UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

 

FORM 10-Q

 

 

For the quarterly period ended September 30, 2004
or

 

 

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 10, 2004, 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.

 

 

FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q and the materials incorporated by reference herein include “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,” “will,” “should” 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 efforts to implement new financial software, our liquidity and sources of funding and our capital expenditures.  All 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.  We continue to face liquidity problems caused by our significant debt burdens and continuing net losses.  The consummation of the sale of its ownership interests in us by Westar Industries, Inc., a wholly owned subsidiary of Westar Energy, Inc., which we refer to collectively as Westar, our former majority owner that beneficially owned approximately 88% of our common stock, to POI Acquisition, L.L.C. and POI Acquisition I, Inc., entities formed by Quadrangle Capital Partners L.P., Quadrangle Select Partners L.P., Quadrangle Capital Partners-A L.P. and Quadrangle Master Funding Ltd., which we refer to collectively as Quadrangle, and the assignment of Westar’s rights and obligations as the lender under our revolving credit facility to POI Acquisition, L.L.C., resulted in a $285.9 million non-cash charge against our income in the first quarter of 2004 to establish a valuation allowance for deferred tax assets that we believed were not not realizable, and the sale is expected to further materially adversely affect our financial position, results of operations and liquidity.  If we do not consummate the Quadrangle debt restructuring described in this 10-Q, we would likely be forced to seek a different out-of-court debt restructuring and/or seek the protection of federal bankruptcy laws to reorganize our indebtedness, and in connection with any such restructuring or reorganization, the interests represented by currently outstanding shares of our common stock would likely be substantially diluted or cancelled in whole or in part and our creditors may receive less than 100% of the face value of their claims.  Statements made in the Form 10-Q regarding the sale by Westar, the planned Quadrangle debt restructuring and the possible effect of these matters on us also constitute forward-looking statements.  The forward-looking statements included herein are made only as of the date of this report and we undertake no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.  Please refer to “Risk Factors” in our Form 10-K for the year ended December 31, 2003 for more information regarding risks and uncertainties that may cause our actual results to differ materially from the results anticipated in our forward-looking statements.

 

 

Unless the context otherwise indicates, all references in this report to the “Company,” “Protection One,” “we,” “us,” “our” or similar words are to Protection One, Inc., its direct wholly owned subsidiary, Protection One Alarm Monitoring, Inc., 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,				December 31,
		2004				2003
ASSETS
Current assets:
Cash and cash equivalents		$		21,531		$			35,203
Restricted cash		1,781				1,810
Receivables, net of reserve of $5,961 and $6,899 at September 30, 2004 and December 31, 2003, respectively		23,809				23,670
Inventories, net		5,389				6,221
Prepaid expenses		3,210				5,522
Tax receivable from Westar		26,088				26,088
Deferred tax assets		30				33,899
Other		8,557				3,955
Total current assets		90,395				136,368
Property and equipment, net		29,122				31,921
Customer accounts, net		193,302				244,744
Goodwill		41,847				41,847
Deferred tax assets, net of current portion		46				252,411
Tax receivable from Westar, net of current portion		7,933				—
Deferred customer acquisition costs		104,710				94,225
Other		7,663				7,506
Total Assets		$	475,018			$		809,022
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIENCY IN ASSETS)
Current liabilities:
Current portion of long-term debt, including $215,500 due to related parties		$		547,022		$	215,500
Accounts payable		3,396				5,314
Accrued liabilities		31,347				31,258
Deferred revenue		33,592				33,253
Total current liabilities		615,357				285,325
Long-term debt, net of current portion		—				331,874
Deferred customer acquisition revenue		54,191				44,209
Other liabilities		1,835				1,440
Total Liabilities		671,383				662,848
Commitments and contingencies (see Note 6)
Stockholders’ equity:
Preferred stock, $.10 par value, 5,000,000 shares authorized		—				—
Common stock, $.01 par value, 150,000,000 shares authorized, 128,125,584 shares issued at September 30, 2004 and December 31, 2003		1,281				1,281
Additional paid-in capital		1,379,474				1,379,434
Accumulated other comprehensive income		150				78
Deficit		(1,542,658			)	(1,200,007				)
Treasury stock, at cost, 29,842,905 shares at September 30, 2004 and December 31, 2003		(34,612			)	(34,612				)
Total stockholders’ equity (deficiency in assets)		(196,365			)	146,174
Total Liabilities and Stockholders’ Equity (Deficiency in Assets)		$		475,018		$	809,022

 

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,
		2004					2003
Revenues:
Monitoring and related services		$			185,974		$		193,555
Other		15,959					15,230
Total revenues		201,933					208,785
Cost of revenues (exclusive of amortization and depreciation shown below):
Monitoring and related services		52,252					55,427
Other		23,085					21,232
Total cost of revenues		75,337					76,659
Gross profit (exclusive of amortization and depreciation shown below)		126,596					132,126
Operating expenses:
Selling		24,047					23,847
General and administrative		74,535					59,880
Amortization and depreciation		58,881					60,295
Total operating expenses		157,463					144,022
Operating loss		(30,867				)	(11,896				)
Other (income) expense:
Interest expense		20,021					18,821
Related party interest		13,399					10,672
Other		(100				)	(2,073				)
Loss before income taxes		(64,187				)	(39,316				)
Income tax benefit (expense)		(278,464				)	13,346
Net loss		$	(342,651			)	$			(25,970	)
Other comprehensive income:
Unrealized gain on marketable securities		72					—
Comprehensive loss		$	(342,579			)	$	(25,970			)
Basic and diluted per share information:
Net loss per common share		$		(3.49		)	$	(0.26			)
Weighted average common shares outstanding (in thousands)		98,283					98,098

 

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,
		2004				2003
Revenues:
Monitoring and related services		$	62,272			$		64,431
Other		5,256				5,327
Total revenues		67,528				69,758
Cost of revenues (exclusive of amortization and depreciation shown below):
Monitoring and related services		17,918				18,238
Other		7,869				7,086
Total cost of revenues		25,787				25,324
Gross profit (exclusive of amortization and depreciation shown below)		41,741				44,434
Operating expenses:
Selling		8,486				7,768
General and administrative		18,991				19,559
Amortization and depreciation		19,546				19,981
Total operating expenses		47,023				47,308
Operating loss		(5,282			)	(2,874			)
Other (income) expense:
Interest expense		6,734				6,145
Related party interest		4,568				4,020
Other		(17			)	18
Loss before income taxes		(16,567			)	(13,057			)
Income tax benefit (expense)		(85			)	4,393
Net loss		$	(16,652		)	$		(8,664	)
Other comprehensive income:
Unrealized gain on marketable securities		63				—
Comprehensive loss		$	(16,589		)	$	(8,664		)
Basic and diluted per share information:
Net loss per common share		$		(0.17	)	$	(0.09		)
Weighted average common shares outstanding (in thousands)		98,283				98,106

 

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,
		2004			2003
Cash flow from operating activities:
Net loss		$	(342,651	)	$	(25,970	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Gain on sale of branch assets		(76		)	(2,050		)
Amortization and depreciation		58,881			60,295
Amortization of debt costs and premium		523			554
Amortization of deferred customer acquisition costs in excess of amortization of deferred revenues		15,567			12,498
Deferred income taxes		286,398			24,729
Provision for doubtful accounts		486			1,292
Other		(76		)	80
Changes in assets and liabilities, net of effects of acquisitions and dispositions:
Receivables, net		(624		)	3,077
Tax receivable from Westar		(7,933		)	(38,212		)
Other assets		(2,420		)	318
Accounts payable		(2,244		)	(420		)
Deferred revenue		261			(2,841		)
Other liabilities		453			(3,737		)
Net cash provided by operating activities		6,545			29,613
Cash flows from investing activities:
Installations and purchases of new accounts		(14		)	(311		)
Deferred customer acquisition costs		(31,879		)	(32,571		)
Deferred customer acquisition revenues		15,808			13,865
Purchase of property and equipment		(4,826		)	(4,186		)
Sale of AV ONE		—			1,411
Proceeds from disposition of assets		314			2,778
Net cash used in investing activities		(20,597		)	(19,014		)
Cash flows from financing activities:
Payments on long-term debt		—			(10,159		)
Proceeds from sale of trademark		160			450
Debt issue costs		—			74
Proceeds from sale of parent company stock- held as treasury		—			11,940
Purchase of Treasury Stock		—			(3		)
Exercise of stock options and Employee Stock Purchase Plan		—			256
Funding from Westar, as former parent		220			1,027
Net cash provided by financing activities		380			3,585
Net cash provided by discontinued operations		—			229
Net increase (decrease) in cash and cash equivalents		(13,672		)	14,413
Cash and cash equivalents:
Beginning of period		35,203			1,545
End of period		$	21,531		$	15,958
Cash paid for interest		$	37,957		$	34,607
Cash paid for taxes		$	264		$	269

 

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., referred to as 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 includes sales, installation and related servicing of security alarm systems for residential and business customers. On February 17, 2004, the Company’s former majority owner, Westar Industries, Inc., referred to as Westar Industries, a wholly owned subsidiary of Westar Energy, Inc, which together with Westar Industries is referred to as Westar, sold its ownership interests in the Company and assigned its rights and obligations as the lender under the revolving credit facility.  See Note 2, “Change in Majority Owner” for a further discussion of the sale transaction.

 

The Company’s unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles, in the United States, or 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 generally accepted accounting principles have been 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, 2003 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission, or the SEC.

 

See Note 10, “Going Concern and Management’s Plan” for management’s plan regarding liquidity and going concern issues and the Quadrangle debt restructuring.

 

In December 2002, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which amends 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 SFAS No. 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, or 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 options is amortized to expense on a straight-line method over the options’ vesting period.  Under SFAS No. 123, compensation expense would have been $0.6 million and $0.1 million in the nine and three months ended September 30, 2004, respectively and $0.5 million and $0.1 million in the nine and three months ended September 30, 2003, respectively.  Information related to the pro forma impact on earnings and earnings per share follows.

 

 

7

 

 

 

In the opinion of management of the Company, all adjustments considered necessary for a fair presentation of the financial statements have been included. The results of operations for the nine- and three-month periods ended September 30, 2004 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 no stock options or warrants that represent dilutive potential common shares for the three and nine months ended September 30, 2004.  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.  These securities were not included in the computation of diluted earnings per share since to do so would have been antidilutive for all periods presented.

 

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

 

2.     Change in Majority Owner:

 

On February 17, 2004, Westar Industries, Inc., a Delaware corporation, sold approximately 87% of the issued and outstanding shares of the Company’s common stock, par value $0.01 per share to POI Acquisition I, Inc., a wholly owned subsidiary of POI Acquisition, L.L.C.  Both POI Acquisition, L.L.C. and POI Acquisition I, Inc. are entities formed by Quadrangle Capital Partners L.P., Quadrangle Select Partners L.P., Quadrangle Capital Partners-A L.P. and Quadrangle Master Funding Ltd., collectively referred to as Quadrangle.  Westar retained approximately 1% of the Company’s common stock, representing shares underlying restricted stock units granted to current and former employees of Westar.  As part of the sale transaction, Westar Industries also assigned its rights and obligations as the lender under the revolving credit facility to POI Acquisition, L.L.C.  Quadrangle paid approximately $122.2 million to Westar as consideration for both the common stock and the revolving credit facility, including accrued interest of $2.2 million, and Westar received additional consideration related to post-closing events.

 

See Note 4, “Debt” for a discussion of the impact of the change in control on the Company’s outstanding debt, Note 8, “Income Taxes” for a discussion relating to the Company’s tax sharing agreement with Westar and Note 10, “Going Concern and Management’s Plan” for a discussion of recent events relating to the planned Quadrangle debt restructuring.

 

8

 

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):

 

 

Amortization expense was $17.1 million and $51.4 million for the three and nine months ended September 30, 2004, respectively.  Amortization expense was $17.3 million and $51.5 million for the three and nine months ended September 30, 2003, respectively.  The table below reflects the estimated aggregate customer account amortization expense for 2004 and each of the four succeeding fiscal years on the existing customer account base as of September 30, 2004 (in thousands).

 

		2004			2005			2006			2007			2008
Estimated amortization expense		$	68,612		$	52,322		$	51,961		$	45,641		$	20,000

 

There were no changes in the carrying amounts of goodwill for the three or nine months ended September 30, 2004 or 2003.  The Company completed its annual impairment testing during the third quarter of 2004 on its Multifamily segment and determined that no additional impairment of goodwill was required as of July 1, 2004.  The Company’s North America segment has no goodwill and, therefore, did not require testing as of July 1, 2004.  No impairment charge has been recorded in the first nine months of 2004.  If we fail future impairment tests for either goodwill or customer accounts, we will be required to recognize additional impairment charges on these assets in the future.

 

4.     Debt:

 

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

 

		September 30,				December 31,
		2004				2003
Revolving Credit Facility, maturing August 15, 2005, variable, 8.50% at September 30, 2004 (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% (b)		190,925				190,925
Senior Subordinated Discount Notes, maturing June 2005, fixed 13.625% (c)		30,257				30,609
		547,022				547,374
Less current portion (d)		(547,022			)	(215,500		)
Total long-term debt		$		—		$	331,874

(a)   On November 12, 2004 the Company made a $14.5 million principal payment to Quadrangle on the revolving credit facility.  On November 10, 2004 the interest rate on the revolving credit facility increased to 8.75%.

(b)   The Company intends to retire $26.6 million of 7.375% Senior Unsecured notes in connection with the Westar tax sharing settlement.

(c)   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, 2004 and December 31, 2003 was $0.4 million and $0.7 million, respectively.

(d)   See discussion below regarding the potential impact if an event of default and acceleration occurs under the indenture relating to the 13 5/8% senior subordinated discount notes, or if the revolving credit facility is accelerated, on the various debt instruments.

 

9

 

The indenture relating to the 13 5/8% senior subordinated discount notes requires the Company to give notice of its intention to repurchase the notes within 30 days following the date of a change in control and to consummate the repurchase within 60 days of such notification.  Under the terms of this indenture, because the Company did not offer to repurchase such notes following the Westar sale transaction, its inaction constitutes a covenant breach, which breach, if not cured within 30 days after receipt of appropriate notice, would constitute an event of default under the indenture for the 13 5/8% senior subordinated discount notes.

 

Upon any such event of default, the trustee or the holders of such senior subordinated discount notes may seek to exercise certain remedies available to them under the indenture governing the notes, including, without limitation, acceleration of the notes, though the subordination provisions of the indenture restrict the Company’s ability to make any payment to the holders of such notes upon acceleration of such notes in certain circumstances.  The acceleration of the 13 5/8% senior subordinated discount notes, if not rescinded or satisfied, would cause a cross default to be triggered under the indenture for the 8 1/8% senior subordinated notes, which had aggregate outstanding principal of $110.3 million as of September 30, 2004.  If such acceleration and cross default should occur, the Company does not have the funds available to repay the indebtedness, and the Company could be forced to seek relief under the U.S. Bankruptcy Code or an out-of-court restructuring.

 

The $201.0 million outstanding as of November 15, 2004 under the revolving credit facility is in default due to the change in control of Protection One consummated on February 17, 2004 and non-compliance with financial covenants.  The Company has entered into a standstill agreement with Quadrangle, however, pursuant to which, among other things, Quadrangle agreed to waive the change in control default and other specified defaults, and the Company agreed, among other things, that it could not borrow any additional amounts under the revolving credit facility.  Upon the expiration or termination of this standstill agreement, Quadrangle may exercise its rights under the revolving credit facility and declare the indebtedness to be due and payable.  The parties have agreed to extend the standstill agreement until the earlier of the closing date of the Quadrangle debt restructuring, described in Note 10, “Going Concern and Management’s Plan,” or the termination of the exchange agreement, which the Company entered into with Quadrangle on November 12, 2004 and is described in Note 10.  Acceleration of the revolving credit facility, if not rescinded or satisfied, would cause cross defaults under the Company’s other debt instruments.  If such acceleration should occur, the Company does not have the funds available to repay the indebtedness, and the Company could be forced to seek relief under the U.S. Bankruptcy Code or an out-of court restructuring.

 

The indenture relating to the 13 5/8% senior subordinated discount notes required the Company to make a semi-annual interest payment on June 30, 2004, which the Company deferred until July 30, 2004, prior to the expiration of the interest payment grace period.

 

The Company also deferred payment of the semi-annual interest payment that was due on July 15, 2004 on the outstanding $110.3 million aggregate principal amount of its 8 1/8% senior subordinated notes.  On August 13, 2004 the Company paid the semi-annual interest payment on its 8 1/8% senior subordinated notes, prior to expiration of the interest payment grace period.

 

In addition, the Company deferred payment of the quarterly interest payment that was due on June 30, 2004 on the revolving credit facility.  The Company paid such second quarter interest payment on August 16, 2004.  The Company timely paid the third quarter interest payment on the revolving credit facility that was due on September 30, 2004.

 

The indentures relating to the Company’s 8 1/8% senior subordinated notes and to its 13 5/8% senior subordinated discount notes contain certain restrictions, including with respect to its ability to incur debt and pay dividends, based on earnings before interest, taxes, depreciation, and amortization, or EBITDA.  The definition of EBITDA varies among the indentures and the revolving credit facility.  EBITDA is generally derived by adding to income (loss) before income taxes, the sum of interest expense and depreciation and amortization expense, including amortization of deferred customer acquisition costs and deducting amortization of deferred revenues.  However, under the varying definitions of the indentures, additional adjustments are sometimes required.

 

10

 

The Company’s revolving credit facility contains a number of potential events of default, including with respect to financial covenants which it must maintain.  Under the standstill agreement executed with Quadrangle, which the parties have agreed to extend until the earlier of the closing of the Quadrangle debt restructuring or the termination of their exchange agreement, the Company has received a temporary waiver of certain specified defaults if certain conditions are met.

 

The Company’s revolving credit facility and the indentures relating to certain of its other indebtedness contain the financial covenants and tests, respectively, summarized below:

 

Debt Instrument		Financial Covenant and Test
Revolving Credit Facility		Total consolidated debt/annualized most recent quarter EBITDA—less than 5.75 to 1.0 and 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, 2004, the Company was not in compliance with the covenants under the revolving credit facility, described above, and did not meet the tests under the indentures relating to the Company’s ability to incur additional indebtedness or to pay dividends.  As noted above, the Company entered into a standstill agreement with Quadrangle whereby Quadrangle agreed to grant the Company a waiver of certain specified defaults, including failure to comply with these financial covenants, among others, until the earlier of the closing of the Quadrangle debt restructuring or the termination of their exchange agreement, if certain conditions are met.  Continued failure to meet the tests would result in continuing restrictions on the Company’s ability to incur additional indebtedness or to pay dividends, and the event of default under the revolving credit facility could allow the lenders to declare all amounts outstanding immediately due and payable.

 

 If the Company does not consummate the Quadrangle debt restructuring, it would likely be forced to seek a different out-of-court debt restructuring and/or seek the protection of federal bankruptcy laws to reorganize its indebtedness, and in connection with any such restructuring or reorganization, the interests represented by currently outstanding shares of its common stock would likely be substantially diluted or cancelled in whole or in part and its creditors may receive less than 100% of the face value of their claims.  In addition, the Company has significant debt maturities scheduled for 2005 including its revolving credit facility, 7 3/8% senior notes, and 13 5/8% senior subordinated discount notes.  The Company will need to engage in asset sales and/or refinancings in order to satisfy these maturities.  There can be no assurance the Company will successfully complete such asset sales or refinancings.

 

5.     Related Party Transactions:

 

On February 17, 2004, Westar Industries sold approximately 87% of the issued and outstanding shares of the Company and assigned its rights and obligations under the revolving credit facility to Quadrangle.  See the discussion below and in Note 2, “Change in Majority Owner” for additional information relating to the sale transaction.

 

On November 12, 2004, the Company entered into a tax sharing settlement agreement with Westar and Quadrangle that, among other things, settles all of its claims with Westar relating to the tax sharing agreement and settles all claims between Quadrangle and Westar relating to the Westar sale transaction.  Also, on November 12, 2004, the Company entered into an exchange agreement with Quadrangle to restructure a significant portion of its revolving credit facility. See Note 10, “Going Concern and Management’s Plan” for additional information relating to the Westar tax sharing settlement and Quadrangle debt restructuring.

 

Revolving Credit Facility

 

On February 17, 2004, Westar Industries transferred its rights and obligations as lender under the revolving credit facility to Quadrangle pursuant to the sale agreement.  The Company and Quadrangle entered into a standstill agreement, which the parties have agreed to extend until the earlier of the closing of the Quadrangle debt restructuring or the termination of their

 

11

 

exchange agreement, which, among other things, prohibits the Company from making borrowings under the facility and also temporarily prohibits Quadrangle from exercising its remedies under the facility if certain conditions are met.  The Company accrued interest expense of $4.4 million and $12.7 million for the three and nine months ended September 30, 2004, respectively, and made interest payments to Quadrangle of $8.6 million and $12.7 million on borrowings under the facility for the three and nine months ended September 30, 2004.  See Note 4, “Debt” for additional information relating to the revolving credit facility.  Of the $12.7 million interest accrued for the nine months ended September 30, 2004, $2.2 million was recorded prior to the sale of the Company by Westar.

 

On March 23, 2004, the Company and Quadrangle entered into a fifteenth amendment to the revolving credit facility that modified the confidentiality provision in the revolving credit facility.

 

The Company had outstanding borrowings under the revolving credit facility of $215.5 million at December 31, 2003. 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 and nine months ended September 30, 2003, respectively.

 

Tax Receivable Related to Tax Sharing Agreement

 

The Company had a receivable balance of $34.0 million and $26.1 million at September 30, 2004 and December 31, 2003, respectively, relating to a tax sharing agreement with Westar Energy.  In December 2003, the Company received $20.0 million from Westar Energy as partial payment for the tax benefit utilized in its 2002 tax return filed in the third quarter of 2003.  The receivable balance of $26.1 million at December 31, 2003 reflects the balance of the estimated tax benefit to be utilized by Westar Energy in its 2003 consolidated income tax return plus the remainder of the 2002 tax benefit not paid in 2003.  An additional $7.9 million receivable was recorded for the estimated tax benefit generated in the first quarter prior to February 17, 2004 that Westar Energy will likely be able to utilize in its 2004 consolidated income tax return, which will likely be filed in 2005.

 

The Company had been a member of Westar’s consolidated tax group since 1997.  During that time, Westar made payments to the Company for tax benefits attributable to the Company and utilized by Westar in its consolidated tax return pursuant to the terms of a tax sharing agreement.  Following the consummation of the sale of Westar’s ownership interests in the Company, it is no longer a part of the Westar consolidated tax group.

 

 On November 12, 2004, the Company entered into a tax sharing settlement agreement with Westar and Quadrangle that, among other things, settles all of its claims with Westar relating to the tax sharing agreement and settles all claims between Quadrangle and Westar relating to the Westar sale transaction.  In accordance with the Westar tax sharing settlement, among other things, Westar paid the Company approximately $45.9 million in cash and transferred to it 7 3/8% senior notes of the Company, due 2005, with aggregate principal and accrued interest of approximately $27.1 million.  As previously noted, the Company had a receivable balance of $34.0 million at September 30, 2004 relating to the tax sharing agreement with Westar, and the Company expects to record a tax benefit of approximately $39.0 million as a result of the Westar tax sharing settlement.

 

See Note 8, “Income Taxes” for further discussion relating to the tax sharing agreement and the Westar tax sharing settlement.

 

Kansas Corporation Commission

 

On November 8, 2002, the Kansas Corporation Commission, referred to as KCC, 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

 

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

 

On February 25, 2003, the Company entered into a Partial Stipulation and Agreement, which is referred to as 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 revolving credit facility. Additionally, the Reconsideration Agreement provides that, among other things; (a) the maximum borrowing capacity under the revolving 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 revolving 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 revolving 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 revolving credit facility.

 

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

 

On January 2, 2004, Westar Energy and Westar Industries filed a Joint Motion with the KCC to sell Westar Industries’ equity interest in Protection One to Quadrangle.  The Joint Motion also sought to assign Westar Industries’ interest in the revolving credit facility to Quadrangle.  In the alternative, the Joint Motion sought permission for Westar Energy to sell its

 

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shares of stock in Westar Industries to Quadrangle, at which time Westar Industries’ assets and liabilities would consist of the revolving credit facility and equity interest in Protection One.  On February 13, 2004, the KCC approved the Joint Motion.

 

Administrative Services Agreement

 

Westar Energy provides administrative services to the Company pursuant to an agreement, referred to as the administrative services agreement, which includes accounting, tax, audit, human resources, legal, purchasing, facilities services and use of computer systems.  The administrative services agreement will terminate on February 17, 2005, one year after the date of sale of the Company by Westar unless an earlier termination date is mutually agreed upon.  The Company transitioned from using Westar Energy’s human resources application during the third quarter and anticipates completing a transition from Westar Energy’s accounting application by year end.  Charges of approximately $0.8 million and $2.6 million were incurred for the three and nine months ended September 30, 2004, respectively, compared to charges of approximately $1.1 million and $3.4 million for the three and nine months ended September 30, 2003.  The Company had a net balance due to Westar Energy primarily for these services of $0.6 million and $0.3 million at September 30, 2004 and December 31, 2003, respectively.  See Note 6, “Commitments and Contingencies” for more information regarding the administrative services agreement.

 

AV ONE and Protection One Data Services

 

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., referred to as 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.

 

In June 2002, the Company formed a wholly owned subsidiary named Protection One Data Services, Inc. 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.  The approximately 142 Information Technology employees that had accepted employment with PODS were transferred back to their respective companies 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.

 

Quadrangle

 

In addition to interest accrued and paid under the revolving credit facility, discussed above, the Company paid $0.2 million and $0.4 million, respectively, to Quadrangle for legal expenses incurred by Quadrangle for the three and nine months ended September 30, 2004.  The Company has agreed to pay the costs for the financial and legal advisors for both the senior and subordinated debt holders relating to a potential restructuring of the Company’s indebtedness.  See Note 10, “Going Concern and Management’s Plan” for information relating to the planned Quadrangle debt restructuring.

 

6.     Commitments and Contingencies:

 

Litigation

 

Rogers Litigation

 

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, property damage and mental anguish she allegedly

 

14

 

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, or DTPA, negligent misrepresentation, fraud, intentional misconduct and breach of contract.  Relief sought under the complaint (as amended) 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 the potential liability.  The Company’s primary insurance carrier is providing defense of the action, and the Company is reimbursing the primary insurance carrier for the applicable deductible.  The excess carrier is proceeding under a reservation of rights.  Discovery is on-going in this matter.  Mediation sessions were conducted between the parties on August 20 and November 11, 2004, but the parties have so far been unable to resolve the dispute.

 

The trial date, originally scheduled for September 2004, has been continued to late January 2005.  The Company has provided for what is believed to be a reasonable estimate of loss exposure for this matter.  Since the Company believes it has adequate insurance coverage with respect to the potential liability, in the opinion of management, the outcome should not have a material adverse effect upon the Company’s consolidated financial position or results of operations.

 

Dealer Litigation

 

On May 10, 2004, Nashville Burglar Alarm, LLC, a former dealer, filed a demand for arbitration against Monitoring with the American Arbitration Association, or AAA, alleging breach of contract, misrepresentation, breach of implied covenant of good faith, violation of consumer protection statues and franchise law violations.  Nashville Burglar Alarm, along with five other former dealers, was an original plaintiff in a putative class action lawsuit filed against Monitoring in May 1999, in the U.S. District Court for the Western District of Kentucky (Total Security Solutions, Inc., et al. v. Protection One Alarm Monitoring, Inc., Civil Action No. 3:99CV-326-H).  In that matter, the court granted Monitoring’s motion to stay the proceeding pending the individual plaintiffs’ pursuit of arbitration as required by the terms of their dealer agreements, and AAA refused plaintiffs’ motion to require that all of the claims of the plaintiffs be heard collectively.  Since that time, two of the original plaintiffs in the Total Security Solutions case (not including Nashville Burglar Alarm) were either settled by the mutual agreement of the parties, or dismissed by the AAA.  The remaining original plaintiffs in the Total Security Solutions case have not pursued claims in arbitration.

 

Two other dealers (not plaintiffs in the original Total Security Solutions litigation) filed similar claims in arbitration against Monitoring: Beachwood Security and Ira Beer, who is owner of both Security Response Network, Inc. and Homesafe Security, Inc.  Discovery is ongoing in the Beer matter, and the Beachwood matter was dismissed by AAA.

 

The Company believes it has complied with 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 holdbacks and other payments, or based on other theories of liability.  The Company believes it has materially complied with the terms of its contracts with its dealers.  The Company cannot predict the aggregate impact of these potential disputes with its dealers, which could be material.

 

University of New Hampshire Litigation

 

In August 2003, the University of New Hampshire and Dr. Stacia Sower, a professor at the University, filed separate lawsuits against Monitoring in New Hampshire Superior Court (Stacia 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).  The suit arises from 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.  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

 

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warranties and other causes of action.  Both lawsuits seek unspecified monetary damages, although in correspondence received prior to the filing of suit, damages in excess of $1.1 million are alleged.  The University’s lawsuit also seeks rescission of Monitoring’s contract with the university.

 

Both lawsuits were removed to the United States District Court for the District of New Hampshire, and have been consolidated by the court.  The parties have exchanged written discovery and taken numerous depositions.  The parties have also exchanged reports with regard to liability and damage issues, and filed summary judgment motions with regard to specific contractual defenses raised by Monitoring.

 

Monitoring’s liability insurance carrier has been notified of these claims, and is proceeding under a reservation of rights.  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.  Mediation in this matter was conducted on November 8, 2004, but the parties were unable to resolve the dispute at that time.  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.

 

Milstein Litigation

 

On May 20, 2003, Joseph G. Milstein filed a putative class action suit against Monitoring 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 during the term of their contracts if the customer moves from the monitored premises.  The complaint seeks money damages and disgorgement of profits based on several purported causes of action.  On May 29, 2003, the plaintiff added Monitoring as a defendant in the lawsuit.  On October 28, 2003, the Court granted Protection One’s motion to compel arbitration of the dispute pursuant to the terms of the customer contract.

 

The case is now before the AAA.  The parties fully briefed the “Clause Construction” phase of the arbitration, which required the arbitrator to determine, as a threshold matter, whether the arbitration clause in the contract between the parties permits the arbitration to proceed on a class-wide basis.  The Clause Construction hearing was conducted August 10, 2004, and on October 27, 2004, the arbitrator ruled that the arbitration clause permits the plaintiff to proceed on behalf of a class.

 

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

 

Encompass Insurance Subrogation Claim

 

On May 20, 2004, Encompass Insurance Company, as subrogee of Patrick and Ann Hylant, brought suit against Monitoring, two other monitoring companies and the manufacturer of alarm system equipment in the Circuit Court of Michigan, County of Emmet, Case No. 04-8236-N2, alleging improper and faulty installation of the alarm system.  (Encompass Insurance Company, as Subrogee of Patrick and Ann Hylant v. Sunrise of Petoskey, Inc., Protection One Alarm Monitoring, Inc., Ademco Distribution, Inc. and Emergency 24, Inc.).  The suit arises from a fire which purportedly occurred on October 1, 2002 at the Hylant’s residence.  The complaint alleges negligence, breach of implied warranties, breach of contract and gross negligence on the part of the defendants, and seeks damages in excess of $1 million for alleged casualty losses and property damage.  Based on the evidence adduced to date, Monitoring anticipates that it will file a motion for summary disposition seeking a dismissal as to all of plaintiff’s claims against Monitoring.  Counsel has consulted with the Court and anticipates that a hearing on the contemplated motion for summary disposition will be held in December 2004.  Monitoring’s excess carrier is proceeding under a reservation of rights.  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.

 

General Claims and Disputes

 

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

 

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resolution process for addressing these administrative complaints.  The ultimate outcome of such matters cannot presently be determined; however, in the opinion of management, the resolution of such matters will not have a material adverse effect upon the Company’s consolidated financial position or results of operations.

 

Retention Payments and Severance Arrangements Related to Change in Control

 

In order to retain the services of numerous employees who, as a result of Westar’s announcement of its intent to dispose of its ownership interest in the Company, may have felt uncertain about future ownership, management and direction, 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 obligations related to the retention agreements.  Additional severance amounts of approximately $5.2 million may also be paid under these arrangements to those employees, if any, who are terminated following a change in control.  No significant amounts have been expensed by the Company relating to the severance arrangements.

 

An additional approximately $11.0 million was paid to executive management upon the change in control of the Company on February 17, 2004, pursuant to their employment agreements with the Company.  These payments were included in the general and administrative expense of the Company in the first quarter of 2004.

 

In addition, upon the change in control, $3.5 million was expensed and paid to the financial advisor to the Company’s Special Committee of the Board of Directors in the first quarter of 2004.  In February 2004, the Company recorded an expense of $1.6 million for director and officer insurance coverage that lapsed upon the change in control.  The Company expensed approximately $1.2 million for legal and other professional fees related to the change in control for the year ended December 31, 2003, of which approximately $0.7 million was expensed in the first nine months of 2003.

 

New Management Employment Agreements and Key Employee Retention Plan

 

In July and August 2004, the Company’s senior executives entered into new employment agreements to ensure that the Company will have their continued services during and after the period of the Company’s anticipated restructuring.  The previous employment agreements with these senior executives would have expired on or about August 17, 2004.  The new employment agreements supersede and replace these previous employment agreements.

 

 These employment agreements provide for, among other things, minimum annual base salaries, bonus awards, payable in cash or otherwise, and participation in all of the Company’s employee benefit plans and programs in effect for the benefit of senior executives, including stock option, 401(k) and insurance plans, and reimbursement for all reasonable expenses incurred in connection with the conduct of the business of the Company, provided the executive officers properly account for any such expenses in accordance with Company policies.  The employment agreements also contain provisions providing for compensation to the senior executives under certain circumstances after a change in control of the Company and in certain other circumstances.

 

In order to retain the services of senior management and selected key employees who may feel uncertain about the Company’s future ownership and direction due to the ongoing discussions with the Company’s creditors regarding a potential restructuring of the Company’s indebtedness, the Company’s Board of Directors authorized senior management in June 2004 to implement a new key employee retention plan.  The new retention plan applies to approximately 30 senior managers and selected key employees and provides incentives for such individuals to remain with the Company through a restructuring.  These new retention agreements supersede and replace previous retention agreements which provided additional severance upon a change in control.   The aggregate payout under the plan is expected to be approximately $3.9 million. Approximately $0.9 million has been accrued with respect to the new key employee retention plan for the nine months ended September 30, 2004.

 

Debt Restructuring Charges

 

In addition to its own financial and legal advisors, the Company has agreed to pay the costs for the financial and legal advisors for both the senior and subordinated debt holders relating to a potential restructuring of the Company’s indebtedness.  In addition to amounts already paid to the financial and legal advisors, if a

 

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successful restructuring is completed, the Company expects to pay success and other fees to the financial advisors in an aggregate amount of approximately $6.9 million.  For the three and nine months ended September 30, 2004, the Company has expensed $2.1 million and $5.8 million, respectively, relating to these advisors.

 

ATX preferred stock

 

In 1999, the Company sold its Mobile Services division to ATX Technologies, Inc., or ATX, for cash, a note, and shares of preferred stock of ATX.  The Company did not record a carrying value for the preferred shares at that time based on uncertainties regarding realization value.  To the extent ATX has legally available funds, the preferred stock is redeemable at the Company’s option, which could result in a gain of up to approximately $4.4 million.  In response to the Company’s redemption request in August 2004, ATX advised the Company that it did not have legally available funds to redeem the preferred stock.  Gain, if any, from the redemption of the preferred stock will be recorded only upon realization.

 

SEC Inquiry

 

On or about November 1, 2002, the Company, Westar Energy and its former independent auditor, Arthur Andersen LLP, were advised by the Staff of the Securities and Exchange Commission that the Staff would 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 has cooperated and intends to cooperate further with the Staff in connection with any additional information requested in connection with such inquiry.

 

Administrative Services Agreement

 

The Company understands that Westar Energy, Inc. may claim that the Company should reimburse Westar Energy for an allocation of the costs incurred by Westar in the development of the application systems shared with the Company under the administrative services agreement, described in Note 5, “Related Party Transactions—Administrative Services Agreement.”  The Company believes this claim could be for as much as $1.5 million, but the Company does not believe that it is liable for these costs.

 

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, 2003.  The Company manages its business segments based on 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, 2004

(Dollars in thousands)

 

		North America(1)			Multifamily(2)			Adjustments(3)		Consolidated
Revenues		$	173,512		$	28,421				$	201,933
Adjusted EBITDA(4)		54,191			12,352					66,543
Amortization of intangibles and depreciation expense		55,203			3,678					58,881
Amortization of deferred costs in excess of amortization of deferred revenues		11,997			3,570					15,567
Change in control and reorganization costs		21,282			1,680					22,962
Operating income (loss)		(34,291		)	3,424					(30,867		)
Segment assets		456,522			84,739			(66,243	)	475,018
Expenditures for property		4,498			328					4,826
Investment in new accounts, net		13,705			2,380					16,085

 

Nine Months Ended September 30, 2003

(Dollars in thousands)

 

		North America(1)			Multifamily(2)			Adjustments(3)		Consolidated
Revenues		$	180,177		$	28,608				$	208,785
Adjusted EBITDA(4)		55,156			11,001					66,157
Amortization of intangibles and depreciation expense		56,615			3,680					60,295
Amortization of deferred costs in excess of amortization of deferred revenues		9,452			3,046					12,498
Change in control and reorganization costs		4,732			528					5,260
Operating income (loss)		(15,643		)	3,747					(11,896		)
Segment assets		781,976			94,517			(59,840	)	816,653
Expenditures for property		3,517			669					4,186
Investment in new accounts, net		15,210			3,807					19,017

 

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Three Months Ended September 30, 2004

(Dollars in thousands)

 

		North America(1)			Multifamily(2)			Adjustments(3)		Consolidated
Revenues		$	57,647		$	9,881				$	67,528
Adjusted EBITDA(4)		18,412			4,509					22,921
Amortization of intangibles and depreciation expense		18,333			1,213					19,546
Amortization of deferred costs in excess of amortization of deferred revenues		4,379			1,252					5,631
Change in control and reorganization costs		2,889			137					3,026
Operating income (loss)		(7,189		)	1,907					(5,282		)
Expenditures for property		1,934			63					1,997
Investment in new accounts, net		4,929			725					5,654

 

Three Months Ended September 30, 2003

(Dollars in thousands)

 

		North America(1)			Multifamily(2)			Adjustments(3)		Consolidated
Revenues		$	60,096		$	9,662				$	69,758
Adjusted EBITDA(4)		19,287			3,941					23,228
Amortization of intangibles and depreciation expense		18,746			1,235					19,981
Amortization of deferred costs in excess of amortization of deferred revenues		3,293			928					4,221
Change in control and reorganization costs		1,673			227					1,900
Operating income (loss)		(4,425		)	1,551					(2,874		)
Expenditures for property		1,182			209					1,391
Investment in new accounts, net		4,828			1,004					5,832

(1)           Includes allocation of holding company expenses reducing Adjusted EBITDA by $2.4 million and $5.8 million for the nine months ended September 30, 2004 and 2003, respectively and $0.8 million and $2.0 million for the three months ended September 30, 2004 and 2003, respectively.

(2)           Includes allocation of holding company expenses reducing Adjusted EBITDA by $0.6 million and $1.5 million for the nine months ended September 30, 2004 and 2003, respectively and $0.2 million and $0.5 million for the three months ended September 30, 2004 and 2003, respectively.

(3)           Adjustment to eliminate intersegment accounts receivable.

(4)           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, Protection One believes that Adjusted EBITDA is a factor that is typically considered by senior lenders and subordinated creditors and the investment community in determining the current borrowing capacity and the estimated 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 reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure for each of the periods presented above:

 

		Nine Months Ended September 30,
		2004									2003
		North America			Multifamily			Consolidated			North America			Multifamily			Consolidated
		(Dollars in thousands)
Income (loss) before income taxes		$	(64,490	)	$	303		$	(64,187	)	$	(39,324	)	$	8		$	(39,316	)
Plus:
Interest expense		30,299			3,121			33,420			25,754			3,739			29,493
Amortization of intangibles and depreciation expense		55,203			3,678			58,881			56,615			3,680			60,295
Amortization of deferred costs in excess of amortization of deferred revenues		11,997			3,570			15,567			9,452			3,046			12,498
Change in control and reorganization costs		21,282			1,680			22,962			4,732			528			5,260
Less:
Other income		(100		)	—			(100		)	(2,073		)	—			(2,073		)
Adjusted EBITDA		$	54,191		$	12,352		$	66,543		$	55,156		$	11,001		$	66,157

 

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		Three Months Ended September 30,
		2004												2003
		North America				Multifamily				Consolidated				North America				Multifamily			Consolidated
		(Dollars in thousands)
Income (loss) before income taxes		$	(17,661		)	$		1,094		$	(16,567		)	$	(13,381		)	$	324		$		(13,057	)
Plus:
Interest expense		10,489				813				11,302				8,938				1,227			10,165
Amortization of intangibles and depreciation expense		18,333				1,213				19,546				18,746				1,235			19,981
Amortization of deferred costs in excess of amortization of deferred revenues		4,379				1,252				5,631				3,293				928			4,221
Change in control and reorganization costs		2,889				137				3,026				1,673				227			1,900
Less:
Other (income) expense		(17			)	—				(17			)	18				—			18
Adjusted EBITDA		$		18,412		$	4,509			$		22,921		$		19,287		$	3,941		$	23,228

 

8.     Income Taxes:

 

The Company has historically had a tax sharing agreement with Westar Energy.  Pursuant to this agreement, Westar Energy has made payments to the Company for current tax benefits utilized by Westar Energy in its consolidated tax return irrespective of whether the Company would realize these current benefits on a separate return basis.  As of December 31, 2003, other than for net operating loss carryforwards, no valuation allowance had been established by the Company because the tax sharing agreement utilized a parent company down approach in the allocation of income tax expense among members of the consolidated tax group and, consistent with that approach, no valuation allowance had been allocated to the Company.  As a result of the February 17, 2004 sale transaction whereby Westar sold its investment in the Company, $285.9 million of the Company’s net deferred tax assets were not expected to be realizable, and the Company therefore recorded a non-cash charge against income in the first quarter of 2004 to establish a valuation allowance for these assets.  Absent the completion of a restructuring, the Company is not expected to be in a position to record a tax benefit for losses incurred.

 

In addition, as a result of the sale, except for amounts owed with respect to losses the Company incurred prior to leaving the Westar consolidated tax group, the Company is no longer entitled to receive payments from Westar Energy.  In 2003, the Company received aggregate payments from Westar Energy of $20.0 million.  The loss of these payments will have a material adverse effect on the Company’s cash flow.  On November 12, 2004, the Company entered into a tax sharing settlement agreement with Westar and Quadrangle that, among other things, terminated the Westar tax sharing agreement and settled all of its claims with Westar relating to the tax sharing agreement.  In accordance with the Westar tax sharing settlement, among other things, Westar paid the Company approximately $45.9 million in cash and transferred to it 7 3/8% senior notes of the Company, due 2005, with aggregate principal and accrued interest of approximately $27.1 million.  The Company expects to record a tax benefit of

 

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