Merger Agreement between IASI, Inc., IASG Acquisition Corp. and the registrant*
2.8 Asset Purchase Agreement by and between Roseville Telephone Company, RTC Alarm Monitoring Services and
the registrant*
2.9 Asset Purchase Agreement by and between Custom Design Security, Inc. and Central
Digital Station Monitoring Services, Inc. and the registrant*
2.10 Stock Purchase Agreement dated as of December 15, 2003 between Integrated Alarm Services Group, Inc. and
Lane Industries, Inc. (incorporated by reference to Exhibit 99.1 to the Current Report on Form 8-K filed by
IASG dated December 22, 2003)
3.1 Certificate of Incorporation of registrant*
3.1(a) Certificate of Amendment to the Certificate of Incorporation*
3.2 Amendment to Certificate of Incorporation of registrant*
3.3(a) Amended and Restated By-Laws of registrant*
4.1 Form of Certificate of Common Stock*
5.1 Opinion of Gersten, Savage, Kaplowitz, Wolf & Marcus, LLP*
10.1 ** Stock Option Plan*
10.2 ** Amended and Restated Employment Agreement by and between the registrant and Timothy M. McGinn *
10.3 ** Employment Agreement by and between the registrant and Thomas J. Few, Sr. *
10.4 ** Employment Agreement by and between the registrant and Curtis Quady. *
10.5 ** Employment Agreement by and between the registrant and Brian E. Shea *
10.6 ** Employment Agreement by and between the registrant and Robert Heintz *
10.7 Assignment and Assumption Agreement*
10.8 Lease Agreement between the registrant and Pine Street Associates, LLC for the Albany, New York Office space*
10.9 Lease Agreement between Morlyn and Robert Gallo for the Oakland, New Jersey Office*
10.10 Form of Convertible Note*
10.11 Form of Two-year Note*
10.12 Form of Five-year Note*
10.13 Form of Three-year Note*
10.14 Form of One-year Note*
10.15 $3 million principal amount promissory note issued by registrant to Lynn A. Smith*
10.16 Right of First Refusal Agreement by and between registrant and Criticom IDC Corporation, and Royal Thoughts LLC*
10.17 ADEMCO Letter*
31
10.18 Installing company Monitoring Receivable Financing Agreement by and between the registrant and M&S Partners*
10.19 Receivable Financing Purchase Agreement between McGinn, Smith Acceptance Corp., Pointe Bank, and King Trust 01*
10.20 ** Form of Indemnification Agreement between registrant and member of the Board of Directors*
10.21 Form of note due April 2004*
10.22 ** Employment Agreement by and between the registrant and Michael Moscinski*
11.1 Statement of computation of earning per share***
14 Code of Ethics***
21 List of Subsidiaries***
23.3 Consent of Barnes & Associates*
23.4 Consent of Standard & Poor's Corporate Value Consulting*
24.1 Power of Attorney for Thomas J. Few, Curtis Quady, David Smith and R. Carl Palmer, Jr.*
31 Rule 13a-14 (a)/15d-14(a) Certifications***
32(a) Certification by the Chief Executive Officer relating to a periodic report containing financial statements***
32(b) Certification by the Chief Financial Officer relating to a periodic report containing financial statements***
* Incorporated by reference to Exhibit of same number to the Registration
Statement on Form S-1 (Registration Number 333-101159)
** Constitutes a management contract or compensatory plan or arrangement
required to be filed or incorporated by reference as an Exhibit to this
report pursuant to item 15(c) of Form 10-K
*** Filed herewith
(b) During the last quarter of the fiscal year covered by this report, IASG
filed four reports on Form 8-K. On November 13, 2003, the Company filed a report
on Form 8-K pursuant to Items 7, 9 and 12. On November 21, 2003, the Company
filed a report on Form 8-K pursuant to Items 7 and 9. On November 26, 2003, the
Company filed a report on Form 8-K pursuant to Items 7 and 9. On December 22,
2003, the Company filed a report on Form 8-K pursuant to Items 2 and 7. On
March 1, 2004, the Company filed a report on Form 8-K/A pursuant to Item 7,
amending its previously filed report on Form 8-K dated December 22, 2003.
32
Integrated Alarm Services Group, Inc.
Index
Page (s)
--------
Report of Independent Auditors.............................................F-2
Financial Statements
Balance sheets.................................................F-3
Statements of operations.......................................F-4
Statements of stockholders' (deficit) equity...................F-5
Statements of cash flows.......................................F-6
Notes to financial statements..................................F-7
F-1
Report of Independent Auditors
To the Board of Directors and Stockholders of
Integrated Alarm Services Group, Inc.
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, stockholders' equity (deficit) and cash
flows present fairly, in all material respects, the financial position of
Integrated Alarm Services Group, Inc. and its subsidiaries at December 31, 2003
and 2002, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 2003 in conformity with
accounting principles generally accepted in the United States of America. These
financial statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, on January 1,
2002 the Company adopted Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets.
As discussed in Notes 6 and 12 to the consolidated financial statements, the
Company has had significant transactions with related entities.
/s/ PricewaterhouseCoopers LLP
Albany, New York
March 15, 2004
F-2
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
BALANCE SHEETS
Combined as of December 31, 2002 and Consolidated as of December 31, 2003
As of December 31,
--------------------------------------
2002 2003
------------ -------------
Assets
Current assets
Cash and cash equivalents $ 442,082 $ 35,435,817
Short term investments 3,000,000 --
Current portion of notes receivable -- 735,149
Accounts receivable less allowance for doubtful
accounts of $194,000 in 2002 and $750,000 in 2003 1,499,762 4,312,990
Inventories -- 1,107,899
Prepaid expenses 72,648 1,548,105
Due from related parties 346,608 232,300
------------ -------------
Total current assets 5,361,100 43,372,260
Property and equipment, net 2,708,161 5,762,586
Notes receivable net of current portion and allowance
for doubtful accounts of $131,000 -- 4,525,973
Dealer relationships, net 27,560,912 23,113,617
Customer contracts, net -- 73,571,131
Goodwill, net 7,218,743 85,515,985
Debt issuance costs, net 1,047,221 1,768,281
Other identifiable intangibles, net -- 2,187,464
Restricted cash and cash equivalents 1,163,229 1,100,000
Other assets 568,431 119,033
------------ -------------
Total assets $ 45,627,797 $ 241,036,330
============ =============
Liabilities and Stockholders' (Deficit) Equity
Current liabilities:
Current portion of long-term debt, related party $ 1,738,724 $ --
Current portion of long-term debt 3,059,879 18,765,000
Current portion of capital lease obligations 146,316 431,555
Accounts payable 1,773,930 2,873,707
Accrued expenses 2,906,383 8,816,766
Current portion of deferred revenue 3,812,626 7,576,993
Other liabilities -- 139,066
------------ -------------
Total current liabilities 13,437,858 38,603,087
Long-term debt, net of current portion, related party 10,696,537 --
Long-term debt, net of current portion 29,566,223 46,977,612
Capital lease obligations, net of current portion 361,542 453,811
Deferred revenue, net of current portion -- 312,343
Deferred income taxes 2,458,738 759,425
Other liabilities 384,480 374,119
Due to related parties 285,300 153,203
------------ -------------
Total liabilities 57,190,678 87,633,600
------------ -------------
Commitments and Contingencies
Stockholders' (deficit) 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
709,719 shares at December 31, 2002 and 24,607,731 at
December 31, 2003
709 24,608
Common stock subscribed -- 315,342
Paid-in capital 5,554,289 205,086,659
Accumulated deficit (17,117,879) (52,023,879)
------------ -------------
Total stockholders' (deficit) equity (11,562,881) 153,402,730
------------ -------------
Total liabilities and stockholders' (deficit) equity $ 45,627,797 $ 241,036,330
============ =============
The accompanying notes are an integral part of the financial statements.
F-3
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
STATEMENTS OF OPERATIONS
Combined For the Years Ended December 31, 2001 and
2002 and Consolidated for the Year Ended December 31, 2003
Years Ended December 31,
--------------------------------------------------------
2001 2002 2003
------------ ------------ ------------
Revenue:
Monitoring fees $ 18,783,491 $ 20,136,016 $ 24,099,653
Revenue from customer accounts -- -- 15,854,509
Billing fees 304,116 558,347 112,127
Related party monitoring fees 506,982 1,565,017 292,968
Related party placement fees 974,448 1,236,227 90,437
Service and subcontractor fees -- -- 417,904
------------ ------------ ------------
Total revenue 20,569,037 23,495,607 40,867,598
Cost of revenue (excluding depreciation
and amortization) 13,128,010 15,424,912 16,393,439
------------ ------------ ------------
7,441,027 8,070,695 24,474,159
------------ ------------ ------------
Operating expenses:
Selling and marketing 1,117,228 736,866 1,108,621
Depreciation and amortization 3,581,071 5,580,985 12,322,558
Loss (gain) on disposal of equipment 31,237 (5,605) --
General and administrative 1,834,292 2,530,374 11,167,460
General and administrative-related party -- -- 3,525,000
------------ ------------ ------------
Total operating expenses 6,563,828 8,842,620 28,123,639
------------ ------------ ------------
Income (loss) from operations 877,199 (771,925) (3,649,480)
Other income (expense):
Other income, net 500,000 656,299 295,984
Amortization of debt issuance costs (794,357) (1,619,086) (3,168,315)
Related party interest expense (329,763) (1,284,922) (914,229)
Interest expense (3,290,389) (3,309,021) (12,655,617)
Interest income -- -- 1,613,669
------------ ------------ ------------
Income (loss) before income taxes (3,037,310) (6,328,655) (18,477,988)
Income tax expense (benefit) (703,784) (681,443) 3,526,572
------------ ------------ ------------
Net income (loss) $ (2,333,526) $ (5,647,212) $(22,004,560)
============ ============ ============
Basic and diluted income (loss) per share $ (4.21) $ (9.53) $ (1.95)
============ ============ ============
Weighted average number of common
shares outstanding 553,808 592,785 11,263,455
============ ============ ============
Unaudited:
Pro Forma income tax to give effect to
the conversion from S to C Corporation
status (Note 2):
Income (loss) before benefit from income taxes $ (3,037,310) $ (6,328,655) $(18,477,988)
Income tax expense (benefit) (955,569) (2,871,573) (89,916)
------------ ------------ ------------
Net income (loss) $ (2,081,741) $ (3,457,082) $(18,388,072)
============ ============ ============
Basic and diluted income (loss) per share $ (3.76) $ (5.83) $ (1.63)
============ ============ ============
The accompanying notes are an integral part of the financial statements.
F-4
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
STATEMENTS OF STOCKHOLDERS' (DEFICIT) EQUITY
Combined For the Years Ended December 31, 2001 and 2002 and
Consolidated For the Year Ended December 31, 2003
Common Stock Common Stock Paid-in Accumulated Total Stockholders
Shares Amount Subscribed Capital Deficit (Deficit) Equity
---------- ------- ---------- ------------- ------------ ----------------
Balance January 1, 2001 553,808 $ 554 $ -- $ 2,124,446 $ (9,137,141) $ (7,012,141)
Net loss -- -- -- -- (2,333,526) (2,333,526)
---------- ------- ---------- ------------- ------------ -------------
Balance, December 31, 2001 553,808 554 -- 2,124,446 (11,470,667) (9,345,667)
Net loss -- -- -- -- (5,647,212) (5,647,212)
Issuance of common shares for acquisition
of Criticom 155,911 155 -- 3,429,843 -- 3,429,998
----------- ------- ---------- ------------- ------------ -------------
Balance, December 31, 2002 709,719 709 -- 5,554,289 (17,117,879) (11,562,881)
Net loss -- -- -- -- (22,004,560) (22,004,560)
Issuance of common shares for acquisition
of IASI and affiliates 864,192 865 -- 11,559,079 -- 11,559,944
Predeccessor basis in IASI -- -- -- (17,113,351) (4,351,440) (21,464,791)
Issuance of common shares for consolidation
of Morlyn 17,000 17 -- (17) -- --
Issuance of common shares for initial
public offering of Company's common stock 22,000,000 22,000 -- 187,380,587 -- 187,402,587
Issuance of common shares for exercise of
underwriters' over allotment option 982,729 983 -- 8,452,943 -- 8,453,926
Contingent shares for Criticom purchase 34,091 34 315,342 315,308 -- 630,684
Imputed interest expense associated with
conversion feature of debt -- -- -- 387,821 -- 387,821
Shareholder options -- -- -- 8,550,000 (8,550,000) --
---------- ------- ---------- ------------- ------------ -------------
Balance, December 31, 2003 24,607,731 $24,608 $ 315,342 $ 205,086,659 $(52,023,879) $ 153,402,730
========== ======= ========== ============= ============ =============
The accompanying notes are an integral part of the financial statements.
F-5
INTEGRATED ALARM SERVICE GROUP, INC. AND SUBSIDIARIES
STATEMENTS OF CASH FLOWS
Combined For the Years Ended December 31, 2001 and 2002 and
Consolidated For the Year Ended December 31, 2003
Years Ended December 31,
-------------------------------------------------
2001 2002 2003
------------ ----------- -------------
Cash flows from operating activities:
Net income (loss) $ (2,333,526) $(5,647,212) $ (22,004,560)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization 3,581,071 5,580,985 12,322,558
Amortization of debt issuance costs 794,357 1,619,086 3,168,315
Interest expense - non-cash, notes -- 97,725 387,821
Litigation settlement -- (957,275) --
Provision for (reversal of) bad debts 243,396 (120,736) 1,564,729
Deferred income taxes (716,743) (346,775) 3,339,330
Non-cash service fees -- -- 1,825,000
Loss (gain) on disposal of property and equipment 31,237 (5,605) --
Changes in assets and liabilities, net of effects of acquisitions and
non-cash transactions:
Accounts receivable 4,243 892,034 (1,405,553)
Inventories -- -- (11,613)
Prepaid expenses 35,428 28,782 (1,024,357)
Other assets 13,859 (342,291) 454,070
Due from/to related parties (876,003) 1,203,019 (17,790)
Accounts payable and accrued expenses 192,346 1,386,547 (3,250,941)
Deferred revenue 29,627 (363,800) 707,501
Other liabilities 12,959 (332,640) (293,151)
------------ ----------- -------------
Net cash provided by (used in) operating activities 1,012,251 2,691,844 (4,238,641)
------------ ----------- -------------
Cash flows from investing activities:
Purchase of property and equipment (200,420) (944,970) (603,769)
Proceeds from sale of property and equipment 3,500 7,500 --
Purchase of customer contracts -- -- (10,794,192)
Financing of customer loans -- -- (3,456,867)
Short-term investments -- (3,000,000) 3,000,000
Repayment of customer loans -- -- 730,049
Decrease (increase) in restricted cash and cash equivalents (316,391) (113,538) 2,909,979
Business acquisitions, net of cash acquired (1,192,117) (4,812,010) (49,769,539)
------------ ----------- -------------
Net cash used in investing activities (1,705,428) (8,863,018) (57,984,339)
------------ ----------- -------------
Cash flows from financing activities:
Proceeds of initial public offering -- -- 195,856,510
Proceeds of long-term debt, related party 2,325,000 8,800,000 2,000,000
Proceeds of long-term debt 2,600,000 5,500,000 6,839,404
Payments of obligations under capital leases (112,806) (79,273) (146,540)
Repayment of long-term debt (3,093,782) (6,144,329) (100,173,855)
Repayment of long-term debt, related party (308,539) (2,017,177) (6,909,765)
Debt issuance costs (643,998) (670,000) (249,039)
------------ ----------- -------------
Net cash provided by financing activities 765,875 5,389,221 97,216,715
------------ ----------- -------------
Net increase (decrease) in cash and cash equivalents for the year 72,698 (781,953) 34,993,735
Cash and cash equivalents at beginning of year 1,151,337 1,224,035 442,082
------------ ----------- -------------
Cash and cash equivalents at end of year $ 1,224,035 $ 442,082 $ 35,435,817
============ =========== =============
Supplemental disclosure of cash flow information:
Interest paid $ 3,514,879 $ 4,049,719 $ 13,432,321
============ =========== =============
Income taxes paid $ -- $ -- $ --
============ =========== =============
Supplemental disclosure of non-cash items:
Common stock issued to purchase IASI $ 11,559,944
=============
Debt assumed from a related party $ 1,825,000
=============
The accompanying notes are an integral part of the financial statements.
F-6
1. Description of Business
Integrated Alarm Services Group, Inc. and Subsidiaries ("IASG" or the "Company")
is the successor to KC Acquisition Corporation. In January 2003 KC Acquisition
was re- incorporated by merging into Integrated Alarm Services Group, Inc.
(IASG) (Note 11). IASG provides alarm-monitoring services to independent alarm
dealers and other telemetry customers on a contract basis. IASG operates three
Underwriters Laboratories listed call centers that provide alarm receiving,
processing, notification and related services for the monitoring of various
types of alarm systems. In addition to its call centers, IASG maintains five
regional dealer care locations designed to provide customized services to
independent alarm dealers. Alarm monitoring services for subscribers of
independent alarm dealers are outsourced to IASG. Subscribers contract with
alarm dealers for services like alarm installation, maintenance and monitoring.
In connection with the Company acquisitions in the fourth quarter of 2003, more
fully described in Note 11, the Company has begun to perform installations and
provide maintenance service to its customers.
Morlyn Financial Group (Morlyn), a limited liability company, was formed in May
2000 to assist independent alarm dealers in selling their retail portfolios to
Integrated Alarm Services, Inc. (IASI), a related party of Morlyn. Morlyn
provides due diligence and other related services for IASI and also earns fees
from independent alarm dealers by providing billing services. In January 2003
Morlyn (formerly under common ownership) was acquired by IASG and became a
wholly owned subsidiary.
Criticom-IDC (Criticom) is a wholly owned subsidiary of IASG. Criticom is an S
corporation which provides monitoring services to customers on a contract basis.
Criticom provides alarm-monitoring services to independent alarm dealers and
other telemetry customers as well as Global Positioning Systems (GPS) technology
that customers use to track various types of moveable assets. Criticom operates
an Underwriters Laboratories listed call center that provides alarm receiving,
processing, notification and related services for the monitoring of various
types of alarm systems.
Integrated Alarm Services, Inc. (IASI) which was acquired on January 31, 2003
provides financing and capital to independent security alarm dealers throughout
the United States. IASI provides working capital to the independent dealers
necessary for the growth of the dealers' business and financing for
acquisitions. IASI has built a vertically integrated infrastructure, capable of
handling all aspects of a financing for independent alarm dealers including due
diligence, billing and collections and the securitizing of alarm contracts
assumed upon the foreclosure of loans to dealers for which it provides
monitoring services (through IASG and other non-affiliated entities) to its
customers.
Lane Security, Inc. (Lane) was acquired in December 2003. Its primary operating
entity, Protection Service Industries, L.P., installs, services and monitors
commercial and residential alarm systems in Arizona, California and New Mexico.
2. Summary of Significant Accounting Policies
Principles of consolidated financial statements
The consolidated financial statements include the accounts of IASG and its
subsidiaries from the date of their acquisition. All inter-company balances and
transactions have been eliminated. Prior to the acquisition of Morlyn in January
2003, the financial statements were presented as combined financial statements.
Use of estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates.
F-7
Segment information
The Company believes it operates two reportable segments: (1) Alarm-Monitoring
wholesale services and (2) Alarm- Monitoring retail services. (see Note 15).
Comprehensive income
No statement of comprehensive income has been included in the accompanying
financial statements since the Company does not have any other comprehensive
income to report.
Revenue recognition
IASI provides monitoring services to customers under contracts ranging from one
to five years in duration. Such contracts are cancelable with notice sixty days
prior to the contract expiration date and contain no upfront fees or set up
service. Customers are notified, if required, prior to the maturity date and
contracts automatically renew for an annual term if no action is taken. Revenue
from customer contracts is recognized as services are provided over the related
monitoring contract period when a written contract is in place and collection is
probable. Services may be billed in advance on a monthly, quarterly or annual
basis and amounts billed but not earned are recorded as deferred revenues.
Revenues deferred are recognized on a straight line basis over the term of the
service agreement as the alarm monitoring services are provided.
Interest income from dealer notes receivable is recognized using the interest
method. Accrual of interest income on notes receivable is suspended when a
dealer portfolio is contractually delinquent for one hundred twenty days or
more. The accrual is resumed when the dealer portfolio becomes contractually
current, and past due interest income is recognized at that time. Generally,
IASI forecloses on delinquent accounts and takes ownership of the related
contracts which collateralize the notes. Refunds are granted only upon request
from the customer when a payment is made on a closed account or a payment was
processed where the funds were not payable to IASI.
The Company provides monitoring and billing services for a monthly fee for the
subscribers of independent alarm dealers. The majority of the contracts are
annual. Such contracts contain no upfront fees or setup service. Monitoring and
billing revenue is recognized as the monitoring and billing services are
provided. Deferred revenue represents amounts billed and or collected in advance
of services being provided. Revenues deferred are recognized over the term of
the service agreement as the alarm monitoring and billing services are provided.
Morlyn assists independent alarm dealers in selling their portfolios of
subscriber contracts to IASI. Morlyn receives placement fees for this assistance
in selling the subscriber portfolios. Since these placement fees are contingent
they are recognized generally when the transactions are consummated. Deal
related costs are expensed as incurred.
Installation revenues associated with installing monitoring systems are deferred
and recognized over the expected life of the customer contract, including
extensions.
Cash and cash equivalents
Cash and cash equivalents include cash, certificates of deposit, and money
market funds with original maturities of three months or less at the time of
purchase. The carrying amount of cash and cash equivalents approximates fair
value.
The Company maintains cash and cash equivalents in accounts with financial
institutions in excess of the amount insured by the Federal Deposit Insurance
Corporation. The Company monitors the financial stability of these institutions
regularly and management does not believe there is a significant credit risk
associated with deposits in excess of federally insured limits. At December 31,
2002 and 2003, cash and cash equivalent balances in excess of FDIC limits
approximated $1,107,000 and $14,663,000, respectively.
Short-term investments
Included in short-term investments at December 31, 2002 is $3,000,000 in
marketable securities received under a related party loan agreement. The
carrying amount of short-term investments approximates fair value. These
marketable securities were returned to the related party and the related note
payable cancelled upon the successful completion of the IPO.
Restricted cash and cash equivalents
Cash and cash equivalents restricted under the terms of the Company's debt
obligations are classified to correspond with the classification of the related
debt.
F-8
Notes receivable
IASI which was acquired on January 31, 2003, makes loans to dealers, which are
collateralized by the dealers' portfolio of customer monitoring contracts. Loans
to dealers are carried at the lower of the principal amount outstanding or the
net realizable value of the portfolio underlying the loan. Loans are generally
considered nonperforming if they are 120 days in arrears of contractual terms.
Management periodically evaluates the loan portfolio to assess the
collectibility of dealer notes and adequacy of the allowance for loan losses.
Management reviews certain criteria in assessing the adequacy of the allowance
for loan losses including IASI's 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 customer contracts using recent transaction prices and industry
benchmarks. When a dealer becomes delinquent, the Company generally forecloses
on and takes ownership of the portfolio of customer monitoring contracts.
Allowance for doubtful accounts--Notes Receivable
Changes in the allowance for doubtful accounts were as follows:
January 1, 2003 $ --
Provisions (522,549)
Write-offs 391,695
----------
December 31, 2003 $(130,854)
==========
Contractual maturities of notes receivable as of December 31, 2003 are as
follows:
2004 $ 735,149
2005 1,140,639
2006 1,286,379
2007 1,250,971
2008 862,131
2009 and thereafter 116,853
----------
$5,392,122
==========
At December 31, 2003 notes receivable from dealers was collateralized by
customer monitoring contracts with recurring monthly revenue of approximately
$127,000. Interest income on notes receivable was $1,425,249 for the year ended
December 31, 2003 and is included in interest income in the statement of
operations.
Deferred revenue-notes receivable
Deferred revenue on notes receivable represents amounts paid by the dealers for
services the Company will render in the future. In connection with the loans to
dealers, the Company withholds a portion of the amount loaned to cover services
for the remaining term of the contract. The deferred fees are recognized as
revenues as the billing and collection services are provided to the dealers.
Amounts withheld are nonrefundable.
Accounts receivable
Accounts receivable consists primarily of amounts due from independent alarm
dealers located in the United States. Credit is extended based upon an
evaluation of the customer's financial condition and credit history. Receivables
that are deemed uncollectible have been provided for in the Company's allowance
for doubtful accounts.
Allowance for Doubtful Accounts--Accounts Receivable
F-9
Changes in the allowance for doubtful accounts were as follows:
January 1, 2001 $ (226,323)
Provisions (243,396)
Write-offs 154,983
-----------
December 31, 2001 (314,736)
Reversal of Provisions 120,736
-----------
Decmber 31, 2002 (194,000)
Provisions (1,042,180)
Write-offs 1,063,598
Recoveries (577,418)
-----------
December 31, 2003 $ (750,000)
===========
Inventories
Inventories are stated at the lower of cost or market. Inventories include
commercial and residential alarm system components, parts and supplies. Cost is
determined using the first-in, first-out method. Provision for potentially
obsolete or slow moving inventory is made based on analysis of inventory levels
and forecasts.
Customer contracts
Customer monitoring contracts are acquired from the dealers' pre-existing
portfolios of contracts or assumed upon the foreclosure on dealers' loans. These
acquired customer contracts are recorded at cost which management believe
approximates fair value. Customer 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 customer contracts using recent transaction prices and industry
benchmarks at the time of foreclosure.
Customer contracts are amortized over the term that such contracts are expected
to remain a customer of the Company. The Company on an ongoing basis conducts
comprehensive reviews of its attrition experience and adjusts its estimated
lives of customer contracts. As a result of the Company's comprehensive review
in 2003, no adjustment to estimated lives was required. Direct incremental costs
resulting from the installation of Company owned security systems are deferred
and amortized over the estimated lives of the customer contracts, including
extentions.
The Company's amortization methods below consider the average estimated life and
historical and projected attrition rates determined from actual experience and a
recent attrition study and consists of the following portfolios:
Acquired as a result of the IASI merger:
Existing at January 31, 2003 Accelerated method Period
- ----------------------------------- ----------------------------- --------
Existing portfolio accounts (bulk) 150% Declining balance 8 years
Dealer acquired new accounts (flow) 160% Declining balance 8 years
Contracts assumed from dealers 160% Declining balance 4 years
Acquired subsequent to the IASI merger:
Acquired after January 31, 2003
- -----------------------------------
Existing portfolio accounts (bulk) Straight-line plus attrition 18 years
Dealer acquired new accounts (flow) 200% Declining balance 12 years
Contracts assumed from dealers 200% Declining balance 8 years
Debt issuance costs
Debt issuance costs represents direct costs incurred in connection with
obtaining financing with related parties and banks. Debt issuance costs are
being amortized over the life of the related obligations using the effective
interest method.
F-10
Other identifiable intangibles
Other identifiable intangibles, which include trade names and partnering
(marketing) relationships, are being amortized over their estimated lives of 6
years.
Property and equipment
Property and equipment are reported at cost less accumulated depreciation. When
assets are sold, retired or otherwise disposed of, the related costs and
accumulated depreciation are removed from the respective accounts, and any
resulting gain or loss is recognized. Property and equipment are depreciated
using the straight-line method over the following estimated useful lives:
Furniture, leaseholds and equipment 3-10 years
Vehicles 3-5 years
Building and building improvements 10-39 years
Computer software 3-5 years
Leasehold improvements are being amortized over the shorter of the estimated
useful life of the asset or lease term. Equipment under capital lease is being
amortized over the lease term.
Repairs and maintenance are charged to expense as incurred. Renewals and
betterments are capitalized. When assets are sold, retired or otherwise disposed
of, the applicable costs and accumulated depreciation or amortization are
removed from the accounts and the resulting gain or loss, if any, is recognized.
Dealer relationships
Alarm monitoring services for subscribers of independent alarm dealers are
outsourced to the Company. The Company acquires such dealer relationships from
other monitoring companies. The Company amortizes the cost of dealer
relationships using declining balance accelerated methods. The Company primarily
utilizes the 150% declining balance method over 15 years.
Goodwill
Goodwill was being amortized on a straight-line basis over its estimated useful
life of 15 years through December 31, 2001. Effective January 1, 2002, the
Company adopted Statement of Financial Accounting Standards (SFAS) No. 142,
"Goodwill and Other Intangible Assets". SFAS No. 142 changed the accounting for
goodwill from an amortization method to an impairment-only approach. An initial
transition impairment test of goodwill was required as of January 1, 2002. The
Company completed this initial transition impairment test during the second
quarter of 2002, which did not result in any impairment charges. The Company's
impairment test is performed in the third quarter of each year, to date no
impairment charge has been required. Management will evaluate goodwill for
impairment on an annual basis in accordance with SFAS No. 142.
For purposes of applying SFAS No. 142, the Company has determined that it has
two reporting units consistent with its two operating segments. Fair value of
the reporting units and the related implied fair value of its goodwill was
established using valuation techniques based upon multiples of earnings and
discounted cash flows. The Company has identified no impairment charges. (See
Note 5)
Accrued expenses consist of the following:
December 31,
-------------------------
2002 2003
---------- ----------
Accrued payroll, vacation and bonuses $ 507,399 $2,914,987
Holdbacks on acquired customer contracts -- 3,341,881
Other accrued expenses 2,398,984 2,559,898
---------- ----------
Total $2,906,383 $8,816,766
========== ==========
Stock based compensation
The Company accounts for activity under the employee stock plans using the
intrinsic value method prescribed by Accounting Principals 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
F-11
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.
Year ended December 31,
------------------------------------------
2001 2002 2003
----------- ----------- ------------
Net loss, as reported $(2,333,526) $(5,647,212) $(22,004,560)
Less: Stock-based compensation expense
determined under fair value method for all
awards, net of related tax effects -- -- (129,600)
----------- ----------- ------------
Pro forma net loss $(2,333,526) $(5,647,212) $(22,134,160)
=========== =========== ============
Net loss per share, as reported-basic and diluted $ (4.21) $ (9.53) $ (1.95)
=========== =========== ============
Pro forma net loss per share-basic and diluted $ (4.21) $ (9.53) $ (1.97)
=========== =========== ============
Income taxes
For federal and state income tax purposes, IASG was treated as an S corporation
until the acquisition of IASI on January 31, 2003 and accordingly the Company's
income taxes or credits resulting from earnings or losses were payable by or
accrued to its shareholders. For federal and state income tax purposes, IASG
became a C corporation effective January 31, 2003 which results in recording
current and deferred income taxes from its earnings and losses and recognizing
the tax consequences of "temporary differences" between financial statement and
tax basis of existing assets and liabilities.
For federal and state income tax purposes, Morlyn was treated as a limited
liability company (LLC) until January 31, 2003 and accordingly the income taxes
or credits resulting from earnings or losses were payable by or accrued to its
members.
Advertising costs
The Company's policy is to expense advertising costs in the period in which the
expense is incurred. Advertising expense was $30,500, $8,278, and $47,255 for
the years ended December 31, 2001, 2002 and 2003, respectively.
Net loss per share
The Company computes net loss per common share in accordance with Statement of
Financial Accounting Standards No. 128, "Earnings per Share" (SFAS 128) and SEC
Staff Accounting Bulletin No. 98 (SAB 98). Under the provisions of SFAS 128 and
SAB 98, basic and diluted net loss per common share is computed by dividing the
net loss available to common stockholders for the period by the weighted average
number of shares of common stock outstanding during the period. Because the
Company is in a net loss position, there are no potentially dilutive securities
outstanding. Accordingly, the number of weighted average shares outstanding as
well as the amount of net loss per share are the same for basic and diluted per
share calculations for the periods reflected in the accompanying financial
statements.
Risks and uncertainties
The Company operates in one industry and two segments. A principal element of
the Company's business strategy is to acquire wholesale security system alarm
monitoring businesses and related security alarm monitoring contracts or
businesses. Acquisitions of monitoring call centers involve a number of special
risks, including the possibility of unanticipated problems not discovered prior
to the acquisition, account attrition (i.e. cancellation) and the diversion of
management's attention from other business activities in order to focus on the
assimilation of such acquisitions.
The Company is subject to operational and regulatory risk. Liabilities may arise
due to system failures and false alarms. New technologies may cause existing
technologies to become obsolete. Future government or other organizational
regulations and standards could have an adverse effect on the Company's
financial position, results of operations or cash flow.
F-12
Impairment of long-lived assets and long-lived assets to be disposed of
The Company accounted for long-lived assets in accordance with the provisions of
Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for the
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed of through
December 31, 2001. SFAS No. 121 required that long-lived assets and certain
identifiable intangibles be reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future undiscounted net cash
flows expected to be generated by the asset. 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. The Company
has identified no such impairment losses.
In August 2001, the Financial Accounting Standards Board (FASB) issued SFAS No.
144, Accounting for the Impairment or Disposal of Long-Lived Assets, which
supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to be Disposed of, and the accounting and reporting
provisions of APB No. 30. SFAS No. 144 addresses financial accounting and
reporting for the impairment or disposal of long-lived assets and is effective
for fiscal years beginning after December 15, 2001, and interim periods within
those fiscal years. SFAS No. 144 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 an
asset to future undiscounted net cash flows expected to be generated by the
asset. Cash flows of dealer relationshps 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. Customer contracts were recorded at fair
value on January 31, 2003, the purchase date. The Company has identifed no
impairment losses.
Recent accounting pronouncements
In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46).
"Consolidation of Variable Interest Entities." In December 2003, the FASB issued
a revision to FIN 46 to clarify some of the provisions of FIN 46, and to exempt
certain entities from its requirements. FIN 46 gives guidance that determines
whether consolidation of a variable interest entity is required. FIN 46 is
effective now for certain special purpose entity relationships and for all other
entity relationships after March 15, 2004. The Company does not expect the
adoption of FIN 46 to have a material effect on its financial statements.
In May 2003, the Financial Accounting Standards Board (FASB) issued Financial
Accounting Standard No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity, (FAS No. 150). The Standard
establishes how an issuer classifies and measures certain financial instruments
with characteristics of both liabilities and equity. This Standard becomes
effective for any financial instruments entered into or modified after May 31,
2003. The Company does not expect the adoption of FAS No. 150 to have a
material effect on its financial statements.
Reclassifications
Certain prior years amounts have been reclassified to conform to the current
year presentation.
3. Property and Equipment
Property and equipment consist of the following at:
December 31
-----------
2002 2003
----------- -----------
Furniture, leaseholds and equipment $ 3,849,614 $ 6,318,218
Vehicles 8,230 897,115
Building and building improvements 582,015 591,328
Computer software 509,157 1,075,027
Land 124,418 124,418
----------- -----------
5,073,434 9,006,106
Less accumulated depreciation and amortization (2,365,273) (3,243,520)
----------- -----------
$ 2,708,161 $ 5,762,586
=========== ===========
Depreciation expense was $475,163, $833,481 and $950,949 for the years ended
December 31, 2001, 2002 and 2003, respectively.
F-13
Unamortized computer software costs totaled $303,547, and $835,514 respectively,
at December 31, 2002 and 2003. Amortization expense related to computer software
was $14,206, $74,113, and $239,513 for the years ended December 31, 2001, 2002
and 2003, respectively. The cost basis of equipment under capital leases
approximated $479,593 and $1,345,093 at December 31, 2002 and 2003,
respectively. Accumulated amortization for equipment under capital lease
approximated $47,115, and $278,872 at December 31, 2002 and 2003, respectively.
4. Debt Issuance Costs
Debt issuance costs consist of the following at:
December 31
-----------
2002 2003
----------- -----------
Debt issuance costs $ 635,825 $ 3,640,336
Debt issuance costs - related party 745,000 --
Accumulated amortization (333,604) (1,872,055)
----------- -----------
$ 1,047,221 $ 1,768,281
=========== ===========
Amortization expense of debt issuance costs for the years ended December 31,
2001, 2002 and 2003 was $794,357, $1,619,086, and $3,168,315 respectively.
Included in amortization expense for the year ended December 31, 2003 is
approximately $ 1,437,000 of debt issuance costs charged to earnings due to the
prepayment of certain debt from IPO proceeds.
5. Goodwill and Intangibles
During the year ended December 31, 2003, goodwill increased by $78,297,242 (see
Note 11) as a result of the following:
Balance at December 31, 2001 and 2002 $ 7,218,743
Acquisition of IASI 51,891,675
Acquisition of Lane 17,630,924
Criticom contingent consideration 630,684
Other acquisitions 8,143,959
-----------
Balance at December 31, 2003 $85,515,985
===========
The amount of goodwill that is expected to be deductible for income tax purposes
is $ 3,127,000.
If SFAS No. 142 had been adopted on January 1, 2001, fiscal 2001 amortization of
goodwill of $601,343 would have been reversed resulting in an adjusted net
(loss) of $(1,732,183). The adjusted basic and diluted (loss) per share would be
$(3.13).
Customer Contracts and Dealer Relationships
Customer contracts at December 31, 2003 consist of the following:
Contracts
Existing Dealer assumed
Portfolio Acquired from dealers Total
------------ ------------ ------------ ------------
Customer contracts (all acquired in 2003) $ 49,341,567 $ 23,062,462 $ 8,058,738 $ 80,462,767
Accumulated amortization (2003 amortization) (1,525,020) (3,516,755) (1,849,861) (6,891,636)
------------ ------------ ------------ ------------
$ 47,816,547 $ 19,545,707 $ 6,208,877 $ 73,571,131
============ ============ ============ ============
Certain customer contracts acquired as part of the IASI acquisition, with a cost
basis of approximately $12,422,000, were subject to optional repurchase by the
seller at a discounted price. Such repurchase was contingent on the seller
complying with certain conditions outlined in the contract purchase agreement
over a six-year period. Management believes the seller has defaulted on the
terms of the agreement and the repurchase option is deemed null and void.
Customer contract amortization expense for the year ended December 31, 2003 was
$6,891,636.
F-14
Dealer relationships consist of the following:
December 31, 2002 Amortization December 31, 2003
----------------- ------------ -----------------
Dealer relationship $ 39,958,089 $ -- $ 39,958,089
Accumulated amortization (12,397,177) (4,447,295) (16,844,472)
------------ ------------ ------------
$ 27,560,912 $ (4,447,295) $ 23,113,617
============ ============ ============
Other identifiable intangibles consist of the following at December 31, 2003:
Trade name $ 1,217,000
Partnering relationships 874,000
Non-compete agreements 129,143
Accumulated amortization (32,679)
------------
$ 2,187,464
============
Other identifiable intangible assets amortization expense for the year ended
December 31, 2003 was $32,679.
Estimated amortization expense of customer contracts, and dealer relationships
and other identifiable intangible assets for the years ending December 31, 2004
through 2008 is as follows:
Customer Dealer Other Identifiable
Year Contracts Relationships Intangible Assets Total
- -------------------------------------------------------------------------------
2004 10,166,251 3,777,286 422,302 14,365,839
2005 8,568,192 2,955,556 403,841 11,927,589
2006 7,486,189 2,581,858 348,500 10,416,547
2007 6,333,564 2,303,889 348,500 8,985,953
2008 5,709,043 2,151,540 348,500 8,209,083
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. The impact of attrition in 2003 was not representative
of what it will be in future periods due to the impact of significant
acquisitions late in the fiscal year.
F-15
6. Long-term debt consists of the following at:
Related Party Promissory Notes:
December 31,
------------------------------------------------------
2002 2003
-------------------------- -----------------------
A series of promissory notes payable to IASI in original amounts $ 673,113 $ --
totaling $1,742,344, maturing from February 2001 to August 2005
Aggregate monthly installments of principal and interest
approximates $56,000. Fixed interest rates range from 23% to 31%;
collateralized by financed accounts receivable. These notes are cross
collateralized with each other. Debt eliminated upon merger with
IASI on January 31, 2003
A series of promissory notes payable to IASI in original amounts 1,152,722 --
totaling $2,325,000, maturing from August 2005 to April 2006
Aggregate monthly installments of principal and interest
approximates $47,500. Fixed interest rates ranging from 12.50% to
17.30%; collateralized by financed accounts receivable. The Company
is required to maintain cash with the lender of $50,000, which is
restricted to be used to satisfy debt service requirements in the
event the Company does not have the cash flow to service the debt
Such amount is included in restricted cash and cash equivalents
Debt eliminated upon merger with IASI on January 31, 2003
Promissory note payable to related party owned by stockholders of 5,377,357 --
the Company in original amount of $5,800,000, maturing July 1,
2007. Aggregate monthly installments of principal and interest of
approximately $129,200. Fixed interest rate of 14.31%; collateralized
by financed accounts receivable. The Company is required to maintain
cash with the lender of $100,000, which is restricted to be used to
satisfy debt service requirements in the event the Company does not
have the cash flow to service the debt. At December 31, 2002 such
amount was not on deposit with the lender. Note retired with
proceeds of IPO
Promissory note payable to related party in the original amount of 585,000 --
$685,000 is at a fixed interest rate of 10%; $100,000 was paid on
October 5, 2002, $585,000 was paid with proceeds of IPO
Promissory notes payable to IASI maturing from August 2003 to 1,647,069 --
February 2006. Aggregate monthly installments of principal and
interest of approximately $63,587. Fixed interest rates range from
16.04% to 20.16%; collateralized by financed accounts receivable. The
Company is required to maintain cash with the lender of $100,000,
which is restricted to be used to satisfy debt service requirements
in the event the Company does not have the cash flow to service the
debt. At December 31, 2002, such amount was not on deposit with the
lender. Debt eliminated upon merger with IASI on January 31, 2003
Promissory note payable to related party maturing March 15, 2004, the 3,000,000 --
maturity date was extended to April 30, 2004 in March 2003. Proceeds
of $3,000,000 received in October 2002 (Note 2). Interest is payable
monthly at Bear Stearn's Broker call rate plus 2.5%. Balloon payment
of principal is due at maturity. Note retired with proceeds of IPO.
F-16
December 31,
------------------------------------------------------
2002 2003
-------------------------- -----------------------
Other Notes:
Promissory notes payable to one bank in original amounts totaling 25,877,281 --
$32,841,000 originally maturing from March 2003 to May 2005
Aggregate monthly installments of principal and interest
approximates $505,000. Fixed interest rates ranging from 8% to
12.5%. Balloon payments due of approximately $11,125,000 in March
2003 (extended to June 2004), $1,750,000 in June 2004, and
$6,412,000 in May 2005; collateralized by financed accounts
receivable. The Company is required to maintain cash with the lender
of $800,000, which is restricted to be used to satisfy debt service
requirements in the event that the Company does not have the cash
flow to service the debt. At December 31, 2002, $504,233 was on
deposit with the lender. Such amount was included in restricted cash
and cash equivalents. The lender had required that certain amounts
needed to fund the following month's debt service payment be
accumulated in a reserve account. At December 31, 2002, $527,556 was
accumulated in the reserve account and is classified as restricted
cash and cash equivalents in these financial statements. Note
retired with proceeds of IPO
$5,500,000 convertible promissory notes payable to investors 5,500,000 5,500,000
maturing September 1, 2005. Quarterly installments of interest of
approximately $123,750. Fixed interest rate of 9.0%; collateralized
by financed accounts receivable
Notes payable to a bank in original amounts totaling $1,506,888 1,248,821 --
Aggregate monthly installments of principal and interest
approximates $53,000 beginning October 1999 through November 2004
with final payments of $405,000 and $255,000 in November 2004 and
December 2004, respectively. Fixed interest rate of 8.75%. At
December 31, 2002, $45,140 was accumulated in a reserve account and
is classified as restricted cash and cash equivalents in these
financial statements. Notes retired with proceeds of IPO
The Company has a note with one lending institution. As of December -- 9,032,982
31, 2003, the monthly installment totals approximately $365,000,
including interest. The debt has a variable interest rate of prime
plus 2.5% and $982,982, maturing in April 2004, has been fixed with
an interest rate swap at 8.3%. The note is collateralized by
specific monitoring contracts with recurring monthly revenue of
approximately $572,000. The note matures in March 2006
The Company has junior debt with monthly installments of -- 51,209,630
approximately $537,000 and interest rates from 9.0% to 12.0%
Balloon payments of $2,301,000, $12,758,000, $26,650,629 and
$4,565,000 are due at April 30, 2004, December 15, 2004, February 1,
2007 and January 1, 2008, respectively, and some of the notes are
collateralized by specific monitoring contracts and notes receivable
----------- -----------
45,061,363 65,742,612
Less: current portion, related party 1,738,724 --
Less: current portion of long-term debt 3,059,879 18,765,000
----------- -----------
$40,262,760 $46,977,612
=========== ===========
F-17
The Company is required to maintain cash in a reserve fund, which is included in
cash-restricted to fund debt service payments on the Senior Debt. Payne Security
Group, LLC's Senior Debt agreement contains affirmative covenants including the
timely payment of taxes and restrictive covenants including fixed charges to
cash flow ratio and attrition ratio. Payne Security Group, LLC was in default of
certain covenants, including the timely payment of taxes, fixed charges to cash
flow and attrition ratios and on March 7, 2003 and May 9, 2003 obtained
permanent waivers from the Senior Debt lender for past violations. With respect
to an attrition covenant, the Company in 2003 and January 2004 has provided
LaSalle with a security interest in approximately $171,000 of additional alarm
contract recurring monthly revenue. After giving effect to the waivers described
above, we are not currently in default of our covenants.
In September 2002, one of the Company's subsidiaries borrowed $5,500,000 from
investors in a private offering. The Company used the proceeds to extinguish a
note payable of $2,600,000 to a bank, to extinguish $900,000 in IASI promissory
notes and to extinguish $740,000 of the SAI Note. The promissory notes are
convertible into IASG's common stock at seventy-five percent of the initial
public offering price. As a result of the initial public offering the benefit of
the conversion to the note holders was $1,833,333, which is being charged to
earnings as interest expense, over the remaining life of the debt (twenty-six
months). The expense for the year ended December 31, 2003 was approximately
$388,000. Upon conversion, any remaining unamortized benefit will be charged to
earnings.
The Company paid related party debt issuance costs of $454,000 and $670,000 for
the years ended December 31, 2001 and 2002, respectively.
Maturities of long-term debt exclusive of capital leases are as follows based on
revised agreements at:
December 31, 2003
-----------------
2004 $ 18,765,000
2005 3,640,000
2006 9,326,983
2007 29,445,629
2008 4,565,000
------------------
$ 65,742,612
==================
7. Stockholders' Equity
On July 29, 2003, the Company successfully completed its initial public
offering. A total of 22,000,000 shares of common stock were issued at a per
share price of $9.25. The net proceeds to the Company after underwriting
commissions (7%) and other direct initial offering costs were approximately
$187,403,000. The common stock trades on the NASDAQ National Market under the
symbol "IASG".
Concurrent with the offering, Messrs. McGinn, Few, Sr., Smith, Quady and the
former shareholders of Criticom, were issued, in the aggregate, non-compensatory
options to purchase 1,900,000 shares of the Company's common stock (the
"Shareholder Options"). The options are non-forfeitable and are exercisable as
follows: (i) 30% will be immediately exercisable on the first anniversary of the
offering; (ii) 30% will be immediately exercisable on the second anniversary of
the offering; (iii) 40% will become immediately exercisable on the third
anniversary of the offering. The exercise price of the options are equal to the
per share offering price ($9.25). The shareholder options arrangement which
contains a cashless exercise provision also permits the Company, at its
discretion, to net-share settle the arrangement by the delivery of unregistered
shares. In accordance with EITF Issue No. 00-19, Accounting for Derivative
Financial Instruments Indexed to, and potentially settled in, a Company's Own
Stock, these shareholder options have been classified as a permanent equity
instrument. Accordingly, the fair value ($8,550,000) of these shareholder
options, as determined under the Black-Scholes option valuation model, has been
charged to accumulated deficit with a corresponding credit to paid-in capital.
On August 27, 2003, the underwriters of the Company's initial public offering
exercised their over allotment option and an additional 982,729 common shares
were issued at a per share price of $9.25. The proceeds to the Company after
underwriting commissions (7%) were approximately $8,454,000.
F-18
Stock-Based Compensation
The Company's 2003 Stock Option Pan ("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 150,000, 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.
Company stock options outstanding as of December 31, 2003 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 9.58 years. As of December 31, 2003 all of
the options outstanding were fully vested and exerciseable.
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 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.
SFAS No. 123 Assumptions and Fair Value
The fair value of each option grant was estimated at the date of grant using the
Black-Scholes option valuation model with the following weighted average
assumption:
Risk-free interest rate.................4.02%
Volatility..............................29%
Option Term (in years)..................10
Dividend yield..........................0%
The weighted average estimated fair value of stock options granted during the
year ended December 31, 2003 was $4.50 per share.
8. Income Taxes
The components of the provision (benefit) for income taxes are as follows:
For the years ended December 31,
----------------------------------
2001 2002 2003
--------- --------- ----------
Current
Federal $ -- $(267,055) $ --
State 12,959 (67,613) 187,241
--------- --------- ----------
Total current 12,959 (334,668) 187,241
Deferred tax (benefit) expense (716,743) (346,775) 3,339,331
--------- --------- ----------
Provision (benefit) for income taxes $(703,784) $(681,443) $3,526,572
========= ========= ==========
F-19
The significant components of deferred income tax (benefit) expense are as
follows:
For the Years Ended December 31,
-----------------------------------------------------
2001 2002 2003
--------- --------- ----------
Deferred tax benefit recognized as a result of
change from "S" to "C" corporation status $ -- $ -- $3,504,945
Deferred tax (benefit) expense (368,764) (388,766) (1,039,464)
Net operating loss carryforward (347,979) 41,991 (5,099,060)
Valuation allowance -- -- 5,972,910
--------- --------- ----------
Deferred income tax (benefit) expense $(716,743) $(346,775) $3,339,331
========= ========= ==========
The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets and deferred tax liabilities at December 31, 2002 and
2003 are as follows:
2002 2003
----------- ------------
Current deferred tax assets (liabilities):
Allowance for bad debts $ -- $ 607,570
----------- ------------
Current deferred tax assets -- 607,570
Valuation allowance -- (607,570)
----------- ------------
Net current deferred tax assets (liabilities) -- --
----------- ------------
Long term deferred tax assets (liabilities):
Charitable contributions carryforward 460 466
Customer contracts -- 29,534,036
Non-compete agreements -- (3,114)
Dealer relationships (3,413,685) (5,699,584)
Depreciation (28,860) (99,745)
Net operating loss carryforward 983,347 11,816,366
----------- ------------
Net long term deferred tax assets (liabilities) (2,458,738) 35,548,425
Valuation allowance -- (36,307,850)
----------- ------------
Net deferred tax assets (liabilities) $(2,458,738) $ (759,425)
=========== ============
The deferred tax liability of $759,425 represents the state deferred tax
liability of IASG which cannot be offset by the state deferred tax asset of its
subsidiaries due to the companies being subject to state taxes in different
state tax jurisdictions.
The provision for income taxes differs from the amount computed by applying the
federal statutory income tax rate of 34% as follows:
December 31,
-------------------------------
2001 2002 2003
------- ------- -------
Pretax loss at statutory tax rate (34.00)% (34.00)% (34.00)%
Effect of state taxes, net of federal benefit - % - % 1.01 %
Effect of net deferred state taxes, net of federal benefit (3.35)% (1.94)% (0.90)%
Tax expense due to conversion from "S" corporation to "C" corporation - % - % 18.97 %
Valuation allowance - % - % 32.32 %
S corporation loss 20.56 % 30.02 % 0.95 %
LLC income (6.58)% (0.54)% - %
Reversal of a tax liabiltiy for a tax year no longer subject to an examination - % (4.22)% - %
Effect of permanent differences - % - % 2.89 %
Other, net 0.20 % (0.09)% (2.15)%
------- ------- -------
Provision (benefit) for income tax (23.17)% (10.77)% 19.09 %
======= ======= =======
F-20
C corporation income (loss) before provision for income taxes was ($1,788,618),
($840,936) and ($18,302,306) for the years ended December 31, 2001, 2002 and
2003, respectively.
As a result of the merger of KC Acquisition with IASG during January 2003, KC
Acquisition, KCF, Morlyn and Criticom are no longer considered flow through
entities to their shareholders and members and, therefore, must record current
and deferred income taxes from their earnings and losses, and recognize the tax
consequences of "temporary differences" between financial statement and tax
basis of existing assets and liabilities. At the time of the change in the tax
status from an "S" corporation to a "C" corporation, the Company incurred an
additional deferred tax liability of approximately $3.5 million. This is a
component of income tax expense in 2003.
At December 31, 2003, the Company has approximately $28,989,000 of net operating
loss carryforwards, which begin to expire in 2020. As the result of ownership
changes caused by the IPO and related to the acquisition of Lane, approximately
$23,367,000 of these net operating losses are subject to IRC Section 382
limitations, which significantly limits the Company's ability to utilize these
net operating losses on an annual basis.
Additionally, as a result of the acquisition of Lane, the Company acquired
customer contracts that have a tax basis that is approximately $22,444,000 in
excess of book basis. A portion of this excess tax basis is considered to be
"built-in-loss" pursuant to IRC Section 382 and is also subject to an IRC
Section 382 limitation, which significantly limits the Company's ability to
utilize the tax amortization deduction from these contracts on an annual basis.
During 2003, a valuation allowance of $36,915,420 was established. The Company
did not have a valuation allowance established prior to 2003. A valuation
allowance of $30,942,510 was established in 2003 as a result of acquisitions. As
a result of operations, an additional $5,972,910 of valuation allowance was
recorded against the Company's deferred tax assets.
In assessing whether deferred tax assets are realizable, management considers
whether or not it is more likely than not that some portion or all deferred tax
assets will be realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible. Management considers the
projected future taxable income and tax planning strategies in making this
assessment.
If the portion of the valuation allowance associated with the acquisitions is
reversed in the future, the benefit of any reversal would (a) first be applied
to reduce to zero any goodwill related to the acquisitions (b) second to reduce
to zero other non-current intangible assets related to the acquisitions and (c)
third to reduce income tax expenses.
9. Loss Per Common Share
Loss per common share is as follows:
December 31,
2001 2002 2003
----------- ----------- ------------
Numerator
Net income (loss) $(2,333,526) $(5,647,212) $(22,004,560)
Denominator
Weighted average shares outstanding 553,808 592,785 11,263,455
Basic and diluted income (loss) per share $ (4.21) $ (9.53) $ (1.95)
Weighted average shares outstanding excludes Company stock to be issued from
potential stock option exercises and debt conversions from Shareholder options
(1,900,000), Director options (48,000) and debt conversion (792,793) because
such common stock equivalents are anti-dilutive.
F-21
10. Commitments and Contingencies
Leases
The Company is obligated under operating leases for facility, property and
equipment expiring at various dates through February 2010. Rent expense amounted
to $595,333, $635,602 and $ 465,385 for the years ended December 31, 2001, 2002
and 2003, respectively.
In addition, the Company leases vehicles, telephone systems and computer
equipment under capital leases.
Minimum future annual rental commitments under non-cancelable capital and
operating leases at December 31, 2003 are as follows:
Year Capital Operating
- --------------------------------------- ---------- ------------
2004 $ 520,086 $ 1,291,804
2005 333,580 768,593
2006 113,976 677,068
2007 30,408 574,134
2008 15,379 373,526
Thereafter -- 184,700
--------- ------------
$ 3,869,825
============
Total minimum lease payments 1,013,429
Amounts representing interest (128,063)
---------
Present value of minimum lease payments 885,366
Current portion (431,555)
---------
Long-term portion $ 453,811
=========
In April 2003, the Company entered into a three-year contract with a committed
two-year term with AT&T, Inc. for communications services. As part of that
contract, the Company is required to use $780,000 per year for the first two
years of the contract.
In September 2003, the Company entered into a five year lease for office space
for its headquarters in Albany, NY. The lease is for approximately 21,000 square
feet. The lease period is November 15, 2003 through November 14, 2008. The lease
has a five year renewal option. Annual rents will be $190,000 for years one and
two and $225,000 for years three through five.
Royalty agreement
The Company had a trademark and sub-license agreement for the use of the Smith &
Wesson name in marketing alarm systems and monitoring services. The agreement
had a term of nine years and ten months that commenced on March 1, 1998 and was
to expire on December 31, 2008, with certain termination provisions. The
agreement required minimum royalties of $600,000 for 1999 and $700,000 per year
for each year thereafter payable in quarterly installments of $175,000 beginning
in the first quarter of 2000. The agreement was renegotiated in August 2000 to
eliminate minimum requirements. Royalty payments were based upon actual
royalties earned under the sub-lease agreement for actual new sales and existing
monitoring revenues without any minimums. The Company terminated this
relationship on August 31, 2002 without any future commitments. Royalty expense
was $71,833 and $25,435 for the years ended December 31, 2001 and 2002,
respectively.
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.
F-22
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. In August 2003, we filed a motion to dismiss
the claim against us, which was opposed by the plaintiff on August 27, 2003. The
Court's decision on the motion is still pending. 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 believes the resolution of this
matter will not have a material adverse effect on its financial condition,
results of operations or cash flows.
On December 9, 2003, a complaint was filed against the Company in the United
States District Court in the southern District of New York entitled Ian Meyers
v. Integrated Alarm Services Group, Inc., et al. The Plaintiff alleges, among
other things, that the Company and its professionals engaged in transactions
with the Company that were designed to defraud plaintiff out of funds he was
entitled to pursuant to Plaintiff's agreement with First Integrated Capital
Corporation ("FICC"), his employer, and a company in which he had an equity
interest. In January 2003, Payne Security Group, LLC and Guardian Group, LLC
were acquired by us and became our wholly owned subsidiaries. In connection with
the acquisition of Payne Security Group, LLC, we issued an aggregate of 50,250
shares to TJF Enterprises, LLC, and FICC. In connection with the acquisition of
Guardian Group, LLC, we issued an aggregate of 16,750 shares to TJF Enterprises,
LLC, and FICC. The controlling shareholders of FICC have material equity
interest in the Company with one of its shareholders serving as the Company's
CEO and another of its shareholders serving as one of the Company's Directors.
In particular plaintiff alleges that the Company and certain of its principals
removed valuable revenue-generating assets from FICC and transferred the FICC
contracts to the Company for less than fair value. Plaintiff is seeking damages
in the amount of $3,000,000. A mediation conference before the court has been
scheduled for April 22, 2004. The Company believes that the suit is without
merit and intends to vigorously defend itself. We believe the resolution of this
matter will not have a material adverse effect on our 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.
Executive compensation
In connection with the acquisition of AHS, the Company entered into a three year
employment agreement with the former owner of AHS. The agreement provides for
annual compensation of $420,000 and an annual bonus commencing in 2004 equal to
19% of the amount by which AHS's pre-tax income (as defined in the agreement)
for such year exceeds $1,250,000. The Company has the option to make a one-time
payment up to 125% of AHS' pre-tax income to the employee under a bonus buy-out
provision as defined in the agreement, at which time the Company would have no
further annual bonus obligation to the employee. The employee for calendar years
2006-2009 has the right to elect a bonus buy-out. Furthermore, the bonus buy-out
shall automatically trigger upon the expiration of the employment term, and
under other circumstances as defined in the agreement. The agreement also
provides that during the employment term, the employee on an annual basis, will
be granted options to acquire Company common stock if AHS achieves certain
earnings levels. Such option grants may result in future charges to earnings.
11. Acquisitions
All goodwill on acquisitions completed in 2003 was recorded in the alarm
monitoring retail services segment.
On December 15, 2003, the Company purchased all of the issued and outstanding
capital stock of Lane Security, Inc. ("Lane") for approximately $43 million in
cash. The funds used to acquire Lane were derived from the Company's working
capital. The Company acquired all of Lane's issued and outstanding capital stock
from Lane's parent corporation, Lane Industries, Inc. ("Parent"), a privately
held corporation. The acquisition of Lane was beneficial to the Company due to
its sizable portfolio of commercial and residential contracts and its
infrastructure in place to install additional security systems. Neither the
Company nor any of its officers, directors or affiliates have any material
relationship with the Parent.
Lane, through its primary operating affiliate, Protection Service Industries,
L.P. of Rancho Cucamonga, California, installs, services and monitors commercial
and residential alarm systems in Arizona, California and New Mexico. The
principal assets acquired were alarm monitoring contracts consisting of
Recurring Monthly revenue totaling $1,770,000 which represents the equivalent of
approximately 59,000 contracts. Also included in the acquisition were accounts
receivable, inventory, fixed assets and other operating assets. Liabilities
assumed included capitalized leases, accounts payable, accrued expenses and
other current liabilities. The purchase price is subject to a working capital
adjustment which is defined in the acquisition agreement. Currently the Company
and Parent (the seller) are negotiating the final purchase price adjustment. The
results of Lane are included in the Company results from the date of acquisition
(December 15, 2003).
F-23
The preliminary allocation of the purchase price of approximately $43,255,000 is
as follows:
December 15, 2003
Assets:
Current Assets (including cash of $315,000) $ 3,752,000
Property and equipment 3,399,000
Intangibles, principally customer contracts 28,547,000
Goodwill 17,631,000
Other --
------------
Total assets 53,329,000
------------
Liabilities and Stockholders' Deficit:
Current Liabilities 9,827,000
Other 247,000
------------
Total liabilities 10,074,000
------------
Net purchase price $ 43,255,000
============
Integrated Alarm Services, Inc. (IASI) which was acquired on January 31, 2003
provides financing and capital to independent security alarm dealers throughout
the United States. IASI provides working capital to the independent dealers
necessary for the growth of the dealers' business and financing for
acquisitions. IASI has built a vertically integrated infrastructure, capable of
handling all aspects of financing for independent alarm dealers including due
diligence, billing and collections and the securitizing of alarm contracts. IASI
owns a significant portfolio of residential and commercial alarm contracts and
contracts assumed upon the foreclosure of loans to dealers for which it provides
monitoring services (through IASG and other non-affiliated entities) to its
customers. The acquisition of IASI was strategically important to the Company
due to the complimentary services it provided to dealers and the ability to
expand into an additional market segment.
In connection with the acquisition of IASI and affiliates, the Company issued
864,192 shares of its common stock, of which 525,452 shares were issued to
minority interests for a total fair value of approximately $11,560,000 related
to these acquisitions. The predecessor cost basis in net assets acquired was
approximately $(21,465,000), for which 338,740 shares of common stock were
issued. The transaction was accounted for under the purchase method of
accounting.
The preliminary allocation of the purchase price of approximately $11,560,000 is
as follows:
January 31, 2003
-----------------
Assets:
Current Assets (including cash of $8,082,000) $ 10,735,000
Customer contracts 33,105,000
Goodwill 51,892,000
Other 21,396,000
-------------
Total assets $ 117,128,000
=============
Liabilities and Stockholders' Deficit:
Current liabilities $ 16,415,000
Long-term debt, net of current protion 109,705,000
Other 913,000
-------------
Total liabilities 127,033,000
Total stockholders' deficit (purchase price of $11,560,000, net
of predecessor cost basis of $(21,465,000)) (9,905,000)
-------------
Total liabilities and stockholders' deficit $ 117,128,000
=============
F-24
The allocation of the purchase price was finalized during the third quarter of
2003. As a result of finalizing the purchase price allocation, goodwill was
increased and customer contracts was decreased by approximately $8,876,000. In
addition, a reduction to amortization expense of approximately $1,308,000 was
recorded in the third quarter of 2003 as a result of the finalization of the
purchase price allocation.
The following unaudited proforma combined results of operations have been
prepared as if the IASI and Lane acquisitions had occurred on January 1, 2002.
Year Ended
December 31,
------------------------------
2002 2003
------------ ------------
Revenue:
Monitoring fees $ 25,328,891 $ 24,099,653
Customer accounts 42,268,994 39,577,106
Installation 5,558,734 4,725,541
Billing fees 558,347 112,127
Related party monitoring fees 206,891 151,983
Service and subcontractor fees 302,750 681,854
------------ ------------
Total Revenue $ 74,224,607 $ 69,348,264
============ ============
Income (loss) from operations $ (4,059,709) $(22,976,456)
============ ============
Loss before income taxes $(13,070,705) $(36,665,692)
============ ============
Net loss $(12,690,705) $(40,192,264)
============ ============
Net loss per share $ (21.41) $ (3.57)
============ ============
The 2003 results include an impairment charge for Lane of $15,164,613 which was
recorded by Lane prior to the acquisition date.
In September 2002, the Company, through a newly formed wholly owned subsidiary
(Criticom-IDC), acquired 100% of the common stock of Criticom International
Corporation (Criticom), a wholesale alarm monitoring business located in
Minneapolis, Minnesota and acquired a 5.03% interest in Royal Thoughts, LLC, a
Minnesota limited liability company engaged in the development of new monitoring
applications and monitoring technologies for emerging markets. The purchase
price was $4,319,087, net of cash acquired of $579,591, which consisted of
$1,000,000 in cash, 155,911 shares of the Company's common stock, as well as a
note totaling $685,000. Additional shares of the Company's common stock may be
issued to the sellers based on the future performance of Criticom. In 2003,
Criticom achieved its performance targets, as a result, the former shareholders
of Criticom will receive 68,182 shares of Company common stock with an aggregate
value of $630,684. At December 31, 2003, shares totaling 34,091 have been issued
and the balance to be issued in 2004 is included in common stock subscribed at
December 31, 2003. The transaction was accounted for under the purchase method
of accounting.
The preliminary allocation of the purchase price of $4,319,087 is as follows:
Dealer relationships $ 6,098,443
Accounts receivable 877,376
Prepaid expenses and other assets 240,996
Property and equipment 862,838
Due from related party 484,018
Accounts payable and accrued expenses (550,093)
Deferred revenue (1,389,489)
Capital leases (554,582)
Long-term debt (1,750,420)
------------
Net assets acquired $ 4,319,087
============
F-25
The following unaudited proforma combined results of operations have been
prepared as if the acquisition had occurred on January 1, 2001.
Year Ended
December 31,
-----------------------------
2001 2002
------------ ------------
Revenue:
Monitoring fees $ 24,204,494 $ 23,592,544
Billing fees 304,116 568,243
Related party monitoring fees 506,982 1,358,126
Related party placement fees 974,448 1,236,227
World Trade Center disaster recovery program -- 1,945,272
------------ ------------
Total revenue $ 25,990,040 $ 28,700,412
============ ============
Income (loss) from operations $ 782,079 $ (714,738)
------------ ------------
Loss before income taxes $ (3,291,207) $ (6,393,526)
------------ ------------
Net loss $ (2,588,130) $ (5,603,769)
============ ============
The proforma results of operations do not purport to represent what the
Company's results of operations would actually have been had the acquisition
been effected for the periods presented, or to predict the Company's results of
operations for any future period.
In January 2002, the Company acquired certain operating assets of RTC Alarm
Monitoring Services (RTC), a wholesale security system alarm monitoring business
located in Roseville, California. No liabilities were assumed by the Company.
The transaction was accounted for under the purchase method of accounting.
The allocation of the purchase price of $5,088,057 is as follows:
Dealer relationships $4,375,046
Equipment 500,000
Accounts receivable 213,011
----------
Net assets acquired $5,088,057
==========
The purchase price was financed with a promissory note from a related party
owned by stockholders of the Company in the amount of $5,800,000. The Company
paid a fee of $175,000 to a related party in connection with this financing. The
results of RTC are included in the accompanying financial statements from the
date of acquisition.
In October 2001, the Company acquired certain operating assets of Custom Design
Security (CDS), a wholesale security system alarm monitoring business located in
Sarasota, Florida. No liabilities were assumed by the Company. The transaction
was accounted for under the purchase method of accounting.
The allocation of the purchase price of $1,192,117 is as follows:
Dealer relationships $1,020,448
Equipment 106,669
Accounts receivable 65,000
----------
Net assets acquired $1,192,117
==========
F-26
The purchase price was financed with debt from IASI (Note 6). The results of
operations of CDS are included in the accompanying financial statements from the
date of acquisition.
In April 2001, the Company recorded $500,000 in other income from SAI. SAI is a
publicly traded corporation in the alarm monitoring industry that is unrelated
to the Company. SAI and KC had entered into a merger agreement. The $500,000
represents a break up fee related to the failed merger with SAI.
In April 2002, the Company settled an outstanding legal dispute related to the
failed merger of the Company and SAI. As part of the Monital acquisition, the
Company obtained financing of $1,500,000 from SAI (Note 6). The funds were used
to purchase Monital and pay related expenses. The note was originally due
December 31, 2001 with interest of $225,000. The litigation settlement modified
the note agreement and as a result $957,275 was recorded as other income for the
year ended December 31, 2002. The remaining debt obligation was paid in full in
December 2002.
On November 21, 2003, the Company acquired all of the outstanding stock of
American Home Security, Inc. (AHS) and certain assets of Emergency Response
Network, Inc. (ERN), (collectively referred to as the acquirees) for
approximately $15.0 million inclusive of direct acquisition costs. The acquirees
install and service residential alarm monitoring systems in the Nevada area. The
acquisition has been accounted for as a purchase and the results of the
acquirees are included in the Company's results of operations from the date of
acquisition (November 21, 2003). In addition the former owner of AHS will
receive additional consideration of up to 130,000 shares of Company common stock
and up to 140,000 Company stock options, if AHS achieves certain earnings levels
in 2004. Furthermore, the Company entered into a three year employment agreement
with the former owner of AHS. The agreement provides for annual compensation of
$420,000 and an annual bonus commencing in 2004 equal to 19% of the amount by
which AHS's pre-tax income (as defined in the agreement) for such year exceeds
$1,250,000. The Company has the option to make a one-time payment up to 125% of
AHS' pre-tax income to the employee under a bonus buy-out provision as defined
in the agreement, at which time the Company would have no further annual bonus
obligation to the employee. The employee for calendar years 2006-2009 has the
right to elect a bonus buy-out. Furthermore, the bonus buy-out shall
automatically trigger upon the expiration of the employment term, and under
other circumstances as defined in the agreement. The agreement also provides
that during the employment term, the employee on an annual basis, will be
granted options to acquire Company common stock if AHS achieves certain earnings
levels. The contingent consideration which includes Company common stock and
stock options issuable upon the achievement of certain earnings levels, may
result in future charges to earnings.
The purchase price has been allocated to the fair value of assets acquired and
liabilities assumed on November 21, 2003, the date of acquisition, as follows:
Current assets (includes cash of $33,000) $ 411,000
Customer contracts 5,905,000
Other identifiable intangibles 1,086,000
Goodwill 8,144,000
Other assets 8,000
------------
Total assets 15,554,000
------------
Current liabilities 537,000
------------
Net purchase price $ 15,017,000
============
On a proforma basis, as if the acquisition of AHS and ERN occurred on January 1,
2002, revenue, loss from operations, loss before income taxes, net loss and loss
per share would not differ materially from the amounts reflected in the proforma
results combining IASI and Lane shown above.
The weighted average lives of amortizable intangible assets are eighteen years
for customer contracts, six years for other identifiable intangible assets.
12. Related Party Transactions
As discussed throughout the footnotes to the combined and consolidated financial
statements, the Company has had significant transactions with related parties.
Whether the terms of these transactions would have been the same had they been
between non-related parties cannot be determined.
F-27
During February 2003, the Company made a cash payment of $1,700,000 to Capital
Center Credit Corporation (CCCC) which is controlled by the Chief Executive
Officer and a Director of the Company. Also, during 2003, the Company assumed
approximately $1,825,000 of debt from CCCC. As a result, for the year ended
December 31, 2003, IASG recognized general and administrative expense of
$3,525,000.
IASG provides alarm monitoring services to related parties which are owned by
stockholders of the Company. Revenue earned from these alarm monitoring services
was $506,982, $1,565,017 and $292,968 for the years ended December 31, 2001,
2002 and 2003, respectively of which $443,658, $1,358,126 and $140,985
respectively, was from IASI.
In 2001 and 2002, IASG and IASI were in negotiations over alarm monitoring
services provided by IASG to customers of IASI that IASI claims should have been
disconnected from service. IASG granted IASI concessions on alarm monitoring
services of $993,000 and $35,000 for the years ended December 31, 2001 and 2002,
respectively.
Morlyn provides due diligence and other related services to IASI. Revenue earned
from these services was $974,448, $1,236,227 and $90,437 for the years ended
December 31, 2001, 2002 and 2003, respectively.
The Company incurred $329,769, $1,284,922 and $914,229 respectively, in related
party interest for the years ended December 31, 2001, 2002 and 2003 of which
$328,650, $621,155 and $167,359, respectively, was to IASI.
Amounts due from related parties at:
December 31,
------------------------
2002 2003
-------- --------
Integrated Alarm Services, Inc.:
Monitoring fees $ 49,928 $ --
Unfunded debt service reserve 100,000 --
Capital Center Credit Corp.:
Advances 84,018 --
Interest 12,662 --
RTC Trust:
Unfunded debt service reserve 100,000 --
Unreimbursed disbursements:
SPT2 Trust -- 143,064
Capital Trust -- 71,356
Other Trusts -- 17,880
-------- --------
$346,608 $232,300
======== ========
F-28
Amounts due to related parties at:
December 31,
------------------------
2002 2003
-------- --------
McGinn, Smith:
Debt issuance cost $ 2,251 $ --
Integrated Alarm Services, Inc.:
Other 34,000 --
Stockholder:
Advances 249,049 --
Undistributed collections:
SPT Trust -- 137,599
Other Trusts -- 15,604
-------- --------
$285,300 $153,203
======== ========
13. Fair Value of Financial Instruments
Fair value estimates, assumptions, and methods used to estimate the fair value
of the Company's financial instruments are made in accordance with the
requirements of SFAS No. 107, "Disclosure about Fair Value of Financial
Instruments". The Company has used available information to derive its
estimates. However, because these estimates are made as of a specific point in
time, they are not necessarily indicative of amounts the Company could realize
currently. The use of different assumptions or estimating methods may have a
material effect on the estimated fair value amounts.
The carrying values of the Company's financial instruments (including cash and
cash equivalents, short-term investments, accounts receivable, accounts payable,
accrued expenses and deferred revenue) as of December 31, 2002 and 2003 are a
reasonable estimate of their fair value due to the short-term nature of the
instruments. The fair value of related party debt is not determinable since it
is not negotiated at arms length. The carrying value of the Company's bank debt
and notes receivable approximates fair value.
Swap Arrangement
At December 31, 2003 the Company had an interest rate SWAP arrangement (maturing
March 15, 2004) to fix the interest rate at 8.3% on approximately $983,000 of
floating rate senior debt. The interest rate SWAP does not qualify as a hedge,
accordingly changes in fair value are recorded as interest expense in the
statement of operations. The fair value of the SWAP at December 31, 2003 was
approximately $2,509.
14. Benefit Plans
The Company maintained various plans that provided health, dental and life
insurance benefits to all eligible employees. Medical and dental coverage was
provided under a partially self-insured plan by the Company that contained an
excess loss insurance agreement with New England Financial. The self-insurance
limit is $50,000 per occurrence per year. Insurance expense under the plan was
$390,410 and $390,200, for the years ended December 31, 2001 and 2002,
respectively.
Effective August 1, 2002, the Company terminated its relationship with New
England Financial and transferred those employees covered under that plan to a
plan with Aetna - U.S. Healthcare. The Aetna - U.S. Healthcare plan provided
fully insured medical coverage. In conjunction with the adoption of the Aetna -
U.S. Healthcare plan, the Company initiated coverage of dental benefits through
Delta Dental. Insurance expense under these plans was $242,445, $398,801 and
$212,348 for the years ended December 31, 2001, 2002 and 2003, respectively.
Effective May 1, 2003, the Company terminated it relationship with Aetna - U.S.
Healthcare and transferred employees covered under that plan to a plan with
United Health Care. Dental benefits continue to be provided under the Delta
Dental Plan. Insurance expense under these plans was $ 581,258 for the year
ended December 31, 2003.
F-29
Employees of Criticom were provided with medical, dental and life insurance
plans provided by The Principal Financial Group. These plans were fully insured
and the insurance expense under the plans was $65,277 for 2002 and $ 81,960 for
2003. Effective May 1, 2003, employees covered under these plans were
transferred to the Company's United Health Care and Delta Dental Plans.
IASI, PSI and other acquired companies, provide health care coverage to their
employees primarily through locally sponsored health maintenance organization
plans. The total cost of these various plans for 2003 was $104,094.
The Company's 401(k) retirement plan was started by an acquired company on June
29, 1993. All employees are eligible after meeting a minimum service
requirement. The Company has not made a matching contribution and, therefore,
has no recorded expense.
IASI formed the Integrated Alarm Systems, Inc. 401(k) Retirement Plan effective
August 1, 2002. The recorded expense for the year ended December 31, 2003 was
approximately $6,000.
PSI sponsors a defined contribution plan under which all employees are eligible
to participate. The Plan is intended to meet the qualifications of Internal
Revenue Code Section 401(k). Under the Plan's provisions, employees may
contribute the IRS specified maximum of their compensation on a pre-tax basis.
PSI makes matching contributions up to 6% of an employee's compensation.
Employees vest in PSI matching contributions at a rate of 33% per year beginning
after the first year of service. The expense recorded for the year ended
December 31, 2003 was approximately $4,000.
15. Segment and Related Information
In connection with the acquisition of IASI, the Company acquired IASI's
financing services business. As a result, IASG believes it has two reportable
segments: (1) Alarm-Monitoring wholesale services and (2) Alarm-Monitoring
retail services. The reportable segments are considered by management to be
strategic business units that offer different services and each of whose
respective long-term financial performance is affected by similar economic
conditions. The Company has determined its reportable segments based on its
method of internal reporting which is used by management for making operational
decisions and assessing performance.
The alarm-monitoring services segment provides monitoring services to a broad
range of independent alarm-monitoring dealers. The alarm-monitoring retail
services segment provides working capital to independent alarm-monitoring
dealers. This is accomplished by purchasing alarm monitoring contracts from the
dealer or by providing loans using the dealer's alarm monitoring contracts as
collateral. IASI provides monitoring services (through IASG and other
non-affiliated entities) to its customers.
The accounting policies of each of the segments are the same as those described
in the summary of significant accounting policies, as outlined in note 2.
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 year ended December 31, 2003. Prior to
January 31, 2003, the Company operated in only one segment, alarm-monitoring
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.
F-30
Summarized financial information for the twelve months ended December 31, 2003,
concerning the Company's reportable segments is shown in the following table:
Alarm-Monitoring Alarm-Monitoring Consolidated
Wholesale Services Retail Services Total
------------------ ------------------- -------------------
Net revenue from external customer $ 24,392,622 $ 16,474,976 $ 40,867,598
Cost of revenue (including depreciation and amortization) 19,761,707 8,954,290 28,715,997
Income (loss) from operations 71,111 (3,720,591) (3,649,480)
Interest income 150,652 1,463,017 1,613,669
Interest expense 3,032,512 10,537,334 13,569,846
Income (loss) before income taxes (3,304,303) (15,173,685) (18,477,988)
Total assets 36,034,265 205,002,065 241,036,330
Goodwill 7,849,427 77,666,558 85,515,985
Capital expenditures 196,089 407,680 603,769
Purchase of contracts and businesses -- 60,563,731 60,563,731
Depreciation and amortization 5,235,638 7,086,920 12,322,558
16. Selected Quarterly Financial data (Unaudited)
March 31 June 30 September 30 December 31 Year to date
-------- ------- ------------ ----------- ------------
(amounts in thousands, except for per share amounts)
2003
Total revenue $ 8,754 $ 9,763 $ 9,732 $ 12,619 $ 40,868
Gross margin 4,933 5,916 5,485 8,140 24,474
Net Loss* (10,862) (5,254) (4,366) (1,523) (22,005)
Basic and diluted loss per share (8.44) (3.30) (0.25) (0.06) (1.95)
Weighted average number of shares of
common stock outstanding 1,287 1,591 17,269 24,584 11,263
2002
Total revenue $ 5,379 $ 5,611 $ 5,789 $ 6,717 $ 23,496
Gross margin 1,833 1,428 2,344 2,466 8,071
Net loss (1,570) (925) (653) (2,499) (5,647)
Basic and diluted loss per share (2.83) (1.67) (1.18) (3.52) (9.53)
Weighted average number of shares of
common stock outstanding 554 554 554 710 593
* The first quarter of year 2003 includes tax expense of approximately $3.5
million due to the Company's change in tax status from an "S" corporation to a
"C" corporation.
F-31
Signatures
Pursuant to the requirements of Section 13 or 15(d) 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.
Integrated Alarm Services Group, Inc.
Dated: March 29, 2004 By: /s/ Timothy M. McGinn
-------------------------------------------------
Timothy M. McGinn
Chairman of the Board and Chief Executive Officer
Dated: March 29, 2004 By: /s/ Michael T. Moscinski
-------------------------------------------------
Michael T. Moscinski
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed by the following persons on behalf of the registrant in the
capacities and on the dates indicated.
Date Title Signature
Dated: March 29, 2004 Chairman of the Board and By: /s/ Timothy M. McGinn
Chief Executive Officer -------------------------------------------------
Timothy M. McGinn
Dated: March 29, 2004 Vice Chairman, President, By: /s/ Thomas J. Few
Chief Operating Officer, -------------------------------------------------
and Principal Executive Officer Thomas J. Few
Dated: March 29, 2004 Executive Vice President By: /s/ Curtis Quady
and Director -------------------------------------------------
Curtis Quady
Dated: March 29, 2004 Executive Vice President By: /s/ Brian E. Shea
-------------------------------------------------
Brian E. Shea
Dated: March 29, 2004 Chief Financial Officer By: /s/ Michael T. Moscinski
-------------------------------------------------
Michael T. Moscinski
Dated: March 29, 2004 Vice President, Finance and By: /s/ Robert Heintz
Administration and -------------------------------------------------
Principal Accounting Officer Robert Heintz
Dated: March 29, 2004 Director By: /s/ David L. Smith
-------------------------------------------------
David L. Smith
Dated: March 29, 2004 Director By: /s/ John Meriwether
-------------------------------------------------
John Meriwether
Dated: March 29, 2004 Director By: /s/ A. Clinton Allen
-------------------------------------------------
A. Clinton Allen
Date Title Signature
Dated: March 29, 2004 Director By: /s/ R. Carl Palmer, Jr.
-------------------------------------------------
R. Carl Palmer, Jr.
Dated: March 29, 2004 Director By: /s/ Timothy J. Tully
-------------------------------------------------
Timothy J. Tully
Dated: March 29, 2004 Director By: /s/ Ralph S. Michael
-------------------------------------------------
Ralph S. Michael
Dated: March 29, 2004 Director By: /s/ John Mabry
-------------------------------------------------
John Mabry