UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

 

For the transition period from               to               

 

 

 

Indicate by check mark whether each of the registrants (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 such registrants were required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ý  No o

 

Indicate by check mark whether each of the registrants is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes o No ý

 

As of November 7, 2003, Protection One, Inc. had outstanding 98,282,679 shares of Common Stock, par value $0.01 per share. As of such date, Protection One Alarm Monitoring, Inc. had outstanding 110 shares of Common Stock, par value $0.10 per share, all of which shares were owned by Protection One, Inc. Protection One Alarm Monitoring, Inc. meets the conditions set forth in General Instructions H(1)(a) and (b) for Form 10-Q and is therefore filing this form with the reduced disclosure format set forth therein.  Protection One’s sole asset is Protection One Alarm Monitoring and Protection One Alarm Monitoring’s wholly owned subsidiaries, as such there are no separate financial statements for Protection One Alarm Monitoring, Inc.

 

 

FORWARD-LOOKING STATEMENTS

 

Certain matters discussed in this Form 10-Q are forward-looking statements intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements generally can be identified as such because the context of the statement includes words such as we “believe,” “expect,” “anticipate” or other words of similar import. Similarly, statements herein that describe our objectives, plans or goals also are forward-looking statements. Such statements include those made on matters such as our earnings and financial condition, litigation, accounting matters, our business, our efforts to consolidate and reduce costs, our customer account acquisition strategy and attrition, our liquidity and sources of funding and our capital expenditures. All such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Please refer to “Risk Factors” in our Form 10-K for the year ended December 31, 2002 with respect to such risks and uncertainties as well as certain important factors, among others, that could cause actual results to differ materially from our expectations.  Westar Energy, Inc. (“Westar Energy”) which beneficially owns approximately 88% of the Company’s common stock has announced its intention to sell its ownership interest in the Company.  Any such sale may materially adversely affect the Company’s financial position and liquidity and the Company may need to restructure its indebtedness in an out-of-court proceeding and/or to seek the protection of the federal bankruptcy laws to reorganize. Statements made in this Form 10-Q regarding this potential sale by Westar Energy and its possible impacts or effects upon the Company also constitute forward-looking statements.

 

 

Unless the context otherwise indicates, all references in this Report on Form 10-Q to the “Company,” “Protection One,” “we,” “us” or “our” or similar words are to Protection One, Inc., its direct wholly owned subsidiary, Protection One Alarm Monitoring, Inc., which we refer to in this document as “Monitoring,” and Monitoring’s wholly owned subsidiaries.  Protection One’s sole asset is, and Protection One operates solely through, Monitoring and Monitoring’s wholly owned subsidiaries.  Both Protection One and Monitoring are Delaware corporations organized in September 1991.

 

2

 

PART I

 

FINANCIAL INFORMATION

 

ITEM 1.   FINANCIAL STATEMENTS

 

PROTECTION ONE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

 

(Dollars in thousands, except for per share amounts)

(Unaudited)

 

		September 30, 2003			December 31, 2002
ASSETS
Current assets:
Cash and cash equivalents		$	15,958		$	1,545
Restricted cash		1,807			2,616
Receivables, net		21,715			26,084
Inventories, net		7,007			7,213
Prepaid expenses		4,621			4,672
Related party tax receivable		31,672			20,745
Deferred tax assets, current		8,561			8,256
Other		3,916			4,094
Assets of discontinued operations		—			1,117
Total current assets		95,257			76,342
Property and equipment, net		31,507			37,754
Customer accounts, net		261,935			312,785
Goodwill		41,847			41,847
Related party tax receivable, net of current portion		27,286			—
Deferred tax assets, net of current portion		261,530			286,645
Deferred customer acquisition costs		90,212			75,403
Other		7,079			6,796
Total assets		$	816,653		$	837,572
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt		$	—		$	10,159
Accounts payable		5,303			5,795
Accrued liabilities		32,098			35,921
Due to related parties		2,023			995
Deferred revenues		32,798			35,115
Liabilities of discontinued operations		—			428
Total current liabilities		72,222			88,413
Long-term debt, net of current portion		547,485			547,798
Deferred customer acquisition revenue		40,932			31,662
Other liabilities		1,541			1,552
Total liabilities		662,180			669,425
Commitments and contingencies (Note 6)
Stockholders’ equity:
Preferred stock, $0.10 par value, 5,000,000 shares authorized		—			—
Common stock, $0.01 par value, 150,000,000 shares authorized, 127,949,184 shares and 127,796,745 shares issued at September 30, 2003 and December 31, 2002, respectively		1,279			1,278
Additional paid-in capital		1,379,372			1,382,024
Deficit		(1,191,566		)	(1,165,596		)
Investment in parent		—			(14,950		)
Treasury Stock, at cost, 29,842,905 and 29,840,405 shares at September 30, 2003 and December 31, 2002, respectively		(34,612		)	(34,609		)
Total stockholders’ equity		154,473			168,147
Total liabilities and stockholders’ equity		$	816,653		$	837,572

 

The accompanying notes are an integral part of these
condensed consolidated financial statements.

 

3

 

PROTECTION ONE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF

OPERATIONS AND COMPREHENSIVE LOSS

 

(Dollars in thousands, except for per share amounts)

(Unaudited)

 

		Nine Months Ended September 30,
		2003			2002
					(As Restated See Note 10)
Revenues:
Monitoring and related services		$	193,555		$	205,012
Other		15,230			14,569
Total revenues		208,785			219,581
Cost of revenues (exclusive of depreciation and amortization shown below):
Monitoring and related services		55,427			60,007
Other		21,232			26,749
Total cost of revenues		76,659			86,756
Gross profit (exclusive of depreciation and amortization shown below)		132,126			132,825
Operating expenses:
Selling		23,847			19,938
General and administrative		59,880			64,746
Amortization and depreciation		60,295			62,007
Loss on impairment		—			338,104
Total operating expenses		144,022			484,795
Operating loss		(11,896		)	(351,970		)
Other (income) expense:
Interest expense		18,821			24,042
Related party interest		10,672			8,183
Gain on retirement of debt		—			(19,285		)
Other		(2,073		)	(667		)
Loss from continuing operations before income taxes		(39,316		)	(364,243		)
Income tax benefit		13,346			130,338
Loss from continuing operations before accounting change		(25,970		)	(233,905		)
Loss from discontinued operations, net of taxes		—			(2,927		)
Cumulative effect of accounting change, net of taxes
Continuing operations		—			(541,330		)
Discontinued operations		—			(2,283		)
Net loss		(25,970		)	(780,445		)
Other comprehensive income:
Foreign currency translation gain		—			863
Reclassification adjustment for foreign currency translation loss included in discontinued operations		—			1,499
Total other comprehensive income		—			2,362
Comprehensive loss		$	(25,970	)	$	(778,083	)
Basic and diluted per share information:
Loss from continuing operations per common share		$	(0.26	)	$	(2.38	)
Loss from discontinued operations per common share		$	—		$	(0.03	)
Cumulative effect of accounting change on continuing operations per common share		$	—		$	(5.52	)
Cumulative effect of accounting change on discontinued operations per common share		$	—		$	(0.02	)
Net loss per common share		$	(0.26	)	$	(7.95	)
Weighted average common shares outstanding (in thousands)		98,098			98,110

 

The accompanying notes are an integral part of these
condensed consolidated financial statements.

 

4

 

PROTECTION ONE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF

OPERATIONS AND COMPREHENSIVE LOSS

 

(Dollars in thousands, except for per share amounts)

(Unaudited)

 

		Three Months Ended September 30,
		2003			2002
					(As Restated See Note 10)
Revenues:
Monitoring and related services		$	64,431		$	66,807
Other		5,327			5,558
Total revenues		69,758			72,365
Cost of revenues (exclusive of amortization and depreciation shown below):
Monitoring and related services		18,238			19,540
Other		7,086			8,052
Total cost of revenues		25,324			27,592
Gross profit (exclusive of amortization and depreciation shown below)		44,434			44,773
Operating expenses:
Selling		7,768			7,192
General and administrative		19,559			21,523
Amortization and depreciation		19,981			20,551
Total operating expenses		47,308			49,266
Operating loss		(2,874		)	(4,493		)
Other (income) expense:
Interest expense		6,145			7,220
Related party interest		4,020			3,368
Gain on retirement of debt		—			(2,551		)
Other		18			(784		)
Loss from continuing operations before income taxes		(13,057		)	(11,746		)
Income tax benefit		4,393			4,405
Loss from continuing operations		(8,664		)	(7,341		)
Income from discontinued operations, net of taxes		—			85
Net loss		$	(8,664	)	$	(7,256	)
Other comprehensive income:
Foreign currency translation gain		—			—
Reclassification adjustment for foreign currency translation loss included in discontinued operations		—			—
Comprehensive loss:		$	(8,664	)	$	(7,256	)
Basic and diluted per share information:
Loss from continuing operations per common share		$	(0.09	)	$	(0.08	)
Loss from discontinued operations per common share		$	—		$	—
Net loss per common share		$	(0.09	)	$	(0.08	)
Weighted average common shares outstanding (in thousands)		98,106			97,944

 

The accompanying notes are an integral part of these
condensed consolidated financial statements.

 

5

 

PROTECTION ONE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

		Nine Months Ended September 30,
		2003			2002
					(As Restated See Note 10)
Cash flow from operating activities:
Net loss		$	(25,970	)	$	(780,445	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Gain on retirement of debt		—			(19,285		)
Gain on sale of assets		(2,050		)	(722		)
Loss on discontinued operations, net of tax		—			2,927
Cumulative effect of accounting change, net of taxes		—			543,613
Loss on impairment of customer accounts		—			338,104
Amortization and depreciation		60,295			62,007
Amortization of debt costs and premium		554			1,225
Amortization of deferred customer acquisition costs in excess of deferred revenues		12,498			15,713
Deferred income taxes		24,729			(106,695		)
Provision for doubtful accounts		1,292			3,948
Other		80			161
Changes in assets and liabilities, net of effects of acquisitions and dispositions:
Receivables, net		3,077			3,410
Related party tax receivable		(38,212		)	(22,662		)
Other assets		318			(1,820		)
Accounts payable		(420		)	2,839
Deferred revenue		(2,841		)	(3,965		)
Other liabilities		(3,737		)	(7,782		)
Net cash provided by operating activities		29,613			30,571
Cash flows from investing activities:
Purchases of new accounts		(311		)	(1,736		)
Deferred customer acquisition costs		(32,571		)	(31,918		)
Deferred customer acquisition revenues		13,865			12,324
Purchase of property and equipment		(4,186		)	(5,653		)
Purchase of parent company bonds		—			(67,364		)
Proceeds from sale of parent company bonds		—			67,364
Sale (purchase) of AV ONE		1,411			(1,378		)
Proceeds from disposition of assets		2,778			18,609
Net cash used in investing activities		(19,014		)	(9,752		)
Cash flows from financing activities:
Payments on long-term debt		(10,159		)	(83,504		)
Proceeds from long term-debt		—			44
Proceeds from sale of trademark		450			—
Debt issue costs		74			(2,400		)
Borrowings  from Westar Credit Facility		—			76,500
Purchase of parent company stock- held as treasury		—			(13,831		)
Proceeds from sale of parent company stock- held as treasury		11,940			—
Purchase of Treasury Stock		(3		)	(2,178		)
Exercise of stock options and Employee Stock Purchase Plan		256			452
Funding from parent		1,027			532
Net cash provided by (used in) financing activities		3,585			(24,385		)
Net cash provided by discontinued operations		229			908
Net increase (decrease) in cash and cash equivalents		14,413			(2,658		)
Cash and cash equivalents:
Beginning of period		1,545			3,671
End of period		$	15,958		$	1,013
Cash paid for interest		$	34,607		$	40,149
Cash paid for taxes		$	269		$	184

 

The accompanying notes are an integral part of these
condensed consolidated financial statements.

 

6

 

PROTECTION ONE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(Unaudited)

 

 

1.                                      Basis of Consolidation and Interim Financial Information:

 

Protection One, Inc. (“Protection One” or the “Company”), a Delaware corporation, is a publicly traded security alarm monitoring company.  Protection One is principally engaged in the business of providing security alarm monitoring services, which include sales, installation and related servicing of security alarm systems for residential and business customers. Westar Industries, Inc. (“Westar Industries”), a wholly owned subsidiary of Westar Energy, Inc. (“Westar Energy”), owns approximately 88% of the Company’s common stock.  Westar Energy is a public electric utility and is regulated by the Kansas Corporation Commission (“KCC”).  Westar Energy is also the Company’s principal source for external capital needed to operate its business through a credit facility and through payments made under a tax sharing agreement.  Westar Energy has filed a plan with the KCC in response to an order issued by the KCC to restructure and reduce debt.  In that plan, Westar Energy announced its intention to sell its investment in the Company.  Westar Energy, as part of exploring its strategic alternatives for the Company, engaged an investment banker to conduct a private auction process to sell Westar Energy’s interest in the Company, which Westar Energy desires to sell as part of a sale of the entire Company (including the public shares).  In October 2003, Westar Energy advised the Board of Directors of the Company that Westar Energy was considering possible bids which would involve only the sale of the Company’s common stock held by Westar Industries and of the debt owed to Westar Industries under the Westar Credit Facility (or only the sale of Westar Industries by Westar Energy).  The orders entered by the KCC regarding Westar Energy  and Westar Energy’s consummation of its plan to sell its ownership interest in us could have a material adverse effect upon the Company’s liquidity.

 

If Westar Energy and Westar Industries were to no longer collectively own, directly or indirectly, more than 50% of the voting control of the Company, then there will be a default under the Westar Credit Facility.  Should such a default exist, the Company will no longer have the right to borrow under the Westar Credit Facility and the lender(s) can declare the entire unpaid balance of the obligations under the facility immediately due and payable, terminate the commitment to extend credit and take other actions adverse to the Company.  Acceleration of the Westar Credit Facility would in turn constitute a default under the indentures which govern our debt securities and allow the trustees or our bondholders to also accelerate this indebtedness or take other actions adverse to the Company.  Westar Energy’s sale of its interests in the Company by selling Westar Industries, would not by itself constitute a default under the Westar Credit Facility as long as Westar Industries continued to own at least 50% of the voting control of the Company.  Apart from whether or not a default occurs under the Westar Credit Facility, the indentures governing all of the Company’s debt securities require that, following a change in control (such as would occur if Westar Energy completes the sale of its investment in the Company, or a sale of its investment in Westar Industries), the Company must offer to repurchase the debt securities in certain circumstances.  The 13⁵/₈ % senior subordinated discount notes require the Company to make a repurchase offer at approximately 101% of the principal amount, plus interest in the event of a change in control.  The 7³/₈% senior notes and 8¹/₈% senior subordinated notes require the Company to make a repurchase offer at 101% of the principal amount, plus interest, in the event of a change in control coupled with two ratings downgrades that were to occur after the date the Company announced an intent to pursue a transaction that would result in a change in control. The Company’s management believes that, given the liquidity concerns resulting from such an event, a two ratings downgrade is likely.  The Company lacks the funds to repay the Westar Credit Facility.  The Company also lacks the funds to repurchase its debt securities.  Furthermore, management does not believe that alternative financing could be arranged to pay these debts unless a new majority owner of the Company were to make a substantial equity investment in the Company or otherwise provide substantial credit support to the Company.  The Company is not in any discussions with any investors with respect to such equity investment or credit support.  Thus, if the Westar Credit Facility and/or the notes become due or are accelerated, such events would have a material adverse effect on the Company’s liquidity and financial position.  In addition, upon Westar Energy’s sale of the Company’s common stock, the Company will lose its right to receive reimbursements of future tax losses under the tax sharing agreement (see note 8) with Westar Energy.  If not replaced with an alternative source of liquidity, the loss of the tax sharing agreement would have a material adverse effect on the Company’s liquidity and financial position.  The Company’s Board of Directors authorized management of the Company to explore whether the Company could retire the Westar Credit Facility absent a refinancing of it.  Management developed such a plan and presented it to both Westar Energy and the Company’s Board of Directors.

 

The Company’s unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q.  Accordingly, certain information and footnote disclosures normally included in financial statements presented in accordance with GAAP have been

 

7

 

condensed or omitted. These financial statements should be read in conjunction with the audited financial statements and notes thereto for the year ended December 31, 2002, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”).

 

The Company’s strategy is to improve returns on invested capital by realizing economies of scale from increasing customer density in the largest urban markets in North America.  The Company plans to accomplish this goal by: (i) retaining its customers by providing quality customer service from its monitoring facilities and its branches; and (ii) using its national presence, strategic alliances and strong local operations to persuade the most desirable residential and commercial prospects to enter into long term agreements with the Company on terms that permit it to achieve appropriate returns on capital.

 

The Company has reported annual losses since its inception and Westar Energy has announced that it intends to sell its investment in Company stock.  Additionally, the Company’s current primary financing source is through a credit facility with Westar Energy and credit available under such facility has been reduced (see Notes 4 and 5).  Payments made to the Company by Westar Energy under the tax sharing agreement are another important source of liquidity to the Company.  Management of the Company has evaluated these conditions and events in establishing its operating plans for the Company.  In addition to the plans and strategies noted in the paragraph above, management plans to carefully monitor the level of investment in new customer accounts, continue control of operating expenses, curtail other capital expenditures, if necessary, and if the Company is not sold, resume efforts to extend or replace the credit facility upon its maturity in January 2005.  If Westar Energy does not sell its ownership interest in the Company, management believes that the funds provided from operations and from the Westar Credit Facility, coupled with receipts under the tax sharing agreement (see Note 8), will be sufficient throughout 2004.  If Westar Energy sells its ownership interest in the Company, management does not believe there will be sufficient funds from operations to continue as a going concern without a significant equity contribution or credit support from the new majority owner(s).

 

In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which amends Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation.”  SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation.  In addition, it amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.  This Statement requires that companies follow the prescribed format and provide the additional disclosures in their annual reports for fiscal years ending after December 15, 2002. The Company applies the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” as allowed by SFAS Nos. 123 and 148, and related interpretations in accounting for its stock-based compensation plans.  The Company has adopted the disclosure requirements of SFAS No. 148.

 

For purposes of the pro forma disclosures required by SFAS No. 148, the estimated fair value of the options is amortized to expense on a straight-line method over the options’ vesting period.  Under SFAS No. 123, compensation expense would have been $0.1 million and $0.5 million in the three and nine months ended September 30, 2003, respectively and $0.2 million and $0.7 million in the three and nine months ended September 30, 2002, respectively.  Information related to the pro forma impact on earnings and earnings per share follows (in thousands, except for per share amounts).

 

		Nine Months Ended September 30,
		2003			2002
Net loss, as reported		$	(25,970	)	$	(780,445	)
Add:  Stock-based employee compensation expense included in reported net loss, net of related tax effects		67			67
Deduct:  Total stock option expense determined under fair value method for all awards, net of related tax effects		(504		)	(660		)
Net loss, pro forma		$	(26,407	)	$	(781,038	)
Net loss per common share (basic and diluted):
As reported		$	(0.26	)	$	(7.95	)
Pro forma		$	(0.27	)	$	(7.96	)

 

8

 

		Three Months Ended September 30,
		2003			2002
Net loss, as reported		$	(8,664	)	$	(7,256	)
Add:  Stock-based employee compensation expense included in reported net loss, net of related tax effects		22			22
Deduct:  Total stock option expense determined under fair value method for all awards, net of related tax effects		(139		)	(220		)
Net loss, pro forma		$	(8,781	)	$	(7,454	)
Net loss per common share (basic and diluted):
As reported		$	(0.09	)	$	(0.08	)
Pro forma		$	(0.09	)	$	(0.08	)

 

In the opinion of management of the Company, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation of the financial statements have been included. The results of operations for the nine months ended September 30, 2003 are not necessarily indicative of the results to be expected for the full year.

 

Restricted cash on the accompanying balance sheet represents a trust account established as collateral for the benefit of the insurer of the Company’s workers’ compensation claims.  The Company receives interest income earned by the trust.

 

The Company has issued stock options and warrants of which approximately 0.3 million and 0.4 million represent dilutive potential common shares for the three and nine months ended September 30, 2003, respectively, and 1.9 million and 1.8 million for the three and nine months ended September 30, 2002, respectively.  These securities were not included in the computation of diluted earnings per share for those periods presented with net losses since to do so would have been antidilutive.

 

Certain reclassifications have been made to prior year information to conform with the current year presentation.

 

2.                                      Impairment Charge Pursuant to New Accounting Rules:

 

Effective January 1, 2002, the Company adopted the new accounting standards SFAS No. 142, “Accounting for Goodwill and Other Intangible Assets,” and SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets.”  SFAS No. 142 establishes new standards for accounting for goodwill.  SFAS No. 142 continues to require the recognition of goodwill as an asset, but discontinues amortization of goodwill.  In addition, annual impairment tests must be performed using a fair-value based approach as opposed to an undiscounted cash flow approach required under prior standards.  The completion of the impairment test by the Company, based upon a valuation performed by an independent appraisal firm, as of January 1, 2002, indicated that the carrying value of goodwill had been impaired and an impairment charge was recorded as discussed below.

 

SFAS No. 144 establishes a new approach to determining whether the Company’s customer account asset is impaired.  The approach no longer permits the Company to evaluate its customer account asset for impairment based on the net undiscounted cash flow stream obtained over the remaining life of goodwill associated with the customer accounts being evaluated.  Rather, the cash flow stream to be used under

 

9

 

SFAS No. 144, is limited to future estimated undiscounted cash flows from assets in the asset group, which include customer accounts, the primary asset of the reporting unit, plus an estimated amount for the sale of the remaining assets within the asset group (including goodwill).  If the undiscounted cash flow stream from the asset group is less than the combined book value of the asset group, then the Company is required to mark the customer account asset down to fair value, by way of recording an impairment, to the extent fair value is less than its book value.  To the extent net book value is less than fair value, no impairment would be recorded.

 

The new rule substantially reduces the net undiscounted cash flows used for customer account impairment evaluation purposes as compared to the previous accounting rules.  The undiscounted cash flow stream was reduced from the 16 year remaining life of the goodwill to the 9 year remaining life of customer accounts for impairment evaluation purposes.  Using these new guidelines, the Company determined that there was an indication of impairment of the carrying value of the customer accounts and an impairment charge was recorded as discussed below.

 

To implement the new standards, the Company engaged an independent appraisal firm to help management estimate the fair values of goodwill and customer accounts.  Based on this analysis, the Company recorded a net charge of approximately $765.2 million in the first quarter of 2002.  The charge is detailed as follows:

 

		Goodwill			Customer Accounts			Total
					(in millions)
North America Segment:
Impairment charge - continuing operations		$	509.4		$	338.1		$	847.5
Impairment charge – discontinued operations		2.3			1.9			4.2
Estimated income tax benefit		(65.1		)	(118.4		)	(183.5		)
Net charge		$	446.6		$	221.6		$	668.2
Multifamily Segment:
Impairment charge		$	104.2		$	—		$	104.2
Estimated income tax benefit		(7.2		)	—			(7.2		)
Net charge		$	97.0		$	—		$	97.0
Total Company:
Impairment charge		$	615.9		$	340.0		$	955.9
Estimated income tax benefit		(72.3		)	(118.4		)	(190.7		)
Net charge		$	543.6		$	221.6		$	765.2

 

 

The impairment charge for goodwill is reflected in the consolidated statement of operations as a cumulative effect of a change in accounting principle.  The impairment charge for customer accounts is reflected in the consolidated statement of operations as an operating cost.  These impairment charges reduced the recorded value of these assets to their estimated fair values at January 1, 2002.

 

The Company retained an independent appraisal firm and performed an impairment test as of July 1, 2002 (the date selected for its annual impairment test), with the independent appraisal firm providing the valuation of the estimated fair value of the Company’s reporting units, and no impairment was indicated.  After regulatory actions (see Note 5, “Related Party Transactions”), including Kansas Corporation Commission Order No. 55, which prompted Westar Energy to advise the Company that it intended to dispose of its investment in the Company, the independent appraisal firm was again retained to perform an additional valuation so that the Company could perform an impairment test as of December 31, 2002. Order No. 55 limited the amount of capital Westar Energy could provide to the Company which increased the Company’s risk profile.  Therefore, the Company reevaluated its corporate forecast, reduced the amount

 

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of capital invested over its forecast horizon and lowered its base monthly recurring revenue to incorporate actual 2002 results, which resulted in a lower valuation than the July 1, 2002 valuation.  The Company recorded an additional $90.7 million impairment charge, net of $13.3 million tax, to reflect the impairment of all remaining goodwill of its North America segment in the fourth quarter of 2002.

 

A deferred tax asset in the amount of $190.7 million was recorded in the first quarter of 2002 for the tax benefit shown above and an additional deferred tax benefit of $13.3 million was recorded with the fourth quarter impairment charge.  If Westar Energy completes its intended disposal of Protection One, however, the Company’s net deferred tax asset of $270.1 million at September 30, 2003 might not be realizable and the Company might not be in a position to record a tax benefit for losses incurred.  As a result, the Company would be required to record a charge against income for the portion of its net deferred tax assets determined not to be realizable. This charge could be material and could have a material adverse effect on the Company’s business, financial condition and results of operations.

 

The Company is required to perform impairment tests for long-lived assets prospectively when the Company determines that indicators of potential impairment are present.  Goodwill is required to be tested at least annually for impairment.  Declines in market values of the Company’s business or the value of its customer accounts that may occur in the future may require additional write-down of these assets in the future.  The Company retained an independent appraisal firm and completed its annual impairment testing during the third quarter of 2003 on their Network Multifamily segment and determined that no additional impairment of goodwill is required as of July 1, 2003.  The Company’s North America segment has no goodwill and, therefore, did not require testing as of July 1, 2003.  No impairment charge was recorded in the first nine months of 2003.

 

3.                                      Intangible Assets - Customer Accounts and Goodwill:

 

The following reflects the changes in the Company’s investment in purchased customer accounts (at cost) for the following periods (in thousands):

 

		Nine Months Ended September 30, 2003			Three Months Ended September 30, 2003			Year Ended December 31, 2002
Beginning customer accounts, net		$	312,785		$	279,146		$	719,679
Acquisition of customer accounts		330			15			1,195
Amortization of customer accounts		(51,456		)	(17,271		)	(68,929		)
Impairment charge		—			—			(338,104		)
Sale of accounts		(93		)	(93		)	(398		)
Other		369			138			(658		)
Ending customer accounts, net		$	261,935		$	261,935		$	312,785

 

The investment at cost in customer accounts at September 30, 2003 and December 31, 2002 was $946.2 million and $945.1 million, respectively. Accumulated amortization of the investment in customer accounts at September 30, 2003 and December 31, 2002 was $684.2 million and $632.3 million, respectively.  The table below reflects the estimated aggregate customer account amortization expense for 2003 and each of the four succeeding fiscal years on the existing customer account base as of September 30, 2003.

 

		2003			2004			2005			2006			2007
		(Dollars in thousands)
Estimated amortization expense		$	68,713		$	68,612		$	52,322		$	51,961		$	45,641

 

There were no changes in the carrying amounts of goodwill for the three and nine months ended September 30, 2003.  The changes in the carrying amounts of goodwill for the year ended December 31, 2002, are as follows (in thousands):

 

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		North America Segment			Multifamily Segment			Total
Balance as of December 31, 2001		$	613,414		$	150,035		$	763,449
Impairment losses (Note 2)		(613,414		)	(104,188		)	(717,602		)
Realization of purchased tax assets		—			(4,000		)	(4,000		)
Balance as of December 31, 2002		$	—		$	41,847		$	41,847

 

4.                                      Debt:

 

Long-term debt and the fixed or weighted average interest rates are as follows (in thousands):

 

		September 30, 2003			December 31, 2002
Westar Credit Facility with Westar Industries, maturing January 5, 2005, variable 6.1% (a)		$	215,500		$	215,500
Senior Subordinated Notes, maturing January 2009, fixed 8.125%		110,340			110,340
Senior Unsecured Notes, maturing August 2005, fixed 7.375%		190,925			190,925
Senior Subordinated Discount Notes, maturing June 2005, fixed 13.625% (b)		30,720			31,033
Convertible Senior Subordinated Notes, maturing September 2003, fixed 6.75%		—			9,725
Other debt obligations, including capital leases		—			434
		547,485			557,957
Less current portion		—			(10,159		)
Total long-term debt		$	547,485		$	547,798

 

(a)                         Represents weighted average interest rate before fees on borrowings under the facility at September 30, 2003.  The weighted-average annual interest rate before fees on borrowings at December 31, 2002 was 5.2%.

(b)                        The effective rate to the Company is 11.8% due to amortization of a premium related to the notes.  The unamortized balance of the premium at September 30, 2003 and December 31, 2002 was $0.8 million and $1.2 million, respectively.

 

The Company’s ability to borrow under the facility is subject to compliance with certain financial covenants, including a leverage ratio of 5.75 to 1.0 and an interest coverage ratio of 2.10 to 1.0. In addition, the Company’s ability to borrow under this facility, is subject to a number of conditions which must be met at the time of borrowing, including:  (i) there having been no material adverse event; (ii) no default or potential default exists; and (iii) the Company’s representations, including one regarding the Company’s solvency, are true and correct.  The Company may not be able to meet some or all of these conditions in light of the Company’s financial condition together with the potential sale by Westar Energy of its interests in the Company, and Westar Energy's disclosure in its Form 10-Q for the quarter ended September 30, 2003, that (a) the reduction by $165.6 million of the likely net realizable proceeds Westar Energy would receive from a sale based on the ranges of value it received from multiple potential buyers and (b) the substantial risk that Westar Energy may not recover the outstanding amount of the Westar Credit Facility upon a sale of its interests in the Company.  The Company's inability to borrow under the Westar Credit Facility would have a material adverse effect on the Company’s liquidity and financial position. The Company's ability to renew an existing eurodollar borrowing under the Westar Credit Facility is also subject to these conditions. All of the Company’s outstanding borrowings under the Westar Credit Facility are currently in eurodollars.  If the outstanding eurodollar borrowings were to renew as prime rate borrowings, which renewal is permitted notwithstanding the Company's possible inability to satisfy the foregoing conditions, the Company would incur an additional $3.5 million of annual interest expense at existing interest rates.

 

Some of the indentures governing the Company’s outstanding senior and subordinated notes contain similar covenants with different calculations relating to the Company’s ability to incur indebtedness.  The Company was in compliance with all covenants contained in these indentures at September 30, 2003.

 

In June 2003, the Company used available cash to purchase $8.4 million of its 6.75% Convertible Senior Subordinated Notes which would have matured in September of 2003.  In September 2003 the Company retired the remaining $1.3 million of its 6.75% Convertible Senior Subordinated Notes.  The notes were purchased at face value and no gain or loss was recorded on the transactions.

 

In June 2003 the Company and Westar Industries executed the thirteenth and fourteenth amendments to the Westar Credit Facility that, among other things, extended the maturity date of the credit facility to January 5, 2005 and increased the applicable borrowing rate on Eurodollar borrowings from LIBOR plus 3.75% to LIBOR plus 5.00%.

 

In accordance with the Partial Stipulation and Agreement (see Note 5, Related Party Transactions) approved by the KCC, the Westar Credit Facility with Westar Industries provides for borrowings up to $228.4 million with a variable interest rate. Additionally, the KCC has required the Westar Credit Facility to be paid in full upon the sale of all or a majority of Westar Energy’s investment in the Company’s common stock to a new owner.

 

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Apart from the KCC order, if Westar Energy and Westar Industries were to no longer collectively own, directly or indirectly more than 50% of the voting control of the Company, then there would be a default under the Westar Credit Facility.  Should such a default exist, the Company will no longer have the right to borrow under the Westar Credit Facility and the lender(s) can declare the entire unpaid balance of the obligations under the facility immediately due and payable, terminate the commitment to extend credit and take other actions adverse to the Company.  Acceleration of the Westar Credit Facility would in turn constitute a default under the indentures which govern our debt securities and allow the trustees or our bondholders to also accelerate this indebtedness or take other actions adverse to the Company.  Westar Energy's sale of its interests in the Company by selling Westar Industries, would not by itself constitute a default under the Westar Credit Facility as long as Westar Industries continued to own at least 50% of the voting control of the Company.  Apart from whether or not a default occurs under the Westar Credit Facility, the indentures governing all of the Company’s debt securities require that following a change in control (such as would occur if Westar Energy completes the sale of its investment in the Company, or a sale of its investment in Westar Industries) the Company must offer to repurchase the debt securities in certain circumstances.  The 13⁵/₈% senior subordinated discount notes require the Company to make a repurchase offer at approximately 101% of the principal amount, plus interest in the event of a change in control.  The 7³/₈% senior notes and 8¹/₈% senior subordinated notes require the Company to make a repurchase offer at 101% of the principal amount, plus interest, in the event of a change in control coupled with two ratings downgrades that were to occur after the date the Company announced an intent to pursue a transaction that would result in a change in control. The Company’s management believes that, given the liquidity concerns resulting from such an event, a two ratings downgrade would be likely.  The Company lacks the funds to repay the Westar Credit Facility.  The Company also lacks the funds  to repurchase its debt securities. Furthermore, management does not believe that alternative financing could be arranged to pay these debts unless a new majority owner of the Company were to make a substantial equity investment in the Company or otherwise provide substantial credit support to the Company.  The Company is not in any discussions with any investors with respect to such equity investment or credit support. Thus, if the Westar Credit Facility and/or the notes become due or are accelerated, such events would have a material adverse effect on the Company’s liquidity and financial position.  In addition, upon Westar Energy’s sale of the Company’s common stock, the Company will lose its right to receive reimbursements for future tax losses under the tax sharing agreement (see note 8) with Westar Energy.  If not replaced with an alternative source of liquidity, the loss of the tax sharing agreement would have a material adverse effect on the Company’s liquidity and financial position.

 

 

5.                                      Related Party Transactions:

 

On November 8, 2002, the Kansas Corporation Commission issued Order No. 51 which required Westar Energy to initiate a corporate and financial restructuring, reverse specified accounting transactions described in the Order, review, improve and/or develop, where necessary, methods and procedures for allocating costs between utility and non-utility businesses for KCC approval, refrain from any action that would result in its electric businesses subsidizing non-utility businesses, reduce outstanding debt giving priority to reducing utility debt and, pending the corporate and financial restructuring, imposed standstill limitations on Westar Energy’s ability to finance non-utility businesses including the Company. These standstill protections require that Westar Energy seek KCC approval before it takes actions such as making any loan to, investment in or transfer of cash in excess of $100,000 to the Company or another non-utility affiliate, entering into any agreement with the Company or another non-utility affiliate where the value of goods or services exchanged exceeds $100,000, investing, by Westar Energy or Westar Energy’s affiliate, of more than $100,000 in an existing or new non-utility business and transferring any non-cash assets or intellectual property to the Company or another non-utility affiliate.  In addition, Westar Energy must charge interest to the Company and other non-utility affiliates at the incremental cost of their debt on outstanding balances of any existing or future inter-affiliate loans, receivables or other cash advances due Westar Energy.  The Order also suggested that the sale by Westar Energy of the Company’s stock should be explored, along with other alternatives, as a possible source of cash to be used to reduce Westar Energy debt. An additional provision affecting the Company includes a requirement that it cannot sell assets having a value of $100,000 or more without prior KCC approval.

 

On December 23, 2002, the Kansas Corporation Commission issued Order No. 55 clarifying and modifying the November 8, 2002 Order.  One such clarification was that Westar Energy and Westar

 

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Industries would be prohibited from making payments to the Company under the tax sharing agreement until certain requirements were met by Westar Energy regarding their debt.

 

On January 10, 2003, Protection One filed a petition seeking reconsideration of certain aspects of Order No. 55.  Specifically, the Company requested that the Commission reconsider and revise Order No. 55 so that it clearly does not interfere with the Company’s contractual arrangements with Westar Energy and Westar Industries, including, but not limited to the tax sharing agreement and the Westar Credit Facility.

 

On February 11, 2003, the parties to the KCC proceeding filed a Limited Stipulation and Agreement, which sought the KCC’s approval for Protection One to sell all of its Westar Energy stock to Westar Energy.  The KCC approved the Limited Stipulation and Agreement on February 14, 2003.  Protection One sold its Westar Energy stock to Westar Energy on February 14, 2003 for $11.6 million.  At December 31, 2002 this Westar Energy stock was recorded as a reduction of stockholders’ equity, similar to treasury stock, in the approximate amount of $15.0 million.  In January 2003, the Company received approximately $0.3 million in dividends on the stock which resulted in reduction in the investment in parent. The difference between the cost and proceeds received from Westar Energy was reflected as a reduction of contributed capital from Westar Energy in the first quarter of 2003.

 

On February 25, 2003, the Company entered into a Partial Stipulation and Agreement (the Reconsideration Agreement) with the Staff of the KCC, Westar Energy, Westar Industries and an intervener.  The Reconsideration Agreement requested that the KCC issue an order granting limited reconsideration and clarification to its order issued December 23, 2002.  The Reconsideration Agreement also requests that the KCC authorize Westar Energy and Westar Industries to perform their respective obligations to the Company under the tax sharing agreement and the Westar Credit Facility. Additionally, the Reconsideration Agreement provides that, among other things; (a) the maximum borrowing capacity under the Westar Credit Facility will be reduced to $228.4 million and the maturity date may be extended one year to January 5, 2005; (b) Westar Energy may provide funds to Westar Industries to the extent necessary to perform its obligations to the Company under the Westar Credit Facility; (c) Westar Energy will reimburse the Company approximately $4.4 million for expenses incurred in connection with services provided by Protection One Data Services and AV One, Inc. to Westar Energy and Westar Industries, and for the sale of AV One, Inc. to Westar Energy; and  (d) the Management Services Agreement between the Company and Westar Industries is cancelled.

 

On March 11, 2003, the KCC issued Order No. 65 conditionally approving the Reconsideration Agreement. The KCC imposed the following on the terms of the Reconsideration Agreement: (a) the Westar Credit Facility must be paid off upon the sale of all or a majority of Protection One common stock held by Westar Industries, and this pay-off must be a condition of any sale by Westar Industries of Protection One’s stock; (b) Westar Energy must provide advance notice to the KCC if the payment to the Company under the tax sharing agreement exceeds approximately $20 million; (c) Protection One must receive KCC approval prior to selling any assets exceeding $100,000 and Westar Energy and Westar Industries must receive KCC approval prior to selling their stock in Protection One; and (d) Protection One must waive potential claims against Westar Energy and Westar Industries relating to certain inter-company agreements.  In addition, the KCC reserved the right to impose a deadline for the sale by Westar Industries of its Protection One stock.  Westar Energy is precluded from extending any credit to the Company except for borrowings the Company may make under the Westar Credit Facility.

 

The Company, Westar Energy and Westar Industries also agreed that they will provide the Kansas Corporation Commission with periodic reports on the progress of their efforts to sell Westar Energy’s equity investment in Protection One.

 

In addition, on March 19, 2003, the Company submitted two letters to the KCC in response to KCC Order No. 65, one of which was addressed to the KCC and the other of which was addressed to Westar Energy.  As described in the letters, the Company agreed to (i) release Westar Energy from certain claims relating to Protection One Data Services, Inc (“PODS”), AV One, Inc. and the Management Services Agreement and (ii) accept the conditions set forth in Order No. 65 relating to matters other than PODS, AV

 

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One, Inc. and the Management Services Agreement.  The Company does not intend to seek reconsideration of Order No. 65.

 

The Company had outstanding borrowings under the Westar Credit Facility with Westar Industries of $215.5 million at September 30, 2003 and December 31, 2002. The Company accrued interest expense of $3.4 million and $9.0 million and made interest payments of $3.1 million and $8.8 million on borrowings under the facility for the three months and nine months ended September 30, 2003, respectively.  The Company accrued interest expense of $3.4 million and $8.2 million and made interest payments of  $2.8 million and $7.0 million on borrowings under the facility for the three months and nine months ended September 30, 2002, respectively.  Pursuant to the Reconsideration Agreement, the maximum borrowing capacity of the Westar Credit Facility was reduced from $280.0 million to $228.4 million.  Accordingly, Westar Energy agreed to refund approximately $0.5 million to the Company in amendment fees.  This amount was refunded on June 24, 2003 upon execution of the thirteenth amendment to the Westar Credit Facility.

 

On June 30, 2003 the Company paid $0.5 million amendment fee to Westar Industries for the fourteenth amendment to the Westar Credit Facility.  This amendment extended the maturity date of the facility to January 5, 2005 and increased the applicable margin on Eurodollar borrowings to 5.00%.

 

On June 30, 2003 Westar Industries paid the Company approximately $0.5 million partially as consideration for the Company’s grant of a license to Protection One Europe Holding S.A. to use the Protection One trademark and name in certain European countries.  Revenues from this agreement will be recognized over the life of the licensing agreement.

 

During the first nine months of 2002, the Company acquired from Westar Industries $83.9 million face value of the Company’s bonds for $66.8 million.  These bonds were purchased at Westar Industries’ cost, which generally approximated fair value.  As a result of these transactions, a gain of $16.6 million was recognized in the first nine months of 2002.  No bonds were repurchased from Westar Industries in the first nine months of 2003.

 

During the first six months of 2002 the Company acquired in open market purchases approximately $41.2 million of Westar Energy 6.25% notes, approximately $21.6 million of Westar Energy 6.875% notes and approximately $4.6 million of Westar Energy 7.125% notes.  All of these notes were subsequently sold at cost to Westar Energy prior to June 30, 2002.  During the first nine months in 2002 the Company acquired in open market purchases approximately $12.6 million of Westar Energy common stock and approximately $1.5 million of Westar Energy preferred stock.  In addition, in the first quarter of 2002, the Company acquired $0.3 million of Westar Energy preferred securities and $0.1 million of ONEOK, Inc. common stock, all of which were subsequently sold at cost to Westar Energy on March 27, 2002.  At December 31, 2002, the Company held 850,000 shares of Westar Energy common stock at a cost of approximately $13.0 million and 34,213 shares of Westar Energy preferred stock at a cost of approximately $2.0 million for a combined cost of approximately $15.0 million which is reflected in the equity section of the Company’s balance sheet.  These securities were sold to Westar Energy on February 14, 2003 for approximately $11.6 million, as discussed above.

 

On June 21, 2001, the Company entered into an amendment to the Contribution Agreement dated as of July 30, 1997 between the Company and Westar Energy.  This amendment permitted Westar Energy’s beneficial ownership of the Company’s outstanding common stock to exceed 85% provided that its beneficial ownership on a fully diluted basis does not exceed 81% of the outstanding shares.  The amendment to the Contribution Agreement was approved by the Company’s continuing directors as required by the terms of the Contribution Agreement.

 

The Company had a receivable balance of $59.0 million and $20.7 million at September 30, 2003 and December 31, 2002, respectively, relating to a tax sharing agreement with Westar Energy.  The Company expects to receive $31.7 million from Westar Energy as payment for the tax benefit Westar Energy utilized in its 2002 consolidated income tax return filed in the third quarter of 2003. However, the KCC has authorized Westar Energy to pay up to $20 million for tax benefits and has required Westar Energy to

 

15

 

notify the KCC prior to making any payment in excess of $20 million.  Westar Energy has stated in its Form 10-Q for the fiscal quarter ended September 30, 2003 that it intends to pay the Company the tax sharing payment on the closing of its proposed sale of its interest in the Company.  Westar Energy further stated that, in the event such a transaction is not completed by December 31, 2003, Westar Energy would pay the Company on such date any amounts it has been authorized to pay by the KCC and if necessary, would then initiate a process to seek the KCC’s approval to pay any remaining amounts.  In 2002, the Company received aggregate payments from Westar Energy of $1.7 million.  The loss of these payments would have a material adverse effect on cash flow.

 

An additional $27.3 million receivable was recorded for the estimated tax benefit generated in the first nine months of 2003 that Westar Energy will be able to utilize in its 2003 consolidated income tax return which will be filed in 2004.  In February 2002, the Company received $1.7 million from Westar Energy for payment of the tax receivable at December 31, 2001. See Note 8 for further discussion relating to income taxes.

 

Westar Energy provides administrative services at their fully loaded cost to the Company pursuant to an agreement (the “Administrative Services Agreement”), which includes accounting, tax, audit, human resources, legal, purchasing and facilities services.  Charges of approximately $1.1 million and $3.4 million were incurred for the three months and nine months ended September 30, 2003, respectively, compared to charges of approximately $0.6 million and $3.6 million for the three months  and nine months ended September 30, 2002, respectively.  The Company had a net balance due to Westar Energy of $2.0 million and $1.0 million at September 30, 2003 and December 31, 2002, respectively.

 

In November 2001, the Company entered into an agreement (the “Management Services Agreement”) pursuant to which it paid to Westar Industries, beginning with the quarter ended March 31, 2002, a financial advisory fee, payable quarterly, equal to 0.125% of the Company’s consolidated total assets at the end of each quarter.  The Company incurred $1.3 million and $4.0 million of expense for the three and nine months ended September 30, 2002, respectively, for the financial advisory fee which is included in general and administrative expenses on the statement of operations.  During the fourth quarter of 2002, the management fee was suspended.  This agreement was terminated in accordance with the Reconsideration Agreement and the remaining balance due was paid during the fourth quarter of 2002.

 

On June 5, 2002, the Company acquired the stock of a wholly owned subsidiary of Westar Industries named Westar Aviation, Inc. for approximately $1.4 million.  The Company subsequently changed the name of the newly acquired corporation to AV ONE, Inc. (“AV ONE”) and entered into an Aircraft Reimbursement Agreement with Westar Industries.  Under this agreement, Westar Industries agreed to reimburse AV ONE for certain costs and expenses relating to its operations.  In accordance with the Reconsideration Agreement, Westar Energy reimbursed the Company for all costs incurred relating to the services provided to Westar Energy and Westar Industries and on March 21, 2003, repurchased the stock of AV ONE at book value.  The Company did not incur any gain or loss on the transaction since the sale was transacted at book value.

 

On September 17, 2002, Westar Energy was served with a federal grand jury subpoena by the United States Attorney’s Office concerning, among other things, the use of aircraft leased by Westar Industries, and by AV ONE.  Since that date, the United States Attorney’s Office has served additional information requests on Westar Energy, its subsidiaries, including AV ONE, and certain employees of Westar Energy and AV ONE.  The Company is cooperating with the grand jury and Westar Energy in connection with such requests.

 

In June 2002, the Company formed a wholly owned subsidiary named Protection One Data Services, Inc. (PODS) and on July 1, 2002 transferred to it approximately 42 of its Information Technology employees.  Effective July 1, 2002, PODS entered into an outsourcing agreement with Westar Energy pursuant to which PODS provided Westar Energy information technology services.  As a condition of the agreement, PODS offered employment to approximately 100 Westar Energy Information Technology employees.  Operation of the subsidiary and the provision of such services were discontinued as of December 31, 2002.  Revenues from these operations totaled $11.2 million for the six months of their operation ending December 31, 2002 and net income was $0.3 million for that period.  The approximately 142 Information Technology employees that had accepted employment with PODS were transferred back to their respective companies as of the December 31, 2002.  PODS had a $1.1 million receivable from Westar Energy as of December 31, 2002. On March 21, 2003, in accordance with the Reconsideration Agreement, Westar Energy paid the Company $1.1 million for the balance due under the outsourcing agreement.

 

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6.                                      Commitments and Contingencies:

 

In 1999, six former Protection One dealers filed a class action lawsuit against Protection One Alarm Monitoring, Inc. (“Monitoring”) in the U. S. District Court for the Western District of Kentucky alleging breach of contract arising out of a disagreement over the interpretation of certain provisions of their dealer contracts.  The action is styled Total Security Solutions, Inc., et al. v. Protection One Alarm Monitoring, Inc., Civil Action No. 3:99CV-326-H (filed May 21, 1999).  In September 1999, the Court granted Monitoring’s motion to stay the proceeding pending the individual plaintiffs’ pursuit of arbitration as required by the terms of their agreements.  On June 23, 2000, the Court denied plaintiffs’ motion for collective arbitration. On or about October 4, 2000, notwithstanding the Court’s denial of plaintiffs’ motion for collective arbitration, the six former dealers filed a Motion to Compel Consolidation Arbitration with the American Arbitration Association (“AAA”).  On November 21, 2000, the AAA denied the dealers’ motion and advised they would proceed on only one matter at a time. Initially, only Masterguard Alarms proceeded with arbitration. On March 8, 2002, Masterguard’s claims against the Company were settled by the mutual agreement of the parties.

 

On July 25, 2002, Complete Security, Inc., a dealer which was among the original plaintiffs in the Total Security Solutions court proceeding, initiated arbitration proceedings against Monitoring, alleging breach of contract, misrepresentation, consumer fraud and franchise law violations.  On September 2, 2003, Complete Security’s claims against the Company were settled by the mutual agreement of the parties.

 

Two dealers, not plaintiffs in the original Total Security Solutions litigation — Security Response Network, Inc. and Homesafe Security, Inc. — have brought similar claims in arbitration against the Company.  Discovery is on-going in the Security Response Network and Homesafe Security matters.

 

The Company believes it has complied with the terms of its contracts with these former dealers, and intends to aggressively defend against these claims. In the opinion of management, none of these pending dealer claims, either alone or in the aggregate, will have a material adverse effect upon the Company’s consolidated financial position or results of operations.

 

Other Protection One dealers have threatened, and may bring, claims against the Company based upon a variety of theories surrounding calculations of holdback and other payments, or based on other theories of liability.  The Company believes it has materially complied with the terms of its contracts with dealers.  The Company cannot predict the aggregate impact of these potential disputes with dealers which could be material.

 

On July 2, 2002, Monitoring received a letter from the University of New Hampshire, asserting claims against Monitoring due to Monitoring’s alleged failure to properly monitor a low-temperature freezer used by the University to store research specimens, which failure allegedly caused damage to or destruction of  scientific specimens.  The University’s letter alleged losses of $250,000. On or about August 13, 2002, Monitoring received a letter from counsel to Dr. Stacie Sower, whom we understand to be a professor at the University whose specimens were among those allegedly damaged or destroyed, alleging that the loss was approximately $1.1 million.

 

Monitoring entered into a tolling agreement with the University and Dr. Sower, extending the applicable statute of limitations to August 7, 2003, in order to allow claimants time to further investigate the cause of the freezer failure and potentially resolve the matter without resorting to litigation. The parties engaged in informal discovery and settlement discussions during the tolling period.

 

In early August, 2003, Dr. Sower and the University filed separate lawsuits against Monitoring in New Hampshire Superior Court (Stacie Sower v. Protection One Alarm Monitoring, Inc. and University of New Hampshire v. Protection One Alarm Monitoring, Inc. & CU Security, Docket Number 03-C-0199). Dr. Sower’s suit alleges breach of the duty of care, violations of New Hampshire Revised Statute Chapter 358-A, products liability, and other causes of action. The University’s suit alleges negligence, breach of contract, breach of implied covenant of good faith and fair dealing, negligent or intentional misrepresentation, strict liability, violations of New Hampshire Revised Statute Chapter 358-A, breach of implied warranties, and

 

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other causes of action. Both lawsuits seek unspecified monetary damages. The University’s lawsuit also seeks rescission of Monitoring’s contract with the University.

 

Both lawsuits were removed, without objection, to the United States District Court for the District of New Hampshire.  The Company has answered the complaints, filed a counterclaim against the University of New Hampshire (seeking a declaratory judgment that the University of New Hampshire is contractually obligated to defend and/or indemnify Monitoring as to the claims asserted by Dr. Sower) and filed a cross-complaint against the subcontractor who installed portions of the alarm system, seeking indemnification.  The subcontractor has answered the Company’s cross-complaint with a denial of any obligation to indemnify the Company in connection with this matter.  The parties have informally agreed to have the two cases consolidated and the Court has issued a consolidation order effectively joining the cases under one case number.

 

Monitoring’s liability insurance carrier has been notified of these claims. Monitoring intends to vigorously defend against any and all claims relating to this matter, and believes it has adequate insurance coverage with respect to any potential liability arising from this suit.  In the opinion of management, the outcome of this dispute will not have a material adverse effect upon the Company’s consolidated financial position or results of operations.

 

On August 2, 2002, Monitoring, Westar Energy, Inc. and certain former employees of Monitoring, as well as certain third parties, were sued in the District Court of Jefferson County, Texas, by Regina Rogers, a resident of Beaumont, Texas (Case No. D167654). Ms. Rogers has asserted various claims due to casualty losses and property damage she allegedly suffered as a result of a fire to her residence on August 17, 2000. In her complaint, Ms. Rogers alleges that Protection One and certain of its employees were negligent, grossly negligent and malicious in allegedly failing to properly service and monitor the alarm system at the residence. The complaint also alleges various violations of the Texas Deceptive Trade Practices Act (“DTPA”), fraud and breach of contract. Relief sought under the complaint includes actual, exemplary and treble damages under the DTPA, plus attorneys’ fees. Although the complaint does not specify the amount of damages sought, counsel for the plaintiff has previously alleged actual damages of approximately $7.5 million. The Company believes it has adequate insurance coverage with respect to any potential liability. The Company’s primary insurance carrier is providing defense of the action, and the excess carrier is proceeding under a reservation of rights. In the opinion of management the outcome will not have a material adverse effect upon the Company’s consolidated financial position or results of operations.

 

On May 20, 2003, Joseph G. Milstein filed a putative class action suit against Protection One Alarm Services, Inc. in Los Angeles Superior Court (Milstein v. Protection One Alarm Services, Inc., John Does 1-100, including Protection One Alarm Monitoring, Inc, Case No. BC296025).  The complaint alleges that Mr. Milstein, and similarly situated Protection One customers in California, should not be required to continue to pay for alarm services on their homes after they have moved from the home. The complaint seeks money damages and disgorgement of profits based on alleged breach of contract, breach of the covenant of good faith and fair dealing, fraud by intentional misrepresentation, fraud by negligent misrepresentation and concealment, violation of California Business & Professions Code §17200, and violation of the California Consumer Legal Remedies Act.  On May 29, 2003, the plaintiff added Protection One Alarm Monitoring, Inc. as a defendant in the lawsuit.

 

On October 28, 2003, the Court granted Protection One’s motion to compel arbitration of the dispute per the terms of the customer contract.

 

Monitoring maintains that the claims asserted in this matter are without merit, and Monitoring intends to vigorously defend against any and all claims relating to this matter.

 

The Company is a party to claims and matters of litigation incidental to the normal course of its business. Additionally, the Company receives notices of consumer complaints filed with various state agencies.  The Company has developed a dispute resolution process for addressing these administrative complaints.  The ultimate outcome of such matters cannot presently be determined; however, in the opinion of management of

 

18

 

the Company, the resolution of such matters will not have a material adverse effect upon the Company’s consolidated financial position or results of operations.

 

In order to retain the services of numerous employees who may have felt uncertain about the future ownership, management and direction of the Company, as a result of Westar Energy’s announcement to dispose of its ownership interest in the Company (see Note 9), the Company entered into retention and severance arrangements with approximately 190 employees to provide incentives for such employees to remain with the Company through the sales process.  On October 31, 2003, the Company paid approximately $5.1 million to those employees who fulfilled their obligation related to the retention agreement.  Additional severance amounts of approximately $11.0 million may also be paid under these arrangements to those employees, if any, who are terminated following a change in control.  As of September 30, 2003, $4.4 million has been expensed related to the retention payment.  No amounts have been expensed by the Company relating to the severance arrangements.  Upon a change in control of the Company, an additional approximately $10.5 million will be paid to other key employees.  No amounts have been expensed relating to these additional payments to key employees.  In addition, upon a change in control, customary fees and expenses will be paid to the financial advisor to the Company’s Special Committee of the Board of Directors.  The Company has expensed approximately $0.4 million for legal and other professional fees related to a possible change in control.

 

The Company, Westar Energy and its former independent auditor, Arthur Andersen LLP, have been advised by the Staff of the Securities and Exchange Commission that the Staff will be inquiring into the practices of the Company and Westar Energy with respect to the restatement of their first and second quarter 2002 financial statements announced in November 2002 and the related announcement that the 2000 and 2001 financial statements of the Company and Westar Energy would be reaudited.  The Company is cooperating with the Staff in connection with such inquiry.

 

7.                                      Segment Reporting:

 

The Company’s reportable segments include North America and Multifamily.  North America provides residential, commercial and wholesale security alarm monitoring services, which include sales, installation and related servicing of security alarm systems in the United States.  Multifamily provides security alarm services to apartments, condominiums and other multi-family dwellings.

 

The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies in the Company’s Form 10-K for the year ended December 31, 2002.  The Company manages its business segments based on adjusted earnings before interest, income taxes, depreciation and amortization (including amortization of deferred customer acquisition costs and revenues) and other income and expenses (“Adjusted EBITDA”).

 

		Nine Months Ended September 30, 2003											Nine Months Ended September 30, 2002
		(Dollars in thousands)											(Dollars in thousands)
		North America(1)			Multifamily(2)			Adjustments(3)		Consolidated			North America(1)			Multifamily(2)			Adjustments(3)		Consolidated
Revenues		$	180,177		$	28,608				$	208,785		$	190,946		$	28,635				$	219,581
Adjusted EBITDA(6)		50,424			10,473					60,897			52,748			11,106					63,854
Amortization of intangibles and depreciation expense		56,615			3,680					60,295			58,026			3,981					62,007
Amortization of deferred costs in excess of deferred revenues		9,452			3,046					12,498			11,678			4,035					15,713
Loss on impairment		—			—					—			338,104			—					338,104
Operating income (loss)		(15,643		)	3,747					(11,896		)	(355,060		)	3,090					(351,970		)
Segment assets		781,976			94,517			(59,840	)	816,653			885,488			99,610			(50,620	)	934,478
Expenditures for property		3,517			669					4,186			4,789			864					5,653
Investment in new accounts, net		15,210			3,807					19,017			16,843			4,487					21,330

 

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		Three Months Ended September 30, 2003											Three Months Ended September 30, 2002
		(Dollars in thousands)											(Dollars in thousands)
		North America(4)			Multifamily(5)			Adjustments(3)		Consolidated			North America(4)			Multifamily(5)			Adjustments(3)		Consolidated
Revenues		$	60,096		$	9,662				$	69,758		$	62,382		$	9,983				$	72,365
Adjusted EBITDA(6)		17,614			3,714					21,328			15,484			4,264					19,748
Amortization of intangibles and depreciation expense		18,746			1,235					19,981			19,205			1,346					20,551
Amortization of deferred costs in excess of deferred revenues		3,293			928					4,221			2,693			997					3,690
Operating income (loss)		(4,425		)	1,551					(2,874		)	(6,414		)	1,921					(4,493		)
Expenditures for property		1,182			209					1,391			1,834			491					2,325
Investment in new accounts, net		4,828			1,004					5,832			6,894			1,340					8,234

 

(1)  Includes allocation of holding company expenses reducing Adjusted EBITDA by $5.8 million and $5.0 million for the nine months ended September 30, 2003 and 2002, respectively.

(2)  Includes allocation of holding company expenses reducing Adjusted EBITDA by $1.5 million and $1.1 million for the nine months ended September 30, 2003 and 2002, respectively.

(3)  Adjustment to eliminate inter-segment accounts receivable.

(4)  Includes allocation of holding company expenses reducing Adjusted EBITDA by $2.0 million and $1.2 million for the three months ended September 30, 2003 and 2002, respectively.

(5)  Includes allocation of holding company expenses reducing Adjusted EBITDA by $0.5 million and $0.3 million for the three months ended September 30, 2003 and 2002, respectively.

(6)  Adjusted EBITDA does not represent cash flow from operations as defined by generally accepted accounting principles, should not be construed as an alternative to operating income and is indicative neither of operating performance nor cash flows available to fund the cash needs of Protection One. Items excluded from Adjusted EBITDA are significant components in understanding and assessing the financial performance of Protection One. Protection One believes presentation of Adjusted EBITDA enhances an understanding of financial condition, results of operations and cash flows because Adjusted EBITDA is used by Protection One to satisfy its debt service obligations and its capital expenditure and other operational needs, as well as to provide funds for growth. In addition, Adjusted EBITDA is used by senior lenders and subordinated creditors and the investment community to determine the current borrowing capacity and to estimate the long-term value of companies with recurring cash flows from operations. Protection One’s computation of Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. The following table provides a calculation of Adjusted EBITDA for each of the periods presented above.

 

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		Nine Months Ended September 30,
		2003									2002
		(amounts in thousands)
		North America			Multifamily			Consolidated			North America			Multifamily			Consolidated
Income (loss) from continuing operations before income taxes		$	(39,324	)	$	8		$	(39,316	)	$	(363,424	)	$	(819	)	$	(364,243	)
Plus:
Interest expense		25,754			3,739			29,493			28,316			3,909			32,225
Amortization of intangibles and depreciation expense		56,615			3,680			60,295			58,026			3,981			62,007
Amortization of deferred costs in excess of deferred revenues		9,452			3,046			12,498			11,678			4,035			15,713
Loss on Impairment								—			338,104			—			338,104
Less:
Gain on retirement of debt		—			—			—			(19,285		)	—			(19,285		)
Other non-recurring income		(2,073		)	—			(2,073		)	(667		)	—			(667		)
Adjusted EBITDA		$	50,424		$	10,473		$	60,897		$	52,748		$	11,106		$	63,854

 

 

		Three Months Ended September 30,
		2003									2002
		(amounts in thousands)
		North America			Multifamily			Consolidated			North America			Multifamily			Consolidated
Income (loss) from continuing operations before income taxes		$	(13,381	)	$	324		$	(13,057	)	$	(12,458	)	$	712		$	(11,746	)
Plus:
Interest expense		8,938			1,227			10,165			9,379			1,209			10,588
Amortization of intangibles and depreciation expense		18,746			1,235			19,981			19,205			1,346			20,551
Amortization of deferred costs in excess of deferred revenues		3,293			928			4,221			2,693			997			3,690
Less:
Gain on retirement of debt		—			—			—			(2,551		)	—			(2,551		)
Other non-recurring (income) expense		18			—			18			(784		)	—			(784		)
Adjusted EBITDA		$	17,614		$	3,714		$	21,328		$	15,484		$	4,264		$	19,748

 

8.                                      Income Taxes:

 

The income tax benefit recorded for the nine-month period ended September 30, 2003 is approximately 34% of the pre-tax loss.  This rate represents the expected effective rate for 2003. The Company has a tax sharing agreement with Westar Energy which allows it to be reimbursed for tax deductions utilized by Westar Energy in its consolidated tax return.  If Westar Energy completes its intended disposition of its investment in the Company, the net deferred tax assets, which were $270.1 million at September 30, 2003, might not be realizable and the Company might not be in a position to record a tax benefit for losses incurred.  The Company would be required to record a non-cash charge against income for the portion of its net deferred tax assets it determines not to be realizable. This charge could be material and could have a material adverse effect on the Company’s business, financial condition and results of operations. The amount of deferred taxes increased by approximately $204.0 million upon the recording of impairment charges in the first and fourth quarters of 2002 as discussed above.  In addition, as a result of a sale, the Company would no longer receive payments from Westar Energy for current tax benefits utilized by Westar Energy.  The Company had a receivable balance of $59.0 million and $20.7 million at September 30, 2003 and December 31, 2002, respectively, from Westar Energy related to these tax benefits.  The Company expects to receive $31.7 million from Westar Energy as payment for the tax benefit Westar Energy utilized in its 2002 consolidated income tax return filed in the third quarter of 2003.  However, the KCC has authorized Westar Energy to pay up to $20 million for tax benefits and has required Westar Energy to notify the KCC prior to making any payment in excess of $20 million and Westar Energy has stated that it will request KCC approval to pay any additional amount.  In addition, the Company recently requested payment of the unpaid tax sharing benefits. Westar Energy has stated in its Form 10-Q for the fiscal quarter ended September 30, 2003 that it intends to pay the Company the tax sharing payment on the closing of its proposed sale of its interest in the Company. Westar Energy further stated that, in the event such a transaction is not completed by December 31, 2003, Westar Energy would pay the Company on such date any amounts it has been authorized to pay by the KCC and if necessary, would then initiate a process to seek the KCC’s approval to pay any remaining amounts.  In 2002, the Company received aggregate payments from Westar Energy of $1.7 million.  The loss of these payments would have a material adverse effect on cash flow.

 

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9.                                      Recent Developments:

 

In August of 2003, the Company was notified by the New York Stock Exchange (NYSE) that it was not in compliance with the NYSE’s listing standards, specifically the price of the Company’s stock had fallen below $1 per share.  Under NYSE guidelines, the Company must return to compliance with the continued listing criteria within six months following receipt of the NYSE’s notification, subject to certain NYSE conditions, or the NYSE may delist the Company’s stock from trading on the NYSE.  Although the Company has notified the Exchange that it intends to take action to cure the price condition within the designated time frame, due to the majority shareholder’s pursuit of a sale of its interest in the Company, the Company has not taken any action beyond the prudent management of its business.  Management does not believe (and no assurance can be given) that the Company will be successful in returning to compliance with NYSE continued listing criteria, and avoid being delisted by the NYSE.  Should the Company’s shares cease being traded on the NYSE, the Company believes that its common stock  would not be eligible to trade on any other national securities exchange or Nasdaq and may thereafter trade only in the over-the-counter bulletin board market, if eligible, or “pink sheets”.  Delisting by the NYSE may have a material adverse effect on the trading price of our common stock.

 

In May 2003, the Company received approximately $2.5 million related to the purchase holdback amount from the sale of its Sonitrol business in June 2001.  This was recorded as a gain on sale of assets and is included in other income in the consolidated statement of operations and comprehensive loss.

 

On November 8, 2002 the KCC issued an Order that, among many findings and directives, requested Westar Energy to consider selling its investment in Protection One.  In early 2003, Westar Energy announced that it intends to sell its equity investment in Protection One, and the Company and Westar Energy are currently exploring strategic alternatives for the Company, including the possible sale of the Company.

 

To facilitate this process, the Company’s Board of Directors (the “Board”) formed a Special Committee in January 2003 comprised of independent directors.  The Special Committee has been authorized by the Board to, among other things: (i) monitor the continuing proceeding between Westar Energy and the KCC on behalf of the Company; (ii) monitor Westar Energy’s process with respect to selling its equity investment in the Company; (iii) consider whether it is in the best interests of the Company and all of its stockholders that the Company participate in that sales process and, if so, direct and oversee that participation; (iv) review and evaluate any proposal by Westar Energy to divest its equity investment in the Company, which  will be called a Controlling Stockholder Proposal; (v) determine whether any Controlling Stockholder Proposal is fair to and in the best interests of the Company and all of its stockholders; (vi) determine whether there are strategic alternatives for the Company to any Controlling Stockholder Proposal that would provide a greater benefit to the Company and all of its stockholders than such Controlling Stockholder Proposal; and (vii) determine what action(s), if any, the Company should take in response to any Controlling Stockholder Proposal.

 

In February 2003, the Special Committee announced that it had retained Bear, Stearns & Co. Inc. to serve as its financial advisor.

 

Westar Energy, as part of exploring its strategic alternatives for the Company, engaged an investment banker to conduct a private auction process to sell Westar Energy’s interest in the Company, which Westar Energy desired to sell as part of a sale of the entire Company (including the public shares).  The Special Committee authorized and the Company entered into a letter agreement with Westar Energy pursuant to which the Company agreed to provide confidential information to prospective bidders who executed confidentiality agreements.  In exchange, Westar Energy agreed to inform the Company of the names of bidders and to provide to the Company copies (omitting the bidders’ names) of any written summaries or presentations of bids that were made to Westar Energy’s board of directors involving a minority shares transaction.  As part of the letter agreement, Westar Energy also agreed to give the Company advance notice of any bid involving a minority shares transaction prior to Westar Energy’s execution of a term sheet or definitive agreement or the approval of such a transaction by Westar Energy’s board of directors.  As of

 

22

 

the date hereof, the Company has not received any notification or copies of any such materials, whether required by the letter agreement or otherwise, from Westar Energy.  In October 2003, Westar Energy advised the Board of Directors of the Company that Westar Energy was considering possible bids which would involve only the sale of the Company’s common stock held by Westar Industries and of the debt owed to Westar Industries under the Westar Credit Facility (or only the sale of Westar Industries by Westar Energy).  In addition, Westar Energy informed the Company at that time that the  aggregate consideration in these bids for both the Company common stock held by Westar Industries and the debt owed to Westar Industries was less than the outstanding principal amount of Company debt owed to Westar Industries under the Westar Credit Facility.  Westar Energy in its Form 10-Q for the quarterly period ended September 30, 2003 reduced its estimated net realizable proceeds from a sale of its interests in the Company based on the ranges of value received from multiple potential buyers and announced that there is a substantial risk that, in connection with a sale of its interest in the Company, that Westar Energy may not recover the full outstanding balance of the Westar Credit Facility.

 

If the Westar controlling interest is acquired by one of these bidders, management believes the new majority owner may seek to restructure the Company’s debts.  The Company is not a party to negotiations between Westar Energy and the bidders, although Westar Energy has provided the Company from time to time with general information about the auction process and its status and results including among other matters the names of the bidders and general information regarding ranges of the bidders valuations of the Company.  The Special Committee requested in October, 2003 that Westar Energy provide it with detailed information regarding the bidders and their final bids and other detailed information.  Westar Energy declined to provide the requested detailed information stating that it was confidential and proprietary to Westar Energy and the bidders and that certain of the requested information was not available to Westar Energy. As of the date hereof, the Company does not know (i) whether the information provided to the Company in October 2003 about the bids then being considered continues to be an accurate current description of those bids, or (ii) whether Westar Energy will sell its interests in the Company to any of those bidders or to some other person, nor does the Company know the price or other terms upon which Westar Energy may sell its interests in the Company.  The Company cannot provide any assurances that the Company will have any information relating to these matters prior to Westar Energy publicly disclosing such matters to its securities holders.  Other than as described in Notes 1, 4, 5 and 8, the Company cannot predict the impact on the Company, its stockholders or its creditors of any of these actions by Westar Energy or the disclosure by Westar Energy of its actions relating to these matters.  The Company cannot provide any  assurances regarding what actions a new majority owner of the Company (or a new owner of Westar Industries) may cause the Company to take, including whether a new majority owner would (a) invest sufficient equity capital or provide credit support to meet the Company’s liquidity needs, (b) cause the Company to seek to restructure its debts, (c) cause the Company to seek to reorganize under the federal bankruptcy laws which may involve the possible elimination or cancellation of the current common stock of the Company with little or no value being given to the current stockholders of the Company, and/or (d) cause Westar Industries to transfer its shares of Company common stock to itself or to another entity resulting in a default under the Westar Credit Facility.  The Company does not intend to issue any public announcements regarding Westar Energy’s potential sale of its interests in the Company or to otherwise update the foregoing description for subsequent events regarding its potential sale of its interests in the Company or information it provides to the Company regarding its potential sale of its interest in the Company until either a public announcement by Westar Energy of a transaction or the date of filing of the Company’s next quarterly report.  Stockholders and other security holders or buyers of the Company’s securities or the Company’s other creditors should not assume that material events subsequent to the date of this Form 10-Q have not occurred.

 

10.                               Restatement of 2002 Consolidated Financial Statements:

 

Subsequent to the Company’s filing its Form 10-Q on November 14, 2002 and as reflected in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002, the Company determined it would restate its quarterly financial information for each of the first three quarters of 2002.  Since adopting Staff Accounting Bulletin 101 on January 1, 2000, the Company had capitalized as property and equipment the direct and incremental costs of the electronic security systems (equipment and associated labor) that it installs in homes or businesses and for which the Company retains title.  The Company had amortized this equipment to depreciation expense over the expected life of the customer.  The Company’s North America segment utilized a 10-year accelerated amortization method and its Multifamily segment utilized a 9-year straight line amortization method.  Direct and incremental selling costs in excess of deferred revenues incurred in connection with the installation of these systems were capitalized as deferred customer acquisition cost and amortized over the initial contract term.

 

In connection with most security system installations, the Company also incurs costs related to system enhancements for which title passes to the customer and which are capitalized as deferred customer acquisition costs.

 

Management of the Company determined that the costs capitalized as property and equipment should have been capitalized as deferred customer acquisition costs and included with other such costs and amortized as discussed above.  For the North America segment the initial contract term is typically 3 years for residential customers and 5 years for commercial customers and for the Multifamily segment the initial contract term typically ranges from 5 to 10 years. The impact of this change on the financial results of 2001 and 2000 was not significant and was reflected in the first quarter results of 2002.

 

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As a result of the above restatement, the accompanying condensed consolidated statements of operations for the nine and three months ended September 30, 2002 and the condensed consolidated statement of cash flows for the nine months ended September 30, 2002 have been restated from the amounts previously reported to correct the accounting for the impact of the restatement.  A summary of the affected line items is as follows:

 

Changes to Statements of Operations

 

		Nine Months Ended September 30, 2002
		As Previously Reported(3)			As Restated
		(Dollars in thousands, except per share amounts)
Other revenues		$	13,996		$	14,569
Total revenues		219,008			219,581
Other cost of revenues		13,342			26,749
Total cost of revenues		73,349			86,756
Gross profit		145,659			132,825
Selling expense		17,276			19,938
Amortization and depreciation		66,359			62,007
Total operating expenses		487,036			484,795
Operating loss		(341,377		)	(351,970		)
Loss from continuing operations before income taxes (1)		(353,650		)	(364,243		)
Income tax benefit (1)		126,349			130,338
Loss from continuing operations before accounting change (1)		(226,750		)	(233,905		)
Net loss		$	(773,290	)	$	(780,445	)
Basic and diluted per share information:
Loss from continuing operations (1)		$	(2.31	)	$	(2.38	)
Net loss		$	(7.88	)	$	(7.95	)

 

Changes to Statements of Operations

 

		Three Months Ended September 30, 2002
		As Previously Reported (3)			As Restated
		(Dollars in thousands, except per share amounts)
Other revenues		$	5,212		$	5,558
Total revenues		72,020			72,365
Other cost of revenues		4,955			8,052
Total cost of revenues		24,494			27,592
Gross profit		47,526			44,773
Selling expense		6,473			7,192
Amortization and depreciation		22,170			20,551
Total operating expenses		50,717			49,266
Operating loss		(3,191		)	(4,493		)
Loss from continuing operations before income taxes (1)		(10,444		)	(11,746		)
Income tax benefit (1)		3,747			4,405
Loss from continuing operations before accounting change (1)		(6,146		)	(7,341		)
Net loss		$	(6,061	)	$	(7,256	)
Basic and diluted per share information:
Loss from continuing operations (1)		$	(0.06	)	$	(0.08	)
Net loss		$	(0.06	)	$	(0.08	)

 

24

 

Changes to Statements of Cash Flows

 

		Nine Months Ended September 30, 2002
		As Previously Reported (3)			As Restated
		(In Thousands)
Net loss		$	(773,290	)	$	(780,445	)
Amortization and depreciation		66,359			62,007
Amortization of deferred customer acquisition costs in excess of deferred revenues (2)		216			15,713
Deferred income taxes (1)		(102,705		)	(106,695		)
Purchases of new accounts		(17,372		)	(1,736		)
Deferred customer acquisition costs (2)		$	(16,282	)	$	(31,918	)

 

(1)          Previously reported amounts have been reclassified to conform to the current year presentation resulting from the Company’s adoption of new accounting standards in July 2002 which required gains from extinguishment of debt, previously reported as extraordinary gains, to be reported as other income.

(2)          Previously reported amounts have been reclassified to conform to the current year presentation.

(3)          Previously reported amounts have been adjusted to reflect Protection One Data Services as discontinued operations.

 

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations updates the information provided in and should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2002.

 

Important Matters

 

We have reported annual losses since our inception and Westar Energy has announced that it intends to sell its investment in us.  Additionally, our current primary financing source is through a credit facility with Westar Energy and credit available under such facility has been limited. Payments made to us by Westar Energy are another important source of liquidity for us under the tax sharing agreement. We have evaluated these conditions and events in establishing our operating plans.  In addition, we plan to carefully monitor the level of investment in new customer accounts, continue control of operating expenses, curtail other capital expenditures, if necessary, and if we are not sold, resume efforts to extend or replace the credit facility upon its maturity in January 2005. Management believes, assuming that there is not a transfer in ownership of the shares of Protection One, Inc.’s capital stock owned by Westar Industries or some other form of change of ownership which results in Westar no longer owning, directly or indirectly more that 80% of the voting control of us, that the funds provided from operations and from the Westar Credit Facility, coupled with receipts under the tax sharing agreement, would be sufficient to fund operations throughout 2004.  However, Westar Energy has announced its intention to sell its interest in us.  Completion of a sale by Westar Energy could have a material adverse effect upon our financial position and liquidity and we may need to restructure our indebtedness in an out-of-court proceeding and/or to seek the protection of the federal bankruptcy laws to reorganize.

 

Westar Energy, as part of exploring its strategic alternatives for the Company, engaged an investment banker to conduct a private auction process to sell Westar Energy’s interest in us, which Westar Energy desired to sell as part of a sale of the entire company (including the public shares).  The Special Committee authorized and we entered into a letter agreement with Westar Energy pursuant to which we agreed to provide confidential information to prospective bidders who executed confidentiality agreements.  In exchange, Westar Energy agreed to inform us of the names of bidders and to provide to us copies (omitting the bidders’ names) of any written summaries or presentations of bids that were made to Westar Energy’s

 

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board of directors involving a minority shares transaction.  As part of the letter agreement, Westar Energy also agreed to give us advance notice of any bid involving a minority shares transaction prior to Westar Energy’s execution of a term sheet or definitive agreement or the approval of such a transaction by Westar Energy’s board of directors.  As of the date hereof, we have not received any notification or copies of any such materials, whether required by the letter agreement or otherwise, from Westar Energy.  In October 2003, Westar Energy advised our Board of Directors that Westar Energy was considering possible bids which would involve only the sale of our common stock held by Westar Industries and of the debt owed to Westar Industries under the Westar Credit Facility (or only the sale of Westar Industries by Westar Energy).  In addition, Westar Energy informed us at that time that the aggregate consideration in these bids for both our common stock held by Westar Industries and the debt owed to Westar Industries was less than the outstanding principal amount of our debt owed to Westar Industries under the Westar Credit Facility.  Westar Energy in its Form 10-Q for the quarterly period ended September 30, 2003 reduced its estimated net realizable proceeds from a sale of its interests in us based on the ranges of value received from multiple potential buyers and announced that there is a substantial risk that, in connection with a sale of its interest in us, that Westar Energy may not recover the full outstanding balance of the Westar Credit Facility.

 

If the Westar controlling interest is acquired by one of these bidders, management believes the new majority owner may seek to restructure our debts.  We are not a party to negotiations between Westar Energy and the bidders, although Westar Energy has provided us from time to time with general information about the auction process and its status and results including among other matters the names of the bidders and general information regarding ranges of the bidders valuations of the Company.  The Special Committee requested in October, 2003 that Westar Energy provide it with detailed information regarding the bidders and their final bids and other detailed information.  Westar Energy declined to provide the requested detailed information stating that it was confidential and proprietary to Westar Energy and the bidders and that certain of the requested information was not available to Westar Energy.  As of the date hereof, we do not know (i) whether the information provided to us in October 2003 about the bids then being considered continues to be an accurate current description of those bids, or (ii) whether Westar Energy will sell its interests in us to any of those bidders or to some other person, nor do we know the price or other terms upon which Westar Energy may sell its interests in us.  We cannot provide any assurances that we will have any information relating to these matters prior to Westar Energy publicly disclosing such matters to its securities holders. Other than as described above, we cannot predict the impact on us, our stockholders or our creditors of any of these actions by Westar Energy or the disclosure by Westar Energy of its actions relating to these matters.  We cannot provide any assurances regarding what actions a new majority owner of the Company (or a new owner of Westar Industries) may cause us to take, including whether a new majority owner would (a) invest sufficient equity capital or provide credit support to meet our liquidity needs, (b) cause us to seek to restructure our debts, (c) cause us to seek to reorganize under the federal bankruptcy laws which may involve the possible elimination or cancellation of the current common stock of the Company with little or no value being given to the current stockholders of the Company, and/or (d) cause Westar Industries to transfer its shares of Company common stock to itself or to another entity resulting in a default under the Westar Credit Facility.  We do not intend to issue any public announcements regarding Westar Energy’s potential sale of its interests in us or to otherwise update the foregoing description for subsequent events regarding its potential sale of our interests or information it provides to us regarding its potential sale of our interest until either a public announcement by Westar Energy of a transaction or the date of filing of our next quarterly report.  Stockholders and other security holders or buyers of our securities or the Company’s other creditors should not assume that material events subsequent to the date of this Form 10-Q have not occurred.

 

Overview

 

Protection One is a leading provider of property monitoring services, providing electronic monitoring and maintenance of alarm systems to approximately 1.1 million customers in North America as of September 30, 2003.  Our revenues are generated primarily from recurring monthly payments for monitoring and maintaining the alarm systems that are installed in our customers’ homes and businesses.  We provide our services to residential (both single family and multifamily residences), commercial, and wholesale customers.  The composition of our customer base as of September 30, 2003 and December 31, 2002 is presented in the following table:

 

		Percentage of Total
Market Segment		September 30, 2003		December 31, 2002
Single family and commercial		53.5	%	55.4	%
Wholesale		14.6		13.9
Protection One North America Total		68.1		69.3
Multifamily/Apartment		31.9		30.7
Total		100.0	%	100.0	%

 

Our company is divided into two business segments:

 

Protection One North America, which we refer to as North America, generated approximately $180.2 million, or 86.3%, of our revenues in first nine months of 2003 and is comprised of Protection One Alarm Monitoring, Inc., our core alarm monitoring business, and our wholesale monitoring business, which provides alarm monitoring services to independent alarm companies.

 

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Network Multifamily, which we refer to as Multifamily, generated approximately $28.6 million, or 13.7%, of our revenues in the first nine months of 2003 and is comprised of our alarm monitoring business servicing apartments, condominiums and other multifamily dwellings.

 

Summary of Significant Matters

 

Net Loss.  We incurred a net loss of approximately $26.0 million in the first nine months of 2003.  This net loss reflects a decline in revenues, substantial charges incurred by us for amortization of customer accounts, and interest incurred on indebtedness.  We do not expect to have earnings in the foreseeable future.

 

Impairment Charge Pursuant to New Accounting Rules.  Effective January 1, 2002, we adopted the new accounting standards SFAS No. 142, “Accounting for Goodwill and Other Intangible Assets,” and SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets.”  SFAS No. 142 establishes new standards for accounting for goodwill.  SFAS No. 142 continues to require the recognition of goodwill as an asset, but discontinues amortization of goodwill.  In addition, annual impairment tests must be performed using a fair-value based approach as opposed to an undiscounted cash flow approach required under prior standards.  The completion of the impairment test, based upon a valuation performed by an independent appraisal firm, as of January 1, 2002, indicated that the carrying value of goodwill had been impaired and an impairment charge was recorded as discussed below.

 

SFAS No. 144 establishes a new approach to determining whether our customer account asset is impaired.  The approach no longer permits us to evaluate our customer account asset for impairment based on the net undiscounted cash flow stream obtained over the remaining life of goodwill associated with the customer accounts being evaluated.  Rather, the cash flow stream to be used under SFAS No. 144, is limited to future estimated undiscounted cash flows from assets in the asset group, which include customer accounts, the primary asset of the reporting unit, plus an estimated amount for the sale of the remaining assets within the asset group (including goodwill).  If the undiscounted cash flow stream from the asset group is less than the combined book value of the asset group, then we are required to mark the customer account asset down to fair value, by way of recording an impairment, to the extent fair value is less than its book value.  To the extent net book value is less than fair value, no impairment would be recorded.

 

The new rule substantially reduces the net undiscounted cash flows used for customer account impairment evaluation purposes as compared to the previous accounting rules.  The undiscounted cash flow stream was reduced from the 16 year remaining life of the goodwill to the 9 year remaining life of customer accounts for impairment evaluation purposes.  Using these new guidelines, we determined that there was an indication of impairment of the carrying value of the customer accounts and an impairment charge was recorded as discussed below.

 

To implement the new standards, we engaged an independent appraisal firm to help management estimate the fair values of goodwill and customer accounts.  Based on this analysis, we recorded a net charge of approximately $765.2 million in the first quarter of 2002.  The charge is detailed as follows:

 

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		Goodwill			Customer Accounts			Total
					(in millions)
North America Segment:
Impairment charge - continuing operations		$	509.4		$	338.1		$	847.5
Impairment charge – discontinued operations		2.3			1.9			4.2
Estimated income tax benefit		(65.1		)	(118.4		)	(183.5		)
Net charge		$	446.6		$	221.6		$	668.2
Multifamily Segment:
Impairment charge		$	104.2		$	—		$	104.2
Estimated income tax benefit		(7.2		)	—			(7.2		)
Net charge		$	97.0		$	—		$	97.0
Total Company:
Impairment charge		$	615.9		$	340.0		$	955.9
Estimated income tax benefit		(72.3		)	(118.4		)	(190.7		)
Net charge		$	543.6		$	221.6		$	765.2

 

The impairment charge for goodwill is reflected in the condensed consolidated statement of operations as a cumulative effect of a change in accounting principle.  The impairment charge for customer accounts is reflected in the condensed consolidated statement of operations as an operating cost.  These impairment charges reduce the recorded value of these assets to their estimated fair values at January 1, 2002.

 

We retained an independent appraisal firm and performed an impairment test as of July 1, 2002 (the date selected for our annual impairment test), with the independent appraisal firm providing the valuation of the estimated fair value of our reporting units, and no impairment was indicated.  After regulatory actions (see Note 5, “Related Party Transactions”), including Kansas Corporation Commission, or KCC, Order No. 55, which prompted Westar Energy to advise us that it intended to dispose of its investment in us, the independent appraisal firm was again retained to perform an additional valuation so that we could perform an impairment test as of December 31, 2002. Order No. 55 limited the amount of capital Westar Energy could provide to us which increased our risk profile.  Therefore, we reevaluated our corporate forecast, reducing the amount of capital invested over our forecast horizon and lowered our base monthly recurring revenue to incorporate actual 2002 results, which resulted in a lower valuation than the July 1, 2002 valuation.  We recorded an additional $90.7 million impairment charge, net of  $13.3 million tax, to reflect the impairment of all remaining goodwill of our North America segment in the fourth quarter of 2002.

 

A deferred tax asset in the amount of $190.7 million was recorded in the first quarter of 2002 for the tax benefit shown above and an additional deferred tax benefit of $13.3 million was recorded with the fourth quarter impairment charge.  However, if Westar Energy completes its intended disposal of Protection One, our net deferred tax asset of $270.1 million at September 30, 2003 might not be realizable and we might not be in a position to record a tax benefit for losses incurred.  As a result, we would be required to record a charge against income for the portion of our net deferred tax assets determined not to be realizable. This charge could be material and could have a material adverse effect on our business, financial condition and results of operations.

 

We are required to perform impairment tests for long-lived assets prospectively when we determine that indicators of potential impairment are present.  Goodwill is required to be tested at least annually for impairment.  Declines in market values of our business or the value of our customer accounts that may occur in the future may require additional write-down of these assets in the future. We completed our annual impairment testing during the third quarter of 2003 on our Network Multifamily segment and determined that no additional impairment of goodwill is required as of July 1, 2003.  Our North America

 

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segment has no goodwill and, therefore, did not require testing as of July 1, 2003. No impairment charge was recorded in the first nine months of 2003.

 

Securities and Exchange Commission Inquiry.  We, Westar Energy and its former independent auditor, Arthur Andersen LLP, have been advised by the Staff of the Securities and Exchange Commission that the Staff will be inquiring into the practices of Westar Energy with respect to the restatement of its first and second quarter 2002 financial statements announced in November 2002 and the related announcement that the 2000 and 2001 financial statements of Protection One and Westar Energy would be reaudited.  We are cooperating with the Staff in connection with their inquiry.

 

Amendments to Westar Credit Facility.  We and Westar Industries entered into two separate amendments to the Westar Credit facility in the first nine months of 2003.  The Thirteenth Amendment decreased the maximum capacity of the Westar Credit Facility from $280 million to $228.4 million.  Accordingly, Westar Industries refunded approximately $0.5 million to us in amendment fees.  The Fourteenth Amendment to the Westar Credit Facility, among other things, extended the maturity date of the facility to January 5, 2005 and increased the applicable borrowing rate on Eurodollar borrowings from LIBOR plus 3.75% to LIBOR plus 5.00%.  In June 2003, we paid an amendment fee to Westar Industries in the approximate amount of $0.5 million.

 

Sale of Protection One Europe Trademark.  We entered into an agreement with Westar Industries for rights to our Protection One Europe trademark.  In June 2003 Westar Industries paid us approximately $0.5 million partially as consideration for granting a license to Protection One Europe Holding S.A. to use the Protection One trademark and name in certain European countries.  Revenues from this agreement will be recognized over the life of the licensing agreement.

 

Potential Write Down of Deferred Tax Assets. We have a pro-rata tax sharing agreement with Westar Energy.  Pursuant to this agreement, Westar Energy makes payments to us for current tax benefits utilized by Westar Energy in its consolidated tax return. If Westar Energy completes its intended disposition of its investment in us, our net deferred tax assets, which were $270.1 million at September 30, 2003, might not be realizable and we might not be in a position to record a tax benefit for losses incurred.  We would be required to record a non-cash charge against income for the portion of our net deferred tax assets we determine not to be realizable. This charge could be material and could have a material adverse effect on our business, financial condition and results of operations. The amount of our deferred taxes increased by approximately $204.0 million upon our recording of impairment charges in the first and fourth quarters of 2002 as discussed above.  In addition, as a result of a sale, we would no longer receive payments from Westar Energy for current tax benefits utilized by Westar Energy.  We had a receivable balance of $59.0 million and $20.7 million at September 30, 2003 and December 31, 2002, respectively, from Westar Energy related to tax benefits.  In 2002, we received aggregate payments from Westar Energy of $1.7 million.  The loss of these payments would have a material adverse effect on our cash flow.

 

Retirement of Additional Debt.  In June 2003, we used available cash to purchase $8.4 million of our 6.75% Convertible Senior Subordinated Notes which would have matured in September 2003.  In September 2003 we retired the remaining $1.3 million of our 6.75% Convertible Senior Subordinated Notes.  The notes were purchased at face value and no gain or loss was recorded on the transactions.  In the first nine months of 2002, we purchased from Westar Industries $8.3 million face value of our 13⁵/₈ % bonds for $7.5 million, $59.1 million face value of our 8¹/₈ % bonds for $43.7 million, $2.5 million face value of our 7³/₈ % bonds for $2.2 million, and $14.0 million face value of our 6³/₄ % bonds for $13.4 million for an aggregate purchase of $83.9 million face value of our bonds for $66.8 million.  In addition, we purchased on the open market $9.9 million face value of our 7³/₈ % bonds for $8.7 million, $7.4 million face value of our 8¹/₈ % bonds for $5.7 million, and $1.6 million face value of our 13⁵/₈ % for $1.6 million for an aggregate purchase of $18.9 million face value of our bonds for $16.0 million.  As a result of these transactions, we recognized a gain of approximately $19.3 million in the first nine months of 2002.

 

Share Repurchase.  In the first quarter of 2003, we acquired 2,500 shares of our common stock in open market purchases for $3,400.  No additional shares were acquired in the second or third quarters.  In the

 

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first nine months of 2002, we acquired 1.0 million shares of our common stock for approximately $2.2 million.

 

Recurring Monthly Revenue.  At various times during each year, we measure all of the monthly revenue we are entitled to receive under contracts with customers in effect at the end of the period. Our computation of recurring monthly revenue may not be comparable to other similarly titled measures of other companies and recurring monthly revenue should not be viewed by investors as an alternative to actual monthly revenue, as determined in accordance with generally accepted accounting principles.  We had approximately $20.4 million and $21.3 million of recurring monthly revenue as of September 30, 2003 and 2002, respectively.  The decrease is primarily a result of our net loss of 26,039 customers during the twelve month period ending September 30, 2003.  While the rate of decrease is significantly slower than it was in prior years, we expect this trend will continue until we reduce attrition on the North American retail portfolio of accounts to a level lower than recorded in this reporting period and we have access to the capital needed to invest in creating at least as many accounts as we lose.  Until we are able to reverse this trend, net losses of customer accounts will materially and adversely affect our business, financial condition and results of operations.

 

We believe the presentation of recurring monthly revenue is useful to investors because the measure is used by investors and lenders to value companies such as ours with recurring revenue streams.  The table below reconciles our recurring monthly revenue to revenues reflected on our consolidated statements of operations.

 

		Nine months ended September 30,
		2003			2002
		(in millions)
Recurring Monthly Revenue, or RMR, at 9/30		$	20.4		$	21.3
Amounts excluded from RMR:
Amortization of deferred revenue		0.7			0.3
Other revenues (a)		2.1			2.8
Revenues  (GAAP basis) :
September		23.2			24.4
January – August		185.6			195.2
January – September		$	208.8		$	219.6

 

		Three months ended September 30,
		2003			2002
		(in millions)
Recurring Monthly Revenue, or RMR, at 9/30		$	20.4		$	21.3
Amounts excluded from RMR:
Amortization of deferred revenue		0.7			0.3
Other revenues (a)		2.1			2.8
Revenues  (GAAP basis) :
September		23.2			24.4
July – August		46.6			48.0
July – September		$	69.8		$	72.4

 

(a)  Revenues that are not pursuant to monthly contractual billings.

 

Our recurring monthly revenue includes amounts billable to customers with past due balances which we believe are collectible. We seek to preserve the revenue stream associated with each customer contract, primarily to maximize our return on the investment we made to generate each contract. As a result, we

 

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actively work to collect amounts owed to us and to retain the customer at the same time. In some instances, we may allow up to six months to collect past due amounts, while evaluating the ongoing customer 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 for our North America segment relies primarily on internally generated sales. In June 2001, we notified most of our remaining domestic dealers that we were terminating our dealer arrangements with them and therefore would not be extending or renewing their contracts.  We currently have a salaried and commissioned sales force that utilizes our existing branch infrastructure in approximately 60 markets.  The internal sales program generated 38,107 accounts and 32,715 accounts in the nine months ended September 30, 2003 and 2002, respectively.  Our Multifamily segment also utilizes a salaried and commissioned sales force to produce new accounts.  Customer additions and losses by segment are reflected in the table below:

 

		Nine Months Ended September 30,						Three Months Ended September 30,
		2003			2002			2003			2002
North America Segment (1):
Customer additions		38,557			33,606			13,586			12,660
Customer losses		(61,909		)	(78,696		)	(17,748		)	(24,067		)
Net decrease in account base		(23,352		)	(45,090		)	(4,162		)	(11,407		)
RMR additions		$	1,250,801		$	1,213,537		$	422,023		$	466,731
RMR losses		$	(1,999,319	)	$	(2,835,551	)	$	(689,271	)	$	(815,538	)
Net decrease in RMR		$	(748,518	)	$	(1,622,014	)	$	(267,248	)	$	(348,807	)
Multifamily Segment (2):
Customer additions		20,691			18,989			5,202			6,607
Customer losses		(13,688		)	(15,659		)	(4,129		)	(5,276		)
Net increase in account base		7,003			3,330			1,073			1,331
RMR additions		$	239,852		$	229,573		$	79,368		$	59,566
RMR losses		$	(171,983	)	$	(220,245	)	$	(43,318	)	$	(91,811	)
Net increase (decrease) in RMR		$	67,869		$	9,328		$	36,050		$	(32,245	)

 

(1)          Customer and RMR additions do not include the activity in our wholesale business.  RMR additions include additional RMR for new contracts providing additional services to existing customers.  The net change in wholesale customers and wholesale RMR for each period presented is included in customer losses and RMR losses.  RMR losses also include the net increase or decrease in RMR relating to services already being provided to existing customers.

(2)          RMR additions and RMR losses reflect the net change in RMR related to access control and resident optional contracts.  RMR losses also include changes in RMR on existing customers.

 

We are a partner in a marketing alliance with BellSouth Telecommunications, Inc. to offer monitored security services to the residential, single family market and to small businesses in seventeen of the larger metropolitan markets in the nine-state BellSouth region.  The marketing alliance agreement may be terminated by either party upon 180 days notice or earlier upon the occurrence of certain events.

 

Under this agreement, we operate as “BellSouth Security Systems from Protection One” from our branches in the nine-state BellSouth region.  BellSouth provides us with leads of new owners of single family residences in its territory and of transfers of existing BellSouth customers within its territory.  We follow up on the leads and attempt to persuade them to become customers of our monitored security services.  We also market directly to small businesses.  We pay BellSouth an upfront royalty for each new contract and a recurring royalty based on a percentage of recurring charges. Approximately one-fifth of our new accounts created in the first nine months of 2003 and one-fourth of our new accounts created in the twelve months of 2002 were from this arrangement.

 

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We continually evaluate our customer creation and marketing strategy, including evaluating each respective channel for economic returns, volume and other factors and may shift our strategy or focus, including the elimination of a particular channel.

 

Attrition.  Subscriber attrition has a direct impact on our results of operations since it affects our revenues, amortization expense and cash flow.  We define attrition as a ratio, the numerator of which is the gross number of lost customer accounts for a given period, net of the adjustments described below, and the denominator of which is the average number of accounts for a given period.  In some instances, we use estimates to derive attrition data.  We make adjustments to lost accounts primarily for the net change, either positive or negative, in our wholesale base and for accounts which are covered under a purchase price holdback and are “put” back to the seller.  We reduce the gross accounts lost during a period by the amount of the guarantee provided for in the purchase agreements with sellers.  In some cases, the amount of the purchase holdback may be less than actual attrition experience.  We do not reduce the gross accounts lost during a period by “move in” accounts, which are accounts where a new customer moves into a home installed with our security system and vacated by a prior customer, or “competitive takeover” accounts, which are accounts where the owner of a residence monitored by a competitor requests that we provide monitoring services.

 

Our actual attrition experience shows that the relationship period with any individual customer can vary significantly.  Customers discontinue service with us for a variety of reasons, including relocation, service issues and cost.  A portion of the acquired customer base 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.

 

We monitor attrition each quarter based on a quarterly annualized and trailing twelve-month basis. This method utilizes each segment’s average customer account base for the applicable period in measuring attrition.  Therefore, in periods of customer account growth, customer attrition may be understated and in periods of customer account decline, customer attrition may be overstated.

 

Customer attrition by business segment for the three and twelve months ended September 30, 2003 and 2002 is summarized below:

 

		Customer Account Attrition
		September 30, 2003				September 30, 2002
		Annualized Third Quarter		Trailing Twelve Month		Annualized Third Quarter		Trailing Twelve Month
North America		10.3	%	11.4	%	11.8	%	14.9	%
Multifamily		4.9	%	5.9	%	6.4	%	6.7	%
Total Company		8.6	%	9.7	%	10.2	%	12.6	%

 

The net change in our wholesale base has an impact on the reported attrition results.  Our customer attrition, excluding the net change in our wholesale base, for the three and twelve months ended September 30, 2003 and 2002 is summarized below.

 

		Customer Account Attrition, Excluding Wholesale
		September 30, 2003				September 30, 2002
		Annualized Third Quarter		Trailing Twelve Month		Annualized Third Quarter		Trailing Twelve Month
North America		15.2	%	14.4	%	15.5	%	18.7	%
Multifamily		4.9	%	5.9	%	6.4	%	6.7	%
Total Company		11.4	%	11.3	%	12.3	%	14.9	%

 

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Critical Accounting Policies

 

Our discussion and analysis of results of operations and financial condition are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP.  The preparation of these consolidated financial statements requires us to make estimates and judgments that affect 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 bad debts, inventories, customer accounts, goodwill, income taxes, 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 Consolidated Financial Statements of our 2002 Form 10-K includes a summary of the significant accounting policies and methods used in the preparation of our consolidated financial statements.  The following is a brief description of the more significant accounting policies and methods we use.

 

Revenue and Expense Recognition.  Revenues are recognized when security services are provided. System installation revenues, sales revenues on equipment upgrades and direct and incremental costs of installations and sales are deferred for residential customers with monitoring service contracts.  For commercial customers and our national account customers, revenue recognition is dependent upon each specific customer contract.  In instances when we pass title to a system unaccompanied by a service agreement or we pass title at a price that we believe is unaffected by an accompanying but undelivered service, we recognize revenues and costs in the period incurred.  In cases where we retain title to the system or we price the system lower than we otherwise would because of an accompanying service agreement, we defer and amortize revenues and direct costs.

 

Deferred system and upgrade installation revenues are recognized over the estimated life of the customer utilizing an accelerated method for our residential and commercial customers and a straight-line method for our Multifamily customers.  Deferred costs in excess of deferred revenue are recognized utilizing a straight-line method over the initial contract term, typically two to three years for residential systems, five years for commercial systems and five to ten years for Multifamily systems.  To the extent deferred costs are less than deferred revenues, such costs are recognized over the estimated life of the customer utilizing the same method as with the related deferred revenues.

 

The table below reflects the impact of this accounting policy on the respective line items of the Statement of Operations for the nine months and three months ended September 30, 2003 and 2002.  The “Total Amount Incurred” line represents the current amount of billings that were made and the current costs that were incurred for the period.  We then subtract the deferral amount and add back the amortization of previous deferral amounts to determine the amount we report in the Statement of Operations.

 

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		For the nine months ended September 30,
		2003									2002
		Revenues-other			Cost of revenues other			Selling expense			Revenues-other			Cost of revenues other			Selling expense
		(in thousands)
North America segment:
Total amount incurred		$	23,848		$	27,937		$	26,332		$	23,926		$	29,761		$	24,017
Amount deferred		(13,345		)	(17,449		)	(10,795		)	(11,859		)	(17,341		)	(9,591		)
Amount amortized		3,147			6,334			6,265			1,632			9,501			3,809
Amount included in Statement of Operations		$	13,650		$	16,822		$	21,802		$	13,699		$	21,921		$	18,235
Multifamily segment:
Total amount incurred		$	702		$	4,247		$	2,091		$	709		$	5,035		$	1,821
Amount deferred		(520		)	(4,055		)	(272		)	(465		)	(4,722		)	(264		)
Amount amortized		1,398			4,218			226			626			4,515			146
Amount included in Statement of Operations		$	1,580		$	4,410		$	2,045		$	870		$	4,828		$	1,703
Total Company:
Total amount incurred		$	24,550		$	32,184		$	28,423		$	24,635		$	34,796		$	25,838
Amount deferred		(13,865		)	(21,504		)	(11,067		)	(12,324		)	(22,063		)	(9,855		)
Amount amortized		4,545			10,552			6,491			2,258			14,016			3,955
Amount reported in Statement of Operations		$	15,230		$	21,232		$	23,847		$	14,569		$	26,749		$	19,938

 

		For the three months ended September 30,
		2003									2002
		Revenues-other			Cost of revenues-other			Selling expense			Revenues-other			Cost of revenues-other			Selling expense
		(in thousands )
North America segment:
Total amount incurred		$	8,273		$	9,373		$	8,488		$	8,996		$	11,532		$	9,266
Amount deferred		(4,704		)	(5,982		)	(3,529		)	(4,610		)	(7,059		)	(3,927		)
Amount amortized		1,192			2,315			2,170			672			2,105			1,260
Amount included in Statement of Operations		$	4,761		$	5,706		$	7,129		$	5,058		$	6,578		$	6,599
Multifamily segment:
Total amount incurred		$	233		$	1,111		$	610		$	315		$	1,631		$	587
Amount deferred		(200		)	(1,116		)	(47		)	(184		)	(1,451		)	(66		)
Amount amortized		533			1,385			76			369			1,294			72
Amount included in Statement of Operations		$	566		$	1,380		$	639		$	500		$	1,474		$	593
Total Company:
Total amount incurred		$	8,506		$	10,484		$	9,098		$	9,311		$	13,163		$	9,853
Amount deferred		(4,904		)	(7,098		)	(3,576		)	(4,794		)	(8,510		)	(3,993		)
Amount amortized		1,725			3,700			2,246			1,041			3,399			1,332
Amount reported in Statement of Operations		$	5,327		$	7,086		$	7,768		$	5,558		$	8,052		$	7,192

 

Valuation and Amortization of Customer Account and Goodwill Intangible Assets. Customer accounts are stated at cost, net of accumulated amortization.  Goodwill represents the excess of the purchase price over the fair value of net assets acquired by us.  Goodwill is tested for impairment on at least an annual basis or as circumstances warrant.  Customer accounts are tested on a periodic basis as circumstances warrant.  For purposes of this impairment testing, goodwill is considered to be directly related to the acquired customer accounts.  Factors we consider important that could trigger an impairment review include the following:

 

•                  high levels of customer attrition;

•                  continuing recurring losses above our expectations; and

•                  adverse regulatory rulings.

 

An impairment test of customer accounts would have to be performed when the undiscounted expected future operating cash flows by asset group, which consists primarily of capitalized customer accounts and related goodwill, is less than the carrying value of that asset group.  An impairment would be recognized if the fair value of the customer accounts is less than the net book value of the customer accounts. See

 

34

 

“Summary of Significant Matters — Impairment Charge Pursuant to New Accounting Rules” for a discussion of the impairment recorded on these assets in the first quarter of 2002 pursuant to the adoption of new accounting rules.

 

Customer Account Amortization.  The choice of an amortization life is based on our estimates and judgments about the amounts and timing of expected future revenues from customer accounts and average customer account life.  Selected periods were determined because, in our opinion, they would adequately match amortization cost with anticipated revenue.  We periodically use an independent appraisal firm to perform lifing studies on our customer accounts to assist us in determining appropriate lives of our customer accounts.  These reviews are performed specifically to evaluate our historic amortization policy in light of the inherent declining revenue curve over the life of a pool of customer accounts, and our historical attrition experience.  We have identified the following three distinct pools of customer accounts, each of which has distinct attributes that effect differing attrition characteristics.  For the North America pools, the results of the lifing studies indicated to us that we can expect attrition to be greatest in years one through five of asset life and that a declining balance (accelerated) method would therefore best match the future amortization cost with the estimated revenue stream from these customer pools.

 

Our amortization rates consider the average estimated remaining life and historical and projected attrition rates.  The amortization method for each customer pool is as follows:

 

Pool		Method
North America:
- Acquired Westinghouse Customers		Eight-year 120% declining balance
- Other Customers		Ten-year 135% declining balance
Multifamily		Nine –year straight-line

 

The results of a lifing study performed by a third party appraisal firm in the first quarter of 2002 showed a deterioration in the average remaining life of customer accounts.  The report showed our North America customer pool can expect a declining revenue stream over the next 30 years with an estimated average remaining life of 9 years.  Our Multifamily pool can expect a declining revenue stream over the next 30 years with an estimated average remaining life of 10 years.  Taking into account the results of the lifing study and the inherent expected declining revenue streams for North America and Multifamily, in particular during the first five years, we adjusted the amortization of customer accounts for our North America and Multifamily customer pools to better match the rate and period of amortization expense with the expected decline in revenues.  In the first quarter of 2002, we changed the amortization rate for our North America pool to a 10-year 135% declining balance method from a 10-year 130% declining balance method. The change to this ten year 135% accelerated method, provides for a better matching to the declining revenue stream, in particular during the first five years, where the year over year decline is greatest and a significant portion of the revenue stream is expected to be received. For the Multifamily pool we will continue to amortize on a straight-line basis, utilizing a shorter nine year life. The change to the nine year life straight-line method provides for a better matching to the declining revenue stream, in particular during the first five years, where the decline is greatest and a significant portion of the revenue stream is expected to be received.  We accounted for these amortization changes prospectively beginning January 1, 2002, as a change in estimate.

 

Income Taxes.  As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate.  Significant management judgment is required in determining our provision for income taxes and our deferred tax assets and liabilities.  This process involves us estimating 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.  These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered.  To the extent we believe that recovery is not more likely than not, we must establish a valuation allowance.  No valuation allowance has been established as we follow a parent

 

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---

 

company down approach in the allocation of income tax expense between our parent and others included in the consolidated income tax return and no valuation allowance is necessary at our parent company level.

 

Westar Energy makes payments to us for current tax benefits utilized by Westar Energy in its consolidated tax return pursuant to a tax sharing agreement, which is an important source of liquidity for us.  If Westar Energy completes its intended disposition of its investment in us, our net deferred tax assets, which were $270.1 million at September 30, 2003, might not be realizable and we might not be in a position to record a tax benefit for losses incurred.  We would be required to record a non-cash charge against income for the portion of our net deferred tax assets we determine not to be realizable. This charge could be material and could have a material adverse effect on our business, financial condition and results of operations.  In addition, as a result of a sale, we would no longer receive payments from Westar Energy for tax benefits utilized by Westar Energy.  In 2002 we received aggregate payments from Westar Energy of $1.7 million and our tax receivable at September 30, 2003 is $59.0 million, of which $31.7 million is reflected as current. However, the KCC has authorized Westar Energy to pay up to $20 million for tax benefits and has required Westar Energy to notify the KCC prior to making any payment in excess of $20 million.  Westar Energy has stated in its Form 10-Q for the fiscal quarter ended September 30, 2003 that it intends to pay us the tax sharing payment on the closing of its proposed sale of its interest in us.  Westar Energy further stated that, in the event such a transaction is not completed by December 31, 2003, Westar Energy would pay the Company on such date any amounts it has been authorized to pay by the KCC and if necessary, would then initiate a process to seek the KCC’s approval to pay any remaining amounts.  The loss of these payments would have a material adverse effect on our cash flow.

 

Operating Results

 

We separate our business into two reportable segments: North America and Multifamily.  North America provides security alarm monitoring services, which include sales, installation and related servicing of security alarm systems.  We sold our Canadian operations in July 2002, which previously had been included in our North America segment.  We are therefore excluding the impact of the Canadian operations in the following analyses.  Multifamily provides security alarm services to apartments, condominiums and other multi-family dwellings.

 

Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30, 2002

 

Protection One Consolidated

 

During the first nine months of 2003 compared to the first nine months of 2002, revenues decreased approximately $10.8 million, or 4.9%, to $208.8 million from $219.6 million, respectively, primarily due to the decline in the size of our customer base.  Cost of revenues decreased approximately $10.1 million, or 11.6%, to $76.7 million in the first nine months of 2003 from $86.8 million in the first nine months of 2002, primarily due to a decrease of $3.5 million in amortization of deferred customer acquisition costs, a decrease of $2.5 million in telecommunication costs and a decrease of $2.5 million in service costs.  General and administrative costs decreased approximately $4.8 million, or 7.5%, to $59.9 million in the first nine months of 2003 from $64.7 million in the first nine months 2002, primarily due to decreases of $4.0 million from the cancellation of our Management Services Agreement with Westar Industries, $2.7 million in bad debt expense primarily due to recoveries of written off accounts and improved collection experience on accounts receivable, $1.8 million in charges related to facility closings, and $0.9 million in corporate advertising primarily related to our national advertising sponsorships.  These decreases were partially offset by increases of $4.4 million for the retention bonus accrual and $2.6 million in our director and officer liability insurance premiums.  Selling costs increased approximately $3.9 million, or 19.6% to $23.8 million in the first nine months of 2003 from $19.9 million in the first nine months of 2002, primarily due to increased efforts to generate new customers through our internal sales force and increased amortization of deferred selling costs.  Interest expense decreased by approximately $2.7 million, or 8.5%, to $29.5 million in the first nine months of 2003 from $32.2 million in the first nine months of 2002, primarily due to a reduction in the weighted average interest rate of our variable debt and a reduction of fixed rate debt.  Other income of approximately $2.1 million relates primarily to the receipt in May 2003 of purchase holdback amounts from the sale of our Sonitrol business in June 2001.

 

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North America Segment

 

We present the table below for comparison of our North America operating results for the periods presented. Next to each period’s results of operations, we provide the relevant percentage of total revenues so you can make comparisons about the relative change in revenues and expenses.

 

		Nine Months Ended September 30,
		2003					2002
		(dollars in thousands)
Revenues:
Monitoring and related services		$	166,527		92.4	%	$	177,247		92.8	%
Other		13,650			7.6		13,699			7.2
Total revenues		180,177			100.0		190,946			100.0
Cost of revenues:
Monitoring and related services		49,152			27.3		53,686			28.1
Other		16,822			9.3		21,921			11.5
Total cost of revenues		65,974			36.6		75,607			39.6
Gross profit		114,203			63.4		115,339			60.4
Selling expense		21,802			12.1		18,235			9.5
General and administrative expense		51,429			28.5		56,034			29.3
Amortization of intangibles and depreciation expense		56,615			31.4		58,026			30.4
Loss on impairment		—			—		338,104			177.1
Operating loss		$	(15,643	)	(8.6	)%	$	(355,060	)	(185.9	)%

 

2003 Compared to 2002.  We had a net decrease of 23,352 customers in the first nine months of 2003 as compared to a net decrease of 45,090 customers in the first nine months of 2002.  The average customer base for the first nine months of 2003 and 2002 was 732,110 and 784,229, respectively, or a decrease of 52,119 customers. The number of customers decreased primarily because our customer acquisition strategies were not able to generate accounts in a sufficient volume at acceptable cost to replace accounts lost through attrition.  We expect that this trend will continue until we reduce attrition on the North American retail portfolio of accounts to a level lower than recorded in this reporting period and we have access to the capital needed to invest in creating at least as many accounts as we lose.  Until we are able to reverse this trend, net losses of customer accounts will materially and adversely affect our business, financial condition and results of operations. We believe the decrease in annualized attrition is due to a company wide focus on retaining our current customers, the consolidation of our call centers and the conversion to one common technology platform.  We are currently focused on reducing attrition, developing cost effective marketing programs, and generating positive cash flow.

 

Further analysis of the change in the North American account base between the two periods is discussed below.

 

		Nine Months Ended September 30,
		2003		2002
Beginning Balance, January 1,		743,786		806,774
Additions		38,557		33,606
Customer losses		(58,317	)	(75,504	)
Other (a)		(3,592	)	(3,192	)
Ending Balance, September 30,		720,434		761,684
Annualized attrition		10.6	%	12.8	%

 

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(a) Other consists primarily of customer sites that had no associated recurring revenue, therefore the loss of these accounts does not reduce our recurring monthly revenue.  Other also includes attrited accounts covered by purchase holdbacks.  As of September 30, 2003, we no longer have any accounts covered by purchase holdbacks.

 

Monitoring and related service revenues decreased approximately $10.7 million, or 6.0%, to $166.5 million in the first nine months of 2003  from $177.2 million in the first nine months of 2002, primarily due to the decline in our customer base.  These revenues consist primarily of contractual revenue derived from providing monitoring and maintenance service.

 

Other revenues decreased approximately $0.1 million, or 0.4%, to $13.6 million in the first nine months of 2003 from $13.7 million in the first nine months of 2002.  These revenues consist primarily of revenues generated from our internal installations of new alarm systems, as well as amortization of previously deferred customer acquisition revenue.  Installation revenues consist primarily of sales of burglar alarms, closed circuit televisions, fire alarms and card access control systems to commercial customers.

 

Cost of monitoring and related services revenues for the first nine months of 2003 decreased by $4.5 million, or 8.4%, to $49.2 million from $53.7 million in the first nine months of 2002. The decrease in the first nine months of 2003 compared to the first nine months of 2002 is primarily due to decreases of $2.5 million in both telecommunication and service costs.  Costs of monitoring and related services revenues as a percentage of the related revenues decreased to 29.5% in the first nine months of 2003 from 30.3% in the first nine months of 2002.  These costs generally relate to the cost of providing monitoring service and include the costs of monitoring, billing, customer service and field operations.

 

Cost of other revenues for the first nine months of 2003 decreased approximately $5.1 million, or 23.3%, to $16.8 million compared to $21.9 million for the first nine months of 2002.  These costs as a percentage of other revenues were 123.2% for the first three quarters of 2003 as compared to 160.0% for the first nine months of 2002.  The decrease in 2003 is primarily due to a $3.2 million decrease in amortization of previously deferred customer acquisition costs.  These costs consist primarily of equipment and labor charges to install alarm systems, closed circuit televisions, fire alarms and card access control systems sold to our customers, as well as amortization of previously deferred customer acquisition costs.

 

Selling expenses for the first nine months of 2003 increased $3.6 million, or 19.6%, to $21.8 million from $18.2 million in the first nine months of 2002.  The increase is primarily due to a $2.5 million increase in amortization of previously deferred selling costs.  These costs primarily relate to the cost of maintaining our sales force, including the amortization of previously deferred commissions.  Selling expense also includes the costs of our telesales department and advertising expense.

 

General and administrative expenses in the first nine months of 2003 decreased $4.6 million, or 8.2%, to $51.4 million from $56.0 million in the first nine months of 2002. This decrease is generally comprised of a decrease of $4.0 million due to the termination of our Management Services Agreement with Westar Industries, a $2.4 million decrease in bad debt expense, a $1.8 million decrease in charges related to facility closures, and a $0.9 million decrease in other outside services due to completion of information technology projects.  These decreases were partially offset by an increase in wage expense of which $3.9 million relates to an employee retention plan implemented in the first quarter of 2003 and an increase of $2.6 million in premiums to insurance companies related to director and officer liability insurance.  As a percentage of total revenues, general and administrative expenses decreased in the first nine months of 2003 to 28.5% from 29.3% in 2002.

 

Amortization of intangibles and depreciation expense for the first nine months of 2003 decreased by $1.4 million, or 2.4%, to $56.6 million from $58.0 million in the first nine months of 2002.  This decrease is comprised of a reduction in subscriber amortization expense of $0.2 million and a reduction of $1.2 million in depreciation expense.

 

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Multifamily Segment

 

The following table provides information for comparison of the Multifamily operating results for the periods presented. Next to each period’s results of operations, we provide the relevant percentage of total revenues so that you can make comparisons about the relative change in revenues and expenses.

 

		Nine Months Ended September 30,
		2003					2002
		(dollars in thousands)
Revenues:
Monitoring and related services		$	27,028		94.5	%	$	27,765		97.0	%
Other		1,580			5.5		870			3.0
Total revenues		28,608			100.0		28,635			100.0
Cost of revenues:
Monitoring and related services		6,275			21.9		6,321			22.1
Other		4,410			15.4		4,828			16.8
Total cost of revenues		10,685			37.3		11,149			38.9
Gross profit		17,923			62.7		17,486			61.1
Selling expense		2,045			7.1		1,703			6.0
General and administrative expenses		8,451			29.6		8,712			30.4
Amortization of intangibles and depreciation expense		3,680			12.9		3,981			13.9
Operating income		$	3,747		13.1	%	$	3,090		10.8	%

 

2003 Compared to 2002.  We had a net increase of 7,003 customers in the first nine months of 2003 compared to a net increase of 3,330 customers in the first nine months of 2002.  The average customer base was 333,414 for the first nine months of 2003 compared to 328,214 for the first nine months of 2002.  The change in Multifamily’s customer base for the period is shown below.

 

		Nine Months Ended September 30,
		2003		2002
Beginning Balance, January 1,		329,912		326,549
Additions		20,691		18,989
Customer losses		(13,688	)	(15,659	)
Ending Balance		336,915		329,879
Annualized attrition		5.5	%	6.4	%

 

Monitoring and related services revenues  for the first nine months of 2003 declined $0.8 million, or 2.7%, to $27.0 million compared to $27.8 million in the first nine months of 2002 primarily due to a decline in our RMR per customer and reduced contract buyouts offset by an increase in the average customer base of 1.6%.  The decline in recurring monthly revenue per customer is primarily due to an increasing number of renewals, which provide for contract extensions at a reduced RMR.  These revenues consist primarily of contractual revenue derived from providing monitoring and maintenance service.

 

Other revenues for the first nine months of 2003 increased $0.7 million, or 81.6% to $1.6 million from $0.9 million in the first nine months of 2002 primarily due to an increase in amortization of previously deferred customer revenue of $0.8 million pursuant to Staff Accounting Bulletin (SAB) 101, which requires deferral of revenue over the life of the customer.  Other revenues consist primarily of amortization

 

39

 

of deferred revenue associated with the sale of alarm systems and revenues from the sale of access control systems.

 

Cost of monitoring and related revenues for the first nine months of 2003 remained consistent with 2002 at $6.3 million.  These costs generally relate to the cost of providing monitoring and maintenance service and include the costs of monitoring, customer service and field service.  Cost of monitoring and related revenues as a percentage of related revenues increased to 23.2% in the first nine months of 2003 from 22.8% in the first nine months of 2002.

 

Cost of other revenues for the first nine months of 2003 decreased by $0.4 million, or 8.7%, to $4.4 million from $4.8 million in the first nine months of 2002 primarily due to a decrease in deferred cost amortization totaling $0.3 million. These costs consist principally of amortization of deferred installation costs and the costs to install access control systems.

 

Selling expense in the first nine months of 2003 increased $0.3 million, or 20.1%, to $2.0 million from $1.7 million in the first nine months of 2002 primarily due to higher selling expense amortization of $0.1 million pursuant to SAB 101 and higher advertising costs.

 

General and administrative expenses for the first nine months of 2003 decreased $0.2 million, or 3.0%, to $8.5 million from $8.7 million in the first nine months of 2002.  This decrease is primarily due to lower insurance costs totaling $0.2 million, a $0.2 million decline in bad debt expense, and a $0.2 million decrease in legal costs, offset by a $0.6 million increase in employment costs primarily related to an employee retention plan and a $0.3 million increase in management fees allocated from Protection One.

 

Amortization of intangibles and depreciation expense for the first nine months of 2003 decreased by $0.3 million, or 7.6%, to $3.7 million from $4.0 million in the first nine months of 2002.  This decline is primarily due to a reduction in subscriber intangibles related to the settlement and contract buyout in late 2002 of significant units under contract with one developer.

 

Three Months Ended September 30, 2003 Compared to Three Months Ended September 30, 2002

 

Protection One Consolidated

 

Revenues decreased approximately $2.6 million in the third quarter of 2003, or 3.6%, to $69.8 million from $72.4 million in the third quarter of 2002, primarily due to the decline in the size of our customer base.  Cost of revenues decreased approximately $2.3 million, or 8.2%, to $25.3 million in the third quarter of 2003 from $27.6 million in the third quarter of 2002 primarily due to a decrease of $0.9 million in telecommunication costs and a decrease of $0.8 million in service costs.  General and administrative costs decreased approximately $2.0 million, or 9.1% to $19.5 million in the third quarter of 2003 from $21.5 million in the third quarter of 2002 primarily due to decreases of $1.3 million from the cancellation of our Management Services Agreement with Westar Industries, $1.0 million in charges related to facility closures and, $0.6 million in bad debt expense primarily related to recoveries of previously written off accounts and improved collection experience on accounts receivable.  These decreases were partially offset by increases of $1.8 million for the retention bonus accrual and $0.7 million in our insurance premiums.  Selling costs increased approximately $0.6 million, or 8.0% to $7.8 million in the third quarter of 2003 from $7.2 million in the third quarter of 2002 primarily due to increased efforts to generate new customers through our internal sales force.  Interest expense decreased by approximately $0.4 million, or 4.0% to $10.2 million in the third quarter of 2003 from $10.6 million in the third quarter of 2002 primarily due to a reduction in our outstanding debt balances partially offset by an increase in the weighted average interest rate of our variable debt.

 

North America Segment

 

We present the table below for comparison of our North America operating results for the periods presented. Next to each period’s results of operations, we provide the relevant percentage of total revenues so you can make comparisons about the relative change in revenues and expenses.

 

40

 

		Three Months Ended September 30,
		2003					2002
		(dollars in thousands)
Revenues:
Monitoring and related services		$	55,335		92.1	%	$	57,324		91.9	%
Other		4,761			7.9		5,058			8.1
Total revenues		60,096			100.0		62,382			100.0
Cost of revenues:
Monitoring and related services		16,101			26.8		17,546			28.1
Other		5,706			9.5		6,578			10.6
Total cost of revenues		21,807			36.3		24,124			38.7
Gross profit		38,289			63.7		38,258			61.3
Selling expense		7,129			11.9		6,599			10.6
General and administrative expense		16,839			28.0		18,868			30.2
Amortization of intangibles and depreciation expense		18,746			31.2		19,205			30.8
Operating loss		$	(4,425	)	(7.4	)%	$	(6,414	)	(10.3	)%

 

2003 Compared to 2002.  We had a net decrease of 4,162 customers in the third quarter of 2003 as compared to a net decrease of 11,407 customers in the third quarter of 2002.  The average customer base for the third quarter of 2003 and 2002 was 722,515 and 767,388, respectively, or a decrease of 44,873 customers. The number of customers decreased primarily because our customer acquisition strategies were not able to generate accounts in a sufficient volume at acceptable cost to replace accounts lost through attrition.  We expect that this trend will continue until we reduce attrition on the North American retail portfolio of accounts to a level lower than recorded in this reporting period and we have access to the capital needed to invest in creating at least as many accounts as we lose.  Until we are able to reverse this trend, net losses of customer accounts will materially and adversely affect our business, financial condition and results of operations. We believe the decrease in annualized quarterly attrition is due to a company wide focus on retaining our current customers, the consolidation of our call centers and the conversion to one common technology platform.  We are currently focused on reducing attrition, developing cost-effective marketing programs, and generating positive cash flow.

 

Further analysis of the change in the North American account base between the two periods is discussed below.

 

		Three Months Ended September 30,
		2003		2002
Beginning Balance, July 1,		724,596		773,091
Additions		13,586		12,660
Customer losses		(18,541	)	(22,676	)
Other (a)		793		(1,391	)
Ending Balance, September 30,		720,434		761,684
Annualized quarterly attrition		10.3	%	11.8	%

 

(a) Other consists primarily of customer sites that had no associated recurring revenue, therefore the loss of these accounts does not reduce our recurring monthly revenue.  Other also includes attrited accounts covered by purchase holdbacks.  As of September 30, 2003, we no longer have any accounts covered by purchase holdbacks.

 

41

 

Monitoring and related service revenues for the third quarter of 2003 decreased approximately $2.0 million, or 3.5%, to $55.3 million from $57.3 million in the third quarter of 2002 primarily due to the decline in our customer base.  These revenues consist primarily of contractual revenue derived from providing monitoring and maintenance service.

 

Other revenues for the third quarter of 2003 decreased by approximately $0.3 million, or 5.9%, to $4.8 million from $5.1 million in the third quarter of 2002 due to lower outright commercial sale revenue, partially offset by an increase in the amortization of previously deferred customer revenue.  Other revenues consist primarily of revenues generated from our internal installations of new alarm systems, as well as amortization of previously deferred customer acquisition revenue.  Installation revenues consist primarily of sales of burglar alarms, closed circuit televisions, fire alarms and card access control systems to commercial customers.

 

Cost of monitoring and related services revenues for the third quarter of 2003 decreased by $1.4 million, or 8.2%, to $16.1 million from $17.5 million for the third quarter of 2002.  The decrease in the third quarter of 2003 compared to the third quarter of 2002 is primarily due to decreases in telecommunication and service costs of $0.9 million and $0.8 million, respectively.  Costs of monitoring and related services revenues as a percentage of the related revenues decreased to 29.1% in the third quarter of 2003 from 30.6% in the third quarter of 2002.  These costs generally relate to the cost of providing monitoring service and include the costs of monitoring, billing, customer service and field operations.

 

Cost of other revenues for the third quarter of 2003 decreased approximately $0.9 million, or 13.3%, to $5.7 million from $6.6 million in the third quarter of 2002.  These costs as a percentage of other revenues were 119.8% for the third quarter of 2003 as compared to 130.1% for the third quarter of 2002.  The decrease in 2003 is primarily due to lower outright commercial sales, partially offset by an increase in amortization of previously deferred customer acquisition costs.  These costs consist primarily of equipment and labor charges to install alarm systems, closed circuit televisions, fire alarms and card access control systems sold to our customers as well as amortization of previously deferred customer acquisition costs.

 

Selling expenses for the third quarter of 2003 increased $0.5 million, or 8.0% to $7.1 million from $6.6 million in the third quarter of 2002.  The increase is generally due to an increased emphasis on internal sales generation and the resulting increase in sales commissions, wages, benefits, and support costs as well as an increase in the amortization of previously deferred commissions.  These costs primarily relate to the cost of maintaining our sales force, including the amortization of previously deferred commissions.  Selling expense also includes the costs of our telesales department and advertising expense.

 

General and administrative expenses for the third quarter of 2003 decreased $2.1 million, or 10.8%, to $16.8 million from $18.9 million in the third quarter of 2002.  This decrease is generally comprised of a decrease of $1.3 million due to the termination of our Management Services Agreement with Westar Industries, a $1.0 million decrease in expense related to facility closures, a $0.8 million decrease in professional and other outside services due to completion of special projects and fewer legal fees and, a $0.6 million decrease in bad debt expense offset by an increase in wage and related expense of $2.5 million primarily related to an employee retention plan implemented in the first quarter of 2003 and an increase in premiums paid to insurance companies of $0.7 million primarily due to an increase in director and officer liability insurance.  As a percentage of total revenues, general and administrative expenses were approximately 28.0% and 30.2% the third quarter of 2003 and 2002, respectively.

 

Amortization of intangibles and depreciation expense for the third quarter of 2003 decreased by $0.5 million, or 2.4%, to $18.7 million from $19.2 million in the third quarter of 2002.  This decrease is comprised of a reduction in subscriber amortization expense of $0.1 million and a reduction of $0.4 million in depreciation expense.

 

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Multifamily Segment

 

The following table provides information for comparison of the Multifamily operating results for the periods presented. Next to each period’s results of operations, we provide the relevant percentage of total revenues so that you can make comparisons about the relative change in revenues and expenses.

 

		Three Months Ended September 30,
		2003					2002
		(dollars in thousands)
Revenues:
Monitoring and related services		$	9,096		94.1	%	$	9,483		95.0	%
Other		566			5.9		500			5.0
Total revenues		9,662			100.0		9,983			100.0
Cost of revenues:
Monitoring and related services		2,137			22.1		1,994			20.0
Other		1,380			14.3		1,474			14.8
Total cost of revenues		3,517			36.4		3,468			34.8
Gross profit		6,145			63.6		6,515			65.2
Selling expense		639			6.6		593			5.9
General and administrative expenses		2,720			28.2		2,655			26.6
Amortization of intangibles and depreciation expense		1,235			12.8		1,346			13.5
Operating income		$	1,551		16.0	%	$	1,921		19.2	%

 

2003 Compared to 2002.  We had a net increase of 1,073 customers in the third quarter of 2003 as compared to a net increase of 1,331 customers in the third quarter of 2002.  The average customer base was 336,379 for the third quarter of 2003 compared to 329,214 for the third quarter of 2002.  The change in Multifamily’s customer base for the period is shown below.

 

		Three Months Ended September 30,
		2003		2002
Beginning Balance, July 1,		335,842		328,548
Additions		5,202		6,607
Customer losses		(4,129	)	(5,276	)
Ending Balance		336,915		329,879
Annualized quarterly attrition		4.9	%	6.4	%

 

Monitoring and related services revenues for the third quarter of 2003 declined $0.4 million, or 4.1%, to $9.1 million compared to $9.5 million in the third quarter of 2002. The decrease was the result of a decline in revenue related to contract buyouts and a decline in our recurring monthly revenue per customer primarily related to an increasing number of renewals, which provide for contract extensions at a reduced monthly rate.  This decline was offset by an increase in the average customer base of 2.2%. These revenues consist primarily of contractual revenue derived from providing monitoring and maintenance service.

 

Other revenues for the third quarter of 2003 increased $0.1 million, or 13.2% to $0.6 million from $0.5 million in the third quarter of 2002 primarily due to an increase in amortization of previously deferred customer revenue of $0.2 million pursuant to SAB 101, which requires deferral of revenue over the life of

 

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the customer.  These revenues consist primarily of amortization of deferred revenue associated with the sale of alarm systems and revenue from the sale of access control systems.

 

Cost of monitoring and related revenues for the third quarter of 2003 increased $0.1 million, or 7.2%, to $2.1 million from $2.0 million in the third quarter of 2002.  The increase in the third quarter of 2003 compared to the third quarter of 2002 is primarily the result of an increase in field service costs.  Cost of monitoring and related revenues as a percentage of related revenues increased to 23.5% in the third quarter of 2003 from 21.0% in the third quarter of 2002 primarily due to the decline in revenue related to contract buyouts.  These costs generally relate to the cost of providing monitoring and maintenance service and include the costs of monitoring, customer service and field operations.

 

Cost of other revenues  for the third quarter of 2003 decreased $0.1 million, or 6.4%, to $1.4 million from $1.5 million in the third quarter of 2002 primarily due to a $0.2 million decrease in access control system installations.  These costs consist primarily of amortization of deferred installation costs and the costs to install access control systems.

 

Selling expense for the third quarter of 2003 remained the same at $0.6 million compared to the third quarter of 2002.

 

General and administrative expenses for the third quarter of 2003 and 2002 were $2.7 million.  The decline in legal costs of $0.1 million and lower telecom expense of $0.1 million was offset by a $0.1 million increase in management fees allocated from Protection One and increased employment costs of $0.2 million primarily related to an employee retention plan.

 

Amortization of intangibles and depreciation expense for the third quarter of 2003 decreased by $0.1 million, or 8.2% to $1.2 million from $1.3 million in the third quarter of 2002.  This decline is primarily due to a reduction in subscriber intangibles resulting from the settlement and contract buyout in late 2002 of significant units under contract with one developer.

 

Liquidity and Capital Resources

 

Westar Energy, which owns 88% of our common stock, is also our principal source of the external capital we need to operate our business through a credit facility and through payments made under a tax sharing agreement.  Westar Energy has filed a plan with the KCC in response to an order issued by the KCC to restructure and reduce debt.  In that plan, Westar Energy announced its intention to sell its investment in us.  The orders entered by the KCC regarding Westar Energy could and Westar’s Energy’s consummation of its announced plan to sell its ownership interest in us would have a material adverse effect upon our liquidity.

 

We obtain most of our external cash requirements under the $228.4 million Westar Credit Facility which expires January 5, 2005.  As of September 30, 2003, we had $12.9 million available to us under the Westar Credit Facility and $16.0 million of cash.  In prior years, we also have obtained funds from a tax sharing agreement with Westar Energy.

 

The KCC has ordered Westar Energy not to extend any credit to us except under the Westar Credit Facility, and has authorized Westar Energy to provide funds to meet its obligations under the Westar Credit Facility and to extend the term of the Westar Credit Facility for one year to January 5, 2005.  Additionally, the KCC ordered that the Westar Credit Facility must be paid in full upon the sale of all or a majority of our common stock to a new owner. During the second quarter of 2003, the Westar Credit Facility was amended to extend the maturity date to January 5, 2005.  KCC orders also preclude us from raising money through the sale of assets in excess of $100,000 without prior KCC approval.  We have in the past few years tried to obtain a line of credit from third party sources, but have been unable to do so.

 

Under the tax sharing agreement we expect to receive $31.7 million from Westar Energy as payment for the tax benefit Westar Energy utilized in its 2002 consolidated income tax return filed in the third quarter of 2003.  However, the KCC has authorized Westar Energy to pay up to $20 million for tax benefits and has

 

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required Westar Energy to notify the KCC prior to making any payment in excess of $20 million.  Westar Energy has stated that it will request KCC approval to pay any additional amount.  In addition, we recently requested payment of the unpaid tax sharing benefits. Westar Energy has stated in its Form 10-Q for the fiscal quarter ended September 30, 2003 that it intends to pay us the tax sharing payment on the closing of its proposed sale of its interest in us. Westar Energy further stated that, in the event such a transaction is not completed by December 31, 2003, Westar Energy would pay us on such date any amounts it has been authorized to pay by the KCC and if necessary, would then initiate a process to seek the KCC’s approval to pay any remaining amounts.  We cannot predict whether the KCC would attempt to prohibit Westar Energy from making any payments to us in excess of $20 million under the tax sharing agreement.

 

Westar Energy, as part of exploring its strategic alternatives for the Company, engaged an investment banker to conduct a private auction process to sell Westar Energy’s interest in us, which Westar Energy desired to sell as part of a sale of the entire company (including the public shares).  The Special Committee authorized and we entered into a letter agreement with Westar Energy pursuant to which we agreed to provide confidential information to prospective bidders who executed confidentiality agreements.  In exchange, Westar Energy agreed to inform us of the names of bidders and to provide to us copies (omitting the bidders’ names) of any written summaries or presentations of bids that were made to Westar Energy’s board of directors involving a minority shares transaction.  As part of the letter agreement, Westar Energy also agreed to give us advance notice of any bid involving a minority shares transaction prior to Westar Energy’s execution of a term sheet or definitive agreement or the approval of such a transaction by Westar Energy’s board of directors.  As of the date hereof, we have not received any notification or copies of any such materials, whether required by the letter agreement or otherwise, from Westar Energy.  In October 2003, Westar Energy advised our Board of Directors that Westar Energy was considering possible bids which would involve only the sale of our common stock held by Westar Industries and of the debt owed to Westar Industries under the Westar Credit Facility (or only the sale of Westar Industries by Westar Energy).  In addition, Westar Energy informed us at that time that the aggregate consideration in these bids for both our common stock held by Westar Industries and the debt owed to Westar Industries was less than the outstanding principal amount of our debt owed to Westar Industries under the Westar Credit Facility.  Westar Energy in its Form 10-Q for the quarterly period ended September 30, 2003 reduced its estimated net realizable proceeds from a sale of its interests in us based on the ranges of value received from multiple potential buyers and announced that there is a substantial risk that, in connection with a sale of its interest in us, that Westar Energy may not recover the full outstanding balance of the Westar Credit Facility.

 

If the Westar controlling interest is acquired by one of these bidders, management believes the new majority owner may seek to restructure our debts.  We are not a party to negotiations between Westar Energy and the bidders, although Westar Energy has provided us from time to time with general information about the auction process and its status and results including among other matters the names of the bidders and general information regarding ranges of the bidders valuations of the Company.  The Special Committee requested in October, 2003 that Westar Energy provide it with detailed information regarding the bidders and their final bids and other detailed information.  Westar Energy declined to provide the requested detailed information stating that it was confidential and proprietary to Westar Energy and the bidders and that certain of the requested information was not available to Westar Energy.  As of the date hereof, we do not know (i) whether the information provided to us in October 2003 about the bids then being considered continues to be an accurate current description of those bids, or (ii) whether Westar Energy will sell its interests in us to any of those bidders or to some other person nor do we know the price or other terms upon which Westar Energy may sell its interests in us.  We cannot provide any assurances that we will have any information relating to these matters prior to Westar Energy publicly disclosing such matters to its securities holders. Other than as described above, we cannot predict the impact on us, our stockholders or our creditors of any of these actions by Westar Energy or the disclosure by Westar Energy of its actions relating to these matters.  We cannot provide any assurances regarding what actions a new majority owner of the Company (or a new owner of Westar Industries) may cause us to take, including whether a new majority owner would (a) invest sufficient equity capital or provide credit support to meet our liquidity needs, (b) cause us to seek to restructure our debts, (c) cause us to seek to reorganize under the federal bankruptcy laws which may involve the possible elimination or cancellation of the current common stock of the Company with little or no value being given to the current stockholders of the Company, and/or (d) cause Westar Industries to transfer its shares of Company common stock to itself or to another entity resulting in a default under the Westar Credit Facility.  We do not intend to issue any public announcements regarding Westar Energy’s potential sale of its interests in us or to otherwise update the foregoing description for subsequent events regarding its potential sale of our interests or information it provides to us regarding its potential sale of our interest until either a public announcement by Westar Energy of a transaction or the date of filing of our next quarterly report.  Stockholders and other security holders or buyers of our securities or the Company’s other creditors should not assume that material events subsequent to the date of this Form 10-Q have not occurred.

 

If Westar Energy and Westar Industries were to no longer collectively own, directly or indirectly more than 50% of the voting control of the Company, then there will be a default under the Westar Credit Facility.  Should such a default exist, we will no longer have the right to borrow under the Westar Credit Facility and the lender(s) can declare the entire unpaid balance of the obligations under the facility immediately due and payable, terminate the commitment to extend credit and take other actions adverse to us.  Acceleration of the Westar Credit Facility would in turn constitute a default under the indentures which govern our debt securities and allow the trustees or our bondholders to also accelerate this indebtedness or take other actions adverse to us.  Westar Energy's sale of its interests in us by selling Westar Industries, would not by itself constitute a default under the Westar Credit Facility as long as Westar Industries continued to own at least 50% of the voting control of the Company.  Apart from whether or not a default occurs under the Westar Credit Facility, the indentures governing all of our debt securities require that following a change in control (such as would occur if Westar Energy completes the sale of its investment in us, or a sale of its investment in Westar Industries) we must offer to repurchase the debt securities in certain circumstances.  The 13⁵/8 % senior subordinated discount notes require us to make a repurchase offer at approximately 101% of the principal amount, plus interest in the event of a change in control.  The 7³/8% senior notes and 8¹/8% senior subordinated notes require us to make a repurchase offer at 101% of the

 

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principal amount, plus interest, in the event of a change in control coupled with two ratings downgrades that were to occur after the date we announced an intent to pursue a transaction that would result in a change in control. As of September 30, 2003, we had outstanding $29.9 million principal amount of the 13⁵/₈% senior subordinated discount notes,  $190.9 million principal amount of the 7³/₈ % senior notes and $110.3 million principal amount of the 8¹/₈ % senior subordinated notes.  We believe that given the liquidity concerns resulting from such an event a two ratings downgrade is likely.  We lack the funds to repay the Westar Credit Facility.  We also lack the funds to repurchase our debt securities. Furthermore, management does not believe that alternative financing could be arranged to pay these debts unless a new majority owner was to make a substantial equity investment in us or otherwise provide substantial credit support to us.  We are not in any discussions with any investors with respect to such equity investment or credit support. Prior efforts by management to obtain additional capital have not been successful and management does not believe that additional equity investment or credit support could be obtained at this time.  Thus, if the Westar Credit Facility and/or the notes become due or are accelerated, such events would have a material adverse effect on our liquidity and financial position.  In addition, upon Westar Energy’s sale of our common stock, we will lose our right to receive reimbursements for future tax losses under tax sharing agreement (see note 8) with Westar Energy.  If not replaced with an alternative source of liquidity, the loss of the tax sharing agreement would have a material adverse effect on our liquidity and financial position.  Our Board of Directors authorized management to explore whether we could retire the Westar Credit Facility absent a refinancing of it.  Management developed such a plan and presented it to both Westar Energy and our Board of Directors.

 

Although at September 30, 2003, we were in compliance with the financial covenants under the Westar Credit Facility and we expect to remain in compliance for the remainder of the year, our ability to borrow under this facility is subject to a number of conditions which must be met at the time of borrowing, including:  (i) there having been no material adverse event; (ii) no default or potential default exists; and (iii) our representations, including one regarding our solvency, are true and correct.  We may not be able to meet some or all of these conditions in light of our financial condition together with the potential sale by Westar Energy of its interests in us, and Westar Energy's disclosure in its Form 10-Q for the quarter ended September 30, 2003, that (a) the reduction by $165.6 million of the likely net realizable proceeds Westar Energy would receive from a sale based on the ranges of value it received from multiple potential buyers and (b) the substantial risk that Westar Energy may not recover the outstanding amount of the Westar Credit Facility upon a sale of its interests in us.  Our inability to borrow under the Westar Credit Facility would have a material adverse effect on our liquidity and financial position.  Our ability to renew an existing eurodollar borrowing under the Westar Credit Facility is also subject to these conditions. All of our outstanding borrowings are currently in eurodollars.  If the outstanding eurodollar borrowings were to renew as prime rate borrowings, which renewal is permitted notwithstanding our possible inability to satisfy the foregoing conditions, we would incur an additional $3.5 million of annual interest expense at existing interest rates.

 

In June 2003 we repurchased $8.4 million in debt that would have matured in September 2003 at book value.  We retired the remaining $1.3 million principal amount of our convertible senior subordinated notes that matured in September 2003.  While we believe we will have adequate cash to meet our needs through 2004 from internally generated sources, the Westar Credit Facility, payments made to us under the tax sharing agreement and from asset sales, factors such as economic conditions, or the inability to obtain required KCC approvals could impair our liquidity.

 

In order to retain the services of numerous employees who may have felt uncertain about the future ownership, management and direction of the company as a result of Westar Energy’s announcement to dispose of its ownership interest in us (see Note 9 to our financial statements), we entered into retention and severance arrangements with approximately 190 employees to provide incentives for such employees to remain with us through the sales process.  On October 31, 2003 we paid approximately $5.1 million to those employees who fulfilled their obligation related to the retention agreement.  Additional severance amounts of approximately $11.0 million may also be paid under these arrangements to those employees, if any, who are terminated following a change in control.  Approximately $1.8 and $4.4 million was expensed in the three and nine months ended September 30, 2003, respectively, related to the retention payment and approximately $0.6 million is expected to be expensed in October 2003.  No amounts have been expensed by us relating to the severance arrangements.  Upon a change in control of the company, an additional approximately $10.5 million will be paid to other key employees.  No amounts have been expensed relating to these additional payments to key employees.  In addition, upon a change in control, customary fees and expenses will be paid to the financial advisor to our Special Committee of the Board of Directors.  We have expensed approximately $0.4 million for legal and other professional fees related to a possible change in control.

 

Operating Cash Flows for the Nine Months Ended September  30, 2003.  Our operations provided a net $29.6 million in cash flow in the first nine months of 2003, a decrease of $1.0 million compared to net cash provided of $30.6 million in the first nine months of 2002 primarily due to a decrease in working capital.

 

Investing Cash Flows for the Nine Months Ended September 30, 2003.  We used a net $19.0 million for our investing activities in the first nine months of 2003.  We received proceeds of $1.4 million from the sale of our AV ONE operations and approximately $2.5 million from the purchase holdback relating to the sale of our Sonitrol business in 2001.  We invested a net $19.0 million in cash to install and acquire new accounts, and $4.2 million to acquire fixed assets.  In the first nine months of 2002, we invested a net $21.3 million in cash to install and acquire new accounts and $5.7 million to acquire fixed assets.

 

Financing Cash Flows for the Nine Months Ended September 30, 2003.  Financing activities provided a net $3.6 million in cash for the first three quarters of 2003 compared to a net use of $24.4 million in cash for financing activities in the first nine months of 2002. We received $11.9 million in the first quarter of 2003 from Westar Energy related to the sale of our Westar Energy securities.  In the first nine months of 2002 we

 

46

 

paid approximately $82.9 million to acquire $102.8 million in face amount of our long term debt and acquired 1,000,000 shares of our outstanding stock for $2.2 million.

 

In the first nine months of 2003, we did not increase our borrowings under the Westar Credit Facility.  At September 30, 2003 the Westar Credit Facility had a weighted average interest rate before fees of 6.1% and an outstanding balance of  $215.5 million.

 

 In the first nine months of 2002, we increased our borrowings under the Westar Credit Facility by $76.5 million.  At September 30, 2002 the Westar Credit Facility had a weighted-average interest rate before fees of 5.6% and an outstanding balance of  $214.0 million.

 

Debt and Equity Repurchase Plans.  We may from time to time purchase our debt and equity securities in the open market or through negotiated transactions.  The timing and terms of purchases, and the amount of debt or equity actually purchased will be determined based on market conditions and other factors.

 

Material Commitments.  We have future, material, long-term commitments made in the past several years in connection with our growth. No assurance can be given that we will be able to meet these commitments. The following reflects these commitments as of September 30, 2003:

 

Debt Security		Maturity Date		Amount
				(in thousands)
Westar Credit Facility		January 2005		$	215,500
Senior Subordinated Discount Notes (a)		June 2005		29,872
Senior Unsecured Notes		August 2005		190,925
Senior Subordinated Notes		January 2009		110,340
Total				$	546,637

 

(a)  Excludes $0.8 million premium which is being amortized to income.

 

We had no off-balance sheet transactions or commitments as of or for the nine months ended September 30, 2003.

 

We have future, material, long-term commitments made in the past several years in connection with our growth.  The following reflects our commitments as of September 30, 2003:

 

At September 30, 2003:		Payment Due by Period
		2003			2004 – 2005			2006 – 2007			Thereafter			Total
		(Dollars in thousands)
Contractual Cash Obligations
Long-term debt		$	—		$	220,797		$	—		$	110,340		$	331,137
Operating leases		2,234			10,694			3,808			1,925			18,661
Unconditional purchase obligations (a)		1,015			2,030			—			—			3,045
Total contractual cash obligations		$	3,249		$	233,521		$	3,808		$	112,265		$	352,843

 

(a)  Contract tariff for telecommunication services.

 

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The table below shows our total commercial commitments and the expected expiration per period:

 

At September 30, 2003:		Amount of Commitment Expiration Per Period
		2003			2004 – 2005			2006 – 2007			Thereafter			Total
		(Dollars in thousands)
Other Commercial Commitments
Line of credit		$	—		$	215,500		$	—		$	—		$	215,500
Standby letters of credit		2,000			—			—			—			2,000
Total commercial commitments		$	2,000		$	215,500		$	—		$	—		$	217,500

 

Most of the long-term debt instruments contain restrictions based on “EBITDA”.  The definition of EBITDA varies among the various indentures and the Westar Credit Facility.  EBITDA is generally derived by adding to income (loss) before income taxes, interest expense and depreciation and amortization expense.  However, under the varying definitions of the indentures, various and numerous additional adjustments are sometimes required.

 

The Westar Credit Facility and the indentures relating to our other indebtedness contain the financial covenants summarized below:

 

Debt Instrument		Financial Covenant
Senior Credit Facility		Total consolidated debt/annualized most recent quarter EBITDA less than 5.75 to 1.0.
		Consolidated annualized most recent quarter EBITDA/latest four fiscal quarters interest expense greater than 2.10 to 1.0
Senior Subordinated Notes		Current fiscal quarter EBITDA/current fiscal quarter interest expense greater than 2.25 to 1.0
Senior Subordinated Discount Notes		Total debt/annualized current quarter EBITDA less than 6.0 to 1.0
		Senior debt/annualized current quarter EBITDA less than 4.0 to 1.0

 

At September 30, 2003, we were in compliance with the covenants under these debt instruments and we expect to remain in compliance for the remainder of the year.  Our ability to borrow is subject to the conditions discussed in the beginning portion of this Management’s Discussion and Analysis of Financial Condition and Results of Operations which we may not be able to satisfy.

 

These debt instruments also restrict our ability to pay dividends to stockholders, but do not otherwise restrict our ability to fund cash obligations.

 

Credit Ratings.  Standard & Poor’s and Moody’s Investors Service are independent credit-rating agencies that rate our debt securities.  On April 2, 2002, Moody’s downgraded its ratings on our outstanding securities due to concerns regarding our leveraged financial condition, the cash investment required to obtain new customers, our attrition experience and our commitment to debt and equity repurchases. Moody’s outlook remained negative citing unresolved operations problems and uncertainty surrounding long-term resolution of our liquidity issues. Upon a change in control of the Company, management believes that a two ratings downgrade would likely occur as discussed above and in Notes 1 and 4 of the Notes to Condensed Consolidated Financial Statements.  As of November 7, 2003, our public debt was rated as follows:

 

		Senior Unsecured Debt		Senior Subordinated Unsecured Debt		Outlook
S & P		B		CCC+		Negative
Moody’s		Caa1		Caa3		Negative

 

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In general, revenue declines and reductions in operating margin leave our credit ratings susceptible to further downgrades which make debt financing more costly and more difficult to obtain on terms which are economically favorable to us.

 

Capital Expenditures.  We anticipate making capital expenditures of approximately $34 million in 2003, consisting of approximately $25 million in customer acquisition costs and $9 million for fixed assets. Of such amounts, we have expended through September 30, 2003 approximately $19 million and $4 million for customer acquisitions and fixed assets, respectively.  Capital expenditures for 2004 and 2005 are expected to be approximately $36 million and $40 million, respectively.  Of these amounts approximately $26 million and $30 million would be used for customer acquisition costs in 2004 and 2005, respectively, with the balance for fixed assets. These estimates are prepared for planning purposes and are revised from time to time.  Actual expenditures for these and possibly other items not presently anticipated will vary from these estimates during the course of the years presented.  If Westar Energy does not sell its ownership interest in us, we believe that our capital requirements will be met through the use of internally generated funds, asset sales (we may not sell assets in excess of $100,000 without KCC approval), the Westar Credit Facility or external financings.  If Westar Energy sells its ownership interest in us, we do not believe there will be sufficient funds from operations to continue as a going concern without a significant equity contribution or credit support from the new majority owner(s).  See “Liquidity and Capital Resources” above.

 

Tax Matters.  Westar Energy makes payments to us for current tax benefits utilized by Westar Energy in its consolidated tax return pursuant to a tax sharing agreement.  If Westar Energy completes its intended disposition of its investment in us, our net deferred tax assets, which were $270.1 million at September 30, 2003, might not be realizable and we might not be in a position to record a tax benefit for losses incurred.  We would be required to record a non-cash charge against income for the portion of our net deferred tax assets we determine not to be realizable. This charge could be material and could have a material adverse effect on our business, financial condition and results of operations. The amount of our deferred taxes increased by approximately $190.7 million upon our recording of an impairment charge in the first quarter of 2002 and approximately $13.3 million in the last quarter of 2002 as discussed above.  In addition, as a result of a sale, we would no longer receive payments from Westar Energy for current tax benefits utilized by Westar Energy.  We had a receivable balance of $59.0 million and $20.7 million at September 30, 2003 and December 31, 2002, respectively, from Westar Energy related to current tax benefits.  However, the KCC has authorized Westar Energy to pay up to $20 million for tax benefits and has required Westar Energy to notify the KCC prior to making any payment in excess of $20 million.  Westar Energy has stated that it will request KCC approval to pay any additional amount.  In addition, we recently requested payment of the unpaid tax sharing benefits.  Westar Energy has stated in its Form 10-Q for the fiscal quarter ended September 30, 2003 that it intends to pay us the tax sharing payment on the closing of its proposed sale of its interest in us. Westar Energy further stated that, in the event such a transaction is not completed by December 31, 2003, Westar Energy would pay us on such date any amounts it has been authorized to pay by the KCC and if necessary, would then initiate a process to seek the KCC’s approval to pay any remaining amounts. We cannot predict whether the KCC would attempt to prohibit Westar Energy from making any payments to us in excess of $20 million under the tax sharing agreement.  In 2002, we received aggregate payments from Westar Energy of $1.7 million.  The loss of these payments would have a material adverse effect on our cash flow.

 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We have not experienced any significant changes in our exposure to market risk since December 31, 2002.  For additional information on our market risk, see Item 7A of the Form 10-K for the year ended December 31, 2002.

 

ITEM 4.  CONTROLS AND PROCEDURES

 

As of September 30, 2003, the end of the period covered by this quarterly report, we, under the supervision and with the participation of our management, including our chief executive officer and the chief financial officer, performed an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures.  Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were (a) effective to ensure that information required to be disclosed by us in reports filed or submitted under the Exchange Act is timely recorded, processed, summarized and reported and (b) include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports filed or submitted under the Exchange Act is accumulated and communicated to management, including its chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.  Our management, including our chief executive officer and chief financial officer, recognize that any set of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving management’s control objectives.  Our management, including our chief executive officer and chief financial officer, believe that, as of September 30, 2003, our disclosure controls and procedures were effective to provide reasonable assurance of achieving management’s control objectives.

 

There was no change in our internal controls over financial reporting that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

 

 

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PART II

 

OTHER INFORMATION

 

ITEM 1.  LEGAL PROCEEDINGS.

 

Information relating to legal proceedings is set forth in Note 6 of the Notes to Consolidated Financial Statements included in Part I of this report, which information is incorporated herein by reference.

 

ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS.

 

None.

 

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

 

None.

 

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS.

 

None.

 

ITEM 5.  OTHER INFORMATION.

 

None.

 

 

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K.

 

(a) Exhibits. The following exhibits are filed with this Quarterly Report on Form 10-Q or incorporated by reference.

 

                                                                             

Exhibit Number		Exhibit Description
10.1		Confidentiality Agreement Side Letter between Protection One, Inc. and Westar Energy, Inc. dated May 21, 2003.
31.1		Certification pursuant to Rule 13a-14 under the Securities Exchange Act of 1934
31.2		Certification pursuant to Rule 13a-14 under the Securities Exchange Act of 1934
32.1		Certification pursuant to Section 906 of the Sarbanes – Oxley Act of 2002

 

(b)          Reports on Form 8-K.  No reports on Form 8-K were filed during the quarter ended September 30, 2003.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrants have duly caused this report to be signed on their behalf by the undersigned thereunto duly authorized.

 

Date:		November 14, 2003		PROTECTION ONE, INC.
				PROTECTION ONE ALARM MONITORING, INC.
				By:	/s/      Darius  G. Nevin
				Darius G. Nevin, Executive Vice President and Chief Financial Officer

 

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